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

by Bethany McLean

Wing and his 20-member team would need to line up producers to provide the huge gas supply for the plant, some 300 million cubic feet a day. Since the nearest gas fields were beneath the North Sea, they had to arrange construction of a new 140-mile pipeline.

In any power-plant deal, the financial close is a major event. It means that the developer (in this case, Enron) will immediately be repaid the millions in expenses it has incurred to get the project off the ground. Teesside was supposed to be built largely with borrowed money: project financed, as they say in the business. Project financing allows developers to stretch their own capital by investing just a sliver of the cost of any project. Instead of looking to Enron for repayment of the debt, the lenders would instead rely on cash flows from the project, comforted by the presence of the long-term contracts for gas supply and purchase of the plant’s power and steam. Because the financing was non-recourse, Enron would have no legal obligation to cover any default. The equity investment in such financing was often split with partners, which means Enron could build and control projects in which its own money represented as little as 10 percent of the total cost.

By early 1993, the buzz about Teesside had helped generate a near frenzy in Europe about gas’s rosy prospects, setting in motion what was dubbed “the dash for gas.” It was at that very moment, with prices near their peak, that Enron signed a long-term contract to take another 260 million cubic feet of gas per day, starting in 1996, from North Sea fields known as J-Block. That was enough gas to fill the rest of the pipeline capacity that Enron had reserved, giving the company twice as much as it needed for Teesside. Here’s the most astonishing part, though: the J-Block purchase, negotiated with a consortium led by Phillips Petroleum, was a take-or-pay agreement. Despite all the problems Enron had had with take-or-pay in the United States, it had agreed to do it again in England.

Enron Capital and Trade Resources, ECT,

Mark’s critics contend that the shockingly poor performance of the assets she built stripped Enron of its financial strength and that, in being so richly rewarded for building those assets, she looted the company along the way.

they decided to carve up Enron Power into three divisions: Europe, the United States, and an emerging-markets business called Enron Development. Mark got Enron Development. The only problem was that Enron didn’t have an emerging-markets business: Mark had been handed a division without a single asset and with only a handful of employees.

Government development agencies such as the Overseas Private Investment Corporation (OPIC) and the Export-Import Bank were willing to loan money to fund big energy projects,

And while Enron International executives loved putting deals together, the business had a flaw that was endemic to Enron: no one felt responsible for managing the projects once they were up and running. Mark’s developers saw their role as getting the deal done:

The money Enron poured into projects that never were built—and such a failed deal could soak up tens of millions—was supposed to be written off. In Vietnam, for instance, one accountant says that Enron spent some $18 million trying to build a power plant, only to see the project canceled. Yet Enron International often booked such costs as an asset on the balance sheet, in what came to be known around the company as “the snowball.” Usually the rationale was that there was no official letter saying the project was dead, so therefore, officially, it wasn’t. Rich Kinder had a rule: the snowball had to stay under $90 million. But it eventually ballooned to over $200 million. A second problem: the assumptions Enron made to justify its deals assumed that nothing would ever go wrong. Of course, the banks financing the deals were making the same assumption; this was a mania, after all. But building energy projects in poor countries—often run by dictators and where capitalism was still a new concept—was absolutely fraught with peril,

What one former international executive calls the “fatal flaw” in the business was the compensation structure. Developers got bonuses on a project-by-project basis. The developers would calculate the present value of all the expected future cash flow from a project. This was also the model the banks used to lend money. When the project reached financial close—that is, when the banks lent money but before a single pipe was laid or foundation was poured—they were paid. No wonder the developers were so eager to move on to the next deal; they had no financial incentive to follow through on the one they’d just completed. And the money they stood to make was stunning, amounting to some 9 percent of the project’s total value. In other words, if the developers estimated that the project would ultimately bring Enron $100 million, the developers took home $9 million.

The deeper problem, one that emerged in later years, was that no one was held responsible for the operation of a project, yet it was the operation that produced the real money.

In Dabhol, India, about a hundred miles south of Bombay on a remote volcanic bluff overlooking the Arabian Sea, sits an enormous modern power plant.

The plant was the largest-ever foreign investment in India and it was supposed to be Enron’s first step in a grand, $20 billion scheme to reshape India’s energy sector.

India’s energy sector has always been run by the government and is a bureaucratic quagmire. All power is sold through state electricity boards, most of which totter on the edge of bankruptcy because so much power is either stolen or given away to farmers. The boards can’t raise rates because India’s politicians don’t want to ask its citizens to pay more for power.

Mark inked a 20-year power-purchase contract with the Maharashtra State Energy Board (MSEB). The terms called for Enron to build an enormous, 2,015 megawatt plant—bigger than Teesside. The construction would be done in two phases at an estimated cost of $2.8 billion.

Just weeks after Bechtel bulldozers began flattening the red rock hillside in Dabhol, there was an ominous development. In Indian state elections that took place in March 1995, the ruling Congress Party in Maharashtra lost to a Hindu nationalist coalition that had campaigned on an anti–foreign investment platform and a promise to “push Enron into the Arabian Sea.”

hundreds of protesting villagers swarmed over the site, and a riot broke out. Human Rights Watch and Amnesty International eventually charged security forces guarding Dabhol for Enron with human-rights abuses; Human Rights Watch blamed Enron for being “complicit.”

The first phase began producing power in May 1999, almost two years behind schedule, and construction started on phase 2. Costs would ultimately climb to $3 billion. Then everything came to a stop. The MSEB refused to pay for all the power, and it became clear that getting the government to honor the guaranteees would not be an easy task.

Today, Dabhol, in which Enron invested some $900 million, sits silent, a gigantic, wasted marvel of modern technology.

In 1999, Enron agreed to pay $100 million over 30 years to have the stadium named Enron Field; Enron also got a 30-year contract, which it valued at some $200 million, to manage the stadium’s energy needs.

in 1995, Lay was elected to the board of the American Enterprise Institute, a right-leaning think tank that is a meeting place for Washington’s conservative elite. Future vice president Dick Cheney was also a trustee;

the Overseas Private Investment Corporation and the Export-Import Bank, which provided loans and loan guarantees for development projects in the third world.

Enron employees were encouraged to make their travel plans through Lay/Wittenberg Travel Agency in the Park, which was 50 percent owned by Lay’s sister Sharon. In fact, Lay himself initially owned a minority interest in the travel agency, which he sold after being warned about the impropriety.

Fifteen percent a year. That’s what Enron was promising investors: that its earnings per share would grow at a clip of 15 percent a year.

Enron Global Power and Pipelines (EPP). Its stated purpose was to purchase Rebecca Mark’s assets from Enron, thereby taking them off Enron’s balance sheet and freeing capital for Enron to reinvest.

But there was also a second benefit: by selling assets to EPP, Enron could realize profits at once, which would help it hit its earnings targets instead of waiting for them to drift in over the years.

Enron, they decided, would retain slightly more than 50 percent of the assets, but it would set up an oversight committee consisting of three directors who would independently approve every transaction. Astonishingly, Arthur Andersen agreed that this would mean Enron didn’t control EPP and could therefore book profits when it sold assets to EPP. It was, all in all, a remarkably sleazy solution. For their work, Arthur Andersen was paid $750,000 and V&E $1.2 million. Oh, and the chairman of EPP? That was Rich Kinder.

On his way out the door, Kinder took one other thing, the most important of all. He cut a deal to buy Enron’s interest in something called Enron Liquids Pipeline for about $40 million in cash. There was no fairness-opinion done, and Enron sought no competing bids (though it had had the stake on the block for some time). “He knew that system [the liquids pipeline] better than anybody else and he cut one hell of a deal when he left,” says a former executive. That he did. Within a matter of months Kinder had joined up with his old University of Missouri classmate Bill Morgan to form a company called Kinder Morgan. The assets he bought from Enron were the foundation of the company; they included interests in two natural-gas liquids pipelines, one carbon dioxide pipeline and a rail-to-barge coal-transfer terminal.

profit margins in the gas-trading operation had begun to slip as competitors, such as the Natural Gas Clearinghouse (later renamed Dynegy), El Paso, and a host of others had flooded into the business, establishing their own gas-trading desks.

So even though Enron had become the biggest player in the business of buying and selling natural gas contracts, controlling some 20 percent of the market, Skilling was fretting about the future. His solution? To do even more trading and extend it beyond natural gas. He wanted Enron to trade electric power. This was his next Big Idea.

his rationale went something like this: the wholesale electricity market (that is, the power that was sold back and forth among electric utilities) was huge—by Enron’s estimates, about $91 billion a year, triple the size of the market for natural gas. Assuming the company could create an electricity-trading business and claim 20 percent of it, the payoff would be enormous. As the first big entrant in the power-trading business, Enron would be able to create liquidity and exploit the big early profit margins that result from a young, inefficient market. Plus, the federal government was about to pass a law opening the way for deregulation of electricity.

one more big difference between the two businesses: unlike natural gas, electric power can’t be stored. This meant that electricity prices were highly volatile, far more than natural gas. That volatility increased the potential for big profits—and big losses.

his chief deal maker, approached dozens of utilities, none of which wanted anything to do with Enron. Finally, though, he found one: a midsize utility in Oregon, called Portland General.

Skilling, who today blames Mark for spending Enron into bankruptcy, signed off on many of her projects.

Mark wanted to buy a British water utility, called Wessex, as the opening move in building a new Enron subsidiary that she would run. The cost would be $2.4 billion.

What Skilling thought to himself but didn’t say aloud was that approving this deal would get Rebecca Mark out of his way, once and for all.

Signing long-term contracts to provide gas and electricity required understanding all kinds of risks—pricing, delivery, credit, and so on—and knowing how to hedge those risks.

It is business wisdom that many of a company’s best deals are the ones it doesn’t do. That was never the belief at Enron, a place that was defined by deal making.

Incredibly, traders and originators sat on panels that ranked the same RAC executives who reviewed their transactions.

Little attention was paid to customer relationships, since nobody was going to get a big bonus for keeping the customer happy. “We managed to screw and piss off every major utility customer we had,”

Employees were repeatedly encouraged to buy Enron shares; on average, they kept more than half their 401(k) retirement holdings in Enron shares.

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.

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.

The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control.

to a staggering degree, Enron’s “profits” and “cash flow” were the result of the company’s own complex dealings with itself.

But if it’s impossible to mark the moment Enron crossed the line, it’s not hard at all to know who led the way. That was Andrew Fastow, the company’s chief financial officer.

“All the rules create all these opportunities. We got to where we did because we exploited that weakness.” Here’s how another former employee describes the process: “Say you have a dog, but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules for what constitutes a duck: yellow feet, white covering, orange beak. So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, ‘This is a duck! Don’t you agree that it’s a duck?’ And the accountants say, ‘Yes, according to the rules, this is a duck.’ Everybody knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling it a duck.”

Arthur Andersen. It was founded in 1913 by a Northwestern University professor (whose name, naturally enough, was Arthur Andersen).

Arthur Andersen started the first training school for accountants, recruiting young men straight out of college so he could indoctrinate them in the Andersen way.

Spacek was also interested in computers and technology, and when employees came to him with an idea—that Andersen should help corporations figure out how to use these complicated new machines—he helped push it forward, setting up the industry’s first consulting arm.