Focus Take-Aways

Rating (10 is best)

Overall Applicability Innovation Style

To purchase individual Abstracts, personal subscriptions or corporate solutions, visit our Web site at www.getAbstract.com or call us at our U.S. offi ce (954-359-4070) or Switzerland offi ce (+41-41-367-5151). getAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. getAbstract maintains complete editorial responsibility for all parts of this Abstract. The respective copyrights of authors and publishers are acknowledged. All rights reserved. No part of this abstract may be reproduced or transmitted in any form or by any means, electronic, photocopying, or otherwise, without prior written permission of getAbstract Ltd (Switzerland).

The Smartest Guys in the Room

The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean and Peter ElkindPortfolio © 2003434 pages

• Enron, a massive energy management fi rm, turned out to be a house of cards.

• Its strong written code of ethics apparently did not infl uence day-to-day operations.

• Jeff Skilling, hotshot COO and, later, CEO, spun fantastic tales about Enron’s rich prospects. Analysts, auditors and reporters believed him without skepticism.

• Instead of stopping the fraud, Enron’s board rubber-stamped management.

• Enron made Andy Fastow its CFO in ‘98 despite his lack of accounting know-how.

• As CFO, Fastow used his considerable power on Wall Street to intimidate, manipulate and ultimately destroy people who should have policed his conduct.

• He helped engineer and personally profi ted from shady transactions that allowed Enron to hide massive debts and report good results — until it declared bankruptcy.

• Enron’s failure shook confi dence in American markets and corporate governance.

• Enron’s board and the various independent analysts who covered the company denied any responsibility for their failure to know and tell the truth about the massive fraud.

• Skilling told Congress that Enron’s only problem was liquidity and the ensuing panic was like a run on a bank. He denied personal, corporate or accounting wrongdoing.

9 7 8 10

Leadership & Mgt.

Strategy

Sales & Marketing

Corporate Finance

Human Resources

Technology & Production

Small Business

Economics & Politics

Industries & Regions

Career Development

Personal Finance

Concepts & Trends

The Smartest Guys in the Room © Copyright 2004 getAbstract 2 of 5

Relevance

What You Will Learn

In this Abstract, you will learn the whole, detailed story of the rise and fall of Enron.

Recommendation

Enron is, of course, old news by now. The company went bankrupt in 2001, and its

spectacular collapse was merely the fi rst of a series of notorious corporate scandals.

Most of the story Bethany McLean and Peter Elkind tell in their book has already

appeared in newspaper and magazine accounts and in other, rush-to-publish books that

hit the market during or shortly after the events described. However, these authors have

assembled what may be the single most comprehensive, detailed account and written

it like an anecdote-rich, lively business-based novel. We do wish they had included a

timeline and a list of sources, since they have had the benefi t of being able to draw on

all of that other work, on indictments and on testimony before courts and Congress, but

their account is engrossing and complete. If you read just one book on the Enron scandal,

getAbstract.com believes this may be the book to read.

Abstract

The End

At 2:00 a.m. on Sunday, December 2, 2001, attorneys for Enron fi led a petition for

Chapter 11 bankruptcy. Enron had no choice — it had tried to arrange to be acquired or

merged, but its overtures had been rebuffed. This was an astonishing end to the U.S.’s

seventh largest fi rm.

Six months later, a court found Enron’s auditor, Arthur Andersen, guilty of destruction of

evidence. The evidence consisted of memoranda, letters and thousands and thousands of

pages of other information about Enron. David Duncan, the Arthur Andersen partner who

had helped instigate the document shredding, also pled guilty to obstruction of justice.

Securities analysts tried to use the Andersen convictions as an excuse for their own

malpractice. They claimed that Enron manipulated its accounting but that since a

respected auditor, Arthur Andersen, had signed off on the accounting, they could hardly

be blamed for relying on the numbers. Their claims rang hollow to those who knew

how Wall Street worked. Most securities analysts labored for banks and brokerage fi rms

that had done big business with Enron, and they had paid for that privilege by ensuring

that their analysts sang Enron’s praises. Some of those major banks and brokerage

fi rms became targets of Securities Exchange Commission (SEC) and Justice Department

investigations after the scandal broke. Merrill Lynch accepted a settlement under which

it paid $80 million in fi nes, but it did not admit any guilt.

Meanwhile, Enron’s own board of directors disclaimed any responsibility for failing to

oversee the company’s operations or to make sure that the executives were doing business

legally and ethically. They said that the company’s clever managers had deceived and

blinded them, presenting false numbers that they had no reason to doubt. But Enron’s

fraud was hidden in plain view. Some astute short sellers and hedge fund operators saw

the same numbers, knew what they meant, and bet big money on the Enron emperor’s

unacknowledged nudity. Their bets paid off handsomely when Enron went down. It

“It is utterly beyond question that in reshaping Enron after he was named its presi- dent, Skilling turned it into a place where fi nan-cial deception became almost inevitable.”

“Like many of the other major play-ers in the Enron saga, Jeff Skilling made his way to the top of Amer-ican business by sheer force of will.”

The Smartest Guys in the Room © Copyright 2004 getAbstract 3 of 5

strains credulity to imagine that the board members, with their access to privileged

information and their power to hire or fi re managers, could not see as much as outsiders

with access only to fraudulent fi nancial reports.

But most people involved with Enron lost. Employees lost. Stockholders lost. Pension funds

lost. Even people who never bought a share of Enron stock lost when Enron went down,

because Enron’s failure rocked the fi nancial foundations of America. What happened?

The Frauds

Many things were wrong with Enron and, after its demise, many people were

willing to explain them. But the proximate cause of Enron’s failure was a series of

illegitimate fi nancial transactions involving what accountants and investment bankers

call structured fi nancings.

The story of Enron’s fi nancial prestidigitation began innocuously enough in 1998, when

newly appointed CFO Andy Fastow, age 36, suggested to Enron’s top managers that the

company should issue additional stock. President and COO Jeff Skilling and Chairman

and CEO Ken Lay were not keen on the idea because they felt that issuing more stock

might hurt Enron’s stock price. Fastow convinced them. The new issue raised $800

million. Then Fastow got creative. He had to, because management had promised Wall

Street that the company would grow marvelously. But growth required even more capital

and Fastow had just three ways to get it:

• Borrow — But the more Enron borrowed, the higher its cost of borrowing became.

Banks and bond buyers base their lending decisions on a company’s risk. The more

a company borrows, the higher its risk and the lower its credit rating. The lower its

credit rating, the more it has to pay to borrow.

• Issue stock — The company had issued stock successfully, and its stock price was

high. However, the law of supply and demand works in the stock market as in any

other market. The more shares of stock in a company there are on the market, the

smaller each share is. Issuing a disproportionate number of shares “dilutes” the

stock. As a result, the more stock there is, the smaller the share of the company each

stock represents and, other things being equal, the lower the stock price. Enron’s

shareholders bought their shares in expectation of rising, not falling stock prices. If

the stock price started to slide, they would probably sell, forcing it down even farther.

Thus, Jeff Skilling was cool to Andy Fastow’s 1998 proposed stock issue. Enron may

have lucked out that time, but it couldn’t luck out every time.

• Structured fi nance — Using certain innovative transactions, Enron could make bil-

lions of dollars in capital appear without borrowing or issuing stock.

The choice among these was no choice at all. Fastow opted for structured fi nance. The

degree to which Skilling and Lay assented is still a question for the courts to decide.

Many observers doubt that executives as sharp as these two could have been entirely

unaware of Fastow’s creativity or innocent of any involvement in it. In fact, Cliff Baxter,

another Enron executive, told Skilling he was concerned, noting, “You could never tell

whether deals were clean because they were so complicated.” When the dimensions of

Enron’s malfeasance became public, Baxter committed suicide.

To get a glimmer of an understanding of what Fastow created, begin with Whitewing.

To establish Whitewing in 1997, Enron borrowed $579 million from Citigroup and

another $500 million from a Citigroup affi liate. A few equity investors bought stock

“Baxter had a towering ego and a volatile person-ality…Though he eventually made millions at Enron, he also com-plained frequently that he was under-paid and unappre-ciated.”

“To the outside world, the person who was Enron, who had a repu-tation for turning impossible con-cepts into glittering realities, was not Skilling. It was Rebecca Mark.”

“One of Enron’s key advantages over its competi-tors was informa-tion: it simply had more of it than its competitors.”

The Smartest Guys in the Room © Copyright 2004 getAbstract 4 of 5

in Whitewing, which in turn bought $1 billion of Enron preferred stock and paid $79

million to the equity investors as a return on their investment. A lay observer would look

at this and conclude that Enron had borrowed a lot of money. True. But accounting rules

allowed Enron to treat Whitewing as a “minority interest transaction,” which let Enron

account for its borrowing as investment in a joint venture. Whitewing owned only Enron

stock, but the market did not object to its structure and Enron’s stock price rose.

In 1999, Enron got even more creative. It set up another structure called Osprey. Enron

raised $100 million from some insurance fi rms and bankers, offering in exchange some

paper that committed Osprey to pay a fi xed return. To the untrained eye, this looks like

borrowing. To Enron’s auditors, it must have looked like stock in Osprey, because that

is how they allowed Enron to treat it. Enron then borrowed $1.4 billion from various

institutional investors for Osprey, using a third of the money to pay off the Citigroup

loan that created Whitewing. Osprey now owned Whitewing. Enron used the rest of the

money cleverly, too. When Enron needed revenues to meet fi nancial projections, Osprey

would “buy” assets from Enron. Osprey had two very signifi cant characteristics:

• Enron said that if Whitewing’s assets (Enron preferred stock) weren’t worth enough

to pay back investors, Enron would issue stock to compensate for any shortfall.

• If Enron’s credit rating were to slip to non-investment grade or if its stock traded

under $28 per share, investors could demand immediate repayment.

Accounting rules allowed Enron to act as if it had no debt, even though it was clearly

on the hook for the Osprey borrowings. In addition to structures like Whitewing and

Osprey, Enron also made liberal use of “securitization,” which means selling investors a

share in a stream of revenues. Banks sell mortgages to investors using “securitization.”

Credit card companies also use securitization to turn their receivables into ready cash.

Enron used an accounting device called a special purpose entity (SPE). Accounting

regulations clearly stated that if as little as three percent of an SPE’s ownership was

independent of Enron, Enron could treat the SPE as a totally independent entity, and say

little or nothing about it on its own books. Enron securitized revenues it anticipated from

risky deals such as Third World power plants. In theory, nothing is particularly wrong

with SPEs, but Enron did some things that appear to be very wrong indeed:

• The independence of Enron’s “independent investors” was questionable; often they

were customers or employees, their relatives or friends, or other interested parties.

• Enron often promised implicitly or explicitly that it would “take care of” lenders,

again fl exing the defi nition of independence to the breaking point.

• Essentially, Enron borrowed huge sums of money from investors and reported the

borrowings as revenues or cash fl ow instead of as debt.

Enron’s use of structured fi nancings and SPEs was probably the most aggressive in

history. It may be an indication of Andy Fastow’s wit that he named a number of his most

creative fi nancings after characters in the fi lms Star Wars and Jurassic Park.

The Cover Up: “He Who Pays the Piper Calls the Tune.”

As long as Enron concealed the truth from investors, its share price continued to

rise. In theory, the stock market is full of checks and balances, including sharp-eyed

analysts, bankers and regulators who are alert for fraud and whose duty it is to keep

companies from doing the sort of things that Enron did. All of these checks and

balances failed to stop Enron. Why?

“People at Enron simply didn’t believe they were vulnerable.”

“Everything was perception; noth-ing was real.”

“The enormous profi ts Enron’s traders made in 2000 and the fi rst half of 2001 had raised a fi nal, sobering question: how long could they keep it up?”

“There were other warning signs. Enron’s debt was climbing rapidly — $3.9 billion of debt was added on the balance sheet in the fi rst nine months of 2000 alone — which didn’t make sense.”

The Smartest Guys in the Room © Copyright 2004 getAbstract 5 of 5

• Auditor confl ict of interest — Enron’s auditor was Arthur Andersen, which was

charged with auditing Enron’s books and either persuading the company to correct

any irregularities or informing investors that the books were not quite kosher. But

Andersen did a lot of other business with Enron. In fact, in 2000, Andersen earned

$52 million from its business with Enron, and most of that had nothing to do with

auditing. The old saying, “He who pays the piper calls the tune” sums up Arthur

Andersen’s attitude to Enron. Investors paid Andersen nothing. Enron paid it a lot.

Moreover, Enron often hired some of its best-paid executives from Anderson’s ranks.

No wonder auditors were careful not to embarrass, anger or annoy Enron; it was the

goose that laid golden eggs. Within the fi rm, Anderson’s people knew Enron was

“high risk,” but they had no incentive to share that assessment with investors.

• Analyst confl ict of interest — Analysts knew a good bit about Enron’s internal prob-

lems. As early as 1999, a J.P. Morgan analyst drew attention to the fact that Enron

was booking revenues it couldn’t hope to receive for years (if at all). Howard Schilit,

president of the Center for Financial Research and Analysis, told Congress, “For any

analyst to say that there were no warning signs in the public fi lings, they could not

have read the same public fi lings that I did.” However, analysts had no incentive to

blow the whistle on Enron. In the past, they might have seen their jobs as evaluating

stocks on behalf of investors. In the new Wall Street, however, analysts worked for

big institutions that demanded demonstrable revenue from every department. Ana-

lysts were supposed to be team players who protected the fi rm’s relationships with

valuable, profi table clients, such as Enron — that paying piper.

• Board confl ict of interest — Enron has a star-studded board of directors. In theory,

boards work for investors. But, in fact, almost every director on almost every board is

selected by the CEO. The positions pay well, offer good perks and generally demand

relatively little. Although somewhat more is now demanded of board members as a

result of the Enron collapse, Enron’s board members had little to gain and a great deal

to lose by challenging or defying their piper-paying, tune-calling management.

The Enron Drama

The nuts and bolts of Enron’s fi nancial shenanigans and the systemic failures that

allowed its managers to perpetrate one of the greatest frauds of all time happened against

a backdrop of color and drama. Inside Enron, power struggles pitted the ruthlessly

Machiavellian Jeffrey Skilling against the fl amboyant, brilliant Rebecca Mark. A couple

of big players had affairs inside and outside of the offi ce. For instance, the fi rm suffered

great skullduggery at the hands of Nanjing-born Lou Lung Pai, a brilliant trader who

cheated his colleagues with the same equanimity with which he cheated on his wife and

children. He maintained an ex-stripper as a sort of concubine and had a child by her.

Enron traders exploited California’s energy crisis, gaming the rules to pocket millions at

the expense of the state’s taxpayers. But as colorful as those things are, they are not the

enduring part of the Enron story. A massive structural failure allowed Enron to occur,

and might allow another Enron to occur in the future.

About The Authors

Bethany McLean and Peter Elkind are Fortune magazine senior writers.

“Above all else, Jeff Skilling believes this: ‘They killed a great company’.”

“’It started out as pure, clear, legiti-mate deals,’ says a former senior Enron executive, ‘And each deal gets a little bit messier and mess-ier. We started out just taking one hit of cocaine, and the next thing you know, we’re im- porting the stuff from Columbia.’”