The Smartest Guys in the Room

by Bethany McLean & Peter Elkind

Cover image

Publisher: Portfolio
Copyright: 2003, 2004
Printing: 2006
ISBN: 1-59184-053-8
Format: Trade paperback
Pages: 424

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Written by two senior writers for Fortune magazine, The Smartest Guys in the Room is a comprehensive history and analysis of the rise of Enron and its dramatic and catastrophic collapse. It starts (after background on Ken Lay) when Lay becomes CEO of Houston Natural Gas in 1984 and concludes with the collapse of Enron late in 2001, with an epilogue covering the further trials and criminal charges up to October of 2006. Along the way it paints a fascinating and compelling picture not only of what Enron did as a company (something that I found mysterious prior to reading this book), but also the personalities that ran it and the details of where and how it went wrong. California power trading is, of course, a chapter in the story, but the story is far larger than that.

This was surprisingly compelling reading. One wouldn't expect that of a 420 page book frequently concerned with the details of complex accounting games, corporate fraud, and complex commodity trading, but McLean and Elkind do an excellent job with pacing, balance between detail and readability, and juggling of the huge cast. I cringed a bit when the introductory dramatis personae covered five pages, but I almost never needed to refer to it; people, events, and aspects of Enron business were introduced and refreshed as needed without tangling up the story. The end, once the business started falling apart, was as hard to put down as a good novel.

You also don't have to be a financial expert to understand this story, although it is helpful to know something about the language of finance and the markets. McLean and Elkind seem to be pitching the book at about the average Fortune reader. You should know the difference between stocks and bonds, the basic meaning of a derivative, and enough economics to follow the brief provided definitions of concepts like commodities, a futures contract, liquidity, and a hedge. McLean and Elkind don't take a lot of time explaining economics for the beginner, but they do explain non-basic concepts when they come up. The book should be within the grasp of any reasonably well-informed investor.

The core of the Enron story is the people, an array of brilliant, egotistical, and arrogant executives who create a corporate culture that selects for raw intelligence and vicious competition and discards most of the social virtues typical of a corporation. Both the intelligence and the arrogance come through clearly. Whatever else those involved in the Enron story were, they were smart. The company was filled with straight-A business school students, people capable of solving advanced equations in their head, and brilliant economists who came up with both revolutionary trading techniques and ways of exploiting legal loopholes before anyone else. One of the triumphs of this book is that it captures not only the weaknesses but also the strengths of Enron and shows how much talent was let loose in an environment with no effective controls.

A surprising part of the Enron story is the disappearance of Ken Lay once the company is up and running. McLean and Elkind paint a picture of a CEO who hates conflict, refuses to say no to anyone, is blindly loyal to his inner circle, and only stops anything through passive-aggressive avoidance. It's unclear for much of Enron's story how much Lay knew about the day-to-day operations; what is clear is that he exerts little or no control or braking. The COO (Jeff Skilling for most of the story) is the one who runs the company. Lay gladhands politicians, manages the board, hobnobs with the corporate elite, and enjoys every moment of a lavish high-class lifestyle.

What he turns loose, perhaps via inaction as much as intention, is a stunningly vicious culture of one-upsmanship, internal competition, put-downs, in-fighting, and greed. Enron executives and traders had free rein to compete even against other divisions of Enron, and gloried in it. Many of the top executives believed strongly in pure libertarian free-market economics, in a social Darwinist notion of dog-eat-dog, and in profits as the sole metric on which anyone should be judged. Enron was exclusively about making deals and making money, and the compensation packages reflected it. McLean and Elkind repeatedly pound the point home with detailed numbers until the millions handed out (even when an employee quits!) blur together.

The other half of the picture was Enron's finances. McLean and Elkind start in the early days of the company and provide an excellent education in the financial tricks Enron used, starting with a detailed explanation of mark-to-market accounting. Mark-to-market accounting is an accounting system in which one can book all the profits from a deal as soon as the deal is closed, even before the company earns any real money from it, and was therefore perfect for Enron. Enron, far more than growth, was all about the appearance of growth, aimed at making the stock value climb ever higher (in part because such a huge amount of the compensation structure was built around the stock price). Mark-to-market accounting lets one give the impression that the company is growing much faster than traditional accounting. The drawback, of course, is that in true mark-to-market accounting, one is required to book losses whenever the estimates of the profit over the course of a deal decrease. It was in Enron's numerous ways of bypassing that part of the system that most of the trouble lay.

Enron looked like it was defying the laws of economics in its staggering growth, but McLean and Elkind's lucid explanations show just how it wasn't. There are only three ways to get money to grow a company: through reinvesting profits, through selling additional equity (stock) and thereby diluting the value of all existing stock in the hope that the investment will eventually offset that investor loss and more, or by borrowing money. The first was too slow and the second, since Enron was all about its stock price, was generally unacceptable. Enron was doing the third, borrowing huge amounts of money and then hiding the loans by taking advantage of accounting tricks to keep it out of the company's official recorded debt. They were paying off old loans with new loans, just like a person transferring credit card debt from one card to another. The belief within the company was that they were building towards some new business idea that would make so much money that any debt would be irrelevant, and when a new idea failed to materialize, the pile of debt collapsed and the company imploded almost overnight.

Enron did some things well, and The Smartest Guys in the Room is good about acknowledging and describing them. Enron did a lot to bring natural gas to the forefront, as a cleaner-burning and often more environmentally friendly fuel than oil or coal, and completely changed the way that natural gas was traded on the market in ways that helped the whole market. Natural gas trading, which is what first kicked the company into overdrive, was a legitimately huge idea. The hubris came in believing it would be only one of many, and that the company could repeat the feat on demand.

The other thing this book makes painfully clear is the failure of every oversight system to bring Enron under control and to detect the ways in which they were cheating and gaming the system. It also makes painfully clear the dishonest and self-serving attempts of those oversight bodies to avoid the deserved blame for not doing their jobs. Yes, Enron created a corporate environment where greedy egoists and, later, outright crooks thrived. However, the inevitable existence of such people is exactly why we have oversight. Watching everyone else point the finger back at Enron executives and claim no personal responsibility because they were deceived is sickening. McLean and Elkind pick out the signs and and warnings, point to early articles, show the places where specific oversight bodies should have known to dig deeper and didn't, and towards the end, show how institutional investors with far less information than the oversight bodies clearly had a better understanding of what was going on.

I came into this book with some sympathy for Arthur Anderson, the accounting and audit firm used by Enron that was destroyed in the wake of the Enron debacle. I came away with none whatsoever. It's murky whether anyone at Arthur Anderson knew for certain that something illegal was going on. It's abundantly clear that in order to keep Enron's business (in other words, out of greed, the motive of many of Enron's enablers), Arthur Anderson carefully looked the other way, chose not to learn of problems, signed off on deceptive and misleading statements, and blatantly ignored their own internal controls and review boards. Enron's legal firm, Vinson & Elkins, comes away looking similarly tainted (if less interesting since they're less widely known).

The SEC is simply absent, except at the very end when the problems were too obvious to ignore. This I'm inclined to attribute to lack of funding and thus inability to pursue as many complaints and reports as they should. The credit agencies have less excuse. They could have stopped the ballooning Enron debt far earlier by downgrading Enron's bond rating, as the off-the-balance-sheet debt certainly deserved. Credit rating agencies are understandably reluctant to downgrade below investment grade, since this is the nuclear weapon of bond trading and often triggers automatic contract terms that can destroy a company, but Enron was three grades above junk status even while the company was collapsing. But they never investigated Enron's strange filings and bizarre disclosures enough to put the picture together.

About the stock market analysts, the less said, the better. The Smartest Guys in the Room makes abundantly clear just how rigged and dishonest the entire system of stock market analysis is.

But the greatest contempt has to be reserved for the Enron board. The other agencies listed are the second, third, or fourth lines of defense against a dishonest or corrupt corporation. The corporate board of directors is the first line of defense, and the job of a board member is to investigate, analyze, and make decisions to oversee and stop exactly the sorts of things that Enron was doing. And yet, the Enron board, as is sadly typical for corporations, was in the back pocket of Lay and abrogated their oversight responsibilities almost entirely. Apart from a few desultory attempts to check on a few facts, abandoned at the least impediment, the board sat back and did nothing. Worse than nothing: it approved, again and again, the actions that led directly to Enron's collapse. The argument that they were decieved to me simply means the charge should be criminal negligence instead of conspiracy in a fraud; it changes my opinions of their actions hardly at all.

As mentioned above, the California power crisis is covered but plays a smaller role than many may think. Here again, McLean and Elkind show a balanced and thorough understanding of where Enron was uniquely at fault and where Enron was just another player in a dirty game. With electrical power trading, Enron wasn't doing anything others in the market weren't also doing. They lay out how the California power disaster, while still murky in its exact causes, probably should be laid at the feet of the bizarre and broken way the power market was unevenly deregulated as much as at the feet of any particular trading corporation, all of whom were actively exploiting loopholes that one could drive trucks through. Enron was, however, far more arrogant and vicious than most of its competitors, and hence opened itself up as an easy public relations target.

As you can see, that's a lot of material, and I'm only touching on the highlights. This is a fascinating book. In the process of diving into one of the most spectacular corporate collapses in US history, it provides fascinating information about how the corporate world functions, about markets and trading, and about the energy industry. It also delivers a memorable cast of characters.

The one flaw also leads me to add the disclaimer that the above analysis is based on McLean and Elkind's work and not on independent confirmation. Throughout, they use a journalistic style of attribution, quoting specific individuals and citing them when it fits into the prose, but not using the end notes or detailed citations of an academic work. This is a problem. It is, to a degree, unavoidable, as they explain in the authors' notes. Due to the ongoing court cases, the marginal legality or outright illegality of many of Enron's dealings, and the handshake agreements between corporations, many of their sources refused to be identified or would only speak as background sources. But there are court filings, bankruptcy documentation, discovery, and Enron's own disclosures at the end when it was desperately attempting to come clean, and I'm certain that information also went into this book and probably shores up many of the details. Without academic citations, however, one has no way of knowing which parts of this story could be independently confirmed. This book desperately needed comprehensive end notes; in their absence, one must extend a lot of trust in McLean and Elkind.

That being said, the book passes the smell test and feels like a concrete and thorough piece of journalism. It's also a compelling story, well-told, and one of the better non-fiction books I've read. If you have a basic understanding of economics and any interest in US corporate governance, I highly recommend it.

Rating: 9 out of 10

Reviewed: 2007-10-25

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