Enron is a name familiar to any one in this century, as one of the largest corporate scandals in history. But what exactly is this scandal? Why did the company which was a media darling on Wall Street, crash so badly? How did Enron manage to fool investors, consultants into thinking it was making profits? How did Enron manage to bully Govt officials, lawmakers, accountants, employees to have it’s own way? What exactly went wrong? Questions which have fascinated many but again no easy answers. The fraud was on such a massive level, that explaining it is beyond the scope here.
One of the best ways to get an insight into the scandal is the documentary Enron:The Smartest Guys in the Room by Alex Gibney. Based on the book of the same name by Fortune 500 reporters Bethany McLean and Peter Elkind, the movie has a narration by actor Peter Coyote. The movie broadly looks at 3 areas – the rise of Enron, it’s role in the 2000 California power crisis and the actual scandal that bought down Enron. Enron is quite familiar to many in India, due to the Dabhol Power plant and the resulting fiasco.
The Rise of Enron
Enron started out in 1985 when the Omaha based InterNorth purchased the Houston Natural Gas, and the new company was registered as Enron. Former Houston Natural Gas CEO Ken Lay was given the charge, and he later moved the company’s HQ to Houston. Ken Lay wanted to completely re brand the entire business, and he was instrumental in getting the name. Enron started out primarily as an infrastructure company involved in power transmission and distribution. It was during this time we had that whole drama involving Dabhol power plant and one when looks at what happened in California, we should be indeed thankful, that we were spared Enron’s dirty tricks out here.
During the period 1998-2000, Enron grew at a rapid pace. It claimed its fortunes through marketing of commodities, derivatives and futures. So from a purely infrastructure based company Enron was now more of a trading organization. Now what exactly was Enron doing here?
Ok I am not a financial expert nor much into stock trading stuff. So I will try to explain in lay man terms. Say some one wanted to buy a certain quantity of steel, so he contacts another trader to purchase that steel. So in this case steel is a commodity which is being traded. Now you have organizations which act as a mediator between buyers and sellers, they help the sellers fix a price, and assist in negotiation between buyer and seller. This is what Enron was doing and from where it claimed it’s profits.
Enron became the media darling and Wall Street’s blue eyed boy. From 1996 to 2001, Fortune magazine named Enron as “America’s most Innovative Company” sadly unaware that the innovations were more to do with accounting. In 2000 it was rated as “One of the Best Companies to Work With” as the media got taken in by their plush offices, it’s employee policies and a professional management.
California Power Crisis
In 1996 the State of California signed a deregulation bill, which would free it’s energy market from regulation. Prior to 1996, the market in California was controlled by private players like PG&E, SCE and San Diego Gas, but subject to intense regulation, in order to prevent profiteering. These firms sold their power generation plants to private players like Enron and Reliant, who were not covered by the regulations. When de regulation took place it was more of a half hearted process. Wholesale prices were freed from regulations, while retail prices were still regulated.
So we had a scenario where the utility companies had to pay a fortune to buy power from players like Enron, but the retail prices did not see any consequent increase. So in effect it meant that company A would buy 100, 000 MW of power from Enron for around 20$ million dollars( please not the figures are hypothetical), but in effect it could do nothing about the prices in the tightly regulated retail market. And this is where Enron took advantage of the loopholes. What it did, was stop power supply, manipulate the prices to it’s own advantage and cause artificial constraints. Most of the blackouts were not due to any power failure, but due to companies like Enron, free from the regulations, manipulating prices at will, and playing ducks and drakes with the state’s power supply. The FERC( Federal Energy Regulation Comission) which was expected to step in and regulate this, became a spectator and just watched Enron merrily manipulate the prices.
The documentary has extensive interviews with then California Governor Gray Davis, who had to bear the brunt of this crisis. So bad was the situation during 2000 and 2001, that price rises and rolling blackouts made life a nightmare for residents of California. Governor Davis in fact had to declare an emergency in 2001 to deal with this crisis. **We keep harping about power privatization in India as a mantra. But if not handled properly this is what is going to result. One interesting scene in the documentary is that of Arnold Schwarzenegger, present day Governor, meeting Ken Lay during the power crisis, and attending a board meeting of Enron.
The Fall
While Enron was busy charming investors and Wall Street journalists, in reality, the company was running into huge losses. What Enron did in effect was simple, it set performance targets for it’s executives. In this case the performance targets was creating an illusion that the company was rolling in profits. So in order to make it’s stock price rise, executives, accountants and top level officers started to indulge in financial manipulations and the targets were set to cover up more and more losses. With insider information, the executives started to trade stocks among themselves. In pure layman’s terms it means if you were working in Enron, and you knew that the stock was in reality worthless, you could trade it within the company making money for yourself, which is what most of the people there did. Sadly investors knew nothing about it, and still continue to hold on, believing that they were sitting on a gold mine.
Now there is a difference between investor and employee. When you say you have invested in Reliance, it means you have shares or stock of the company, you don’t work there. So while you are free to trade in their shares, you really don’t have much clue to what is going on inside. And this is precisely what was happening at Enron. The top management and executives sold their shares, while the investors were asked to hold on, claiming that the price would rise further after Enron hit a record 90$ per stock in 2000. Ken Lay mislead most of these share holders, by claiming all was fine, when in fact Enron was sinking like the Titanic. Jeffery Skilling it’s CEO, came down on those Wall Street journalists who saw the truth that the emperor had no clothes. When the stock fell to 15$, on October 2001, the game was up.