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

by Bethany McLean

  Back then, oil trading was the hot new thing, both on Wall Street and in the oil patch. The big oil companies had long traded contracts promising to deliver oil in the future. This was a way to lock in a profit and mitigate the risk that oil prices would rise or fall. But the business had been limited by a couple of factors. For one thing, there was no standard contract for oil, which meant that the details of every trade had to be hammered out separately. And second, these contracts, by definition, meant that a cargo of oil would be delivered (or received)

  at a certain time in the future. Because there was so little trading—so little liquidity, as they say in the business—there was little opportunity and a lot of risk for those who didn’t actually want to take possession of the oil. These factors tended to keep most speculators away.

  In 1983 the New York Mercantile Exchange began to trade crude oil futures, in effect, a standard version of these contracts. Yes, the contract still theoretically came with the obligation to deliver, or receive, oil in some future month. But now that there was a standard contract, it could be traded many times over before anyone had to receive any oil. (If, indeed, oil was received at all: many times, the contracts were settled financially.) Suddenly oil looked a lot like other commodities, such as soybeans or pork bellies, or a financial instrument, like a stock or a bond. Suddenly, you could speculate in the stuff.

  As a general rule, trading begets more trading. As a market becomes liquid—meaning that it’s easier to find a willing buyer or seller—it attracts more participants. That further increases the liquidity, which further attracts new participants. Fueled by this so-called virtuous circle, the oil-trading business exploded in the mid-1980s. Texaco and the other major oil companies were no longer content to trade merely as a price hedge. Now they hoped to make money purely on the act of trading. It wasn’t long before they all had trading desks. And it wasn’t just the energy industry that piled in. Wall Street firms like Drexel Burnham Lambert (whose most famous employee was Michael Milken) and Goldman Sachs jumped into the business. So did many less reputable players, sketchy fly-by-nighters who saw a chance to make quick profits. By some accounts, those early years in the oil-trading business were wild and woolly. There were all kinds of little scams being run, even by the reputable trading firms. Yet there was also a seemingly limitless opportunity to make money.

  Borget, for his part, loved playing the role of a big-time oil trader. He kept Dom Pérignon and caviar in the office refrigerator for afternoon toasts. He and his traders dressed casually—Borget would even wear jeans—before the term business casual was widespread. They all drove company cars and ate daily catered lunches. A former trader named David Ralph Hogin recalls that Borget drove a Mercedes; when Hogin asked for a Mercedes, too, he was told that “Lou’s the only one who has a Mercedes. Would you settle for a Cadillac?” Enron Oil’s offices in Valhalla were sleek and modern and sheathed in glass, a far cry from the more modest quarters favored by energy industry executives. Borget himself could be charming, but he also could be intimidating; he had an odd combination of corporate polish and a trader’s swagger. “He was very intelligent, very imposing, sophisticated, and slick,” recalls someone who knew him then. Traders were loyal to him; they liked both his unflappability and his steadfastness in sticking by his trading decisions.

  “We were the golden-haired boys in the Enron fold,” recalls Hogin. In 1985, the year of the InterNorth-HNG merger, Borget’s group made $10 million. The following year—a year when Enron’s ongoing business lost money—the oil traders made $28 million for the company. That year their bonus pool was $9.4 million, to be split among just a handful of traders. (Borget kept the lion’s share for himself.) And there was every expectation that Borget and his crew would keep pumping profits into the company. As Borget himself put it reassuringly, in a 1986 report he prepared for the Enron board: oil trading “as done by professionals in the industry today, using the sophisticated tools available, can generate substantial earnings with virtually no fixed investment and relatively low risk. . . .” In other words, it was the perfect modern business.

  Or was it?

  • • •

  The first sign that Enron Oil might not be what it appeared came in early 1987. On the morning of January 23, David Woytek, the head of Enron’s internal audit department, received a startling phone call from someone at the Apple Bank in New York. An Enron account had been opened by a man named Tom Mastroeni. Mastroeni was a nervous yes-man who served as the treasurer of Enron Oil. Wire transfers amounting to about $5 million had been flowing in from a bank in the Channel Islands, and over $2 million had flowed out to an account in Mastroeni’s name. Alarmed, Woytek immediately called Enron’s general counsel, Rich Kinder, who was rapidly becoming Ken Lay’s most trusted lieutenant.

  Kinder told Woytek to track down Borget’s nominal superiors, John Harding and Steve Sulentic, who oversaw Enron Oil from Houston. While Woytek tried to track down the two men, his deputy, John Beard, made another frightening discovery: the Apple Bank account could not be found anywhere on Enron’s books. To the auditors, this reeked of disaster. Beard jotted his worst fears in his notes: “misstatement of records, deliberate manipulation of records, impact on financials for the year ending 12/31/86.”

  But according to internal documents, court testimony, and notes detailing these events, Sulentic and Harding had an explanation for the whole thing. The Apple Bank account was part of a tactic Borget had used to “move some profits from 1986 into 1987 through legitimate transactions,” Woytek noted in a memo; Borget had done so because “Enron management had requested” it. Nor was this the first time that Borget had shifted profits. Since 1985, the oil trader had been setting up prearranged deals with other entities—they had names like Isla, Southwest, and Petropol—that in essence allowed Enron Oil to generate a loss on one contract then have the loss cancelled out by a second contract that would generate a gain in the same amount. Using this technique, Borget had repeatedly moved income from one quarter to another. In his memo, which he sent to Lay and other Enron executives, Woytek described this as the creation of “fictitious losses.”

  Harding now insists that whatever happened was not profit shifting, just the “prepayment of expenses,” and that he believed Borget’s actions were perfectly legal. But in testimony given over a decade ago, Borget said that Harding asked him to shift profits, originally for tax reasons. He also said that Harding approved bonuses as if the shifted profits from Enron Oil had remained in the year in which they were earned. For his part, Sulentic later testified that Enron Oil and other subsidiaries were “routinely instructed by Enron senior management to shift profits from month to month and year to year.”

  It was easy enough to understand why Enron would want to do this: like every public company, it hoped to show Wall Street that it could produce steadily increasing earnings, which is what the stock market rewards. Indeed, lawyers later charged that Enron used the profit shifting for precisely that purpose. But it also had a more pressing reason: Enron’s ability to get bank loans absolutely depended on its ability to show earnings. Under the terms of its long-term bank debt, Enron was required to produce a certain amount of income every quarter, at least 1.2 times the interest on its debt. What’s more, because Enron was so strapped for cash, it constantly needed new loans to pay back maturing loans. In 1986, for instance, Enron had over $1 billion in commercial paper—short-term loans that mature quickly—that needed to be refinanced. With all its mid-1980s problems, Enron was constantly on the verge of being in violation of its loan agreements. As Lay put it in an Enron annual report about that time: “The present business climate provides no margin for error.”

  Later, in court testimony, Borget described Enron Oil as “the swing entry to meet objectives each month.” Extra earnings in one quarter didn’t do Enron much good—unless the income could somehow be deferred to help the company meet its targets in the next quarter. It was all very logical, really. Profit shifting can be done l
egally—though even then it amounts to earnings manipulation. What subsequent events showed was that no one wanted to dig deeply enough to see if Borget and Mastroeni were staying on the right side of the law.

  • • •

  On February 2 Borget and Mastroeni were summoned to Houston. They met in

  the office of a man named Mick Seidl, an old Ken Lay buddy who had followed Lay from Florida Gas to Enron and served as his number two. Woytek and Beard, the internal auditors, were there, as were a number of Enron’s senior executives, including Kinder, Harding, and Sulentic. (Some people remember Lay being present; Harding says he wasn’t there.) Sulentic defended the transactions. In a memo he wrote summarizing his views, he argued that Enron Oil’s Apple Bank account, and its transactions with Isla, Southwest, and Petropol “represents a sincere effort on their [Borget and Mastroeni’s] part to accomplish the objective of a transfer of profitability from 1986 to 1987.” He did concede that the methods Borget and Mastroeni had used were “not acceptable,” but he didn’t recommend any sort of punishment, not even a public admission of what had happened.

  Next up was Mastroeni. While admitting that he had diverted funds to his personal account, he insisted that it was merely part of the profit-shifting tactic and that he had always intended to repay the money. He presented bank statements, however, that the auditors knew had been doctored, because they had gotten the original documents from Apple Bank. What was Mastroeni’s explanation? He and Borget had paid a bonus to a trader and didn’t want to have to explain it to corporate executives. Stunningly, most of the Enron executives in the room appeared to accept Mastroeni’s explanation. Mastroeni wasn’t even reprimanded. Neither was Borget. Says an Arthur Andersen accountant who was involved, “No one pounded the table and said these guys are crooks. They thought they had the golden goose, and the golden goose just stole a little money out of their petty cash.”

  Still, the internal auditors continued to dig. They discovered a $7,800 deposit into the Apple Bank account from the sale of Borget’s company car. There were payments totalling $106,500 to an M. Yass. Was this a play on “My ass?” Not at all! Borget said he was an English broker who had faciliated the bonus to the Enron trader; Mastroeni claimed he was a Lebanese national. They searched directories of trading organizations looking for the names Isla, Southwest, and Petropol and came up empty-handed. They went to Valhalla but didn’t get very far. Finally, they got the word: they were to return to Texas and turn the investigation over to Enron’s accountants at Arthur Andersen. “Fieldwork . . . not completed based on advise [sic] from Houston,” jotted Beard at the time. There was no doubt by then what the auditors thought of the Enron Oil operation. “They were a bunch of scam artists,” one of them said years later.

  For the next few months, the Arthur Andersen team took up the investigation, but they didn’t get much further than the internal auditors did. The Enron executives were terrified of offending Borget. Before the accountants went to Valhalla to interview Borget, Seidl sent the head oil trader a memo detailing Andersen’s concerns so that he would be better prepared to address them. After one conference call among Arthur Andersen, Seidl, and Borget, Seidl sent a telex to Borget. “Lou,” it read. “Thank you for your perservance [sic]. [Y]ou understand your business better than anyone alive. Your answers to Arthur Andersen were clear, straightforward, and rock solid—superb. I have complete confidence in your business judgment and ability and your personal integrity.” Then he added, “Please keep making us millions. . . .”

  In late April, Arthur Andersen discussed its findings with the audit committee of the board. The accountants told the board that they “were unable to verify ownership or any other details” regarding Enron Oil’s supposed trading partners. They noted that the Apple Bank transactions had no purpose beyond shifting profits. And they’d found a few other troubling things. For instance, Enron Oil was supposed to have strict controls to prevent the possibility of large losses; its open position in the market was never supposed to exceed 8 million barrels, and if losses reached $4 million, the traders were required to liquidate the position. Yet when the Arthur Andersen auditors had tried to check whether Enron Oil was complying with the policy, they later reported, they discovered that Borget and Mastroeni had made a practice of “destroying daily position reports.”

  Still, Andersen refused to opine on the legality of what had come to be known internally as Borget and Mastroeni’s “unusual transactions,” claiming that it was beyond their professional competence. Nor were the auditors willing to say whether the profit shifting had a material effect on Enron’s financial statements. Both things would require the company to disclose the transactions to the Securities and Exchange Commission, restate its earnings, and face possible sanctions from the IRS. Instead, the auditors said, they were relying on Enron itself to make those determinations. And Enron did. Arthur Andersen noted that the firm had received a letter from Rich Kinder and another Enron lawyer concluding that “the unusual transactions would not have a material effect on the financial statements . . . and that no disclosure of these transactions is necessary.”

  And that, stunningly enough, was that. According to the minutes of that same board meeting, “Dr. Jaedicke called upon management for a matter that involved Enron Oil Corporation that was investigated by the company and subsequently investigated by Arthur Andersen. . . . After a full discussion, management recommended the person involved be kept on the payroll but relieved of financial responsibility and a new chief financial officer of Enron Oil Corporation be appointed. The committee agreed with reservations. . . .”

  “Management,” says Woytek, was Lay—who openly said at the board meeting that the traders made too much money to let them go. And the new watchdog chief financial officer was none other than Steve Sulentic, who, once he moved to Valhalla, reported to Borget. “Dr. Jaedicke” referred to Dr. Robert Jaedicke, then the dean of the Graduate School of Business at Stanford and the head of Enron’s audit committee.

  Two months later, what lawyers later called a “whitewash” was completed when an Enron lawyer wrote a memo—which Kinder eventually sent to the board—concluding that the profit-shifting deals were “legitimate common transactions in the oil trading business” and that they did not “lack economic substance.” In other words, there was no reason to report the transactions to the outside world. It was an absurd position to take, given that an in-house auditor had called the transactions “fictitious.” But not terribly surprising. As one lawyer on the Enron side remarked many years later, “Enron knew they were crooks. But they thought they were profitable crooks.”

  • • •

  As it turned out, Borget and Mastroeni weren’t engaging in criminal acts just for the good of the company. They were stealing from Enron as well. They were keeping two sets of books, one that was sent to Houston and one that tracked the real activities of Enron Oil. They were paying exorbitant commissions to the brokers who handled their sham transactions and demanding kickbacks. The so-called counterparties—Isla and Southwest and Petropol—weren’t legitimate trading entities. They were creations of Borget and Mastroeni, phony companies they set up in the Channel Islands. Mastroeni’s Apple Bank account was indeed one of the places he and Borget were hiding money they had skimmed from the company. In total, the two men and the other brokers stole some $3.8 million from Enron. And with Ken Lay and the other Houston executives so willing to look the other way, they would have gotten away with it, too, except that they made the one mistake Enron couldn’t abide. They stopped making money.

  Back in Houston there had always been a few executives who were skeptical of the oil traders. One was Mike Muckleroy, the head of Enron’s liquid-fuels division and a former naval officer. An experienced commodities trader, Muckleroy had begun to hear rumors in mid-1986 that Enron Oil was making massive bets on the direction of oil prices. One thing that had long seemed obvious to Muckleroy was that Enron Oil had to be ignoring the trading limits that were supposed to
prevent the traders from huge losses. Nothing else made sense. After all, the limits didn’t just keep losses under control; they also had the inevitable effect of limiting gains as well. To Muckleroy, it just didn’t seem possible that the Enron’s oil traders could be racking up their eye-popping profits without exceeding their trading limits. He took his worries to Seidl, who scoffed and replied that Muckleroy must be jealous of Borget’s bonus.

  The rumors wouldn’t go away. At least a half dozen times, Muckleroy says, he pressed his concerns with Seidl. Finally, Seidl sent him to Lay. But the Enron CEO was no more interested in looking into it than Seidl had been; he told Muckleroy that he was being paranoid. “What do I have to do to get you to understand that this could do devastating damage to our company?” Muckleroy asked Lay. Then, in the summer of 1987, Muckleroy began to hear from friends in the business, as he later recalled, “that we were huge on the wrong side of a trade.” But so unconcerned were the Enron brass that at the company’s mid-August board meeting, the Enron board increased Borget’s trading limits by 50 percent. One skeptical Enron executive who attended that meeting returned to his office and told a colleague: “The Enron board believes in alchemy.”

  It wasn’t until October that the truth began to come out—and then only because there was simply no way to hide it any longer. On October 9, 1987, Seidl met Borget for lunch at the Pierre hotel in Manhattan. It was supposed to be a social lunch; Seidl’s wife was upstairs in her room, waiting to join them. But as soon as Borget explained the situation to Seidl, he immediately called his wife and told her to stay put. He spent the rest of the lunch trying to absorb what Borget was telling him. For months, Borget had been betting that the price of oil was headed down, and for months, the market had stubbornly gone against him. As his losses had mounted, he had continually doubled down, ratcheting up the bet in the hope of recouping everything when prices ultimately turned in his direction. Finally, Borget had dug a hole so deep—and so potentially catastrophic—that there was virtually no hope of ever fully recovering. Borget was confessing because he had no choice.