Enron

1. 0:00 – 3:15

   Why Enron now: FTX parallels and setting the frame

   1. DRDavid Rosenthal0:00

      obviously, the context is we're doing this episode because of FTX.

   2. BGBen Gilbert0:02

      Right. It's a related party transaction, one could say.

   3. DRDavid Rosenthal0:05

      It's like LJM. [chuckles]

   4. BGBen Gilbert0:07

      It's like, you know, the Raptors.

   5. DRDavid Rosenthal0:08

      You know what LJM stands for, right?

   6. BGBen Gilbert0:10

      It's his kids and his wife, right?

   7. DRDavid Rosenthal0:12

      [laughing]

   8. BGBen Gilbert0:12

      What a psychopath. Can't possibly be fraud if it's named after my family.

   9. DRDavid Rosenthal0:18

      I feel like this story is like American Psycho in Houston.

   10. BGBen Gilbert0:21

       Yes. Oh, my God, yes!

   11. SPSpeaker0:23

       Who got the truth? Is it you? Is it you? Is it you? Who got the truth now? Is it you? Is it you? Is it you? Sit me down, say it straight. Another story on the way. Who got the truth?

   12. BGBen Gilbert0:40

       Welcome to season 11, episode seven of Acquired, the podcast about great technology companies... Well, sometimes not so great companies, [chuckles]

   13. DRDavid Rosenthal0:49

       [chuckles]

   14. BGBen Gilbert0:49

       and the stories and playbooks behind them.

   15. DRDavid Rosenthal0:51

       Not so great companies, and the stories, and cooked books behind them.

   16. BGBen Gilbert0:56

       Oh, there you go.

   17. DRDavid Rosenthal0:58

       That's a dad joke.

   18. BGBen Gilbert0:59

       That is a dad joke. I am Ben Gilbert, and I'm the co-founder and managing director of Seattle-based Pioneer Square Labs, and our venture fund, PSL Ventures.

   19. DRDavid Rosenthal1:06

       And I'm David Rosenthal, and I'm an angel investor based in San Francisco.

   20. BGBen Gilbert1:12

       And we are your hosts. Well, listeners, it brings me no joy to do this episode, but it seems all too appropriate in this moment in 2022. Today, we tell the story of Enron. It was the seventh biggest company in America by market cap. It was heralded as the pioneer of a new business model during a new technology era. Executives had endorsements, or at least friendships and public appearances, with multiple US presidents. It had the Houston Astros baseball stadium, Enron Field, bearing its name. It was even named Fortune Magazine's Most Innovative Company six years in a row.

   21. DRDavid Rosenthal1:52

       Including in 2001, the year it went bankrupt.

   22. BGBen Gilbert1:56

       Unbelievable. Less than a year after its stock hit an all-time high, Enron filed for the largest bankruptcy in American history to that point. This story is every bit as crazy as the FTX story that we are all watching play out in real time. The parallels are totally uncanny. A financial trading company that got over-leveraged, thought they could do no wrong, and got tangled up in a web of self-dealing to try and paper over their problems. Individuals profited richly, while shareholders were none the wiser. The biggest difference really is that somehow Enron managed to do it all as a public company in plain daylight the entire time, and with much bigger dollar amounts.

   23. DRDavid Rosenthal2:37

       We have a big thank you to say here. The idea for this episode came from our good friend and past Acquired guest, Andrew Marks. I was in New York on the way back from Lisbon, and I had breakfast with Andrew, and we were talking about FTX, of course, and everything going on, and I was like: "How can Acquired add to the conversation right now about FTX?" And he was like: "I've got a good idea. You guys should do Enron." And I was like, boom! That is what Acquired can add to this conversation.

   24. BGBen Gilbert3:07

       Well, on the FTX note, suffice to say, we will definitely be appending a new intro to that episode.

   25. DRDavid Rosenthal3:14

       Indeed.

2. 3:15 – 8:45

   Sponsor break and show setup: disclaimers, sources, and the lens for the story

   1. BGBen Gilbert3:15

      Well, for our presenting sponsor this episode, we are back with Fundrise CEO Ben Miller to share more about their growth tech investing business, the Fundrise Innovation Fund.

   2. DRDavid Rosenthal3:26

      So you've now been investing out of the Innovation Fund for a few months. Give us the pitch. What's the offering?

   3. SPSpeaker3:34

      So right now, what do companies need more than anything else? It's funding. They have to have enough capital to get across the next 18 to 24-month downturn. So we are providing $10 million uncapped SAFEs for technology companies with at least 10 million in revenue and high growth. So 10 for 10, I'll say.

   4. DRDavid Rosenthal3:56

      It's like ESPN 30 for 30, the Fundrise 10 for 10.

   5. SPSpeaker4:00

      Yeah. So uncapped SAFE, so we don't set the price, the market does.

   6. BGBen Gilbert4:04

      And is there a discount, or do you just convert at the next round?

   7. SPSpeaker4:08

      Convert to the next round. We're thinking a flat 10% discount, but the more important thing is that the company gets to extend their runway, and we get to invest in the best companies.

   8. BGBen Gilbert4:21

      And why does this make sense for you? Why are you okay doing these uncapped notes right now?

   9. SPSpeaker4:26

      So the most important thing in venture capital is to invest in the best companies, period, end of story. And so we provide the companies essentially the best price set by the market, and we get into the best companies.

   10. DRDavid Rosenthal4:41

       It's so great. If you think back a year or two ago, doing uncapped SAFEs in growth stage companies, that was the total fools thing to do. But now in this market, I think it's actually brilliant because the days of companies just raising their next round at ludicrous prices are probably not gonna happen. I think you can get in at a great price, and this is an awesome product for founders to get the runway to get to that next round.

   11. SPSpeaker5:03

       Right. It's fundamentally a fit to our structure of an open-ended evergreen fund with no carried interest.

   12. BGBen Gilbert5:10

       And you are doing these uncapped notes, but you're also participating in growth rounds, is that right? Like, if they've got a term sheet and other investors, you can also participate in that round.

   13. SPSpeaker5:20

       That's basically almost the same as an uncapped SAFE because you're going into a round that was priced, and you're extending the runway. The smart CEOs know that the most important thing is time.

   14. BGBen Gilbert5:32

       Our thanks to Fundrise. If you wanna join the over 350,000 individuals investing with Fundrise, you can click the link in the show notes, and if you're a founder and wanna get in touch about having the Innovation Fund participate in your next funding round, email notvc, that's N-O-T-V-C, @fundrise.com.... After this episode, join the Slack. Thirteen thousand smart, curious, thoughtful, well-researched people are in there, and we'll be discussing this episode. And without further ado, David, take us in. Listeners, this is not investment advice. David and I may hold investments in the companies we discuss, although I don't think you can invest in any of these companies anymore.

   15. DRDavid Rosenthal6:09

       Oh, I've got a fun little thing that I'll bring up right at the end of the episode about investing in Enron that blew my mind when I learned this.

   16. BGBen Gilbert6:16

       All right, all right. This show is for informational and entertainment purposes only. David, over to you.

   17. DRDavid Rosenthal6:22

       I feel like we also need a disclaimer that this is not accounting advice.

   18. BGBen Gilbert6:25

       This is not accounting advice.

   19. DRDavid Rosenthal6:27

       This is gonna be fun because this is such history now, Enron, and, um, there are many really good books out there. So you read The Smartest Guys in the Room, right?

   20. BGBen Gilbert6:37

       By Bethany McLean. Yep.

   21. DRDavid Rosenthal6:39

       And I read Conspiracy of Fools by Kurt Eichenwald, both of which I think are really good. Conspiracy of Fools is great. It is a very, very well-researched history of Enron, and I thought a good place to start is right at the end of the prologue of Conspiracy of Fools. Kurt Eichenwald writes this, and I just thought it was so perfect to frame the Enron story [chuckles] and the FTX story today. He says: "This, then, is more than the tale of one company's fall from grace. It is, at its base, the story of a wrenching period of economic and political tumult, as revealed through a single corporate scandal. It is a portrait of an America in upheaval at the turn of the 21st century, a country torn between its worship of fast money and its zeal for truth, between greed and high-mindedness, between Wall Street and Main Street. Ultimately, it is the story of the untold damage wreaked by a nation's folly, a folly that in time we are all but certain to see again." [chuckles]

   22. BGBen Gilbert7:44

       It's so literary. My God, those words! After trying to consume an insane amount of Enron stuff over the last couple weeks, the thing that occurs to me is this is something that can only occur to this height in a bull market, where there's so much capital saturating so many opportunities that people are willing to go way out on the risk curve looking for returns, where there's so much FOMO playing into it, that they sort of have to pile into these low-disclosure, super risky type of assets 'cause everything else is, uh, already at all-time highs and crazy multiples. And of course, it's the people's fault driving the car that gets us here, but the environment around the car on the road is definitely facilitating it.

   23. DRDavid Rosenthal8:27

       Well, the investor community, as we saw happen over the last couple years here, just loses all incentive and desire to ask questions.

   24. BGBen Gilbert8:36

       Yeah.

   25. DRDavid Rosenthal8:37

       Um, that is what happened 20-plus years ago. So how did we get there then?

   26. BGBen Gilbert8:44

       And where did Enron come from?

3. 8:45 – 13:12

   1970s energy shocks and the deregulation wave that made Enron possible

   1. DRDavid Rosenthal8:45

      Where did Enron come from? We start in the 1970s in the United States, where a series, for those of you who know your American and indeed world history, a series of oil crises and energy crises shock the nation and the world. First, in 1973, when OPEC, the Organization of Petroleum Exporting Countries, starts an oil embargo on the US and other Western nations, and the price of energy triples. Think about this. We're talking about the impact of the Russia-Ukraine war on prices in Europe. This was way worse. The consequences of that were that the stock market crashed immediately. The economy entered a huge recession. I mean, this was the end. This was the slamming of the door on the post-World War II American economic growth miracle. This killed it. And when... We've talked about this on the show a few times. The 1970s were brutal. We talked about interest rates going so high. It was because of this, this first oil shock in 1973 and the second in 1979. Unemployment hits ten percent. CPI and inflation is above five percent for pretty much the entire decade. It hits a high of twelve point four percent in 1980.

   2. BGBen Gilbert10:09

      Wow!

   3. DRDavid Rosenthal10:10

      And then famously, when Paul Volcker takes over as chairman of the Fed in 1979-

   4. BGBen Gilbert10:16

      Brings the hammer down.

   5. DRDavid Rosenthal10:17

      He brings the hammer down. I didn't realize how high this was. He raised the fed funds rate-

   6. BGBen Gilbert10:22

      That was at zero a year ago.

   7. DRDavid Rosenthal10:24

      That was at zero a year ago, and that everybody's freaking out 'cause it's at, what? Like three and a half now or something like that. People think it might go to four or five, and that's crazy, and that's tanking the economy. Do you know how high Volcker raised it in the early 1980s?

   8. BGBen Gilbert10:37

      Ten percent?

   9. DRDavid Rosenthal10:38

      Above nineteen percent.

   10. BGBen Gilbert10:42

       Whoa! I assume it had to be, 'cause I had always heard that mortgages hit eighteen, so I always assumed that the mortgages had to be higher than the fed funds rate.

   11. DRDavid Rosenthal10:49

       Yeah, I don't think it was above nineteen percent for long, but when it was, I mean, that's like the base lowest interest rate possible. So mortgages must have been in the twenties at that point in time.

   12. BGBen Gilbert10:59

       Wow, crazy.

   13. DRDavid Rosenthal11:01

       My God, and that finally did break the back of inflation, but the cost was immense. Uh, doing this research really helped me understand more about the '80s. You know, in the go-go years of the '80s, it was because coming out of this horrible decade of the 1970s.

   14. BGBen Gilbert11:19

       Oh, yeah. Of course, this was the birth of the Wall Street mania because the super high interest rates from the Volcker era would have led to unbelievably low multiples on any asset you could buy. So of course, you've got tons of room to run on investing at bargain basement prices for things that are gonna go up.

   15. DRDavid Rosenthal11:40

       Yep. Now, what was it that precipitated all this? Like I said, it was the energy crises, oil shocks and the energy shocks. So starting in the mid-'70s, and it takes-... really fifteen, twenty years for all this legislation to wind through the government. The US government starts deregulating the energy markets in the US. So if you go back to our episodes on Rockefeller and Standard Oil, the initial energy markets in the US were monopolies. Like, it was Standard Oil, right? [chuckles] You know? And then when the government brought the hammer down on Standard Oil and the energy monopolies, everything got regulated, and utilities, energy producers, all became regulated government entities where prices of energy were set by the government.

   16. BGBen Gilbert12:24

       And when you say regulated, you know, there's different flavors of this. There's something where the government could actually own the utility, and you pay the government for the services, but there's also sort of a middle ground where something is so important to the public that price controls are put into place, or the free market is not allowed to reign free. The government would do something like grant an exclusive monopoly to a certain company and say, "But the prices have to be here," or, "But you can't make that much margin on it."

   17. DRDavid Rosenthal12:52

       You know, this makes sense, especially in the post-World War II American economy and way of life. Power is critically important. Electricity, gasoline, for homes, for businesses, for commuting, for factories, all this stuff takes power. Like, you want stability and low prices.

   18. BGBen Gilbert13:12

       Yep.

4. 13:12 – 22:16

   Ken Lay’s rise: from economist and civil servant to energy-market innovator

   1. DRDavid Rosenthal13:12

      But then after the '70s, of course, this all gets shook up. So in 1978, Jimmy Carter signs the National Energy Act, which starts to open back up parts of the energy economy in the US to free market competition. And the first big area of the energy industry that deregulates is the natural gas industry. So enter one Kenneth Lee Lay. Lay, like our first protagonist of this season, Sam Walton, Lay was born in rural Missouri in 1942, after Walton. His father was a Baptist preacher who ran a general store out in the Missouri countryside. That ended up failing, and Lay grew up very, very poor, but his family believed in education, and when his older sister graduated high school, his family wanted her to go to college, so they moved the whole family to Columbia, Missouri.

   2. BGBen Gilbert14:12

      Wow, it's, like, literally the same story. That's crazy.

   3. DRDavid Rosenthal14:14

      Literally, it's the same story, so that she could live at home, which was the only way they could afford for her to attend to go to the University of Missouri at Columbia. Very, very lovely place, which we have now been to multiple times for Capital Camp. So she goes to the University of Missouri. Ken would follow in her footsteps, also go to the University of Missouri, where he would discover a lifelong passion for economics. He's a star student in the economics department. He graduates. He goes on to work in the oil industry after he graduates. On the nights and weekends while he's working in the industry, he completes a PhD in economics, and then one day, he gets a call in the, uh, mid-1970s from his old advisor from Missouri, his old professor, who just got nominated to the Federal Power Commission, right as all of this deregulation is starting to percolate its way through the government. And so he calls up Lay and says: "Come join me here in DC and help me work through all this with the government and the industry." So Lay ends up serving as the deputy under secretary of energy in the Department of the Interior, right as these oil shocks are happening and deregulation is starting to be talked about. After a few years, he goes back into industry at Florida Gas, a pipeline company in Florida, as the president and number two operator within the company.

   4. BGBen Gilbert15:42

      So, so far in this guy's career, he sounds like the real deal.

   5. DRDavid Rosenthal15:45

      He totally is.

   6. BGBen Gilbert15:46

      PhD economist, civil servant, working in the government, getting DC exposure, going into industry to actually get some operating experience, grew up in a hard era, and sort of, like, had to fight his way through adversity.

   7. DRDavid Rosenthal16:01

      Yep, he's never deployed for combat, but during Vietnam, he ends up going into the Navy. He becomes, like, a naval intelligence officer.

   8. BGBen Gilbert16:08

      Hmm.

   9. DRDavid Rosenthal16:09

      By all outward appearances, he seems like a real good guy at this point in time. He marries his college sweetheart, you know, true American story. So late '70s, early '80s, he's the number two executive at this natural gas pipeline company in Florida, and in 1982, his former boss had moved over to the big leagues in the energy industry. He'd gone to a company called TransCo Energy, based in Houston, Texas, which is-

   10. BGBen Gilbert16:44

       Silicon Valley of the oil and gas sector.

   11. DRDavid Rosenthal16:47

       The Silicon Valley of the oil and gas sector, the New York City to the, uh, financial industry of the oil and gas sector. Everything... If you wanna be in energy in America, you wanna be in Texas, either in Dallas or Houston, but I think at this point in time-

   12. BGBen Gilbert17:01

       Houston

   13. DRDavid Rosenthal17:02

       ... probably Houston.

   14. BGBen Gilbert17:03

       Yep.

   15. DRDavid Rosenthal17:04

       So Lay is now in the big time, and as is fitting for now being in the big time and of the era, he leaves his wife behind in Florida and moves to Houston with his new wife, who was his secretary at Florida Gas.

   16. BGBen Gilbert17:22

       Unfortunately, classic for this story.

   17. DRDavid Rosenthal17:24

       Classic. This is not the last time we're gonna hear something to this effect in people's personal lives in the Enron story. So right as he arrives in Houston at TransCo, two things are happening. One, as I've been talking about all along here, deregulation is finally percolating through to industry. Carter signed the Energy Act. It's in full swing. But two, surprisingly, here in 1982, energy prices fall for the first time in a decade. So as a result, right after Lay shows up-... Transco runs into a problem. It's contracted to buy a whole bunch of oil and gas assets from various producers, various drillers, you know, around Texas and around the country, and those contracts have Transco buying the assets at a ever-increasing price, because the prices of oil and gas have only been going up for the last decade. But market prices have just fallen, so they're really kind of in the lurch here. People think that Transco might go under. Lay, remember, he's a PhD economist, and he's really quite brilliant. He comes up with an idea based on all of the economic theory that he knows. He's like: "What if we set up a trading market for this oil and gas that we're contracted to buy, and especially in natural gas, which is now deregulated enough, that I think we can do this. And rather than us as the pipeline company buying all of this gas from the producers, we'll just operate the pipelines in the middle, and we'll make this market, and we'll let the end consumers of the gas, you know, the factories, the utilities..." You know, consumers aren't buying this directly, but the utility companies are. "We'll let them, through us, trade with the producers, and we can create a spot market for energy." This becomes a huge success. This is like a massive, massive innovation.

   18. BGBen Gilbert19:21

       Hmm. And so Transco is doing this?

   19. DRDavid Rosenthal19:23

       Transco is doing this. So Lay, he becomes like a total industry legend. He pioneers this. So before Transco and Lay, the whole idea of, like, any form of trading or financialization of energy, of oil and gas, didn't really exist, 'cause it was all regulated by the government before then.

   20. BGBen Gilbert19:43

       Right. Not to mention, securitization wasn't a trend even in finance yet. Today, you can securitize anything. We had, of course, in 2008, everyone became familiar with the term mortgage-backed securities, but securitization in the '80s and '90s became all the rage in finance to basically get anything off your books. You could increase the velocity at which a financial company could operate by packaging up risk and selling it to someone else, so that you could make new loans off your books or something like that. And, of course, this was gonna come to energy at some point, but it's important to remember that securitization is still a reasonably new concept, even on Wall Street.

   21. DRDavid Rosenthal20:18

       Yep. So two things: One, this is not yet securitization of energy assets. This is simply just making a market for the first time between producers and consumers of the energy, where they can buy and sell on the spot market.

   22. BGBen Gilbert20:36

       At a real-time appropriate price.

   23. DRDavid Rosenthal20:38

       Real-time price. Like, today, I need energy. I'm going to look at the market that Transco is now making. I am going to buy as a consumer of energy at today's market price, whereas in the past, it was all long-term contracts that the pipelines had entered into with the producers, and then the consumers of the energy would buy it from the pipelines.

   24. BGBen Gilbert20:59

       I see. Okay, so we're like crawl, walk, run here.

   25. DRDavid Rosenthal21:02

       Crawl, walk, run.

   26. BGBen Gilbert21:03

       Yeah.

   27. DRDavid Rosenthal21:03

       Yeah, this is crawling, but as I said, this is Lay. This is Lay's baby. Literally, this is the opening of the floodgates, and he was the very perfect person to do this because he had the industry experience. He's now been close to a decade working in the industry. He had the economics training, and he had the government experience. He knew that the deregulation was now at the right point. It had trickled out into industry enough that this is possible, so he really was the perfect person to do this.

   28. BGBen Gilbert21:31

       Hmm.

   29. DRDavid Rosenthal21:32

       So on the back of that, in June of 1984, Lay, remember, he's number two at Transco, he gets poached by another big Houston energy company, Houston Natural Gas, to come over as the CEO, the number one. He's made it to the top. He's made his mark. He is the big shot at this point in Houston.

   30. BGBen Gilbert21:52

       Yep.
5. 22:16 – 35:24

   InterNorth + Houston Natural Gas merger: culture clash and the birth of ‘Enron’

   1. DRDavid Rosenthal22:16

      He does, for the moment. [chuckles] So then, the very next year, in 1985, he gets a call from the CEO of one of the larger competitors, a company called InterNorth, which was not based in Houston, but rather based in Omaha, Nebraska. You know, a few companies based in- [chuckles] ... Omaha, Nebraska.

   2. BGBen Gilbert22:39

      Small head office based in Omaha.

   3. DRDavid Rosenthal22:41

      Exactly. Small head office. Despite being based in Omaha, though, InterNorth, at this point in time, no Berkshire Hathaway involvement, is the largest pipeline company in America, and they were a relatively conservative, kinda old-school, in many ways, as we'll see, sort of parochial Nebraska company, despite having the largest pipeline in the country, and they were being pursued by the corporate raider. [chuckles] It's so funny how everything is coming together here in the Acquired season. The famed 1980s corporate raider, Irwin Jacobs, but not that Irwin Jacobs.

   4. BGBen Gilbert23:16

      I was gonna say, I remember reading this and looking it up and being like, "Okay, good. Woof, it's not our Qualcomm Irwin."

   5. DRDavid Rosenthal23:21

      I first heard about this other bizarro Irwin Jacobs when doing the research for the Qualcomm episode, 'cause every time I'd type it into Google, I would occasionally get hits for some other famous business person that clearly was not like the hero Irwin Jacobs, but the anti-hero Irwin- [chuckles] ... Jacobs. So 1980s corporate raider Irwin Jacobs is pursuing InterNorth, and the CEO of InterNorth wants to merge with HNG as almost like a kinda poison pill to, like, make the combined company too big for Jacobs or any other raider to pursue. So they negotiate a deal.... InterNorth ends up buying HNG for $2.3 billion, which was a 40% premium to the stock price.

   6. BGBen Gilbert24:03

      Which is big. I mean, usually the floor of what a board will accept is something around 20%, but a 40% premium, they paid a pretty penny to go buy Ken Lay's HNG here.

   7. DRDavid Rosenthal24:13

      It wasn't quite the case of minnow swallowing the whale, like they were closer in size than the Cap Cities ABC deal, but definitely InterNorth was the bigger company, but it was clear that Lay and the HNG guys were gonna be running the show from then on.

   8. BGBen Gilbert24:28

      Hmm. Yeah, I think that Bethany McLean sort of puts it in this way, where it's almost like InterNorth got hoodwinked, where they knew they were paying a lot, but they knew it was important to get, but then once they started looking at the deal with a couple of months of retrospect, they were like, "Wait a minute, we gave HNG a lot of board seats, and their executives are having a lot of influence on the combined company, and wait a minute, we just gave away the company."

   9. DRDavid Rosenthal24:56

      Yes, and specifically, this culture clash manifests in the question of where the headquarters for this new company-

   10. BGBen Gilbert25:04

       [chuckles]

   11. DRDavid Rosenthal25:05

       ... is gonna be. The old InterNorth management team and board members, they, of course, want to keep the company in Omaha, and all the board members are sort of politically connected in Omaha. They're like, "We don't want this company moving to the big city of Houston, taking all these jobs out of Omaha. It's important that the company stays here." And Lay, of course, he's very political, he's very diplomatic. He's sort of willing to say the right things to appease the board, but he has no interest in moving to Omaha. Like, he's in the big city in Houston. He's a player in the industry. He's now a Texas oil man. He wants to stay in Houston.

   12. BGBen Gilbert25:38

       Yeah, and to be super clear here, InterNorth had a ridiculously valuable hard asset. This is now quoting from Bethany's book: "Among its 20,000 miles of pipeline was a genuine prize, Northern Natural, the major north-south line feeding gas from Texas into Iowa, Minnesota, and much of the rest of the Midwest." So this is sort of the first example of someone in Enron land getting the better part of an economic deal, even though on the other side of the deal, there's a real hard asset that has quantifiable value for end users, for customers. Yeah.

   13. DRDavid Rosenthal26:17

       Eventually, as we'll see, they give up on even caring about that. [chuckles]

   14. BGBen Gilbert26:21

       Yes.

   15. DRDavid Rosenthal26:22

       So like we were saying, this culture clash between the two companies manifests itself in the headquarters location. So what do they do? They do what any management team and company would do when you're trying to justify your decision to the board, they hire McKinsey & Company.

   16. BGBen Gilbert26:38

       I mean, you can't make this stuff up.

   17. DRDavid Rosenthal26:39

       You totally can't make this up. This becomes completely freaking key to the story. Like, no headquarters study, no Enron. [chuckles] Uh, because the desk on which this assignment lands is a young, hotshot, superstar junior partner at McKinsey in the Houston office, one Jeffrey Skilling, who had joined McKinsey after Harvard Business School, where he was a Baker scholar, you know, top 5% of the class. And famously, I think he had quite the reputation there, and I think he was happy to broadcast this story. He got in because the, uh, dean of Harvard Business School interviewed him on a trip to Houston. I think Skilling was working in Houston at the time. He'd graduated from SMU, and the dean interviewed him and asked him if he was smart, and Skilling replied to the dean, "I'm effing smart." And he didn't say it in exactly those words.

   18. BGBen Gilbert27:38

       This is a family-friendly podcast, you know, we're not Jeff Skilling.

   19. DRDavid Rosenthal27:41

       Although we will actually say the words of some profanity that Skilling utters later, because it is absolutely key to the story. Skilling shows up in Omaha to present to the board his findings, which is that obviously the company should be in Houston. [chuckles] Even all the political wrangling aside, it makes sense that the largest pipeline company in the world at that point in time should be based in Houston, not in Omaha.

   20. BGBen Gilbert28:04

       And we should be clear here, there's this interesting thing going on at the time with natural gas, where it's sort of perceived as the good guy, and you're already starting to see this American ire toward the dirty big oil and coal and natural gas, which is, of course, a previously thought to be useless by-product of extracting crude oil. You know, you can make gasoline out of it, you can make all this great stuff out of crude oil, and then there's this natural gas, which didn't have great use cases until lots of scientific discoveries and reasons why we all use it to heat our homes now, or, or many people use it to heat their homes. But it was viewed as this sort of like next great frontier of pseudo-clean energy, and so it was a place where a lot of people in the energy business wanted to be going.

   21. DRDavid Rosenthal28:53

       Yes. Oh, such a good point. I'm glad you paused here, and we should discuss a little bit. Natural gas had lots of things going for it. One was sort of the environmental, you know, cleaner than oil, you know, all that. Two was that certainly it was the first part of the energy industry to be deregulated enough that you could do interesting things with it. But three, I, I think probably the biggest tailwind in its favor in America was, you know, you said oil had started to develop this sort of dirty connotation. I think a lot of that was because of OPEC and the oil embargoes. Like, here's this foreign oil that America's dependent on. I mean, even to this day, like, you know, how much are politicians campaigning on reduce our dependence on foreign oil, blah, blah, blah, blah, blah? You know, yeah, all goes back to the 1970s.

   22. BGBen Gilbert29:39

       Yep. Yeah, it's interesting how, uh, natural gas was the, the sort of electric power of its day in terms of perception.

   23. DRDavid Rosenthal29:47

       It was the Tesla of the 1980s. [laughing]

   24. BGBen Gilbert29:50

       [chuckles] Not to mention, there's all these just phenomenal other knock-on effects to it, where, you know, you can pipeline it.... You move it all over the place. You can store it really easily, so you can store lots of energy in a super dense way in case you don't need it in one place, but you do need it in another. It has these great sort of natural properties that make it not only really useful for the end consumer, but as this deregulation is coming in, it makes it a great asset to use in your free market enterprise.

   25. DRDavid Rosenthal30:17

       Okay, so back to this fateful HNG InterNorth board meeting in Omaha in, uh, I think this is now 1986. 1985 or 1986. Skilling, the hotshot McKinsey consultant, is sitting there in the waiting room, getting ready to go present to management and the board when the prior CEO, the number one, remember Lay is number two after the merger, walks out and informs Skilling that he's gonna keep on going because he has just been fired by the board, and Lay has engineered the coup, [chuckles] that Lay is now the CEO of the company. So, uh, there really isn't much time for the headquarters discussion in this board meeting, and what time they do have, the board is like, "No, obviously, we're keeping it in Omaha," and, you know, Lay's the consummate politician. He knows better than to press his luck. Like, he just got what he wanted. He's not gonna fight with his new board at this board meeting.

   26. BGBen Gilbert31:12

       To the very end, for Ken Lay, I don't think he ever said anything in a public or pseudo-public context that was confrontational or pissed anybody off.

   27. DRDavid Rosenthal31:21

       To the very bitter end. [chuckles] So the headquarters move does not happen at that meeting. It does happen shortly thereafter, but this is where Skilling and Lay meet for the first time, and, uh, Lay comes out in his very, you know, sort of politician manner after the board meeting is over. He apologizes to Skilling for all the drama. He says, "You know, look, I've read your work on the study. You really did an excellent, excellent job. Like, I would love to keep the relationship going with you and McKinsey. We're gonna have a lot of work to do with this combined company. I want you to be our McKinsey partner back in Houston, who's gonna lead a whole bunch of strategic initiatives for us." [chuckles]

   28. BGBen Gilbert32:00

       Yes, so it begins.

   29. DRDavid Rosenthal32:02

       And so it begins. So Lay's now settled in. He's in charge. He's the chairman, he's the CEO, and he decides that he wants to get a new name for this company. You know, HNG InterNorth, that, you know, it sounds too old, and, you know, it's reeking of his predecessor.

   30. BGBen Gilbert32:20

       And it is true that all these energy companies had just the worst names. I mean, it's all these like, completely meaningless prefixes and suffixes, like co and corp and inter, and it's like in Office Space, Intertech. They're all named something like that.
6. 35:24 – 39:38

   Early warning signs: rogue traders, weak controls, and Lay’s permissive leadership

   1. DRDavid Rosenthal35:24

      Yep, and they're running the proto-trading playbook that Lay pioneered back in his early days, and pretty quickly after this, they actually face their first trading scandal. Did you read about this?

   2. BGBen Gilbert35:38

      I did. It's such a predecessor. Like, it's such an obvious personality flaw of Ken Lay is to look the other way, and it's, like, amazing that it happened, what, 10 years before the big scandal?

   3. DRDavid Rosenthal35:51

      ... So two traders at the new Enron, who are actually based in New York, they start embezzling money from the company. They're filing fake trades, they're filing fake tax returns, they're creating false bank accounts. They have a false bank account, famously, I think, in the name of, uh, Mr. M. Gas, which clearly, this will give you a window into the-

   4. BGBen Gilbert36:12

      [chuckles]

   5. DRDavid Rosenthal36:12

      - sophomoric nature of traders and trading cultures.

   6. BGBen Gilbert36:16

      Just write that out and figure it out for yourself.

   7. DRDavid Rosenthal36:18

      So the company picks up on this, it comes to Lay's attention, and, uh, you know, everybody recommends, the company's auditors at Arthur Andersen, you know, recommend to the board-

   8. BGBen Gilbert36:27

      The premier accounting firm of the day.

   9. DRDavid Rosenthal36:29

      Premier Big Five accounting firm at the time. They recommend that Lay and the company should fire these guys. Obviously, they're stealing from the company, they're falsifying trades. And Lay's like: "Well, you know, these guys, it's really bad. It's bad what they did. We should censor them for sure. You know, we should set up some controls, make sure this doesn't happen again, but they're really good traders. You know, they've really made a lot of money for the firm. I don't think we should fire them. You know, that, that feels like a big step." And everybody's like, "Uh, okay?"

   10. BGBen Gilbert37:03

       They were funneling money to their own bank accounts.

   11. DRDavid Rosenthal37:05

       Yeah. [laughing]

   12. BGBen Gilbert37:06

       Um. [chuckles]

   13. DRDavid Rosenthal37:08

       Uh, but Lay lets it slide, and, um, he is immediately rewarded for his faith in them and his, uh, decision here. Almost immediately, they do what any sophomoric people in a situation like that would do, who just got away with one, they go way risk on. So they go on tilt, and they rack up, within the next few months, almost a billion dollars, one B, that's a B, a billion dollars, this is in the late '80s, of trading losses. Oh, which that would be enough to bring down the whole firm at the get-go.

   14. BGBen Gilbert37:43

       Well, and you got to think, the enterprise value of the combined company, I don't have it in front of me, but you had a, I don't know, five-ish billion dollar company buy a two-and-a-half-ish billion dollar company, and so, you know, whole enterprise value of the firm can't be more than ten billion dollars.

   15. DRDavid Rosenthal37:57

       And these two bozos just racked up a billion dollars in trading losses. This time, Lay does fire them, and fortunately for young Enron and for Lay, but unfortunately for the rest of the world, this happens early enough in the quarter that the trading floor is able to dig out enough of these losses that they don't have to report the whole billion-dollar loss come earnings time, and only end up reporting, I think, less than a hundred million dollars of losses. So the company miraculously survives. So you would think that Lay would learn his lesson here, but no, this is Kenneth Lay we're dealing with.

   16. BGBen Gilbert38:32

       And let's, for a moment, say, why are there traders? That's sort of an interesting thing that's happening here. I thought this was a pipeline company. I thought this was a logistics company that moved natural gas from one place to another and charged customers for the services associated with that. Well, the traders originally are there, to your point, to sort of help match supply to demand. You know, it's not like everybody's just got a computer in front of them where they can automatically be buying the right products to fit their needs at the right price at this moment in time. You sort of need to interface with people, and those people can quote spreads wherever they want. They can say, "Uh, I got a seller for this price, and you're the buyer, and I'm sort of sensing that you'll buy for that price. Okay, I'll matchmake supply to demand. I'll quote a spread where I think I can make the most possible money on this trade, and we'll go with that." And so this is the beginning of them being both a logistics, energy transportation company, and also a financial organization of sorts, a trading desk.

   17. DRDavid Rosenthal39:31

       Yes, a trading desk, a proto-financial institution for the energy industry.

   18. BGBen Gilbert39:37

       Yep.

7. 39:38 – 45:39

   Skilling’s ‘Bank for Gas’: inventing energy derivatives and the investment-bank model

   1. DRDavid Rosenthal39:38

      So speaking of, back to Houston and the promised McKinsey strategic engagement, it's happening. Jeff Skilling is lead hotshot partner to develop a strategic plan for this very thing, the new finance and trading operations of Enron. And one day, Skilling has a absolutely brilliant idea, brilliant by his own estimation, and he proclaims it to everybody how brilliant it is. What if Enron goes one step further from Lay's kind of original innovation of creating a spot market for energy, and rather than just being sort of the facilitator of the market, being the pipeline in the middle, what if Enron started acting even more like an investment bank in this industry? And the phrase that he uses for this idea is Enron becoming a, quote, "Bank for gas." And the idea is that they can go to oil and gas producers, to drillers, and they can buy up a lot of the future production that's gonna come out of their wells, kind of almost like the old companies used to do. But rather than Enron then being the customer for what's gonna come out of those wells, they repackage everything here. This is the securitization that you were talking about a minute ago, Ben. They repackage all of these future energy commodities, they slice it and dice it, and then they resell it to buyers, to consumers of energy, on kind of whatever timeline and term length they wanted. So we've gone now the industry from the pipelines, buy the assets from the producers, buy the energy commodities from the producers, and then sell them to customers. Lay's innovation is, like, create a market where you let the producers and the customers trade directly today.

   2. BGBen Gilbert41:33

      In real time, spot markets, where everyone is subject to I don't know what tomorrow's price is gonna be, I'll quote it to you tomorrow. So you, you have inherent risk that tomorrow's price could be higher, so sorry, but that is what it is.

   3. DRDavid Rosenthal41:45

      Yep. So Skilling's innovation here is, let's turn this into a full-fledged kind of financial derivatives market and let buyers and sellers write contracts and buy contracts for-... any amount of this commodity in the future at a set price, so true futures contracts.

   4. BGBen Gilbert42:05

      And the most sort of early legitimate use case for this is, imagine you are a local utility who's trying to provide natural gas to your town, and, you know, you've been using this great spot market that Enron stood up to figure out, you know, what's the price gonna be tomorrow? You're pretty worried about it skyrocketing in the event of some unknown black swan event or something like that. So wouldn't it be nice if you could hedge your exposure to that risk by also negotiating a futures contract, where you say, "Well, let me lock in a certain rate, and, yeah, I know it's gonna be more expensive than it is now, but at least nothing bad can happen, and then I can sort of be predictable in the way that I'm thinking about what my spend's gonna be over the next three months"? So that's, like, a super legitimate use case of one of these futures contracts that they could trade using Enron.

   5. DRDavid Rosenthal42:53

      You can imagine all sorts of utility here.

   6. BGBen Gilbert42:55

      Yep.

   7. DRDavid Rosenthal42:56

      So Enron does it. They pioneer this market that would come to be known, and is, I think, and assume still, a very, very large part of the energy market today, called energy derivatives. And Skilling and Enron invent it and pioneer it.

   8. BGBen Gilbert43:11

      And at this point, the energy is the underlying asset. The derivative itself is not particularly interesting other than its own utility for if you are actually buying or selling the underlying asset. That's, like, an important thing to note. Everyone will lose their heads later and get excited about the derivative on its own. They don't care what it's a derivative of. It's a tradable thing that numbers go up, numbers go down. It reminds me a lot of some of crypto over the last year. It's like trading Dogecoin.

   9. DRDavid Rosenthal43:42

      Right. Does anybody even know what this coin is or is supposed to do? Does anybody care?

   10. BGBen Gilbert43:46

       No, but I can speculate on it. And so there is a very interesting, almost innocent, early beginning of why you would offer energy derivatives that completely falls apart over time as everyone loses their head. And Skilling's still outside, right, when he pitches this idea?

   11. DRDavid Rosenthal44:04

       He's still at McKinsey at this point. Yes, for the moment, and still in this next thing. They realize this is a, a new concept they need to bring to the market. How are they gonna bootstrap up this new derivatives market? Well, they kind of need the producers to get on board. They need to get the supply, the raw supply that they can then financialize, securitize, turn into these derivatives. And the way that they can really convince producers to wanna do this is if they fund them. [chuckles] So just like an investment bank, they now start going out and doing these development deals and co-development deals with drillers, saying, "Hey, we'll fund you. We will finance your exploration, your drilling," and as part of financing that, Enron is gonna lock up the rights to then securitize the future production out of your assets.

   12. BGBen Gilbert44:54

       Which again, on its own, not a malicious strategy. Think about our Qualcomm episode: "Hey, Sony, will you spin up a new venture that we'll co-invest in to make flip phones that use CDMA so we can prove to everyone else in the market that CDMA is a viable technology? We'll invest in it. You just have to provide these strategic assets. You can own half of it," blah, blah, blah. It is a common way to bootstrap an ecosystem, to use your dollars to incentivize other participants to bring a thing into your ecosystem.

   13. DRDavid Rosenthal45:22

       And, you know, honestly, like, if the story were to stop there, this probably would be a great company, bringing huge innovation to a commodity market. Yeah, probably this market should work this way. It should be financialized and securitized. Energy assets are commodities.

   14. BGBen Gilbert45:38

       Yep.

8. 45:39 – 53:49

   Mark-to-market accounting: the engine that turns projections into profits

   1. DRDavid Rosenthal45:39

      Unfortunately, that is not where the story ends. Far, far, far from it. So 1990, now we're a couple of years into the Lay-Enron era, and Lay and the vice chairman of the company, a guy named Rich Kinder, who later would leave Enron before all the dirt hits the fan and start Kinder Morgan.

   2. BGBen Gilbert45:59

      You can think of Rich Kinder, for now, as the hard assets guy. He's the guy that really understands the intrinsic value of delivering hydrocarbons through a pipe to customers and trying to build a company that is just executing really well on doing that.

   3. DRDavid Rosenthal46:14

      Yes. So the two of them, they work on convincing Skilling. They think this is a big idea, and this is the future of Enron. They work on convincing Skilling to leave McKinsey and come over and join Enron as the full-time CEO of this new gas bank that they're gonna call the Enron Finance division. And in a very telling move, tells you a lot about what you need to know about Jeff Skilling as a person, they're talking about this, and they're negotiating. He decides he wants to take them up on the offer. He's gonna leave McKinsey. He calls them up to do the final negotiations of the terms of his offer. He calls them up from the hospital, where he is with his wife while his wife is in labor with their, I think, second child. That tells you where his priorities lie. Obviously, that marriage does not last too much longer.

   4. BGBen Gilbert47:05

      [chuckles] I love how you say obviously there.

   5. DRDavid Rosenthal47:06

      Yeah, obviously. [chuckles] Obviously. So Skilling comes in, he takes over Enron Finance, starts this new division.

   6. BGBen Gilbert47:14

      It is worth pointing out the thing that he made a necessary condition in order for him to join and do this. Do you know what that thing is?

   7. DRDavid Rosenthal47:22

      Ooh, I don't.

   8. BGBen Gilbert47:24

      It was that Jeff Skilling insisted that in order to join Enron and start this new division, Ken Lay and the board had to agree to use mark-to-market accounting.

   9. DRDavid Rosenthal47:36

      I did not realize that Skilling was looking that far ahead and made it a condition of his joining.

   10. BGBen Gilbert47:41

       This shows how unbelievably savvy he is. He sort of realized he couldn't build a business-

   11. DRDavid Rosenthal47:46

       Well, he is effing smart, according to him.

   12. BGBen Gilbert47:49

       Yeah. [chuckles] He could not build the business that he wanted to without doing this. He literally called it, and this is in The Smartest Guys in the Room, "a lay-my-body-across-the-tracks issue-

   13. DRDavid Rosenthal47:58

       Wow!

   14. BGBen Gilbert47:58

       ... about joining the company."

   15. DRDavid Rosenthal47:59

       I wonder if he talked about it from the delivery room.

   16. BGBen Gilbert48:02

       [laughing] Awful. All right, so what is mark-to-market accounting? It's worth, uh... 'Cause we'll get into this a bunch, but let's understand it conceptually.

   17. DRDavid Rosenthal48:10

       Yeah. It ends up taking a while for Enron to be able to implement this, that we'll get into, but go for it.

   18. BGBen Gilbert48:15

       ... So normally, if you're in the business of delivering gas to customers who will pay for it, you account for the cost that it takes to physically move the gas when you deliver it, at the time you're delivering it, and the cash that your customers pay you, that's your revenue, and you recognize that when they pay you. But imagine you're in a different business, like trading stocks. You probably should be accounting for the market value of everything you buy and sell, whether or not you have actually sold it. Like, if you bought Tesla at $20 a share, and it's now worth $200 a share, you should reflect that you have a gain, albeit an unrealized one. This is mark-to-market accounting.

   19. DRDavid Rosenthal48:54

       And famously, all VCs do this, right? You talk about marks, you know, of your portfolio.

   20. BGBen Gilbert49:00

       Right. Company raises an upround from a third party who's setting a new price. That is what the market is saying this asset is worth, and you get to account for that value even though you haven't actually received the cash. You know, just because you haven't sold your Tesla shares, it doesn't mean that you don't have an unrealized gain, or just 'cause the VC hasn't realized the liquidity event from that company, it doesn't mean that the company's not worth more. So Skilling obviously really wanted this mark-to-market treatment, and while you can imagine that it's probably easy to abuse mark-to-market accounting rules, it is probably okay if you can avoid the temptation. But it is [chuckles] worth pointing out that Enron, when they did adopt this, became the very first non-financial company to use this method.

   21. DRDavid Rosenthal49:46

       Yeah. Well, oh, boy, we're gonna talk quite a bit more about mark-to-market accounting in a minute, but let's just say the potential for a litany of abuse is high, very, very high, especially for what is an operating company, not actually a financial firm.

   22. BGBen Gilbert50:04

       Yeah. Mark-to-market accounting, to me, is the epitome of "With great power comes great responsibility," because it really does open up this question of, like, okay, well, what is the market price? And how do you discover the true market price of something? When someone's not paying you for it and giving you the cash, doesn't it seem a little squishy to say what the thing is actually worth?

   23. DRDavid Rosenthal50:25

       Oh, put a pin in that. We're gonna- [laughing]

   24. BGBen Gilbert50:27

       All right.

   25. DRDavid Rosenthal50:27

       We're gonna come back to that. So, um, Skilling, I guess after this, "lay his body on the tracks" moment in the delivery room at the hospital, he comes in, he joins Enron, running the new Enron finance division, where he's CEO of the division. He gets a big equity stake in the company tied to the performance of his division. Think a lot as we go through this story about incentives and the behavior that they drive. So he models this division just like an investment bank. He starts building out big trading floors in the Enron office in Houston. You know, he wants to have this be just like Wall Street, you know, here in Houston. Brings on trader-type folks. Most famously, he's a side character here, mostly because nobody could ever actually figure out, or from the outside, what this guy actually did at Enron, but this guy named Lou Pai, who already was at Enron. [chuckles] But this guy-

   26. BGBen Gilbert51:22

       I can't even hear his name-

   27. DRDavid Rosenthal51:23

       Oh, my God

   28. BGBen Gilbert51:24

       ... without chuckling.

   29. DRDavid Rosenthal51:24

       Oh, my God. Like, if you've watched the movie of The Smartest Guys in the Room, it's a really good movie, the movie version of the book. It's so mid-2000s. Like, they use all this weird B-roll footage. So Lou, [chuckles] like I said, nobody could ever actually figure out from the outside what he does at Enron, but one thing that he becomes really known for is his love of strippers.

   30. BGBen Gilbert51:46

       And not just conceptually, he would eventually leave his wife and marry a stripper.
9. 53:49 – 1:17:22

   Special Purpose Entities (SPEs) and Andersen: off-balance-sheet magic and double counting

   1. DRDavid Rosenthal53:49

      So the big hire that Skilling makes as he's setting up this division is one Andrew Fastow, a former banker from Continental Illinois Bank, where he worked in Chicago, and he was part of the, uh, structured financing division at Continental Illinois. Continental Illinois had the inglorious honor of becoming the largest bank failure in history until Washington Mutual during the financial crisis. This is the sort of cloth that Fastow is cut from.... When Skilling is recruiting him to come in and run structured finance at Enron, he talks with him, he hears about his experience, and he's like: "You, sir, are the man for the job."

   2. BGBen Gilbert54:30

      And you look at Andy Fastow and you hear him talk, and you kind of want to trust him. He's the picture of a polished, thoughtful finance executive who's thought this through, who has all the I's dotted and the T's crossed. He's good-looking, like he's the picture of the like successful '80s confident businessman, but with no slime on him. When you hear Skilling talk, you're like, "I don't know. I'm not sure this guy has my best interest at heart." The thing with Fastow is you actually do think he has your best interest at heart.

   3. DRDavid Rosenthal54:59

      He's like the American Psycho guy. He's like a banker.

   4. BGBen Gilbert55:02

      Yes.

   5. DRDavid Rosenthal55:02

      He is a banker, except he just comes from the bank that was the largest bank failure in history. So he comes in, and Skilling sets him to work doing structured financing. The primary thing that they're doing is they're packaging up these financing deals that Enron had started doing for the producers, for the drillers. Remember, they're trying to kickstart the market, bootstrap supply for this derivatives market, so they're doing all these financings for drillers out there, for oil producers. They don't really want those assets on the Enron books, and so they devise this scheme that they become acquainted with through Arthur Andersen, through the accountants and auditors, of using special purpose entities to package up these investments that they're making in producers and get them off of the Enron books. And it turns out, they learn through doing this, that at the time, if you set up a separate legal entity from the company, a special purpose entity, this is different than a special purpose vehicle that, you know, people use for investing in startups today. Is this a special purpose entity? If you set this up, as long as at least three percent, three, one, two, three percent, of the capital in that entity comes from outside investors, you can still have the company itself own ninety-seven percent [chuckles] of the economics of that entity, and you can remove it from your consolidated accounting books. You can just wipe it out of your accounting, say, "This is now owned and controlled by an independent third-party entity," and the test for it being independent is that three percent, a minimum of three percent of the capital, comes from outside sources.

   6. BGBen Gilbert56:52

      We live in a system that enabled this fraud. I want to keep reiterating that over and over and over again. Until Sarbanes-Oxley passed in 2002, because of this scandal and some other scandals, but largely because of Enron, we just existed in a system where all of this was exploitable and just waiting for someone who did not have the scruples to just finally come in and exploit all these loopholes.

   7. DRDavid Rosenthal57:21

      Totally. There were no lids on the cookie jars. [chuckles]

   8. BGBen Gilbert57:24

      There were no lids.

   9. DRDavid Rosenthal57:25

      No lids.

   10. BGBen Gilbert57:26

       And you might ask, "Well, this doesn't seem like that big a deal." Imagine these things are, like, hugely loss-making, but you're trying to go tell equity investors, people who own the Enron stock, how great your company is. It would be great if all their losses weren't showing up in your financial statements.

   11. DRDavid Rosenthal57:42

       Enron doesn't care about the quality of the assets or projects that it's investing in with these producers. It just wants to lock up the contracts for what someone would project the future oil and gas that's gonna come out of these wells. Enron doesn't actually care if they're well-run, or they're gonna make money, or the valuations make sense. They just want to lock up the deals, so they do a lot of really bad deals.

   12. BGBen Gilbert58:04

       Yep, massive incentive misalignment. And you said we weren't gonna get into mark-to-market accounting yet, but I have to introduce... Okay, so I'm Enron. I make a crap investment in your oil production project, and I say, "I want you to exclusively trade the financial derivatives around all the natural gas flowing out of your production facility through Enron." And you say, "Okay." And I say, "How much do you think is gonna eventually flow out of that?" And you tell me a number, and I say, "Well, if I take the most aggressive possible circumstance for what the price of that could be over time and the amount of volume that that could produce over time, and I take the most aggressive possible stance on the amount of interesting financial instruments that I could make out of that, I think you and I can agree that this deal that we're signing is a ludicrously valuable deal for me, Enron. The right to generate all this revenue from trading the assets that come out of your production facility, let's write this down. Let's paper this. The discounted future cash flows of all of the money that I'm gonna make from your production facility, that's really big."

   13. DRDavid Rosenthal59:15

       What you're telling me, these numbers that you put on paper that maybe I encouraged you to make them higher. [chuckles]

   14. BGBen Gilbert59:20

       Right. That's really great. I don't care about my equity investment in your thing. Like, we're gonna put that off into a special purpose entity. We're never gonna talk about it again. I don't really care if that goes to zero. But, hey, I use mark-to-market accounting, so because I just signed this deal where all of the future cash flows of this thing are looking really good, I'm gonna recognize that as revenue today. And I know I'm not getting any cash today, but my income statement, yep, you better bet that I am generating a ton of income from this deal that we just signed.

   15. DRDavid Rosenthal59:49

       Okay, so there's a bunch of both story and explanation we gotta talk about here. So we've talked a bunch about mark-to-market accounting. Despite Skilling apparently laying himself on the tracks about this being non-negotiable about coming in, it wasn't like Enron could just say, and Skilling could just say, "Oh, we're doing mark-to-market accounting." They had to make the case to Arthur Andersen, to the auditors, that Andersen could get comfortable with them doing this. Andersen says, like: "I don't know, this is really out there, like, very borderline that you guys could use mark-to-market accounting as an operating oil and gas company."... I don't know that we feel comfortable with this unless the SEC signs off on it. And so Skilling is like, "Great, let's take this to the SEC." So Andersen takes it to the SEC. The SEC rejects it. They come back to Skilling, and they're like, "As expected, the SEC is like, 'This is crazy. You can't do this.' " Skilling's like, "I wanna go talk to the SEC."

   16. BGBen Gilbert1:00:45

       And he's a ludicrously compelling character. There is an intellectual purity about him, where he can create an argument that sounds really, really compelling. This has worked for him many times in his life, so he's like, "Sure, I'll just go explain it to the SEC. They'll get it."

   17. DRDavid Rosenthal1:00:59

       And he spins this story that amazingly, the SEC somehow becomes convinced that this is a good idea, and they sign off on it.

   18. BGBen Gilbert1:01:09

       I think this is really an interesting point in the story. This is the only instance where you have someone who is complicit in allowing Enron to run the playbook that they did, who doesn't have a conflict of interest. Andersen Tax was getting paid tons of fees. The lawyers who signed off on lots of stuff over the years were getting paid tons of fees. All the employees had all this stock. They were incentivized for it to go up.

   19. DRDavid Rosenthal1:01:34

       Yeah, this is the one really puzzling one.

   20. BGBen Gilbert1:01:37

       This is one where, like, the person whose job it is at the SEC to approve this or not approve it, they don't have a vested interest.

   21. DRDavid Rosenthal1:01:44

       Here's probably also a good point to bring up the Arthur Andersen conflict. It's not just that Enron is a big audit client for them. [chuckles] At this point in time, pre-Sarbanes-Oxley and pre the fall of Arthur Andersen, all the accounting firms had attached consulting arms under the same roof. So Andersen had Andersen Consulting, which would go on to become Accenture after the demise of Andersen.

   22. BGBen Gilbert1:02:08

       This is nuts. I don't think I really grasped this.

   23. DRDavid Rosenthal1:02:10

       The conflict here is immense.

   24. BGBen Gilbert1:02:12

       This whole thing took down Arthur Andersen, and what they did [chuckles] for the consulting arm was they rebranded it Accenture and spun it out into its own thing.

   25. DRDavid Rosenthal1:02:22

       And at this point in time, all the senior partners at the firm, like, it's one and the same. They're all making money from these engagements. Enron became Andersen's biggest client in the world. They were making fifty million dollars a year from Enron, half of which was audit and tax fees, and half of which was consulting fees. At any point in time, Enron could just-- maybe it'd be hard for them to switch their auditors, but they could switch their consultants at the drop of a hat. There were huge incentives for Andersen to let them get away with what they wanted to keep the client happy. It was their biggest client in the world!

   26. BGBen Gilbert1:02:56

       There were no lids on the cookie jars.

   27. DRDavid Rosenthal1:02:58

       Okay, so miraculously for the evil guys at Enron, [chuckles] this gets through the SEC. Now, we've explained a little bit thus far about how good mark-to-market accounting can be for Enron. It's so much better than that.

   28. BGBen Gilbert1:03:12

       Better. Better for running a pump and dump.

   29. DRDavid Rosenthal1:03:15

       This is where the whole thing comes together in just, like, an unbelievable way. The parallels to crypto, they're crazy. Once they implement mark-to-market accounting, Ben, you explained a little bit the deals there a minute ago. You do a deal with a producer, and you say, "Hey, whether or not you're gonna be able to execute on these plans, let's pump up these projections, make them look as big as possible, and then I, Enron, will recognize as revenue today my projected cash flows based on this Excel spreadsheet for the next twenty years." The SEC allowed them to go out to twenty years, that they could collapse into today revenue. So twenty years of future cash flows, I'm gonna recognize that as revenue today [chuckles] with, like, no expenses associated with it.

   30. BGBen Gilbert1:03:58

       Here's why you could argue it's sort of fair: because there's at least twenty years of future cash flows baked into the stock price of any asset. So, you know, if I'm buying a stock and holding it on my books, in the enterprise value of that stock, I am accounting for twenty-plus years in the future of the cash flows that come out of it then.
10. 1:17:22 – 1:32:28

    LJM and institutionalized self-dealing: Fastow’s related-party empire

    1. DRDavid Rosenthal1:17:22

       So like we were saying, that dynamic gets to the point where it's so big, they can't find enough suckers to even do three percent of the equity and capital in these crappy deals that, again, Enron's on both sides of, even though the special purpose entity is independent, quote, unquote. So Fastow and Skilling come up with yet another brilliant idea. Rather than going and doing road shows, signing up, you know, other entities to do this, what if they had their own fund? [chuckles]

    2. BGBen Gilbert1:17:52

       [chuckles]

    3. DRDavid Rosenthal1:17:52

       A captive fund, part of the Enron family, but was separate, was independent, that could put up this three percent of the equity needed for every deal.

    4. BGBen Gilbert1:18:02

       God, we could call this episode Arm's Length, but not really.

    5. DRDavid Rosenthal1:18:06

       So they, um, they go to Andersen, and they're like: "Well, what if we do this? And what if Andy, what if Fastow [chuckles] sets up this fund and is the general partner in it, and we only use it for, you know, stuff that helps Enron? And, like, yes, he's the CFO of Enron, but he'll also be the general partner of this fund, you know, that's gonna do deals with Enron, but it's only deals that are gonna be good for Enron." And Andersen's like, "Uh, that seems really bad. You should probably go to the board and get sign-off on this very, very obvious conflict of interest."

    6. BGBen Gilbert1:18:36

       Yeah.

    7. DRDavid Rosenthal1:18:38

       ... So they do. They take this to the board, and they present it. Fastow presents it to the board as like-

    8. BGBen Gilbert1:18:43

       "I'm willing to fall on this sword to do this for you guys."

    9. DRDavid Rosenthal1:18:47

       "I'm taking one for the team, guys."

    10. BGBen Gilbert1:18:49

        Never mind the fact that, like, he has full private equity economics on this deal. I don't know if it's two and twenty or whatever it is, but there's management fees, there's carry. Like, he is the general partner of a private equity fund that is only getting good deals because you know that he's gonna screw Enron to get the private equity fund to get great terms on these deals. Ugh. So he's pitching the board.

    11. DRDavid Rosenthal1:19:13

        He's pitching the board. The board is like: "Great, thanks for taking one for the team, Andy. This is gonna be great for Enron. Really appreciate your hard work." You know, basically a bunch of attaboys and slaps on the back. So yeah, as you mentioned, this is a private equity fund that he gets two percent management fees, twenty percent of the profits. You know, ends up across a series of funds being hundreds and hundreds of millions of dollars that he's managing.

    12. BGBen Gilbert1:19:36

        I think Fund One was small-ish, but Fund Two was two hundred million.

    13. DRDavid Rosenthal1:19:40

        Yeah, we'll get into what it is, uh, exactly in a minute here. The management fees of a fund, in theory, are supposed to support the cost of running the fund, you know, like headcount salaries, rent, office space, all the resources you need. He's the CFO of Enron. Everybody who works on the fund is an Enron employee. Enron is paying the [chuckles] salaries of everybody. The office is Enron. There's no headcount, there's no funds, you know, all the Bloomberg terminals, all the legal, all the accounting.

    14. BGBen Gilbert1:20:10

        He's pulling someone off their day job every time they need to negotiate a deal between his fund and Enron and saying, "Okay, you wear the Enron hat on this time and negotiate against me, and I'll wear the private equity hat." And they're calling that arm's length.

    15. DRDavid Rosenthal1:20:24

        So all the management fees, there's no expenses. They're just straight flowing to him. The real kicker, we were joking about this before the episode, and that should have told everybody where his real incentive lies, he decides to name the suite of funds LJM Capital. What does LJM stand for? It stands for Leah, Jeffrey, and Matthew, which are the names of his wife and kids. [chuckles] So there's no question who is benefiting from what is going on here, and it's not Enron.

    16. BGBen Gilbert1:20:52

        Unbelievable. And there's the squirreliest, most circuitous route to trying to find disclosures on this. Whenever it's convenient to say so, there are claims that the board was fully on board with this. Whenever you're looking for the smoking gun, it's really difficult to find anyone's signatures or discussion of this in the board minutes. It's especially difficult to find Jeff Skilling's signature on anything, even though the whole agreement was Skilling will sign off as the final approver on, I think, deals, but definitely Fastow's compensation from this. There are documents that surface that have a variety of signatures on them, but not Skilling's. He very intentionally was like, "Uh, I'm not actually gonna sign off on this, but it's kinda good for Enron that it happens, so I'm gonna let it keep happening."

    17. DRDavid Rosenthal1:21:39

        Well, it is good because these funds, this vehicle, you know, everything that Fastow is now running, can put up the three percent capital for this special purpose entity, so they don't need to involve any outside people in all of this.

    18. BGBen Gilbert1:21:51

        Not to mention, all the people investing capital are these big banks, and so it further entrenches major financial institutions, Merrill Lynch, J.P. Morgan, all these big people that Enron wants to continue to have incentivized for their success further in owning assets that are associated with Enron.

    19. DRDavid Rosenthal1:22:10

        Yes. So everybody in Enron is so hyped up about this, that in 1999, Fastow starts a campaign within Enron with Lay and Skilling and the PR people in Enron to get himself nominated for the CFO of the Year [chuckles] in the CFO magazine annual rankings of CFO. He ends up not winning, but he does get a special award from CFO Magazine for CFO Excellence in the category of Capital Structure Management. So they do, over a few years, tons, tons of these deals, and two things are always true about the deals. One, Fastow is finding a way for Fastow to benefit and get rich, you know, LJM. We know who number one is here. Two, Enron also benefits because it's now just turbocharging this whole flywheel and getting the bad stuff off the balance sheets and booking revenues associated with these deals. Eventually, Enron also makes Fastow the head of corp dev. So [chuckles] he is now the head on all sides of the transactions. He's the CFO. He is the head of corporate development, who would be the person charged with negotiating the Enron side of the table against the outside investors, the LJM, but he runs everything.

    20. BGBen Gilbert1:23:25

        It's so, so wild. At the time that they do end up actually disclosing this, which I don't want to flash too far forward, but it's worth showing this detail, they do sort of disclose it. They say: "Oh, there exists an entity that's managed by a member of the management team that does deals with Enron." It's, like, one sentence, and then when the shit really hits the fan, they say: "Oh, well, a previously disclosed entity did deals this quarter, but that's been previously disclosed." There ends up being, like, a billion-dollar loss or some crazy, don't quote me on that, but some massive, massive loss, and they're like: "Oh, we disclosed this whole thing before." And it, it all ties back to this one sentence, where they're just saying, "A member of the management team has a related entity that does transactions with Enron."

    21. DRDavid Rosenthal1:24:13

        So this is where everything starts to unravel. Investors in the media start asking around about this. Like, by this point in time, we're now in, uh-

    22. BGBen Gilbert1:24:23

        Early 2001.

    23. DRDavid Rosenthal1:24:24

        Yeah. Lay has now stepped back to just be chairman. Skilling has been promoted to be CEO of the whole company. Fastow is still CFO, plus head of corp dev, plus running these LJM funds, unrelated funds. People are starting to ask around about what's going on at Enron, and-... people assume when this disclosure comes out, that it's Skilling who's running these funds, and they're like, "Oh, my God! Is the CEO doing this?" And so, um, I think it's the Wall Street Journal calls up Enron PR, and they're like: "Yo, uh, what's up here?" And like- and then Enron PR is like, " Oh, no, no, no. It's not Skilling. Don't worry. It's Fastow." [laughing]

    24. BGBen Gilbert1:25:04

        [laughing] They just immediately threw him under the bus.

    25. DRDavid Rosenthal1:25:06

        Threw him under the bus. Everybody hated Fastow in the company, apparently.

    26. BGBen Gilbert1:25:10

        Uh, especially late in the game here, 'cause people could figure out that he was getting rich on these LJM structures. He actually had-- LJM Three was in the works to be a billion-dollar fund, and if that came together, he was just gonna peace out and go do that.

    27. DRDavid Rosenthal1:25:23

        You just can't make this stuff up. So as that all starts happening, Fastow and Skilling in the company, you know, eventually decide, "All right, Andy, you've really taken one for the team here. You can either stay at Enron, be the CFO, and head to corp dev, or you can go run these funds. You can no longer do both. People are asking too many questions." And so Fastow, he asked for some time, the weekend, to go think about it, talk to his wife. He comes back to Skilling, and he's like: "I'm loyal to Enron. I'm staying here. I'm gonna give up. I'm gonna sell off my interest."

    28. BGBen Gilbert1:25:56

        Sell my interest. I'm gonna get all my economics out of the interest while they're at an all-time high.

    29. DRDavid Rosenthal1:26:01

        Here's what he does. Back before the funds, when they were just doing kinda one-off deals, Fastow had a direct report in the finance organization, a guy named Michael Kopper, and he and Kopper came to a, uh, understanding.

    30. BGBen Gilbert1:26:17

        A lot of understandings around this company.
11. 1:32:28 – 1:39:46

    Growth theater and new markets: power, water, bandwidth, and the California crisis

    1. BGBen Gilbert1:32:28

       It's probably worth flashing back to, like, the 1997 timeframe to start talking about what was happening outside the office of the CFO at Enron, 'cause they're going nuts. They've [chuckles] realized that they've accounted for all the future points on the board last year, and so they've got to do a whole bunch of stuff to show a bunch of growth, because boy, is the stock pumping, and boy, does the stock need to pump in order for them to continue all these new equity issuances to give them the cash to do all this wild stuff. So they've got the pipelines. They're not particularly interested in that very old business that's kind of hard to, um, fake or tinker with or innovate on top of. And so they're like, "Okay, the trading business, you know, sometimes we take big losses, but sometimes we- wild speculation can give us really big profits, or at least paper profits, so let's trade more stuff." So they get into the electricity business. So this, uh, for the first time, they move beyond natural gas. Of course, they find out that trading power is hard because unlike gigantic pipelines and tanks where you can store natural gas, you can't store electrons. Famously, batteries are very inefficient, so it's not like you can charge up batteries and store all the electrons there for a while until you need them somewhere else. You basically need to be producing the electrons at the exact same rate that you are consuming them. So that makes an electricity market interesting, but much harder than what they were doing in natural gas. They also expand into water, especially internationally. That's also very hard because all water droplets are not created equal. There's different impurities, different salinities that you have to treat. Of course, in the US, there's also no federal order requiring those who own water pipes to let anyone move stuff around inside of them the way that you have in natural gas and electricity. You know, these people who own the water pipes, own the water pipes, and if they want to tell you, "You can't put your stuff in here, and you can't make money off our asset," they're allowed to do that. So what else happens? They spin up trading teams for pulp and paper, weather derivatives, freight, metals trading, until they finally stumble on the thing that is really gonna make them money: bandwidth. Fiber optic network.

    2. DRDavid Rosenthal1:34:44

       Internet bandwidth.

    3. BGBen Gilbert1:34:45

       Enron, the tech company.

    4. DRDavid Rosenthal1:34:47

       [chuckles] Enron, the tech company. The stock goes nuts when this gets announced. One quick note that we would be remiss if not talking about on this episode with regard to the power trading that they get into, the electricity trading, they become a key player in the total disaster that is the California blackouts.

    5. BGBen Gilbert1:35:06

       It's hard to know if they caused it or if they just profited from it.

    6. DRDavid Rosenthal1:35:11

       They certainly profited, and they might have helped cause it.

    7. BGBen Gilbert1:35:14

       Yes. So what happened here? So this is worth talking about. So the California power markets were being deregulated, much like the natural gas markets, but not fully. The Enron traders, who are these pure capitalists, they're these pure sort of like, "If there's a dollar on the table, it is my ethical responsibility to go take it, no matter what the impacts are, because I have an intellectual purity to-

    8. DRDavid Rosenthal1:35:39

       I don't think there's a lot of intellectual, uh, justification going on. [chuckles] More visceral.

    9. BGBen Gilbert1:35:44

       No, I think there is. I think it's a deeply philosophical thing, where people believe that free markets are virtuous, and the only sort of virtuous thing to do is to have everything be a completely deregulated, open, free market and lay the rules of the game out clearly and then play the game however the rules say that you can play them.

    10. DRDavid Rosenthal1:36:05

        Yes, I think there's two classes. I think the Skillings and, like, the Kenneth Lays of the world fit that bill. I think a lot of the actual day-to-day traders are more just, like, red meat, you know, like, trade or make money guys. [chuckles]

    11. BGBen Gilbert1:36:18

        Yeah. So what happened here? Well, the state of California decided that they didn't want to go full free market, so they put in lots of safety measures that ended up being the opposite of that, 'cause usually when you add a new sort of mechanism into a free market, it can be played in a variety of different ways. So on the one hand, it seems reasonable to have controls in place. On the other hand, it entered a lot of new rules onto the playing field for these traders to exploit. So people would run experiments to test if they were exploitable, they would see the results, and then they would go hard, and they would be rewarded for going hard. And so-... You know a company is not on the right side of history when memos start circulating on the floor with names like Death Star, Fat Boy, Get Shorty, and Ricochet.

    12. DRDavid Rosenthal1:37:08

        These are various trading strategies in the California energy market?

    13. BGBen Gilbert1:37:12

        Yeah, just four of the trading strategies, but it's worth articulating some of the crazy stuff they did. So what is Death Star? Well, it was this experiment where Enron went into the market and filed an imaginary transmission schedule in order to get paid to alleviate congestion that didn't really exist. So this sort of like, "Can we spike something to watch the impact on something else, and then make money from a contract on the impact of it somewhere else?" Or Fat Boy was a scheme where Enron would submit a schedule to the marketplace reflecting demand that wasn't actually there, and then watching what sort of happened when that demand tried to be fulfilled, and there was nowhere to put it. So then there was a big extra amount of electricity being produced somewhere, they could profit from that. Get Shorty, selling power that Enron didn't actually have for use as reserves, with the expectation that Enron would never actually be called upon to supply the power, or it could just buy it later at a lower price. Or the worst of them all, Ricochet, where Enron would work with someone who's generating power in California, a utility-

    14. DRDavid Rosenthal1:38:18

        Oh, is this where they have them shut it down for maintenance?

    15. BGBen Gilbert1:38:21

        No, they w- this was where they would export it out of the state, and they had control over the transmission lines, so they could do that. And then, when California realized, "Oh, crap! We need energy," then they would, uh, have a contract in place where Enron would get paid to bring it back in at much, much higher prices, which the industry would start calling this megawatt laundering, 'cause that's really what it was.

    16. DRDavid Rosenthal1:38:43

        Well, and I think what they would do as part of it, too, is call up generation plants where they had relationships, and, like, encourage them to shut down for maintenance at specific points in time when they knew it would cause blackouts and spike the [chuckles] price.

    17. BGBen Gilbert1:38:55

        And that's exactly what it did. So, I mean, I am confident that people died from this. This is one of those things where, like, if you're randomly depriving huge swaths of California from power, hospitals, schools, people's homes, it's not fun and games. I mean, it is profiting from terrible, harmful activities to people.

    18. DRDavid Rosenthal1:39:14

        And this has such far-reaching impact. I mean, this was one of, if not the major reason, that California Governor Gray Davis gets recalled-

    19. BGBen Gilbert1:39:22

        Yep

    20. DRDavid Rosenthal1:39:22

        ... and then Arnold Schwarzenegger gets elected governor. Like, this was the key issue, and Enron and other trading companies were totally manipulating the market.

    21. BGBen Gilbert1:39:33

        Yep. So power trading, this whole thing is going on, that's sort of one corner of Enron. Another corner of Enron is this thing, Enron Energy Services, which this, I believe, is the division that Lou Pai ran.

    22. DRDavid Rosenthal1:39:46

        Mm, yep.

12. 1:39:46 – 1:49:59

    Enron the ‘internet company’: broadband hype, staged operations, and Enron Online

    1. BGBen Gilbert1:39:46

       But in '97, this was the current hotness for what to get investors excited about as the future of Enron. 'Cause they sort of had done the, you know, we're a pure marketplace, then we're a financial derivatives, then they got mark-to-market accounting and started doing all the international development, they started doing power. Well, Enron Energy Services [chuckles] is this thing that Skilling really wants to sell this story about how it's taking off. And so let me just read this passage from The Smartest Guys in the Room, 'cause I think this probably articulates the insidiousness of the Enron culture better than anything else. "So analysts come to Houston. They tour the sixth floor of the EES war room. There, they beheld the very picture of a sophisticated, booming business. A big open room, bustling with people, all busy working the telephones, hunched over computer terminals, seemingly cutting deals and trading energy. Giant plasma screens displayed electronic maps, which could show sites of EES's many contracts and prospects. Commodity prices danced across an electronic ticker. 'It was impressive,' recalls John Olson, who at the time covered the company for Merrill Lynch. 'It was a veritable beehive of activity. It was also a veritable sham.' The war room had been rapidly fitted out explicitly to impress the analysts. Though EES was just then gearing up, Skilling and Pai had staged it all to convince the visitors that things were really hopping. On the day the analysts arrived, the room was filled with Enron employees. Many of them, though, did not work on the sixth floor at all. They were secretaries, EES staff from other locations, non-EES employees who had been drafted for the occasion, coached on the importance of appearing busy. One, an administrative assistant named Kim Garcia, recalls being told to bring her personal photos to make it look as if she actually worked at the desk where she was sitting. She spent most of the time talking to her girlfriends on the phone. After getting the all clear signal, Garcia packed up her belongings and returned to her real desk on the ninth floor. The analysts had no clue they'd been hoodwinked."

    2. DRDavid Rosenthal1:41:43

       Oh, my God, this is like a classic boiler room ruse. This is [chuckles] great!

    3. BGBen Gilbert1:41:47

       Unbelievable, and that was '97. That was four years before the fall they were pulling crap like that.

    4. DRDavid Rosenthal1:41:55

       Should we talk about the, um, broadband services and internet division?

    5. BGBen Gilbert1:41:59

       Absolutely. Enron, the internet company, suddenly, magically. I mean, this company started by merging two pipelines, and here they are, the seventh most valuable company in the world, because they're somehow the company that's gonna capitalize on this new internet thing.

    6. DRDavid Rosenthal1:42:14

       Did you read about how they did a deal with Blockbuster-

    7. BGBen Gilbert1:42:18

       [chuckles] Yes

    8. DRDavid Rosenthal1:42:18

       ... this new division?

    9. BGBen Gilbert1:42:19

       This is the best. I mean, y- this is like, truly, you can't make this stuff up.

    10. DRDavid Rosenthal1:42:22

        This is, like, tailor-made for Acquired.

    11. BGBen Gilbert1:42:24

        Before the Blockbuster/Netflix thing, and before Blockbuster even considered streaming, they offered a video-on-demand product that was provided by Enron's fiber. Somehow, Enron was doing the servers and digital delivery.

    12. DRDavid Rosenthal1:42:40

        And this was video-on-demand being like, um, if you were, like, a cable or satellite subscriber, on your cable box, you could get video on demand, right? Like, this wasn't the internet- this isn't internet streaming. This is, like, on demand, but via the cable infrastructure, right?

    13. BGBen Gilbert1:42:55

        ... I think that's right. I think they only had bad movies. I don't think they were able to lock up good ones. I don't think, however, they ended up delivering it, I don't think the consumer demand was really there.

    14. DRDavid Rosenthal1:43:04

        Oh, the, the service never launched. But, of course, with Enron's mark-to-market-

    15. BGBen Gilbert1:43:08

        [chuckles]

    16. DRDavid Rosenthal1:43:08

        - they booked over $100 million in revenue on day one for it, and then they offloaded the project to a special purpose entity.

    17. BGBen Gilbert1:43:15

        $110 million. Even better, David. So they offloaded it to a special purpose entity. At some point, they tore up the contract. I don't know if it was Enron or Blockbuster, but they basically said, "This deal sucks. No one wants this." So you know what they did? They created an even bigger impact to revenue in the positive direction, like more than $100 million, because a new thing had happened. It's not a contract, it's the lack of a contract. So now they have the ability to do deals with everyone. They're not locked into an exclusive deal with Blockbuster. So that creates a huge amount of future value for Enron, the company, their shareholders, and so they literally recognized revenue even bigger than the Blockbuster deal-

    18. DRDavid Rosenthal1:43:58

        Wow!

    19. BGBen Gilbert1:43:58

        ... after the lack of Blockbuster deal.

    20. DRDavid Rosenthal1:44:00

        Oh, I didn't see that. That's amazing.

    21. BGBen Gilbert1:44:02

        It is wicked stuff. I mean, this is where you're just like, "You guys are criminals."

    22. DRDavid Rosenthal1:44:08

        Okay, so before we come back to the wheels starting to fall apart in 2001, there's one more piece of the, uh, intervening go-go years we should talk about. You want to talk about Enron Online?

    23. BGBen Gilbert1:44:19

        Yes. So, of course, we were referring to the bandwidth trading, which also is much more difficult than trading natural gas. I mean, like, how exactly is that all gonna work, trading available bandwidth, especially when there's this, like, massive last mile problem to everyone's homes, and if someone needs more bandwidth in one place than another, like, how is that gonna work? You're just physically gonna widen the wires? Or I didn't- I think people just didn't really understand these concepts yet. And so there's, like, lots of excitement around what Enron's doing in trading bandwidth, around being an internet company, but they actually do launch an internet product. Now, the internet product is really just to advantage their in-house business, and this one, to me, seems like it's probably not fraud. It's just an example of, like, evil but beneficial-for-shareholders business strategy. In November of '99, they launched something called Enron Online, and what this is, is it allows all of Enron's counterparties to trade with them electronically. So they stand up an exchange, like a exchange you can access through a web browser, much like FTX, but Enron itself is the counterparty to every trade. They don't even pretend that they're not on the other side of most transactions.

    24. DRDavid Rosenthal1:45:38

        Oh, my God, I didn't make the FTX-Alameda connection in this. This is too good.

    25. BGBen Gilbert1:45:43

        It is just the craziest thing, where they're just like: "Yep, we're the counterparty to every single trade here, so we're gonna generate a little bit of spread on the exchange, and we're probably gonna get beneficial pricing being the counterparty because we have the most information in the market for everything that's being traded on here, 'cause it is our marketplace, and we're gonna use that information." It's a pretty savvy data advantage. Now, unfortunately, what they do with that data advantage is they do manipulate markets, and that, I believe, leads to some part of the downfall case against them, where they are, uh, controlling commodity prices and stuff like that. But that, I thought, in '99, that early, is a, is a pretty savvy way to use the internet for evil. [chuckles]

    26. DRDavid Rosenthal1:46:31

        You know, a really funny thing, maybe we'll talk about this more in Playbook, is at the same time, this is, I think, really best reflected in both Skilling and Fastow. They were all so smart and yet also so stupid. The combination of brilliance and stupidity in one person and one group of people, it's really something.

    27. BGBen Gilbert1:46:52

        It's almost like it was smart, but it was cognitive dissonance, where, like, they just thought the rug was infinitely large, that they could just keep sweeping stuff under it, and that at some point it would never become an issue for them. And Skilling, you watch some of his testimony, 'cause everyone else pleaded the Fifth. Skilling stood trial and tried to defend himself. He really does look like a man who thought he did nothing wrong. It's crazy to me how Skilling... I mean, I think he really was delusional, that there was so much innovation here, that he thought it was okay. I don't know. There are examples of where you could draw a different conclusion, but you're right, they were smart, and I don't know that they were also stupid. I think they also just had a lot of cognitive dissonance that it somehow wouldn't all come tumbling down.

    28. DRDavid Rosenthal1:47:41

        I've actually been thinking about this recently, both [chuckles] in the context of FTX and just generally also, being a new parent makes you think about some of this stuff. Like, it's probably good to be smart. It's certainly good to be of above-average intelligence, good for you as your success in the world. But there's a certain point, I think, where, like, increased intelligence either is neutral or negative to your ultimate happiness, [chuckles] and I think it's cases like this, like Enron, like FTX. Like, there's no question that SBF, you know, and a lot of the people involved in FTX and Alameda were brilliant, but, like, they're too smart. Like, they end up hurting themselves, you know, and, like, the Enron case is the same thing.

    29. BGBen Gilbert1:48:22

        And is it the smarts, or is it the cockiness? 'Cause clearly, what was happening here is they just thought no one would ever catch them. I think that is really what started to come out is... I mean, Fastow went five years without having to disclose how much compensation he was getting from the LJM partnerships. He just thought, "I'll just keep self-dealing."

    30. DRDavid Rosenthal1:48:41

        But you're right about Skilling. It's a little more than that with Skilling. He's the only one who doesn't end up pleading the Fifth. Like, he defends himself to the end.
13. 1:49:59 – 2:01:13

    Scrutiny begins: Chanos, Bethany McLean, ‘impenetrable’ financials, and Skilling’s meltdown

    1. BGBen Gilbert1:49:59

       Yeah. So the first cracks in the armor start in September of 2000. So the stock is still on its way up and hasn't peaked yet, but you have a short seller named Jim Chanos, who, for the first time, is starting to make noise around just the most basic fundamentals here. "Hey, I'm reading your quarterly reports, and they're completely impassable. You're technically disclosing a bunch of stuff. I have no idea what you're disclosing. Can you help me understand the business? How do you make money?" And you then start to have reporters getting involved, 'cause reporters love getting tips from short sellers, 'cause short sellers have a massive financial incentive to go and investigate and figure out what companies are gonna fail, and that's a really good where there's smoke, there's fire for reporters. So, you know, reporters start getting involved, and the big question is sort of like: How does Enron make money? And as people start digging in with Skilling and with Lay and with Fastow and granting interviews and doing this sort of stuff-

    2. DRDavid Rosenthal1:50:55

       Nobody can figure it out.

    3. BGBen Gilbert1:50:57

       No one can figure it out, and you get conflicting statements. Like, you hear Skilling say, "It couldn't be more obvious. You just need to dig in and understand our business. We're very clear, we're very communicative, we're not hiding anything." And then two sentences later, you hear something like, "Well, we don't wanna tell our competitors how we make money, so, of course, we're not gonna share details like that." And you're like, "Sorry, what?"

    4. DRDavid Rosenthal1:51:16

       The cognitive dissonance is just-

    5. BGBen Gilbert1:51:18

       Crazy.

    6. DRDavid Rosenthal1:51:19

       Yep. So one of the reporters that Chanos... I don't know, one of or, or the only reporter that he goes to is Bethany McLean-

    7. BGBen Gilbert1:51:28

       At Fortune.

    8. DRDavid Rosenthal1:51:29

       At Fortune, [chuckles] the same publication that names Enron the most innovative and best managed company in America. Amazing.

    9. BGBen Gilbert1:51:38

       Yes.

    10. DRDavid Rosenthal1:51:39

        So she publishes, on March 5th, 2001, an article entitled, "Is Enron Overpriced?" question mark.

    11. BGBen Gilbert1:51:46

        Which is wonderfully innocuous. "Oh, it's merely a price issue."

    12. DRDavid Rosenthal1:51:49

        It's not that bad of an article from Enron's perspective. Like, the biggest question it raises is not one of fraud. It's exactly what you said, Ben. It's like Enron is a black box. Nobody can figure out what's going on here. But there's no accusations of fraud or anything wrong going on, et cetera. There have been some other articles, but this is the first big article, like, kind of questioning what's going on at Enron.

    13. BGBen Gilbert1:52:12

        The subhead is, "It's in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a high multiple?" That is the most innocuous and reasonable question to ask, 'cause when you go and compare it, you actually do industry comparables. Before the fall, its stock's trading at an all-time high, everything seems up and to the right. [chuckles] In fact, just in that January, January of '01, they've rebranded from the world's leading energy company to the world's leading company. It's literally the subhead, [chuckles] the tagline for the company.

    14. DRDavid Rosenthal1:52:46

        Oh, can we talk about the, um, company slogan that they used in their commercials, which was, "Ask why"? [chuckles]

    15. BGBen Gilbert1:52:52

        [chuckles]

    16. DRDavid Rosenthal1:52:52

        That's literally the company's slogan. When people ask them why of, like, about how their financials, they can't tell you.

    17. BGBen Gilbert1:52:58

        There was discussion of whether they should be the world's coolest company, but literally, the only reason they didn't do that is 'cause it didn't translate well, so they just went with the world's leading company. There is video footage of Jeff Skilling unveiling the new slogan at a shareholder meeting, and everyone clapping. It's like, "The world's leading company? That's not a mission. What do we do?"

    18. DRDavid Rosenthal1:53:18

        I want to be the world's leading podcast. What do you think, Ben?

    19. BGBen Gilbert1:53:20

        [chuckles] But that's actually a thing.

    20. DRDavid Rosenthal1:53:22

        I guess that is a thing. [chuckles]

    21. BGBen Gilbert1:53:24

        Anyway, so the financials, it's worth highlighting... A good time to pick is maybe March of 2000. It was trading at 55x trailing earnings, which, if you look at, and you think it's an energy company, you comp it against Duke Energy, which is a, a reasonable competitor, it's two and a half times the multiple. You're like, "Hmm, okay, well, maybe it's more than an energy company. Maybe I'm missing something here."

    22. DRDavid Rosenthal1:53:45

        It's an internet company.

    23. BGBen Gilbert1:53:47

        Yeah. But then you're like, "Okay, well, maybe it's like a trading firm, then. Maybe it's like a Goldman Sachs." Well, Goldman Sachs is only trading at this point at 17 times earnings, so why is Enron trading at 55 times earnings? And you're like, "Wait a minute." Then you start digging in, and you're like, "Well, when I can see Goldman Sachs's earnings, I can sort of tie it out to the rest of the financial statements and see earnings eventually showing up as cash." But this is a company that's trading two and a half to three times higher than any reasonable comp, and if you actually start digging in and looking at their free cash flow or looking at any return on investment metric that you decide to pick, it's terrible. There's no cash, and there's really no return on invested capital ever showing up, and sometimes their return on invested capital is actually less than their cost of capital. So when you look at the cash of this business, it's awful.

    24. DRDavid Rosenthal1:54:39

        Yes, indeed it is.

    25. BGBen Gilbert1:54:42

        And the first part, the high multiple, is Enron overpriced question. That's a reasonable conversation to have. And this is a good thing that friend of the show, Andrew Marks, pointed out: When you see terrible returns on invested capital, and you see no free cash flow showing up ever or poor free cash flow dynamics, that's probably when there's fraud.

    26. DRDavid Rosenthal1:55:02

        If there's very high revenue growth, very high reported-... earnings and profit on the income statement, and there is low return on invested capital and poor free cash flow dynamics, probably your radar screen should be going off.

    27. BGBen Gilbert1:55:17

        Yep. And this, of course, is a thing that short sellers pay a lot of attention to. They look for companies that have all of those metrics that we just described trending in exactly those directions, 'cause that's probably where there's a big accounting issue that's about to happen.

    28. DRDavid Rosenthal1:55:31

        And the big cognitive dissonance, I think, is the reported profits versus the cash flow. 'Cause you think about, like, startups, right? Lots of startups, for instance, can be reporting high revenue growth, but be burning lots of cash as they're investing in growth and operations and whatnot. In Enron's case, and in the case of a lot of frauds, they're reporting high revenue growth and high profits on the income statement, but also burning cash.

    29. BGBen Gilbert1:55:54

        Yep. So people are starting to figure this out, short sellers, journalists, and eventually, finally, finally, some analysts manage to shake loose of the "My job is to say Enron is awesome" thing, and they start to ask hard questions on earnings calls. 'Cause for the longest time, it has been that you were rewarded for saying Enron's great 'cause the stock would go up, and then you would look like a genius. And anytime anybody said Enron wasn't great, either they were proven wrong by the stock price, or they would get slapped at work because they're saying, "Hey, this is a huge client of ours. We do lots of business with them." 'Cause Enron did lots of business with everybody.

    30. DRDavid Rosenthal1:56:33

        Kept everybody on the payroll. So are you talking about the April 17th, 2001, earnings call?
14. 2:01:13 – 2:13:47

    Collapse sequence: Skilling quits, hidden obligations surface, whistleblower ignored, paper stops rolling

    1. DRDavid Rosenthal2:01:13

       ... So what happens next? Nobody inside or outside the company could predict. Within a couple months, by August of 2001, Skilling had just taken over at the beginning of the year as CEO of the company. In the beginning of August, Skilling goes to Lay, who's still the chairman of the board, and says, "I'm quitting. I'm resigning. I'm out. I can't handle this."

    2. BGBen Gilbert2:01:38

       And he cites personal reasons. "I don't want to blame this on my family, so I can't, in the press release, say that I want to spend more time with my family, even though I do. All you can say is personal reasons, and I'm out just because-

    3. DRDavid Rosenthal2:01:49

       "My mental health is falling apart, you know, I can't take it."

    4. BGBen Gilbert2:01:52

       "I want to spend time teaching. I want to do philanthropic efforts. This isn't what I wanted. This isn't fun," blah, blah, blah.

    5. DRDavid Rosenthal2:01:58

       In Conspiracy of Fools, and it sounds like it was the same in Smartest Guys in the Room, it is sort of painted as like, yeah, he really was having a mental breakdown, and that was the motivation here. You have to ask, though, the tide is going out. Skilling is, as much as anybody, everybody's to blame here. Certainly, Lay's to blame, Fastow's to blame, but I think you could argue Skilling is, like, the most to blame.

    6. BGBen Gilbert2:02:26

       Skilling was the architect of the demise. Lay, you could make an argument, was out to lunch the whole time. He was a key enabler, at the very least.

    7. DRDavid Rosenthal2:02:36

       And Fastow certainly was evil, but was acting on direction from Skilling.

    8. BGBen Gilbert2:02:42

       Yeah, sometimes. Other times, he saw a cash grab opportunity for himself.

    9. DRDavid Rosenthal2:02:45

       Well, he was embezzling for himself, but in terms of, like, damage to the company and, like, perpetuating this house of cards, Skilling was the architect to the house of cards. So you got to ask, does he see that the tide's going out in the market? "This house is gonna collapse. I need to get out now." And he starts selling stock as he's leaving, and then after he leaves, he sells a lot of Enron stock.

    10. BGBen Gilbert2:03:11

        And all the executives were at this point. Ken Lay had been on a selling plan for the last couple of years.

    11. DRDavid Rosenthal2:03:16

        Oh, we need to talk about how Ken Lay was selling. [chuckles]

    12. BGBen Gilbert2:03:19

        Ken Lay was so over-leveraged. He had received advice from his money manager saying, "You really should diversify. All of your wealth is tied up in Enron stock. It's all you've had since 1986, and it's really run." And so what he does, and it's so confusing 'cause he's savvy. I don't know why he does this. Instead of diversifying, he, like, claims he's diversifying, but what he's actually doing is doubling down. So instead of selling his Enron stock, he starts taking margin loans against his Enron stock and using that to invest in other things. Now, Enron's stock starts collapsing. He starts getting margin called, and so he's then needing to sell Enron stock in order to service the debt that he used to invest in these other projects.

    13. DRDavid Rosenthal2:04:03

        This is my own speculation. This is not alluded to in, certainly not in Conspiracy of Fools, but when I took a step back and looked at what was going on here, you know, Lay is not a bozo. He may have been out to lunch, but he knew what was going on here for sure, [chuckles] and, like, he was probably just as evil as any of them.

    14. BGBen Gilbert2:04:21

        And when we say out to lunch, physically, what was he doing? He was taking one of the Enron corporate jets around, sometimes to vacation with his family, sometimes to pick his daughter up from France, but often to DC to hobnob.

    15. DRDavid Rosenthal2:04:32

        Yeah, with the Bush family and other people in the Bush administration, and even in between the two Bush administrations, with the Clinton administration. He gave a bunch of money there, too, and did meetings with Clinton administration officials. So I think what might've been going on here, yes, Ken had most of his net worth in Enron stock, and then he started doing margin loans against that stock with banks, and then we'd get the margin calls, and he would have to repay them. But the way he repaid them was he took cash loans from Enron. So Enron loaned him-

    16. BGBen Gilbert2:05:06

        Oh, my God!

    17. DRDavid Rosenthal2:05:07

        ... cash.

    18. BGBen Gilbert2:05:08

        What a merry-go-round.

    19. DRDavid Rosenthal2:05:09

        And Ken backed his collateral for that cash that he ended up then repaying the loans to Enron with, was the Enron stock that he originally had taken the margin loans against. So he got the cash out of Enron, used it to repay the loans that he had gotten the money from the banks, right? And then the repayment mechanism of all this is Ken's equity goes back to the company. So nowhere do sales show up. Nowhere does it show up to any publicly available information that Ken Lay is selling his Enron shares. It just looks like there's anti-dilution happening at the company, the company's repurchasing shares. So I think you could make an argument, and this is all circumstantial, that this is, like, totally nefarious, a way to get money out without alerting the market that the chairman is selling.

    20. BGBen Gilbert2:05:59

        I think you nailed it. I think there's another thing that's in Smartest Guys in the Room, where they reference the fact that I don't think for his particular sales, they classified under some weird thing where they didn't have to disclose it till after the fiscal year, rather than in quarter, and so he was able to sell an enormous amount before having to report it.

    21. DRDavid Rosenthal2:06:18

        Yeah. All told, I think Lay sells about three hundred million dollars worth of Enron stock via these transactions. Skilling sells about two hundred million, and Fastow and a bunch of the other executives sell a whole bunch, too.

    22. BGBen Gilbert2:06:33

        And Fastow actually makes sixty million dollars from the LJM partnerships, from fees, carry, and selling partnership interests, so he actually makes more from the LJMs than I think he does in total comp at Enron ever.

    23. DRDavid Rosenthal2:06:46

        Which the board never knew, and then as everything is really starting to devolve, and we'll get into that now, at one point, the board corners Fastow, and they ask him, "How much money have you made from these partnerships?" And he tells them, and they immediately fire him. [chuckles]

    24. BGBen Gilbert2:07:01

        So, and here's the one twinge of a smoking gun on Skilling, of why he was quitting, that a Wall Street Journal reporter sort of unearthed in a conversation with him. It's in a pseudo-innocuous conversation. It's like this kind of-... I'm leaving for personal reasons, blah, blah, blah, and he drops one line, and he goes, "And watching the stock price fall is just so depressing. I probably wouldn't have quit if not for that." And then the reporter goes, "Wait, what? "

    25. DRDavid Rosenthal2:07:28

        [laughing]

    26. BGBen Gilbert2:07:28

        "That doesn't sound like a personal reason. That sounds like a business reason."

    27. DRDavid Rosenthal2:07:31

        Yeah.

    28. BGBen Gilbert2:07:32

        That's when they can really take that ball and run with it, and realize all the layers of what's going on here. A big one was, and this is a thing that got way reformed after Enron, all communication from the company to employees, to investors, and between the board and executives to set their compensation, is about the stock price.

    29. DRDavid Rosenthal2:07:54

        Yeah. They're always saying, "Buy the stock."

    30. BGBen Gilbert2:07:57

        Yes, not about any intrinsic characteristics. The company's not giving guidance on just, "Hey, here's what we think revenue's gonna be," and they're not telling employees what you should tell employees, which is, "I don't really know if this will go up or down, but here's the direction I think the intrinsic, measurable parts of the business are gonna go." What Enron is telling everyone is, "I think the stock will go up." What Ken Lay, what Skilling are telling people is, "Stock should be a hundred and twenty-five. What's it doing down at forty? This is terrible!"
15. 2:13:47 – 2:48:37

    Endgame: Andersen shredding, SEC inquiry, Dynegy deal fails, bankruptcy and aftermath (SOX + codas)

    1. DRDavid Rosenthal2:13:47

       Everybody's a little distracted. They're able to pull through [chuckles] for at least another couple of weeks. Later, though, by kinda early October, everybody's recovered enough, you know, in the rest of the financial community from September 11th, that they resume the questioning of Enron. The Wall Street Journal starts running stories about LJM and speculating on how much they think Fastow might have pulled out of these entities and earned for himself at the expense of the company. Arthur Andersen starts getting real nervous about their role in enabling all of this, and then-

    2. BGBen Gilbert2:14:25

       Arthur Andersen sort of premeditates, there might be an investigation at some point, and we are not allowed to destroy any evidence once there's been an investigation notified to us. So maybe let's get ahead of it, and let's shred more documents than we've ever shredded in the entire history of the firm before we get served something by an attorney.

    3. DRDavid Rosenthal2:14:45

       So Arthur Andersen Legal, on October 12th, sends an email to the Houston office-

    4. BGBen Gilbert2:14:51

       God, this email

    5. DRDavid Rosenthal2:14:52

       ... literally directing them, in writing in an email, to start destroying any and all non-finalized documents that are related to Enron, either digital or physical, quote, "In accordance with the firm's document retention policy." They've never sent anything like this or done anything like this for any other client.

    6. BGBen Gilbert2:15:13

       And then they followed up with a second sentence that says, "Just so that we're in accordance with the policy."

    7. DRDavid Rosenthal2:15:19

       Yes, the policy. This is the policy. [chuckles]

    8. BGBen Gilbert2:15:22

       This is a regularly scheduled. Of course, I'm just reminding you to do the regularly scheduled policy, which this email may set the policy, but, you know, do what the policy says.

    9. DRDavid Rosenthal2:15:31

       So the Houston office of Arthur Andersen, they go on for weeks. Like, the volume of evidence destroyed here, tens of thousands of emails deleted. That's, like, the easy to get your mind around. The amount of physical documents that they shred, they cannot physically shred the paper fast enough. They are shredding one ton of paper every single day. That's the maximum capacity. This goes on for weeks, dozens of tons of paper that they shred of documents related to Enron. [chuckles] My God, if they weren't guilty before, they sure look guilty of something bad now.

    10. BGBen Gilbert2:16:13

        And I think, you might know more than I do here, but I think Arthur Andersen went under not because they were found guilty of anything, but because when this all started playing out and they went in the news as being Enron's auditors for all this document destruction, for being really sloppy, they were complicit and sloppy. Enron needed to do a handful of restatements that were just straight-up Arthur Andersen's fault. I think their customers all just left, and so Arthur Andersen basically ran out of business.

    11. DRDavid Rosenthal2:16:46

        Well, it's somewhere in between. So Andersen itself, I don't believe, ever faces any, certainly no criminal actions for its direct role within Enron, I don't believe, but they do face criminal action from the Department of Justice and the SEC over destroying of documents, and as a result of that, the SEC in 2002, middle of 2002, revokes Andersen's CPA license, so literally bars them from-

    12. BGBen Gilbert2:17:19

        Oh, I didn't realize that. Okay.

    13. DRDavid Rosenthal2:17:21

        They had already started to lose tons of clients because, shocker, Andersen was also the auditor of WorldCom, [chuckles] which would be an even bigger bankruptcy that would happen shortly after Enron. So they'd already started to lose clients, and then the SEC revokes their license, and that's the end of the firm. Like, it's done. It's over. They employed 85,000 people, gone.

    14. BGBen Gilbert2:17:40

        And it really was the most reputable firm in the world.

    15. DRDavid Rosenthal2:17:43

        And it was destroyed. It's over. But back to Enron. [chuckles] So it was October 12th that Andersen starts shredding. On October 16th, Ben, like you were saying, Enron reports earnings. They announce $638 million of losses for, like, the first time on their income statement, and they say they have to do a restatement of shareholder equity and restate $1.2 billion worth of shareholder equity related to improper accounting of off-books entities.

    16. BGBen Gilbert2:18:14

        And this is the Raptors, right?

    17. DRDavid Rosenthal2:18:16

        I think this is the Raptors. It may have been some others, too.

    18. BGBen Gilbert2:18:19

        I love that it's called the Raptors. [laughing] Okay, this is Fastow. There's four entities, Raptor one, two, three, and four. They also have other names for some reason. They, they're, like, referred to in multiple ways, but they're off-balance-sheet vehicles that Enron's basically using to hide large debt loads they're carrying and huge losses. In fact, I think the Raptors start co-signing deals or at least sort of commingling so that if one can't pay something off, then the other one's on the hook for it.

    19. DRDavid Rosenthal2:18:49

        Well, I think the Raptors are also like, uh, what's the right word? Apothesis, is that, like, the biggest, most grandest example of Enron's just, like, awfulness in accounting? The Raptors, I believe, were hedges, intended to be hedges on some of Enron's investments, but the actual mechanism and the underlying collateral that they used for the hedge-... was Enron stock itself. So they became this, like, massively toxic, like, they didn't actually hedge anything, and all it did was double the exposure to, like, a broad-based stock market hit.

    20. BGBen Gilbert2:19:23

        It kind of feels like even if Enron hadn't started falling apart before September 11th, September 11th would have been the trigger, because they had all this correlated risk. So as soon as their stock stopped going up for any reason, then the whole thing would crumble.

    21. DRDavid Rosenthal2:19:39

        And indeed, that is what happens. So October 22nd, the SEC announces that they are launching an inquiry into Enron's accounting. The next day, the 23rd, is when the board calls in Fastow and demands to know how much money he's made in the LJM funds. They find out, they fire him. They instate the former company treasurer, Jeff McMahon, who had been the treasurer, but then Fastow had ousted him because he wasn't loyal enough to Fastow. He comes back into the finance department, this time as the CFO. McMahon learns that not only did Fastow not know how much debt Enron as an organization had, he also didn't know how much cash they had, and he also didn't know the maturity schedule of the debt. So he didn't know, and thus, nobody in finance knew, the company didn't know, when they had to repay the debt.

    22. BGBen Gilbert2:20:28

        Which, to me, this is the biggest example of they thought the rug that they were sweeping stuff under was infinitely large because they had no plan to service any of this debt or track any of it. There was no plan! They just somehow never thought they would need to, or it would catch up to them. I don't know.

    23. DRDavid Rosenthal2:20:45

        Well, and I guess, to, you know, what you've been saying the whole episode, which is true, if the markets had always been good and the stock price had always gone up, they always could have just issued more equity to cover any cash needs [chuckles] that they had.

    24. BGBen Gilbert2:20:55

        Right.

    25. DRDavid Rosenthal2:20:55

        But obviously, that's not gonna happen now. So it takes McMahon and his new team a couple days to pull all that together. When they do, they figure out the company is basically already insolvent, so they need emergency financing. So they do the only thing that they can do, which is they pull down all the revolving credit lines they have with all of their banks. These are outstanding revolving lines that look kind of like credit cards, so revolving lines of credit with banks.

    26. BGBen Gilbert2:21:24

        They actually went and asked the banks, "Hey, can we get new debt lines with you?" And every single one said no. And so they pulled the credit lines, which the banks have no option. It's already negotiated and signed.

    27. DRDavid Rosenthal2:21:34

        Enron drew down the credit lines.

    28. BGBen Gilbert2:21:36

        Yes. So Enron draws down those credit lines, and then they issue a press release that they've done this in order to, A, assure shareholders that, you know, they're on a great financial footing, 'cause now they have all this cash, and B, show the banks' support and that they stand behind Enron. You're like, "No, no, no, no, no, they had no choice."

    29. DRDavid Rosenthal2:21:53

        And the banks are fighting them tooth and nail on all this. Yeah. So after they do that, the credit agencies immediately downgrade Enron's credit rating, finally. It's shocking that they hadn't until then.

    30. BGBen Gilbert2:22:05

        Moody's, like, they've been complicit the whole time in just-

Episode duration: 3:32:42