Review: The Smartest Guys in the Room, pt1

I bought the original October 2003 edition of this book way back in December 2013. By that point – unbeknownst to me – the second edition had already been published, which probably catalogues the fates of many former Enron executives. Nevertheless, this book was fascinating – despite having taken me 10 years to read it – and it contains numerous lessons that are just as valid today as they were 20 years ago.

Enron’s rise can be attributed to Ken Lay’s experience, connections, and timing. He was uniquely positioned – by virtue of his education and DC insider status – to take advantage of Reagan-era deregulation of the natural gas industry, and he used it to full advantage. However, Enron’s early years showed a corporate culture that would later lead to its demise: Lay’s hands-off attitude toward those who made money (by whatever means) showed in how he handled Louis Bourget, who embezzled money and later went to jail. Lay tended to hire cronies, and only afterward give them jobs, which subverted his chain of command. He also refused to check subordinates’ egos or make the tough decisions himself, preferring instead to play glad-handing politician.

Jeff Skilling replaced Rich Kinder as Chief Operating Officer (COO) in 1997, accepting the job on the condition that Enron adopt mark-to-market accounting. Skilling was a brilliant consultant, but as a manager he hated 1.) cleaning up other people’s messes, and 2.) getting involved in details. He had terrible ideas about who to hire (guys with “spikes”), how to maintain loyalty (by showering people with money) and how to manage (his peer evaluation system). He focused exclusively on “the big picture,” and dismissed anyone who disagreed with him or pointed out troubling details (HE was the smartest guy in the room). This being the mid-90s boom economy, though, Enron’s faults were masked by bull economy mania.

Beginning with Enron International (EI) under Rebecca Mark, Enron began experienced a series of failures. International business is, by its very nature, fraught with problems and risks, but Enron always assumed the best when predicting future income streams. Using mark-to-market accounting, EI would make foreign direct investment deals and post the future income all at once, without regard for the innate risk involved with international projects. Enron had a flair for glamour, but also overspending, and EI was sold off in 1998. However, the spin-off, Azurix, didn't do any better in the water business, and Mark was fired in 2000. Skilling’s clique rejoiced in her failure, seeing it as a vindication of his business model, but failed to appreciate that Enron was consequently saddled with Azurix’s debt.

Skilling had trouble managing an important question: “Can earnings grow at 15+% sustainably?” The collective answer was “yes,” but he ignored an important qualifier – “so long as stock options continue to vest for executives who meet that goal, and you don’t really worry about our methods.” Given the incentives involved, executives found ways to make it look like they were doing great, all the while pushing the true price to the more distant future.

Before 1997, Rich Kinder had been the guy who made the tough decisions for Lay and and kept everyone in line. However, with Skilling as president and COO, things got out of control. Skilling weakened the internal oversight division, created toxicity through his peer evaluation system, ignored favored-subordinates’ ethics-breaching affairs, and let employees move themselves around in a classic example of what I call “Kindergarten soccer.” The mark-to-market accounting system also grew rife with unchecked abuses, as future cash flows were often entirely imagined. Toni Mack’s 1993 article “Hidden Risks” in Forbes foresaw the problems involved, but in the heady days of the late 1990s, these warning had all been forgotten. Skilling moved the focus away from pipelines and natural gas trading toward glitzier things like Broadband internet access and speculation trading.

During this time, Skilling also brought Andrew Fastow on board. Fastow specialized in creating Special Purpose Entities (SPEs) that could hide off-balance sheet debt, and rose to become Chief Financial Officer. However, despite Fastow being fêted as a genius (and awarded CFO of the Year by CFO Magazine in 2000), he was only really good at that one thing. This made Enron look profitable, even though its cash flow wasn’t there to back it up. In addition. Rick Causey was a weak Chief Accounting Officer, and often served as a mere enabler for Fastow's schemes rather than a check on unethical behavior.

At the same time, Enron’s auditor, Arthur Anderson, let its consulting wing’s profit motives trump its accounting wing’s concerns. They saw their job as “providing good customer service” rather than “properly informing the public.” Analysts and finance pundits, too, proved biased in their assessments of Enron. For example, Fortune magazine named Enron the most innovative company in America for six consecutive years. Those who benefited from Enron’s success story perpetuated the glass-half-full side of Enron’s story, and either dismissed or doen-played the glass-half-empty side.

In describing how Enron issued off-balance-sheet debt, backing it up with Enron stock, bankers gushed. By hiding debt in ways that could be unreported on annual statements, one Lehman Bros banker said, “He has invented a ground-breaking strategy.” In the bull-run economy, it was easy to assume the stock would continue to go up, so banks continued to lend money, and investment talking heads continued to issue “buy” statements on Enron’s behalf. Fastow got an exemption from Enron’s code of ethics, and used his insider status as CFO to profit from Enron.

Convinced of his own incredible intelligence and far-sighted vision, Skilling led Enron to enter the broadband industry and California’s electric power industry. Broadband proved a bust for two reasons: 1.) internet access and data packets just weren’t like natural gas – you couldn’t “reallocate” bandwidth, and 2.) content-on-demand was still about seven years away (YouTube didn’t start until 2006, and Netflix only started streaming in 2007). Despite its big promises, Enron Broadband only wasted a lot of money.

The California energy market proved to be a terrible strategic move, too. While Enron stood to gain in the long run from a successful de-regulation, its traders instead acted entirely on their short-term interests and sabotaged the company’s wider goals. They exploited quirks in California’s system to create artificial shortages, drove up prices, and caused blackouts. This brought a huge wave of profits, but in doing so they angered the public and undercut Enron’s long-term interests. Nevertheless, Enron placed the blame entirely on California. As Skilling famously stated, "We're on the side of angels." [Source]

In spring 2000, the dot-com bubble burst, tanking the valuations of many internet companies. Although Enron was at first buoyed by its other ventures (like the California energy business), other failures led to greater scrutiny, and short-sellers began to question whether Enron might be on the decline as well.

Enron’s stock peaked at $90 in August 2000, but that was its high water mark. Over the next year, Enron suffered a series of blows which seriously affected Enron’s public image. The backlash in California, a discovered $700 million accounting error, the leftover debts from Azurix coming due, the discovery and unwinding of Andrew Fastow’s SPEs, the 9/11 attacks, an explosion at Teeside, and the downsides of Skilling’s mark-to-market accounting all hammered Enron’s stock.

In August 2001, Skilling resigned, forcing Ken Lay to come back to everyday operations. Then, as reporters kept asking harder and harder questions about Fastow’s secret machinations and how much he’d profited at his employer’s expense, Fastow was fired in October.

By this time (10/24/2001) what Lay billed as a “perception” problem was becoming a cash problem. As the stock price fell, more and more debts that were backed up by stock became due, pushing the stock farther and farther down. As Enron sought more and more cash just to maintain operations, creditors wanted more and more details about what they were getting themselves into, until Enron could no longer keep a lid on anything.

At first, Lay sought a buyout from Dynegy, but continued bad news and a clash of corporate cultures (Enron traders were just too arrogant to accept being bought out) made this unfeasible. Enron filed for bankruptcy in December 2002.