Massive Structural Failure
The Smartest Guys in the Room

Massive Structural Failure

Business authors Bethany McLean and Peter Elkind dissect the Enron saga, emphasizing the Wall Street structural failures that enabled Enron’s massive fraud.

Enron may seem like yesterday’s news, but its history remains illuminating. Business journalists Bethany McLean – who also wrote All the Devils Are Here – and Peter Elkind – who also wrote Client 9 – offer a comprehensive, detailed account, written as a business novel, rich with anecdotes. Their recounting is knowledgeable, engrossing and detailed. McLean and Elkind miraculously render Enron’s complex financial shenanigans completely comprehensible. If you’re going to read only one book on the Enron scandal, this is the one.

The End

At 2 AM on Sunday, December 2, 2001, Enron filed for Chapter 11 bankruptcy. Six months later, a court found Enron’s auditor, Arthur Andersen, guilty of destroying thousands of pages of evidence about Enron.

It is utterly beyond question that in reshaping Enron after he was named its president, (Jeff) Skilling turned it into a place where financial deception became almost inevitable.Bethany McClean and Peter Elkind

The US Securities Exchange Commission (SEC) and the Justice Department embarked on investigations of major banks and brokerage firms. As a result, for example, Merrill Lynch paid an $80 million fine, but it admitted no guilt.

Enron’s fraud was hidden in plain view. Some astute short sellers and hedge fund operators profited handsomely when it went down, but most people involved with Enron lost. Employees lost. Stockholders lost. Pension funds lost. Enron’s failure rocked the financial world. What happened?

Fraud

McLean and Elkind explain that the proximate cause of Enron’s failure was illegitimate financial transactions involving what accountants and investment bankers call “structured financings.”

The problems began in 1998 when Enron’s then-new CFO Andy Fastow, 36, suggested to its top managers that the company should issue additional stock. President and COO Jeff Skilling and Chairman and CEO Ken Lay felt issuing more shares might hurt Enron’s stock price. But, when the new issue raised $800 million, Fastow got creative. Enron’s management had promised Wall Street that the company would grow, and growth required more capital.

Fastow could borrow cash, but the more a company borrows, the higher its risk and, thus, the lower its credit rating. The lower its credit rating, the more a company has to pay for borrowed funds. Enron already had issued stock, and issuing a disproportionate number of shares “dilutes” the value of each share. But, by using certain innovative transactions, Enron could make billions of dollars in capital appear without borrowing or issuing stock.

One of Enron’s key advantages over its competitors was information: it simply had more of it than its competitors.Bethany McLean and Peter Elkind

In 1997, Fastow established Whitewing, a “special purpose entity” that would own Enron stock. Equity investors bought stock in Whitewing, which bought $1 billion of Enron preferred stock and paid $79 million to those investors. Enron also borrowed $579 million from Citigroup and another $500 million from a Citigroup affiliate. A lay observer would conclude that Enron had borrowed a lot of money. But accounting rules allowed Enron to label its borrowing as investment in a joint venture. Enron’s stock price rose.

In 1999, Enron set up a structure called Osprey and raised $100 million from insurance firms and banks, offering in exchange paper that committed Osprey to pay a fixed return. Enron then borrowed $1.4 billion for Osprey from institutional investors, using a third of the money to pay the Citigroup loan that created Whitewing. Osprey now owned Whitewing. When Enron needed revenues to meet its financial projections, Osprey would “buy” assets from Enron.

Enron made liberal use of “securitization”– selling investors a share in a stream of revenues. Banks, for example, sell mortgages to investors using securitization. Enron used an accounting device called a special purpose entity (SPE). Accounting regulations stated that if three percent of an SPE’s ownership was independent of Enron, Enron could treat the SPE as a totally independent entity. Whitewing and Osprey were SPEs. Essentially, Enron borrowed huge sums from investors and reported those borrowings as revenues or cash flow instead of as debt.

Coverup

As Enron concealed the truth from investors, its share price rose. The stock market’s checks and balances failed to stop Enron’s deceit. McLean and Elkind explain why. The accounting firm Arthur Andersen was responsible for auditing Enron’s books. Andersen’s auditors should either have persuaded Enron to correct its irregularities or to inform its investors of its deceptive practices. But, in 2000, Andersen earned $52 million doing business with Enron; those fees didn’t have much to do with auditing. Investors paid Andersen nothing. Enron paid it a lot and hired executives from Andersen’s ranks. Andersen’s people knew Enron was “high risk,” but they had no incentives to share that assessment with investors.

Analysts also knew about Enron’s internal problems. As early as 1999, a JP Morgan analyst drew attention to Enron’s practice of counting money it couldn’t hope to receive for years, if at all, as current earned revenue. But analysts, too, lacked an incentive to blow the whistle on Enron. Analysts work for big institutions that demand demonstrable revenue from every department. Analysts had mandates to protect their firms’ relationships with valuable, profitable clients, such as Enron.

Enron also had a star-studded board of directors. In theory, boards work for investors. But corporate CEOs select almost every director on almost every board. The positions pay well, offer seductive perks and demand little. Enron’s board members had little to gain and much to lose by challenging or defying its management.

Drama

Enron’s financial shenanigans – one of the greatest frauds of all time – occurred as in-house power struggles pitted the ruthlessly Machiavellian Jeffrey Skilling against the flamboyant, brilliant Rebecca Mark, head of Enron International, a subsidiary. 

Above all else, Jeff Skilling believes this: ‘They killed a great company’.Bethany McLean and Peter Elkind

Their enduring legacy is a massive structural failure that could allow another Enron-type event in the future.

Symbiosis

Bethany McLean and Peter Elkind, skilled, experienced business journalists with unusually acute antennae for the gestalt of Enron’s era, clarify the complexities of Enron’s frauds with expert insights and explain those frauds in simple prose. Those outside the financial world may not grasp every nuance of Enron’s complex machinations – and who would want to, really? – but they will understand the basics from this account. And, more significantly, they will completely comprehend Enron’s symbiotic relationships with its accountants, auditors and analysts – the relationships that enabled Enron’s illegalities.

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