Why Enron Went Bust Start with arrogance. Add greed, deceit, and financial chicanery. What do you get? A company that wasn't what it was cracked up to be. FORTUNE Monday, December 24, 2001 By Bethany McLean

Former Enron CEO Jeff Skilling

"Our business is not a black box. It's very simple to model. People who raise questions are people who have not gone through it in detail. We have explicit answers, but people want to throw rocks at us."

So said Enron's then-CEO, Jeff Skilling, in an interview I had with him last February. At the time--less than ten months ago, let's recall--Enron's market capitalization was around $60 billion, just a shade below its all-time high, and its status as a Wall Street darling had not yet begun to crumble. I was working on a story that would ultimately raise questions about Enron's valuation, and I'd called with what I considered fairly standard queries in an effort to understand its nearly incomprehensible financial statements. The response from Enron was anything but standard. Skilling quickly became frustrated, said that the line of inquiry was "unethical," and hung up the phone. A short time later Enron spokesperson Mark Palmer called and offered to come to FORTUNE's New York City office with then-CFO Andy Fastow and investor-relations head Mark Koenig. "We want to make sure we've answered your questions completely and accurately," he said.

Now, in the wake of Enron's stunning collapse, it looks as if the company's critics didn't throw enough rocks. The world is clamoring for those "explicit answers," but Skilling, long gone from Enron--and avoiding the press on the advice of his lawyers--is in no position to provide them. As for "completely and accurately," many would argue that the men running Enron never understood either concept. "One way to hide a log is to put it in the woods," says Michigan Democrat John Dingell, who is calling for a congressional investigation. "What we're looking at here is an example of superbly complex financial reports. They didn't have to lie. All they had to do was to obfuscate it with sheer complexity--although they probably lied too."

Until recently Enron would kick and scream at the notion that its business or financial statements were complicated; its attitude, expressed with barely concealed disdain, was that anyone who couldn't understand its business just didn't "get it." Many Wall Street analysts who followed the company were content to go along. Bulls, including David Fleischer of Goldman Sachs, admitted that they had to take the company's word on its numbers--but it wasn't a problem, you see, because Enron delivered what the Street most cared about: smoothly growing earnings. Of course, now that it's clear that those earnings weren't what they appeared, the new cliche is that Enron's business was incredibly complicated--perhaps even too complicated for founder Ken Lay to understand (something Lay has implied since retaking the CEO title from Skilling last summer). Which leads to a basic question: Why were so many people willing to believe in something that so few actually understood?

Of course, since the Enron collapse, there are other basic questions as well--questions for which there are still no adequate answers. Even today, with creditors wrangling over Enron's skeletal remains while the company tries desperately to find a backer willing to keep its trading operations in business, outsiders still don't know what went wrong. Neither do Enron's employees, many of whom expressed complete shock as their world cratered. Was Enron's ultimate collapse caused by a crisis of confidence in an otherwise solid company? Or were the sleazy financial dealings that precipitated that crisis--including mysterious off-balance-sheet partnerships run by Enron executives--the company's method of covering up even deeper issues in an effort to keep the stock price rising? And then there's the question that's been swirling around the business community and in Enron's hometown of Houston: Given the extent to which financial chicanery appears to have take place, is someone going to jail?

A Culture of Arrogance
If you believe the old saying that "those whom the gods would destroy they first make proud," perhaps this saga isn't so surprising. "Arrogant" is the word everyone uses to describe Enron. It was an attitude epitomized by the banner in Enron's lobby: the world's leading company. There was the company's powerful belief that older, stodgier competitors had no chance against the sleek, modern Enron juggernaut. "These big companies will topple over from their own weight," Skilling said last year, referring to old-economy behemoths like Exxon Mobil. A few years ago at a conference of utility executives, "Skilling told all the folks he was going to eat their lunch," recalls Southern Co. executive Dwight Evans. ("People find that amusing today," adds Evans.) Or how about Skilling's insistence last winter that the company's stock--then about $80 a share--should sell for $126 a share? Jim Alexander, the former CFO of Enron Global Power & Pipelines, which was spun off in 1994, once worked at Drexel Burnham Lambert and sees similarities. "The common theme is hubris, an overweening pride, which led people to believe they can handle increasingly exotic risk without danger."

To be sure, for a long time it seemed as though Enron had much to be arrogant about. The company, which Ken Lay helped create in 1985 from the merger of two gas pipelines, really was a pioneer in trading natural gas and electricity. It really did build new markets for the trading of, say, weather futures. For six years running, it was voted Most Innovative among FORTUNE's Most Admired Companies. Led by Skilling, who had joined the company in 1990 from consulting firm McKinsey (he succeeded Lay as CEO in February 2001), Enron operated under the belief that it could commoditize and monetize anything, from electrons to advertising space. By the end of the decade, Enron, which had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business known as "wholesale energy operations and services." From 1998 to 2000, Enron's revenues shot from $31 billion to more than $100 billion, making it the seventh-largest company on the Fortune 500. And in early 2000, just as broadband was becoming a buzzword worth billions in market value, Enron announced plans to trade that too.

But that culture had a negative side beyond the inbred arrogance. Greed was evident, even in the early days. "More than anywhere else, they talked about how much money we would make," says someone who worked for Skilling. Compensation plans often seemed oriented toward enriching executives rather than generating profits for shareholders. For instance, in Enron's energy services division, which managed the energy needs of large companies like Eli Lilly, executives were compensated based on a market valuation formula that relied on internal estimates. As a result, says one former executive, there was pressure to, in effect, inflate the value of the contracts--even though it had no impact on the actual cash that was generated.

Because Enron believed it was leading a revolution, it encouraged flouting the rules. There was constant gossip that this rule breaking extended to executives' personal lives--rumors of sexual high jinks in the executive ranks ran rampant. Enron also developed a reputation for ruthlessness, both external and internal. Skilling is usually credited with creating a system of forced rankings for employees, in which those rated in the bottom 20% would leave the company. Thus, employees attempted to crush not just outsiders but each other. "Enron was built to maximize value by maximizing the individual parts," says an executive at a competing energy firm. Enron traders, he adds, were afraid to go to the bathroom because the guy sitting next to them might use information off their screen to trade against them. And because delivering bad news had career-wrecking potential, problems got papered over--especially, says one former employee, in the trading operation. "People perpetuated this myth that there were never any mistakes. It was astounding to me."

Trading Secrets
"We're not a trading company," said Fastow during that February visit. "We are not in the business of making money by speculating." He also pointed out that over the past five years, Enron had reported 20 straight quarters of increasing income. "There's not a trading company in the world that has that kind of consistency," he said. "That's the check at the end of the day."

In fact, it's next to impossible to find someone outside Enron who agrees with Fastow's contention. "They were not an energy company that used trading as a part of their strategy, but a company that traded for trading's sake," says Austin Ramzy, research director of Principal Capital Income Investors. "Enron is dominated by pure trading," says one competitor. Indeed, Enron had a reputation for taking more risk than other companies, especially in longer-term contracts, in which there is far less liquidity. "Enron swung for the fences," says another trader. And it's no secret that among non-investment banks, Enron was an active and extremely aggressive player in complex financial instruments such as credit derivatives. Because Enron didn't have as strong a balance sheet as the investment banks that dominate that world, it had to offer better prices to get business. "Funky" is a word that is used to describe its trades.

But there's an obvious explanation for why Enron didn't want to disclose the extent to which it was a trading company. For Enron, it was all about the price of the stock, and trading companies, with their inherently volatile earnings, simply aren't rewarded with rich valuations. Look at Goldman Sachs: One of the best trading outfits in the world, its stock rarely sells for more than 20 times earnings, vs. the 70 or so multiple that Enron shares commanded at their peak. You'll never hear Goldman's management predicting the precise amount it will earn next year--yet Enron's management predicted earnings practically to the penny. The odd mismatch between what Enron's management said and what others say isn't just an academic debate. The question goes to the heart of Enron's valuation, which was based on its ability to generate predictable earnings.

Why didn't that disconnect seem to matter? Because like Enron's management, investors cared only about the stock price too. And as long as Enron posted the earnings it promised (and talked up big ideas like broadband), the stock price was supposed to keep on rising--as, indeed, it did for a while. Institutions like Janus, Fidelity, and Alliance Capital piled in. Of course, earnings growth isn't the entire explanation for Wall Street's attitude. There were also the enormous investment-banking fees Enron generated. Nor was asking questions easy. Wall Streeters find it hard to admit that they don't understand something. And Skilling was notoriously short with those who didn't immediately concur with the Enron world-view. "If you didn't act like a light bulb came on pretty quick, Skilling would dismiss you," says one portfolio manager. "They had Wall Street beaten into submission," he adds.

Where Are the Profits?
Although it's hard to pinpoint the exact moment the tide began to turn against Enron, it's not hard to find the person who first said that the emperor had no clothes. In early 2001, Jim Chanos, who runs Kynikos Associates, a highly regarded firm that specializes in short-selling, said publicly what now seems obvious: No one could explain how Enron actually made money. Chanos also pointed out that while Enron's business seemed to resemble nothing so much as a hedge fund--"a giant hedge fund sitting on top of a pipeline," in the memorable words of Doug Millett, Kynikos' chief operating officer--it simply didn't make very much money. Enron's operating margin had plunged from around 5% in early 2000 to under 2% by early 2001, and its return on invested capital hovered at 7%--a figure that does not include Enron's off-balance-sheet debt, which, as we now know, was substantial. "I wouldn't put my money in a hedge fund earning a 7% return," scoffed Chanos, who also pointed out that Skilling was aggressively selling shares--hardly the behavior of someone who believed his $80 stock was really worth $126.

Not only was Enron surprisingly unprofitable, but its cash flow from operations seemed to bear little relationship to reported earnings. Because much of Enron's business was booked on a "mark to market" basis, in which a company estimates the fair value of a contract and runs quarterly fluctuations through the income statement, reported earnings didn't correspond to the actual cash coming in the door. That isn't necessarily bad--as long as the cash shows up at some point. But over time Enron's operations seemed to consume a lot of cash; on-balance-sheet debt climbed from $3.5 billion in 1996 to $13 billion at last report.

Skilling and Fastow had a simple explanation for Enron's low returns. The "distorting factor," in Fastow's words, was Enron's huge investments in international pipelines and plants reaching from India to Brazil. Skilling told analysts that Enron was shedding those underperforming old-line assets as quickly as it could and that the returns in Enron's newer businesses were much, much higher. It's undeniable that Enron did make a number of big, bad bets on overseas projects--in fact, India and Brazil are two good examples. But in truth, no one on the outside (and few people inside Enron) can independently measure how profitable--or more to the point, how consistently profitable--Enron's trading operations really were. A former employee says that Skilling and his circle refused to detail the return on capital that the trading business generated, instead pointing to reported earnings, just as Fastow did. By the late 1990s much of Enron's asset portfolio had been lumped in with its trading operations for reporting purposes. Chanos noted that Enron was selling those assets and booking them as recurring revenue. In addition, Enron took equity stakes in all kinds of companies and included results from those investments in the figures it reported.

Chanos was also the first person to pay attention to the infamous partnerships. In poring over Enron documents, he took note of an odd and opaque mention of transactions that Enron and other "Entities" had done with a "Related Party" that was run by "a senior officer of Enron." Not only was it impossible to understand what that meant, but it also raised a conflict-of-interest issue, given that an Enron senior executive--CFO Fastow, as it turns out--ran the "Related Party" entities. These, we now know, refer to the LJM partnerships.

When it came to the "Related Party" transactions, Enron didn't even pretend to be willing to answer questions. Back in February, Fastow (who at the time didn't admit his involvement) said that the details were "confidential" because Enron "didn't want information to get into the market." Then he explained that the partnerships were used for "unbundling and reassembling" the various components of a contract. "We strip out price risk, we strip out interest rate risk, we strip out all the risks," he said. "What's left may not be something that we want." The obvious question is, Why would anyone else want whatever was left either? But perhaps that didn't matter, because the partnerships were supported with Enron stock--which, you remember, wasn't supposed to decline in value.

Skilling Sends a Signal
By mid-August enough questions had been raised about Enron's credibility that the stock had begun falling; it had dropped from $80 at the beginning of the year to the low 40s. And then came what should have been the clearest signal yet of serious problems: Jeff Skilling's shocking announcement that he was leaving the company. Though Skilling never gave a plausible reason for his departure, Enron dismissed any suggestion that his departure was related to possible problems with the company. Now, however, there are those who speculate that Skilling knew the falling stock price would wreak havoc on the partnerships--and cause their exposure. "He saw what was coming, and he didn't have the emotional fortitude to deal with it," says a former employee.

What's astonishing is that even in the face of this dramatic--and largely inexplicable--event, people were still willing to take Enron at its word. Ken Lay, who stepped back into his former role as CEO, retained immense credibility on Wall Street and with Enron's older employees, who gave him a standing ovation at a meeting announcing his return. He said there were no "accounting issues, trading issues, or reserve issues" at Enron, and people believed him. Lay promised to restore Enron's credibility by improving its disclosure practices, which he finally admitted had been less than adequate.

Did Lay have any idea of what he was talking about? Or was he as clueless as Enron's shareholders? Most people believe the latter. But even when Lay clearly did know an important piece of information, he seemed to be more inclined to bury it, Enron-style, than to divulge it. After all, Enron's now infamous Oct. 16 press release--the one that really marked the beginning of the end, in which it announced a $618 million loss but failed to mention that it had written down shareholders' equity by a stunning $1.2 billion--went out under Lay's watch. And Lay failed to mention a critical fact on the subsequent conference call: that Moody's was considering a downgrade of Enron's debt. (Although Skilling said last February that Enron's off-balance-sheet debt was "non-recourse" to Enron, it turns out that that wasn't quite true either. Under certain circumstances, including a downgrade of Enron's on-balance-sheet debt below investment grade, Enron could be forced to repay it.)

Indeed, facing a now nearly constant barrage of criticism, Enron seemed to retreat further and further from Lay's promises of full disclosure. The rather vague reason that Enron first gave for that huge reduction in shareholders' equity was the "early termination" of the LJM partnerships. That was far from enough to satisfy investors, especially as the Wall Street Journal began to ferret out pieces of information related to the partnerships, including the fact that Fastow had been paid millions for his role at the LJMs. As recently as Oct. 23, Lay insisted that Enron had access to cash, that the business was "performing very well," and that Fastow was a standup guy who was being unnecessarily smeared. The very next day Enron announced that Fastow would take a leave of absence.

We now know, of course, that Enron's dealings with its various related parties had a huge impact on the earnings it reported. On Nov. 8, an eye-popping document told investors that Enron was restating its earnings for the past 4 3/4 years because "three unconsolidated entities should have been consolidated in the financial statements pursuant to generally accepted accounting principles." The restatement reduced earnings by almost $600 million, or about 15%, and contained a warning that Enron could still find "additional or different information."

And sophisticated investors who have scrutinized the list of selected transactions between Enron and its various partnerships are still left with more questions than answers. The speculation is that the partnerships were used to even out Enron's earnings. Which leads to another set of questions: If Enron had ceased its game playing and come completely clean, would the company have survived? Or did Enron fail to come clean precisely because the real story would have been even more scandalous?

The Last Gasp
On the surface, the facts that led to Enron's Dec. 2 bankruptcy filing are quite straightforward. For a few weeks it looked as if Dynegy (which had long prided itself on being the anti-Enron) would bail out its flailing rival by injecting it with an immediate $1.5 billion in cash, secured by an option on Enron's key pipeline, Northern Natural Gas, and then purchasing all of Enron for roughly $10 billion (not including debt). But by Nov. 28 the deal had fallen apart. On that day Standard & Poor's downgraded Enron's debt below investment grade, triggering the immediate repayment of almost $4 billion in off-balance-sheet debt--which Enron couldn't pay.

But even this denouement comes with its own set of plot twists. Both companies are suing each other: Enron claims that Dynegy wrongfully terminated the deal, "consistently took advantage of Enron's precarious state to further its own business goals," and as a result has no right to Enron's Northern Natural pipeline. Dynegy calls Enron's suit "one more example of Enron's failure to take responsibility for its demise." No one can predict how the suits will pan out, but one irony is clear: Enron, that new-economy superstar, is battling to hang on to its very old-economy pipeline.

To hear Dynegy tell it, a central rationale for abandoning the deal was what might be called the mystery of the missing cash. General counsel Ken Randolph says that Dynegy expected Enron to have some $3 billion in cash--but an Enron filing revealed just over $1 billion. "We went back to Enron and we asked, 'Where did the cash go? Where did the cash go?' " says CEO Chuck Watson. "Perhaps their core business was not as strong as they had led us to believe," speculates Randolph. Dynegy also claims that Enron tried to keep secrets to the last. Enron's lack of cash was revealed to the world in a filing on the afternoon of Monday, Nov. 19. Watson says he got the document only a few hours earlier--but that Lay had a copy on Friday. "I was not happy," says Watson. "It's not good form to surprise your partner."

Sagas like this one inevitably wind up in the courts--and Enron's is no exception. Given that credit-rating agency Fitch estimates that even senior unsecured-debt holders will get only 20% to 40% of their money back, the battles among Enron's various creditors are likely to be fierce. Nor has Enron itself conceded yet. The company's biggest lenders, J.P. Morgan Chase and Citigroup, have extended $1.5 billion of "debtor in possession" financing to Enron, which will enable it to continue to operate at least for a while. And Enron is still searching for a bank that will back it in restarting its trading business.

In the meantime, the courts will also be trying to answer a key question: Who should pay? Enron's Chapter 11 filing automatically freezes all suits against the company itself while the bankruptcy is resolved. But while Enron may seek the same protection for its executives, lawyers predict that the attempt will fail and that the individuals will have to fend off a raft of suits. Some think that criminal charges are a possibility for former executives like Skilling and Fastow. But such cases require proof of "knowing, willful, intentional misconduct," says well-known defense attorney Ira Sorkin. And a criminal case requires a much higher standard of proof than a civil case: proof beyond a reasonable doubt rather than a preponderance of the evidence. That's a high bar, especially since Enron executives will probably claim that they had Enron's auditor, Arthur Andersen, approving their every move. With Enron in bankruptcy, Arthur Andersen is now the deepest available pocket, and the shareholder suits are already piling up.

In any conversation about Enron, the comparison with Long-Term Capital Management invariably crops up. In some ways, it looks as if the cost of the Enron debacle is far less than that of LTCM--far less than anyone would have thought possible, in fact (see next story). But in other ways the cost is far greater. Enron was a public company with employees and shareholders who counted on management, the board, and the auditors to protect them. That's why one senior Wall Streeter says of the Enron saga, "It disgusts me, and it frightens me." And that's why, regardless of how the litigation plays out, it feels as though a crime has been committed.