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

by Bethany McLean

  The lead originator on the Sithe deal was a man named Kenneth Duane Rice, who soon became one of Skilling’s closest deputies. Among Skilling’s confidants, Rice stood out as conspicuously normal. A veterinarian’s son from the prairie town of Broken Bow, Nebraska, Rice was a wrestler at the University of Nebraska, where he earned a degree in electrical engineering. Fifteen years later, he retained the clean-cut good looks, wholesome manner, and boyish charm of a college jock. Rice’s father was a frugal and demanding man who made Rice earn his spending money by yanking nails from old boards on the family farm and helping out with midnight cesareans. Never an avid student, Rice later joked that “it was easier to get a degree than tell my dad I wasn’t going to go to college.” Rice married his college sweetheart, a future pediatrician, six months after going to work as an engineer at InterNorth. He later earned an MBA at Creighton University in Omaha, then moved to Houston and started selling spot-market gas to industrial customers. It became clear that he was a natural salesman.

  Because of its size and importance, the Sithe deal also served as the bell cow for Rice’s career. It brought hefty bonuses, lots of options, and big promotions. But even more than that, by vaulting Rice into Skilling’s inner circle, Sithe put Rice in a position to make tens of millions more. He went on to cut more big deals, assume top jobs in ECT, and run Enron’s high-stakes (and ill-fated) broadband venture.

  Sithe made Skilling a big winner, too. In 1992, ECT’s net income more than doubled, to $122 million, making it the second-biggest contributor to En-

  ron’s bottom line. When the year was over, Enron bought out 30 percent of his phantom-equity stake in ECT for $4.7 million in cash and stock. That meant that the company was now valuing Skilling’s two-year-old “start-up” at a staggering $650 million.

  • • •

  Is it a surprise to learn that even as the originators were landing long-term supply contracts, they were increasingly coming into conflict with Pai’s traders? Perhaps not. There is a natural tension in any such business over how to divide the spoils. But given the ethos Skilling was instilling at ECT and that Lou Pai was running the trading desk, bitter conflict was inevitable. There was simply too much money at stake.

  The traders’ power stemmed from a simple fact: they had a great deal of say in deciding just how profitable an originator’s deal would be. That’s because the deal’s profits didn’t depend just on the terms of the sale. Every bit as important was the spread between the agreed-on sale price for the gas and what it would cost Enron to supply that gas. Yes, the finance group was negotiating agreements with gas producers to buy some of what was needed, but the trading desk had to round up a lot more.

  With each big new origination deal, more and more of the burden for meeting the demand—and hedging the price risk—fell to the traders. For short-term deals, the New York Mercantile Exchange prices provided a benchmark. But there was no NYMEX futures market beyond 18 months. Prices for 20-year deals like Sithe were set by deploying models and plotting curves, models and curves that were, at best, educated guesswork and, thanks to Pai’s clout, set at the discretion of the trading desk.

  There was some justification for the traders’ power in setting prices. Long after the originators had gotten their big bonuses and moved on to other deals, the traders were still going to have bear the risk that the contract would become unprofitable. (It was impossible to fully hedge a deal like Sithe.) They needed to build in some cushion so that they could increase their chances of making money even if prices changed over time, as they surely would.

  But the disputes that took place between the traders and the originators over how to price a deal went far beyond normal corporate infighting. They turned into pitched battles over how much each camp—traders, marketers, and finance—got to claim from a deal’s profits. One executive likened the process to what happened when a village woodsman hauled in a big kill. “At Enron, you had hunters, skinners, and hangers-on. You’d get a big carcass that the organization would dive all over and strip of all the value—skin, bones, and meat.”

  If it meant more money for him and his group, Pai was more than willing to cheat his ECT brethren. One former trading executive recalls that when finance executives approached him on the trading floor to obtain prices for selling the gas they’d acquired from a producer, Pai, behind his back, would secretly signal thumbs-down, meaning that the trader should quote a below-market price. And when a marketing originator came to the trader to get a price for buying gas, Pai would give a thumbs-up, to quote an above-market price. The effect of this would be to steal some of the expected profit spread for the trading desk from the deal makers. “The line is you show them the same price you’d show anybody else that called on the phone or better,” says the trading executive. “If you’re showing them a worse price than you show Morgan Stanley, you’re screwing them. Lou took me aside on more than one occasion for not taking enough money out of the transaction for the trading desk.” Of all the corrosive things Lou Pai did at Enron, nothing did more to emphasize the mercenary nature of life at Enron and undermine any vestige of teamwork. But Skilling, ever the believer in creative tension, didn’t see a problem.

  The battles between the traders and the deal makers were also aggravated by cultural differences. The origination teams cultivated personal relationships with customers and hammered out deals with them over many months. The traders did business by phone and computer in a matter of seconds. The originators viewed the traders as bloodless mercenaries, who, as one prominent member of the group put it, “would sell their mom for a buck.” The traders viewed the originators as dinosaurs, destined for extinction; they believed they were bringing harsh economic efficiency to what had long been a good-old-boy business.

  This conflict climaxed every six months, the result of another innovation Skilling had imported from his consulting days: an elaborate peer-review system. At McKinsey, Skilling had served on the powerful committee that assessed the performance of all consultants worldwide. One of the first things he did upon joining Enron was set up a similar system, officially called the Performance Review Committee (PRC).

  Early on, when ECT was still small, the PRC seemed a useful innovation. It swept out obvious deadwood and identified and rewarded up-and-comers. But over time, its goals were distorted, and the PRC had more to do with manipulating the system than with honestly evaluating talent. Employees called it “rank-and-yank.”

  Twice a year, every ECT employee (except Skilling), from managing director down to secretary, underwent individual review. It began with extensive written “feedback reports” from bosses and colleagues that assessed their performance on five sets of criteria. The real action took place at a string of marathon sessions held at local hotels, where panels would debate and rank each employee on a scale of 1 to 5—1 being the best and 5 the worst—while the individual’s photo was projected on a screen in front of the group. Most of the ranking categories involved collaborative qualities, such as “teamwork/interpersonal” and “communication/setting direction.” What really counted, though, was the bottom line. “If they were making money and being total jerks to people, we’d always forgive them for that,” says one early ECT executive. “They might be a 5 in teamwork, but if they were a 1 in earnings, they were a 1. If you weren’t doing deals, we had trouble valuing your contribution to the company.”

  Still, it wasn’t all just about money. It was also about friendship. Executives simply refused to tell the truth about weak members of their team with whom they were friendly, knowing that all the other executives in the room were doing the exact same thing. Rather than reflecting a true meritocracy, the PRC became a perversion of it. “People manipulated the system,” recalls a former top executive. “It became a question of who could argue better, who could debate better, and, in some cases, who could shout the loudest.” Sometimes managers would purposely sabotage one candidate in order to ensure room at a higher level for one of their favorites.

  For ind
ividual employees, the stakes were large. Those rated a 1 got huge bonuses. A ranking of 2 or 3 could cost a vice president a six-figure sum. And those at the bottom were supposed to be fired if they didn’t improve their ranking at the next PRC. Because Skilling insisted that the ranking be distributed along a curve, at least 10 percent of the workforce had to be placed in the bottom group, marked for execution.

  Predictably, the sessions got ugly. Because traders and deal makers with the same title were rated together, by representatives of both groups, the PRC became a place to duke out their mutual grievances and debate their relative worth. “A trader could go out and generate $5 million of earnings in a day,” noted one early ECT hire. “The numbers can be huge. A lot of the controversy stemmed around the fact that for originators to generate the same type of earnings, the effort is ten times greater.”

  And so the argument went: should a hot trading hand be more richly rewarded than a gas-supply deal that had taken nine months to negotiate? Why should effort matter as much as profits? Every single ranking had to be unanimous, encouraging horse-trading and the occasional filibuster. The entire process consumed huge amounts of time for everyone involved. Sessions for executives, where the debate got the hottest, sometimes ran from 8 A.M. until after midnight. As Skilling and his defenders saw it, the PRC produced the best of Enron, rewarding brains, innovation, and dedication. But many thought it brought out the worst of Enron: ruthlessness, selfishness, and greed.

  • • •

  Of all the guys with spikes that Skilling gathered around him in those early days of ECT, none was as close to him as Cliff Baxter. Baxter’s particular talent was in the arena of mergers and acquisitions; he was Skilling’s in-house M&A specialist. Over time, Baxter’s deals helped get Enron into the retail-energy-services business, electricity trading, and broadband. The two men lunched together several times a week. They regularly sneaked away from the company’s smoke-free offices for a furtive cigarette in a parking garage across the street. And Baxter was one of the few who could barge into Skilling’s office unannounced and say whatever was on his mind. After Baxter died, Skilling told friends: “I probably spent five times as much time with Cliff as anybody else.”

  A police sergeant’s son from a Catholic family in Amityville, Long Island, Baxter had put himself through New York University then joined the air force, rising to captain. After leaving the military, he earned his MBA at Columbia University in 1987. He worked as an investment banker before joining Enron’s Washington office in 1991. Not long after that, Baxter approached Skilling to advise him that Enron was “wasting my talents.” Skilling hired him.

  Like Pai, whom he despised, Baxter was someone who could have thrived only at Enron. Blunt, blustery, and bombastic, Baxter had a towering ego and a volatile personality. He was a devoted friend and a generous mentor—he once loaned a new Enron arrival $40,000 to buy a luxury car—but he was also exceedingly sensitive to perceived slights involving his own status and compensation. He could be giddily happy when he was in the middle of a deal and go into a deep, unshakable funk when he wasn’t. “He was,” says one former executive, “a bundle of contradictions. He was very aggressive, but at the same time he was the most insecure man I’ve ever seen in my life. He’d present something in such a strident way, and then afterwards, he’d come up to you privately and say, ‘Was that right?’ ”

  He was also brutally honest. Almost alone among those close to Skilling, Baxter was quick to voice moral indignation, something he did frequently over the years. He didn’t hesitate to tell others when they’d done something wrong. He clashed bitterly with other ECT executives, especially Pai.

  Though he eventually made millions at Enron, he also complained frequently that he was underpaid and underappreciated. While Baxter had many fans, he was, in many ways, not an easy man to like.

  But Skilling didn’t care. Baxter, he later told people, “was the best deal guy I ever saw,” and that’s all that mattered. And Baxter was good. Meticulously organized, he planned out his deal strategies in tiny, neat handwriting and had a keen sense of how events might unfold. When he was in the middle of a transaction, he’d be transformed, as if the intensity of the deal was an intoxicant he couldn’t resist. “Cliff Baxter is like an Indy race car,” Ken Rice used to say about him. “If you wanna play, Cliff Baxter is the one you want. But you don’t want to take him out of the garage to go to the 7-Eleven.”

  In 1995, in a dark mood after wrapping up a deal, he spent an entire lunch berating Skilling, telling him how he’d made a mess of his life. When Baxter finally stopped ranting, Skilling advised him to see a doctor. “Are you saying I’m crazy?” Baxter demanded. He was incensed that Skilling could suggest such a thing. “That’s it—I quit!”

  That summer, he took a job at Koch Industries, a big, privately owned commodities conglomerate in Wichita, Kansas. It was “a bungee trip,” in the words of a former Enron executive. Koch Industries was a conservative midwestern company, and there was no way it could absorb Baxter’s outsized ego. Shortly after arriving at Koch, he insisted that he could travel only on the corporate jet. “He just couldn’t survive in a normal atmosphere,” says a former colleague. Baxter had already bought a house and moved his wife and two children up to Wichita. But just weeks after he’d left for Koch, he was already putting out feelers about returning. He finally called Skilling himself. “What would you think about my coming back?” he asked. “A lot of people up here are real jerks.”

  Skilling wanted Cliff back; before Baxter left, he had given him an open offer to return. There was one hitch. Though Skilling was firmly in charge, he had been promoting the notion that ECT operated like a professional firm, where top executives acted almost as partners. So he submitted the issue to a monthly meeting of ECT’s 13 managing directors and sought the group’s blessing. But Skilling, who knew there was sentiment within the group that Baxter was more trouble than he was worth, wasn’t going to take a chance that the answer would be no. He made a point of greasing the deal with a rare personal appeal to Pai. “I know you’re going to raise a stink about this—don’t,” Skilling pleaded.

  When Baxter got the official word, it was early evening. The next morning he jumped in his car and started off on the 600-mile trip back to Houston, leaving his family photos, Rolodex, and deal toys behind in his office. Koch executives arrived the next morning to discover that Baxter, after just two months on the job, had disappeared without a word.

  • • •

  There was one final piece of the puzzle. If ECT was going to grow as rapidly as Skilling wanted, he needed more than long-term gas contracts and more than a trading operation. He also needed a way to finance it all. Financing was his most serious constraint, the one thing that could hold him back. Enron was reluctant to pour money into ECT. Kinder had told Skilling that he wanted ECT to be able to fund itself and that any capital Enron put into ECT would count against the phantom equity the top executives held in the division.

  The cash flow from the hard assets Skilling controlled didn’t come close to meeting his needs, given how many people he was hiring and how much he was spending to make the new business grow. And he could hardly plow the profits back into the operation: because of mark-to-market accounting, most of those earnings were only paper profits. The actual cash wouldn’t be seen for years.

  That left the banks. But Skilling didn’t want to depend heavily on bank loans either. Part of the reason was that he couldn’t: Enron already had lots of debt, which put serious limits on how much any division could borrow. Besides, borrowing itself was a constraint. Loans required collateral and had to be repaid; loans had a way of tying your hands, not freeing them.

  But there were other, newer techniques for raising capital, one in particular that Skilling found especially compelling. Back when he was a consultant, Skilling had been deeply influenced by a well-known McKinsey partner named Lowell Bryan. Bryan was one of the pioneers of securitization: the practice of pooling loans together a
nd selling them to outside investors in the form of a security. For instance, a credit card company, instead of tying up its own capital by keeping credit card loans on its balance sheet, could bundle them together and sell them into the marketplace. Then it could use the capital it reaped from the securitization sale to make more loans. 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.

  And that’s exactly what Skilling was seeking to do: remove capital and balance sheets as constraints on growth. And since so much else about ECT was modeled on the financial-services industry, why not securitization as well? Why couldn’t ECT bundle, say, the loans it was making to struggling gas producers? Why couldn’t it use securitization techniques to generate capital that would allow it to grow faster than would otherwise be possible? Why couldn’t Skilling transform this aspect of the national gas business as well? So that’s what he did. Which is to say, that’s how Enron first got into the business of setting up special-purpose entities.

  Unlike some of the later special-purpose entities Enron created, these early deals were entirely aboveboard; the company even publicized them. The first such deal, completed in 1991, was called Cactus. Despite its many complex wrinkles, it was, at its core, a securitization deal. Enron bundled some $900 million of the money it had promised to front for gas producers and sold shares on those deals, as a package, to a group of high-powered investors, including General Electric. Under the terms of the deal, the group would then sell the gas back to Enron, which would resell it to wholesale customers like Sithe Energies. As a result of Cactus, the debt was eliminated from Enron’s balance sheet and ECT was handed cash to accelerate its growth.