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

by Bethany McLean

First quarter 2000: EBS announces $59 million in revenues. It gets almost the entire amount by exchanging surplus strands of fiber on its own network for strands built by competitors that expand its reach. This helps to build out EBS’s virtual network, and it also taps into an accounting oddity that Enron is happy to exploit: the fiber Enron is selling can be accounted for as an immediate gain, while the fiber it is purchasing can be depreciated over 20 years. Though no cash changes hands, this produces an instant boost to the bottom line for both parties. These deals, popular among many telcom companies desperate to show revenue growth, become known in the industry as fiber swaps.

To make its numbers for the fourth quarter, Enron resorted to a positively breathtaking scheme, a truly brazen feat of accounting duplicity. Enron Broadband ended its year by booking $53 million in earnings on a deal that was well on its way toward collapse and hadn’t produced a single penny of profit.

Cox had landed an exclusive 20-year agreement with Blockbuster, the nation’s biggest video-rental chain, to collaborate on a new video-on-demand service. Under the agreement’s terms, Blockbuster would use its Hollywood clout to obtain licenses for films and other content while Enron would be responsible for figuring out how to stream it into homes.

A big piece of the challenge for video-on-demand was solving what’s known as the last-mile problem—getting the content from Enron’s network into people’s homes. That required negotiating agreements with the phone companies that provided local DSL service across the country. Enron executives, according to a Blockbuster official, had assured the video chain they had the phone companies “in our pocket”—and under the terms of the deal, Blockbuster had the right to walk away if Enron hadn’t gotten them all on board by December.

But without all the phone companies on board, Enron was reduced to conducting testing in three of the cities using tiny providers. Only about 300 households were involved; in Seattle, the test was limited to just three apartment buildings. Much of the testing didn’t even use standard DSL equipment.

Here’s how it worked: even before the pilot program was begun, EBS calculated a value for the entire 20-year Blockbuster deal, based on projections—wildly speculative, of course—about future DSL use, customer video purchases, the speed of the rollout, market share, expenses, and other factors. Then, through a series of transactions, it sold most of its interest in the Blockbuster contract to an outside buyer. EBS then began booking profits up front.

Blockbuster executives say they were astounded to find out months later that Enron had booked $111 million in profits on their unprofitable venture.

Black summed up his EES experience this way to a colleague: “It’s like going to work every day with your hair on fire and nothing to put it out with but a hammer.”

But Enron wasn’t really hedging against a true economic loss; rather, it was using the Raptors to hedge against an accounting loss. It did this through a dizzyingly complex series of derivative transactions that essentially amounted to tapping, once again, the value of its own shares. As the underperforming assets placed in the Raptors continued to decline in value, the Raptors would have to pay Enron—therefore giving Enron a gain that would offset the loss. Voilà! The company had avoided having to report a decline on its income statement.

instead of being funded with Enron stock, this Raptor held warrants in New Power—the very investment that it was supposed to hedge. This meant that if the price of New Power fell, Porcupine’s obligation to Enron would grow at the same time that its ability to pay on the hedge was dropping. Thus, “this extraordinarily fragile structure” (as the special board report later described it) was “the derivatives equivalent of doubling down on a bet.” Porcupine could survive only if New Power shares, which were about to go public, climbed in the aftermarket.

In 2000 alone, the Raptors alone shielded Enron from more than $500 million in losses. In their brief lifespan, they allowed Enron to avoid booking an astonishing $1 billion worth of losses—effectively tripling the profits Enron reported to investors during that period.

He insisted that there was no rational basis for LJM to agree to use some SPEs to prop up others.“Heads I win, tails you lose,” as Bass described

agreed to “bridge” the Raptors through the end of the year. Without telling Bass, they cross-collateralized the four Raptors for 45 days, enabling Enron to avoid reporting $500 million in losses. (LJM2 was paid $50,000 for its trouble.)

His life changed forever when he began looking into a company called Baldwin United. Baldwin, which had been formed from the merger of a piano maker and an insurance company that sold annuities, was one of the hottest stocks of that era. After months of dogged research, Chanos realized that the high-flying Baldwin was, in essence, a giant Ponzi scheme that raised money secretly through subsidiaries, turned the money over to the parent to support its enormous capital consumption, and used aggressive mark-to-market assumptions on its portfolio of annuities to create fabulous earnings growth.

But by the fall of 1983, Baldwin had filed for bankruptcy, and the scandal had burst into the open. In 1985, Wall Street firms settled with the annuity holders for $140 million. That same year, Chanos founded Kynikos, named after a sect of ancient Greek philosophers that believed the key to life was self-discipline and independence of thought.

While Enron’s reported earnings were growing smoothly, the business didn’t seem to be generating much cash—and you can’t run a business without cash. In fact, Enron had negative cash from its operations in the first nine months of 2000. (It was impossible to analyze the full year because Enron released an income statement only when it announced earnings—not a balance sheet or a cash-flow statement. Only when the report was filed with the SEC a month or so later could anyone really dig through the numbers. This soon became a huge issue.)

he was concerned that Enron was not disclosing how much money Fastow was making from LJM, as the law seemed to require. As a rule, if top executives are making substantial sums from an entity that does business with the company, they have to tell shareholders.

When Enron’s 2000 proxy was filed in late March, it contained no information about Fastow’s pay. Mintz, relying on lawyers from Enron and Vinson & Elkins, had used a loophole to avoid disclosing what Fastow was earning. Because not all transactions between LJM2 and Enron had officially settled, the lawyers maintained that they couldn’t calculate Fastow’s income yet.

his departure was termed an involuntary termination, which meant that all of Kopper’s options and restricted stock vested.

sinecure.

Frantic for a way out, Lay decided to secretly take advantage of a little-known quirk surrounding executive loans: they can at times be paid off by selling stock back to the company. What’s more, unlike regular executive stock sales, which have to be disclosed almost at once, these sales don’t have to be disclosed until after the end of the year. Back in May 1999, Lay had modified his loan agreement to include this loophole; starting in November 2000, Lay began repeatedly drawing down a $4 million line of credit he had with Enron, using it to pay off his creditors and then repaying the loan by selling stock.

One scenario Buy presented envisioned a truly chilling chain of events. It begins with the announcement that Enron would miss its quarterly-earnings target, triggering a massive stock sell-off. This, in turn, leads to the collapse of the company’s balance sheet, because it forces the unwinding of all the off-balance-sheet vehicles that were capitalized with Enron stock, which prompts downgrades in Enron’s credit ratings, which trigger the material adverse change clauses in the company’s trading contracts, which cause its trading partners to start demanding that Enron post cash collateral, which of course it doesn’t have. All of this, in turn, wipes out Enron’s remaining liquidity and destroys investor confidence.

Some decided they didn’t care; watching Skilling hype broadband all the way down had dented their faith. “The bloom was off the rose,” says one. Yet other traders quickly came up with their version of a Titanic joke: “Women and children first—right after Jeff.”

Lay contacted Jim Derrick, Enron’s general counsel, and they quickly made arrangements to have Watkins’s allegations investigated by an outside law firm—namely, Vinson & Elkins. Watkins, of course, had explicitly offered the commonsense advice that another firm handle the matter; indeed, V&E had done legal work on the very transactions she was complaining about. But Lay later said he had concluded this conflict could be managed and that it made sense to hand the assignment to lawyers already familiar with the complexities of Enron. V&E certainly fit that bill: it was every bit as intimate with Enron as Arthur Andersen.

The balance-sheet error, of course, was a mistake. But Enron argued—incredibly—that this $1.2 billion balance-sheet error wasn’t “material” under accounting rules, because it amounted to only about 8.5 percent of Enron’s total net worth.

Even more astonishing, the release didn’t even mention the separate $1.2 billion cut in shareholders’ equity—which wouldn’t show up on the accompanying financial statements since Enron never released its updated balance sheet until well after the quarterly-earnings statements.

Several minutes into the question period, Lay was handed a written query, which he read aloud: “I would like to know if you are on crack. If so that would explain a lot. If not, you may want to start because it’s going to be a long time before we trust you again.”

With Enron’s stock continuing to sink, panic was taking hold. The immediate problem was that Enron had been unable to roll its commercial paper—the portfolio of unsecured short-term loans that all big companies use to fund their day-to-day needs. Renewing such debt was normally a routine matter. Though the amounts involved were huge (for Enron, about $2 billion), the exposure was so brief (as little as 24 hours) that, for lenders, it was really nothing to worry about—unless they had reason to wonder if the company would survive long enough to pay it back.

The company lacked the kind of sophisticated cash-management systems that big companies required. McMahon couldn’t even find a maturity schedule showing when all Enron’s debt would need to be repaid—a basic tool in corporate finance. In fact, with all the tangled off-balance-sheet machinations—obscuring what obligations were truly Enron’s, obscuring even what was truly debt—no one could immediately tell McMahon how much money Enron owed.

Even as David Duncan and others were generating a written record of what was going on, a 38-year-old in-house lawyer named Nancy Temple had begun looking over their memos, advising them to edit out language, and even destroy documents that might look bad in court. As it turned out, this campaign to sanitize Andersen’s files proved even more lethal than the firm’s craven accounting.

Andersen had just paid a $7 million fine in connection with the billion-dollar accounting fraud at Waste Management; it was operating under an SEC cease-and-desist order barring it from further misconduct.

In the days to come, Temple continued to edit internal documents even as they were being generated; at one point, she suggested deleting senior Andersen partners from the circulation list for Enron e-mails because it “increases their likelihood of being a witness.”

“Your secrets are safe with us.”) Andersen’s offices in London, Portland, and Chicago joined in, shredding their Enron documents. In addition to the paper, almost 30,000 e-mail messages and computer files were deleted.

One of the prices of becoming a supplicant is having to expose yourself to unfamiliar scrutiny.

At another board meeting two days later, there was an even more sobering legal presence: Martin J. Bienenstock, corporate America’s grim reaper. Bienenstock, with the New York firm of Weil Gotshal & Manges, was the nation’s preeminent bankruptcy lawyer.

The list of those suing the company grew to include Enron’s own employees, who had seen much of their retirement-plan savings disappear. They claimed Enron’s top executives had misled them about the riskiness of Enron shares and locked them into their plummeting holdings for a month while the company changed plan administrators. Between the company’s savings and stock-ownership plans—60 percent of the total assets in both consisted of Enron stock— 20,000 Enron employees lost about $2 billion in 2001.

Then came the clincher: Lay wasn’t going to leave. Enron was prepared to take Joe Foster on but only as an interim vice chairman.

a routine court hearing on “initial orders,” which would allow the bankrupt company the ability to conduct ordinary business, like paying employees and vendors.

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.

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.

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.

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.

Indeed, in many ways, Enron was a legal fraud. Fastow’s guilty plea—and Skilling’s and Lay’s convictions—were due to specific incidents where prosecutors could show that the Enron executives had crossed the line. But they didn’t speak to the larger fact that Enron’s financials were basically a complete misrepresentation of reality.