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The Smartest Guys in the Room by Bethany McLean and Peter Elkind.
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The failure of Enron in the early 2000’s is one of the largest bankruptcies in US history (with Lehman Brothers in 2008 as the largest). Its accounting scandal led to Enron’s bankruptcy as well as the dissolution of Arthur Andersen, one of the big five accounting firms. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts.

Today the name “Enron” still evokes a reflexive repulsion, a feeling that these were simply bad people doing illegal things. But, we think, that’s in the past. Surely we’ve evolved as a society, and by thinking hard enough, you or I can avoid these problems.

In reality, when you dig into the details, 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.

You might be surprised to learn that most of Enron’s accounting tactics were not technically illegal at the time - they were actually publicly celebrated for being financial innovations. Shareholders, employees, investment bankers, and accountants all benefited from the situation and enabled Enron for years. They only stopped when it became untenable.

The most important takeaway from The Smartest Guys in the Room is to understand the key enabling conditions for Enron’s deception. When multiple conditions mutually reinforce each other and create positive feedback loops, a massively outsized result - a lollapalooza - can happen.

These are also the warning signs you can use to detect unstable situations and desist from bad behavior.

Accounting practices that disguised the fundamentals

The root of Enron has to be the accounting tactics that enabled deception. They let Enron book more revenue than they actually earned; keep losses and debt off balance sheets. If these were disallowed, the money-losing state of Enron would have been apparent far sooner.

  • Mark-to-market accounting allowed booking the total value of a deal immediately, rather than spaced out over time.
  • Complicated SPE deals allowed Enron to borrow money while keeping it off their balance sheet
  • One-time asset sales were booked as recurring revenue
  • Deals that were actually dead were fictitiously kept alive to avoid a writedown that quarter

All this structure became so convoluted that no one totaled up the big picture. No one pieced together the dependencies between Enron’s deals, and how the dominoes would fall if Enron’s stock price fell.

Lesson: Resist the temptation of clever accounting tricks that mislead on fundamentals, even if they’re technically legal. You may eventually deceive even yourself on the true fundamental strength of the situation.

Poorly constructed compensation structures that rewarded unprofitable behavior

A pattern of Enron’s compensation style was to reward short-term behaviors (like stock price or closing deal sizes) without concern for long-term value (like profitability). And according to the book’s author, Skilling happily fed greed, believing it was the best motivator for performance.

  • Deal makers were given bonuses for the deal value when it closed, not on the generation of actual cashflow. With optimistic projections, deal makers got paid for bad unprofitable deals.
  • Employees got bonuses for short-term stock prices, thus incenting bad behavior to prop up stock price.
  • Senior managers like Skilling got large bonuses for stock performance. This prompted over-optimistic projections to Wall Street, which intensified the speed of rushing into bad businesses (Enron Broadband) and created end-of-quarter scrambles to make earnings.

Lesson: Make sure your compensation structures align with the fundamental goals of the business, and that there are balancing check points

Believable guiding visions

These party lines began with good intentions, but as Enron slipped into a gray zone, they helped justify bad behavior.

Enron saw itself as revitalizing an industry populated by dinosaurs and bringing efficiency through privatization and free markets. With a missionary

Andy Fastow’s department saw itself as a financial wizard, pushing the boundary of possibility while staying within the lines of...

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The Smartest Guys in the Room Summary Enron's Beginning and Promise

The Smartest Guys in the Room chronicles the history of Enron, from beginning to end. Putatively, it began with good intentions and a believable vision. Then, as it focused on short-term stock prices, it became corrupted by deceptive accounting, making more egregious bets.

Ken Lay Sees an Opportunity

Ken Lay, founder and CEO of Enron, believed in efficient markets. The 1970s energy crisis caused natural gas to become deregulated. Lay saw an opportunity to profit from this deregulation.

Lay had served in various roles in gas companies before heading Houston Natural Gas (HNG) in 1984. His vision was to control a large fraction of pipeline which would allow better negotiating leverage.

Larger Omaha company InterNorth, in danger of being taken over by corporate raiders, wanted to defensively increase its size and debt load. It acquired HNG in 1985, with terms very favorable for HNG. Ultimately, Lay gained control of the board and became CEO of the company, renaming it Enron.

Things didn’t immediately work out quite as well as Lay hoped. A glut of gas on the market depressed prices and put Enron’s long-term gas contracts underwater. Management of the combined entity was...

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The Smartest Guys in the Room Summary Enron's Bad Practices

The Start of Bad Practices

Trading companies are too volatile to reliably produce increasing earnings. So rather than claiming to be a speculation company, Skilling branded Enron as a logistics company, finding the most cost-effective way to delivery power from any plant to any customer. This provided cover for incomprehensible businesses.

Skilling feared that any appearance of losses would shatter the illusion of Enron being wizard risk managers, so fought hard to hide them.

Skilling’s obsession with Enron’s stock price and with meeting quarterly Wall Street targets got Enron addicted to bad business practices:

  • Skilling would ask analysts, “what earnings do you need to keep our stock price up?” This was the number he targeted, regardless of whether it was conceivably achievable by the company.
  • Quarters would end with execs scrambling to fill “holes” in the company’s earnings and cover up losses. Deals scheduled to close on later timelines were accelerated, at the expense of costly long-term concessions for Enron.
  • Enron used mark-to-market accounting for its deals, which allowed booking the total value of a deal immediately, rather than spaced...

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The Smartest Guys in the Room Summary Enron Digs a Deeper Hole

The bad practices were begun to hide losses and prop up stock price. As the fundamental core of Enron failed to yield actual revenue, Enron felt forced to expand its deception, putting off its day of reckoning to later.

Enron’s Two Big (Failed) Bets

All the financial machinations around SPEs were meant as temporary measures while Enron bet big on its next two major businesses. Both of them, however, sustained massive losses.

Enron Energy Services - Retail Utilities

Enron’s historical bread and butter was large wholesale contracts with commercial buyers. But it believed there was a coming wave of deregulation, where federal/state governments would release municipalities from local monopolies to allow the free market to drive prices down. Enron could then sell directly to businesses and homes.

In reality, the federal government wasn’t interested in intervening in state affairs, and only a few states started pilot programs toward deregulation (New Hampshire, Pennsylvania, California).

In the few hotspots it could work in, Enron campaigned aggressively to recruit consumer households to sign up, promising lower utility costs. However, the local suppliers...

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The Smartest Guys in the Room Summary Cracks Start to Appear

Despite Enron’s best efforts to conceal their losses, by late 2000, skepticism started mounting. The dotcom bubble had fallen from its peak, and company fundamentals were being questioned.

On December 2000, Jeff Skilling was announced to succeed Ken Lay as CEO, taking place in February. This was already planned well in advance - his contract had a trigger - if he weren’t named CEO by end of 2000, he could leave and be paid over $20MM.

SPEs, Again

Enron embarked on new schemes to lock in gains while avoiding booking losses.

In 2000, SPEs called Raptors would buy underperforming Enron assets. If the assets continued to decline in value, the Raptors would pay Enron, thus giving Enron a gain that would offset the loss.

In reality, these transactions were grounded on Enron stock. This led to positive feedback loops:

  • An increasing Enron stock price would allow further ability to keep losses from public view, which would in turn increase stock price.
  • However, if Enron shares fell, the Raptors would be less able to pay back Enron, which would cause further share cratering.

By late 2000, the assets in SPEs declined in value, and Enron needed its stock to continue...

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The Smartest Guys in the Room Summary Enron's Final Moments

The nightmare scenario is more or less what happened at the end of 2001. Over a series of months, Enron collapsed, one step after another.

Internal rumors began circulating about issues at Enron.

  • Accountants looking into the SPE deals realized that the falling value of assets in the SPEs, along with the falling Enron stock price, were going to become difficult to pay off. “It’s a bit like robbing the bank in one year and trying to pay it back 2 years later.”
  • It was known that EES’s losses were being hidden in wholesale. In an employee letter: “This is common knowledge...and is actually joked about.”

The SPE Raptor deals ran into trouble.

  • The Raptor deals became underwater by 9 figures, especially in the market hit after September 11.
  • Andersen auditors realized they made an accounting error - Raptor restructuring had been booked as a boost in shareholder equity and needed to be reversed, costing equity $1.2 billion.
    • This would be recorded as a simple equity reduction, rather than a restatement, which would admit mistakes and trigger SEC inquiries and lawsuits.
  • COO Whalley argued to take the hit and clean up. They felt Enron would recover...

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The Smartest Guys in the Room Summary The Legal Aftermath and Enron's Legacy

As the largest bankruptcy in US history to that point, the public demanded heads. And there were many responsible parties to punish.

The clearly illegal smoking guns led to straightforward convictions - Fastow’s misrepresentations about LJM; asset sales that were booked as revenue but in reality had a guarantee to be rebought, which meant it was a loan.

Arthur Andersen, previously one of the big five accounting firms, was convicted of obstruction of justice in 2002 for shredding documents. It voluntarily surrendered its licenses to practice as CPAs in 2002.

  • (The Supreme Court later reversed the conviction in 2005, though by that point its besmirched reputation prevented it from gaining any clients.)

The banks agreed to write big settlement checks, ultimately producing $7.2 billion for shareholders (about 20 cents for each dollar lost).

Beyond these, the legal difficulty was that most of the financial maneuvers were not technically illegal (which is why Fastow so brazenly boasted about the structures, and Wall Street praised them).

There also was no smoking gun that indicated either Lay or Skilling knew the extent of risk taken and predicted Enron’s demise. On...

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The Smartest Guys in the Room Summary Enabling Conditions of Enrons Deception

How was Enron able to get away with its bad behavior for so long, even when its operations involved thousands of people with partial insight into the problems? Here we take a look at the major conditions that promoted Enron’s deception. These are themes that might recur in future disasters.

(Shortform note: while the original book mostly tells a chronological story, we pulled the themes and patterns from the book to form this chapter.)

People with Incentives to Tolerate Bad Behavior

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.

Furthermore, everyone looked to each other for validation. “Surely all these other people can’t be wrong!” Yet no one realized no one else had done their due diligence.

In a culture where earnings are prized above all, earners have the leverage to conduct bad behavior, unpunished. Threaten to quit and you get what you want. This culture promotes caring about self rather than the longevity of the company.

  • In the 1980s, an Enron...

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The Smartest Guys in the Room Summary Personal Traits of Enron Managers

Much is written about the management styles of the senior executives at Enron. They each had idiosyncracies that, when combined, led to a proliferation of problems.

Jeff Skilling, COO then CEO

  • An intellectual purist, a designer of ditches, not a digger of ditches. Often slow to recognize when reality didn’t match theory. Left the execution details to his lieutenants.
    • “I’m not particularly interested in the balance sheet. It seemed to be doing well. We always had money.”
    • In the retail Enron Energy Services business, Skilling disparaged the operators of utilities as “buttcrack “ workers. “This stuff sells. Now we have to actually do something for the customers. That’s the easy part.”
  • A gambler at heart, always assumed he could beat the odds. (He was wiped out in the stock market twice in his teens.)
  • Convinced he was the smartest guy in the room - anyone who disagreed wasn’t smart enough to get it
    • He bullied analysts who questioned how Enron made...

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The Smartest Guys in the Room Summary Shortform Exclusive: How to Avoid an Enron

Here we invert the question - how do you avoid building an Enron? Make sure you avoid the bad practices of Enron with this checklist.

  • Don’t tolerate bad behavior just because they’re making money for you.
  • Don’t avoid doing diligence because you believe that everyone else has done their due diligence. Everyone else likely believes the same, and it’s possible no one has done diligence.
  • Do sanity checks even if you fear being called dumb. Lose your ego around being intelligent - if something seems too complicated for you to understand, it’s probably not because you’re dumb. Someone might be actively hiding something.
  • Set compensation schemes correctly - in service of long-term value and sustainability, not in terms of misleading short-term metrics.
  • Avoid these standard excuses that are more reassuring than they should be.
    • ...

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Table of Contents

  • 1-Page Summary
  • Enron's Beginning and Promise
  • Enron's Bad Practices
  • Enron Digs a Deeper Hole
  • Cracks Start to Appear
  • Enron's Final Moments
  • The Legal Aftermath and Enron's Legacy
  • Enabling Conditions of Enrons Deception
  • Personal Traits of Enron Managers
  • Shortform Exclusive: How to Avoid an Enron