The Smartest Guys in the Room

The Amazing Rise and Scandalous Fall of Enron

Focus Take-Aways

Leadership & Mgt. • Enron, a massive energy management ﬁ rm, turned out to be a house of cards. Strategy • Its strong written code of ethics apparently did not inﬂ uence day-to-day operations. Sales & Marketing • Jeff Skilling, hotshot COO and, later, CEO, spun fantastic tales about Enron’s rich Corporate Finance 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 • He helped engineer and personally proﬁ ted from shady transactions that allowed Industries & Regions Enron to hide massive debts and report good results — until it declared bankruptcy. Career Development • Enron’s failure shook conﬁ dence in American markets and corporate governance. Personal Finance • Enron’s board and the various independent analysts who covered the company denied Concepts & Trends 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 (10 is best)

Overall Applicability Innovation Style 9 7 8 10

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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 ﬁ rst 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 beneﬁ t 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

The End At 2:00 a.m. on Sunday, December 2, 2001, attorneys for Enron fi led 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 “It is utterly beyond seventh largest fi rm. question that in reshaping Enron after he was Six months later, a court found Enron’s auditor, Arthur Andersen, guilty of destruction of named its presi- evidence. The evidence consisted of memoranda, letters and thousands and thousands of dent, Skilling pages of other information about Enron. David Duncan, the Arthur Andersen partner who turned it into a had helped instigate the document shredding, also pled guilty to obstruction of justice. place where fi nancial deception became almost Securities analysts tried to use the Andersen convictions as an excuse for their own inevitable.” 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 fi rms 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 fi rms became targets of Securities Exchange Commission (SEC) and Justice Department investigations after the scandal broke. Merrill Lynch accepted a settlement under which “Like many of the it paid $80 million in fi nes, but it did not admit any guilt. other major players in the Enron Meanwhile, Enron’s own board of directors disclaimed any responsibility for failing to saga, Jeff Skilling made his way to oversee the company’s operations or to make sure that the executives were doing business the top of Amer- legally and ethically. They said that the company’s clever managers had deceived and ican business by blinded them, presenting false numbers that they had no reason to doubt. But Enron’s sheer force of will.” 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 © Copyright 2004 getAbstract 2 of 5 strains credulity to imagine that the board members, with their access to privileged information and their power to hire or fi re managers, could not see as much as outsiders with access only to fraudulent fi nancial reports. “Baxter had a towering ego and But most people involved with Enron lost. Employees lost. Stockholders lost. Pension funds a volatile person- lost. Even people who never bought a share of Enron stock lost when Enron went down, ality…Though he because Enron’s failure rocked the fi nancial foundations of America. What happened? eventually made millions at Enron, he also com- The Frauds plained frequently Many things were wrong with Enron and, after its demise, many people were that he was under- willing to explain them. But the proximate cause of Enron’s failure was a series of paid and unappre- illegitimate fi nancial transactions involving what accountants and investment bankers ciated.” call structured fi nancings. The story of Enron’s fi nancial 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:

• Borrow — But the more Enron borrowed, the higher its cost of borrowing became. “To the outside world, the person Banks and bond buyers base their lending decisions on a company’s risk. The more who was Enron, a company borrows, the higher its risk and the lower its credit rating. The lower its who had a repu- credit rating, the more it has to pay to borrow. tation for turning impossible con- • Issue stock — The company had issued stock successfully, and its stock price was cepts into glittering high. However, the law of supply and demand works in the stock market as in any realities, was not other market. The more shares of stock in a company there are on the market, the Skilling. It was smaller each share is. Issuing a disproportionate number of shares “dilutes” the Rebecca Mark.” 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 ﬁ nance — Using certain innovative transactions, Enron could make bil- lions of dollars in capital appear without borrowing or issuing stock.

The choice among these was no choice at all. Fastow opted for structured ﬁ nance. 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 “One of Enron’s unaware of Fastow’s creativity or innocent of any involvement in it. In fact, Cliff Baxter, key advantages another Enron executive, told Skilling he was concerned, noting, “You could never tell over its competitors was informa- whether deals were clean because they were so complicated.” When the dimensions of tion: it simply had Enron’s malfeasance became public, Baxter committed suicide. more of it than its competitors.” 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 afﬁ liate. A few equity investors bought stock

The Smartest Guys in the Room © Copyright 2004 getAbstract 3 of 5 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 “People at Enron at this and conclude that Enron had borrowed a lot of money. True. But accounting rules simply didn’t allowed Enron to treat Whitewing as a “minority interest transaction,” which let Enron believe they were account for its borrowing as investment in a joint venture. Whitewing owned only Enron vulnerable.” 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 fi rms and bankers, offering in exchange some paper that committed Osprey to pay a fi xed 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 “Everything was perception; noth- money cleverly, too. When Enron needed revenues to meet fi nancial projections, Osprey ing was real.” would “buy” assets from Enron. Osprey had two very signifi cant characteristics: • 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. 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 “The enormous Osprey, Enron also made liberal use of “securitization,” which means selling investors a profi ts Enron’s share in a stream of revenues. Banks sell mortgages to investors using “securitization.” traders made in Credit card companies also use securitization to turn their receivables into ready cash. 2000 and the fi rst half of 2001 had Enron used an accounting device called a special purpose entity (SPE). Accounting raised a fi nal, regulations clearly stated that if as little as three percent of an SPE’s ownership was sobering question: independent of Enron, Enron could treat the SPE as a totally independent entity, and say how long could they keep it up?” 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:

• 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 fl exing the defi nition of independence to the breaking point. • Essentially, Enron borrowed huge sums of money from investors and reported the “There were other borrowings as revenues or cash fl ow instead of as debt. warning signs. Enron’s debt was Enron’s use of structured fi nancings and SPEs was probably the most aggressive in climbing rapidly — $3.9 billion of debt history. It may be an indication of Andy Fastow’s wit that he named a number of his most was added on the creative fi nancings after characters in the fi lms Star Wars and Jurassic Park. balance sheet in the fi rst nine The Cover Up: “He Who Pays the Piper Calls the Tune.” months of 2000 alone — which As long as Enron concealed the truth from investors, its share price continued to didn’t make rise. In theory, the stock market is full of checks and balances, including sharp-eyed sense.” 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 © Copyright 2004 getAbstract 4 of 5 • Auditor confl ict 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 “Above all else, Andersen did a lot of other business with Enron. In fact, in 2000, Andersen earned Jeff Skilling $52 million from its business with Enron, and most of that had nothing to do with believes this: ‘They killed a great auditing. The old saying, “He who pays the piper calls the tune” sums up Arthur company’.” 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 fi rm, Anderson’s people knew Enron was “high risk,” but they had no incentive to share that assessment with investors. • Analyst confl ict of interest — Analysts knew a good bit about Enron’s internal prob- lems. 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 fi lings, they could not have read the same public fi lings that I did.” However, analysts had no incentive to “’It started out as blow the whistle on Enron. In the past, they might have seen their jobs as evaluating pure, clear, legiti- stocks on behalf of investors. In the new Wall Street, however, analysts worked for mate deals,’ says a former senior big institutions that demanded demonstrable revenue from every department. Ana- Enron executive, lysts were supposed to be team players who protected the fi rm’s relationships with ‘And each deal valuable, profi table clients, such as Enron — that paying piper. gets a little bit messier and mess- • Board confl ict of interest — Enron has a star-studded board of directors. In theory, ier. We started out boards work for investors. But, in fact, almost every director on almost every board is just taking one hit selected by the CEO. The positions pay well, offer good perks and generally demand of cocaine, and the relatively little. Although somewhat more is now demanded of board members as a next thing you know, we’re im- result of the Enron collapse, Enron’s board members had little to gain and a great deal porting the stuff to lose by challenging or defying their piper-paying, tune-calling management. from Columbia.’” The Enron Drama The nuts and bolts of Enron’s fi nancial 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 fl amboyant, brilliant Rebecca Mark. A couple of big players had affairs inside and outside of the offi ce. For instance, the fi rm 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.