Summary of “The Smartest Guys in the Room”:

Bethany McLean and Peter Elkind wrote the national bestseller “The Smartest Guys in the Room.”  The book catalogs the rise of Enron, the financial crisis that would eventually consume it, and explained the subsequent accounting scandal.  We do not write this missive to celebrate the devastating losses created by Enron Corporation.

As long-time subscribers know, KCR’s research team holds the lessons of financial history in high regard.  We do so because financial history is, at its core, a chronicle of the behavioral errors that have gripped humankind since records were kept.  Our research works to contextualize today’s markets within a data-driven and historical framework.

KCR believes we are at one of those manic inflection points where historical context is critical.  We write up our takeaways from some of the investing greats to help better inoculate ourselves from the shills and influencers who seem uncommonly powerful today.

While those individuals profess near-divine knowledge about the future, we remain committed to bringing lessons of the past to light.  We believe this to be the best book on Enron.  The authors’ work brings incredible detail and domain knowledge to the Enron scandal’s key players.

This work is designed to bring history forward.  As always, any current or new subscriber is welcome to a free copy of any of the books we have written up.  Due to the stunning detail, remarkable prose, and the complexity underpinning the fall of Enron, we have broken our takeaways into two distinct pieces.

This first one will cover the material through Chapter 9.  We will send the remaining 14 Chapters out tomorrow.  We understand everyone is busy.  Having read the book twice in the past, we set out thinking our recollection of Enron’s implosion was mostly complete.  We were wrong.  There is so much to learn that we encourage others to read the book again as our notes below, while quick and succinct, cannot do the authors’ justice.

Authors’ Notes & Acknowledgements:

Quote: 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. … Ultimately, though, this is a story about people. –page v

  • The research done to write this book was simply monumental
  • The researchers drilled into 1,000s of pages and conducted 100s of interviews
  • Enron’s bankruptcy filing was the genesis for the work as it carries an extraordinary lesson for investors

Introduction:

Quote: Fortune magazine named it ‘America’s most innovative company’ six years running.  Washington luminaries like Henry Kissinger and James Baker were on its lobbying payroll.  Nobel laureate Nelson Mandela came to Houston to receive the Enron Prize.  The president of the United States called Enron chairman Lay ‘Kenny Boy.’ –page xx

  • The book begins with Enron’s Vice Chairman, Cliff Baxter, taking his own life via a pistol to the head
  • The authors contrast the guilt and shame felt by Baxter with Enron’s CEO, Jeff Skilling, who had been hailed as a visionary and felt the firm had fallen prey to a “cabal of short sellers”
  • The Enron story is one where the firm’s personalities trumped principals creating a yawning gap between perception and reality

Chapter 1: Lunch on a Silver Platter

Quote: [Ken Lay, Enron’s Founder & Chairman] was acclaimed as a business sage, a man of transcendent ideas who had harnessed change in an industry deeply opposed to it. In the public face he presented, Lay seemed to care deeply about bettering the world. –page 3

  • The chapter explains how changing government policy goals and incentives were at the heart of Enron
  • Enron’s rise transformed Lay into the classic American rags-to-riches story
  • Unfortunately, with riches came a powerful sense of personal entitlement with executives using the company to enrich relatives and friends through related party transactions

Chapter 2: Please Keep Making Us Millions

Quote: Of course, easy money is rarely as easy as it looks; such was the case with Enron’s oil trading division.  By the time Ken Lay and his minions…were willing to face up to what they should have seen all along – the oil traders had come within a whisker of bankrupting the company. –page 15

  • We are introduced to Enron’s oil trading business in this chapter
  • Oil trading was initially used for real hedging purposes by oil companies but became a speculative vehicle that generated much-needed profits for Enron
  • The head of oil trading, Louis Borget, took outsized risks to create large profits, creating a cult of personality around himself that sought to conceal illegal conduct within the firm
  • The board and senior management looked the other way as the oil trading division broke accounting rules to mislead investors and bankers
  • Despite overwhelming evidence of misconduct, an SEC investigation inexplicably went nowhere
  • Eventually, things blew up, and a multi-year restatement of results was required – but the firm survived
  • We are also introduced to Rich Kinder, who would become Enron’s COO and eventually leave in disgust

Chapter 3: We Were the Apostles

Quote: [Jeffrey Skilling] could instantly simplify highly complex issues into a sparkling, compelling image.  And he presented his ideas with a certainty that bordered on arrogance and brooked no dissent.  He used his brainpower not just to persuade but to intimidate. –page 28

  • This chapter explains Jeff Skilling’s background and movement to the CEO of Enron Finance
  • Being wiped out in his youth in both bonds and stocks did nothing to diminish Skilling’s ambition
  • He would go on first to Harvard Business School and then to McKinsey, which ramped an outsized ego that led him to be dubbed a man who was “Often wrong, never in doubt”
  • At McKinsey, he would flourish, rise through the ranks quickly and become a consultant to Enron
  • Skilling invented a “gas bank” allowing sellers and buyers to enter into long-term contracts, joined Enron, launched the trading division, and persuaded the company and SEC to allow mark to market accounting which would allow Enron to book the estimated lifetime profits of trades up front
  • The chapter does a remarkable job explaining the complexity of “financialization” of natural gas via Skilling’s trading in its nascent years
  • The authors also explain how prone to abuse mark to market accounting was in this setting – effectively creating an epic example of the accruals anomaly

Chapter 4: The First Prima Donna

Quote: [John Wing, effective head of Enron’s Power Projects business] was every bit as aggressive as Skilling and every bit as arrogant. … In his fiefdom, he demanded total loyalty – to himself, not Enron. –page 44

  • We learn about John Wing’s background and importance to Enron’s growth in power projects
  • Having graduated from West Point and Harvard Business School, Wing served in military intelligence during the Vietnam war – brutal and brash, his relationship with Enron was one of constant friction
  • A ruthless negotiator who suggested herding lawyers into rooms to be shot, Wing was effective at creating large and real profits (unlike the mark-to-market profits of Skilling’s division) for Enron by building cogeneration and other power plants
  • Like Skilling, Wing had a knack for seeing how to exploit changing government regulations
  • He became famous for getting the Teesside plant up in the UK, which created power equivalent to 4% of the UK’s total demand

Chapter 5: Guys with Spikes

Quote: Skilling believed that greed was the greatest motivator, and he was only too happy to feed it. –page 55

  • We learn about Skilling’s staffing and creation of Enron Capital & Trade Resources (ECT)
  • The chapter contains a detailed homage to a culture where intolerable personalities were not just embraced but also rewarded as blind greed brought real or manufactured profits
  • Skilling populated ECT with a collection of mercenaries who all demanded fealty from their peers
  • The entire culture of Skilling’s enterprise was one of combat, and we meet the terrifying Lou Lung Pai and Cliff Baxter (the man who committed suicide at the start of the book) whose brutal M&A talents endeared him to Skilling
  • The authors also introduce us to Andrew Fastow and the critical advent of securitization as a method to finance Skilling’s rapidly growing, profit-rich but cash-poor division
  • In summary, “Guys with Spikes” is about Skilling’s quest for employees who had a single skill he needed

Chapter 6: Empress of Energy

Quote: To the outside world, the person who was Enron, who had a reputation for turning impossible concepts into glittering realities, was not Skilling.  It was Rebecca Mark. –page 70

  • We learn about Rebecca Mark’s rise to Enron fame
  • Previously working for John Wing, Mark became the head of Enron’s physical projects in Developing Economies where she would both make herself fabulously wealthy and help bring Enron to its knees
  • Like the many other influential Enron employees in the book, Rebecca Mark embraced a fiefdom culture based on the well-being of herself and her group above that of Enron
  • Although she and Skilling were enemies internally, the two shared the same methods of building the appearance of success by finding novel methods of financing, recognizing long-dated estimated profits immediately, and infusing their various personal narratives with grandiose religious metaphors
  • Notably, both Skilling (deregulation) and Marks (government-backed lending) depended on, and exploited, government systems and incentives to build their illusions of success
  • Charged with building physical infrastructure in far-flung parts of the world, Mark built a culture where she and her minions were paid on the projected future profits at the time a deal was struck
  • Predictably this meant her division became deal-focused, often ignored details and project implementation with disastrous results
  • The chapter discusses the epic disaster of the Dabhol power plant development brokered by Marks which made her a luminary in the eyes of many financial journalists and netted her and her team a fortune but which, due to a catastrophic failure of implementation, become emblematic of all the incentive, compensation and funding failures that would eventually bring Enron to total collapse

Chapter 7: The Fifteen Percent Solution

Quote: That’s what Enron was promising investors: that its earnings per share would grow at a clip of 15% a year.  … Companies that grow at double-digit rates are classified by investors as growth companies, and they tend to have higher stock valuations than slower-growing companies. … The problem is that whenever a growth company disappoints Wall Street … the punishment is usually severe. –pages 92-93

  • This chapter explains how the massive equity incentive package held by CEO Ken Lay created a perfect petri-dish for earnings manipulation
  • One of the chapter’s foundational themes is that Ken Lay became more celebrity than CEO, as he basked in the adulation his wealth and influence brought him
  • In the background, Rich Kinder continued to work hard to maintain the firm’s earnings momentum but found Ken Lay’s politicking and endless caretaking of the Board of Directors distasteful and departed
  • Despite professing a detachment from details, Ken Lay would participate in and green-light numerous deals to family as well as the bizarre quasi-legal accounting schemes of selling entities while retaining control of them to inflate profits
  • The overarching theme of this chapter can be summarized as: cult of personality + conflicts of interest = a devastating corporate culture prone to turning a blind eye to unethical conduct

Chapter 8: A Recipe for Disaster

Quote: When investors are in love with a stock, they’ll forgive a lot.  The analysts…work hard to put a positive gloss on even the most ho-hum corporate announcements.  But when Wall Street goes negative on a stock, the opposite phenomenon takes place: a remorseless skepticism takes hold, as investors search for clues that more bad news is on the way. –page 102

  • A pivotal chapter that deals with the rapid changes that occurred after the hard-nosed operator, Rich Kinder had resigned in 1996

The chapter is so important we cannot do it justice.  Here are a few quick notes to remember:

  • Skilling becomes President and COO in December 1996 and instantly moves his cronies into positions of power
  • His affinity for the big picture and inability to execute on the actual successful implementation and operations he dreams up take center stage
  • His distaste for physical assets hits its zenith as he manages to move Enron into the business of power-trading despite having no competitive advantage whatsoever
  • He also manages to sell off EOG, one of Enron’s crown jewels and profit centers due, in part, to his dislike for the oil and gas company’s volatile earnings, which didn’t foot with his need to appease Wall Street
  • Certain of his “big ideas” and convinced he is a “Great Man,” he comes to believe that no price was too high or loss too big when entering a business he believes what you pay doesn’t matter because of his horribly misguided belief he could “make it up in the long-run”
  • Skilling uses his role as COO to push out Rebecca Mark and her asset-rich business
  • The “prima donna vs. prima donna” fight is over, but the reckless spending, shady accounting, complex structuring of entities and related party transactions only accelerates

Chapter 9: The Klieg-Light Syndrome

Quote: It is utterly beyond question that in reshaping Enron after he was named its president, Skilling turned it into a place where financial deception became almost inevitable. –page 114

  • Here we learn about Skilling’s obsession with Enron’s stock price and how he catered to and kept Wall Street happy through various and sundry nefarious means
  • Chief among them was his creation of a “Risk Assessment & Control” department, “the RAC” which was held out to Wall Street as the reason Enron could create such smooth and steadily rising profits
  • In reality, the RAC adopted sophisticated computer and statistical methods that, when fed ridiculous inputs, could make even the worst project look like it was worth doing
  • Enron became reliant on ever-higher mark-to-market valuations of private investments to keep Wall Street happy – a practice that would leave observers stunned post the collapse
  • Skilling also began the process of “jamming quarters” – when a quarter-end approached, and the company was clearly going to miss Wall Street estimates
  • Rather than issue warnings and communicate the deficiency to Wall Street, the call went out to Enron executives demanding they engage in a mad scramble to meet or beat the quarter
  • This practice would later be derided for the savage toll it took on employees and for incentivizing the worst possible behavior of Enron’s employees

We will pause here and ask you to re-read those last few bullets and look at the market darlings today.  Do you not see the myriad analogs in many stocks today?  This is not complicated in our view.

KCR hopes these notes have opened some eyes.  Please look out for the remainder of our summary of the book tomorrow.   As always, we would like to thank our subscribers for their kindness and support.

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