PDF Summary:The Smartest Guys in the Room, by Bethany McLean and Peter Elkind
Book Summary: Learn the key points in minutes.
Below is a preview of the Shortform book summary of The Smartest Guys in the Room by Bethany McLean and Peter Elkind. Read the full comprehensive summary at Shortform.
1-Page PDF Summary of The Smartest Guys in the Room
The failure of Enron in the early 2000’s is one of the largest bankruptcies in US history. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts. This book recounts the rise and fall of Enron, and how the company constructed a massively complex accounting scandal that was doomed to failure.
Enron’s downfall is the predictable mixture of human greed, poorly structured incentives, and lack of sanity checks when everyone has their fingers in the pie. In smaller ways, we too are subject to the same pulls as Enron managers and employees. The warning - if we were put into the same situation, we might not have behaved any differently.
(continued)...
Stakeholders/watchdogs overlooking bad behavior as long as they were profiting
People who could have stepped in and intervened didn’t, often because they had a large personal stake in Enron’s success. Further, the more Enron became a success (like in terms of stock price or deal flow), the more beholden the stakeholders were to Enron.
- Shareholders (employees and the public in general) didn’t look very hard, as long as the stock price rose and employees got bonuses. Why stop the party?
- Enron’s accountants (Arthur Andersen) couldn’t lose Enron as a client (Enron kept accountants waiting in the wings), so they tolerated their practices despite internal skepticism. Furthermore, Enron gave many Andersen accountants cushy jobs.
- Investment bankers earned large fees from Enron’s complicated deals, even when they knew they were skirting the intent of the law. Bankers who ran bigger deals got promotions. They competed for Enron’s business.
- Buy-side analysts at banks who were supposed to be independent were strongly pressured to give buy ratings, since companies would only work with positive banks.
- Short sellers were a useful counterforce, since they had a large incentive to expose wrongdoing.
Lesson: Correct for your own incentive bias when you analyze a situation.
Looking to others believing they had done their due diligence
When you have multiple reputable people on board, everyone thinks everyone else has done their diligence. Surely all these other people can’t be wrong! In reality, no one has done their diligence.
- Employees thought the board and accountants would keep bad behavior in check, and thought public markets were heavily incented to detect bad behavior.
- The board trusted the internal risk department, which in reality was a yes-man and thought their only job was to sign off on deals.
Lesson: Don’t trust other people’s due diligence. Assume they have the worst possible incentives to overlook problems. Do your own due diligence from first principles.
Big bets on businesses that failed
According to the author, the accounting tricks were meant to be short-term bridges to the real new money-makers: Enron Energy Services (retail utilities) and Enron Broadband.
Enron plowed a ton of money into these businesses, in typical Enron “move fast and go big or go home.” Their read of the market and industries was wrong.
Enron’s optimistic promises to Wall Street created a situation where Enron had to deliver fast on businesses, or else their stock price would plummet.
Lesson: Don’t excuse bad practices as temporary measures until your saving grace comes around.
Complex dependencies that required progressively bigger risks or face complete failure
Enron built layers of financial dependencies in a constant push to raise stock prices. In essence, it kicked the can down the road, hoping that salvation would come at some point.
- For example, Enron’s mark-to-market accounting might put the value of a 20-year deal down as recurring revenue in one quarter. Wall Street expected this to be real recurring revenue, which meant Enron had to book larger deals that had bad long-term prospects to keep up appearances.
Here was the nightmare scenario (that materialized):
- Enron’s stock price was high because of misleading accounting and overoptimistic projections.
- If Enron ever missed earnings, its stock price would fall.
- If its stock fell, its SPE deals would unwind (since they were predicated on Enron stock prices), causing Enron to have to book massive debt on its balance sheet or issue new shares. This would cause further stock price falls.
- This increased debt would cause a downgrade of Enron’s creditworthiness to junk status.
- This would trigger provisions in Enron’s debt agreements to pay back loans early, and trading partners to demand cash collateral.
- Since Enron didn’t actually have cash, its ability to pay would progressively worsen, causing trading partners to withdraw and further decrease revenue.
- This would cause bankruptcy.
Lesson: Don’t create scenarios where you kick accountability down the road and bet on a big salvation moment. Take moves to de-risk moment to moment, and take a big write down earlier. Be even more wary if this is an existential risk, since for the sake of staying alive you might take more desperate steps.
An unwillingness to consider the worst case scenario seriously
Because of such strong incentive bias, social proof, and self-consistency bias, Enron managers refused to believe that the stock price would ever fall and trigger the nightmare scenario.
Lesson: Seriously consider the worst case scenario, and think about ways that you can mitigate this.
Bad appointments to senior managers
Generally, promoting people who had the wrong kind of ambition (more to themselves than to the fundamental health of the company).
- Andy Fastow, known for experience creating financial structures rather than financial prudence, was promoted to CFO.
- Ken Lay was more interested in being a public figure than in managing the business.
- The board was weak, filled by Ken Lay with people who had reciprocal relationships with Enron.
Lesson: Hire people with the right kind of ambition, who want to grow the long-term success of the company (and are incented correctly).
Punishments for dissent/skepticism
Internally, Enron skeptics were punished for voicing discontent or blocking deals. They were reassigned to less glamorous parts of the company or publicly humiliated on their failure (like Rebecca Mark).
- Enron partners (accountants, bankers) who voiced discontent lost the deals. Enron managers even strongly encouraged the dismissal of employees who added friction to deals.
- Skilling had a tactic of making people feel dumb for asking questions. “All the data is out there. If you don’t get it, you’re just dumb.” Naturally, in the heady times of the dotcom boom, people didn’t want to look dumb or be wrong, in case Enron turned out to be a huge success.
Lesson: In your search for the truth, put aside the centering of your ego around being smart. If something seems too complicated for you to get, it’s probably not your fault - keep pressing.
Want to learn the rest of The Smartest Guys in the Room in 21 minutes?
Unlock the full book summary of The Smartest Guys in the Room by signing up for Shortform .
Shortform summaries help you learn 10x faster by:
- Being 100% comprehensive: you learn the most important points in the book
- Cutting out the fluff: you don't spend your time wondering what the author's point is.
- Interactive exercises: apply the book's ideas to your own life with our educators' guidance.
Here's a preview of the rest of Shortform's The Smartest Guys in the Room PDF summary: