Lessons from Enron
Buying shares of stock on the stock market is similar in many ways to the acquisition of a business. The buyer of shares of stock is making a decision to acquire a business (albeit a small fraction of one), and bases that decision, in large part, on financial statements. Thus, while the Enron story does not involve an acquisi-tion of a business per se, there are, with the benefit of 20-20 hindsight, some important lessons to be drawn from it nevertheless for those involved in buying and selling businesses. In the article that follows, we will explore this subject in more detail.

There is a lot of gray area in the accounting world. The old joke about accountants, illustrated below, is worth trotting out in light of the Enron scandal. While it appears that Enron and
its accountants may have pushed the envelope too far, the point that can not be stressed enough is that audited financial statements should never be taken as the gospel truth. For someone buying
stock on the stock market, there is little else you can do except rely on published financials and analyst recommendations. But for someone involved in an M&A transaction however, there is much more that can be done and should be done. “Managing” earnings is a common practice in many companies and a buyer needs to understand the extent to which the financials as presented have been so “managed.” In depth discussions with the seller’s inside and external accountants, review of auditor’s workpapers, discussions with employees, etc. are all necessary steps in due diligence for a potential buyer. In addition, as a further layer of protection, a buyer should insist on strong contractual representations and warranties about the accuracy of the financials. One aspect of the Enron story involved the collapse of Dynegy’s deal to acquire Enron in 2001. No doubt Dyergy took a fine-toothed comb to Enron’s books, way beyond its audited financials, and didn’t like what it saw. While Enron was able to snooker the public, it was not able to snooker a sophisticated potential acquirer.

If you can’t understand a company’s financials or its business, don’t buy it. This should go without saying, but we’ll say it nevertheless.

Words like opaque, impenetrable, complex and incomprehensible have all been used by those that have looked at Enron’s financials. It is safe to say that probably 99% of sophisticated investors and analysts could not really understand them. And this is to say nothing about all the liabilities that were not even disclosed in Enron’s financials, those “off-balance sheet” liabilities associated with Enron’s “Special Purpose Entities,” another complicated subject in and of itself.

The nature of Enron’s business itself was similarly hard to comprehend. We know that Ford
makes cars, Microsoft makes soft-ware and GE makes refrigerators. What does Enron do? According to its 2000 Annual Report, “Enron manages efficient, flexible networks to reliably deliver physical products at predictable prices.” What does this mean? The chart on this page shows that while Enron was #7 on the Fortune 500 list last year (it has risen to #5 on this year’s recently released list!!), it had relatively few employees. Is this a clue that perhaps Enron was not as big of a
company as it purported to be? Certainly it raises questions. What does all this mean in the context of an acquisition transaction? It means that a seller has to pass the smell test. A seller whose financials or business is so complex or difficult to understand may very well be hiding something. If the seller you are dealing with is not an open book, be very, very careful.

Knowledge of fraud in an organization runs deep. One of the more amusing stories about Enron involved the creation of a completely fake trading room to impress analysts during a tour of Enron’s headquarters. Both the Chairman and President of the company were reportedly personally involved in setting up this fake trading room, which was complete with desks, telephones, computers, family photographs and employees who made believe they were conducting a trading operation as analysts were given a tour of company offices. One former employee estimated that Enron may have spent $500,000 on this charade. While not terribly significant by itself, it does show that there was a culture of deceit at Enron and that it takes more than a senior officer or two to perpetrate a large scale financial fraud. If a company is cooking the books, there will be a lot of employees below the senior executive level that are either participating in the fraud or who have knowledge of it. It pays for a buyer in due diligence to get to know these people in informal settings to find out as much as possible.