The Smartest Guys in the Room by Bethany McLean & Peter Elkind
As sordid a tale of ego and excess as the RJR Nabisco buyout appears in Barbarians at the Gate (review here), at least there does not seem to have been anything illegal going on. Unethical, perhaps. Greedy, undoubtedly. The battle of megalomaniacs is what makes the saga so interesting twenty years later. But at the end of the day RJR and Nabisco still exist (though in decidedly different forms), they still have employees, and their shareholders were not left completely out in the woods.
None of this can be said for Enron, which essentially spontaneously combusted via bankruptcy in late 2001, and managed to take venerable Big Five accounting firm Arthur Andersen along with it into the oblivion of business history. The story of Enron's "amazing rise and scandalous fall" has been the subject of several books, including Kurt Eichenwald's Conspiracy of Fools. First on the scene were a pair of Fortune writers, Bethany McLean and Peter Elkind; McLean had reported on Enron for the magazine and had been amongst the first journalists to turn a more critical eye toward the company, as early as March 2001 (still years after folks should have noticed what a boondoggle it was). They published The Smartest Guys in the Room in October 2003, less than two years after the company went bankrupt. Two years later the book was made into a documentary by the same name.
The story begins near the end, with the January 2002 suicide of Cliff Baxter, a senior Enron executive who had resigned the previous May. He had also been one of the closest friends of former Enron CEO Jeffrey Skilling, who was still making the case that Enron was a victim, not a villain, in the recent turmoil:
More than anyone else, Skilling had come to personify the Enron scandal. Part of it was his audacious refusal, in the face of a dozen separate investigations, to run for cover. Alone among Enron's top executives summoned before a circuslike series of congressional hearings, Skilling had ignored his lawyers' advice to take the Fifth and defiantly spoke his piece. The legislators were convinced that Skilling had abruptly resigned as CEO of the company--just four months before Enron went belly up--because he knew the game was over. But Skilling wouldn't have any of it... "Enron was a great company," Skilling repeatedly declared. And indeed that's how it seemed almost until the moment it filed the largest bankruptcy claim in U.S. history.
The Smartest Guys in the Room is not just the story of Enron's fall. Rather, it takes the long journey all the way from the start, with a young Kenneth Lay cutting his teeth in the natural gas business, finally rising to the top of Houston Natural Gas in 1984. Convinced that deregulation of the natural gas industry was imminent, "Lay operated on one theory: get big fast." Fortune shined upon him in the figure of InterNorth, an Omaha-based pipeline company that offered to purchase Lay's company. Lay and his negotiation team obliged, "letting" InterNorth buy Houston Natural Gas, with a couple catches: they would have to pay a 50% premium on the current stock price, and Lay would have to take over the combined company within 18 months. Not a bad deal for Lay, though it got even better when Lay bullied the InterNorth CEO out almost immediately, with the help of consultants from McKinsey (including a young man named Jeff Skilling). Slowly but surely, Lay began to purge the InterNorth faction, install his own men, and even come up with a new name for the company:
After four months of research, the New York consulting firm Lay had hired had settled on Enteron in time for the merged business's first annual meeting, in the spring of 1986. But then the Wall Street Journal reported that Enteron was a term for the alimentary canal (the digestive tract), turning the name into a laughingstock. Though it meant reprinting 75,000 covers that had already been printed for the new annual report, the board convened an emergency meeting and went with a runner-up on the list: Enron.
Of course, it would only be 15 years before the name Enron itself became a laughingstock. As McLean and Elkind trace the rise of Enron, we see the entrance of major players like Skilling, Rebecca Mark (who ascends to lead the disastrous international division before resigning in disgrace... with $80M in cashed-in stock options), and financial "wizard" Andrew Fastow. Several themes quickly emerge: Enron executives think they are smarter than everyone else, believe they are entitled to live off the company's expense accounts, and have virtually no idea how to run a successful business. Take Mark's international division for example:
What one former international executive calls the "fatal flaw" in the business was the compensation structure. Developers got bonuses on a project-by-project basis. The developers would calculate the present value of all the expected future cash flow from a project. This was also the model the banks used to lend money. When the project reached financial close--that is, when the banks lent money but before a single pipe was laid or foundation was poured--they were paid.
No wonder the developers were so eager to move on to the next deal; they had no financial incentive to follow through on the one they'd just completed... It was crazy.. under this new pay arrangement, the only thing that matter was making the deal happen. The more deals Enron International did, and the bigger they were, the richer the developers got. The system encouraged international executives to gamble without risk. The deeper problem, one that emerged in later years, was that no one was held responsible for the operation of a project, yet it was the operation that produced the real money.
Yet preposterous as this was, it was not illegal. It was simply the sort of unbelievably bad decision-making that would normally scare off Wall Street and drive a company into bankruptcy. And yet Enron was just hitting its stride, and had years of double-digit growth ahead of it (McLean and Elkind have to sheepishly admit that Fortune named Enron the most innovative company six years in a row). How did that happen? It turns out that Skilling, incompetent though he might be at, you know, producing anything of value, was a master at manipulating Wall Street. He understood that financial analysts thrived on a company's financial data, its accounting. So that's where the growth and profits had to be. On paper:
Invariably, as the quarter drew to a close, Enron's top executives would realize they were going to fall short of the number they'd promised Wall Street. At most companies, when this happens, the CEO and chief financial officer make an announcement ahead of time, warning analysts and investors that they're going to miss their number. In other words, the reality of the business drives the process of dealing with Wall Street. Not at Enron. Enron's reality began and ended with hitting the target. And so, when the the realization took place that the company was falling short, its executives undertook a desperate scramble to fill the holes in the company's earnings. At Enron, that's what they called earnings shortfalls--"holes."
At first, a lot of the holes could be filled by accelerating deals, often conceding major negotiating points simply to get the papers signed before the quarter ended. But the bad business decisions kept adding up, and the holes kept getting begin. And thus the reliance on the number crunchers increased, until Enron was leaning "heavily on mark-to-market accounting to help reach its earning goals." In its simplest terms, the way Enron used this accounting method was so to immediately book on paper all of the earnings it expected to earn from a deal as soon as the deal was signed. Thus a 10-year deal projected to be worth $40M per year signed in 2001 could be counted as $400M in earnings in 2001 rather than as the money actually flowed in. The obvious problem is that such projections could be, and at Enron were, heavily manipulated; rosier projections equals bigger earnings. This would be somewhat alleviated if Enron had treated its anticipated losses in the same way, booking anticipated losses immediately even if the losses would not be realized all at once. But Enron never did that. Projected earnings were booked immediately, anticipates losses ignored forever:
At the end of each quarter, for example, Enron was supposed to write off its dead deals. To review what needed to be booked, [Enron Chief Accounting Officer Richard] Causey met individually with the heads of the origination groups. At one meeting, an executive recalled, Causey kept coming back to a dead deal and asking: Was it possible the deal was still alive?
Finally the executive took the hint--and the deal was declared undead. Enron deferred the hit for another quarter. "You did it once, it smelled bad," says the executive. "You did it again, it didn't smell as bad."
Causey is now in federal prison for securities fraud. But even his valiant efforts could only go on for so long before financial analysts noticed that things were not adding up. Of course, they would only notice if all this accounting were taking place on Enron's corporate balance sheet. And this is where Andy Fastow really shined:
[I]f it's impossible to mark the moment Enron crossed the line, it's not hard at all to know who led the way. That was Andrew Fastow, the company's chief financial officer... Fastow became Enron's Wizard of Oz, creating a giant illusion of steady and increasing prosperity. Fastow and his team were the financial masterminds, helping Enron bridge the gap between the reality of its business and the picture Skilling and Lay wanted to present to the world. He and his group created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now. Fastow's fiefdom, called Global Finance, was, as Churchill said about the Soviet Union, a riddle wrapped in a mystery inside an enigma that was Enron's string of successively higher earnings.
Of course, eventually the whole thing unraveled. Many of Fastow's financial maneuvers were premised on the constant rise of Enron's stock price. As soon as a few short sellers and journalists started poking around in early 2001, and the stock prices stagnated and then dropped, it was mere months before the whole scheme collapsed. And with that collapse went thousands of jobs and tens of billions of dollars in vanished investments.
With good reason, McLean and Elkind end their narrative with the bankruptcy filing. At the time of the book's publication, the first wave of indictments had already been handed down to the likes of Lay and Fastow, but the authors had no way of knowing how these relatively novel prosecutions would turn out. It was months later that Fastow decided to enter his guilty plea and cooperate against his former colleagues in exchange for leniency for himself and his wife. Lay's trial would not take place until early 2006, when he and co-defendant Skilling would both be convicted of most of the numerous counts of conspiracy, false statements, securities fraud and insider trading lodged against them. Lay would die before his sentencing hearing, thus requiring the judge to vacate the convictions. Skilling was sentenced to more than 24 years and a $45M fine, but earlier this year the 5th Circuit ordered a new sentencing hearing while upholding the convictions. He's still looking at a likely double-digit term of confinement. Ironically, Fastow, probably the most personally culpable for the house of cards that came tumbling down in late 2001, was so cooperative that prosecutors lobbied the judge on his behalf; he'll be released in December 2011. Funny how those things work out.
It is also interesting to note the many parallel forces there were enabling the Enron scheme ten years ago and then the credit and subprime mortgage structure whose collapse rocked the markets last year. McLean and Elkind devote an entire chapter, titled "Everybody Loves Enron," to all the external forces that knowingly or negligently conspired to assist Enron's undeserved rise. Most obviously, the accountants were in on it. The banks and financial analysts were too busy getting rich off consulting fees to risk asking any questions about what in the world Enron actually did ("There was simply too much investment-banking business at stake not to have a screaming buy on the stock... the Chinese Wall had long since broken down, and during the bull market, analysts became increasingly instrumental in helping their firms land banking business.") The credit agencies' hands were dirty too:
[I]nstead of acting as the ultimate watchdog, the credit analysts unwittingly served the opposite purpose: they gave all the other market participants a false sense of security. Stock analysts and investors alike took solace in the fact that the credit analysts gave Enron an investment-grade rating... Thus did the responsibility to truly analyze Enron land nowhere. And thus the stock continued its climb.
Sounds awfully familiar, doesn't it? This too would almost be funny, if it was not so infuriatingly sad.