What's up guys and welcome back to wall street millennial on this channel, we've covered many corporate frauds and disasters today, we're looking back at the biggest fraud in world history, we're talking about none other than the iconic enron scandal once named the most innovative company in america. Enron's market cap reached a peak of 60 billion dollars. Unfortunately, it was all a mirage meticulously constructed by the mastermind ceo, jeffrey skilling, when the fraud unraveled millions of investors lost billions of dollars in what would eventually come to be known. As the largest and most sophisticated fraud the world has ever seen.

Enron was a complicated company with many layers of fraud in this video we'll take a deep dive into their business, how they orchestrated the massive fraud and how they were finally exposed. This video was chosen by our channel members. Members get access to our backlog of videos before they're released to the public. Our current backlog has many interesting videos about stocks.

Investing and corporate frauds members also get to vote on some of our video topics. Thank you. Enron was an energy and commodity company based in houston, texas. The nature of their business was very complicated and even industry analysts had trouble understanding what they actually did.

This complexity made it possible for their fraud to go undetected for many years. Enron can trace its roots. All the way back to the 1930s, when a small natural gas company called inner north was founded in omaha nebraska internorth was an energy company that focused on the production and distribution of natural gas. Natural gas could have been considered an advanced technology at a time as many people were still using wood-burning stoves for cooking and heating as more and more households got connected to the grid, inner north's business exploded and they expanded rapidly throughout the united states in 1985.

Internorth acquired houston-based natural gas pipeline company hng to form h g inter-north inc. The combined entity was the second largest natural gas pipeline company in the country. At the time long-time energy executive, kenneth, lay was appointed. Ceo of the new company.

Lei was obsessive about the company's image and spent 100 thousand dollars on consumer focus groups and consulting groups to come up with a new name for the company. They eventually settled on enron, which sounded modern and was less cumbersome to say at this point. Enron was a relatively boring company. They produced transported and sold natural gas.

Just like any other company in the industry. They were a multi-billion dollar business, but they were by no means a household name. This all changed in 1989 when they hired consulting firm mckinsey and company to come up with new growth opportunities for the business. One of the mckinsey consultants working on the project was a young man by the name of jeff skilling skilling thought of a brilliant idea.

Instead of producing and delivering natural gas to utilities, enron could instead guarantee the price of gas to a customer and pay a different company to deliver. The gas electricity rates are highly variable. Electricity buyers such as utility companies would love such a scheme because they can lock in a given price for electricity. The certainty about what price they'll have to pay makes it easier for them to plan and create budgets.

The system works as follows: the electricity buyer pays enron. A fixed amount of money today in exchange enron, would be contractually obligated to pay for the delivery of some fixed amount of natural gas at some point in the future. If the price of natural gas goes up, enron loses money on the position and vice versa. However, because the utility companies are risk averse, they will be willing to pay a slight premium on the contract price in exchange for the certainty, because of this enron could make a slight profit on each transaction.

Ceo kenneth lay thought this was a brilliant idea. Their legacy energy business was extremely capital intensive. If they wanted to grow, they had to invest billions of dollars in new power plants or pipelines, which can also take many years to build if they adopted skilling's idea of guaranteeing natural gas contracts. Instead, they could reinvent the company into a high-growth financial institution.

To this end, lay created enron, gas bank. They hired traders who would buy and sell contracts for purchase and delivery of natural gas lay convinced jeff skilling to leave his job at mckinsey to join enron. As the head of the gas bank in the following years, the gas bank was extremely successful, lay decided to sell the majority of the company's pipelines and other physical assets to go all in on the gas bank idea in a matter of just a few years. He transformed enron from a boring energy company to an innovative financial institution.

Throughout the 1990s skilling expanded enron's financial trading arm rapidly, they moved beyond natural gas, expanding to many different commodities. They started trading electricity price contracts with the utility companies and lumber price contracts. With paper manufacturers, they even entered exotic areas by making financial derivatives for the weather companies whose businesses are impacted by the weather could buy weather contracts from enron to hedge, their risk. In the late 90s, the dot-com bubble was inflating and the internet was all the rage with investors to take advantage of the dot-com craze.

Skilling announced enron's most ambitious project. Yet in 2000 they announced that they'd be creating a nationwide high-speed internet network. Enron would create contracts with internet providers to sell bandwidth on this network. Enron was creating financial markets for assets, never traded on exchanges before you could buy natural gas, coal or even internet connection just as easily as you could buy a stock or bond.

This was revolutionary with the potential to be worth tens or even hundreds of billions of dollars and enron. Didn't just talk the talk. They also walked the walk in 1994, they had nine billion dollars of revenue. Just six years later, in 2000, their revenue had increased tenfold to more than 100 billion dollars.

Their net profit was also steadily growing, with year-over-year increases every year except 1997.. In 2000, they reported almost 1 billion dollars of net profit. With all this good news, investors were buying enron stock hand over fist with the valuation peaking at 90 dollars per share in 2000, giving the company a market cap of over 60 billion dollars. This gave the stock evaluation 60 times.

Earnings which indicates investors thought the company would continue its strong growth for many years to come. This seemed reasonable at the time, because the tremendous opportunities ahead of them skilling told analysts that the broadband trading business would eventually add 40 billion dollars to enron's market cap. But not everyone was buying into enron's hype. In 2001, fortune magazine, journalist, bethany mclean talked to an anonymous short seller who was bearish on the stock.

She published an article in fortune magazine called, is enron, overpriced in the article she said, enron had a very opaque business and even the wall street analysts covering the stock had trouble explaining how the company makes money in their financial reports. They would simply say that they made revenue by trading natural gas, electricity, metals and other commodities when asked how they actually made money trading these commodities, they refused to answer for competitive reasons. Also, the broadband business which made up the crux of enron's bowl case was still years away from profitability and faced tremendous uncertainty. Wall street was surprisingly accepting of the company's lack of transparency and blindly trusted skilling's bullish projections.

One goldman sachs analyst even compared enron to michael jordan, you don't know exactly how he's going to score each game, but you know he almost always wins. In the same way. Analysts didn't know exactly how enron made its revenue, but given their track record, they just assumed the company could keep growing. Unfortunately, throughout the 90s, business was not doing as well as skilling.

It hoped, instead of being profitable as they claimed their enron. Online commodities marketplace was actually losing billions of dollars every year and the company is racking up tens of billions of dollars worth of debt. These losses were unacceptable to president jeff skilling and ceo kenneth lay for the stock price to continue going up. They needed revenue and profitability to grow quarter after quarter.

To this end, they hired andrew fasto as chief financial officer fasto was a financial wizard who had two major tricks off his sleeve to turn the company's losses into profits. The first trick was to adopt mark to market accounting under this method, anticipated future profits from any deal. The company enters into are recognized up front as they've already been realized. For example, in 1999 enron's broadband division signed a deal with movie rental company blockbuster to create a movie streaming.

Business enron made some back of the envelope calculations saying the deal would eventually make them 110 million dollars in profits based on the mark to market accounting they booked. These anticipated profits almost immediately. If the deal were to fail to make as much profit as projected, they were supposed to take a right down which would cancel out the profits they booked earlier. Since most of enron's deals ended up being failures.

Mark to market accounting alone wouldn't be enough to sustain the company's supposed profitability. This is where fasto's second piece of financial history came into play. He created hundreds of special purpose entities that were technically not on enron's balance sheet. If one of their deals failed or generated a loss, they would transfer the losses to the special purpose entity to avoid recognizing the loss on their own income statement or balance sheet by 2001.

These entities held tens of billions of dollars worth of enron's debt and accumulated losses. Fasto personally controlled these entities and skimmed hundreds of millions of dollars from the transactions to line his own pockets. Skilling likely knew that faster was skimming but turned a blind eye, because these special purpose entities were crucial to the fraud enron's auditor, arthur anderson was complicit in the fraud as well. In addition to being in ron's auditor, they also provided business consulting services for the company.

In 2000 alone, enron paid anderson over 50 million dollars in fees. Anderson didn't want to blow the whistle on the fraud, as this meant jeopardizing their lucrative relationship. Every quarter enron would have to transfer billions of dollars worth of debt to its special purpose entities. Many of the special purpose entities were funded by investment banks and other institutional investors, the capital that they went to enron indirectly through these energies was backed by enron stock.

If the stock price fell below a certain threshold, they would stop supplying capital and enron would be forced to recognize the losses on their own balance sheet. In february of 2001, skilling was appointed as ceo, replacing kenneth lay who stayed on as chairman of the board, but he knew that time was running out. Enron was running out of cash. It would be impossible for them to keep the fraud up much longer.

Just six months after taking the job skilling resigned in august of 2001., he cited personal reasons, but in reality he was trying to flee the sinking ship before its inevitable collapse. Around the same time, he sold more than 60 million dollars worth of stock. He was replaced by chairman and former ceo kenneth lay the very next day enron. Vice president sharon watkins sent an anonymous letter to lay informing him of the counting improprieties that she observed.

When lay failed to respond to her letter, watkins met with him in person to explain the extent of the fraud that she uncovered in the company's accounting department even after this lay still refused to do anything by this time. Enron was truly on its last legs. When skilling had resigned, the stock price was in the 40 to 50 range. In october, they were forced to report a 618 million dollar quarterly loss, as the fraud was getting too big for their special purpose.

Entities to handle just a few days later, the sec launched a probe into their accounting practices. In december they ran out of cash and were forced to file for chapter 11 bankruptcy protection, the enron bankruptcy shocked. The world 60 billion dollars was lost in the matter of a few months and was the largest corporate bankruptcy in history. At the time, tens of thousands of employees were laid off to add insult to injury.

Many of them put the majority of their 401ks into enron's own stock, which was now worthless right after bankruptcy executives took what little money they had left to pay high level executives, 744 million dollars in salaries and bonuses. In light of the disaster, the u.s senate called on senior enron executives to testify under oath about their involvement in the bankruptcy former cfo anthony fasto, invoked his fifth amendment rights against self-incrimination and refused to answer any questions. He was the architect of the fraud and lined his own pockets to the tune of hundreds of millions of dollars. Chairman and ceo kenneth lay also refused to answer questions.

Former ceo jeff skilling as well as vice president sharon, watkins agreed to testify under oath. She encouraged me to meet with mr lay personally i fully expected mr lay to conduct a thorough investigations into my concerns. I was disappointed that such was not the case. I was incredibly frustrated with mr lay's actions or lack thereof.

I believe that enron had a brief window to salvage itself. This past fall and we miss that opportunity because of mr lay's failure to recognize or accept that the company had manipulated its financial statements throughout the global finance group as well as upper management. I believe it was well understood that the raptor entities were primarily backstopped with enron stock. It wasn't a hidden fact.

I do think certain people thought it was some magic structure that was acceptable, but but others that had some concerns about it kept their concerns mainly to themselves lay, was intimately involved in the fraud and what watkins told him came as no surprise. He didn't open any investigation into enron's accounting practices, because this would only expose his own involvement. Raptor refers to one of the special purpose entities that fasto made to hide enron's losses: raptor provided capital to enron in exchange for enron, stock, the transactions between enron and the special purpose entity such as raptor, were obviously fraudulent. They should have raised alarm bells.

For any honest executives reviewing them, let me begin with a recap of what i understand about what enron has said in recent sec filings. First, there has been a restatement of three items, none of which affected cash flow or future period earnings. Second, there may have been self-dealing by a small number of executives, among whom i have not and cannot be counted, but in addition to those statements, there is also a raft of currently unproven assertions of additional accounting issues, the primary ones relating to something called the raptor Hedges, what do we know about these hedges? We know that the company's accountants arthur anderson agreed with the treatment of these transactions all the way up to their technical group in chicago. We also know that the powers team hired another accountant that apparently disagrees with anderson, and i take it all so that ms watkins also disagrees with anderson.

If the focus of this hearing is a game of dueling accountants, i will state right now that i'm not an accountant and probably have little to add to that debate between experts. I know that you will be asking questions about who did what at enron, but i hope in addition to those technical issues, you will also ask about how a company as strong as enron can be bankrupted by what i call a run on the bank. I have some thoughts that i think a number of you have asked for that might be helpful and are important to the financial system, but before we start there are a few things. I think this record should reflect.

I will not respond to all the outrageous things said about me in this process, because some have been so silly that they merit no response. Three others, however, do merit a response. First, i have not lied to the congress or anyone else about my recollection of events while out while i was at enron. Second, i never duped ken lay.

I heard miss watkins testify to her opinion. I have no idea what the basis is for that opinion. Third, i do not believe that my testimony is contradicted by or is materially different than, the testimony of either mr mcmahon or mr mintz, for both of whom i have a tremendous amount of respect and now. Finally, a few observations about this congressional process, to which i and others have been subjected.

What has happened thus far primarily in the house, should be cause for concern of every american. The entire management and board of enron has been labeled everything from hucksters to criminals, with a complete disregard for the facts and evidence assembled. These untruths shatter lives and they haven't, and they do nothing to advance the public understanding of what happened at enron. The framers of the bill of rights are watching my dilemma, like that of other innocents called before these committees is whether to take refuge in constitutional protections.

To avoid your questions or stand on the constitutional presumption of innocence to proclaim the truth, i am here and prepared to answer the committee's questions, because i have nothing to hide. I take and will continue to take full responsibility for my actions as a senior executive of enron corporation. While i worked at enron, i served the shareholders in the board of directors faithfully when i left enron on august 14th. I did not believe the company was in financial, pure apparel, and i have no knowledge of anyone and had no knowledge of any wrongdoing by its employees.

Skilling denied all wrongdoing he claimed to have no knowledge of how andrew faster was manipulating the financial statements. However, fasto pled guilty to the fraud and agreed to cooperate with authorities in the prosecution of other executives, including skilling. He provided credible evidence that both jeff skilling and kenneth lay knew exactly what was going on. He created the fraudulent special purpose entities with their knowledge and consent.

In 2006, skilling was found guilty and sentenced to 24 years in prison in 2018. He was released early after serving 14 years. Kenneth lay was also found guilty, but died of a heart attack before his sentencing. Andrew fasto was initially sentenced to 10 years, but this was reduced to 6 in light of his cooperation with prosecutors.

The most shocking aspect of the enron fraud was how sophisticated it was. There were dozens of people involved at the highest levels of the organization for many years. At its peak, it was the seventh largest company in the u.s, and almost every single investment bank had analysts covering the stock. Despite this, no one was able to uncover the fraud publicly until it got so big as to collapse under its own weight.

Alright guys that wraps it up for the enron story, if you want to see more videos like this make sure to hit the subscribe button. What do you think about the enron scandal? Let us know in the comments section below as always. Thank you so much for watching and we'll see you in the next one wall, street millennial, signing out.