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The Fable of the CEO, the Short Seller, and the Chairman

By Doug Wakefield with Ben Hill

As former Enron executive Ken Lay has recently taken the stand in his defense, we are reminded yet again of how this story of greed and deceit serves as a microcosm for much of corporate America today. Since I had the pleasure of interviewing Jim Chanos, who Lay's defense accuses of wrongdoing, I thought it would be interesting to review the facts. In so doing, it should become painfully obvious that both parties cannot be right and that someone is, indeed, lying.

Though it does not bother me to recount the facts of the Enron scandal, which in and of themselves look to incriminate Lay, my intention is to warn investors so that they do not fall prey to similar ploys that lie ahead. The spring of 2006 is not all that different from the spring of 2000, and as these next few years unfold, we are sure to hear of more Enrons, Worldcoms, and Tycos.

Let's begin by contrasting the words and actions of Enron's former CEO, Lay, with those of renowned short seller, Jim Chanos, and former SEC Chairman, Arthur Levitt. Rather than tell this tale of woe from my own standpoint, I will look to an article in the May 22, 2006 edition of Fortune, Chanos' testimony before Congress in February of 2002, and Levitt's book - Take on the Street.

In discussing Lay's culpability, the Fortune article did not mince words.

"After three weeks of listening to testimony from the defendants - testimony that was deeply cynical, at odds with knowable facts, and palpably discordant with how the world of business actually operates - it [is] almost impossible for us to believe the former CEOs didn't know precisely what they were doing.

For example, there was a letter from Lay's chief of staff, Steve Kean, telling him, 'We are faced with too many bad but true (or at least plausible) allegations that we have to deal with,' which 'no amount of spin' could overcome. The problems, Kean added, include 'creative or aggressive accounting'; 'overhyping of the stock'; and 'a near-mercenary culture, which encourages organizations to hide problems.'" 1

Still, Lay had remained extremely optimistic even up to one month before Enron declared bankruptcy. Of course, the article notes that Lay sold $80 million worth of Enron stock in 2001.

"During the same period Lay told employees that Enron stock was an 'incredible bargain' when in fact he was unloading almost two-thirds of his Enron shares." 2

As we can plainly see, as investors, a healthy dose of skepticism can be a valuable asset. When we receive "advice" from any individual or company, we would do well to consider all of the angles and any potential conflicts of interest. In the investment industry, a better paycheck and increased job security often come at the expense of true objectivity. Whether we are looking at company management, with large amounts of stock options; Wall Street analysts trying to court investment banking business; the media, who are funded by companies' advertisement dollars; or the halls of academia, who are funded by companies' and organizations' research grants, the odds are against us ever receiving the down and dirty on any given subject that jeopardizes these flows of money.

We would also do well to look at increased (or large amounts of) insider selling. Though there is no Holy Grail and the system is not without its problems, with the help of the Internet and the increased flow of information, insider transactions are more readily available to investors. Though some will point to the need for diversification, corporate insiders rarely voluntarily sell large portions of their holdings if they believe their company's stock will continue to increase in price.

The article goes on to note that Lay denies knowledge of any wrong doing, and instead believes that Enron fell victim to a concerted effort by short sellers to drive the stock down.

"The defense has repeatedly ridiculed the prosecution's contention that there was a conspiracy to inflate profits at Enron, instead presenting its own conspiracy theory: that a cabal of short-sellers were to blame for the company's demise. 'There were short-sellers that were organized and working together and conspiring together.' Lay testified. As the details of this supposed conspiracy were fleshed out during the defendants' time on the stand, it seemed increasingly absurd." 3

In February of 2002, the US House of Representatives' Committee on Energy and Commerce asked Jim Chanos, one of the "cabal of short sellers," to give testimony regarding the demise of Enron. After all, Chanos' insights allowed his investors to know about, and ultimately profit from, Enron's problems over a year before Enron filed bankruptcy. In October of 2000, Chanos became aware of Enron's use of "gain-on-sale" accounting and believed that Enron was using this accounting method to materially overstate its earnings.

"Basically 'gain-on-sale' accounting allows a company to estimate the future profitability of a trade made today, and book a profit today based on the present value of those estimated future profits.

Our interest in Enron and the other energy trading companies was piqued because our experience with companies that have used this accounting method has been that management's temptation to be overly aggressive in making assumptions about the future was too great for them to ignore. In effect, 'earnings' could be created out of thin air if management was willing to 'push the envelope' by using highly favorable assumptions." 4

After analyzing Enron's cash flow and realizing that Enron was likely going backward while it was reporting "profits" to shareholders, Chanos began studying Enron's financial disclosures more closely.

"We were also troubled by Enron's cryptic disclosure regarding various 'related party transactions' described in its financial statements. We read the footnotes about these transactions over and over again but could not decipher what impact they had on Enron's overall financial condition. Another disturbing factor in our review of Enron's situation was what we perceived to be the large amount of insider selling of Enron stock by Enron's senior executives. Such selling in conjunction with our other financial concerns added to our conviction. 5 [Italics mine]

In the spring of 2001, we heard reports, confirmed by Enron, that a number of senior executives were departing from the company. Further, the insider selling of Enron stock continued unabated. 6 [Italics mine]

To us, however, the most important story was the abrupt resignation in August 2001 of Enron's CEO, Jeff Skilling, for 'personal reasons.' In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what 'official' reason is given." 7

As evidenced in this testimony, as opposed to the hype that other sources give when a stock's price is moving up, short sellers and sell-side researchers often offer unsurpassed information on what is really happening with a company. Our research paper, Riders on the Storm; Short Selling in Contrary Winds, is replete with examples like that of Chanos. When a stock or the stock market is rising, most investors operate from the mindset of, "If it ain't broke, don't fix it." This will prove to be a very costly and foolish attitude.

In his closing remarks to the Committee on Energy and Commerce, Chanos points out that there are too many conflicts of interest for outside accounting firms to blow the whistle on financial fraud in companies that they "independently" audit; that the leeway in the use of estimates and forecast in Generally Accepted Accounting Principles (GAAP) can be used by dishonest management to mislead far more then inform; and that the "Safe Harbor" Act of 1995 has harmed investors by shielding dishonest managements and lax "watchdog" accounting firms from legal recourse. 8

As the acting SEC chairman at the time of Enron's demise, Arthur Levitt is thoroughly familiar with the facts of this case. In his book, Take on the Street, Levitt poignantly summarizes the issues surrounding the Enron scandal.

"Enron borrowed heavily to finance an aggressive expansion, but didn't want a mountain of debt to reduce its credit rating or depress the share price. So instead of listing debt on the balance sheet, Enron formed hundreds of off-the-book partnerships. The partnerships, called 'special purpose entities' (SPEs) in accounting lingo, allowed the company to take in capital from outsider investors or lenders, such as pension funds and insurance companies, to finance its many ventures.

The SPEs let Enron manipulate its accounts by inflating earnings and hiding losses. The SPEs also helped Enron keep investors in the dark on total debt levels, artificially improve its credit rating, and enrich several top managers who participated in the partnerships.

[Arthur] Andersen [Enron's "independent" auditor] had many, many opportunities to prevent this tragedy. It did not force Enron to clearly explain to investors any of the partnerships, which exposed shareholders to huge financial liabilities. Subpoenaed documents and the internal investigation by a special committee of Enron's board show that Andersen played a major role in setting up some of the partnerships, and then blessed their accounting treatment. This is a conflict of interest for any auditor.

Documents also show that Andersen knew as early as August 2001 about accounting irregularities at Enron, [yet] stood by its client for another three months before forcing it to restate five years' worth of earnings.

I think it's fair to say that Andersen's independence was compromised. Whereas Andersen was paid $25 million for its audit work, it received even more than that - $27 million - for nonaudit services. According to internal memos, Andersen expected total Enron fees eventually to grow to $100 million, making Enron its largest client by far.

When you add it all up, investors lost more than $60 billion. Some five thousand Enron employees lost their jobs, and many also lost their retirement savings. Enron executives, meanwhile, made $1.2 billion by cashing in stock options in the two years prior to the company's collapse." 9

It is well worth noting that Lay sent a letter to Levitt pleading for Levitt and the SEC to reconsider proposed SEC rules that would have curtailed Enron's arrangement with Arthur Andersen. Lay writes,

"This arrangement [between Enron and Andersen] has been found to be extremely valuable.

The proposed rule would preclude independent auditors from performing 'certain internal audit services.' The description of inappropriate activities included in your current proposal is so broad that it could restrict Enron from engaging its independent auditors to report on the company's control processes on a recurring basis as the company now has arranged. I fund this troubling.

The SEC has supported a number of measures to ensure that audit committees are informed of auditor's activities and feel the burden of determining auditor independence. Enron's audit committee takes those responsibilities very seriously. Given the wide-ranging impact of your proposed changes, I respectfully urge the Commission to reassess the need for such broad regulatory intervention." 10

Clearly, Lay saw great value in the services that Arthur Andersen performed for Enron and wanted to head off any legislation that would threaten the relationship as it existed.

Today, there are those like Chanos, whose independent research, investment tools, and resolve have allowed them to position their clients accordingly. They know that more than a few corporate leaders have cooked the books to inflate their stock prices and cash out their options before their stock goes down in flames (like Enron). During the last three years investors have looked only at the "bottom line," accepting price appreciation as the sole measure of excellence. Soon, we will understand once again why ethics should never take a back seat to short-term performance.

To read some of our other postings, we welcome you to visit our website. If you are growing more and more convinced that an economic storm is in front of us, then I strongly encourage you to download a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds. You will find this available to those who sign up for our monthly newsletter, The Investors Mind: Anticipating Trends through the Lens of History, which is offered at no cost.


  1. Fortune - Special 2006: Real Estate Survival Guide, May 15, 2006; Dispatches: No More Mr. Nice Guy, Peter Elkind & Bethany McLean, pages 72 and 73
  2. Ibid, page 74
  3. Ibid
  4. Testimony of James S. Chanos of Kynikos Associates, Ltd concerning Enron Corporation before the Committee on Energy and Commerce of the United States House of Representatives, February 6, 2002, page 2
  5. Ibid, pages 3 and 4
  6. Ibid, page 5
  7. Ibid, page 6
  8. Ibid, pages 7 and 8
  9. Take on the Street: What Wall Street and Corporate America Don't Want You to Know/What You Can Do to Fight Back (2002) Arthur Levitt, pages 140 - 143
  10. Ibid, page 300


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