By: Bethany McLean and Peter Elkind
Published in 2003
Recommendation and thoughts
Without question I recommend this book to anyone interested in business, scandal, and complex deception. I give it 5 out of 5 stars and will most definitely read it again. I’ve only been able to mention a fraction of the information this book contains and only a small number of the characters of Enron. All these people are very interesting and to get the whole picture you really should read the book. If you like this review, then you will love the book even more.
Basic review
The epic rise and fall of Enron had many contributing players. This book mostly follows three main players. First, the long-time CEO Ken Lay who spent most of his time glad handing, and relationship building. Second, Andrew Fastow, the CFO who played a major role in the deception with his aggressive accounting and use of special purpose entities (SPEs). Lastly, the book follows Jeff Skilling who served as COO but also had a brief stint as CEO. Skilling was the man with big ideas (big enchiladas as referred to in the book) who ultimately drove the company into the ground due to his obsession with the stock price. This obsession was the driving factor of the funny-business accounting that took place in order to meet Wall-Street-analyst expectations to keep the stock price up.
Summary
This book is long which is great because it allows for exquisite detail about the entire rise and fall of the company. It’s not just Ken Lay, Andrew Fastow, and Jeff Skilling that contributed to rise and destruction of Enron but there are many other, for lack of better words side-characters, that contribute to the ascension and implosion of the company. There are people like Cliff Baxter who tragically took his own life after the scandal broke. Lou Pai who led his subordinates with a mercenary nature. Ken Rice who eventually was assigned to Enron’s broadband division which helped run Enron into the ground. Rebecca Mark who ran Enron’s international development division and was a superstar in the male dominated Industry.
Rebecca and Skilling had huge problems with each other and battled fiercely for the spotlight. Eventually, Skilling wrestled control of the company when COO Rich Kinder was pushed out of the company by Ken Lay and replaced with Skilling. As COO Skilling transformed the company, getting rid of almost all hard assets and turning Enron into a trading company. The only problem was trading companies don’t have the type of valuations that Skilling wanted. As a trading company it would be near impossible to hit the earnings needed to keep the wall-street-analysts happy. Analysts needed to be happy to drive the stock price up and trading companies often have wild, unpredictable earnings. So, what did Skilling…. What did Enron do? They lied. “We are a logistics company not a trading company” Skilling said on multiple occasions. This lie was the basis of how they got away with everything they did.
Just because Enron lied about what type of company they were, doesn’t mean everyone should have believed them. So why did the analysts, the banks and the credit rating agencies believe them? In short, the answer comes down to the usual answer, MONEY. The banks were making a fortune doing investment banking deals with Enron and analysts at the time got famous for being very bullish on stocks. The credit-rating agencies, who should have been truly independent, had no reason to give Enron a pass but were convinced by everyone else that Enron was fine. In other words, the banks, the analysts and to a certain extent the credit rating agencies, were all complicit in Enron’s incredible rise to the top.
If we talk about complicity, we cannot leave out Arthur Anderson who at the time they were the world’s premier auditing firm. They let Enron get away with what I’ll call “super sketchy accounting” for many years. In the build-up of the hammer coming down on Enron they even started shredding all their Enron documents because they were already entrenched in other recent accounting scandals. One of my favorite anecdotes from this book must be that the fall of Enron brought about the destruction of Arthur Andersen whose very founder once surrendered a rich contract from a railroad company because they wouldn’t account in the proper way. If only Arthur Andersen had the giblets of its founder and were willing to turn down business on principle, they may still be around today. Near the end, Enron was paying them about a million dollars a week.
Enron fell because of sketchy accounting, accounting that was approved by Arthur Andersen. So, what was so wrong with their accounting? Jeff Skilling, a Harvard educated MBA was always enthralled with the big idea. As one executive at Enron said, “Jeff Skilling is a designer of ditches not a digger of ditches”. He believed that ideas should be rewarded far more than actual implication. This is imperative to understand because it’s the explanation for Enron’s, or rather Skilling’s, insistence on the use of mark-to-market accounting.
What is mark-to-market accounting?
Mark to market accounting is a method used by the financial industry whereas most other industries use cost accounting. Why did Skilling want to use it? Mark-to-market accounting allowed the total value of the deal to be counted toward Enron’s earnings the day a deal was signed. If companies use mark-to-market accounting, they often see rapid growth at first…. But the only way to keep growing is to do more and more deals the next quarter than the quarter before because everything is counted up-front. Mark-to-market accounting isn’t necessarily bad, though it can be abused. In normal mark-to-market accounting the values of the assets and or liabilities that are counted upfront are reevaluated and disclosed at the current values but that’s not what Enron did.
Enron made their pricing curves, off which their accounting took place, very generous and favorable for themselves. This allowed Enron to hit their earnings numbers required to keep the stock price up. In fact, they would even reevaluate deals done in the past and mark them even more favorably to fill the gaps and short falls in their earnings at the end of the quarter. Enron lived and died by their end of quarter numbers because Jeff Skilling saw the stock price as his “ultimate scorecard”.
Mark-to-market accounting was important to Skilling because it allowed for rapid growth, it inherently rewards the idea, rather than the implication because the deal counts up-front toward earnings. However, if mark-to-market accounting is abused by using inaccurate pricing curves for deals and inaccurate valuation, or reevaluation, of deals then it will no doubt cause a liquidity problem. In other words, if you worry about the value that can be reasonably assigned to a deal and not how much money the deal will bring in, there is nothing stopping anybody from saying a bad deal, that is actually losing money, is good for the company and its earnings. When this happens, cash will dry up because it’s not as important as looking good by hitting the numbers required by wall street.
How did Enron stay afloat if they didn’t have the necessary cash to survive?
In steps Andy Fastow with his Enron team, a division called global finance. Charged with not only financing the company, but also filling in earnings shortfalls at the end of quarter, Andy Fastow was willing to push as aggressively as need be. To move debt off Enron’s balance sheet Andy and his team would create special purpose entities or SPEs. These SPEs essentially create an entity that is controlled by a company but is in essence its own entity. Therefore, debt can be moved from a company to the SPE. For some reason, this qualifies the company to take the debt off their balance sheet even though they are technically in control of the SPE and are still responsible for the debt. The term for this debit is off-balance-sheet debt. The only real rule for such debt to qualify for off balance sheet treatment is that there must be at least 3% ownership of the SPE by someone other than the controlling company.
These SPEs also had a different use. Enron wasn’t just saddling these SPEs with their losing deals and all their debt. They were also securitizing their assets and selling them to the SPEs. This was beneficial because it was a way of raising money. Essentially, they were taking a loan against their assets but in an unconventional way. By doing it this way, they were able to keep this debt off their balance sheet but could still use the cash raised in the process. So, who was supplying the 3% needed qualify the SPEs for off balance sheet treatment? Again, in steps Andy Fastow.
Andy was perhaps most of the reason that the Enron saga blew up the way it did. He was certainly willing to push the legality of Enron’s accounting to the absolute limits. But his greatest deception must be that of LJM. LJM was a private equity fund that he set up and managed himself to invest in deals with Enron. Andy Fastow found himself in a position where he was negotiating deals on behalf of LJM, a fund in which he was the general partner, against Enron. This wouldn’t have been a problem except he was the CFO of Enron. In other words, he was negotiating against himself.
Because of this unique situation, Fastow was able to bludgeon the banks into investing into his fund. He was a master at letting the banks know that if they didn’t do what he wanted, i.e., invest in LJM, then they wouldn’t receive any investment banking business from Enron. Because Enron was so big, this was very enticing for the banks. They could make a fortune from investment banking fees if they got a piece of the Enron Pie. They were also willing to invest because Andy was able to negotiate with himself. It’s hard not to come out on top when you let yourself win. LJM won handsomely at the expense of Enron.
It’s important to note that the Enron’s board was aware of this conflict of interest that Andy had. They saw the money that would be made from management fees associated with LJM and the return for the general partner of the fund as a bonus for Andy. He was doing good work as CFO, so they thought that he deserved it. Indeed, they were told that Andy was only spending three hours a week on LJM and had they known that he had made over 60 million dollars as LJM’s general partner they would have seen his conflict differently.
The LJM partnership was good for Enron in that it was able to raise money through securitization but at what cost? When the depth of the happenings of Enron were exposed, very little could be done to save the company.
Whose fault was it?
As well written as this book is, as well investigated as the Enron story has become, it really can’t be said whose fault it was. There are too many unknowns. A lot of blame can be placed on Jeff Skilling, Andrew Fastow, and Ken Lay but blame should also be cast on the enablers of Enron. Wall street played a big part in Enron’s story, as did the banks and credit rating agencies. Enron’s board deserves a fair share of the blame for not probing into the happening of the company they were entrusted. There is plenty of blame to go around. It’s safe to say that the fall of Enron was caused by a collection of many different reasons many of which are stated in this book and even fewer mentioned in this review.