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

by Bethany McLean

  Skilling later explained that it was politically impossible for him to stop Enron International dead in its tracks. In addition to Lay’s favor, Mark had strong support from the board. “I should have thrown myself under the truck on some of them,” Skilling later told friends. “But what would it have accomplished? I didn’t feel like I was in a position to stop it.” But the irony remains: Skilling, who today blames Mark for spending Enron into bankruptcy, signed off on many of her projects.

  • • •

  Enron being Enron, Mark got a rich new contract when she left her job running International, with a $710,000 salary and 450,000 additional stock options. (In 1998 and 1999, Enron also forgave over $1.6 million in loans.) And Mark being Mark, though she’d been relegated to the sidelines, she didn’t stay there for long. Just a month after her appointment as vice chairman, she proposed to the board that it allow her to lead Enron into a business it was already contemplating: the business of water.

  Mark wanted to buy a British water utility, called Wessex, as the opening move in building a new Enron subsidiary that she would run. The cost would be $2.4 billion. Water was a treacherous game, dominated by the French giants Vivendi and Suez Lyonnaise des Eaux. The politics of water were complicated, the profit margins razor thin. The companies that succeeded in the business understood how to keep costs to a minimum, not exactly Enron’s strength.

  But Mark made a compelling case. “The world’s running out of water,” she declared. The water business was going to be deregulated—right up Enron’s alley. It was an unparalleled opportunity, she insisted. Mulling over the issue, the directors wondered what their fellow board member, Jeff Skilling, thought about the idea.

  “If it works,” he said coolly, “it could be a good business.” What Skilling thought to himself but didn’t say aloud was that approving this deal would get Rebecca Mark out of his way, once and for all. The price of the acquisition was steep (as Skilling figured it, she was overpaying by about $200 million), but that never bothered him. Besides, under the terms of her deal, she’d have to raise all additional capital on her own. If she failed, well, that would be her problem. For all these reasons, it seemed to Skilling that it was worth doing, regardless of whether it made sense for the company.

  Even with Skilling’s blessing, not all the directors were convinced. When it came time to vote, two directors voted against the acquisition, the only time in recent memory that an Enron board vote was not unanimous. Still, it went through, and Rebecca Mark was back in business.

  She originally wanted to call her new company WaterMark. Instead, she chose Azurix, a name that was devised by a brand consultant. It would only take a few years before Mark’s new company, with its fancy new name, would provide the first visible crack in Enron’s facade.

  CHAPTER 9

  The Klieg-Light Syndrome

  It is utterly beyond question that in reshaping Enron after he was named its president, Skilling turned it into a place where financial deception became almost

  inevitable.

  In no small part, that’s because there were so many other kinds of decep-

  tion taking place. Skilling created a freewheeling culture that he touted as innovative—but didn’t rein in the excesses that came with it. He preached the gospel of intellectual capital, claiming that it was critically important to give smart people the resources and freedom to let creativity flourish, but looked the other way when this became a license for wastefulness and self-indulgence. He bragged about Enron’s sophisticated controls but undermined them at every turn. He was openly scornful of steady, asset-based businesses that grew slowly but generated cash—then swept them away to make room for a series of ever-bigger, ever-riskier bets that brought in almost no cash at all.

  Worst of all, Skilling created impossible expectations and unbearable internal pressures by holding Enron out to Wall Street as something that it simply wasn’t. He created a wild, out-of-control experiment yet presented it as a well-oiled machine that generated steadily growing profits. He offered the world a powerful, even charismatic, vision of the new Enron. But the Enron Skilling was describing—and which by 1998 Wall Street and the press were once again lapping up—wasn’t even close to reality.

  • • •

  Consider the issue of risk. It would be hard to think of a more important concept for Enron than managing risk. Traders risked losing money every time they made a trade. Signing long-term contracts to provide gas and electricity required understanding all kinds of risks—pricing, delivery, credit, and so on—and knowing how to hedge those risks. Figuring out whether a deal was worth doing was nothing if not an exercise in calculating risk: did the size of the potential return justify the risk of all the things that could go wrong? That’s a question that every executive at every company has to be willing to tackle. A company that lacked the ability to manage risk properly simply had no business doing the kinds of deals Enron did on a daily basis.

  When reporters and analysts inquired about the company’s risk-management abilities, Skilling had a ready answer: he pointed to Enron’s Risk Assessment and Control department, known inside the company as RAC. Though Skilling had had small risk-management teams at ECT, he set up RAC as a stand-alone unit in 1996. Skilling knew Wall Street wanted to see a strong system of internal controls and after he was named president, he made RAC a centerpiece of management presentations to Wall Street analysts, investors, and credit-rating agencies. RAC was the part of the company that had the analytical skills—and presumably the authority—to prevent Enron from doing anything stupid. Skilling imposed a requirement that RAC had to review virtually all Enron deals—even international ones—and he bragged constantly about the sophisticated oversight that RAC provided, which he portrayed as sacred. “Only two things at Enron are not subject to negotiation: the firm’s personnel evaluation policy and its company-wide risk-management program,” Skilling told a corporate-finance journal.

  On paper, RAC sounded terrific. Its mission was to assess the economic, financial, credit, and political risk in every Enron deal of more than $500,000. Its analysts pored over numbers, challenged assumptions, tested models, checked price curves, and monitored portfolios. It employed former bankers, accountants, statistical wizards, and MBAs—a crack team of experts in every aspect of a commercial transaction. RAC had resources, too: by the late 1990s, a $30 million budget, access to a $600 million computer system, and 150 professionals. Most of all, as Enron described it, RAC had independence and clout. The formal mechanism for expressing its findings was a document called a deal-approval sheet—or DASH. The DASH, which contained space for signatures of everyone who needed to approve the project, summarized the deal, the range of projected returns, and the risks that it presented. Later iterations of the form included a box for RAC’s recommendation: it could approve the transaction or it could tell management “do not proceed.”

  The top man at RAC was Rick Buy, who had joined Skilling at ECT in 1994 after years as a vice president in the energy department at Bankers Trust. Buy was named the company’s chief risk officer in 1998 and promoted to senior vice president of Enron in early 1999, at the age of 46. Skilling described Buy as Enron’s “top cop” and frequently pointed out that he reported regularly to the audit committee of the Enron board. No one flat-out declared that RAC had veto power over a deal. But this was, after all, Enron’s control group. The implication was clear: if Buy thought a deal was too risky, Enron wouldn’t do it.

  Thanks to RAC, Enron was able to portray itself as a company that could safely take on more risk than other companies, precisely because it had the right controls in place. As Buy himself once put it: “You won’t make money these days without taking on risk. We want to take on risk—a lot of risk—subject to prescribed limitations and insight into the associated outcomes. If the outcomes are palatable, we’ve got an appetite.” Indeed, Enron claimed that its risk systems were so good that there was no need to slow the frantic pace of deal making. “We move fast ar
ound here; things cook,” Buy explained in a promotional videotape for Arthur Andersen, Enron’s auditing firm. “I mean, it’s a high-stress, high-pressure, fast-moving place. You don’t want anyone . . . that’s going to slow you down or bog you down or not be value-added. . . .”

  Wall Street was dazzled. “We rely heavily on Enron’s risk-management ability,” Todd Shipman, an analyst with the Standard & Poor’s credit-rating agency, told Fortune. “You can’t overemphasize how important that is. It’s the underpinning to everything. . . . It gives you a nice, warm, fuzzy feeling. . . . Even though they’re taking more risk, their market presence and risk-management skills allow them to get away with it. . . . Enron has such extraordinary risk-management capabilities that we look at them differently.” Rick Walker, managing director in the Houston office of Chase Manhattan Bank, added: “Rick has figured out how to profit from risk. Consequently, Enron has become a company defined by the way in which it handles risk.”

  But how much of the RAC story reflected the reality of life inside Enron? It was certainly true that RAC had substantial resources and talented analysts. But the part about RAC being a serious force within the company, able to stop bad deals dead in their tracks: that part wasn’t even close to the truth. And everyone in the company knew it. “RAC was a hurdle, a speed bump, but not an obstacle,” says a former Enron managing director. “If a deal had overwhelming commercial support, it got done. I treated them like dogs, and they couldn’t do anything about me. The process was there, sure, but the support wasn’t. If RAC had complained about me and I got paid $100,000 less bonus, I would have changed. Never happened. I told my guys to fuck ’em.” A former RAC vice president agrees: “We didn’t approve shit,” he says.

  RAC’s ineffectiveness was largely a reflection of the executive Skilling picked to run it. Rick Buy was a pleasant, paunchy man with glasses—a soft-spoken sort, uncomfortable with confrontation. When his analysts raised issues with a deal, Buy would dutifully take them up the chain of command. But in a head-to-head with the company’s senior traders and originators, it was no contest, as those on both sides of the table recognized. “RAC existed to keep analysts happy, to keep the story alive,” says one veteran originator. “Buy was a decent guy but not smart enough or strong enough to be in that position.” A former senior Enron executive says: “Rick’s the right guy to evaluate the risk. He’s not the right guy to stand down the guys who want their deals done. They’d ram it down his throat.”

  It is business wisdom that many of a company’s best deals are the ones it doesn’t do. That was never the belief at Enron, a place that was defined by deal making. “The corporate culture was such that you never said no to a deal,” says a Buy friend who worked in corporate finance. “It was ‘how do you make a deal work?’ ” Buy, she adds, “didn’t want to be seen as someone saying no to a deal.” In fact, Buy later insisted that saying no wasn’t even part of his job description. He eventually told his staff that RAC’s charge was simply to describe a transaction, analyze its risks and possible returns, and tell senior management: “you guys make your mind up.”

  There were times when frustrated RAC executives refused to sign off on a bad deal, but Buy would overrule them. In 1998, John Hopley, who served for four years as one of Buy’s top deputies, opposed a deal promoted by ECT executives in Europe, who wanted to invest about $20 million in a British company named Techboard, which made fiberboard for kitchen cabinets. Hopley opposed the deal because the company was in the British equivalent of bankruptcy and even the originators’ projected returns—which assumed the company would be able to navigate its way out of the mess—were small. He refused to sign the DASH. So Buy signed it instead. Three months after signing the agreement, the company went into liquidation, and Enron wrote off its entire $20 million investment. “Rick and the group were under a tremendous amount of pressure,” says a former RAC executive. But Buy, he adds, “was not as forceful as he could have been in laying down the law.”

  According to RAC employees, the deal makers were often allowed to set absurdly optimistic assumptions for the complex models that spat out the likelihood of various outcomes for a transaction. “Every attempt was made to really strong-arm RAC with regard to the assumptions,” says one RAC vice president. After completing its analysis, RAC had to circulate its draft comments for the DASH on a given transaction—and the deal makers actually had the right to edit them. When RAC employees complained, they were told to negotiate what they would say in the DASH with the deal makers. “In many instances,” says the vice president, “the actual drafting of the language was done with an originator at the same table, very much suggesting the language that should go in there.”

  Often, entire deals went to RAC just a few days before the close of the quarter, leaving little time to scrutinize transactions involving hundreds of millions of dollars, and putting enormous pressure on RAC to sign off, because the company needed the deals to hit its numbers. “The mentality was to do whatever they can to go over, under, and right through us; that was the objective,” says one RAC veteran.

  The performance-review process was another way the deal makers beat RAC into submission. Incredibly, traders and originators sat on panels that ranked the same RAC executives who reviewed their transactions. Everyone was supposed to act honorably, but there were clear opportunities for retaliation (“he doesn’t cooperate; he’s hard to deal with”), and Buy wasn’t able to protect them. “If you really pissed off an originator, that came up in the PRC,” says a RAC vice president. “Those guys could really tag you and tag you hard. You could get knocked down from the first or second group to the third or fourth group,” for some RAC executives, enough to make a six-figure difference in their annual bonus. And some originators didn’t hesitate to use this very threat as a club during negotiations with RAC, warning the deal analyst: “This deal’s going to get done whether you like it or not. If your name’s not attached to it, it’s going to look bad for you.”

  Buy agonized constantly over his situation. One Enron originator remembers him complaining over lunch in early 1999 that “he had a real problem with the job: he felt like he didn’t matter. I said, ‘Quit!’ ” the dealmaker recalled. “He said, ‘I have to stay because I’m making a ton of money.’ ” Buy’s cash compensation hit $400,000 in 1999, but his big money loomed from stock options, and he’d need to stick around for a couple of more years for most of them to vest. (In 2001, Buy unloaded Enron shares worth $4.3 million.)

  Did Skilling realize how ineffectual Buy was? In fact, he did. He used to tell associates that Buy wasn’t strong enough to stand up to the deal makers; when Skilling left Enron, he even told Ken Lay to replace Buy with someone tougher and more aggressive. But if he understood that, why didn’t Skilling replace Buy himself? In private meetings with those who raised this issue, Skilling argued he could personally make up for Buy’s weakness because he was so aggressive in challenging deals himself.

  This was one of Skilling’s delusions, though. In fact, in his own way, Skilling was as big a problem as Buy. He personally approved some deals even when he was openly skeptical, especially if they were backed by one of his trusted deputies. “I don’t like this deal. I hate this deal!” Skilling would announce in a meeting. Then he’d look over at the senior deal maker backing the transaction and tell him he was getting a pass: “If you really want to do it, this is your silver bullet, but I’m going to hold you responsible.” After recounting how the scene too often played out, one RAC executive slowly shook his head: “There were a lot of silver bullets.”

  After Enron fell, Skilling continued to defend his system, blaming RAC’s weakness on Buy for failing to use the power he’d been given. But Amanda Martin, the former Enron executive who once presided over the ECT deal makers, believes that Skilling’s selection of a “meek” chief risk officer was no accident: “If Buy had said, ‘I will not sign off—I will go to the board,’ Jeff would have caved and killed the deal.” As Martin sees it, Buy’s refus
al to press the issue allowed Skilling to maintain that he always respected the integrity of RAC. If Buy had gone to the board, she says, “He would not have had the plausible deniability he wanted. Jeff played chicken, and he never got run off the road.”

  • • •

  So much of the culture Skilling instilled at Enron was just like RAC: it sounded great in theory, but the reality was something else entirely. Skilling used to say that a culture that supported innovation, as Enron’s did, needed to be willing to accept failure: “I’ll take a smart, thoughtful guy who fails over a person who is successful,” he declared in one interview. But what company can afford to hang on to executives who fail too often? At Enron, though, there was virtually no consequence for cutting a bad deal. Skilling might say he was going to hold deal makers responsible, but he rarely did, and the deal makers all knew it. On the contrary, by the time it was clear that the deal had gone south, the originator would have gotten his bonus and moved on.

  Another Skilling precept: a company that worried too much about costs would discourage original thinking. “I don’t think we should be doing stupid things,” he later explained, “but I don’t think a penny-pinching environment is one that fosters creative ideas. We are not the Wal-Mart of the natural-gas business. We are the Mercedes-Benz of the natural-gas business.” An Enron managing director summed up the philosophy this way: “If you are focusing on costs, you’re fucking up.”

  How did this play out in the daily lives of Enron employees? Not surprisingly, people began spending as if every day were Christmas. Expenses soared, for items large and small. Want a new PalmPilot? No problem; it was on your desk in hours. Fancy a new flat-panel monitor for your computer? It would be waiting for you the next day. On many floors in the Enron building, catered lunches arrived daily.

  The sense of entitlement, bankrolled with corporate cash, was shared by many at Enron, from Ken Lay to the secretarial staff, most of whom carried Enron-purchased cell phones. There was no requirement to use a particular vendor; if you didn’t want to wait for something, you could just pick up the phone and order it yourself. Anyone with a half-baked idea to launch a business in Europe could hop a plane and fly to London. Hundreds of deal makers made a habit of flying first class and staying in deluxe hotels; no one seemed to care. Even junior executives didn’t hesitate to hire expensive consultants; sometimes different business units hired different consultants to study the same idea. The corporate administrative types gave up trying to keep a lid on things. “These people literally did not understand what they were doing and what they were spending,” says Mary Wyatt, who worked as vice president for administration until 1998. “People just did what they wanted.”