This article is an excerpt from the Shortform summary of "The Smartest Guys in the Room" by Bethany McLean and Peter Elkind. Shortform has the world's best summaries of books you should be reading.
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What is the Enron collapse? What are lessons learned from Enron that companies should know about?
Lessons learned from Enron may not have actually been learned. While some companies heeded caution, many other dove headfirst into complicated business practices and schemes. The lessons learned from Enron, had they been fully understood and respected, may have helped avoid the financial crisis of 2008.
Lessons Learned From Enron: History Repeats Itself
In the afterword, the author connects the Enron scandal to the 2008 crisis, and outlines lessons learned from Enron (or not). There were many similarities between the two:
- Multiple stakeholders looked away while they got rich. This even includes the public, which could buy houses more easily than ever before.
- After the crisis, more regulation was passed, with the promise that now everything would be different.
Differences between Enron and 2008 and opportunities for lessons learned from Enron:
- The author believes Enron was genuinely trying to be innovative. It launched new business lines (online energy trading, video on demand, international development).
- In contrast, the banks in 2008 were merely issuing loans to people who couldn’t pay them, repackaging bad loans and misrepresenting their worth.
- There could have been a case where Enron worked out; there was never an option for the latter.
- There were no prosecutions of major bank executives.
It seems, therefore, that we haven’t really learned our lessons, and the future won’t be any different. People will be greedy; there will always be blurry lines around what’s technically legal but immoral. It’s human nature.
Enabling Conditions of Enron’s Deception
How was Enron able to get away with its bad behavior for so long, even when its operations involved thousands of people with partial insight into the problems? Here we take a look at the major conditions that promoted Enron’s deception. These are themes that might recur in future disasters and possible Enron lessons.
(Shortform note: while the original book mostly tells a chronological story, we pulled the themes and patterns from the book to form this chapter.)
People with Incentives to Tolerate Bad Behavior
People who could have stepped in and intervened didn’t, often because they had a large personal stake in Enron’s success. Further, the more Enron became a success (like in terms of stock price or deal flow), the more beholden the stakeholders were to Enron. The fact that everyone let things go is one of the biggest Enron lessons.
Furthermore, everyone looked to each other for validation. “Surely all these other people can’t be wrong!” Yet no one realized no one else had done their due diligence.
In a culture where earnings are prized above all, earners have the leverage to conduct bad behavior, unpunished. Threaten to quit and you get what you want. This culture promotes caring about self rather than the longevity of the company.
- In the 1980s, an Enron oil trader ignored trading limits and siphoned money to himself. This was overlooked by management since his department was a golden goose. Letter from Enron management to trader: “I have complete confidence…please keep making us millions.” (He eventually had a disastrous short position that could have bankrupted the company.)
Breaking down each of the stakeholders in these Enron lessons:
- Employees who had an inkling something was wrong were willing to look the other way for big compensation and a rising stock price. Why would you want the music to stop when you’re planning on buying a vacation home?
- The market seemed to justify what the business was doing – surely professional investors with billions at stake couldn’t be wrong?
- Furthermore, skeptics within the company were publicly punished by being reassigned. For many, the risk of being punished wasn’t worth the gain from exposing wrongdoing.
- In a period of dotcom bullishness, the possibilities were uncapped. All sorts of companies with illusory projections were propped up.
- Investors tolerated Enron’s opacity, since the stock was up and to the right.
- Investors circulated a mythos of Enron being an untouchable, invincible company.
- Arthur Andersen’s consulting had Enron as one of their biggest customers (paying $52MM in 2000). Enron kept competitors closeby to threaten Arthur Andersen into validating their deals.
- AA staff who grew Enron fees were promoted. Further, Enron hired dozens of Andersen accountants, giving individuals pressure to be seen by Enron as a team player.
- Banks earned large fees from Enron’s complicated structured-finance deals ($240 million in 1999), and bankers who grew deal sizes got promotions.
- Like with accountants, Enron kept multiple banks in the wings competing for its business.
- Banks even tolerated Andy Fastow’s self-dealings with his private funds, because he was the gatekeeper between banks and Enron deals.
- Putatively, the analysts issuing buy/sell recommendations should be separate from the investment banking arm of the same bank. In reality, they were closely tied – companies would only give deals to banks who issued a buy recommendation with aggressive price targets.
- In the 2000 era, buy/sell recommendations could move stock prices, so company shareholders resented sell recommendations, however well-reasoned.
- So analysts focused on earnings-per-share estimates to the exclusion of cash and debt.
- Analysts even competed with each other for higher price targets – $100, $115.
- At least one analyst who was skeptical of Enron was pressured to be fired by Fastow.
- Moody’s and S&P should have issued downgrades for the sake of protecting their reputation. They had massive leverage over Enron, since their rating could sink Enron. Why didn’t they dig deeper?
- For one, Enron simply stated they needed sufficiently high ratings to keep getting debt – lowering ratings would force debt paybacks and cause a selloff, which would sink the company. The ratings agencies didn’t want to be single-handedly responsible for sinking a company, just in case they were wrong.
- Further, even ratings agents may have held stock in the public markets and were caught up in the flurry.
Shortform Exclusive: Lessons Learned from Enron and How to Avoid Being Like Them
Here we invert the question – how do you avoid building an Enron? Think about the lessons learned from Enron, and make sure you avoid the bad practices of Enron with this checklist.
- Don’t tolerate bad behavior just because they’re making money for you.
- Don’t avoid doing diligence because you believe that everyone else has done their due diligence. Everyone else likely believes the same, and it’s possible no one has done diligence.
- Do sanity checks even if you fear being called dumb. Lose your ego around being intelligent – if something seems too complicated for you to understand, it’s probably not because you’re dumb. Someone might be actively hiding something.
- Set compensation schemes correctly – in service of long-term value and sustainability, not in terms of misleading short-term metrics.
- Avoid these standard excuses that are more reassuring than they should be.
- “It’s fine to be over-optimistic in our estimates – analysts don’t have to believe it.”
- “The proper controls are in place. I could be removed at any time if I were doing something wrong. The company doesn’t have to do any of these deals – they can reject them at any time.”
- “This will have no impact on our earnings/statements.”
- Don’t let management losing sight of the fundamental nature of business and relax their oversight.
- Avoid too-clever schemes that stretch the rules for the promise of a quick return.
- Don’t overlook seemingly small things like compensation – even small percentage incentives can contribute to the problem. Don’t be sloppier than you need to be, just because small terms don’t seem to matter.
- Don’t believe what the press writes about you (both positive and negative). They see so little of the situation that they’re often not reliable.
- Don’t use superficial markers of progress (deals on paper, valuation of deal) instead of real fundamental progress (cashflow).
- In good heady times, don’t lose grasp on the discipline that got you there. This is when you get overconfident and make bad bets.
- Don’t wait to bite the bullet on bad news. Avoid hoping for a bet-it-all strategy that will pay off and rescue the company.
- Be careful doubling down on a key assumption that, if falsified, would cripple everything. In Enron’s case, they believed their stock price would never fall, allowing them to use Enron stock to prop up shaky deals.
- Don’t avoid taking seriously the concerns of employees on the ground. Be careful of dismissing them as not seeing the bigger picture.
- When the financial grim reaper comes, clamp down spending and appearances immediately. Don’t fly on private jets.
Lessons learned from Enron include transparency, honesty, and following straightforward business practices and avoid complex schemes. Perhaps the lessons learned from Enron can still lead to better business practices.
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Here's what you'll find in our full The Smartest Guys in the Room summary:
- How Enron rose to become one of the world's most promising companies
- How Enron management's greed led it to start cutting corners
- The critical failures that crashed Enron's house of cards to the ground