Enron Scandal: A Devastating Reminder of the Dangers of Debt

By Markets Fool.com

Enron's corporate life had rather humble beginnings. The company was formed in 1985, after Ken Lay merged Houston Natural Gas and InterNorth, two companies in the incredibly steady business of natural-gas pipelines. If Lay had stuck with the sleepy pipeline business, Enron might have never collapsed in scandal. But he wanted to create an energy powerhouse, and he used a lot of debt to do it. In fact, Enron used so much debt that it chose to cover some of it up, along with inflating the profitability it needed to support that debt -- which is what ultimately led to its devastating downfall.

Continue Reading Below

The rise of an energy giant
Enron's initial business was in shipping natural gas on its pipelines, though InterNorth did bring with it some plastics operations, in addition to coal- and petroleum-producing assets. The company didn't meaningfully begin to shift into other businesses until the early 1990s, whenelectricity and natural gas trading began to be Enron's biggest early growth driver. It was the company's trading operations, especially electricity, that started some of its troubles as it pursued bigger profits. The company was even accused of defrauding California out of billions of dollars during its energy crisis, as Enron created electricity shortages in the state in the early 2000s for its own gain. As a result of its actions, energy trading was profitable, though those profits weren't sustainable because of Enron's aggressive tactics.

Energy trading wasn't Enron's only growth strategy. The company pursued a bold diversification strategy whereby it bought or built all sorts of assets around the globe, including electric-generating plants, pulp and paper mills, water plants, and broadband services. Thanks in part to its burgeoning asset base, at its peak Enron was the sixth largest energy company in the world.

However, much of this growth was funded with debt the company took on using elaborate and complex corporate structures and partnerships. When these debt-laden outside structures were exposed, Enron was exposed as having overstated earnings, causing the company's financial house of cards to fall apart.

The bigger they are, the harder they fall
The cracks began to emerge in Enron's foundation in early 2001, after several company executives began to complain about the company's partnership deals. In the years prior, the company had created several off-balance-sheet entities for various purposes, including Chewco, Whitewing, LJM, and Raptors. Chewco was one of the first special-purpose entities. Created by Enron in 1997 and run by a company officer, Chewco was used to acquire a stake in a joint venture the company set up. When the Chewco arrangement was discovered in 2001, Enron ended up negatively restating earnings by$405 million, while the company's indebtedness increased by $628 million.

Enron used these entities to inflate asset values and profitability even while, in some cases, the entities' assets or profits were found to be completely nonexistent. When it came to light that Enron was using creative accounting to hide the fact that its business wasn't as strong as it was reporting, it was game over for the company. By December 2001, the company declared bankruptcy, after it crumbled under the weight of $38 billion in debt. At the time, it was the largest bankruptcy in U.S. history.

Continue Reading Below

Takeaway
Enron used debt to satiate its thirst for growth. In the end, that debt was its undoing, as company executives felt they had no choice but to use unethical means, including fraud, to hide the company's growing debt burden from auditors and investors. The result was a scandal that rocked the energy industry and resulted in one of the greatest financial collapses in U.S. corporate history.

The article Enron Scandal: A Devastating Reminder of the Dangers of Debt originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.