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

by Bethany McLean

  Enron was back in Wall Street’s good graces by 1998. That year, the S&P 500 had yet another big bull market run-up, gaining 27 percent. Enron easily outpaced the market index, rising 37 percent. The analysts had all restored their buy recommendations on the stock and were once again singing the company’s praises. Enron was once again posting steady annual earnings increases of 15 percent and above. The company was beating its quarterly numbers with such regularity that it seemed almost effortless.

  In fact, it was anything but effortless; there was nothing at Enron that required more effort, more cleverness, more deceit—more everything—than hitting its quarterly earnings targets. As out of control as Enron was on a day-to-day basis, the place went practically bonkers when the end of the quarter grew closer. For this, Skilling deserves the lion’s share of the blame.

  By the late 1990s, Enron had made a fundamental shift: trading and deal making were its core. By the estimation of one former executive, of the 18,000 people Enron employed in 1999, a stunning 6,000 were doing deals of one sort or another. And the vast majority of them—perhaps 5,000—were traders and originators working in Skilling’s merchant business, the descendant of ECT. “That was our business,” Skilling would later say. “We bought and sold stuff.”

  But that was something Skilling could never admit to the outside world. Partly that was because if Wall Street understood anything, it understood the inherent dangers of a trading operation. Back in December 1995, Skilling had gotten a taste of just how jittery Wall Street could be about trading. That month a rumor swept the Street: Enron had suffered a huge loss from shorting the gas market in the face of a cold snap that had sent prices soaring. What’s more, the rumor had it, Skilling had been led off the trading floor in handcuffs. The story was false, but it was a tale the market was more than willing to believe; Enron’s stock plummeted 27⁄8 points in a single day, wiping out $750 million in market value. The next morning, Lay, Kinder, and Skilling, who had all been skiing in Colorado, were forced to convene a conference call, where they refuted the rumors and insisted that Enron’s tight system of risk controls made such a catastrophic loss impossible. More than 170 anxious institutional investors and analysts listened in on the call.

  But it wasn’t just Wall Street’s nervousness that caused Skilling to skirt the truth about its core business. This was Enron’s dirty little secret: a company built around trading and deal making cannot possibly count on steadily increasing earnings. Skilling may have sold EOG in part because of the unpredictable nature of its earnings, but what he refused to acknowledge is that there is nothing more unpredictable than a trading desk. A trading desk can make or lose tens of millions of dollars in the blink of an eye. As one former Enron managing director says, “A business that had stable and predictable earnings that’s primarily engaged in the trading of commodities is a contradiction in terms.”

  Precisely because of their volatile earnings, companies whose business is primarily trading invariably have low stock valuations. Goldman Sachs, widely viewed as the best trading firm in the world, has a price/earnings multiple—the key valuation gauge—that rarely goes above 20 times earnings. (That means that the price of a share of the firm’s stock is 20 times the amount of its annual earnings per share.) Goldman Sachs never even attempts to predict its earnings ahead of time. It can’t.

  Enron’s valuation was twice that size by the late 1990s, and Skilling wanted to make it go higher still. So instead of admitting that Enron was engaged in speculation, he claimed it was a logistics company, which merely found the most cost-effective way to deliver power from any plant anywhere to any customer anywhere. There was some truth to that, it just wasn’t the whole truth. The Enron trading desk, Skilling added, always had a matched book—meaning that every short position precisely offset every long position—and made its trading money merely on the commissions, not on speculative risk. Right up until the end, Skilling and his lieutenants stuck to that line, long after it had become demonstrably false.

  That’s one reason why hitting the company’s earnings targets was so hard:

  it wasn’t in a business that naturally generated steadily growing earnings. Here’s the second reason: Skilling’s method of arriving at Enron’s quarterly and annual targets was downright perverse. Instead of going through a rigorous budget process and arriving at a number by analyzing all the business units and their prospects for the coming year as Kinder used to do, he would impose a number based solely on what Wall Street wanted. He would openly ask the stock analysts: “What earnings do you need to keep our stock price up?” And the number he arrived at was the number Wall Street was looking for, regardless of whether internally it made any sense.

  Under Skilling, the budget process at Enron was “a giant game of chicken,” recalls a former executive. “The numbers trickled down. You wanted to say, ‘Wait, I can’t do that.’ But you weren’t doing yourself a service if you did that.” Another executive adds, “It was just the allocation of big numbers. The budget process was last year’s number, plus x percent growth.”

  Invariably, as the quarter drew to a close, Enron’s top executives would realize that 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 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.”

  Calls went out from Skilling and chief accounting officer Rick Causey to the heads of the various company businesses. “We need an extra $15 million!” What rabbits could they pull out of their hats? Deal closings were accelerated so that earnings could be posted by the end of the quarter. This usually required capitulating on key negotiating points, which, over the long term, would likely cost the company millions. But that wasn’t the point: at least they’d make the quarter.

  Enron also relied heavily on mark-to-market accounting to help it reach its earnings goals. Originally, mark-to-market had been used only in the accounting of natural gas futures contracts—that, after all, is what the Securities and Exchange Commission had agreed to back in 1991. Over the years, Enron had quietly extended the practice. It marked-to-market its electric power contracts and trades after it got into that business. Then, in 1996, it began booking profits on its 50 percent portion of JEDI—the partnership it had established in 1993 with CalPERS—using mark-to-market accounting. By 1997, Enron had extended mark-to-market accounting to every portion of its merchant business. It even began using the approach to book profits on private equity and venture-capital investments, where values were extraordinarily subjective. By the end of the decade, some 35 percent of Enron’s assets were being given mark-to-market treatment.

  Enron employed other tricks. Deal makers regularly revisited large existing contracts—some more than five years old—to see if they could somehow squeeze out a few million more in earnings. Sometimes the contracts were restructured or renegotiated; other times, they were simply reinterpreted in ways that made them appear more profitable. “When the last-minute call for earnings went out,” says one high-level deal maker, “I’d go: ‘Which contracts did I do five years ago that had potential value?’ A lot of them you could remark.” Skilling himself labeled the contract portfolio “a gold mine.”

  Earnings projections on mark-to-market deals, based on complex models, were reexamined. Was it possible to be a little more optimistic? A small move in a long-term pricing curve could generate millions in extra accounting profits. The curves often went so far into the future that drawing them was already little more than an educated guess. The danger was that skewing curves to generate more profits was not
only improper but also raised the likelihood that the curves would turn out to be way off base, producing a big mismatch between Enron’s projections and a reality it would eventually have to face. But that, of course, was a future concern, far removed from the crisis of the immediate quarter.

  Another trick was to delay recording losses. At the end of each quarter, for example, Enron was supposed to write off its dead deals. To review what needed to be booked, 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?

  It wasn’t, responded the executive.

  “So there’s no chance of it coming back?”

  No.

  “Is there even a little bit of a chance of it coming back?” asked Causey. “Do you want to look at it again?”

  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.”

  Enron also generated earnings through tax-avoidance schemes. Beginning in 1995, the company executed 11 mind-numbingly complex tax transactions that allowed Enron to bank some $651 million in profits. The deals were cooked up in Enron’s tax department, whose head count grew to 250. The department was run by a grizzled tax lawyer named Bob Hermann, who had begun with Houston Natural Gas back in 1981. The first of the deals, dubbed Project Tanya, involved setting up a special entity to manage deferred compensation and benefit programs, which then issued preferred stock that was transferred back to Enron. It generated $66 million in earnings.

  The point man on the special tax deals was a conspiratorial CPA and lawyer named R. Davis Maxey, who quietly traveled the country meeting with tax specialists at banks and law firms to come up with new ideas. One by one, he teed up deals, which often took as much as a year to develop and were supposed to generate savings that stretched over a period of as long as 20 years. Enron’s high-priced tax advisers—a law firm might earn a fee of $1 million for a single transaction and a bank could earn as much as $15 million—had urged the company to keep a low profile on the schemes, lest they attract the ire of the Internal Revenue Service. But after Skilling became Enron’s COO, the company increasingly turned to its tax department to act like just another profit center—and help the company hit earnings targets by taking more and more of the tax savings early. “In effect, we have created a business segment for Enron that generates earnings,” Maxey wrote in an e-mail.

  Whatever the propriety of these maneuvers, they all had one clear effect:

  they rolled Enron’s problems further into the future, where the issues slowly accumulated.

  • • •

  Like many companies during the bull market, Enron began to invest in other businesses—a few dozen private and public companies. Skilling called this part of the business Enron’s merchant investment portfolio. Not surprisingly, as the company’s holes grew larger, the equity portfolio became yet another earnings-management vehicle.

  Take, for instance, Enron’s investment in Mariner Energy, a privately owned Houston oil and gas company that did deepwater exploration. Enron took control of Mariner in 1996 in a $185 million buyout. Private-equity investments are often tricky to value since they’re not publicly traded; and deepwater drilling is highly speculative. In the years that followed, this made the precise value of the company uncertain. Enron exploited this uncertainty by periodically marking up the value of Mariner as needed to fill earnings holes. Such valuation increases could immediately be booked as mark-to-market income through an aggressive approach called fair-value accounting that Enron began using about that time.

  When Enron got in an earnings bind, says one Enron vice president familiar with the situation, “People were asked to look and see if there’s anything more we can squeeze out of Mariner.” And squeeze they did. Indeed, Mariner served as a sort of piggy bank for Enron earnings. By the second quarter of 2001, Enron had Mariner on its books for $367.4 million, by any reasonable measure, an absurdly high amount.

  Mariner was a prime example of how Enron executives made a mockery of the RAC process. A postbankruptcy review by Enron’s new chief accounting officer concluded that the company’s Mariner investment was really worth less than a third of what Enron had claimed. (This resulted in a write-off of $256.9 million.) In fact, even while the Mariner investment was being marked up to book profits, RAC analysts consistently challenged the valuation. According to the accounting review, Enron, during much of 2001, justified its inflated figure using “a model that was not supported by RAC” and was rigged with outlandish assumptions. Enron carried Mariner on its books throughout this period for about $365 million; its own internal-control group placed its value in a broad range between $47 million and $196 million.

  The review noted: “The accounting for Mariner in the second and third quarters of 2001 used valuations not endorsed by RAC in accordance with the Company’s internal control system.” It added that there was “no documentation justifying this control override” and that “this exception to the established internal accounting control procedures [was] not brought to the attention of the Audit and Compliance Committee for consideration or review.” In fact, according to RAC executives, their own boss, Rick Buy, refused to press the matter of Mariner’s inflated valuation with Enron’s top executives. Buy, a former energy banker, certainly knew the investment well: Enron had appointed him to the Mariner board.

  There was also a part of the merchant portfolio known as the Industrial Group. The twenty or so deal makers who made up this group were led by an Enron executive named J. Kevin McConville. Their job was to make equity investments outside the energy industry but with an eye toward energy-intensive businesses, where Enron might be able to cut related deals to provide their plants with electricity, coal, or gas.

  Beginning in 1997, McConville’s group cooked up a series of such complex deals. They bought equity in a paper manufacturer called Kafus, a steel maker named Qualitech, and a Thai steel mill company called NSM, among others. Ultimately, the only thing the Industrial Group’s deals had in common was this: they all lost money.

  Every Monday morning, a team of RAC analysts met to examine how Enron’s investments were performing. The list of portfolio assets was color-coded: green meant okay, yellow meant the deals needed work, and red meant big trouble. Increasingly, McConville’s investments were turning up red. In several cases, Enron hadn’t just bought equity in each of these companies; it had invested in other ways as well. Take NSM, a $650 million project to redevelop a troubled steel mill in Chonburi, Thailand. Enron not only bought 52 million shares of NSM stock and taken a seat on the NSM board; it also swallowed at least $20 million of a private $452 million junk-bond offering. Long before the plant could be redeveloped, though, the company went bankrupt, generating extensive litigation. Kafus and Qualitech were disasters too. Yet even as his deals deteriorated, McConville was promoted to managing director.

  McConville, a veteran Enron executive, attributes much of the criticism about his deals to jealousy over his rapid promotion. He says that if the energy-supply portion of the projects is considered—on which Enron routinely booked profits—about 30 percent of them made Enron money. He acknowledges that several, such as NSM (“a horrible failure”), turned into disasters.

  What really made his deals look worse than they were, says McConville, was that Enron recorded gains on the private-equity investments to book profits, just as it did with Mariner. “Every one of them was written up [in value],” he says. This meant the paper loss Enron faced was bigger than the cash investment the company had made. And Enron, of course, was loath to acknowledge any losses.

  That had always been the case with Skilling, who loved the gains his private-equity investments could generate but hated having to record the hit when they went south, as was supposed to be done under mark-to-market accounting. As e
arly as 1996, when ECT had moved from merely financing energy companies to making equity investments in them, Skilling fretted over this very issue to his portfolio management advisory committee. One of Fastow’s deputies, then known as Sherron Smith (she later rose to postbankruptcy fame, after getting married, as Sherron Watkins) recalls Skilling saying: “I don’t want to be the one to go tell Enron’s board we’ve had a big loss when we’re supposed to be such great risk managers.”

  Skilling was always looking for a hedge—even an imprecise “dirty hedge”—for Enron investments that, by normal standards, couldn’t be hedged. In one such case, he tried to protect a gain in some securities that couldn’t be sold by ordering Enron’s traders to buy S&P 500 puts. At one point, Watkins recalls, Skilling tried to hire an expert to develop new hedging techniques for locking in gains on Enron’s private-equity investments. After meeting with everyone involved, the candidate refused to take the job, explaining that the venture was doomed to failure because Skilling wanted to accomplish the impossible. “It’s called equity risk for a reason,” he told Watkins.

  For McConville, the day of reckoning arrived in 1999 after RAC toted up the industrial portfolio’s losses: they came to more than $400 million. McConville soon left the company. Belatedly, Skilling decided to pull the plug on new industrial investments. “We understand oil and gas a whole lot better than the steel business in Thailand,” he told his subordinates. “We learned our lesson pretty expensively.”

  Still: $400 million! Even for Enron, that was a big hole, not easily papered over. How was it ever going to be able to cover that amount without wrecking earnings? Deep inside the company, there was another team working on that very problem.