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

by Bethany McLean

  Spacek was also interested in computers and technology, and when employees came to him with an idea—that Andersen should help corporations figure out how to use these complicated new machines—he helped push it forward, setting up the industry’s first consulting arm. What he failed to realize was that consulting would play a major role in corrupting both the accounting profession and Andersen itself.

  Over time, consulting became the tail that wagged the dog. Consulting divisions—which included not only computer assistance but business strategy and risk management, among other things—grew much faster than the auditing divisions, which at many firms became practically loss leaders to help get the consultants in the door. The consultants themselves generated far more money than their accounting counterparts and had far more status. Along with the rise of consulting came a new focus on the bottom line. Accountants hired to audit a company’s books were also expected to help persuade their clients to use the firm’s consultants as well. By the 1990s, there were few firms willing to quit an account on principle, as Arthur Andersen had done so long ago; there was simply too much money at stake. Not surprisingly, accounting standards eroded, and accounting fraud mushroomed.

  At Andersen, the growth and success of its consulting division, Andersen Consulting, led to a long, simmering feud between the accountants and the consultants. In a partnership where profits were shared, the situation became so bitter that in 1989 the consultants were spun off into a separate business unit, but they were still required to share their profits with their poorer audit cousins. (In 1997, the consulting side produced 56 percent of the firm’s revenues—and consulting was growing at nearly twice the rate of auditing.) As a firm, Andersen had two cultures, the sleek, self-satisfied consultants—and the downtrodden auditors who only had to look across the hallway to see that they weren’t keeping up. In December 1997, after several years of open warfare, the consultants voted to split off entirely. The auditors demanded over $14 billion; in 2000, a judge ruled that they would get just $1 billion. The Andersen accountants, left with a slow-growing audit business—it was the smallest of the Big Five accounting firms—began aggressively building a new consulting arm of their own. The pressure to generate fees was intense, and so was the pressure to hold on to clients. Even before Enron, Andersen had been embroiled in several high-profile accounting scandals, including Sunbeam and Waste Management.

  In the Waste Management case, Andersen paid $75 million to settle civil lawsuits, agreed to pay a $7 million fine to the SEC, and promised not to repeat its conduct. In the wake of its settlement with the SEC, the firm circulated a memo to all its partners: “One of the most important lessons from litigation involving our profession is that client selection and retention are among the most important factors in determining our risk exposure. . . . have the courage to say no to relationships that bring unacceptable levels of risk to our firm.”

  Andersen had long since abandoned its founder’s old motto, “think straight, talk straight”; instead, its new slogan was “simply the best.” But by the late 1990s, “simply the best” had a different meaning than it might once have had at Arthur Andersen. Those partners who were viewed internally as simply the best were the ones who kept their clients happy, especially the handful of clients Andersen labeled its crown jewels. Enron was one of them.

  Practically from the day Enron was formed, the company was a big client for Andersen’s Houston office. Between 1988 and 1991, Andersen earned $54 million in fees from Enron. By the late 1990s, that number had skyrocketed; in 2000 alone, Enron paid Arthur Andersen $52 million, over half for consulting services. Enron was one of Andersen’s top four clients, and it dominated the attention of the Houston office, which, thanks to its aggressive energy practice, was the largest and most profitable office in the firm. Within Andersen, the Houston office had a reputation: it was the place to go if you wanted to make partner quickly, and the Enron account was a large part of the reason why. In addition to its external auditing, Andersen at various times also had consulting contracts to handle Enron’s internal auditing and was in charge of auditing Enron’s internal-control system.

  Even that doesn’t begin to describe how close Andersen and Enron were. Over the years, Enron hired at least 86 Andersen accountants, who were lured by the promise of higher pay and Enron stock options. Over time, many important finance jobs at the company were held by people who had worked on the Enron account at Arthur Andersen. Andersen often complained that Enron was raiding its staff, but the firm was also rather proud of it. Although Arther Andersen’s Houston office was just a few blocks from the Enron building, most of the 100 or so Andersen employees who worked on the Enron account spent almost no time there; their offices were at Enron, where they worked alongside the company’s own accountants. They adopted the same business-casual style that was prevalent at Enron, making it hard to tell who was the auditor and who was the client. “It was like these very bright geeks at Andersen suddenly got invited to this really cool, macho frat party,” Leigh Anne Dear, a former Andersen accountant, told the Chicago Tribune.

  In April 2000, when Arthur Levitt, then the SEC chairman, tried to force accounting firms to separate their consulting and accounting practices, Enron leapt to its accountant’s defense. “For the past several years, Enron has successfully utilized its independent audit firm’s expertise and professional skepticism to help improve the overall control environment within the company,” wrote Ken Lay to the agency. “I believe independent audits of the internal control environment are valuable to the investing public. . . .” After a bitter fight, Levitt largely backed down.

  Enron and Andersen even bragged about their closeness in a promotional video. “We basically do the same types of things . . . we’re trying to kinda cross lines and trying to, you know, become more of just a business person here at Enron,” said one Arthur Andersen accountant in the video. Added another, “Being here full time year round day to day gives us a chance to chase the deals with them and participate in the deal making process. . . .”

  The person who best symbolized the unseemly closeness between the com-

  pany and its accounting firm was David Duncan, who was just 38 years old when he was put in charge of the Enron account in 1997. Born in Lake Charles, Louisiana, and raised in Beaumont, Texas, Duncan joined Andersen’s Hous-

  ton office in 1981, straight out of Texas A&M. Rick Causey started at the firm around the same time, and the two men became fast friends. That didn’t change after Causey moved to Enron. They often lunched together at Nino’s, an Italian restaurant frequented by Enron and Andersen employees. They co-

  chaired the Open Heart Open, a Houston golf tournament that benefited the American Heart Association. On at least one occasion, Causey took Duncan and a handful of Andersen accountants to the Masters. Duncan also served on the American Council for Capital Formation—one of Charls Walker’s groups—with Ken Lay.

  Did this bother anyone at Andersen? Actually, it did, but not the people who mattered. There were accountants among the rank and file who thought that Duncan was far too close to his client. But most of Duncan’s bosses viewed him as a rising star who did exactly what he was supposed to do—generate 20 percent to 25 percent in additional fees from Enron each year. Duncan had become a partner in 1995 and took over the Enron account two years later; by 2000, his annual salary hovered around $1 million. He was on Arthur Andersen’s firmwide strategic advisory council and in the fall of 2001 was invited to join chairman Joe Berardino’s advisory council, which consisted of just 21 partners. At the time of Enron’s collapse, he had a shiny life with his wife and three daughters and an expensive house in Houston’s affluent Memorial area. All thanks to the Enron account.

  The problem, of course, wasn’t merely that Duncan was going to the Masters with Causey; it was that he saw things the way the client wanted him to see them and gave his assent to Enron accounting treatments that bore little relationship to economic reality. Did he know how far out on the e
dge Enron’s accounting was? Of course he did. But he was being rewarded at Andersen for keeping the client happy—and that meant becoming every bit as creative as Enron was.

  Within the firm, Enron was labeled “high risk.” That in itself was not unique; Andersen had other clients in the same category. But over the years, the firm’s internal notes on Enron showed just how high risk this client was. “Client is a first mover, and expects to push the edges of established convention, and where they can, create new convention . . . often in very gray areas,” wrote one partner in early 2001. “The transactions are complex, and there is no clear written literature with respect to these transactions,” noted another. Enron, said Andersen, had a “dependence on transaction execution to meet financial objectives.” An internal Andersen appraisal of the client noted that Enron’s “accounting and financial risk” were “very significant.” Andersen said the same thing about Enron’s use of “form over substance” transactions.

  “There are a number of areas,” the firm pointed out to Enron’s board in a 2000 audit update, “where accounting rules have not kept up with the company’s practices. . . . Categorization of activities between certain segments, operating vs. non-operating or recurring vs. non-recurring can be highly judgmental.” Duncan’s own appraisal of Enron’s accounting? “Obviously we are on board with all of these [transactions],” he jotted in a handwritten note after Andersen had completed its 1998 audit, “but many push limits and have a high ‘others could have a different point of view’ risk profile.”

  But just like the Enron executives, Duncan couldn’t see where the cumula-

  tive effect of his decisions was leading. Yes, all the incentives inside Andersen pushed him to see things the way the clients wanted him to see them: his big salary, his rapid rise, his status inside the firm were utterly dependant on keeping Enron happy. But he had started smoking the dope, too, abandoning the auditor’s role of skeptic and becoming a believer himself. Enron was a great company, wasn’t it? Enron’s finance executives were whizzes. They were all on the cutting edge. Sure, they were stretching the rules, but the Andersen team always had a rationale as to why they weren’t breaking the rules. Given the firm’s experience with the Waste Management scandal, the firm could hardly afford another big accounting scandal. Yet in signing off on one risky accounting treatment after another, that was the very large risk Duncan was taking. And he never seemed to realize it until it was much too late.

  What about those times Andersen did object to an Enron transaction? At such times, Enron put the firm under intense pressure. There were times when Causey and others would ask that certain accountants who weren’t “responsive” enough be moved, and Duncan complied. Knowing just how important the $1 million-a-week account was to Andersen, Enron also kept competing firms lurking in the wings. From time to time, Causey would throw a small bit of business to Ernst & Young or PricewaterhouseCoopers, just enough to remind Andersen who was running the show. Inside Global Finance, Arthur Andersen was viewed as “a manageable issue,” says a former Enron employee. “They were pretty easy to push around and bully into doing whatever we wanted them to do.” A midlevel Andersen accountant named Patricia Grutzmacher later testified in court, “When you look at a deal and you give the answer no, and then they appeal the no, and the answer ends up being yes, you just wonder, you know, why are you even there?”

  Andersen had a small elite group that formed something called the Professional Standards Group, which was supposed to make independent rules on particularly tricky accounting issues. Starting around 1999, more and more of the PSG’s time was consumed by Enron; at one point, Andersen’s Houston office was calling the PSG practically on a daily basis. The PSG was supposed to have the final word on any technical accounting question. If the client team wanted to reject the advice, the issue was supposed to be settled by higher-ups at the firm. In addition, the team was supposed to speak to the client with one voice. But Causey understood how the PSG worked and insisted that he be consulted when Enron accounting issues were brought to the PSG’s attention. As Duncan told his partners, Enron demanded “more face time with Chicago to ensure their views are heard directly.” Causey expected Duncan to be Enron’s advocate in dealings with the PSG. Duncan obliged.

  These weren’t just issues that cropped up at the end. The cross-fertilization between client and firm, the willingness of Andersen to push the envelope on accounting decisions, the aggressiveness with which Enron pressed the accountants to see things its way—those were there, in one form or another, for years. As early as 1995, back when Kinder was still president of the company, a Houston-based Andersen auditor named James Hecker decided to have a little fun at Enron’s expense. Hecker never worked on the Enron account, but at lunches and other social occasions, he would hear auditors on the Enron account talk about strategies to “minimize losses” and take liabilities “off the balance sheet.” He heard chatter that Enron was, as he later put it, “very opportunistic in trying to achieve objectives.” Hecker later used the word “shambolic” to describe Enron’s accounting, not that it was completely a sham but that it was substantively illogical, like a duck that’s really a dog. One day, Hecker wrote a parody, which he showed to a few colleagues. Sung to the tune of “Hotel California,” he called it the “Hotel Kenneth-Lay-a”:

  Welcome to the Hotel Mark-to-Market

  Such a lovely face

  Such a fragile place

  They livin’ it up at the

  Hotel Cram-It-Down-Ya

  When the suits arrive, bring your alibis

  Mirrors on the 10-K, makes it look real nice

  And she said, we only make disclosures here

  Of our own device

  And in the partners’ chambers

  Cooking up a new deal

  3% in an SPE

  But they just can’t make it real

  Last thing I remember I was running for the doors

  I had to find the entries back

  To the GAAP we had before

  “Relax,” said the client

  “We are programmed to succeed

  You can audit any time you like

  But we will never bleed”

  Just as the cozy relationship between Enron and Andersen wasn’t a secret, it was also no secret on Wall Street that Enron was an aggressive user of structured finance devices such as special purpose entities (that’s the SPE in Hecker’s song), securitizations, and off-balance-sheet partnerships. “If there was a whiz-bang structure somebody had, the place to sell it was down there on Smith Street, because they were buying,” says one banker. Andy Fastow’s team, says another banker, were “black belts in structured finance.”

  “It started out as pure, clear, legitimate deals,” says a former senior Enron executive. “And each deal gets a little bit messier and messier. We started out just taking one hit of cocaine, and the next thing you know, we’re importing the stuff from Colombia.”

  CHAPTER 11

  Andy Fastow’s Secrets

  In the spring of 1998, shortly after Andy Fastow became Enron’s chief financial officer, he approached Jeff Skilling about using the equity markets to raise money. Selling new shares of stock is one of the most common ways a corporation can raise capital, and in the middle of a roaring bull market, it’s one of the easiest ways as well. Unlike debt, the money never has to be paid back; investors are betting that the company will use the capital wisely and that the stock will go up as a result. If it doesn’t, the investors, not the company, take the hit.

  Although Enron clearly needed capital—it had by then billions in debt and was preparing to spend billions on new business ventures—Skilling and Lay were cool to the idea. Skilling, in particular, was opposed to anything that might hurt the stock price, even temporarily. That’s always the danger when new shares flood the market: the new supply can outstrip the demand for the stock and push the price down. Additional shares also make it harder to hit an earnings-per-share number because there are more s
hares outstanding. As they say on Wall Street, existing shareholders are diluted.

  But Fastow countered that the stock market would easily absorb the shares; Enron hadn’t sold a significant amount of stock in five years, and its executives could surely tell a compelling story. Eventually, Skilling and Lay relented, and Enron raised some $800 million in the offering. Less than a year later, Enron sold more stock. But after that, although Andy Fastow and his group at Global Finance generated billions of dollars of new capital for Enron, never again did they do a financing as simple and straightforward as an equity offering. By then, the era of Enron’s financial subterfuge had begun in earnest.

  In Finance 101, there are only three ways for companies to fund their growth. They can take on debt, issue stock, or draw from their existing cash flow. Enron had committed to Wall Street that it was going to grow rapidly; that was an essential element of the Enron “story.” But all three of these tactics were ruled out at Enron. The company couldn’t put too much debt on its balance sheet because that would hurt its credit rating (and banks would stop lending if Enron’s debt ratios got out of whack). Nor could it use existing cash flow, since Enron didn’t have much real cash flow. And although the equity market was, indeed, available, Skilling had made it clear that he didn’t want to tap it often.

  Yet Enron continued to fund its growth—to the tune of billions of dollars each year—through the miracle of structured finance. Structured finance enabled Enron to raise capital off its balance sheet to an extent no one imagined possible. According to an Enron board presentation, Fastow’s Global Finance group was raising around $20 billion worth of capital a year, mostly through structured finance deals. As Fastow himself once told the board, his job was to “feed the beast.”

  In business terms, it was as if the company had discovered a way to defy the laws of gravity. Using off-balance-sheet vehicles and other complex transactions, Enron seemed to be able to make money magically appear without either adding debt or issuing stock. And that’s precisely how many Enron executives felt, especially those who worked directly for Fastow: they thought they were magicians, reinventing corporate finance, rewriting the rules of the game, thumbing their nose at the way business had always been done.