It was 2001. The tech boom of the 1990s was unraveling as hundreds of upstart internet companies went out of business, pulling the entire stock market into its worst decline since the 1987 crash. And the terrorist attacks of Sept. 11 had just tested America's resolve. Amid that chaotic environment, one of the few business success stories of the 2000s came to a sad end -- energy giant Enron declared bankruptcy.
On Dec. 2, 2001, 17 years ago Sunday, Enron's bankruptcy filing sent new shock waves across the investing world. For years, Enron had built up a reputation for innovation that sent its stock price soaring, but then all of the energy company's accomplishments came crashing down over just a few months. Previously high-flying shares were suddenly worthless, and thousands of workers lost not only their jobs but the value of their employee-owned stock holdings.
Even all these years later, what happened to Enron is worth understanding because of the lessons the debacle offers for investors.
Image source: Enron 2000 annual report.
The rise and fall of Enron
Enron began in 1985 with the merger of two natural gas companies. Early on, Enron sought to grow by expanding its scope beyond natural gas and moved aggressively into electrical power with power plants and other electrical generation assets.
What seemed to drive Enron's top executives, however, were the company's efforts to profit from energy trading. Rather than concentrating on producing and delivering energy products for its customers, Enron used futures contracts to deliver natural gas or electricity at specified future times to make money from those seeking to either to speculate on price movements or to hedge against the risks of unexpected energy-price volatility.
In doing so, Enron took on characteristics that made it look more like a Wall Street investment company than an energy or utility business. The company ended up creating completely new markets that were only loosely connected to the energy markets, including futures contracts tied to weather events and internet bandwidth capacity. That link to the tech boom was especially timely, and by 2000, the stock had skyrocketed, putting Enron into position among the top 10 businesses in the country.
In the end, much of Enron's success turned out to be a mirage. The company created an array of related business entities and used accounting gimmicks to conceal massive business losses and large amounts of debt. Those tactics eventually stopped working, and in October 2001, Enron revealed a huge quarterly loss and said it had systematically overstated its earnings going back at least four years. Utility rival Dynegy contemplated buying Enron in November of that year, but when Dynegy terminated its merger talks later that month, Enron had no choice but to file for Chapter 11 bankruptcy protection.
The aftermath of the bankruptcy filing showed the extent of Enron's wrongdoing -- the energy company was operating a massive fraudulent scheme. Arthur Andersen, then one of the world's preeminent accounting firms, ultimately disclosed that its employees had destroyed Enron documents that could have been used to prosecute the company. One key Enron executive died as the result of an apparent suicide, and former CEOs Jeffrey Skilling and Ken Lay were both convicted on charges of conspiracy and fraud.
In addition, several Enron executives and family members were accused of insider trading. They sold off shares near their highs even as some urged rank-and-file employees and outside investors to keep buying the stock. Convictions resulted for some of those involved, including Skilling and Lay.
What good came out of the Enron debacle?
Enron's collapse was a financial disaster for thousands of people, and its indirect impact hurt millions more. Yet the fiasco prompted several moves that helped ensure investors would be less likely to suffer a similar catastrophe in the future.
The most direct response to the Enron scandal was the passage of the Sarbanes-Oxley Act in 2002. The legislation dramatically expanded the responsibilities of corporations and their executives in providing accurate financial disclosures, ensuring independent audits, and assessing internal controls on financial reporting to curb the potential of internal fraudulent behavior. Sarbanes-Oxley also called for criminal penalties against CEOs, CFOs, or any other executive who certified financial statements in violation of the act, as well as clawbacks of executive compensation.
Despite stricter regulation, the lasting impact of Enron was to cast doubt on the accuracy of financial reporting in general. Investors once burned by Enron and similar scandals were reluctant to put their money back in the stock market. To the extent that their skepticism remained healthy, investors benefited from taking a critical eye to their portfolios. Yet for those who simply fled the stock market entirely, the financial consequences are still playing out.
3 lessons from Enron
There are still several important lessons for investors to take from the Enron scandal. First, it's critical not to have too much of your portfolio invested in a single stock. No matter how compelling the company's story might be, the threat of a reversal that you could never predict can wipe you out if you have too much of your money invested in it.
Second, company employees should be especially cautious about buying their employer's stock. It's tempting to invest in a business you know well, but if something goes wrong, you risk both losing your primary source of income and taking a big hit in your investment portfolio at the same time.
Finally, make sure you understand how a company's business works. Most shareholders couldn't understand Enron's sophisticated trading business, but they didn't really care as long as the stock was moving higher. That left them completely vulnerable to changes in the fundamental health of the business in which Enron was operating. Between the high levels of leverage, complicated derivatives, and management that turned out to be questionable in its honesty and integrity, Enron provided some warning signs to those willing to listen, and shareholders could have avoided some of the damage from the scandal if they'd steered clear.
Seventeen years after the energy company's bankruptcy filing, the Enron scandal still has an influence on the investing world. By recognizing that similar risks still exist today, you can remain vigilant and protect yourself from future scandals.
