The Smartest Guys in the Room (2003) - Bethany Maclean, Peter Elkind

recounts the captivating story of Enron, an energy trading company that was once celebrated as a symbol of market innovation on Wall Street before its dramatic downfall. Enron's journey from great success to bankruptcy due to years of deception almost mirrored its near-collapse just two years after its establishment. The echoes of history seemed to resonate in 2001 when the giant American energy corporation Enron declared bankruptcy, facing issues similar to its early struggles.

As early as 1987, only two years after its inception, Enron was burdened with significant debt.

Enron was established in 1985 following the merger of two pipeline firms, Houston Natural Gas (HNG) and InterNorth. Ken Lay, a smart and ambitious individual, took on the role of CEO, and in 1986, the company was rebranded as Enron. Regrettably, Enron quickly found itself in severe financial trouble. By the beginning of 1986, Enron had reported a $14 million loss in its first year, and by January 1987, its credit rating had plummeted to junk status.

Enron was involved in unethical business practices that had pushed the company to the edge of insolvency, with a particular division known as Enron Oil being the main source of trouble. Instead of engaging in oil production or sales, Enron Oil was solely focused on speculating on oil prices. To make matters worse, the oil traders were manipulating their profits. They would arrange deals with fictitious companies to incur significant losses on one contract, only to offset these losses with a second contract that yielded equal profits, allowing them to shift earnings from one quarter to another. Enron aimed to demonstrate to the financial markets that it was capable of consistently increasing its profits, a trend that would typically be well received by investors. However, by 1987, Enron's risky oil trading activities had resulted in such substantial losses that the entire company was teetering on the brink of bankruptcy. Despite this, Ken Lay reassured Wall Street analysts that the downturn was an isolated incident unlikely to recur. It has since become evident that this type of deception and negligence was deeply ingrained in Enron's corporate culture.

Enron underwent a significant transformation with the arrival of their visionary leader. Despite overcoming its initial crisis, by the end of 1988, Enron faced another serious challenge. The core issue for the company was the absence of a profitable business model, a problem they aimed to address by bringing Jeffrey Skilling on board.

Skilling, previously a consultant at McKinsey and an alumnus of Harvard Business School, joined Enron in 1990 as the CEO of a new division named Enron Finance. Skilling, a highly intelligent individual, played a pivotal role in steering Enron towards success – albeit temporarily. Initially, Skilling transformed Enron into what he termed a Gas Bank, where gas producers would contract to sell their products to Enron, who would then engage customers in agreements. Enron's profit derived from the margin between what it paid the producers and charged the customers. Skilling also identified an opportunity to profit from trading these contracts. The subsequent phase of Skilling's strategy involved advocating for Enron to adopt mark-to-market accounting.

Unlike traditional accounting practices that recognize revenues and profits as they are received, mark-to-market accounting records the estimated total value of a contract on the day it is signed. By immediately recognizing all potential profits, companies using mark-to-market accounting appear to be experiencing rapid growth. This approach is well-received by Wall Street investors, leading to an increase in stock value.

Lastly, Skilling cultivated a corporate culture that prioritized raw intelligence over traditional management skills and practical experience. He famously preferred to hire individuals with unique talents, or "guys with spikes," disregarding any deficiencies they might have. This approach resulted in a workforce comprising egotistical individuals, social outcasts, and schemers – qualities that did not concern Skilling as long as they effectively executed his directives. However, can a company sustain success solely based on the brilliance of its workforce? In the case of Enron, the answer proved to be negative.

Rebecca Mark was the prominent figure associated with Enron and was accountable for fostering its problematic culture of deal-making. Although Jeff Skilling was the one who revolutionized Enron, he remained relatively unknown to the public until the mid-1990s. Rebecca Mark, on the other hand, was the recognizable face of Enron externally, especially as a standout female in a predominantly male-driven industry. Prior to the 1990s, developing nations were typically disregarded by Western corporations, despite their substantial populations and energy requirements. Rebecca Mark led the Enron Development division, tasked with striking energy agreements with numerous developing countries to expand Enron's global presence. She traveled extensively worldwide, and by the mid-90s, Enron Development seemed highly successful, with Mark receiving accolades for her achievements. While she emphasized her physical appearance and charismatic demeanor, Mark's defining trait was her unwavering optimism, firmly believing in positive outcomes. However, despite her confidence, Mark inadvertently fostered a problematic deal-making environment at Enron Development, where employees were driven to prioritize quantity over quality of deals due to the company's flawed compensation system. For instance, developers received bonuses based on individual projects, incentivizing them to close deals without considering the long-term consequences. Consequently, developers lacked motivation to see projects through completion, and there was a lack of accountability within Enron once projects commenced. While Mark remained optimistic, numerous failures occurred. In 1995, Enron invested $95 million in a power plant in the Dominican Republic, only to face payment issues from the government for the generated power. By mid-2000, Enron's substantial investment had yielded a mere $3.5 million return.

Under the leadership of Jeff Skilling, Enron shifted its focus to trading, fostering a culture of risk-taking and deception. Upon his appointment as president and COO in 1996, Skilling wasted no time in reshaping the company to align with his vision. While trading became the primary emphasis, Skilling also marginalized traditional ventures such as pipelines and natural gas production. Despite Enron's prominent standing in the natural gas sector, Skilling aimed for expansion into electricity trading, pushing the company into uncharted territory. In his restructuring efforts, Skilling systematically phased out profitable legacy operations, solidifying trading and deal-making as Enron's core activities by the late 1990s. However, this strategic shift bore unintended consequences, notably creating an environment ripe for risk-taking and financial manipulation. Skilling's questionable approach to meeting earnings targets by fabricating figures to appease Wall Street exacerbated the situation. The inherent volatility of trading operations meant that Enron's financial performance was inherently unstable, leading to increasingly risky deals. The Risk Assessment and Control department, while present, often took a back seat as long as deals had commercial backing, fostering a false image of risk management. To meet investor expectations, Enron resorted to overstating future revenue to defer acknowledging actual losses, perpetuating a cycle of deceit.

Andrew Fastow was responsible for developing financial strategies that enabled Enron to conceal its debt, leading to his own financial gain. While Skilling revolutionized Enron's business operations, it was Fastow who revolutionized its financial management. Fastow, who had been part of Enron's financial department since 1990, was appointed as the Chief Financial Officer (CFO) in 1998. Together with his team, he orchestrated financial schemes to bridge the gap between the actual state of the company's affairs and the facade that Skilling and Lay wished to present to the public. Their method involved creating intricate financial structures to mask Enron's debt. Using Whitewing as an illustration, let's consider this Enron subsidiary established in 1997 with the purpose of acquiring and divesting the company's underperforming assets. For instance, if Enron built a power plant for $8 million, anticipating its value to be $10 million, the company would record a $2 million profit. In the event that the plant's market value fell to $7 million due to poor performance, Enron should have adjusted its books to reflect a $1 million loss instead of the initial $2 million profit. However, instead of doing so, Enron would sell the plant to Whitewing for the full $10 million. Subsequently, Whitewing would resell the plant for $7 million and receive the remaining $3 million in Enron stock. By issuing $3 million in stock, which wouldn't be recorded as a loss, Enron effectively masked a $1 million loss as a $2 million profit. Fastow was not only generating profits for Enron, but he was also skilled at compensating himself. For instance, in 1999, he established a fund named LJM, which derived from the initials of his wife and two sons, Lea, Jeffrey, and Matthew. Similar to Whitewing, LJM invested in Enron’s underperforming stocks, enabling the company to conceal them from its financial records. Nevertheless, Fastow's dual role as the head of LJM and the CFO of Enron posed an evident conflict of interest, as he essentially had the ability to negotiate with himself. Ultimately, Fastow's simultaneous positions enabled him to discreetly amass tens of millions of dollars in personal earnings.

Jeff Skilling believed he had discovered Enron's future in the fields of electrical energy and broadband, but both ventures ultimately failed. Enron's reliance on fraudulent accounting practices as a temporary solution to maintain the appearance of a successful business until Skilling devised a new strategy for generating genuine profits proved unsustainable. Initially, Skilling's focus was on entering the electrical energy sector, as retail electricity was under state government regulation in the mid-1990s. Enron anticipated that deregulation of the market would occur eventually, positioning them to sell electricity directly to consumers nationwide. However, the resistance from local energy providers hindered deregulation efforts, resulting in only a few states easing regulations. Even in California, where Enron could sell power directly, substantial advertising investments failed to attract customers away from established utility providers. Furthermore, Enron's lack of expertise in the electricity sector became evident when they struggled to fulfill promises of efficiency improvements. Despite the setback in the electricity business, Skilling's subsequent plan involving broadband also ended in failure. Enron's attempt to trade bandwidth capacity akin to natural gas trading by developing a cutting-edge broadband network system proved to be far from reality. The technology Enron pledged to deliver, including real-time bandwidth-on-demand, remained largely undeveloped and confined to the laboratory. Enron was unable to fulfill its bandwidth promises, highlighting the shortcomings of Skilling's second strategy.

Despite being aware of Enron's debt concealment, analysts admired the company. It may be surprising to recall that Thomas Kuhn, president of the Edison Electric Institute, once praised Enron's executives as infallible "whiz kids" and compared them to industry giants like Bill Gates and Steve Jobs. Analysts maintained unwavering faith in Enron, evident during the January 2000 annual analysts meeting where Skilling confidently presented the company's ambitious broadband strategy, projecting a value of $29 billion. The analysts, caught up in the excitement, hastily advised investments, leading to a significant stock surge. However, beneath the surface, a group of individuals were privy to Enron's true financial status. Some analysts were aware that the reported earnings far exceeded the actual income, as noted by J.P. Morgan analyst Kyle Rudden in 1999. Furthermore, they knew about the substantial off-balance-sheet debt Enron held, a detail often glossed over in their reports.

In 2000, concerns about Enron's financial stability emerged due to unusual developments within the company. On December 13th of that year, Skilling reached the pinnacle of his career at Enron when he was announced as the new CEO, succeeding Ken Lay. This announcement was celebrated with a flattering cover story in Business Week, where Skilling was hailed as America's second-best CEO, trailing only behind Microsoft's Steve Ballmer. Despite the accolades, doubts about Enron's performance were starting to surface. An article by Jonathan Weil in the Texas Journal, a regional supplement of the Wall Street Journal, published on September 20th, 2000, shed light on the company's use of mark-to-market accounting, a practice that raised concerns about Enron's profitability. This article prompted hedge fund manager Jim Chanos to launch an investigation, revealing that Enron's reported earnings did not align with its actual financial health. His findings were later shared with Fortune magazine, leading to the publication of an article titled "Is Enron Overpriced?" in March 2001. This piece highlighted Enron's cash flow issues, mounting debt, and the growing skepticism surrounding the company in the investment community. The skepticism intensified when Skilling abruptly resigned as CEO on August 14th, 2001, with Ken Lay returning to take over. Despite Skilling's reassurances to investors that the company was in excellent condition, his sudden departure raised suspicions. The unexpected resignation of such a driven CEO after only six months naturally fueled speculation about potential problems at Enron.

Enron collapsed due to its enormous debt and had to declare bankruptcy. Following Skilling’s resignation, Sherron Watkins, a mid-level Enron veteran, sent an anonymous letter to Ken Lay expressing concerns about potential accounting scandals leading to the company's downfall. Despite Lay's confidence in Enron's ability to overcome any challenges, the company's debt and falling stock prices were pushing it into a financial crisis. Several cash-generating deals Enron had made required immediate repayment of billions in debt if the stock price and credit rating fell below certain thresholds. With Enron's financial mismanagement exposed by the media, its stock had already plummeted below these thresholds, and the credit rating was approaching junk status. For instance, Enron's stock had dropped from $90 per share in August 2000 to under $20 per share by October 2001. Enron's executives urgently needed to secure billions of dollars to prevent creditors from shutting down the company, but banks had already indicated that Enron's credit line was exhausted. The only chance to avert bankruptcy was to merge with Dynegy, a company Enron had previously looked down upon. Initially, the merger was well-received by Wall Street traders, but doubts arose later, both among traders and Dynegy executives, about the consequences of joining forces with Enron. Ultimately, the deal fell through, leading Enron to file for the largest bankruptcy in U.S. history on December 2, 2001.

Ken Lay, Jeffrey Skilling, Andrew Fastow, and other Enron executives were convicted of fraud and sent to prison. Following Enron's collapse, all parties involved, including the board of directors, disavowed any responsibility. However, by 2003, their deception began to unravel as the United States Department of Justice prosecutors issued numerous indictments. Ultimately, 33 individuals were indicted, including 25 former Enron executives. Here is what transpired with the top figures - Lay, Skilling, Fastow, and Mark:

In 2004, Fastow pleaded guilty to all charges, serving a six-year prison term before his release in 2011. He confessed to participating in schemes that benefited himself and others at the expense of Enron's shareholders. Fastow acknowledged that he and other senior Enron management members manipulated the company's financial results fraudulently to deceive investors and inflate the stock price and credit rating. Ken Lay passed away without spending any time in prison. He faced ten indictments, including conspiracy, false statements, and fraud, pleading not guilty to all charges but ultimately being found guilty of each one. On July 5th, 2006, before his sentencing, he suffered a fatal heart attack while in Aspen, Colorado, with his wife. Jeffrey Skilling was indicted in 2004 on 35 charges, such as conspiracy, fraud, and insider trading. Despite claiming ignorance of the company's financial state, he was convicted on 19 charges and sentenced in 2006 to over 24 years in prison along with a $45 million fine.

And as for Rebecca Mark?

She departed Enron in August 2000, prior to the scandal becoming public knowledge. Mark sold her Enron shares at their peak, earning $82.5 million, and was never accused of any wrongdoing.