*For six consecutive years a prominent magazine named it America's most innovative company. The innovation, it emerged, was largely in the accounting.*
In August 2000, shares of Enron traded near ninety dollars, and the company was among the most admired enterprises in the United States. It had been named the most innovative company in America by a prominent business magazine for six consecutive years. Its executives were feted, its business model was studied in classrooms, and analysts covering it were overwhelmingly positive. In December 2001, it filed for bankruptcy, and its shares were worth almost nothing.
The company had begun as a pipeline business and had transformed itself into something considerably harder to describe, trading contracts in energy and, eventually, in a range of other commodities and instruments. This transformation was precisely what earned it the reputation for innovation. It was also what made the enterprise nearly impossible for an outsider to understand, and the difficulty of understanding it came to be regarded not as a warning but as evidence of sophistication.
Two accounting practices sat at the centre of what followed. The first permitted the company to record, as current earnings, the profits it expected to earn over the entire life of a long-term contract, based on its own estimates of what those profits would eventually be. Since the estimates were the company's own and the contracts extended many years into the future, this arrangement gave management considerable latitude to determine what its reported earnings would be. Earnings ceased to be a measurement and became, in part, an assertion.
The second involved a network of separate entities, formally distinct from the company, into which unprofitable assets and substantial obligations could be placed. Because these entities were treated as separate, the debts they carried did not appear on the company's own balance sheet, and the company therefore appeared considerably less indebted than it was. The arrangements were complex, they were disclosed in language that revealed very little, and few outside the company understood them.
What is most instructive about the episode is not the deception itself but how thoroughly the ordinary safeguards failed. The company's auditor, one of the largest accounting firms in the world, signed off on the accounts, and also earned substantial fees from the company for consulting work, an arrangement that placed its independence under obvious strain. Analysts at major institutions continued to recommend the shares, in some cases nearly to the end. Rating agencies maintained investment-grade assessments until shortly before the collapse.
The board of directors approved the arrangements, including waiving the company's own conflict-of-interest rules to permit an executive to manage entities that transacted with the company he helped run. Every mechanism designed to protect an outside investor was present, was staffed by qualified people, and did not work. This is the observation an investor should sit with, because it is considerably more troubling than the existence of dishonest executives, which surprises nobody.
The signal that was available, and that some noticed, was not evidence of fraud. It was simply that the company's own disclosures could not be understood. Analysts who read the filings carefully and asked how the company actually generated its earnings did not receive coherent answers, and a small number concluded that a business whose profits could not be explained was not a business they could value. They were, at the time, in a distinct minority, and the majority view was that complexity of this kind was to be expected in a genuinely innovative enterprise.
This is the transferable lesson and it does not require any ability to detect fraud. An investor who cannot explain, in plain terms, how a company converts its activities into cash, is not in possession of the information required to own it. The inability to understand is not a neutral state to be tolerated while relying on the judgement of others. It is itself the disqualifying fact, and it is available to any investor willing to admit it.
The episode also demonstrates a broader property of reported financial figures that is easy to forget. Earnings are not observed; they are constructed, according to rules that permit considerable judgement, by people who have an interest in the result. Cash is harder to manufacture than earnings, which is why investors who attend closely to the cash a business actually generates, and to whether it corresponds to the profits being reported, are considerably better protected than those who accept the earnings figure at face value.
It should be added that no analytical technique reliably detects a determined and sophisticated fraud, and any account suggesting otherwise is selling something. The protection available to an ordinary investor is not detection but structure: owning enough different things that any single fraud cannot be ruinous, and declining to own what cannot be understood. These are modest defences, and they are the ones that actually work.
The aftermath is worth noting because it changed the landscape for every investor who came afterwards. The auditing firm that had signed the accounts, one of the five largest in the world, did not survive the scandal, and its disappearance reduced the profession to four dominant firms. Legislation followed, imposing new obligations on executives to certify their own accounts personally and establishing oversight of the auditors themselves. These reforms were substantial and they have done real good. They have not, however, eliminated the underlying problem, which is that an outside investor is dependent on figures prepared by people with an interest in how those figures appear, and verified by firms that those same people pay. The conflict is structural rather than incidental, and no legislation dissolves it entirely. What the reforms changed is the difficulty of the deception, not the incentive to attempt it.
At VESTFY™ the Enron episode is presented as the strongest available argument for a discipline that sounds almost too simple to matter, which is the willingness to say that one does not understand something and to decline on that basis. A great many of the people who lost everything in this company were not naive. They had simply concluded that their own incomprehension was a deficiency in themselves rather than information about the company, and that conclusion was the error.