The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

The Smartest Guys in the Room by Bethany McLean and Peter Elkind chronicles the rise and collapse of Enron, the Houston-based energy company whose December 2001 bankruptcy was, at the time, the largest in American history.

The narrative opens with Enron's aftermath. On January 25, 2002, Cliff Baxter, a former vice chairman, shot himself near his Houston home. Former CEO Jeff Skilling, Baxter's closest confidant, spent the memorial service in tears. In the following months, Skilling frequented a Houston bar, insisting the company was "in great shape" when he left and blaming short sellers and a run on the bank. The authors frame the story not as simple theft but as a tale of "hubris and greed and rampant self-delusion" driven by "smart people who believed their next gamble would cover their last disaster" (xxvii).

The book traces Enron's origins to Ken Lay, a Baptist preacher's son from rural Missouri who rose through academic excellence and government service to become CEO of Houston Natural Gas in 1984. After a larger company called InterNorth acquired Houston Natural Gas for $2.3 billion, Lay outmaneuvered its directors, seized control, relocated headquarters to Houston, and renamed the company Enron, which was drowning in debt from the start.

An early crisis nearly destroyed the company. Louis Borget, who ran Enron's oil-trading subsidiary, had been generating profits that helped Enron meet its targets. When auditors discovered Borget was conducting sham transactions and diverting funds, executives refused to fire him because he was too profitable. By October 1987, Borget confessed to catastrophic losses on oil bets. A veteran trader managed to reduce the damage to about $140 million. The scandal elevated Rich Kinder, Enron's general counsel and Lay's college classmate, to de facto chief operating officer, bringing badly needed discipline.

The book's central arc begins with Jeff Skilling's arrival. A McKinsey consultant, Skilling devised the "Gas Bank" concept: Enron would act as intermediary between gas producers and customers, capturing profit spreads. He joined Enron in 1990 and demanded mark-to-market accounting, which allows a company to book the entire estimated value of a long-term contract on the day it is signed. The Securities and Exchange Commission (SEC) agreed. The authors identify this as a pivotal turning point: Subjective estimates invited manipulation, reported profits outstripped actual cash, and the company needed ever-larger deals each quarter to show growth.

Skilling built a culture modeled on McKinsey's intellectual meritocracy, instituting a peer-review system called "rank-and-yank" that targeted the bottom 10 percent for termination. His key lieutenants included Lou Pai, who ran the trading desk; Cliff Baxter, a brilliant deal maker; and Ken Rice, who landed a landmark $3.5 billion gas supply contract. A young finance executive named Andrew Fastow devised JEDI, a joint investment partnership with the California Public Employees' Retirement System (CalPERS), the nation's largest public pension fund.

Running in parallel was Rebecca Mark's international empire. Mark, who had a personal relationship with her predecessor John Wing, built Enron International into a globe-spanning operation. Her most ambitious project was the $2.8 billion Dabhol power plant in India. Though celebrated in the press, the international business was plagued by problems traceable to a compensation structure that rewarded developers for closing deals rather than for long-term success.

When Kinder departed in late 1996 after Lay reneged on a promise to make him CEO, Skilling threatened to quit if anyone else got the job. Lay named Skilling president and chief operating officer. Over the following years, Skilling stripped Mark of her empire. Mark launched Azurix, a water company, but the venture proved disastrous and led to her forced resignation in August 2000.

The book's most complex strand concerns Andrew Fastow, Enron's chief financial officer, who built a structured-finance operation raising approximately $20 billion a year through off-balance-sheet vehicles designed to disguise debt and manufacture earnings. These included prepay transactions, essentially disguised loans from banks totaling $8.6 billion. Fastow's most brazen scheme involved two private funds called LJM. The Enron board exempted Fastow from its code of ethics to run LJM1, which purported to hedge a $300 million investment gain using Enron's own stock. LJM2, which raised $392 million from investors, functioned as a warehouse for Enron's troubled assets. Through the Southampton Place partnership, Fastow, his deputy Michael Kopper, treasurer Ben Glisan, and other insiders divided $12.3 million on a collective investment of $70,000.

Meanwhile, Skilling bet the company's future on two ventures. Enron Energy Services (EES) promised businesses energy savings but hemorrhaged cash. Enron Broadband Services (EBS) promised to revolutionize the Internet, but its technology never worked. A deal with Blockbuster for video-on-demand served about 300 households, yet Enron booked $111 million in profits through a monetization scheme. To avoid booking over $1 billion in losses on its declining portfolio, Enron created four special-purpose entities (SPEs), off-balance-sheet vehicles, called the Raptors, funded with Enron stock. Arthur Andersen's lead partner, David Duncan, approved each restructuring, overruling objections from the firm's Professional Standards Group.

Enron's traders also exploited California's newly deregulated electricity market. A team led by Enron trader Tim Belden devised manipulation strategies with names like Fat Boy and Death Star, including submitting false demand schedules and collecting fees to relieve congestion that did not exist. When California's energy crisis erupted in 2000, Belden's desk booked approximately $460 million in profits while executives publicly blamed the state's flawed deregulation.

Skepticism emerged in early 2001. Short seller Jim Chanos built a large position against Enron. McLean's Fortune article "Is Enron Overpriced?" questioned how the company made money. On a conference call, Skilling snapped "Asshole" at a questioner, alarming investors. Key figures departed: Baxter left in April, Pai in June after selling over $250 million in stock, and Rice was pushed aside. Global Finance lawyer Jordan Mintz sent Skilling a memo about Fastow's conflicts, hoping to trigger a conversation, but Skilling later claimed he never received it.

Skilling wrote his first resignation note on April 30, 2001. On August 14, he announced his departure. Two days later, vice president Sherron Watkins wrote to Lay warning Enron might "implode in a wave of accounting scandals." Lay retained Enron's longtime law firm Vinson & Elkins to investigate despite Watkins's advice to use independent counsel. The inquiry concluded nothing warranted further investigation.

The collapse accelerated in October. Enron announced $1.01 billion in charges but buried a $1.2 billion reduction in shareholders' equity. The Wall Street Journal exposed Fastow's partnerships. The SEC opened an informal inquiry, then a formal investigation. Fastow was fired on October 24. Arthur Andersen's Houston office shredded more than a ton of documents and deleted nearly 30,000 electronic files. Andersen discovered that key SPEs, including Chewco, an entity created to buy out CalPERS's stake in JEDI, had failed to meet independent-equity requirements, forcing Enron to restate $586 million in earnings. A rescue merger with crosstown rival Dynegy collapsed when its CEO concluded he could not trust Enron's numbers. On December 2, 2001, Enron filed for bankruptcy.

The final chapter and afterword trace the legal aftermath. Andersen was convicted of obstruction of justice and collapsed. Fastow pleaded guilty and was sentenced to six years. In total, 33 individuals were charged, including 25 former Enron executives. Lay was found guilty on all counts but died of a heart attack 41 days after conviction. Skilling was found guilty on 19 of 28 counts and sentenced to 24 years, later reduced to 14. The authors conclude that the 2008 financial crisis revealed the same systemic problems, suggesting the lessons of Enron went largely unheeded.