Bethany McLean — Enron, FTX, 2008, Musk, frauds, & visionaries

Dwarkesh Patel opens by describing a company that imploded within days, with insider dealing and romantic entanglements between sister companies, a politically generous and well-connected CEO, the company's own stock used as collateral, a short-lived rescue by a former competitor, and fraudulent abuse of mark-to-market accounting. He then reveals that he means Enron, not FTX. His guest, Bethany McLean, first broke the Enron story and wrote The Smartest Guys in the Room. She has also written books on the housing crisis (All the Devils Are Here), on Fannie Mae and Freddie Mac (Shaky Ground) and on fracking (Saudi America).

Patel's first question is how likely it is that Sam Bankman-Fried (SBF) read her book and used it as a playbook. McLean says she half likes the idea, then retracts it because it would make her responsible. Her real answer is that even a reader of the book would probably not see the parallel. Self-delusion is a strong component of stories of business gone wrong. It is rare for a central figure to understand that he is crossing into the dark side, weigh the consequences and choose it anyway. She therefore considers it entirely possible that SBF studied Enron closely and never saw any similarity to what he was doing.

Patel pushes the point: if a man about to repeat the same pattern can read the book without recognizing it, what is the value of documenting such cases? McLean answers that she believes history only imitates the past loosely, and offers a quotation she is not sure how to attribute.

history rhymes, but it doesn’t repeat

She gives two reasons for explaining failures anyway. First, understanding the world has value even without a practical payoff, and people have always needed narrative to make sense of events, especially large societal ones. Second, she allows for a small deterrent effect on the margin. If readers learn that these disasters are usually not planned by bad people who set out to do bad things, but are the work of people who first convince themselves they are doing the right thing and then end up somewhere they never meant to be, a few may be put off from starting down that path.

Patel cites a blog post by the finance writer Byrne Hobart (transcribed as “Bern Hobart”), written before FTX, which argued that the specific problem Enron represented had in effect been fixed. Investors no longer rely on GAAP earnings alone, they model free cash flow, and they are warier of companies that build in conflicts of interest between management and shareholders. Patel adds a possible reading of FTX that fits this view: it was deliberately set up outside the United States, in the Bahamas, and the United States has not seen a fraud of that scale on its own soil. Does that show that post-Enron rules worked?

McLean agrees that the rules worked in the narrow sense Hobart describes. A CFO of a public company would now find it very hard to set up private equity-style funds that he runs and that do all their business with his own company, because everyone would immediately say “that’s Enron”. She also thinks Sarbanes-Oxley helped rein in the abuse of very specific accounting rules that Enron practiced.

She rejects the premise that there was no Enron-scale fraud before FTX, however, because it forgets the global financial crisis. In her view the line between Enron and the crisis is not black and white, with one clear-cut fraud and one acceptable set of practices. Both sit somewhere in the murky middle. Much of what happened at Enron was not outright fraud, which is why she coined the phrase:

legal fraud

Much of what happened in the crisis was likewise legal, which explains the lack of prosecutions, yet it did not produce a healthy market or society. Her evidence that regulation does not hold is the interval between the two laws: Dodd-Frank followed Sarbanes-Oxley in only eight years or so.

McLean doubts that Sarbanes-Oxley did much good beyond its narrow target. She compares George W. Bush's Rose Garden speech at its signing, saying investors were now protected and could take comfort that the laws guarded them from wrongdoing, with Barack Obama's speech eight years later on Dodd-Frank, which she calls remarkably similar. She thinks neither claim was true. Modern markets move and evolve so quickly that the thing that arrives from left field is never the thing the rules were written to prevent.

Patel asks whether, if Enron was legal fraud, the government may have prosecuted Skilling, Fastow and Lay beyond what the law as then written warranted, and whether the sentences were legally excessive. McLean calls this tricky. In absolute terms, she says, Enron needed to be prosecuted and prosecuted aggressively.

She distinguishes two layers. Most of the collapse came from using and abusing accounting rules to create an appearance of economic reality that had nothing to do with actual reality. Real fraud also existed, but at the margin. Andy Fastow stole money from the partnerships for his own benefit. The core of the prosecution's case against Jeff Skilling was an agreement, which she calls “Global Galactic”, between Fastow and Skilling under which the partnerships would never lose money. If a jury believed that agreement existed, it invalidated all the accounting. McLean says that belief was the chief reason Skilling was convicted, along with one set of insider stock sales that she says they can discuss later.

Beyond the legal question, she argues that Enron was a watershed for the country, well beyond business itself. It raised anxiety over whether retirement assets were safe and whether people could trust the company they worked for, so the government had to act firmly. The unfairness appears only in relative terms. After the financial crisis many people left with large sums and gave little or none of it back, and no one involved in a major way paid any price, while Skilling went to jail for over a decade. She sums this up as a difference between the absolute and the relative.

In a side question, Patel asks who earned more from Enron in absolute terms: the investment banks, such as Goldman Sachs and Morgan Stanley, which sold services as the stock rose, or Jim Chanos, who shorted it. McLean says the banks, for sure, because of the investment-banking fees, though she adds that Chanos also made a lot.

Patel notes McLean's view that short sellers act as a useful corrective to irrational exuberance, and asks why they are scarce. If the efficient market hypothesis held, a company with terrible financials and implausible numbers would attract a queue of shorts, and an Enron would not happen. He admits he would like to believe in efficient markets but is struggling to reconcile it with Enron, where reporters were ahead of the market.