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

by Bethany McLean

  In mid-December, Enron treasurer Jeff McMahon contacted Furst about buying an interest in the barge project. According to the SEC, Enron wanted to sell so it could book another $12 million in earnings and $28 million in cash flow. The proposed deal would work like this: if Merrill would take the stake in the barges off its hands by year-end, Enron would arrange a profitable buyback later. Merrill would get a $250,000 up-front fee, a 15 percent annual rate of return on a $7 million equity investment (Enron would finance $21 million in interest-free debt), and an oral guarantee that Enron would “facilitate” Merrill’s “exit from the transaction” by June 30, 2000. Merrill’s internal deal memo captured the essential dynamic: “Enron has strongly requested ML to enter into this transaction. Enron has paid ML approximately $40 million in fees in 1999 and is expected to do so again in 2000.”

  Nonetheless, inside Merrill, there was considerable anxiety about the arrangement. If the buyback guarantee were real, the sale was a sham. On the other hand, if Enron wasn’t really guaranteeing the buyback, Merrill was risking $7 million on an asset—Nigerian barges?—that no one there wanted to own. Merrill hadn’t even done any due diligence on the investment.

  Enron’s promise, of course, had to remain informal. The guarantee couldn’t be made in writing because doing so would disqualify it from the accounting treatment Enron sought. And indeed, Merrill later denied that the guarantee was part of the deal even though the obligation was cited in draft deal documents as well as in e-mails circulated by both Merrill and Enron executives, according to the SEC. Inside Merrill, in fact, executives referred to the deal as a $7 million “handshake” loan to Enron.

  For a few days, Merrill hesitated. Some of its bankers harbored qualms about the appearance of the transaction, if nothing else. One executive who’d reviewed the deal scribbled a handwritten note: “Reputational risk i.e. aid/abet Enron income stmt manipulation. . . .” But to most at the firm, the real issues were risking $7 million and displeasing Enron.

  To resolve these delicate matters, Dan Bayly, global head of investment banking, led a group of Merrill bankers in a conference call with Fastow. The Enron CFO had been putting the heat on Merrill to do the deal—“bear-hugging,” Fastow liked to call it. Now Bayly wanted to make sure they understood one another. Bayly wanted Fastow to know that Merrill was considering the deal as a special favor to Enron; he hoped the CFO would appreciate this act of friendship and presumably reward it with future business. According to the government, he wanted Fastow’s personal assurance that Merrill’s money really wasn’t at risk, that the firm would be taken out in six months’ time. After Fastow told Bayly what he wanted to hear, the Merrill executive ordered his bankers to close the deal.

  The following May, as the deadline for the barge buyout neared without an outside purchaser in sight, an Enron executive noted the consequences of Enron having to repurchase the stake itself: “. . . The investment in the barges will be placed on the balance sheet. This will not only have income implications but require a level of damage control with AA [Arthur Andersen]. As you know, ML’s decision to purchase the equity was based solely on personal assurances by Enron senior management to ML’s Vice Chairman [Bayly] that the transaction would not go beyond June 30, 2000.”

  A few weeks later, with the investment bankers wringing their hands, Enron informed Merrill that it had found a buyer for the barges. It was none other than LJM2. Fastow’s fund purchased Merrill’s equity stake for $7,525,000, exactly the promised return, and assumed the $21 million debt as well. Merrill walked away from the deal with a $775,000 profit. And LJM2 bought into the Nigerian barges with its own take-out promise from Enron. As a deal-approval sheet explained: “LJM2 expects to be bought out by Enron within 7 months. . . .” Instead, Enron managed to find a real outside buyer three months later. Andy Fastow’s fund cleared $650,000.

  On January 18, 2000, Enron issued a press release announcing its fourth-quarter results: ENRON CONTINUES STRONG EARNINGS GROWTH. The company reported earnings of $1.17 per share—matching Wall Street’s expectations. The LJM and Merrill deals had contributed more than half of the quarter’s profits. Without the transactions, Enron would have missed its number. A near catastrophe had been averted.

  • • •

  Jeff McMahon, Enron’s treasurer, had good reason to wish LJM2 well. McMahon owed his job to Fastow, who had installed him as corporate treasurer in 1998, bringing him back from London, where he’d spent three years as CFO of Enron Europe. Fastow had also told him that if LJM2 succeeded, he would put together an even bigger fund—LJM3—and might leave Enron to run it. Then, Fastow explained, he would recommend that McMahon replace him as CFO. It was just the sort of carrot Fastow loved to dangle, yet another way to wield power. Only later did McMahon learn that Fastow had made the same promise to Rick Causey.

  McMahon was no innocent. Like virtually all Enron finance executives, he’d helped put together his share of funny deals over the years to help the company hit its earnings targets. He also didn’t have any particular qualms about the idea of a captive private fund that the company could tap to supply equity for Enron-created SPEs. But when Fastow decided that he would run the fund himself, that, to McMahon, was taking things too far. Bankers were soon complaining to him that his boss was, in effect, blackmailing them into investing in LJM; one even said his firm had been promised Enron’s next bond deal in exchange for an investment. McMahon was also shocked by Fastow’s claims to the board that he was spending less than three hours a week on LJM matters. McMahon knew that the CFO had spent weeks on the road selling his fund to investors.

  McMahon had also expressed skepticism about Enron’s decision to buy back some of the LJM deals. On one approval sheet, he’d written: “There were no economics run to demonstrate this investment makes sense” before crossing out the remark and initialing his approval. It bothered him that Fastow and Kopper were so blatantly exploiting their knowledge of which deals Enron needed to close to meet its budget numbers. He saw how executives were afraid to negotiate too strenuously against LJM, fearing that Fastow and Kopper would retaliate at bonus time. McMahon had complained to Fastow about LJM issues, and he firmly believed that it had cost him. McMahon’s 1999 bonus had been lower than he’d expected; Kopper’s, by contrast, had been off the charts.

  On March 15, McMahon met with Fastow again, complaining about the conflicts and the distraction the partnership presented and telling him that the LJM staffers need to be moved “out of the Enron building.” Fastow had spent part of the morning in a meeting about LJM1’s Rhythms hedge; he would spend most of the rest of his afternoon on LJM meetings and document signings. “I hear you,” he told McMahon. “I’ll fix it.” Unconvinced, McMahon—acting on the advice of Cliff Baxter, who told him that only Skilling could resolve the “Andy problem”—immediately made an appointment with the Enron president for the following day.

  To prepare for the meeting, McMahon sat down and jotted down two pages of notes about his problems with his boss. When McMahon arrived for the 30-

  minute meeting with Skilling, he later recalled, he followed his script closely.

  “Untenable situation,” the notes begin. “LJM situation where AF wears two hats and upside comp is so great creates a conflict I am right in the middle of. I find myself negotiating with Andy on Enron matters and am pressured to do a deal that I do not believe is in the best interests of the shareholders,” McMahon’s notes continued, “My integrity forces me to continue to negotiate the way I believe is correct.” If he had to continue doing this, McMahon told Skilling, according to his notes, “I MUST know I have support from you and there won’t be any ramifications.” If Skilling couldn’t make that promise, McMahon wanted a transfer. “Will not compromise my integrity,” McMahon wrote. He also didn’t want to be punished for it financially, either. “Bonuses do get affected,” he noted, citing his own treatment compared with Kopper’s.

  McMahon spoke almost nonstop for 30 minutes. When he was finished, Skilli
ng assured him he would take care of it.

  Skilling later presented a dramatically different account of the encounter. He insisted McMahon’s primary concern wasn’t the ethics of the situation but the awkwardness of negotiating with his own boss and how that “might impact his compensation package.” He said that he’d advised McMahon to “take a baseball bat to Andy” when negotiating on behalf of Enron and that he wouldn’t pay a price for it at bonus time.

  In any case, the matter was soon resolved. On March 30, Fastow angrily demanded a meeting with McMahon. They met in the CFO’s office at 7:30 the next morning. “I’m not sure we can keep working together,” Fastow told him. Why had McMahon gone behind his back? Didn’t he know everything he told Skilling would get to Fastow?

  The following week, McMahon was approached about transferring into a new business the company was starting, called Enron Net Works. Despite the problems with Fastow, McMahon wasn’t interested, because the new job was a demotion: he liked being the corporate treasurer of a major corporation too much to let go of it easily. But a few days later, Skilling himself came to McMahon’s office to persuade him to take the new job. The future of Enron was in businesses like NetWorks, Skilling insisted. He should take the opportunity.

  As McMahon saw it, the message was clear: what Skilling was really doing was accepting the “or else” portion of his ultimatum. Clearly, the Enron president wasn’t willing to do anything about Fastow and his conflicts, so he was arranging McMahon’s transfer. (Skilling later insisted McMahon’s move represented a promotion and was entirely unrelated to his complaints about LJM.)

  After accepting the transfer, McMahon gave Fastow a list of three candidates he recommended to replace him. None of them got the position. In May 2000, Fastow named his favorite accountant, 35-year-old Ben Glisan, as Enron’s corporate treasurer.

  CHAPTER 14

  The Beating Heart of Enron

  Inside his warped world, Andy Fastow believed he deserved all the money he was taking out of Enron through the LJM partnerships. After all, he and his Global Finance team were the ones whose deals were creating the illusion of a company that could do no wrong. Fastow, Kopper, Glisan, and the other key members of the Global Finance group saw themselves as the core of Enron.

  But there was another group at Enron who believed precisely the same thing, who thought they were the smartest and the best; who thought, in fact, that they represented the beating heart of the coolest company on earth. These were the wholesale traders.

  Almost from the moment Skilling set up the old Gas Bank, the traders had viewed themselves as a breed apart. From the start, Skilling had grafted MBAs and former Wall Streeters onto an organization that was largely made up of old-time oil and gas hands, executives more comfortable with drilling rigs than pricing curves. With Skilling’s encouragement, the traders soon came to see themselves as Enron’s true elite.

  Over the years, though, the culture of the trading floor had undergone some subtle and none too pleasant changes. In the early years, the traders’ feelings of superiority came from the sense that they were creating a new industry from scratch. In later years, although the sense of mission—even, in some cases, the idealism—about the greatness of markets remained, it was overshadowed by the money it was so easy to make. Toward the end of the 1990s came unprecedented volatility, and for traders, volatility is one of the necessary ingredients for making outsize profits. And as trading profits soared, the traders became convinced of their own invincibility. “It was zealotry to greed to arrogance to demise,” says one former executive.

  Arrogance was present in spades—and not just in Enron’s dismissive attitude toward the rest of its industry. It was their work, the traders believed, that was papering over the failures elsewhere inside Enron. Global Finance? Kopper used to complain about the lack of respect he got from the traders. The traders ridiculed Fastow, both for his slight speech impediment—“Willie Whistle,” one used to call him—and for his fondness for a buttoned-up suit. Fastow rarely set foot on the trading floor. “If Enron was arrogant to the industry,” says one former trader, “then we were arrogant to the rest of Enron.” The other Enron businesses, even the sexy new ones like EES and Broadband, were nothing more than “a collection bin of castoffs,” full of employees who couldn’t make it on the trading floor, adds another trader. In time, the traders became nearly impossible to control.

  That was true even for Skilling, who used to lament that dealing with the traders was like “herding ducks. Traders are not just right but absolutely right,” he would add. “Everything is a negotiation. If you asked them to turn left, even if they wanted to turn left, they’d say, ‘Well, how much are you going to pay me to turn left?’ ” Though Skilling was their boss, he seemed intimidated by them. They were like a powerful high school clique that terrorizes even the principal. “They didn’t appear menacing,” says a former executive, “but they were a mob.”

  The traders were smart, by and large, and they were good at what they did. But their insular culture had a dangerous edge; not only was it self-righteous, but it could never see beyond its own value system. The culture that evolved allowed the traders to justify making money in ways companies should never countenance. Most companies with trading desks don’t allow the traders’ ethos to trump all other values, and they don’t allow the traders themselves to run amok. That both happened at Enron was not so much a failure of the traders but of Enron’s top management, which was supposed to keep them in check but wouldn’t—or couldn’t.

  • • •

  The head of Enron North America—as the part of the company that included trading was now called—had always been a member of Skilling’s old guard. For years, of course, Lou Pai had been in charge of the traders. In 1997, when Pai left to take charge of the fledgling EES, Skilling installed Ken Rice as his replacement. Even by then, the trading culture was changing, and the new breed of traders had begun to view Skilling’s old guard as a handful of has-beens who happened to have their umbrellas open when it rained money. They particularly loathed Ken Rice. His proudest accomplishment, the old Sithe deal, had become a millstone around the necks of the traders. His affair with Amanda Martin was also a cause of ire. It wasn’t the affair itself the traders objected to; Martin’s rapid rise through the ranks was an affront to their belief that they were operating in a meritocracy. The traders were convinced that she was getting ahead solely because of her relationship with Rice. She certainly didn’t think like a trader, and they were not about to acknowledge that she might have had some skills as a businesswoman. What the traders also didn’t see is that the world they were creating wasn’t perhaps such a pure meritocracy, either. After all, most of the people who got ahead were the ones who looked and acted like them.

  The third member of the old guard to be put in charge of the traders was Cliff Baxter. He took over in the middle of 1999, when Rice departed for the new broadband division. This was Baxter’s first try at running an Enron business, something he’d openly hankered for. Like Fastow earlier in the decade, he wanted to prove his mettle as a manager who could generate big profits for the company. But by the time he arrived on the scene, the trading culture had hardened. Although the traders liked him well enough, Baxter wasn’t one of them; the traders knew they could safely ignore him. And so they did. Besides, they already had a leader. His name was Greg Whalley. He didn’t have Baxter’s title, but he was their real boss, the one they listened to and the one who truly commanded their respect.

  A former army tank captain, Whalley personified the trader’s view of the world. He saw everything in terms of split-second economics; if he couldn’t buy or sell something right this second, it seemed to have no value to him. His favorite book was Ayn Rand’s The Fountainhead, which extols individual achievement and drive over the will of the group. He believed in a culture that maximized the ability of individuals to make their own decisions and reap their own rewards. “People were able to take risks the way they wanted and be
accountable for it, which is the most sacred thing in a trading shop,” says a former trader. Whalley had the trader’s ability to strip his decision-making of all emotional content, which he viewed as noneconomic. That’s why another executive says that Whalley “would have been content to interact with a computer 360 days a year.” Even more than Skilling, Whalley believed that he could create a pure meritocracy. He instilled a culture on the trading floor that was ruthlessly mercenary.

  Yet he was also a man who commanded enormous personal loyalty and admiration. Part of it was that he was witheringly smart; Skilling often described Whalley as “probably the smartest person I know.” Part of it was that others admired his abilities as a trader. But it was also that he had the kind of personal presence that made people want to follow him, a rarity at Enron. Equally rare was that Whalley, at least in the view of his admirers, did not put his own paycheck above everything else. Not that he was looking out for everyone. The needs of his own clan were Whalley’s top priority: it was “us first,” not “me first.” To his supporters, his black-and-white view of the world did not come across as self-serving but rather as reflecting a genuine intellectual belief. Many of the traders worshiped him. “Whalley is a screaming stud,” they’d say. “He’s everything you would want in a boss or a friend.” “People would run through walls for him.”

  The driven, workaholic son of a pilot for Federal Express, Whalley graduated from West Point in 1984 with a degree in economics and spent the next six years in the army, serving in Germany and Kentucky. In 1990, he resigned to go to Stanford Business School, then joined Enron in one of the first classes of associates. One person who interviewed him was struck by his passion for the trading business, not just the trading itself but the esoteric intellectual arguments that went along with it. He was 30 by then, older than most of his fellow associates, and he immediately stood out for his intelligence and his tremendous confidence, two of the greatest assets an Enron employee could have. Whether through ambition or curiosity, he was always looking outside his own sphere for another problem he could fix. That was another rare trait at Enron, and it helped Whalley rise rapidly. He was a natural trader, and even after he became a top executive, he never completely stopped trading, running his own oil trading book right up to the end. (One set of Enron daily position reports shows that he was down about $30 million for the year when Enron collapsed.) In 1996, Whalley was chosen to help start Enron’s trading operations in Europe. Two years later, he returned to Houston, and though he held a number of different titles over the next several years, everybody at Enron understood what his real job was. Whalley controlled the traders. The old guard—Baxter, Rice, and Pai—used to refer to him as “the union boss.”