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

by Bethany McLean

But his real genius was a certain brutish political skill. Pai was Enron’s fiercest corporate warlord. He made short work of the executives who had been placed over him. He took credit for others’ achievements, ridiculed adversaries behind their backs, undermined them in front of colleagues, and simply ignored orders that he didn’t like.

In 1987, Bryan wrote that “securitization’s potential … is great because it removes capital and balance sheets as constraints on growth.” He believed that most financial-services companies would be greatly aided by securitizing their loan portfolios.

One weekend in 1995, while rock climbing there Skilling fell 20 feet and seriously hurt his ankle. A local doctor told him that he could do nothing: the ankle was so badly mangled that Skilling needed to go to a big-city hospital for surgery. Scheduled to leave the next day on a four-day trip to Germany, Skilling bought a set of crutches and hobbled onto the plane. The surgery took place a month later; reassembling his ankle required a bone graft, two pins, and three screws. Skilling later looked on his decision as “setting an example for the organization: things need to get done.”

As a manager, Burns was everything Skilling wasn’t. He motivated people not by throwing money at them but by taking an interest in their lives and making them feel appreciated. He had exquisite people skills. As one ECT employee put it, “He could fire you and you’d feel good about it.” Though Burns lacked Skilling’s crackling intelligence, he had the kind of practical management skills that most companies treasure—and that Skilling never had. He also had little tolerance for the kind of outrageous behavior and free spending that Skilling routinely indulged, or for guys with spikes. “He was the human part of the team,” says an old ECT hand.

One way Enron managed its earnings, even then, was by reworking its long-term supply contracts—which would then allow it to post additional earnings, thanks to mark-to-market accounting.

“If Buy had said, ‘I will not sign off—I will go to the board,’ Jeff would have caved and killed the deal.”

As Martin sees it, Buy’s refusal to press the issue allowed Skilling to maintain that he always respected the integrity of RAC. If Buy had gone to the board, she says, “He would not have had the plausible deniability he wanted. Jeff played chicken, and he never got run off the road.”

Precisely because of their volatile earnings, companies whose business is primarily trading invariably have low stock valuations. Goldman Sachs, widely viewed as the best trading firm in the world, has a price/earnings multiple—the key valuation gauge—that rarely goes above 20 times earnings.

Under Skilling, the budget process at Enron was “a giant game of chicken,” recalls a former executive. “The numbers trickled down. You wanted to say, ‘Wait, I can’t do that.’ But you weren’t doing yourself a service if you did that.” Another executive adds, “It was just the allocation of big numbers. The budget process was last year’s number, plus x percent growth.”

Enron’s reality began and ended with hitting the target. And so, when the realization took place that the company was falling short, its executives undertook a desperate scramble to fill the holes in the company’s earnings. At Enron, that’s what they called earnings shortfalls—“holes.” Calls went out from Skilling and chief accounting officer Rick Causey to the heads of the various company businesses. “We need an extra $15 million!” What rabbits could they pull out of their hats?

And yet he was unhappy. Why? Because even though he was making more money than he’d ever made in his life (and was married to an heiress), he could see plainly that his pay wasn’t even close to what the big earners at Enron were raking in. Even worse, it probably never would be. The people who made the big money at Enron were the executives who either ran divisions or landed big deals.

But executives like Fastow, in finance, were never going to make that kind of money. And that’s because the finance department, important though it was to ECT’s success, wasn’t a profit center in its own right. It didn’t contribute directly to Enron’s earnings; as they say in business, it didn’t have its own P&L. (The letters P&L stand for profit and loss. The phrase means that a division isn’t just a cost center; it makes money for the company.) “The whole story about Andy is that if you didn’t have a P&L at Enron and you didn’t add a lot of money to the P&L, you weren’t a man,” says a former colleague.

“Andy didn’t have the knowledge base required to be the CFO of a major company,” says one of his former bosses at Continental. He had a narrow set of skills—creating financial structures—and lacked the experience and judicious temperament the job required, the willingness to say no to deals and the attention to basics necessary to insure that the company’s balance sheet remained strong. “Andy didn’t have a risk-control bone in his body,” says Sherron Watkins.

He had never stopped seething over the fact that people in finance weren’t considered as important at Enron as the deal makers or the traders, and part of his motivation was to change that perception.

Can you see how this would be an alluring notion for a big company that spends tens of million of dollars each year to light, heat, and cool its offices? Just as consultants had cropped up to handle the complicated computer needs of large corporations, saving them money in the process, Enron was promising to do the same with energy. Its ability to lock in prices on the trading floor would eliminate the worry that volatile energy costs would blow a hole in a company’s budget.

In addition, Enron was promising to use its energy know-how to make efficiency improvements that would save even more money. “That was the pitch,” recalls an early EES executive: “ ‘You go focus on building your widget, and we’ll worry about the energy side of the business. We’re the energy experts.’ ” Depending on the size and term of the contract—some ran as long as 15 years—EES was promising savings of anywhere from 5 percent to 15 percent.

What’s more, this new thrust by EES was taking Enron somewhere it didn’t belong. A business like the one EES was launching requires attention to detail, devotion to customer service, and a willingness to understand—and care about—the nitty-gritty of a company’s energy issues. Enron was promising, for instance, to make energy-efficiency improvements, many of which would require big up-front expenditures. But what did Enron executives know about energy efficiency? Nothing. Enron was promising to run the cooling and heating systems, hire the energy-maintenance staff, change the lightbulbs, and pay the bills. Enron had never shown that it could manage that sort of operation.

One thing Enron was good at quickly came into play, though: cutting deals. EES started out signing pure commodity contracts—selling gas or electricity to companies. When it became clear these weren’t going to generate big profits, EES started bundling the sale of power and gas with energy-management services, in what it called total energy outsource contracts. Offering big customers millions in guaranteed savings, EES began rapidly signing up high-profile clients.

It’s important to note, however, that this “total contract value”—the phrase Enron was using to keep score—bore no relation to either revenues or profits. The term merely represented Enron’s calculation of the cost of all the energy and infrastructure needs a customer had outsourced to EES over the life of the contract. If Enron agreed to supply $500 million worth of electricity to a large corporation over a ten-year period, that $500 million was included as part of the total value of the contract, even if Enron was likely to lose money on the sale. But the number was still useful to the company: it was a way to show growth and to dazzle Wall Street.

It was also a veritable sham. The war room had been rapidly fitted out explicitly to impress the analysts. Though EES was then just gearing up, Skilling and Pai had staged it all to convince their visitors that things were already hopping. On the day the analysts arrived, the room was filled with Enron employees. Many of them, though, didn’t even work on the sixth floor. They were secretaries, EES staff from other locations, and non-EES employees who had been drafted for the occasion and coached on the importance of appearing busy. One, an administrative assistant named Kim Garcia, recalls being told to bring her personal photos to make it look as if she actually worked at the desk where she was sitting; she spent most of the time talking to her girlfriends on the phone. After getting the all-clear signal, Garcia packed up her belongings and returned to her real desk on the ninth floor. The analysts had no clue they’d been hoodwinked.

With that kind of incentive, EES executives used all the standard Enron tricks to make their deals look better than they were. Even though state-by-state deregulation was largely stalled, they priced contracts as if it were inevitable, thus making losing deals appear to be winners. They signed 15-year contracts that even they acknowledged would lose money for the first ten years—but included a wildly optimistic price curve that showed steep profits at the end, making up for all the losses. (Tilting the curves, this practice was called.) They underestimated the cost of and overestimated the savings from efficiency improvements. They stomped all over Rick Buy’s risk assessors.

Then, Fastow explained, he would recommend that McMahon replace him as CFO. It was just the sort of carrot Fastow loved to dangle, yet another way to wield power. Only later did McMahon learn that Fastow had made the same promise to Rick Causey.

McMahon spoke almost nonstop for 30 minutes. When he was finished, Skilling assured him he would take care of it. Skilling later presented a dramatically different account of the encounter. He insisted McMahon’s primary concern wasn’t the ethics of the situation but the awkwardness of negotiating with his own boss and how that “might impact his compensation package.” He said that he’d advised McMahon to “take a baseball bat to Andy” when negotiating on behalf of Enron and that he wouldn’t pay a price for it at bonus time.

The traders were smart, by and large, and they were good at what they did. But their insular culture had a dangerous edge; not only was it self-righteous, but it could never see beyond its own value system. The culture that evolved allowed the traders to justify making money in ways companies should never countenance. Most companies with trading desks don’t allow the traders’ ethos to trump all other values, and they don’t allow the traders themselves to run amok. That both happened at Enron was not so much a failure of the traders but of Enron’s top management, which was supposed to keep them in check but wouldn’t—or couldn’t.

A former army tank captain, Whalley personified the trader’s view of the world. He saw everything in terms of split-second economics; if he couldn’t buy or sell something right this second, it seemed to have no value to him. His favorite book was Ayn Rand’s The Fountainhead, which extols individual achievement and drive over the will of the group. He believed in a culture that maximized the ability of individuals to make their own decisions and reap their own rewards. “People were able to take risks the way they wanted and be accountable for it, which is the most sacred thing in a trading shop,” says a former trader. Whalley had the trader’s ability to strip his decision-making of all emotional content, which he viewed as noneconomic. That’s why another executive says that Whalley “would have been content to interact with a computer 360 days a year.” Even more than Skilling, Whalley believed that he could create a pure meritocracy. He instilled a culture on the trading floor that was ruthlessly mercenary.

have. Whether through ambition or curiosity, he was always looking outside his own sphere for another problem he could fix. That was another rare trait at Enron, and it helped Whalley rise rapidly.

At work, he forced the traders to defend their ideas, even when he already agreed with them. He took that same approach even when he wasn’t working. It didn’t seem to matter to him which side of an issue you took; Whalley leaped to the other side, even on such contentious political subjects as abortion, gun control, or gays in the military. He would say, “I love the NRA” or “people who own guns are idiots,” then abruptly switch sides if someone agreed with him too quickly. It was as if he had no particular moral beliefs himself; it was just a big game. He had zero patience for those he felt lacked the kind of pure intellect he admired and could instantly reduce just about anyone to red-faced, quivering shame. “Whalley had a vicious intelligence to him,” says a former colleague. “If you didn’t know what you were talking about, he would pick you to pieces.”

They believed that free markets made the world a fairer place, one where price dictated deals, rather than relationships or other “noneconomic” factors. To them, the lines were clearly drawn: it was visionaries versus Neanderthals. “Enron,” says a former trader, “was all about changing the world, showing up every day to be a pain in the ass to every incumbent.”

The highest compliment a trader could pay a colleague was to call him intellectually pure. The worst insult was to accuse someone of making a deal that wasn’t economic.

An executive named Bill Butler used to stalk the floor with an eight-foot-long black bullwhip in hand, jokingly threatening traders who didn’t seem to be spending enough time on the phone. Their esprit was such that the traders took great pleasure in outsmarting other parts of Enron, and they didn’t show much mercy for one another, either. “If you showed any weakness, the antibodies would attack,” says a former trader. “Life at Enron,” says another, “was the purest form of balls-out guerrilla warfare.”

Several institutional investors say that Dynegy CEO Chuck Watson used to tell them that his company’s strategy was to keep tabs on Enron. If a new Enron idea appeared to be working, he’d have the same business up and running six months later. 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. Enron sent analysts to meetings of the Washington State’s electric commission, where policy makers talked about the level of water in various dams. When the level was high, that meant there was plenty of hydroelectric power, so the traders might short electricity. “Lo and behold, the dam would release water, prices would drop, and we’d make a ton,” says one former executive. “We just sat there dumbfounded, thinking, this can’t be that easy.”

Unlike other Enron ideas, EOL was a brilliant innovation, but it had a hidden cost. Because Enron was involved in every trade, it dramatically increased the capital requirements of the trading business. Just how dangerous this was would become all too apparent—much later.

Skilling turned to Dave Delainey and said, “Is he right about that?” Baxter, always sensitive to perceived slights, was offended; as he later told an investigator, he felt that Skilling had publicly undermined his authority.

The bull market brought with it the rise of a new breed of institutional investor: momentum investors, who bought stocks primarily because they were rising and whose stock-picking discipline was built solely around whether a company beat its earnings-per-share number.

Outsiders who came into regular contact with Skilling hungered to be included on the list of those who got it. This was especially true of Wall Streeters, who pride themselves on their smarts. On the rare occasions when Skilling was pressed, he would react with scorn. “He did not want to be crossed in any manner, shape, or form,” says one major investor. “He had a good McKinsey trick,” says another. “If you asked a question that he didn’t want to answer, he would dump a ton of data on you. But he didn’t answer. If you were brave and said you still didn’t get it, he would turn on you. ‘Well, it’s so obvious,’ he’d say. ‘How can you not get it?’ ” So the analysts and investors would pretend to get it even when they didn’t.

“Think of us as getting into power trading now and being the J. P. Morgan of the 1870s,” he told one investor around 1998. And when Skilling said things like “I think strategic planning is the antithesis of building a corporation,” everyone thought he sounded like a visionary, not an atrocious manager.

As he extolled the virtues of deregulation, people in the room could only nod in agreement; after all, Enron’s market value had increased ninefold over the past decade. “We’ll do it again this coming decade,” Lay said. After the speech, Lay told an aide, “Some of these guys finally seem to get it.” She replied, “Yes, they’re even using some of our language.”

Where would she get the capital to do all these deals, especially now that Enron wasn’t going to provide it? Her audacious plan was to acquire companies quickly and use their cash to build the business.

“She came into the office every day,” says a former Azurix executive, “never acting like anything other than the fearless leader who would lead you out of the darkness.” Mark once told this person: “You never ever wake up in the morning without saying, ‘I will win today.’ ” That quality of unyielding optimism was her greatest strength. And it was also her greatest weakness.

Fat Boy? Death Star? Ricochet? To Sanders, it scarcely mattered whether the strategies were legal or not. He was a litigator; California was in crisis; people were furious. He knew exactly how these nicknames would sound in court. “Is it too late to change the names?” he asked plaintively. “Can’t you just call them Puppy Dog and Momma’s Cooking?”

It seems that no one agrees what the rules should be when it comes to a commodity that is essential to modern life.

That was the problem with thinking about an elegant idea as profits in the bank (or at least on the income statement) from the moment it was conceived. The real world just doesn’t work that way.

“Our company was running downhill, with our arms pinwheeling, as fast as we can,” says one former executive. “You get to a point where your legs can’t keep up with your body. But we all believed we’d get to the bottom of the hill before we collapsed.”

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.

Kynikos has been around for almost 20 years—an aeon in hedge-fund terms—and is one of the few funds focusing exclusively on short selling to have survived the long bull market. Chanos is always on the lookout for overvalued stocks, but more than that, he’s a kind of financial sleuth, who scours balance sheets and financial documents searching for clues that something might be awry inside a company. Although he doesn’t get them all right—in 1995, Chanos was run over shorting AOL—his batting average in recent years is high.

“Any CEO should be able to handle the hardest of questions from the most aggressive of shorts,” says analyst Meade.

Yet Skilling knew that he no longer had the blind loyalty of Enron’s traders, the major source of the company’s profits. Whalley did. So Skilling dithered. To one insider, it appeared that he was hoping something would give and the decision would magically take care of itself. By letting the situation simmer, says one former executive, “Jeff was tightening the noose around his own neck.”

In all the time he had been at Enron, Skilling had always seemed supremely confident; there was never so much as a crack in the facade he presented to the world. But now that he was CEO, the facade was crumbling; there was something raw about Skilling’s angst. He never seemed so alone as he did once he took the job—and once things started to go awry. His old allies were leaving, and he missed them terribly—missed the good times that they represented, when they were all so excited to come to work every day and invent a new industry.

Always before, Skilling was able to come with a new big enchilada to drive the business—and the stock price. That was the part of being a businessman that he loved. But he was out of big ideas. Righting Enron required lowering everyone’s expectations—something he could not bring himself to do—and fixing problems, which he hated. “It was getting hard,” says a former executive, “and Jeff doesn’t do hard.”