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

by Bethany McLean

  Take Arthur Andersen, for example. Just six months after Enron’s bankruptcy, the firm was found guilty in a Houston courtroom of destroying evidence—those thousands of pages of Enron-related material that had been shredded at the prodding of David Duncan and Nancy Temple. As a firm, Andersen was finished even before the trial, decimated by client defections after its federal criminal indictment.

  Andersen’s conviction would later be overturned by the U.S. Supreme Court, citing a flawed jury instruction. Though this would do nothing to alter the firm’s fate, it encouraged those who insisted that Andersen itself was a victim—a victim of an unjust, politically motivated prosecution, and a victim of Enron itself.

  The firm’s partisans pointedly noted that despite the obstruction-of-justice charge that had taken it down, no one had found it guilty of fraudulent accounting. Andersen argued that some dubious Enron accounting moves were merely management’s business decisions that were outside the province of its auditors. Andersen viewed its responsibility as limited to ensuring that the transactions complied with specific accounting principles. And except where Enron lied, Andersen argued, they did technically comply—allowing Enron, through clever use of the rules, to transform dogs into ducks.

  Of course, this argument utterly ignores the larger truth, which is that those transactions added up to a completely illusory picture of Enron’s financial health, to which Andersen was also legally required to attest. History will record that Arthur Andersen, in the legal system’s judgment of its role at Enron, was ultimately found not guilty. But in any commonsense accounting of what happened, it surely was not innocent.

  And so it went. The securities analysts who had covered Enron—many of whom had buy recommendations on the stock right up until the end—claimed that Enron had lied to them. “It now appears that some critical information on which I relied for my analysis of Enron was incomplete or inaccurate,” CSFB’s Curt Launer told Congress. The analysts for Standard & Poor’s and Moody’s offered a similar lament, insisting that the information they were given justified Enron’s investment-grade debt ratings. To be sure, Enron, with Andersen’s assistance, did everything it could to camouflage the truth, but there was more than enough on the public record to raise the hairs on the neck of any self-respecting analyst. Analysts are supposed to dive into a company’s financial documents, pore over the footnotes, get past management’s assurances—and even to get past accounting obfuscations. Their job, in short, is to analyze. If the analysts covering Enron had done that, how could they not have seen a very different story? The short sellers surely did.

  Then there were the banks and investment banks—the best supporting actors of the Enron scandal—without whose zealous participation Enron’s financial shenanigans would simply not have been possible. Hauled before the Senate Permanent Subcommittee on Investigations in the summer of 2002, the bankers could only duck and weave, always denying responsibility. “We have been one of the parties substantially harmed by its [Enron’s] failure,” said a J. P. Morgan Chase banker. Citigroup said it had believed “Enron was making good-faith accounting judgments that were reviewed by Arthur Andersen, which was then the world’s premier auditing firm,” and that the “Audit Committee of Enron’s board exercised meaningful supervision over the company’s accounting policies and procedures.” In other words, it wasn’t our responsibility.

  And here’s the most amazing denial of all: Even Enron’s board of directors—the people formally entrusted with serving as a check on management and with guarding the interests of the shareholders—disclaimed any responsibility. The board said it relied on the advice of Enron’s accountants and lawyers, and that’s where the blame really lies. In response to bitter criticism from Congress, the directors issued a report claiming that they “in good faith . . . prudently performed their fiduciary duties based on the information provided to them.” As for Enron’s accounting contortions, according to the board’s statement, the audit committee “knew that Arthur Andersen was paid specifically to ensure that the ‘innovative structures’ conformed to GAAP, and hence took comfort that Arthur Andersen ‘was OK’ with them.”

  Some board members pointed the finger at Enron’s management. Longtime director John Duncan told investigators after the bankruptcy that he thought “Skilling was brilliant. He was extremely articulate and always seemed to have the right answer.” But, the investigators continued, “Duncan has discovered many facts that make him believe that Skilling did not keep the board fully informed. He cannot recall any discussions with Skilling that the company was encountering or was susceptible to any financial problems.” Another director privately put it this way: “The board was duped. I don’t see any other answer. These things could not have happened without Skilling being a part of it.” The board’s lawyers have reread every presentation Enron executives gave to them, added a director. “There was nothing there for the board to have reason to suspect something was wrong.”

  Of course, there was plenty there to inspire the board to ask tougher questions, had it been so inclined. Was it really “prudent” for Enron, with its lack of cash flow, to have $38 billion in debt? Wasn’t the directors’ responsibility broader than merely listening to “the information provided to them”? According to that narrow, legalistic mind-set, the answer was simple: No.

  No matter who you asked, it was always somebody else’s fault.

  • • •

  In time, these arguments stood revealed as contemptible excuses. Everyone came to pay a price—in one way or another.

  In the immediate, surreal aftermath of Enron’s bankruptcy, lawyers of all sizes and stripes descended on 1400 Smith Street, along with dozens of FBI agents, who confiscated hard drives, hauled off boxes of documents, and excitedly pawed through Fastow’s office in search of the smoking gun. They were gathering evidence for the Justice Department’s newly formed Enron Task Force—a special team of federal prosecutors and FBI agents recruited from across the country, bent on getting to the bottom of things.

  In late January, word emerged of Cliff Baxter’s suicide. His body was discovered less than two months after the bankruptcy filing and ten days after Sherron Watkins’s letter, released by congressional investigators, threw the unwelcome media spotlight in his direction by saying he’d “complained mightily” about LJM. Baxter’s handwritten suicide note, left on the dashboard of his wife’s car, parked in the family garage, was ordered released over the protests of his widow. “I am so sorry for this,” he wrote. “I feel I just can’t go on. I have always tried to do the right thing but where there was once great pride now it’s gone. I love you and the children so much. I just can’t be any good to you or myself. The pain is overwhelming. Please try to forgive me. Cliff.”

  For several years after the bankruptcy filing, Enron continued to operate as a sort of corporate zombie, with thousands of people still required to sort out what was left for creditors, and to operate the pipelines and power plants around the globe. In mid-2002, the new postbankruptcy management wrote down the value of Enron’s assets by a stunning $14 billion, attributing some $3 billion of the hit to “possible accounting errors or irregularities.” A series of reports from a court-appointed bankruptcy examiner—totaling more than 4,000 pages in all—offered an encyclopedic accounting of what had gone wrong, apportioning blame to Enron’s management, directors, bankers, outside accountants, and lawyers. Overall, it appears that Enron’s businesses lost well over $10 billion in cash over the course of their lives.

  Perversely, Enron’s bankruptcy turned out to among the most expensive in history (exceeded since only by that of Lehman Brothers) with lawyers, accountants, restructuring consultants, and other professionals in the case receiving an estimated $1.2 billion. Others, however, did not fare so well. After more than a decade, Enron’s thousands of unsecured creditors eventually received about 53 cents on the dollar. Much of the $21.8 billion recovery came from the sale of assets such as Portland General and Enron’s remaining North Ameri
can pipelines. The 2006 sale of Enron’s interest in 19 overseas power plants and pipelines—the remains of Rebecca Mark’s dearly constructed international empire—raised $2.9 billion of the total. (Dabhol, which remained idle for years after being taken over by Bechtel and GE, was not included.) Settlements with the company’s banks and law firms, accused of contributing to Enron’s demise, added to the pot (Vinson & Elkins paid $30 million).

  In mid-January 2002, UBS Warburg announced that it was buying the Enron trading business, though it wasn’t exactly paying top dollar. In fact, UBS didn’t pay anything at all for the 650 Enron traders. It simply gave Enron the right to a portion of the traders’ profits—one third for the first five years—while assuming none of Enron’s past, present, or future liabilities. Greg Whalley resigned his post at Enron to join UBS.

  As always, the traders cut a good deal for themselves. They were guaranteed $11 million in first-year bonuses, $6 million of which was paid by Enron. Enron itself didn’t do as well, however. UBS never paid a penny to Enron, and after laying off nearly six hundred of the traders, shuttered the Houston operation in early January 2003 and moved the few who were left to Stamford, Connecticut, where the firm’s other commodity trading operations are based. Whalley, facing growing scrutiny from prosecutors, eventually left UBS, taking a job with a Houston hedge fund set up by John Arnold, the former Enron trading superstar. (After extraordinary success with his fund, Arnold retired in 2012 as a billionaire.)

  One by one, many of the energy companies that had followed Enron into the trading game announced that they were cutting back or abandoning the business entirely. The list included Dynegy. That company was already sinking under the weight of skepticism when the Wall Street Journal revealed that it had set up its own special-purpose entity to create cash flow. Two months later, Chuck Watson resigned as CEO. Later, Dynegy paid a $5 million fine to settle charges that it had manipulated natural-gas prices. It continues in business after a bankruptcy reorganization.

  • • •

  Except for Arthur Andersen, the institutions that had made the Enron fraud possible escaped by writing checks—and by promising to change their business practices.

  Bill Lerach, the fearsome plaintiff’s lawyer, led a huge class-action lawsuit on behalf of Enron shareholders. The defendants included company executives and directors, as well as accountants, two law firms, and nine banks that did business with Enron. Nervous about their liability at trial, several of the banks began writing big settlement checks: CIBC paid $2.4 billion, J.P. Morgan Chase $2.2 billion, and Citigroup $2 billion. Others that held out—including Merrill Lynch and CSFB—ended up paying nothing. Before the case reached trial the U.S. Fifth Circuit Court of Appeals ruled that the remaining bank defendants couldn’t be held liable—even if they knowingly engaged in deceptive conduct as part of a scheme to defraud Enron investors—because they didn’t make any false statements to investors themselves. Acknowledging that the banks’ conduct was “hardly praiseworthy,” the court’s majority noted that the ruling “may not coincide . . . with notions of justice and fair play.” (The Supreme Court later supported this ruling.) Nonetheless, Lerach’s litigation produced a record $7.2 billion for shareholders, who received about 20 cents for each dollar of their losses. The plaintiffs’ lawyers in the case earned $688 million, though by then Lerach himself was sitting in federal prison after pleading guilty in a kickback scheme unrelated to the Enron case.

  By then, three of the big banks had come to terms with the SEC as well. In 2003, J. P. Morgan Chase and Citigroup agreed to pay a combined $286 million for “helping to commit a fraud” on Enron’s shareholders, as SEC enforcement chief Stephen Cutler told reporters. The two banks also promised to ensure that their clients that used complex financial structures would account for them in ways that investors could readily understand.

  Merrill Lynch had settled SEC charges of aiding and abetting securities fraud at Enron by agreeing to pay $80 million in fines and penalties, but it wasn’t required to acknowledge that it had done anything wrong. To escape criminal prosecution, Merrill agreed to reform the way it conducted business and to hire an independent auditing firm and an outside monitor to review its business practices for eighteen months. The SEC also charged four individual Merrill executives (including Schuyler Tilney) with aiding and abetting securities fraud. All of them left the firm; Tilney was fired after refusing to testify to the SEC and Justice Department. Their cases were ultimately settled or dropped.

  The SEC’s enforcement proceedings involving Enron continued for nearly a decade after the bankruptcy filing, producing civil cases, large and small, against more than two dozen people, including many who would never face criminal charges. Notable among this group: Jeff McMahon, who paid $300,000 to settle his case, and Lou Pai, who shelled out $31.5 million.

  In mid-2002, the Enron debacle prompted the passage of a controversial new set of corporate-oversight rules known as Sarbanes-Oxley, aimed squarely at the abuses that had led to the scandal. Among other provisions, it required CEOs and CFOs to personally attest to the accuracy of their company’s financial statements; imposed new requirements for auditor independence and independent audit committees; banned most personal loans to executives and board members; barred insider trades during pension-fund blackout periods; and stiffened penalties for securities fraud. President George W. Bush proclaimed the law “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.”

  • • •

  For some, a reckoning of a different sort loomed.

  While the array of government and private civil suits were ultimately settled, providing a small measure of solace (and compensation) to former Enron employees and investors, the biggest hammer belonged to the U.S. Justice Department. The investigation by its special Enron Task Force continued for more than four years. For most of that time, prosecutors produced a slow but steady stream of indictments and plea bargains—ultimately charging thirty-three individuals, including twenty-five former Enron executives—but recording mixed results at trial.

  After the Andersen case, the first indictment came in September 2002, targeting the three NatWest bankers who helped Fastow carry out his Southampton scheme. Improbably, they became a political cause célèbre back in their native England, where they had returned, thanks to their protracted campaign in the British courts and press to resist extradition to the United States. Dubbed “the NatWest Three,” they finally lost their fight and were brought in July 2006 to Houston, where they were forced to wear electronic monitoring devices and were barred from leaving Texas until trial. In February 2008, they each pled guilty to a single count of wire fraud and later received sentences of 37 months.

  Four Merrill Lynch executives—including Dan Bayly, the firm’s former global head of investment banking—faced criminal charges in the Nigerian barge deal. (Schuyler Tilney was never charged.) All four were convicted (along with a midlevel Enron executive; another Enron manager was acquitted), sentenced to between thirty and forty-six months, and sent to prison. But a successful appeal later freed three of the men (including Bayly), and charges against them were ultimately dismissed.

  The cases against most Enron executives proceeded slowly. Prosecutors not only had to unravel Enron’s byzantine accounting, they also had to figure out how to make a criminal case, knowing that defense lawyers would argue that however misleading much of Enron’s accounting may have been, it was not technically illegal. For a long time, the government appeared to be following a strategy of pursuing executives who’d been involved in specific transactions, such as the Nigerian barge deal, where the wrongdoing seemed especially blatant.

  On October 31, 2002, Andy Fastow was indicted. The government charged him with seventy-eight counts of fraudulent conduct, mostly involving the money he had pocketed through deals like RADRs and LJM Swap Sub. Six months later, the Justice Department indicted Ben Glisan for his involvement in Fastow’s schemes. The government also c
harged Lea Fastow with conspiracy to commit wire fraud, money laundering, and filing a false income tax return in connection with the alleged kickbacks involving her husband’s partnership.

  Enron’s much hyped broadband business produced seven more indictments. Top executives Ken Rice, Kevin Hannon, and Joe Hirko, as well as two others, were charged with fraud and insider trading, accused of lying to the investing public about EBS’s technological capabilities to inflate market valuations of the business while collectively selling more than $150 million of stock. Kevin Howard and Michael Krautz were indicted for the Braveheart deal.

  For a time after they were indicted, most of the Enron executives vowed to fight the criminal charges in court. As they saw it, the government was going after them because it needed scalps to show that it was serious about prosecuting corporate crime—and to satisfy public bloodlust in the Enron scandal. Many former Enron broadband executives were appalled at the indictments of Rice, Hirko, and the others, who had been accused of hyping the business and then selling their stock before the truth came out. According to their view, what the Enron executives had done was nothing worse than what dozens of CEOs had done in Silicon Valley, where people who worked for companies with far less to offer than Enron had fed Internet hype, cashed out, and walked away unscathed.