- June 1, 2021
- Posted by: audrey
- Category: Financial Scandals
This scandal is not something recent. However, the lessons it involves is something useful and relevant even in today’s time. The firm peaked in the industry and fell down and crashed! The crash was even bigger than its success and it affected the whole of Wall Street. Thousands of employees lost their jobs and the most shocking part is that one of the most powerful firms in the US just crumbled overnight.
Enron Corporation: a high street darling
The firm saw its beginnings in 1985 when the two natural gas companies Houston Natural Gas Company and InterNorth Incorporated. Following this, Kenneth Lay, the CEO of the former firm became Enron’s CEO and chair. The firm was rebranded into an energy trader and supplier and being very ambitious, he wanted to expand the firm’s capabilities beyond natural gas. As such, it made an aggressive move into electrical power. It invested into power plants and other electrical generation assets.
However, Enron took another direction from other energy companies. Its executive tried to generate a profit from energy trading. How did it do so? Instead of producing and delivering natural energy to clients like conventional firms would, it used future contracts to deliver energy at specific times in the future, which allowed it to make money via the bias of those who wanted to speculate on price movements or to hedge against the risks of unexpected energy-price volatility. As such, Enron became more like a Wall Street investment company.
In 1999, Enron created Enron Online (EOL). This was an electronic trading website that looked at commodities and the firm Enron became the counterparty to all transactions completed on EOL. The company managed to entice a lot of clients because of its reputation, credit and expertise in the energy sector. Following trades etc, it ended up creating completely new markets, such as contracts tied to weather events and internet bandwidth. However, these were only loosely connected to weather events and internet bandwidth capacity. Despite this, the firm was highly praised in the industry. By 2000, its stock grew at a very rate and Enron became one among the top 10 businesses in the country. It was applauded by many for its expansions and ambitious projects. Moreover, for six consecutive years, Fortune named the firm “America’s Most Innovative Company”.
The fall of the Wall Street darling
Nonetheless, by fall 2000, the firm started to crumble under its own weight and its success turned out to be a mirage. It turns out that the firm used accounting techniques to conceal the fact that it was undergoing huge business losses and it was in massive debt. For instance, it used mark-to-market accounting. This is a technique which measures the value of a security based on its current market value instead of its book value. While this is a strategy that can be efficient for trading securities, it is disastrous for businesses. Nonetheless, thanks to this, Enron appeared to be a success financially. Moreover, executives used off-balance-sheet special purpose vehicles to hide its debts and toxic assets from investors and creditors.
However, with time, the techniques stopped working and by 2001, the firm revealed a huge quarterly loss and debts. It was then revealed that it had been consistently overstating its earnings for at least four years. After that, it had to file for bankruptcy and the authorities started paying attention to its operations. As everyone would have guessed, criminal charges against executives ensued. They were charged with conspiracy, insider trading and securities fraud and Wall Street’s darling experienced a fall from grace. In fact, the whole industry felt the impact of this fraud. It is estimated that shareholders lost $74 billion during the years leading up to the bankruptcy and the havoc that was caused led to new regulations and compliance measures being implemented.
Lessons learnt from the debacles
If there is one good that came out of this situation, it is that we could learn several lessons from this chaos.
Learn about a firm well before investing
As mentioned before, Enron was quite different from other traditional energy companies and many of its investors did not understand its business model. Even experts in the sector could not understand some of the transactions. Moreover, the firm used a lot of fancy derivatives which were unnecessary. One of the dangers of the firm is that it relied too much on these speculations and derivative contracts. As such, as an investor, you must be careful when dealing with a firm. Some of the red flags that you must be on the lookout for is whether the company has a complicated business model or its financial derivatives are completely different from others. There is a lack of transparency or a false semblance and these may confuse you. Prioritise firms that are completely transparent in their operations and that offer help and support whenever you need it. For instance, Blue Azurite has a team of experts at your disposal. They are always available to answer your questions, clear your doubts and make sure that you are completely satisfied. Another important factor that comes into play when speaking about Enron its ethic-a moral code of conduct. All companies have a set of rules that they have to abide to and these are based on principles and values. Enron completely disregarded this structure of trust that support a firm and instead, it built a mirage of a reliable one. The fact that that this was possible and the charade kept going on for years says a lot about the jurisdiction in which the firm operates. It is only after the scandal that the US set up more rules and regulations to ensure that such a havoc does not happen again. But by then, it was too late. That is why it is important to choose firm in jurisdictions having well-established laws protecting investors and the likes. For instance, in Mauritius, in which Blue Azurite operates, there are several institutions regulating the activities of financial firm and ensuring that nothing is out of order.