Here’s why Enron collapsed, and the 5 key lessons investors need to takeaway

Some companies are practically synonymous with something, and the company that was known as Enron is synonymous with fraud. It was not the first to fall over, and not the last. But it is the most famous because of how large it became and how much of a Darling it was amongst Wall Street analysts and investors.

There has been much written and depicted about Enron’s rise and fall, as well as that of its executives, including Ken Lay and Jeffrey Skilling, although arguably less since the GFC because the collapse of a few companies (led by Lehman) led to a 4% peak to trough decline for the world’s largest economy. And younger investors may not even remember Enron.

In this article, we recap Enron’s rise and fall, as well as key lessons investors can take away from its collapse.

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The rise and fall of Enron

Enron Corporation was a large American energy, commodities, and services company based in Houston, Texas. Founded in 1985 from the merger of Houston Natural Gas and InterNorth, it grew rapidly during the 1990s and was widely regarded as one of the most innovative companies in the world.

Enron expanded from traditional energy transportation into energy trading, broadband and telecom markets, financial derivatives, and international energy projects. It developed the first large-scale online energy-trading platform: EnronOnline.

At its peak, Enron was the 7th-largest company in the U.S. and a Wall Street darling. Its famous ‘Ask Why?’ campaign said it all. The objective was to present Enron as an innovative company challenging old energy industry norms and to signal to investors, customers, and policymakers that this company supported transparency and curiosity.

Of course, when it all went sour, it all came back to bite them. Because the public weren’t encouraged to “Ask Why” it was simultaneously hiding massive fraud.

How Enron pulled off fraud

There were 3 key ways. First, Enron created hundreds of off–balance sheet partnerships to hide debt and inflate profits. These SPEs took on the main group’s liabilities. But Enron still effectively controlled them, violating the intent of accounting rules. This kept billions in debt off Enron’s books, making the company appear more financially solid than it was.

Second was Mark-to-Market (MTM) Accounting Abuse. Enron booked future estimated profits as current income on the day a contract was signed—often years before any actual revenue came in. If a project was expected to make $100 million over 10 years, Enron might record the entire $100 million immediately. Not just $10m for one year, but the entire amount upfront. If the project later failed (something that would happen occasionally), the losses were hidden using SPEs. This created the illusion of consistent, strong earnings.

Third was asset and revenue overstating. Enron repeatedly overstated the value of assets, reported revenue from sham or circular trades, and manipulated energy prices.

The most notable example of the latter is in the California Energy Crisis when there were price spikes of up to 1000%, rolling blackouts and utility bankruptcies. Enron traders used a range of deceptive strategies to artificially create congestion, scarcity, and price spikes. Internal memos (released later) described the schemes by name. The most infamous was ‘Death Star’ where the company created fake congestion on transmission lines and then got paid for supposedly relieving it…but no electricity was moved by anyone, it was just gaming of the system.

We would also note that Arthur Andersen, one of the “Big Five” accounting firms, both audited Enron and sold consulting services—creating massive conflicts of interest.
They approved improper accounting treatments and even shredded documents once the investigation began. It collapsed out of this scandal.

The aftermath

When the truth came out earnings were restated downward by ~$600 million, billions in hidden debt were revealed, and the share price collapsed from a peak of ~$90 to ~$1. The company filed for bankruptcy in December 2001. Executives were convicted of fraud (most notably Jeffrey Skilling and Andrew Fastow), and Arthur Andersen effectively dissolved.

It led to a number of reforms, including the creation of the PCAOB (Public Company Accounting Oversight Board) to regulate auditors of public company, introduction of auditor independence rules, internal control requirements, whistleblower protections and more stringent accounting rules around SPEs and off-balance sheet entities.

So what do investors need to learn from Enron?

We see 5 key lessons. First, if you don’t understand a business model…Don’t Invest!  Enron’s operations were incredibly complex and opaque. Many investors admitted afterward that they didn’t really understand how Enron made money and wouldn’t have had they known. Obviously, too late for wouldn’t haves.

Second, avoid companies with opaque financial statements. Red flags include extremely complicated revenue models, Large off–balance sheet entities, unusually smooth earnings (too good to be true), aggressive accounting methods, and Large gaps between cash flow and reported earnings.

Third, strong corporate governance matters. A board must actively challenge management, especially with complex financial structures. Enron’s board approved nearly all of Fastow’s SPEs with little scrutiny. Moreover, investors were reluctant to ‘Ask Why?’ until it was too late.

Fourth, auditors are more important than you think. It is them who sign off on a company’s books. Conflicts of interest can lead auditors to overlook fraud. This scandal led to major reforms (e.g., the Sarbanes–Oxley Act). In Australia, all auditors must be approved at an AGM. Think more closely next time before you vote in their favour.

Fifth, and most importantly, investors should not assume a rising stock means a healthy company!