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THE SMARTEST GUYS IN THE ROOM

Bethany McLean and Peter Elkind were Fortune senior writers when this book was originally published in 2003.

McLean’s March 2001 article in Fortune, “Is Enron Overpriced?” was the first in a national publication to openly question the company’s dealings. She now lives in Chicago with her husband, Sean Berkowitz, who was the head of the Enron Task Force when they met in 2006. McLean is a contributing editor at Vanity Fair and a columnist at Reuters.

Elkind, an award-winning investigative reporter, is the author of The Death Shift and Client 9: The Rise and Fall of Eliot Spitzer. A former editor of the Dallas Observer, he has been an associate editor at Texas Monthly and written for The New York Times Magazine and The Washington Post. Now editor-at- large at Fortune, he lives in Fort Worth, Texas.

For Chris —B.M.

For Laura —P.E.

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USA | Canada | UK | Ireland | Australia | New Zealand | India | South Africa | China penguin.com A Penguin Random House Company First published in the United States of America by Portfolio, a member of Penguin Group (USA) Inc., 2003 Updated paperback edition published 2004 This edition with a new foreword and afterword published 2013

Copyright © 2003, 2004 by Fortune, a division of Time, Inc. Foreword copyright © 2013 by Joe Nocera Afterword copyright © 2013 by Bethany McLean and Peter Elkind Penguin supports copyright. Copyright fuels creativity, encourages diverse voices, promotes free speech, and creates a vibrant culture. Thank you for buying an authorized edition of this book and for complying with copyright laws by not reproducing, scanning, or distributing any part of it in any form without permission. You are supporting writers and allowing Penguin to continue to publish books for every reader.

Grateful acknowledgment is made for permission to reprint the following copyrighted works: “Hotel Kenneth Laya” by James A. Hecker, © 1995 James A. Hecker. Used with permission; “Perfect Day” by Tim James and Antonina Armato, © 2001 WB Music Corp., Out of the Desert Music, and Tom Sturges Music o/b/o Antonina Songs. All rights reserved. Used by permission of Warner Bros. Publications U.S. Inc. and Tom Sturges Music.

THE LIBRARY OF CONGRESS HAS CATALOGED THE HARDCOVER EDITION AS FOLLOWS: McLean, Bethany. The smartest guys in the room : the amazing rise and scandalous fall of Enron / Bethany McLean and Peter Elkind. p. cm. Includes index. ISBN 978-1-59184-008-4 (hc.) ISBN 978-1-59184-660-4 (pbk.) ISBN 978-0-69815882-5 (eBook) l. Enron Corp.—History. 2. Energy industries—Corrupt practices—United States. 3. Business failures—United States—Case studies. I. Elkind, Peter. II. Title. HD9502.U54E5763 2003 333.79'0973—dc21

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FOREWORD

In February 2001, as the editorial director of Fortune magazine, I helped edit a short, rigorous story—just four pages long—by a young writer named Bethany McLean, who had joined the magazine some six years earlier from Goldman Sachs and quickly become one of Fortune’s brightest stars. Her story was entitled, simply, “Is Enron Overpriced?”

At its core, Bethany’s article asked one very straightforward question: How does Enron make its money? For years the company had been a Wall Street darling, its stock moving steadily upward with each new quarter’s rising profits. It was seen as the paradigmatic example of a company that had transformed itself from an old-economy stalwart—operating pipelines that moved natural gas —to a new-economy marvel, creating dazzling efficiencies and hedging risks (like the weather!) that no one had ever thought to hedge before. Just a month before Bethany’s story ran, Businessweek had put Enron’s chief executive, Jeffrey Skilling, on its cover, posing with what appeared to be harnessed electricity in his hand, with the cover line “Power Broker.”

But Bethany had been poring through Enron’s financial documents, and what she realized was not just that they were complicated (most big companies have complicated financials) but that they were incomprehensible, even indecipherable. She started calling around to the Wall Street analysts who were so bullish on Enron, asking her simple question.

Some of them told her that Enron was a company you just had to trust. One analyst admitted to her that the company’s earnings were “a black box.” When she reached Skilling himself, the Enron CEO first complained that she “didn’t get it,” something he often said to people who questioned Enron. Then he hung up the phone on her. The Enron public-relations department insisted that if she would just come to Houston and visit the company’s headquarters, the fog would soon lift. But with our deadline fast approaching, the Enron PR department decided that if Mohammed wouldn’t come to the mountain, they would have to

visit Fortune. The company sent a small contingent to New York to meet with Bethany and her editors, including me. Andy Fastow, the company’s chief financial officer, led the Enron team.

It would later be blindingly obvious that Fastow had not told us the truth— how could he, given that much of Enron’s earnings were the result of accounting manipulations that created the illusion of profitability? But even in the moment it was clear that Fastow’s goal was pretty much the same as those financials Bethany had been poring through: to obfuscate and confuse. I can’t remember all the details, but I vividly recall Bethany asking sharp, pointed questions about the company’s business model and Fastow responding with lengthy, nearly unintelligible answers about how Enron was like Toyota, how it should be thought of as a logistics company, etc., etc.—even though Enron’s main business wasn’t actually moving anything from place to place, but rather trading.

And then something happened that Bethany and I would never forget. As the meeting was drawing to a close and the Enron executives were putting on their coats, Fastow turned to Bethany and said, “I don’t care what you say about Enron. Just don’t make me look bad.”

It was such a jarring thing for him to say on the eve of what was clearly going to be an unflattering article about his company. In retrospect, it was a tip- off—to the mentality of the people running Enron and to the fact that there was indeed something fishy about those financial statements—Fastow was, after all, Enron’s CFO. It was a real signal that Bethany—whose story wound up raising all the right questions, even if she didn’t yet have all the answers—was on to something.

Some articles drop like bombshells. Bethany’s wasn’t like that. Instead, it slowly seeped into the consciousness of Wall Street. Enron’s stock had been in the 70s when Bethany’s story was published, not far from its all-time high. Ever so steadily, it began to sink. In April, Skilling was questioned on a conference call by an investor who asked his own tough questions. “Asshole,” Skilling muttered under his breath. In August, Skilling suddenly and unexpectedly quit as chief executive—a move that was all the more stunning because he had taken over as CEO just six months earlier from Enron founder Ken Lay. Though Skilling had effectively been running the company for years, everyone knew how much he had wanted the actual title of chief executive. His resignation triggered a flurry of skeptical stories and questions.

And then came October. With the stock having fallen into the high 30s—and Lay, back as CEO, trying to persuade a now-skeptical Wall Street that

everything was fine—the Wall Street Journal revealed that Fastow had made tens of millions on the side running a pair of limited partnerships that had done business with Enron. That story helped accelerate the feeding frenzy that was already developing, both in the press and on Wall Street, around Enron. By November, Fastow was gone, sacrificed by Lay as he desperately tried to keep Enron afloat. But like any company that trades for a living—just like Lehman Brothers or Bear Stearns seven years later—once Enron had lost the confidence of its trading partners, it was toast. On December 2, 2001, the company filed for bankruptcy.

Even then, though, nobody knew the full story of what had brought down Enron. Fastow’s LJM partnerships got the immediate blame—both inside and outside of Enron—but one of the main points of The Smartest Guys in the Room is that Fastow wasn’t actually the one who brought down Enron. His chicanery —which he’d later testify was approved by Skilling—was actually what was propping up Enron. The real story was that Enron’s businesses weren’t making much money, and that much of their profits were phony. The whole point of Fastow’s dealings, from Enron’s point of view, was to make it appear that the company was a profit machine that it clearly wasn’t. (And if Fastow skimmed a little on the side, well, what can you do?) Enron’s aura had been such that nobody had ever bothered looking into the internal strife, the macho posing, the rampant greed—and the dysfunction in the company’s executive suite, starting with the out-to-lunch Lay and the emotionally unstable Skilling.

Right after Enron filed for bankruptcy, Bethany wrote a terrific cover story about the company’s decline and fall in which she touched on some of these larger themes. In editing the article I realized how well-sourced she was, but I could also clearly see that there was a much bigger, more important story here than simply a crooked CFO who was lining his pockets. Her story made it obvious that the rise and fall of Enron would make a terrific book.

So I went to my bosses and suggested that we—Fortune magazine—take advantage of Bethany’s Enron reporting and write a book about what had happened. Because there was so much to unravel, I suggested she team up with Peter Elkind, a Texas-based Fortune writer who had written a series of fabulous investigative sagas for the magazine. Happily, everyone agreed. In 2003, Portfolio published the first edition of The Smartest Guys in the Room. I am biased, of course, but I contend that it remains the single most authoritative account of this landmark event.

It is far more than that, though. The Smartest Guys in the Room is an almost

anthropological examination of the nature of corporate scandal. Why do values go awry? What happens when the wrong person gets a big job? Why is it so tempting to post false profits instead of telling the truth? How distorting is the prospect of stock market riches?

In the immediate aftermath of Enron, there were at least a half-dozen other big corporate blowups: WorldCom turned out to be cooking its books, and CEO Bernie Ebbers went to jail. Tyco became embroiled in scandal, and its chief, Dennis Kozlowski, also went to prison. But none of these disasters have resonated like Enron. At many business schools, studying Enron is part of the curriculum. Just recently, Andy Fastow, who was released from prison in 2011, gave an unpaid speech in Las Vegas at a conference of fraud examiners. He drew a full-house crowd of 2,500 people. Afterward, some of the fraud examiners and convention staffers asked to have their pictures taken with him. Explained one: “He’s part of history.”

Enron remains the defining scandal of the 21st century. None of those other scandals had the staying power—or the canary-in-the-coal-mine quality—of Enron. This was partly because no other modern-day company, prior to the financial crisis of 2008, had Enron’s vaunted reputation. But it is also because almost everything we later found out about how Enron operated was a harbinger of scandals yet to come. Off-balance-sheet vehicles. Banks doing things they shouldn’t to generate fees. Ratings agencies giving safe ratings to investments that were clearly doomed to fail. Corporate executives using every means possible to maximize short-term revenues—and boost their own multimillion- dollar bonuses—even when those means were, at best, unethical.

Congress held hearings in the wake of the Enron bankruptcy; it even passed a law, Sarbanes-Oxley, that was intended to prevent future scandals. (Among other provisions, the law calls for the CEO and CFO of a publicly traded company to sign a document attesting to the validity of its numbers. Despite numerous instances of post-Enron fraud, the power of that document has never been tested in court.) Newspapers and magazines wrote dozens of articles about how to prevent future Enrons. Jeffrey Skilling and Kenneth Lay were tried and given lengthy sentences (Lay, of course, died of a heart attack before he ever spent a day in jail). And then we all moved on.

No one can say for sure whether a more rigorous Washington response to Enron might have prevented the financial crisis of 2008. But I tend to think so. Both Enron and the financial crisis were the products of the same deregulatory impulse that seized Washington in the 1990s. Enron had exposed the deep,

systemic flaws of the ratings agencies. The off-balance-sheet vehicles Enron used were the same kind of vehicles banks used to hold their collateralized debt obligations—the so-called toxic assets that did so much damage to the financial system when they collapsed. And they existed for the same reason: to hide debt.

On one level, the Enron scandal, as told in the pages that follow, is simply a great, rollicking tale. When Bethany and Peter set out to write The Smartest Guys in the Room, telling that story is all they were really trying to do. But it is impossible to read this book today, a decade after it was first published, and not wonder what might have been—if everyone had been willing to pay just a little more attention.

Joe Nocera July 2013

Op-Ed columnist The New York Times

AUTHORS’ NOTES AND ACKNOWLEDGMENTS

Enron is well on its way to becoming the most intensively dissected company in the history of American business. This book is published as that process continues, with investigations and litigation that will surely drag on for years. Because our aim has been to chronicle the company’s rise and fall—amazing and scandalous indeed—we have deliberately ended our narrative with Enron’s filing of the largest bankruptcy case in U.S. history. We leave it to others to describe the resulting investigations and trials, as well as the jockeying over Enron’s spoiling remains.

Enron’s story is a sprawling tale, and, during the 16 months of intensive reporting that produced this book, it has taken us down many trails. A good portion of our work involved poring through a mountain of public and private documents involving Enron and the colorful cast of players—executives, bankers, auditors, lawyers, investors, and analysts—who appear in these pages. We have reviewed divorce records, executive calendars, personnel files, court records, depositions, personal e-mails, letters, consultants’ studies, internal memos and presentations, board minutes, SEC filings, congressional testimony, and dozens of reports from Wall Street analysts. This massive written record, much of it contemporaneous with what we describe, has provided an extraordinary window into events involving Enron.

Ultimately, though, this is a story about people. We believe we have gained considerable insight into the thinking and behavior of virtually every major character in this book. We have conducted hundreds of interviews with people who worked at every level of the company, from the fiftieth-floor executive suite to the board of directors to the secretarial pool, in addition to scores of others who worked outside Enron. Yet for an assortment of understandable reasons—in some cases, involving the continuing criminal investigations; in other cases, involving the stigma that results from any association with Enron—many of those who spoke to us insisted on talking on “background” only. Under this

arrangement, the information provided was on the record—we could use it freely —but we could not identify the source by name. This allowed many sources who would otherwise have been constrained to speak openly to us. On occasion, with those who saw themselves as likely government targets, facing possible surveillance, our arrangements assumed a cloak-and-dagger quality, with clandestine meetings arranged through coded messages. A few other individuals discussed events in great detail but only through trusted personal surrogates. The result is a book that relies, in considerable part, on unnamed sources.

We are exceedingly grateful for the cooperation, trust, and patience of all those (both named and unnamed) who spoke with us—in more than a few cases, a dozen times or more. Their participation in this project was an act of faith, and their insight has been invaluable.

• • •

This book was made possible through the support of Fortune magazine. The idea for it took hold shortly after Enron filed for bankruptcy, when we realized that there was an extraordinary and compelling business narrative in the company’s collapse and that we wanted to tell that story. We also realized something else: piecing together the fall of Enron was going to be an unusually challenging reporting task. For the reasons discussed above, many of the principals were hardly in a position to talk publicly about their experience. Enron’s financial machinations were also complicated, requiring considerable time and effort to understand—and then to explain.

What made our work manageable was the active involvement of Joseph Nocera, editorial director for the magazine. He served as impresario for this project, guiding us as we did our reporting, then acting as editor extraordinaire once we started writing. He is a true partner in the creation of this book. We are grateful to his wife, Julie Rose, too, who lived through the challenging times of this endeavor along with the rest of us.

Rik Kirkland, Fortune’s managing editor, allowed us to dedicate a year and a half to this project and never wavered from his strong and vocal support. Jeff Birnbaum tapped into his wealth of Washington sources, landing key interviews and pulling together the Washington angles to the Enron story. Colleagues Carol Loomis, Carrie Welch, Laury Frieber, Pattie Sellers, Tim Smith, David Rynecki, David Kirkpatrick, and John Helyar were generous with their advice and wisdom. Brian O’Reilly shared the extensive interviews he conducted with

Enron executives for his story, “The Power Merchants,” published in Fortune’s April 17, 2000, issue. We received valuable reporting aid from former Fortune reporter Suzanne Koudsi. The Time Inc. Business Research Center, especially Doris Burke and Patricia Neering, provided fabulous research help. Arlene Lewis Bascom kept track of the book’s finances. Alix Colow pulled together the photos. Former Assistant Managing Editor James Impoco edited the original Enron story in Fortune written by coauthor McLean and was there with an encouraging word when we most needed it. Time Inc. editor in chief Norman Pearlstine and editorial director John Huey gave their blessing to this project. We hope the result justifies so much faith in us from so many.

We are appreciative of our many colleagues in journalism who broke fresh ground in reporting on Enron, notably Forbes’s Toni Mack, who was asking tough questions back in 1993 and was generous with her friendship and counsel a decade later; freelance writer Harry Hurt; Texas Monthly’s Mimi Swartz; Delroy Alexander, Greg Burns, Robert Manor, Flynn McRoberts, and E. A. Torriero of the Chicago Tribune, for their excellent four-part series on the fall of Arthur Andersen; Peter Behr and April Witt, for their early five-part series on the demise of Enron in the Washington Post; and the Houston Chronicle’s Tom Fowler and Mary Flood, who overcame the hometown paper’s coziness with Enron’s hierarchy to dig into the story. University of San Diego law professor and author Frank Partnoy offered early insights into Enron that were very helpful. The work of Wall Street Journal reporters Rebecca Smith and John Emshwiller made them players in the Enron tale. In the postbankruptcy period, the New York Times, led by Kurt Eichenwald, blanketed the story, covering dozens of angles. We also want to acknowledge the work and generous encouragement of Times business writer David Barboza and Washington correspondent Rich Oppel.

Amid much finger pointing in the nation’s capital, several congressional committees did yeoman work. The U.S. Senate’s Permanent Subcommittee on Investigations, through its detailed reports and hearings on Enron’s incestuous relationship with commercial and investment banks, shed considerable light on dark corners of the Enron tale. We are grateful for the assistance of the committee and its staff, including Elise Bean, Robert Roach, and Mary Robertson. The Senate Committee on Governmental Affairs produced enlightening work on the watchdogs that didn’t bark—government regulators, Wall Street analysts, and credit agencies.

Our stalwart agent, Liz Darhansoff, served as a fierce negotiator, sage critic,

and fervent advocate. Our editor, Adrian Zackheim, instantly understood how a complex business story could make a gripping tale and was with us all the way. We’d also like to thank Will Weisser, Mark Ippoliti, Alex Gigante, David Hawkins, and Bonnie Soodek.

Finally, we owe our greatest debt to our loved ones. Bethany’s parents, Helaine and Robert McLean, while far removed from the

specifics of Enron, added their wisdom to the age-old human elements of the story. Her sister Claire McLean offered constant words of encouragement and perfect company for the occasional shoe-shopping break. Bethany’s husband, Chris Wilford, kept a glass (or two) of wine waiting long into the night. And Barolo provided a constant reminder of what it really means to be a bulldog.

David Elkind, Ellen Duncan, and Mary Clare Ward aided this project in untold ways. Laura Elkind, Peter’s wife, did double duty, offering insightful editorial suggestions and tending bravely to the home front (Stephen, Landon, George, Adele, and Sam) while enduring long absences and late nights of writing with remarkable patience, support, and grace.

To all of them, we are especially grateful.

—Bethany McLean and Peter Elkind September 2004

CONTENTS

Foreword by Joe Nocera Authors’ Notes and Acknowledgments Cast of Characters Our Values Introduction

CHAPTER 1. Lunch on a Silver Platter 2. “Please Keep Making Us Millions” 3. “We Were the Apostles” 4. The First Prima Donna 5. Guys with Spikes 6. The Empress of Energy 7. The 15 Percent Solution 8. A Recipe for Disaster 9. The Klieg-Light Syndrome 10. The Hotel Kenneth-Lay-a 11. Andy Fastow’s Secrets 12. The Big Enchilada 13. “An Unnatural Act” 14. The Beating Heart of Enron 15. Everybody Loves Enron 16. When Pigs Could Fly 17. Gaming California 18. Bandwidth Hog 19. “Ask Why, Asshole” 20. “I Want to Resign” 21. The $45 Million Question

22. “We Have No Cash!” 23. The Pursuit of Justice Afterword Index

CAST OF CHARACTERS

Ken Lay—Founder, chairman, and CEO of Enron. Jeff Skilling—President and chief operating officer. Served as CEO from

February to August 2001. Andrew Fastow—Chief financial officer. Rebecca Mark—CEO of Enron International and later of Azurix.

Jim Alexander—CFO of Enron Global Power and Pipelines (EPP). John Arnold—Enron’s young trading superstar. Ron Astin—Vinson & Elkins lawyer. Cliff Baxter—Jeff Skilling’s chief deal maker and trusted confidant. Briefly

served as CEO of Enron North America. Tim Belden—West Coast power trader who figured out how to game the

California market. Arthur and Robert Belfer—father-son Enron directors and New York–based

investors. Louis Borget—CEO of Enron Oil. Went to jail as a result of Enron Oil scandal. Ray Bowen—Enron finance executive. Became treasurer after Ben Glisan was

fired. Ron Burns—Former CEO of Enron’s pipeline division. Briefly co-CEO with

Skilling of Enron Capital and Trade Resources (ECT). Rick Buy—Head of Risk Assessment and Control division (RAC). Rebecca Carter—Enron’s corporate secretary and Skilling’s second wife. Rick Causey—Chief accounting officer. Margaret Ceconi—Former GE manager who joined Enron Energy Services

(EES). Later tried to blow the whistle. David Cox—Enron Broadband Services’ chief deal maker. Wanda Curry—Enron accountant who dug up problems at EES. Dave Delainey—Executive who took over EES from Lou Pai.

Jim Derrick—Enron’s general counsel. Joseph Dilg—Vinson & Elkins lawyer. Bill Dodson—Michael Kopper’s domestic partner. John Duncan—Enron director and chairman of the board’s executive

committee. Gave Lay his first job as CEO. Jim Fallon—Trading executive who took over Broadband after Ken Rice left. Lea Fastow—Andy Fastow’s wife and former assistant treasurer at Enron. Mark Frevert—Longtime Enron executive. Became vice chairman in the last

months. Ben Glisan—Fastow’s structured-finance accounting whiz. Became Enron

treasurer. Wendy Gramm—Enron director and former chairman of the Commodities

Futures Trading Commission. Wife of U.S. Senator Phil Gramm of Texas. Rod Gray—Rebecca Mark aide. Worked at both Enron International and

Azurix. Mark Haedicke—General counsel, Enron North America. Gary Hamel—Management guru who touted Enron. Kevin Hannon—Former Bankers Trust employee who became Ken Rice’s

deputy at Enron North America and Enron Broadband. John Harding and Steve Sulentic—Louis Borget’s direct superiors at Enron

during Enron Oil scandal. Joe Hirko—Former Portland General CFO who served as co-CEO of Enron

Broadband with Rice. Forrest Hoglund—CEO of Enron Oil and Gas. Kevin Howard—Enron Broadband finance executive who worked on Project

Braveheart. Ron Hulme—Lead McKinsey & Company partner on the Enron account. Robert Jaedicke—Enron director, and chairman of the audit committee. Former

dean of the Stanford Graduate School of Business. Vince Kaminski—Head of Enron’s Research Group. In-house skeptic of

Fastow’s deals. Bob Kelly—John Wing deputy. Rich Kinder—President and chief operating officer before Skilling. Left to start

Kinder Morgan. Louise Kitchen—Trading executive who implemented idea for Enron Online. Mark Koenig—Enron’s head of investor relations. Michael Kopper—Fastow’s top deputy and investor in Chewco partnership.

Later left Enron to run Fastow’s LJM partnerships. Mike Krautz—Enron Broadband finance executive who worked on Project

Braveheart. John Lavorato—Greg Whalley deputy. Later became head of trading in North

America. Judith Lay—Lay’s first wife. Linda Lay—Lay’s former secretary and second wife. Mark Lay—Lay’s son, who worked for the company and later joined a

company that did business with Enron. Robyn Lay—Lay’s stepdaughter, who once had an Enron jet deliver her bed to

Monaco. Sharon Lay—Lay’s sister, whose Houston travel agency got most of its

business from Enron. Charles LeMaistre—Enron director and chairman of board compensation

committee. Former president of the University of Texas M. D. Anderson Cancer Center.

Kathy Lynn—Worked for Fastow at Global Finance. Later employed by Fastow’s LJM partnerships. Investor in Fastow deal.

Kevin McConville—Head of Enron’s Industrial Group. Every deal his group made went sour.

William McLucas—Wilmer, Cutler & Pickering lawyer, special counsel to Enron.

Jeff McMahon—Enron’s corporate treasurer until replaced by Glisan. Became CFO after Fastow was fired.

Nancy McNeil—Lay’s secretary and Kinder’s second wife. Amanda Martin—Enron executive who later joined Azurix. Thomas Mastroeni—Treasurer of Enron Oil under Borget. Pled guilty in the