Would ENRON Even Be That Bad by Today's Standards?

0:00 All right.

0:00 So, what the did Enron actually do?

0:04 Off the top of your head,

0:05 you are probably saying something about creative accounting,

0:09 corporate fraud, or if you are really clever,

0:12 maybe even terms like mark tomarket.

0:14 But what did all of this really mean?

0:16 And perhaps more importantly,

0:18 would it be considered that bad by today's standards?

0:22 The headline story that you are probably familiar with is

0:25 that the business started out as a moderately successful energy company.

0:29 But when compounding profits became harder and harder to come

0:32 by, they resorted to progressively more and more desperate,

0:36 fraudulent activities to keep the party going as long as they could.

0:39 They had convinced the world that they were the smartest men in the room.

0:43 They made impressive but willfully

0:44 reckless projections about their future performance.

0:47 They created complex deal networks to make

0:50 revenue look far better than it actually was.

0:52 And they hid their expenses creatively.

0:54 All so they could cash out

0:56 their shares and make themselves generationally wealthy.

0:58 And oh wait, hold on.

1:00 Hang on, guys.

1:01 Sorry, that's the wrong VCR.

1:02 Let me uh let me just fix that up real quick.

1:04 Okay.

1:05 Okay, there we go.

1:07 The reality is that today Enron

1:09 is synonymous with corporate greed and corruption.

1:12 More than two decades on, it has

1:13 radically reshaped the way business is [music] conducted.

1:16 But in the years since,

1:18 there have been plenty of larger and more brazen examples of outright fraud,

1:22 many of which went largely unpunished and unremembered.

1:25 If you actually go back and understand the story about

1:27 how this company grew so quickly and self-destructed so spectacularly,

1:32 you might just see some concerning trends emerging in the same markets today.

1:37 We learned a lot from Enron, but they may not have been the right lessons.

1:41 The collapse of the deal between Enron and Dyn has left Enron employees stunned.

1:46 Many of them wondering if they'll be getting their next paycheck.

1:49 Eight counts of fraud and [music] conspiracy.

1:51 Lawyers for Jeffrey Skielling and Kenneth Lei threw

1:54 around complicated notions about [music] margin calls and shortselling.

1:57 A few years ago, Enron was the nation's

2:00 seventh largest corporation valued at almost $70 billion.

2:04 Pundits praised the company as a new business model.

2:07 Guilty verdicts in the biggest case of corporate fraud in history.

2:12 Okay, so as always, I put the question to you.

2:14 What was Enron?

2:16 [music] If you are brave enough, then leave your answer in the comments.

2:19 Now, if you can believe it, the company wasn't founded with the express

2:23 intention of becoming a massive fraud.

2:25 And for a while there,

2:26 it was really just a boring old business in a boring old industry.

2:30 Ironically, the story actually starts in Omaha,

2:32 Nebraska with the Northern Natural Gas Company.

2:36 Since the 1930s, this business had been supplying natural gas as a cheap

2:40 source of fuel to industry and households across the northern [music] US states.

2:44 Over time, it acquired several other energy companies,

2:47 as well as a handful of natural resource exploration businesses,

2:51 energy networks, and a business

2:52 that sold propane and propane [music] accessories.

2:55 As these acquisitions grew, the company rebranded to Inter North

2:59 as a holding company for these various operations.

3:02 The company did well by growing and swallowing as many competitors as it could,

3:06 but this risky business strategy eventually

3:08 got company management into some trouble.

3:11 In the late 1970s, the natural [music] gas industry was deregulated.

3:15 The government would no longer guarantee prices for this resource.

3:18 [music] This radically shook up what was

3:20 at the time a very conservative business.

3:23 [music] Inter North's long track record

3:25 of swallowing up lots of other operations also made them bloated and unable

3:30 to adapt quickly to the changing market conditions,

3:33 which put them in the crosshairs of corporate raiders.

3:36 To make matters worse, they didn't really change up their strategy.

3:40 In 1983, they made their biggest acquisition to date,

3:44 the Belco Petroleum Company,

3:45 which was a Fortune 500 business and almost larger than Interself.

3:50 This created a serious problem for the business.

3:53 Bear with my analogy for the moment,

3:55 but it was a bit like that time my Pomeranian ate an entire

3:58 porter house steak that I had left unattended on the kitchen table.

4:02 From the outside, he was still technically a dog,

4:04 but by body weight, he was majority cow.

4:08 Either way, if he had to fend for himself in the wild,

4:11 then to a potential hungry predator,

4:13 he was a tasty meal on top of another tasty meal.

4:17 And that was exactly the situation Inter North found itself in by 1985.

4:21 Activist investors were buying up its stock with the plan

4:24 to take control [music] of the company and then sell off

4:26 all the parts it had acquired over the years at a profit

4:29 before running what was left as an overall leaner operation.

4:33 Hostile takeovers like this had become very common by the 1980s.

4:37 So much so that they were a central

4:39 plot point in the original Wall Street movie.

4:42 The reason it was so ironic

4:43 to have Inter North headquartered in Omaha, Nebraska,

4:47 is that down the road from the office,

4:49 just 5 minutes away, was the new head office of Burkshire Hathaway.

4:53 For a few years, two of the most

4:55 infamous businesses in American corporate history

4:58 could see each other out of their window in an otherwise very low-key city.

5:03 Of course, they both became famous for very different reasons.

5:07 Buffett's Burkshire Hathaway is now held up as a shining example of a slow,

5:11 steady, considered approach to business.

5:13 [music] Inter North and its eventual successor,

5:16 they made history for a uh well, slightly different reason.

5:21 But that's not the last we will be hearing about old man Buffett in this story

5:24 [music] because arguably he was one of the only winners out of this whole thing.

5:29 Either way, seeing how endless acquisitions had made them a slow,

5:34 lumbering target for any hostile takeover,

5:37 Inter's management did the only logical thing and moved

5:40 to make the company even bigger through even more acquisitions.

5:43 In July of 1985, Interth and Houston

5:46 Natural Gas voted to merge into one company.

5:49 Although this was technically a merger on paper,

5:52 Inter North paid $2.3 billion to acquire HNG,

5:56 which at the time was a significant

5:58 premium over what the business was actually worth.

6:00 Once combined, the two new companies went

6:02 by the incredibly creative name HNG Interorth.

6:06 Truly inspired.

6:08 Anyway, [music] the idea was that by making the business so big,

6:11 it would become impossible for any single investor to gain control,

6:15 therefore avoiding a hostile takeover.

6:18 Now, even though technically this was a merger between equals,

6:23 it was always the intention of Inter North's management that they would

6:26 retain control of the organization and run it how they saw fit.

6:30 This didn't really work out for them.

6:32 Despite being smaller,

6:33 Houston natural gas was more dynamic in the less regulated gas market,

6:37 which was something that investors really liked.

6:40 Their business practices very quickly became

6:43 widely adopted throughout the entire combined company.

6:46 In business mergers and acquisitions,

6:48 the smaller company changing how the bigger company operates after

6:52 a takeover is often referred to as the tail wagging the dog.

6:56 There's a lot of dog metaphors in this video.

6:58 I don't really know why.

6:59 A quick side note, a lot of people say the same thing

7:02 happened to Boeing after it merged with Macdonald Douglas during the 1990s.

7:07 Douglas was by far the smaller company,

7:09 but their management team took over Boeing

7:12 from the inside and pushed reckless business practices,

7:15 which arguably resulted in the tragedies which

7:18 have been plaguing the company in recent years.

7:21 Now, apart from being a random interesting fact,

7:24 there is an important business lesson in this parallel,

7:26 so remember it for later.

7:28 But anyway, back at HNG Interorth, the new joint board of the merged

7:32 company immediately ousted its initial CEO, Sam Segnner.

7:36 Even though he was chiefly responsible

7:38 for executing the merger in the first place, it didn't matter to them though,

7:42 so he was quickly replaced with the CEO from HNG, Kenneth Lei.

7:47 Kenneth Lei is often credited as the founder of Enron,

7:50 which isn't strictly true.

7:52 In reality, the business wasn't founded.

7:55 It was just the result of two

7:56 companies merging to avoid their own individual troubles.

8:00 Lelay did make some big changes though.

8:02 As soon as he took over, he moved the headquarters from Omaha to Dallas

8:06 and also set about changing the name.

8:09 He paid a consulting firm $100,000 to come

8:12 up with something more creative than HNG Interorth.

8:16 Lei and the new executive team reportedly wanted a name

8:19 that would evoke forward-looking technological

8:22 connotations like enterprise, energy, and on.

8:27 And if it bore a passing resemblance to Exxon,

8:30 that wouldn't be a problem either.

8:32 With that brief, the well-paid creative team eventually came up

8:36 with a name that will probably sound familiar to you.

8:39 Yep, that's right.

8:40 Enteron.

8:42 Uh, yeah.

8:42 So that was actually the first suggestion for the new name.

8:45 [snorts] Fortunately,

8:46 before the executive team fully committed to this, a few people pointed

8:50 out how Enteron is the medical terminology for the small and large intestines.

8:56 Money well spent, chaps, money well spent.

8:58 Eventually, they just shortened it down to Enron,

9:01 a name that means pretty much nothing.

9:04 Now, up until this point, the company, despite having a few close calls,

9:08 was still just a gas provider with a few

9:10 other diverse interests in the energy space.

9:13 However, what these successive business shakeups had done was

9:17 filter out a lot of the more conservative business

9:20 leaders and left behind a concentrated group of people

9:23 who thought they were the smartest men in the room.

9:26 Adding to that, it became clear how surviving

9:29 in this business meant managers needed to make big,

9:32 bold, decisive moves and worry about the consequences later.

9:36 Now, we all know where that eventually ended up.

9:39 But the bigger question is,

9:40 was this really any different from what is happening in the markets right now?

9:45 Well, it's time to learn how history works to see how Enron drew the fine line

9:49 between endlessly overpromising and criminally underdelivering.

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11:18 From its creation to its implosion,

11:20 Enron was only around officially for 22 years,

11:23 with almost a quarter of that time spent

11:26 on picking up the pieces of its wreckage.

11:28 Before 1990, Enron continued to operate its gas

11:32 and energy businesses to varying degrees of success.

11:35 But even back during these [clears throat] honest years,

11:38 the fight to make things look as good as possible was causing cracks.

11:42 As early as 1987, just 2 years after the company was formed,

11:46 Enron executives from their oil department covered

11:49 up losses of more than $100 million.

11:52 This fraud was later found out in 1993,

11:56 yet [music] didn't actually impact the company at large too much.

12:00 However, it was an early warning sign of its developing culture.

12:04 Failure would not be tolerated.

12:06 If something wasn't going well,

12:07 you could either be honest and get fired or cover it up and enjoy your bonuses.

12:13 Bonuses which were becoming extremely generous.

12:15 By the late 1980s, Enron was a hugely attractive company to work for.

12:20 Their compensation was industry-leading

12:22 and their offices were described as palatial.

12:26 Back then, working for Enron was like working for a top tech company today,

12:31 only more selective.

12:32 But this caused problems.

12:34 If people admitted mistakes or underperformed,

12:36 then they were looked over for promotions or let go.

12:39 Then slowly, one by one, the only people left were those willing to be,

12:43 let's say, tactically selective with reality.

12:46 This cancerous corporate culture was turbocharged in 1990 when Ken Lei and other

12:52 executives at Enron decided that being

12:55 an energy provider wasn't good enough anymore.

12:58 any self-respecting corporate type was getting into the finance

13:01 game and running their own hedge fund.

13:03 That was where the money was really at.

13:05 So, Enron hired Jeff Skielling, who at the time was one of the youngest

13:08 partners ever at the prestigious management consulting firm McKenzie Company.

13:14 His job at Enron was to be CEO of Enron Gas Services,

13:17 a subsidiary of the parent company,

13:19 which was to become a market maker for natural gas and oil.

13:22 A quick thing you need to understand before

13:24 you go any further is that these Enron

13:27 executives loved to make their businesses sound

13:30 far more complicated than they actually were.

13:33 This helped to cover up their deception

13:34 and made them sound smarter than they really were.

13:38 If they were caught stealing cookies in the middle of the night,

13:41 these guys would call it moving energy stores out

13:44 of a concentrated market and realizing

13:46 consumer demand during underserved operating hours.

13:50 So, by the same token,

13:52 the Enron gas services business was really just an investment trading firm.

13:56 Though, instead of trading stocks, bonds, or other financial assets,

14:00 they were trading natural gas between parties

14:02 that produced it and those who consumed it,

14:04 all while trying to make a little bit of money as a middleman.

14:08 [music] To that end,

14:09 they actually took some of their pipelines offline to customers.

14:13 So now instead of just being a pipe that moved natural

14:17 gas from where it was supplied to where it was burnt,

14:20 it was going to be used as a conduit to facilitate market movements.

14:25 To smooth things over with investors,

14:27 the executive team dubbed their new operation a gas bank.

14:31 Remember, at this time, finance was the hot industry to be in.

14:35 Fossil fuels were very 1980s.

14:38 Now, firms dabbling in markets like this can make a lot of money,

14:43 but it's by no means guaranteed, and it's also not very consistent.

14:47 Even the best market makers will make mistakes and lose money from time to time.

14:51 So, you might be able to start to see where this is going.

14:55 Jeff Skielling, the CEO of the new trading branch,

14:59 also hired one last important character,

15:02 a banker called Andy Fasto, the final puzzle piece in the Enron conspiracy.

15:08 Together these financial buffins created two very powerful tools to make sure

15:13 that from here on out all financial results would be good financial results.

15:18 The first was mark tomarket accounting.

15:20 [music] Now the biggest misconception about the story of Enron is

15:24 that this type of accounting was inherently

15:27 the problem which is simply not true.

15:29 All this system of accounting does is note profits

15:32 or losses from tradable assets held within an active market value.

15:37 It is perfectly legal and it's still widely used today.

15:39 In fact, you probably use marktomarket

15:42 accounting more than any other accounting standard.

15:45 For example, if you invest in the market

15:47 through an online broker like Robin Hood,

15:50 you will probably see a daily profit or loss noted for your portfolio.

15:54 That number is marked to market.

15:57 And all it really means is that if you were to sell your assets today,

16:00 that is how much profit you would make from when you purchased them.

16:04 On a larger scale, this is useful for something like

16:07 a bank or a hedge fund because to report a profit,

16:10 they would otherwise have to sell their entire portfolio at the end of the year,

16:14 which obviously isn't reasonable.

16:16 But the reason why mark tomarket accounting was a problem

16:19 for Enron was because unlike a typical financial firm,

16:22 they were trading things that didn't really have

16:25 a market apart from the one they were making up.

16:28 Their new gas bank technically meant that gas

16:32 contracts could be traded like stocks or bonds.

16:35 So they took that idea and pushed

16:37 this accounting system to the absolute extreme.

16:40 If they signed a contract that could be worth $100 million over 20 years,

16:45 they would note that as a profit on day one,

16:48 which would be questionable at the best of times.

16:50 But then they took it even one step further.

16:54 If you open up an investment account on a daily

16:57 basis to nervously check if number go up,

17:01 you will know that sometimes number do not go up, sometimes number go down.

17:07 In a markto-market system,

17:09 the accounting team should also mark down asset values

17:13 as a loss if market transactions suggest that the price has fallen.

17:18 But again, Enron bred a culture where

17:20 reporting failure in any way was almost impossible.

17:23 So, they got creative.

17:25 Ken Lelay told Jeff Skielling to make the numbers look good.

17:28 Jeff Skielling told his new right-hand man, Andy Fasto, to do the same.

17:32 So, he did.

17:33 FTO started a series of offthebooks

17:36 partnerships with nondescript names like LJM1.

17:40 Enron would then bankroll these partnerships as an investments, but crucially,

17:46 Fasto would put in a little bit of his own money as well.

17:49 This technically made these partnerships

17:52 operationally separate from Enron itself.

17:54 The way that Enron executives wanted people to think about

17:57 this is that they were just investing in promising new opportunities.

18:01 It would be like if a small family business bought some shares in Disney.

18:05 Sure, they have some money on the line,

18:07 but they are obviously completely separate operations,

18:11 except that in Enron's case, they were not at all separate operations.

18:15 Enron provided the vast majority of the funding to these shell businesses

18:19 and they did exactly what the Enron executives told them to do.

18:23 And what were they told to do?

18:25 Well, anytime Enron made a trade or had a subsidiary that wasn't doing well,

18:29 these offthebooks companies would come in and buy

18:33 them up at a massively overinflated price.

18:36 That way, Enron could report a profit and make

18:39 their financial statements look good to outside investors.

18:42 This whole system would be like if you

18:44 invested $2,000 in an unopened box of Pokémon cards,

18:49 but for accounting purposes, you assumed that it contained a mint

18:53 condition misprinted shiny Charizard worth $5,000.

18:57 So, you record a profit of $3,000.

19:00 $5,000US 2,000.

19:02 However, a year later, when you actually open the pack,

19:05 you realize that it only contained energy

19:07 cards and a Blastoise valued at $1,000.

19:11 Now, in a true mark tomarket system, you should record a loss of $4,000.

19:16 But if you did that at Enron,

19:18 you would miss out on your enormous annual bonus and almost certainly get fired.

19:22 So, instead of owning up to your loss,

19:24 you invest $9,700 into a new Pokémon card buying business,

19:30 plus have your friend put in $300 of their own money.

19:34 That way, it's not technically just your business.

19:37 This new company then conveniently agrees

19:40 to buy your subpar card collection for $10,000

19:43 by using up all of the cash that was just invested into the business.

19:48 So now you get to claim that the cards

19:50 you purchased for $2,000 were sold for $10,000

19:53 and therefore netted you a profit of $8,000

19:56 at least as far as your disapproving girlfriend is concerned.

19:59 Now of course in reality you haven't really made any money.

20:02 You just moved it around.

20:04 But replace Pokemon cards with overly

20:07 complicated energy contracts and disapproving girlfriend

20:10 with company shareholders and you end up with exactly what Enron was doing.

20:15 Clearly, this was dishonest at best.

20:18 In fact, later on in court, it was proven to be downright fraudulent.

20:23 So, surely regulators would never let

20:26 something like this happen ever again, right?

20:29 Well, there is a very similar game being played right now in private equity.

20:34 Private companies can also be assigned value using a markettomarket system.

20:38 But since their stocks don't trade on public markets every day,

20:41 their value is only really confirmed once they are sold.

20:44 Therefore, private equity firms are incentivized

20:48 to sell the businesses in their portfolio

20:50 that are doing well and forget about the ones that are doing badly.

20:54 When strong performers do well, they get to record profits.

20:57 But if they never sell the duds, they don't have to recognize the losses.

21:01 The problem with this business strategy is that over time,

21:05 if these firms only hold on to their underperformers,

21:08 they are eventually left holding a portfolio full of garbage.

21:12 But hopefully by the time they become a problem,

21:14 the general partner of the firm has already retired.

21:17 Anyway, back at Enron, things were even worse.

21:20 They didn't actually have enough cash to give these shell

21:23 businesses for them to turn around and buy their bad assets.

21:27 So instead, they gave them shares in the company itself.

21:30 Since Enron shares always went up, these businesses could use them as collateral

21:35 to borrow money to buy these assets, which made Enron's profits look good,

21:40 which made their stock price go up even further.

21:43 Enron also paid its employees with stock-based bonuses.

21:47 Its executives made millions of dollars by cashing out their stock,

21:51 and it also made business acquisitions using its own stock.

21:54 What you might not expect is how the executives

21:57 were surprisingly open about how they were reshaping finance.

22:00 They even held several press interviews all about how

22:04 their business was reshaping the way markets are built.

22:07 In a quote to the press, they said,

22:09 "There's always a lot of focus on technological innovation,

22:13 but what really drives a lot of progress is when

22:15 people also figure out how to innovate on the financial model,

22:19 the financial instruments.

22:21 I don't think we've figured out yet the final form of what financing looks like.

22:26 Wait, hang on.

22:27 Sorry, my bad.

22:28 That was actually a quote from Open AI's Sam Ortman from last month.

22:32 I really got to stop getting this stuff mixed up.

22:35 Corporate needs you to find the differences

22:37 between this picture and this picture.

22:40 They're the same picture.

22:42 Anyway, for the Enron execs, the game was pretty simple.

22:46 As long as their stock value went up forever, their system would survive.

22:50 And this created an almost singular

22:52 focus on maximizing short-term stock movements,

22:55 even if it came at the expense of long-term business fundamentals.

23:00 This also saw the business start to desperately chase

23:03 trends that it thought would look good to investors.

23:06 It had already transitioned from a gas

23:08 pipeline company into a pseudo hedge fund.

23:12 But by the end of the 1990s, it had also gone allin on the internet

23:16 to keep up with the hype surrounding.com companies.

23:19 Just like it had laid gas pipelines, it was also laying network cables.

23:24 Eventually, after this charade collapsed,

23:26 people started asking questions about the bizarre

23:29 financial statements the company was producing.

23:32 One commenter pointed out that Enron seemingly were never able to produce

23:37 a balance sheet and an income statement at the same time.

23:41 The stock price tumble was further accelerated

23:43 by market trends following the dotcom crash and 9/11.

23:47 As more and more questions popped up, investors got increasingly nervous,

23:51 and the lenders who were holding Enron stock as collateral got closer to pulling

23:56 the plug on the whole game that had been going on behind the scenes.

24:00 Without that source of cash coming in to massage the numbers,

24:04 the truth was quickly exposed and the whole business seized up in just 6 weeks.

24:09 A merger/bailout was considered with another energy

24:13 company until they actually opened up the books.

24:15 Once they saw what was going on under the hood, they backed out instantly.

24:20 On the morning of December 2nd, 2001, Enron filed for Chapter 11 bankruptcy.

24:25 Just 16 months prior, their stock had been at an all-time high.

24:30 The financial shell games that the company

24:33 was built off were so convoluted and technical,

24:36 it took an outside team of experts more than 5 years to eventually

24:40 untangle everything and try to pay back all the money that was owed.

24:44 By the time everything was all said and done,

24:46 the only assets that the company had which were worth anything

24:50 were those gas pipelines it had started with 20 years earlier.

24:55 In a strange turn of fate,

24:57 Northern Natural Gas, the business that started it all,

25:00 would actually return to Omaha after none other than

25:03 Warren Buffett purchased the distressed assets during Enron's liquidation.

25:07 To this day, they still remain part of Burkshire Hathaway Energy.

25:12 There weren't many other winners in this story, though.

25:15 Regular employees at the company lost

25:17 their pensions and most of their savings since

25:19 they were encouraged to hold on to their Enron stock as a blue chip investment.

25:24 It was difficult for most of them to find new employment in the industry

25:28 since other companies considered their Enron work experience to be a black mark.

25:33 And finally, and to be fair,

25:35 most of the characters from this little show did end up going to prison.

25:38 But would the same thing happen today?

25:40 A lot did change after Enron.

25:42 New laws were introduced to ensure company executives personally

25:47 sign off and remain liable for published financial statements.

25:51 Arthur Anderson, the accounting firm that prepared Enron's books,

25:55 eventually collapsed when it was criminally charged

25:57 and barred from ever working with public companies again.

26:00 And lastly, actual, real,

26:03 genuine protections were put in place to protect whistleblowers coming

26:06 forward about similar fraudulent activities before they could get this big.

26:11 It was all great stuff, but in the years since,

26:14 enforcement of these rules has all but eroded into irrelevance.

26:18 Now we're starting to see a lot of common themes returning.

26:23 Creating revenue through cooperative deal making,

26:26 piping up new opportunities, chasing the hottest new trend,

26:30 a focus on stock market performance

26:32 at the expense of actual business performance,

26:34 convoluted deal structures, insiders cashing out,

26:38 marktomarket accounting that highlights gains and pretends losses don't exist.

26:43 All held together by people that seem too smart to question.

26:46 Go and watch this video next to find out how

26:49 another infamous firm collapsed just 7 years later if you

26:53 want any further proof that learning from history only happens

26:56 when there isn't money to be made from forgetting it.

26:58 And don't forget to like and subscribe to keep on learning how history works.