The Smartest Guys in the Room The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean and Peter Elkind Portfolio © 2003 434 pages

Focus

Take-Aways

Leadership & Mgt.

• Enron, a massive energy management firm, turned out to be a house of cards.

Strategy

• Its strong written code of ethics apparently did not influence day-to-day operations.

Sales & Marketing Corporate Finance

• Jeff Skilling, hotshot COO and, later, CEO, spun fantastic tales about Enron’s rich prospects. Analysts, auditors and reporters believed him without skepticism.

Human Resources

• Instead of stopping the fraud, Enron’s board rubber-stamped management.

Technology & Production

• Enron made Andy Fastow its CFO in ‘98 despite his lack of accounting know-how.

Small Business

• As CFO, Fastow used his considerable power on Wall Street to intimidate, manipulate and ultimately destroy people who should have policed his conduct.

Economics & Politics Industries & Regions Career Development Personal Finance Concepts & Trends

• He helped engineer and personally profited from shady transactions that allowed Enron to hide massive debts and report good results — until it declared bankruptcy. • Enron’s failure shook confidence in American markets and corporate governance. • Enron’s board and the various independent analysts who covered the company denied any responsibility for their failure to know and tell the truth about the massive fraud. • Skilling told Congress that Enron’s only problem was liquidity and the ensuing panic was like a run on a bank. He denied personal, corporate or accounting wrongdoing.

Rating Overall

9

(10 is best)

Applicability

7

Innovation

Style

8

10

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Relevance What You Will Learn In this Abstract, you will learn the whole, detailed story of the rise and fall of Enron. Recommendation Enron is, of course, old news by now. The company went bankrupt in 2001, and its spectacular collapse was merely the first of a series of notorious corporate scandals. Most of the story Bethany McLean and Peter Elkind tell in their book has already appeared in newspaper and magazine accounts and in other, rush-to-publish books that hit the market during or shortly after the events described. However, these authors have assembled what may be the single most comprehensive, detailed account and written it like an anecdote-rich, lively business-based novel. We do wish they had included a timeline and a list of sources, since they have had the benefit of being able to draw on all of that other work, on indictments and on testimony before courts and Congress, but their account is engrossing and complete. If you read just one book on the Enron scandal, getAbstract.com believes this may be the book to read.

Abstract

“It is utterly beyond question that in reshaping Enron after he was named its president, Skilling turned it into a place where financial deception became almost inevitable.”

“Like many of the other major players in the Enron saga, Jeff Skilling made his way to the top of American business by sheer force of will.”

The End At 2:00 a.m. on Sunday, December 2, 2001, attorneys for Enron filed a petition for Chapter 11 bankruptcy. Enron had no choice — it had tried to arrange to be acquired or merged, but its overtures had been rebuffed. This was an astonishing end to the U.S.’s seventh largest firm. Six months later, a court found Enron’s auditor, Arthur Andersen, guilty of destruction of evidence. The evidence consisted of memoranda, letters and thousands and thousands of pages of other information about Enron. David Duncan, the Arthur Andersen partner who had helped instigate the document shredding, also pled guilty to obstruction of justice. Securities analysts tried to use the Andersen convictions as an excuse for their own malpractice. They claimed that Enron manipulated its accounting but that since a respected auditor, Arthur Andersen, had signed off on the accounting, they could hardly be blamed for relying on the numbers. Their claims rang hollow to those who knew how Wall Street worked. Most securities analysts labored for banks and brokerage firms that had done big business with Enron, and they had paid for that privilege by ensuring that their analysts sang Enron’s praises. Some of those major banks and brokerage firms became targets of Securities Exchange Commission (SEC) and Justice Department investigations after the scandal broke. Merrill Lynch accepted a settlement under which it paid $80 million in fines, but it did not admit any guilt. Meanwhile, Enron’s own board of directors disclaimed any responsibility for failing to oversee the company’s operations or to make sure that the executives were doing business legally and ethically. They said that the company’s clever managers had deceived and blinded them, presenting false numbers that they had no reason to doubt. But Enron’s fraud was hidden in plain view. Some astute short sellers and hedge fund operators saw the same numbers, knew what they meant, and bet big money on the Enron emperor’s unacknowledged nudity. Their bets paid off handsomely when Enron went down. It The Smartest Guys in the Room

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strains credulity to imagine that the board members, with their access to privileged information and their power to hire or fire managers, could not see as much as outsiders with access only to fraudulent financial reports. “Baxter had a towering ego and a volatile personality…Though he eventually made millions at Enron, he also complained frequently that he was underpaid and unappreciated.”

But most people involved with Enron lost. Employees lost. Stockholders lost. Pension funds lost. Even people who never bought a share of Enron stock lost when Enron went down, because Enron’s failure rocked the financial foundations of America. What happened?

The Frauds Many things were wrong with Enron and, after its demise, many people were willing to explain them. But the proximate cause of Enron’s failure was a series of illegitimate financial transactions involving what accountants and investment bankers call structured financings. The story of Enron’s financial prestidigitation began innocuously enough in 1998, when newly appointed CFO Andy Fastow, age 36, suggested to Enron’s top managers that the company should issue additional stock. President and COO Jeff Skilling and Chairman and CEO Ken Lay were not keen on the idea because they felt that issuing more stock might hurt Enron’s stock price. Fastow convinced them. The new issue raised $800 million. Then Fastow got creative. He had to, because management had promised Wall Street that the company would grow marvelously. But growth required even more capital and Fastow had just three ways to get it:

“To the outside world, the person who was Enron, who had a reputation for turning impossible concepts into glittering realities, was not Skilling. It was Rebecca Mark.”

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“One of Enron’s key advantages over its competitors was information: it simply had more of it than its competitors.”

Borrow — But the more Enron borrowed, the higher its cost of borrowing became. Banks and bond buyers base their lending decisions on a company’s risk. The more a company borrows, the higher its risk and the lower its credit rating. The lower its credit rating, the more it has to pay to borrow. Issue stock — The company had issued stock successfully, and its stock price was high. However, the law of supply and demand works in the stock market as in any other market. The more shares of stock in a company there are on the market, the smaller each share is. Issuing a disproportionate number of shares “dilutes” the stock. As a result, the more stock there is, the smaller the share of the company each stock represents and, other things being equal, the lower the stock price. Enron’s shareholders bought their shares in expectation of rising, not falling stock prices. If the stock price started to slide, they would probably sell, forcing it down even farther. Thus, Jeff Skilling was cool to Andy Fastow’s 1998 proposed stock issue. Enron may have lucked out that time, but it couldn’t luck out every time. Structured finance — Using certain innovative transactions, Enron could make billions of dollars in capital appear without borrowing or issuing stock.

The choice among these was no choice at all. Fastow opted for structured finance. The degree to which Skilling and Lay assented is still a question for the courts to decide. Many observers doubt that executives as sharp as these two could have been entirely unaware of Fastow’s creativity or innocent of any involvement in it. In fact, Cliff Baxter, another Enron executive, told Skilling he was concerned, noting, “You could never tell whether deals were clean because they were so complicated.” When the dimensions of Enron’s malfeasance became public, Baxter committed suicide. To get a glimmer of an understanding of what Fastow created, begin with Whitewing. To establish Whitewing in 1997, Enron borrowed $579 million from Citigroup and another $500 million from a Citigroup affiliate. A few equity investors bought stock The Smartest Guys in the Room

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“People at Enron simply didn’t believe they were vulnerable.”

“Everything was perception; nothing was real.”

in Whitewing, which in turn bought $1 billion of Enron preferred stock and paid $79 million to the equity investors as a return on their investment. A lay observer would look at this and conclude that Enron had borrowed a lot of money. True. But accounting rules allowed Enron to treat Whitewing as a “minority interest transaction,” which let Enron account for its borrowing as investment in a joint venture. Whitewing owned only Enron stock, but the market did not object to its structure and Enron’s stock price rose. In 1999, Enron got even more creative. It set up another structure called Osprey. Enron raised $100 million from some insurance firms and bankers, offering in exchange some paper that committed Osprey to pay a fixed return. To the untrained eye, this looks like borrowing. To Enron’s auditors, it must have looked like stock in Osprey, because that is how they allowed Enron to treat it. Enron then borrowed $1.4 billion from various institutional investors for Osprey, using a third of the money to pay off the Citigroup loan that created Whitewing. Osprey now owned Whitewing. Enron used the rest of the money cleverly, too. When Enron needed revenues to meet financial projections, Osprey would “buy” assets from Enron. Osprey had two very significant characteristics: • •

“The enormous profits Enron’s traders made in 2000 and the first half of 2001 had raised a final, sobering question: how long could they keep it up?”

Accounting rules allowed Enron to act as if it had no debt, even though it was clearly on the hook for the Osprey borrowings. In addition to structures like Whitewing and Osprey, Enron also made liberal use of “securitization,” which means selling investors a share in a stream of revenues. Banks sell mortgages to investors using “securitization.” Credit card companies also use securitization to turn their receivables into ready cash. Enron used an accounting device called a special purpose entity (SPE). Accounting regulations clearly stated that if as little as three percent of an SPE’s ownership was independent of Enron, Enron could treat the SPE as a totally independent entity, and say little or nothing about it on its own books. Enron securitized revenues it anticipated from risky deals such as Third World power plants. In theory, nothing is particularly wrong with SPEs, but Enron did some things that appear to be very wrong indeed: • • •

“There were other warning signs. Enron’s debt was climbing rapidly — $3.9 billion of debt was added on the balance sheet in the first nine months of 2000 alone — which didn’t make sense.”

Enron said that if Whitewing’s assets (Enron preferred stock) weren’t worth enough to pay back investors, Enron would issue stock to compensate for any shortfall. If Enron’s credit rating were to slip to non-investment grade or if its stock traded under $28 per share, investors could demand immediate repayment.

The independence of Enron’s “independent investors” was questionable; often they were customers or employees, their relatives or friends, or other interested parties. Enron often promised implicitly or explicitly that it would “take care of” lenders, again flexing the definition of independence to the breaking point. Essentially, Enron borrowed huge sums of money from investors and reported the borrowings as revenues or cash flow instead of as debt.

Enron’s use of structured financings and SPEs was probably the most aggressive in history. It may be an indication of Andy Fastow’s wit that he named a number of his most creative financings after characters in the films Star Wars and Jurassic Park.

The Cover Up: “He Who Pays the Piper Calls the Tune.” As long as Enron concealed the truth from investors, its share price continued to rise. In theory, the stock market is full of checks and balances, including sharp-eyed analysts, bankers and regulators who are alert for fraud and whose duty it is to keep companies from doing the sort of things that Enron did. All of these checks and balances failed to stop Enron. Why? The Smartest Guys in the Room

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“Above all else, Jeff Skilling believes this: ‘They killed a great company’.”

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“’It started out as pure, clear, legitimate deals,’ says a former senior Enron executive, ‘And each deal gets a little bit messier and messier. We started out just taking one hit of cocaine, and the next thing you know, we’re importing the stuff from Columbia.’”

•

Auditor conflict of interest — Enron’s auditor was Arthur Andersen, which was charged with auditing Enron’s books and either persuading the company to correct any irregularities or informing investors that the books were not quite kosher. But Andersen did a lot of other business with Enron. In fact, in 2000, Andersen earned $52 million from its business with Enron, and most of that had nothing to do with auditing. The old saying, “He who pays the piper calls the tune” sums up Arthur Andersen’s attitude to Enron. Investors paid Andersen nothing. Enron paid it a lot. Moreover, Enron often hired some of its best-paid executives from Anderson’s ranks. No wonder auditors were careful not to embarrass, anger or annoy Enron; it was the goose that laid golden eggs. Within the firm, Anderson’s people knew Enron was “high risk,” but they had no incentive to share that assessment with investors. Analyst conflict of interest — Analysts knew a good bit about Enron’s internal problems. As early as 1999, a J.P. Morgan analyst drew attention to the fact that Enron was booking revenues it couldn’t hope to receive for years (if at all). Howard Schilit, president of the Center for Financial Research and Analysis, told Congress, “For any analyst to say that there were no warning signs in the public filings, they could not have read the same public filings that I did.” However, analysts had no incentive to blow the whistle on Enron. In the past, they might have seen their jobs as evaluating stocks on behalf of investors. In the new Wall Street, however, analysts worked for big institutions that demanded demonstrable revenue from every department. Analysts were supposed to be team players who protected the firm’s relationships with valuable, profitable clients, such as Enron — that paying piper. Board conflict of interest — Enron has a star-studded board of directors. In theory, boards work for investors. But, in fact, almost every director on almost every board is selected by the CEO. The positions pay well, offer good perks and generally demand relatively little. Although somewhat more is now demanded of board members as a result of the Enron collapse, Enron’s board members had little to gain and a great deal to lose by challenging or defying their piper-paying, tune-calling management.

The Enron Drama The nuts and bolts of Enron’s financial shenanigans and the systemic failures that allowed its managers to perpetrate one of the greatest frauds of all time happened against a backdrop of color and drama. Inside Enron, power struggles pitted the ruthlessly Machiavellian Jeffrey Skilling against the flamboyant, brilliant Rebecca Mark. A couple of big players had affairs inside and outside of the office. For instance, the firm suffered great skullduggery at the hands of Nanjing-born Lou Lung Pai, a brilliant trader who cheated his colleagues with the same equanimity with which he cheated on his wife and children. He maintained an ex-stripper as a sort of concubine and had a child by her. Enron traders exploited California’s energy crisis, gaming the rules to pocket millions at the expense of the state’s taxpayers. But as colorful as those things are, they are not the enduring part of the Enron story. A massive structural failure allowed Enron to occur, and might allow another Enron to occur in the future.

About The Authors Bethany McLean and Peter Elkind are Fortune magazine senior writers.

The Smartest Guys in the Room

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