The Smartest Guys In The Room -- Bethany McLean

The Smartest Guys In The Room

Bethany McLean and Peter Elkind

GENRE: History

PAGES: 440

COMPLETED: August 18, 2020

RATING:

Short Summary

The Smartest Guys in the Room takes a look at Enron and the factors that led to the biggest corporate scandal in history. Bethany McLean digs into Enron’s past — and behind the closed doors of private meetings at the company. Drawing on a wide range of unique sources, the book follows Enron’s rise from obscurity to the top of the business world to its epic collapse.

Key Takeaways

Create Strong Values — As a company, and as an individual, focus on creating a set of core values that can guide you through anything. Enron’s downfall was, in large part, a result of poor, selfish values. The people running the company were shady, and the bad behavior that put the firm in a hole only got worse when adversity came along. When you create strong values, making good decisions become automatic — you behave in alignment with your values.

Enron Was Obsessed With EPS — The leadership team at Enron was obsessed with the company’s earnings per share (EPS), which is what drove most of the shady accounting behavior. Company stock represented the majority of compensation for many of the firm’s leaders. Management used certain accounting loopholes to boost net income and increase the company’s EPS, which led to a higher stock price.

Sarbanes-Oxley Act of 2002 — The Sarbanes-Oxley Act of 2002 is a federal law that was passed following the Enron collapse. Enron abused certain accounting loopholes, and this act put in place certain guidelines for corporate financial record keeping and reporting that are used today to prevent similar corruption.

Favorite Quote

"The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control."

Book Notes

Introduction

Enron was the 7th largest company in the United States at its peak.
- Enron was a Houston-based energy company.
- Ken Lay — CEO of Enron.
Enron went on to file the largest bankruptcy claim in United States history.
Enron was a global company with major projects in China, Brazil, and other places.

Chapter 1

Natural gas (not oil) is what Enron and Ken Lay specialized in.
- Natural gas is transparent, odorless, lighter than air, and lies in underground pockets beside oil deposits.
Prior to the 1970s, natural gas facilitation and pipelines were controlled by the government. Prices were regulated by the government.
Ken Lay saw an opportunity to take control of a pipeline company and make natural gas a free market item where supply and demand dictated prices.
- Lay believed in deregulation. He believed in a free market economy.
Lay was a relatively weak CEO who didn’t put his foot down enough.
- He was more concerned with being liked by politicians and celebrities.
- This led to him losing control of the company down the line.
Lay was an excellent student at the University of Missouri. He studied economics.
- He also worked at Exxon Mobile briefly after graduating.
1970s — There was a natural gas shortage. Schools were shut down because they didn’t have enough to heat the facility.
- This was because the government’s prices were set so low that people felt no motivation to find more natural gas. There was no point.
1990s — The government finally deregulates the natural gas market.
- Pipeline companies were in really bad shape at this time.
Enron’s beginnings were not good. In the company’s first year, it reported a loss of $14 billion.

Chapter 2

1980s — Oil trading became huge.
Mid-1980s — Enron’s oil trading department was making millions of dollars while the rest of the company was losing money.
1987 — Enron’s oil trading department was caught using a technique to shift profits month-to-month, year-to-year. This was done to show Wall Street they could produce consistent profits, which is what drives a stock price up.
- This was also done to secure loans from banks. Banks required Enron to reach certain earnings criteria to get loans.
- Basically, Enron was hiding excess profits in one quarter to use as profits for the next quarter to ensure they were showing consistent increasing earnings.
  - They were shifting these profits by sending the excess profits to the individual bank accounts of some of the department’s leadership group.
    - The idea was that the individuals would pay the right amount of money back to the company the next quarter.
Although internal auditors and accountants were suspicious, they concluded that these actions didn’t impact the company’s financial statements. They didn’t have to report anything to the public or SEC.
- The oil traders were making the company so much money that management basically just gave them a slap on the wrist and didn’t do much else.
- This situation was an early sign of Enron’s shadiness.
The oil traders were basically keeping multiple books and made up fake companies abroad to store and steal money from the company.
- They stole up to $4 million from Enron through shady profit-shifting techniques.
The oil traders eventually ran out of luck. The department’s leadership bet on oil prices going down, but they went up. Enron was short 84 million barrels of oil, or $1 billion.
- Enron’s management team and Lay pretended like they were blindsided by the traders and insisted to Wall Street and the public that this was a one-time disaster.

Chapter 3

Natural gas used to be sold under long-term contracts between producers, pipelines, and local utilities with the price set by the government.
- Enron changed the game with what it called “The Gas Bank”, where Enron acted as a bank in buying and selling natural gas. It capitalized off the spread, as banks do with borrowers and depositors.
  - 1990 — Jeff Skilling is brought on to run the gas bank. The Gas Bank was his idea.
Skilling also created a financial market of sorts using natural gas contracts. Enron secured contracts with natural gas producers and was able to use those to trade with other players in the game, just like options and derivatives in the financial industry.
- They turned natural gas into a tradable commodity, like wheat.
The idea of the Gas Bank and contract trading was revolutionary. Wall Street bought in and Enron began to skyrocket.
Skilling refused to join Enron unless the company used the “mark-to-market” accounting style.
- This style became a centerpiece of Enron’s demise later on.
Mark-to-market accounting basically allowed Enron to claim imaginary profits on its financial statements at the moment an idea or contract was made.
- Ex. Toyota claims all future profits of a car on its statements at the moment the car is thought of, before any cars roll off the assembly line and before any real, tangible profits are made.
- This way of accounting made Enron look amazing on its financial statements because the company was claiming profits that weren’t real yet.
- This method of accounting is used on Wall Street to judge portfolios, but it was not appropriate for natural gas contracts, which often had 20-year lifespans.
  - Essentially, somebody at Enron had to predict what natural gas prices would be 20 years in the future. Impossible.
    - This allowed Enron to abuse the method to predict prices that were potentially way too high and then list revenue from those phantom prices on today’s financial statements.
      - This allowed Enron to always meet and beat analyst expectations, which helped drive their stock price up.

Chapter 4

John Wing, who was in charge of Enron International, struck a deal to build a power plant in England, where natural gas was slowly becoming deregulated in the early 1990s.
- Enron was the first big natural gas player in England.

Chapter 5

1992 — Enron strikes a deal with Sycthe Energy to build a huge natural gas plant in New York City.
- The deal was a 20-year deal where Enron was to supply the company with $3 billion worth of gas.
- It was Enron’s biggest deal to that point.
The dealmakers (securing new gas deals and the traders (trading contracts for profit) often fought at Enron.
- They often fought over who deserved more money.
1993 — Enron’s trading department strikes partnership with CalPERS, one of the most respected institutional investors in the world.
- The partnership had the objective of investing in energy-related investments.
- CalPERS and Enron each put $250 million into the joint account.
- This was a huge partnership for Enron.
By 1996, the trading department at Enron, run by Skilling, was the company’s greatest source of profit.
- Skilling, by this point, was a huge superstar within the company.

Chapter 6

Early 1990s — Enron’s international department begins making deals to produce pipelines and power plants in a bunch of different countries, like China, Brazil, Columbia, and more.
- Enron was a company with serious global reach by the end of the 1990s.
1996 — Rebecca Mark becomes the leader of Enron International.
- One of her problems was rushing to do new deals. This sometimes leads to sloppiness.
Enron’s deal with India to make a power plant was one of its worst.
- The deal was completely one-sided against India. India had to buy huge amounts of gas.
- The deal was hated by the people of India. The government and people basically refused to follow through on the deal.
- Today, the power plant that was built sits idle in India.

Chapter 7

Many of Enron’s management had tons of stock options, which means they deeply cared about the company’s stock price and making sure it went up.
- They were incentivized to do shady things to make sure the stock price performed well.

Chapter 8

1996 — Skilling is made the new Enron Chief Operating Officer and President.
Mid-to-late 1990s — Enron’s growth rate was starting to slow. Skilling and Enron were beginning to get desperate.

Chapter 9

Enron was really loose with its money. The company spent a lot of money to acquire deals.
Skilling was obsessed with Enron’s stock price.
- This is what led to a lot of poor decisions. The company desperately wanted to keep its stock price high.
  - Managers were incentivized because a lot of their compensation came from Enron stock.
Skilling and Enron lied to investors and Wall Street about their core business, which by the mid-to-late 1990s was mostly in trading contracts.
- They knew their stock price would suffer if Wall Street found out they were a trading company primarily. Wall Street doesn’t like companies that engage in speculation for their primary source of profit.
Enron began using mark-to-market accounting in most areas of its business.
- Originally, the SEC only allowed mark-to-market accounting on Enron’s natural gas contracts.
- By the end of the 1990s, 35% of Enron’s assets were being used for mark-to-market accounting.
  - This was done to meet analyst quarterly earnings expectations when it looked like they would fall short.
Tax avoidance and delaying transactions were additional strategies Enron used to meet expectations.

Chapter 10

Andrew Fastow was Enron’s Chief Financial Officer who led the way with the company’s deceptive and fraudulent accounting methods.
- He was the guy Skilling turned to in order to create financial structures that were designed to make Enron look much better than it was.
Arthur Anderson, an accounting firm, was Enron’s auditors.
- They knew Enron was doing shady things, but didn’t do anything about it because Enron was paying the firm nicely.

Chapter 11

Fastow was obsessed with hiding debt on Enron’s financial statements so Enron could continue to borrow money from banks.
- If Enron’s real debt was revealed, banks would not have loaned them money.
Fastow also used process of “securitization” to provide short-term boosts on the company’s financial statements.
- At the time of its eventual bankruptcy, Enron had $2 billion in debt that was a direct result of securitization.
- Again, Enron did everything it could to disguise debt as other things on its books.
  - By the end, Enron had $38 billion in debt, but only $13 billion was shown on its books.
To accomplish all of this shadiness, Enron needed help.
- The investment banks Citigroup and Chase Manhattan turned a blind eye and were willing to help Enron because Enron was paying huge amounts in fees to the two banks.
- Because Enron was swinging deals left and right, it needed money from the banks, which meant Enron paid them a ton in fees.
  - These fees were a big piece of business for both banks.
- Fastow played these two banks by threatening to take Enron’s business elsewhere. This encouraged Citigroup and Chase Manhattan to keep lending money and turning a blind eye.

Chapter 12

Enron’s accounting tricks were never meant to go on forever.
- Skilling’s idea of providing power and gas straight to consumers through the retail market was supposed to give Enron big-time profits and save them from the hole they had dug themselves into.
  - Problem was, the retail market for power and gas was still regulated, unlike the wholesale market, which had become deregulated.
  - Still, Skilling and Lay assumed they could get the retail market deregulated. They were overconfident about this.
    - Lay tried to lobby and get a bill pass, but it didn’t work.
Local utility companies fought Enron to keep the retail market regulated.
- Eventually, Enron was able to get customers. These customers were primarily corporations in California.
Enron’s second way of trying to generate additional profit in 1997: Broadband Internet.
- Skilling saw how Internet companies had sky-high stock prices and he wanted to create a broadband Internet company within Enron.
- They pulled it off, but, instead of generating huge profits as they had hoped, it only ate up a ton of capital and produced very little profit, which put Enron in an even deeper hole and forced Fastow to use more illegal accounting tricks to help the company meet expectations.

Chapter 13

Fastow was super shady.
- He started a separate investment fund that competed with Enron while he was working at Enron.
  - He was then taking money away from Enron and pocketing extra money.

Chapter 14

Late 1990s — Enron created a new department called “Enron online.” This was basically a trading website.

Chapter 15

Enron’s stock price in the 1990s was very impressive. The stock’s return was outperforming the S&P 500 and basically everybody else.
- Keep in mind: the 1990s was a bull market for basically the entire decade.
Meeting EPS expectations was all that mattered to people and all that mattered at Enron.
- This obsession drove Enron’s shady accounting decisions. It was all about earnings.

Chapter 16

This chapter details to rise and fall of Azareks, an Enron side company run by Amanda Mark.

Chapter 17

This chapter details how Enron played California in delivering energy to the state.

Chapter 18

This chapter was about Enron’s experiment with broadband internet.

Chapter 19

This chapter is about the public’s growing skepticism of Enron.
The end of Enron was beginning. Reporters, analysts began looking into the company.
Enron’s stock price was rapidly declining.

Chapter 20

Skilling leaves the company in 2000.
Skilling and Lay took turns bickering with each other in the media.

Chapter 21

Fastow made $66 million off of his side investment funds.
- These funds were supposed to be on the side, but he used them to make a ton of money by using Enron to secure deals.
- He was basically taking money from Enron.
- This all came out when the SEC began investigating Enron.
Still, Lay and Enron stood by Fastow and claimed that he acted ethically.
Fastow was eventually fired.

Chapter 22

Enron’s stock was down to $.61 per share.
Quote: “The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control.”
December, 2001 — Enron files the biggest bankruptcy case in United States history.

Epilogue

This was the biggest corporate scandal in United States history.
Nobody at Enron or associated with the company took accountability.
2002 — Sarbane-Oxley Act federal law is passed.
- This required a CEO and CFO to personally attest and sign the company’s financial statements.
Fastow was indicted and sent to prison.
Lay and Skilling were both convicted to 20+ years in prison.
- Lay died of a heart attack before actually going to prison.
- Skilling ended up serving 13 years in prison.

Mack's Book Notes

Mack's Book Notes

Mack's Book Notes