Unstable Genius: Jeff Skilling and Enron

Being the smartest is great, unless it lands you in prison

Neglecting to Measure Twice. Why are so many smart people not smart enough to realize what they don’t know? Probably because they want to be admired as the “smartest” or the “fastest” to make a judgement. Many times they are correct, but situations in which there is no second measurement are problematic since these constructs entail Iceberg Risk. As we know, 90% of an iceberg is underwater and not visible. Learn to identify situations that look great on the surface but do not hold up to that second measurement since this is where your dreams will likely hit that iceberg. Here is the story of how Jeff Skilling bullied his way through Enron and drove it into bankruptcy and himself into prison.

Neglecting to Measure Twice is one of the Seven Deadly Stupidities.

Jeffrey K. Skilling grew up as the son of a sales manager at an industrial company in Pittsburgh. Skilling was a ferocious student and earned a full scholarship to Southern Methodist University. After college, he worked briefly before attending Harvard Business School to earn his MBA.

At his business school interview, Skilling was asked if he was smart. He allegedly replied, “Yeah, I’m fucking smart.” Skilling graduated in the top five percent of his Harvard class and took a job at McKinsey & Company, the world’s top consulting firm. He soon became the youngest partner in the history of McKinsey.

With this kind of lofty start, where could Skilling’s ambitions take him?

While working at McKinsey, his biggest client was Enron. Enron was an old school oil and gas pipeline company based in Houston. Enron and its predecessor companies, some of which date their origins to the 1920s, was a true brick-and-mortar company. Lots of pipelines running for hundreds of miles, and trucks, heavy equipment, and all the other hardware and buildings necessary to transport oil and gas around the country. Enron was a traditional asset-heavy business in a large and essential industry.

When Enron became Skilling’s biggest consulting client at McKinsey, we had a classic clash of the old and the new. Skilling had a record of over-achievement and pushing the envelope while Enron was a successful, but stodgy, business. 

So, what happened?

Anybody familiar with the Enron story from the 1990s knows Skilling left McKinsey and eventually became the president of Enron. But before Skilling left McKinsey to join Enron, he insisted on a key condition for taking the job: Enron must adopt mark-to-market accounting for the new energy-trading operation that Skilling was to manage.

There can be speculation as to why Skilling insisted on this accounting treatment, but I believe he knew that he was entering a new market (energy trading) and was creating some of the rules along the way.

Having his preferred accounting treatment in hand would make it easier for Skilling to deliver big earnings since there were no reliable comparable businesses to benchmark against. In other words, it would be difficult for investors, analysts, and journalists to measure what he was doing, never mind measuring twice.

Mark-to-market (MTM) accounting is a method of valuing assets and liabilities based on their current market value rather than their historical cost. This means that the value of an asset or liability is recorded on the balance sheet at its current market value rather than its original purchase price. The purpose of mark-to-market accounting is to provide an accurate picture of a company's financial position by reflecting current market conditions.

For example, in the case of investments, if an investment is purchased at $100 and is valued at $110 in the current market, the value of the investment would be recorded as $110 on the balance sheet under mark-to-market accounting.  

Needless to say, with its fleet of machinery and pipelines, Enron had never had any need for MTM, since MTM is a measure used in the financial industry where stock and bond prices change every second AND such prices are visible and verifiable to players in the market. (Hang in there, this concept is important.)

Imagine the discussion inside of Enron:

Bossman: Man, you guys stink. Why didn’t you hit the locker room before showing up in my office?

CoverallsGuy:  Sorry, Boss, but oil and gas are dirty businesses.

Bossman: Well, anyway, this new guy Skilling is coming on board, and he is a heavy hitter.

CoverallsGuy: Great, we need somebody to help figure out the best truck delivery routes and how to get better maintenance deals on our equipment. He know much about transporting sludge? I think it’s the next big opportunity for us.

Bossman: Listen here, you idiot. Skilling is not coming to Enron to hang out in the garage and talk about the trucks and holding tanks. He is bringing a new concept to Enron called Mark-to-Market accounting.

CoverallsGuy: Huh? My brother-in-law is an accountant, maybe he can help us.

Bossman: I have a better idea: Hey Siri, what is Mark-to-Market accounting?

Now we have an oil and gas company adding an energy-trading operation with accounting that is used in the financial services industry.

How the heck can outsiders measure twice? What should they be measuring?

MTM was a non-negotiable condition for Skilling to join Enron and was necessary for him to continue his rise. As we shall see, MTM being live for Skilling as he joined Enron was the cause of the collapse and bankruptcy of the company.

Let’s pretend you run a small division of Merrill Lynch and you have one hundred shares each of a dozen different companies (e.g., Apple, Disney, etc.). At the end of each day when the market closes, you need to mark your portfolio to the market and report your numbers up the management chain. Pretty simple, as all you do is look up the closing prices of Apple, Disney, etc., multiply each by the one hundred shares owned, and add up the totals. That’s marking to market.

What’s the big deal?

For the Merrill Lynch manager, marking to market was easy since the prices of his assets were visible and verifiable by others.

At Enron, things were a bit more complicated. First, let’s remember how it works in Corporate America. The more earnings your division or team produces, the bigger the bonuses at year end.

Enter Skilling, a super-achiever who now had the accounting treatment he wanted. You guessed it, earnings went through the roof.

For several years, Enron’s stock price did nothing but rise. Enron was on all the lists of the world’s most admired companies and best places to work. And why not? With skyrocketing earnings came skyrocketing bonuses and a skyrocketing stock price. Everybody was happy.

While Enron was riding high, some started to question its financial statements. Most of us know that an income statement includes revenues and expenses. Revenues less expenses equal income. 

But there are two other components of the financial statements that professional financial analysts examine: (i) the balance sheet, which lists assets (buildings, equipment, cash on hand) and liabilities (loans and amounts due to others) and (ii) the statement of cashflows that acts as a kind of connector of the income statement and balance sheet.

Finally, somebody was starting to try to measure twice before investing in Enron.

Enron kept the focus on those incandescent income statements and those ever-rising earnings. But as reporters and analysts probed the full set of financials, things were not adding up. Part of this was the perversion of mark-to-market accounting by Skilling and his team. There were tons of assets on the Enron books that were illiquid and not easily valued. Skilling and team simply applied their own valuation (permitted under MTM) and made sure it increased each quarter, thereby creating income, pushing the stock price higher, and increasing bonuses. 

Further, there were all sorts of debt deals executed by Enron to pay for some of these assets and the debt deals were not included in the financial statements. In other words, Skilling and team were making unorthodox investments that made the income statement shine, moved the stock price up, but burned a lot of cash.

Along the way, nobody doubted Skilling’s brilliance. Yes, he was “fucking smart,” no doubt. But he was also a heavy drinker and about as arrogant as they come. On an investor conference call with dozens of participants, Skilling did not like the question from an investment analyst.

What did he do?

He called the analyst an “asshole.” After becoming the president of Enron, he suddenly quit, citing family reasons. Skilling subsequently sold tens of millions of dollars of Enron stock and the company collapsed less than 120 days after his resignation. And he testified (unsuccessfully) that he knew nothing of the company’s problems when he resigned.

Skilling tried to turn a traditional industrial company into a trading and finance business. It turned out to be an accounting mirage that was impenetrable to interpretation and measurement by outside parties, until those parties started asking the right questions. Enron was liquidated through bankruptcy, its stock price went to $0, thousands lost their jobs, and millions lost their investments in Enron.

Skilling wound up serving fourteen years in prison for his role in deceiving the public and costing investors billions of dollars.


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