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

by Bethany McLean

  Determined not to go down with the ship, Watkins began interviewing for a job with Reliant, a rival Houston energy company. But she was determined to tell someone what she’d found. Watkins had no desire to take her fears outside Enron—to talk to the government or the media or even the board. As she saw it, nothing good could come of that. “When a company cooks the books,” she later explained, “their only chance of survival is to come clean themselves.” Her original plan was to meet with Skilling on her last day working there—to tell him that Enron had gone way over the line. But Skilling had quit before she had the chance. His startling exit redoubled Watkins’s belief that Enron was in imminent peril.

  So on the day after Skilling resigned, Watkins spent two hours in her office, tapping out an anonymous one-page letter to Ken Lay. The result read not as a classic whistle-blower screed about right and wrong, but as the product of a hash of motives: one part bitterness on missing out on the big score that so many of her colleagues had enjoyed, one part horror at Enron’s manipulations, and one part fear that they’d be discovered. More than anything else, the letter served as a warning, a dead-on prophecy about what lay ahead.

  Dear Mr. Lay,

  Has Enron become a risky place to work? For those of us who didn’t get rich over the last few years, can we afford to stay? Skilling’s abrupt departure will raise suspicions of accounting improprieties and valuation issues.

  “How do we fix the Raptor and Condor deals?” she asked. Enron had salvaged hundreds of millions in profits through the Raptor hedges, Watkins explained, but they’d have to be paid off with Enron shares, whose value was dropping. “. . . That won’t go unnoticed,” she wrote. “It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future.”

  “I am incredibly nervous that we will implode in a wave of accounting scandals,” Watkins wrote, in a line that would resonate powerfully. “My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past success as nothing but an elaborate accounting hoax. Skilling is resigning now for ‘personal reasons’ but I think he wasn’t having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in 2 years.”

  “Is there a way our accounting guru’s can unwind these deals now?” Watkins asked. “I have thought and thought about how to do this, but I keep bumping into one big problem—we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed a wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001 and it’s a bit like robbing the bank in one year and trying to pay it back 2 years later.” Watkins fretted about the possibility of a whistle-blower dropping a dime on the company with the government—something she wasn’t about to do. “We are under too much scrutiny and there are probably one or two disgruntled ‘redeployed’ employees who know enough about the ‘funny’ accounting to get us in trouble.”

  Watkins had her assistant drop the unsigned letter in a special box for questions to Lay at the upcoming employee meeting, to be held at the Hyatt. But she didn’t have it in her to remain anonymous. She sent a copy of her letter to McMahon, then called to talk to him about it. When Lay didn’t address her issues at the Hyatt, she went to human resources head Cindy Olson, identified herself as the letter writer, and agreed to speak to Lay face-to-face.

  Before the August 22 meeting, Watkins expanded her warning to seven pages, offering fresh details, naming executives she said could back up her charges, and even offering Lay advice on how to manage the problem. She showed a draft to McMahon and sent a version to her mother. No true third party would have entered into the Raptor swaps with Enron, Watkins wrote. Sure, Andersen had blessed the accounting treatment. But “none of that will protect Enron if these transactions are ever disclosed in the bright light of day.” If “the probability of discovery is low enough,” Watkins advised, “we find a way to quietly and quickly reverse, unwind, write down these positions/transactions.” But Watkins was skeptical that anything could be done quietly. “Too many people are looking for a smoking gun.”

  “There is a veil of secrecy around LJM and Raptor,” she continued. “Employees question our accounting propriety consistently and constantly.” Among those sharing her concerns, Watkins cited McMahon (“highly vexed over the inherent conflicts of LJM”) and Cliff Baxter (“complained mightily to Skilling and all who would listen about the inappropriateness of our transactions with LJM”). Eager to grab Lay’s attention, Watkins recounted hearing one midlevel employee say: “I know it would be devastating to all of us, but I wish we would get caught. We’re such a crooked company.” Watkins believed Lay should launch an investigation but steer clear of using Vinson & Elkins and Andersen because of their obvious conflicts. The best case scenario, Watkins advised: “Clean up quietly if possible.” She also told Lay that he shouldn’t name Fastow or Causey to replace Skilling.

  When Watkins arrived at Lay’s office on the fiftieth floor for her 1 P.M. appointment, the Enron chairman was winding up a private lunch with Greg Whalley, one of the candidates for Skilling’s job. As Watkins made her case to Lay, he listened attentively. In truth, none of what Watkins told him should have come as much of a surprise. He had personally approved the waiver on Fastow’s conflicts to let him run the LJMs; the Raptors had gone before both Lay and the entire board; their growing credit deficiencies were reported on daily position reports, distributed to scores of executives at Enron, and the restructuring had been disclosed in Enron’s SEC filings. Still, Lay seemed concerned and surprised at what he was hearing. Watkins later recalled that he winced when reading the comment about Enron being “such a crooked company.”

  “Andy’s a good CFO, right?” Lay interrupted at one point, according to Watkins’ later account of the meeting. “He’s doing a good job, right?” Lay also noted that Enron’s accountants had reviewed the Raptors with their usual care. Perhaps so, said Watkins, but accounting rules generally barred a company from using its stock to boost its income statement, and Andersen had made mistakes in the past, as recent scandals at other Andersen clients showed. Lay asked one more question: “You haven’t gone outside the company with this, have you?” Assured that she had not, Lay ended the meeting by telling Watkins he would deal with the matter and agreed to arrange her transfer away from Fastow, most likely to Cindy Olson’s HR department.

  Lay contacted Jim Derrick, Enron’s general counsel, and they quickly made arrangements to have Watkins’s allegations investigated by an outside law firm—namely, Vinson & Elkins. Watkins, of course, had explicitly offered the commonsense advice that another firm handle the matter; indeed, V&E had done legal work on the very transactions she was complaining about. But Lay later said he had concluded this conflict could be managed and that it made sense to hand the assignment to lawyers already familiar with the complexities of Enron. V&E certainly fit that bill: it was every bit as intimate with Enron as Arthur Andersen. Derrick himself was among the many Enron executives who were V&E alums.

  One of the two lawyers retained to investigate Watkins’ allegations was Joseph Dilg, a senior partner who had been responsible for the firm’s relationship with Enron since 1991. Dilg had reason to be attuned to sensibilities at Enron: with annual billings running at $35 million a year, Enron was the giant firm’s single largest client. Dilg also had reason to be especially attuned to V&E’s interest; he was about to take over as managing partner of the 850-lawyer firm. Only one other V&E lawyer worked on the project: Max Hendrick III, head of the litigation department.

  It was decided that Vinson & Elkins would conduct a very narrow inquiry. The lawyers later noted in their written report that no outside accounting experts were to be hired. There would be no second-guessing of Arthur Andersen’s work. And no one outside the walls of Enron or Arthur Andersen would be interviewed. This, the report would note, would serve merely as a preliminary probe
, to determine whether Watkins had “raised new factual information that would warrant a broader investigation.” Preliminary or not, a special board panel later concluded that this inquiry was essentially a whitewash, noting: “The result of the V&E review was largely predetermined by the scope and the nature of the investigation and the process employed.”

  Even before the investigation could begin, Enron asked another V&E lawyer—a specialist in labor law—for advice on a related matter: namely, what were the company’s options in dealing with Sherron Watkins? The two-page memo from partner Carl Jordan to an in-house Enron lawyer arrived just two days after Watkins met with Lay. It outlined how Enron should manage the situation to minimize the risk of a lawsuit from Watkins as long as she remained at Enron. (Both her new supervisor and Fastow should be told not to treat her “adversely” because she’d spoken up, Jordan advised.)

  But at Enron’s request, Jordan also explored the possibility of firing her. “Texas law does not currently protect corporate whistle-blowers,” he noted. Still, he concluded, getting rid of Watkins wouldn’t be smart. It would invite the sort of ugly lawsuit that would be “very expensive and time consuming to litigate,” and the company’s books and records would then become “fair game during discovery.” In addition, Jordan wrote, “there is the risk that the discharged employee will seek to convince some government oversight agency (e.g., IRS, SEC, etc.) that the corporation has engaged in materially misleading reporting or is otherwise non-compliant. As with wrongful discharge claims, this can create problems even though the allegations have no merit whatsoever.”

  Such niceties were lost on Fastow. After meeting with Lay, Watkins left town for a vacation to Mexico, she recalled in Power Failure, her account of life at En-

  ron, coauthored with Mimi Swartz. In the meantime, the investigation had begun—and Fastow had found out who had fingered him. After receiving a copy of Watkins’s letter from Derrick, he confronted McMahon, accusing him of conspiring with Watkins in hope of landing the CFO’s job. Fastow also demanded that Watkins be fired immediately and her laptop confiscated. When Watkins returned from her trip, she later recalled in Power Failure, her new boss, Cindy Olson, advised her that “Andy is not behaving appropriately.”

  • • •

  Sherron Watkins wasn’t the only Enron employee writing a letter to her superiors warning about the company’s accounting. On August 29, after she was laid off from her job at EES, Margaret Ceconi, who had previously e-mailed the SEC anonymously, wrote her own signed letter to the Enron board, addressing it to Cindy Olson and board secretary Rebecca Carter. It ran ten pages long and warned of huge woes at EES, including wasteful spending, customers threatening to sue over broken promises, and unprofitable contracts that had been booked for profits. But the most alarming part of the letter alleged “SEC violations” involving more than $500 million in losses that EES was “trying to hide in wholesale. Rumor on the 7th floor is that it is closer to $1 billion.” Yet “somehow EES to everyone’s amazement, reported earnings for the second quarter.” She went on: “EES has knowingly misrepresented EES’ earnings. This is common knowledge among all the EES employees, and is actually joked about. But it should be taken seriously.”

  “Some would say the house of cards are falling,” Ceconi wrote. “You are potentially facing shareholder lawsuits, Employee lawsuits. . . . Heat from the analysts and newspapers. The market has lost all confidence and it’s obvious why. You, the board, have a big task at hand. You have to decide the moral or ethical things to do, to right the wrongs of your various management teams. I wish you luck.”

  The letter was never shown to Lay or the Enron board. Ceconi spotlighted serious problems, but because she had been laid off, it was easier to dismiss her letter as the bitter rantings of a disgruntled former employee—which Enron did.

  Ceconi, meanwhile, had also begun anonymously e-mailing, then calling, Prudential analyst Carol Coale. Using the e-mail name of enrontruth, she began feeding Coale tough questions to ask at analysts meetings and conference calls.

  And then, on September 30, while out for drinks and dinner at a Houston tapas bar called Mia Luna’s, Ceconi ran into a table full of high-ranking EES managers, including division CEO Dave Delainey, COO Jeremy Blachman, and star sales executive Angela Schwarz. Ceconi sauntered by their table on the way out. “What are y’all doing here?” she asked. “Trying to figure out how you’re going to make up the numbers again this quarter?” The encounter turned into a shouting match. As Blachman tried to escort her out, Ceconi pulled away and told gawking bystanders: “He’s from Enron—he thinks he owns everybody and everything!”

  In the aftermath of the episode, Ceconi again reported her complaints to the SEC through its Web site, this time identifying Enron as engaging in the abusive accounting. But nothing happened.

  • • •

  In the wake of the Watkins letter, Fastow lost whatever chance he had to move up. Instead, on August 28—14 days after Skilling’s resignation was made public—Lay announced that Greg Whalley, 39, would take over as president and COO while the 46-year old Mark Frevert would assume the senior-statesman role of vice chairman; both would join Lay in the “office of the chairman.” Frevert was an old Enron hand; he’d started in origination, then helped launch Enron’s trading operation in Europe before returning to Houston to serve as chairman and CEO of the wholesale business. But the key player was Whalley. The “union boss” was now the second-most powerful man at Enron.

  Whalley strongly suspected that all wasn’t well, and he wasted no time digging in. At 1:01 A.M. on the day after his promotion was announced, Whal-

  ley e-mailed investor-relations chief Mark Koenig about Lay’s latest cheery pronouncement. “I guess Ken told someone today that we would make the numbers,” Whalley wrote. “We need to be careful until we know what the numbers are.”

  In truth, Lay seemed preternaturally calm. In early September, he laid plans to assemble his newly appointed 25-member management committee for a two-day off-site meeting. It was to begin on a Thursday night with cocktails and a working dinner. Lay’s proposed agenda for the next day began with two of his favorites, Cindy Olson and PR guru Beth Tilney (wife of Merrill banker Schuyler), tackling the topics of “culture” and “vision and values.” Among the issues for discussion: “image and reputation” (“What is it? How do we communicate it?”) and “How do we define Enron?” (“Not a trading company/More than a trading company/A trading company”). Next up: employee compensation and new businesses. The topics of risk management, electricity markets, concerns about the third quarter, and international asset sales were put off until the end of the day.

  After looking over the schedule, Whalley fired off a blunt e-mail to Lay: “I’m sorry I haven’t been more involved in setting this up, but I think the agenda looks kind of soft,” he wrote. “At a minimum, I would like to turn the schedule around and hit the hard subjects like Q3, risk management, and asset sales first. I would also like to see a discussion on our funds flow, and our balance sheet. If we don’t get these things right, none of the rest of it matters. . . . Also,” Whalley went on, offering no deference to Lay’s favorites (jokingly known as “Ken’s harem”), “I notice that Cindy Olson and Beth Tilney are in attendance. This should only be for presentation, as they are not members of the management committee.”

  By the time of the management retreat, the issue of Fastow’s partnerships had surfaced—just barely—in the Wall Street Journal. In an August 28 Heard on the Street column, headlined “Enron Prepares to Become Easier to Read,” reporters Rebecca Smith and John Emshwiller had detailed Lay’s promise of a “humbler,” more open company. In a three-paragraph discussion buried deep in the story, they also noted that CFO Fastow “had quietly ended his ownership and management ties with certain limited partnerships” effective July 31. The story did not identify the partnerships as LJM.

  At the off-site, nine days later, there was considerable grumbling about Fastow’s passion for SP
Es. The commercial executives complained that while they were making money for Enron, Fastow’s finance people kept muddying the waters by stashing their assets in SPEs. Recounting the meeting, Lay later said he asked the two dozen top Enron managers how many of them had made use of Fastow’s structured vehicles. The answer: pretty much everyone.

  • • •

  It took Joe Dilg and Max Hendrick about a month to make up their minds about Sherron Watkins’s allegations. The Vinson & Elkins lawyers interviewed nine Enron executives and two Arthur Andersen partners. Under the ground rules, Jeff Skilling, Cliff Baxter, and Michael Kopper were all off limits because they had left Enron.

  While Jeff McMahon openly voiced his problems with Fastow’s conflict, neither McMahon nor anyone else (except Watkins, of course) presumed to question Andersen’s judgments about Enron’s accounting. In fact, McMahon told the lawyers that a lot of the LJM transactions had been “highly beneficial” to Enron. Greg Whalley said flatly he didn’t share Watkins’s concerns. Causey and Buy insisted everything had been carefully reviewed—by management, lawyers, accountants, and the Enron board—and disclosed (if opaquely) in Enron’s public filings. The view among Enron executives, the lawyers noted, was that the Raptors and Condor were “clever, useful vehicles.”

  Fastow himself had barely calmed down by the time of his own interview. Everything had been blessed, he pointed out to the V&E lawyers, not only by Andersen accountants but by lawyers from Vinson & Elkins. The letter writer, he said, was simply “second-guessing” Andersen’s judgment. While he applauded the employee’s “fortitude” for speaking up, he voiced suspicion about her motives, telling Dilg and Hendrick that the letter writer was “acting in conjunction with a person who wants his job,” namely, McMahon. The LJM-Enron relationship, he said, was “good for LJM and great for Enron.”