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Models of Corporate Fraud - Model 4: Legal Fraud by Bethany McLean

“Legal Fraud:” Bethany McLean, who broke the Enron story for Fortune magazine and ended up writing a book, The Smartest Guys in the Room, puts forward the concept of “legal fraud.” Every action may have been in accordance with the laws and regulations but, taken together, the actions fit into a pattern of “intent to deceive.”

Notes - The Smartest Guys in the Room

  • Enron, a massive energy management firm, turned out to be a house of cards.

  • Its strong written code of ethics apparently did not influence day-to-day operations.

  • Jeff Skilling, hotshot COO and, later, CEO, spun fantastic tales about Enron’s rich prospects. Analysts, auditors and reporters believed him without skepticism.

  • Instead of stopping the fraud, Enron’s board rubber-stamped management.

  • Enron made Andy Fastow its CFO in ‘98 despite his lack of accounting know-how.

  • As CFO, Fastow used his considerable power on Wall Street to intimidate, manipulate and ultimately destroy people who should have policed his conduct.

  • He helped engineer and personally profited from shady transactions that allowed Enron to hide massive debts and report good results — until it declared bankruptcy.

  • Enron’s failure shook confidence in American markets and corporate governance.

  • Enron’s board and the various independent analysts who covered the company denied any responsibility for their failure to know and tell the truth about the massive fraud.

  • Skilling told Congress that Enron’s only problem was liquidity and the ensuing panic was like a run on a bank. He denied personal, corporate or accounting wrongdoing.


  • Securities analysts tried to use the Andersen convictions as an excuse for their own malpractice. They claimed that Enron manipulated its accounting but that since a respected auditor, Arthur Andersen, had signed off on the accounting, they could hardly be blamed for relying on the numbers.

  • Meanwhile, Enron’s own board of directors disclaimed any responsibility for failing to oversee the company’s operations or to make sure that the executives were doing business legally and ethically. They said that the company’s clever managers had deceived and blinded them, presenting false numbers that they had no reason to doubt.

  • Some astute short sellers and hedge fund operators saw the same numbers, knew what they meant, and bet big money on the Enron emperor’s unacknowledged nudity.

  • But most people involved with Enron lost. Employees lost. Stockholders lost. Pension funds lost. Even people who never bought a share of Enron stock lost when Enron went down, because Enron’s failure rocked the fi nancial foundations of America


  • The proximate cause of Enron’s failure was a series of illegitimate financial transactions involving what accountants and investment bankers call structured financings. The story of Enron’s financial prestidigitation began innocuously enough in 1998, when newly appointed CFO Andy Fastow, age 36, suggested to Enron’s top managers that the company should issue additional stock.

  • The new issue raised 800 million. Then Fastow got creative. He had to, because management had promised Wall Street that the company would grow marvelously. But growth required even more capital and Fastow had just three ways to get it:

    • Borrowing ~ cost of borrowing would rise with each borrow.

    • Issuing Stocks ~ Supply/Demand ~ Investors hate diluting

    • Structured finance ~ becoming innovative

  • Cliff Baxter, another Enron executive, told Skilling he was concerned, noting, “You could never tell whether deals were clean because they were so complicated.” When the dimensions of Enron’s malfeasance became public, Baxter committed suicide.

  • To get a glimmer of an understanding of what Fastow created, begin with Whitewing. To esTtablish Whitewing in 1997, Enron borrowed 579 million from Citigroup and another 500 million from a Citigroup affiliate.

  • Accounting rules allowed Enron to treat Whitewing as a “minority interest transaction,” which let Enron account for its borrowing as investment in a joint venture. Whitewing owned only Enron stock, but the market did not object to its structure and Enron’s stock price rose.

  • In 1999, Enron got even more creative. It set up another structure called Osprey. Enron raised 100 million from some insurance fi rms and bankers, offering in exchange some paper that committed Osprey to pay a fi xed return. To the untrained eye, this looks like borrowing. To Enron’s auditors, it must have looked like stock in Osprey, because that is how they allowed Enron to treat it. Enron then borrowed 1.4 billion from various institutional investors for Osprey, using a third of the money to pay off the Citigroup loan that created Whitewing. Osprey now owned Whitewing. Enron used the rest of the money cleverly, too. When Enron needed revenues to meet fi nancial projections, Osprey would “buy” assets from Enron. Osprey had two very signifi cant characteristics:

    • Enron said that if Whitewing’s assets (Enron preferred stock) weren’t worth enough to pay back investors, Enron would issue stock to compensate for any shortfall.

    • If Enron’s credit rating were to slip to non-investment grade or if its stock traded under 28 per share, investors could demand immediate repayment.

  • Accountingrules allowed Enron to act as if it had no debt, even though it was clearly on the hook for the Osprey borrowings. In addition to structures like Whitewing and Osprey, Enron also made liberal use of “securitization,” which means selling investors a share in a stream of revenues.

  • Enron securitized revenues it anticipated from risky deals such as Third World power plants. In theory, nothing is particularly wrong with SPEs, but Enron did some things that appear to be very wrong indeed:

    • The independence of Enron’s “independent investors” was questionable; often they were customers or employees, their relatives or friends, or other interested parties.

    • Enron often promised implicitly or explicitly that it would “take care of” lenders, again flexing the definition of independence to the breaking point.

    • Essentially, Enron borrowed huge sums of money from investors and reported the borrowings as revenues or cash flow instead of as debt.

The Cover Up: “He Who Pays the Piper Calls the Tune.”

All of these checks and balances failed to stop Enron. Why?

  • Auditor conflict of interest — Enron’s auditor was Arthur Andersen, which was charged with auditing Enron’s books and either persuading the company to correct any irregularities or informing investors that th books were not quite kosher. But Andersen did a lot of other business with Enron. In fact, in 2000, Andersen earned 52 million from its business with Enron, and most of that had nothing to do with auditing. The old saying, “He who pays the piper calls the tune” sums up Arthur Andersen’s attitude to Enron. Investors paid Andersen nothing. Enron paid it a lot. Moreover, Enron often hired some of its best-paid executives from Anderson’s ranks. No wonder auditors were careful not to embarrass, anger or annoy Enron; it was the goose that laid golden eggs. Within the firm, Anderson’s people knew Enron was “high risk,” but they had no incentive to share that assessment with investors.

  • Analyst conflict of interest — Analysts knew a good bit about Enron’s internal problems. As early as 1999, a J.P. Morgan analyst drew attention to the fact that Enron was booking revenues it couldn’t hope to receive for years (if at all). Howard Schilit, president of the Center for Financial Research and Analysis, told Congress, “For any analyst to say that there were no warning signs in the public filings, they could not have read the same public filings that I did.” However, analysts had no incentive to blow the whistle on Enron. In the past, they might have seen their jobs as evaluating stocks on behalf of investors. In the new Wall Street, however, analysts worked for big institutions that demanded demonstrable revenue from every department. Analysts were supposed to be team players who protected the fi rm’s relationships with valuable, profitable clients, such as Enron — that paying piper.

  • Board conflict of interest — Enron has a star-studded board of directors. In theory, boards work for investors. But, in fact, almost every director on almost every board is selected by the CEO. The positions pay well, offer good perks and generally demand relatively little. Although somewhat more is now demanded of board members as a result of the Enron collapse, Enron’s board members had little to gain and a great deal to lose by challenging or defying their piper-paying, tune-calling management.

“Above all else, Jeff Skilling believes this: ‘They killed a great company’.”


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