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

by Bethany McLean

Lay even ran into trouble coming up with a trendy new name for the company. After four months of research, the New York consulting firm Lay had hired had settled on Enteron in time for the merged business’s first annual meeting, in the spring of 1986. But then the Wall Street Journal reported that Enteron was a term for the alimentary canal (the digestive tract), turning the name into a laughingstock. Though it meant reprinting 75,000 covers that had already been printed for the new annual report, the board convened an emergency meeting and went with a runner-up on the list: Enron.

For months, Borget had been betting that the price of oil was headed down, and for months, the market had stubbornly gone against him. As his losses had mounted, he had continually doubled down, ratcheting up the bet in the hope of recouping everything when prices ultimately turned in his direction. Finally, Borget had dug a hole so deep—and so potentially catastrophic—that there was virtually no hope of ever fully recovering. Borget was confessing because he had no choice.

Enron Oil was short over 84 million barrels. The position was so huge that it amounted to roughly three months’ output of the gigantic North Sea oil field off the coast of England. If Enron were forced to cover its position, it would have been on the hook for well over $1 billion.

McKinsey partner once told Forbes: “We don’t learn from clients. Their standards aren’t high enough. We learn from other McKinsey partners.”

Although Enron was assuming the traditional role of the banker, it had major advantages over banks. In extending a loan, a bank would try to err on the conservative side, because it had no idea where the price of gas was going. If the price plummeted, the producer might go bankrupt. (In fact, this had happened quite often after the energy bubble of the 1980s burst, which is why so many banks were in trouble.) But Enron absolutely knew the price it could get for the gas: it had already sold it. And because of that knowledge, it was able to lend far more money than a bank typically would.

Enron’s financial filings soon included this phrase: “recognized, but unrealized, income.” In other words, Enron had booked the earnings, but it didn’t yet have the cash.

men: “Never, ever abandon your wingman.” And: “Never, ever do the easy wrong instead of the harder right.”

Most of the ranking categories involved collaborative qualities, such as “teamwork/interpersonal” and “communication/setting direction.” What really counted, though, was the bottom line. “If they were making money and being total jerks to people, we’d always forgive them for that,” says one early ECT executive. “They might be a 5 in teamwork, but if they were a 1 in earnings, they were a 1. If you weren’t doing deals, we had trouble valuing your contribution to the company.”

“Many times the biases against women are those of our own creation,” she told another. “If you approach people thinking that you’re not going to be discriminated against, most often you’re not.”

“If you wanted to get Lay to attend a meeting,” recalls a former executive, “you needed to invite someone important.”

It even began using the approach to book profits on private equity and venture-capital investments, where values were extraordinarily subjective. By the end of the decade, some 35 percent of Enron’s assets were being given mark-to-market treatment.

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. When Enron expanded the use of mark-to-market accounting to all sorts of transactions—was that when it first crossed the line? How about when it set up its first off-balance-sheet partnerships, Cactus and JEDI, with such reputable investors as General Electric and CalPERS? Or when it categorized certain unusual gains as recurring? Or when it created EPP, that “independent” company to which Enron sold stakes in its international assets and posted the resulting gains to its bottom line?

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.”

up were meant to accomplish a fairly simple set of goals: keep fresh debt off the books, camouflage existing debt, book earnings, or create operating cash flow.

Amazingly, the rules developed by the accounting gurus stated that as long as 3 percent of the capital in the SPE came from an independent source and was truly at risk—meaning that it could all be lost if the deal went awry—the SPE qualified as independent. In other words, even if 97 percent of the capital consisted of debt raised by the company selling the assets, the company didn’t have to include that debt on its balance sheet. (Don’t search for the logic behind the 3 percent threshold. There isn’t any. For years, there were some, including a few high-ranking accountants at Arthur Andersen, who argued that 3 percent was absurdly low.)

The accountants would never approve it, he said. Sure they will, Fastow and Kopper told him. “We can get you an opinion letter.” “How do you determine valuation?” he asked. Fastow and Kopper grinned. “It’s whatever you want it to be,” one of them replied.

On the trading floor, where the two pieces of required reading were When Genius Failed, about the collapse of the giant hedge fund Long-term Capital Management, and Reminiscences of a Stock Operator, about the adventures of a turn-of-the-century speculator,

One of Enron’s key advantages over its competitors was information: it simply had more of it than its competitors. Its physical assets provided information, of course. And Enron didn’t stop there. It employed former CIA agents who could find out anything about anyone. Instead of tracking the weather on the Weather Channel, the company had a meteorologist on staff. He’d arrive at the office at 4:30 A.M., download data from a satellite, and meet with the traders at 7:00 A.M. to share his insights. (The traders would also call him for weather reports before they left for vacation.) Early on, Enron employees paid farmers located near power plants to let them put cameras on fences to monitor activity. Later, the stunts grew more elaborate. Once, the company sent an analyst to pose as a porta-potty salesman. His task was to figure out how long a plant was supposed to be under construction so the traders could learn when it might start producing power.

They regularly consulted with the company’s investor relations executives, who quietly gave them what came to be known as earnings guidance. Using that guidance, the analysts came up with their earnings estimates for the next quarter (or the next year), which they would then market to their big institutional clients.

Enron also had the blessing of the world’s preeminent consulting firm: McKinsey, which called Enron employees “petropreneurs.”

In a December 1999 employee meeting an employee asked Skilling if Enron would ever consider merging with a company like Mobil. The Enron president responded: “Well, unfortunately, Mobil has just merged with Exxon, so it won’t be Mobil, which really disappointed me, because if we could have merged with Mobil then we could have been MORON.”

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.

On Thursday, the company drew down the $3 billion in backup credit lines to its commercial paper. To Wall Street, this was instant confirmation of Enron’s desperate straits. Virtually all large companies have such backup credit as part of their financing structure, and they’re technically entitled to tap it whenever they want. But no lender ever expects—or wants—it to be used, since the debt is totally unsecured.

‘There’s just one problem,” someone said. “We’re not sure whether the related party is Michael Kopper—or Michael Kopper’s gay lover.” Ken Lay turned pale. “His gay lover? What the fuck is going on around here?”