The Smartest Guys In The Room: The Rise and Fall of Enron
The title of Bethany McLean and Peter Elkind’s 2003 book about the rise and fall of Enron is conveyed with a knowing wink. Ken Lay, Andy Fastow and Jeff Skilling thought they were smart but the reader knows otherwise.
The Smartest Guys In The Room: The Amazing Rise and Scandalous Fall of Enron
Bethany McLean and Peter Elkind, 2004
In fact Enron did often do smart things. Enron Online, a computerized trading venue for energy contracts launched shortly before the new millennium, was genuinely innovative. The user-friendly EOL was adopted by its rivals but came with a catch: Enron itself served as the counterparty for every trade. That meant it knew exactly what all its competitors were up to and could position for where the gas market was heading next.
Unfortunately — and this is the better-known part of the Enron story — most of the Texas giant’s innovatory activities concerned its balance sheet. I’d wanted to read the McLean/Elkind book for a while because I vaguely knew it was about the perils of structured finance, an area I sometimes write about, but I was unfamiliar with the mechanics. At more than 400 pages the book is a forensic yet colourful exposition of the twisted genius and venality of its leading executives.
There are all kinds of strands to Enron’s failure, one of which — Rebecca Mark’s Enron International infrastructure division — I mention only because of its relevance to the high-profile struggles of U.K. building contractors in 2018. Mark, a charismatic, globetrotting executive desperate to sign deals to raise her profile in the company, led Enron into several money black holes, most infamously a contract to build power plants near Mumbai. The margins on such projects were vulnerable to a myriad of mega-project risks but in the short-term it didn’t matter. Enron International booked the expected lifetime earnings upfront. Unexpected costs and provisions were a tomorrow problem that would be eclipsed by bigger and bigger deals.
In the meantime Mark’s division, like the rest of Enron, disdained efforts to conserve cash, spending freely on private jets, hotels and cash bonuses. A gleaming new corporate headquarters in Houston was completed just in time for its bankruptcy.
Enron’s criminal behaviour — for which its Sun King Chairman Ken Lay, McKinsey-trained CEO Jeff Skilling and CFO Andy Fastow were eventually convicted — was to fake profits and hide debt.
Enron borrowed a huge sum of money but much of it didn’t really look like debt. On one occasion Enron sold three floating power plants off the Nigerian coast to Merrill Lynch, one of its fee-hungry bankers. What Merrill and Enron knew, and its auditors Arthur Andersen may have known, was the unwritten understanding behind the deal. Enron would find a buyer for the barges within just six months, cashing out Merrill’s equity stake at a pre-agreed, handsome profit.
The Nigerian barges amounted to a bespoke form of repo financing, a form of debt, which Enron did on an industrialized scale through its commodity-trading business with billions of dollars of ‘prepays’. Enron sold gas or oil to an entity set up by its lenders. Later it bought similar contracts from the same entity, booking each leg of the contract as trading assets and liabilities. The two separate transactions amounted to a singular loan - with interest. The contemporary notes of the dealmakers involved eliminates the need for an elegant flowchart explanation: “Enron loves these deals as they are able to hide funded debt from their equity analysts,” a Chase Manhattan banker said in a 1998 email.
To pick another small but egregious example, Merrill Lynch agreed a fee, later reduced, of $17 million for another paired commodity trade whose purpose was to generate $50 million of profit that Enron used to make the next quarter’s earnings target. Discussing the deal one Merrill executive told a skeptical colleague that there were “17 million reasons” to go ahead. The question of whether such chunky fees represent deserved commission for bespoke financing or something less edifying is one that Goldman Sachs is currently grappling with in Malaysia.
By 1998 Andy Fastow had risen to become Enron CFO. His attractiveness to Skilling concerned his expertise in using ostensibly independent, off-balance sheet special purpose vehicles. The SPVs, which had eccentric names likes JEDI and Chewco (yes, after Chewbacca), helped Enron meet its targets by purchasing Enron assets and boosting its earnings.
The SPVs were thinly capitalized, first by Fastow personally, also his friends and family and later — as the vehicles grew — by banks eager to curry favour with Enron. They also borrowed money secured by Enron shares. The arrangement was an ‘accounting artifice…rooted in the fundamental belief that Enron stock would never fall’, Mclean and Elkind write.
Fastow deceived Enron about his personal enrichment from the scheme but it wasn’t hard for others to see lines being crossed. In 1999 the firm’s directors breezily agreed to waive the company ethics code to allow Fastow to run a new SPV called LJM. From that entity alone Fastow earned $25 million. An Enron lawyer personally made $1 million on a $5,800 investment with Fastow.
The Enron story is partly one of fraudulent deceit but less so than I imagined before starting the book. In fact few of Enron’s fruitiest deals passed by unquestioned by its advisors. The problem was that the few people best equipped to rein in Enron, those who truly understood its ‘artifice’, had too much to gain by going along.
