Part 1: How to Spot a Corporate Fraud Before It Makes the Headlines

**Bethany McLean** (0:03)
You think that people like auditors and law firms and a board of directors is there to protect you, the individual investor. But the more you learn, the more you realize that their main incentive is keeping the company happy.
And that's still true today.

**Rachel Warren** (0:29)
That was Bethany McLean, the investigative journalist who exposed Enron before Wall Street did, and one of the sharpest financial minds in the business. I'm Motley Fool analyst Rachel Warren. Bethany has spent decades following the money through every major boom and bust in modern financial history, and she has a lot to say about where we are right now. In part one of our conversation, we dig into the psychology behind corporate fraud, how to spot a red flag before it becomes a headline, and why the line between a visionary CEO and a fraudster may be thinner than you think. We hope you enjoy.
Welcome back to Motley Fool Conversations. I'm Motley Fool analyst Rachel Warren. Today I'm joined by veteran investigative journalist and Vanity Fair contributing editor Bethany McLean. Bethany is famously the co-author of the definitive Enron Chronicle, The Smartest Guys in the Room, and has spent decades exposing hidden financial risks from the 8 financial crisis, and all the devils are here to the pandemic corporate bailouts in her book, The Big Fail.
Today we're using her legendary investigative toolkit to give you a masterclass on spotting corporate red flags, evaluating charismatic CEOs, and finding the next hidden market risks. Bethany, welcome to the show.

**Bethany McLean** (1:38)
Thanks for having me on.

**Rachel Warren** (1:41)
You have a remarkable record of being early on massive stories that later blew up. We have to talk a bit about Enron. When you look back at Enron now 25 years ago or so, how much of that collapse was a failure of the raw numbers versus a failure of the gatekeepers who were simply afraid to ask the hard questions?

**Bethany McLean** (2:03)
Well, I think it's both the raw numbers were a failure because the gatekeepers failed in their job. And that to me is still the most instructive lesson from Enron's collapse, which is that you think that people like auditors and law firms and a board of directors is there to protect you, the individual investor. But the more you learn, the more you realize that their main incentive is keeping the company happy.
And that's still true today. And it's not even so much a question just of your greed and who pays them. It's also just human nature. When your approval rests on somebody out saying, Good job, you start to want them to say, Good job. And that happens time and time again. We see that the auditors have failed investors many times since Enron. And so it's just a really important lesson to know that just because the auditors and the lawyers and the board of directors say it's okay, and just because the bankers have a buy rating on the stock, that doesn't mean it's okay.

**Rachel Warren** (3:09)
For members of our audience who might only know Enron as a historical buzzword, maybe you can go through a bit. How did management use complex financial structures, mark-to-market accounting, to turn future projections into fake current profits? Maybe you can walk us through that story a little bit.

**Bethany McLean** (3:26)
It's funny. So I joked when I wrote about Enron way back when, Fortune magazine where I worked at the time had labeled Enron its most innovative company for the previous seven years. And I still think that Enron was the most innovative company in corporate America even 25 years later. Because they used all of those tools in order to make their reported earnings look much better than they were. And one of the fascinating things about Enron is that people think of it as this giant fraud. It actually wasn't. There was a lot of reality to their business.
The fraud lay in just pushing the boundaries of generally accepted accounting principles past the breaking point in a few key ways. But most of what they did was legal.
And what they did was figure out how to create reported earnings, even when the economic substance wasn't there. And they used a whole variety of toolkits from mark-to-market accounting, which is, and the reality is, accounting is a language. Mark-to-market isn't necessarily any better or any worse than using historical prices, which is the other way of doing things. Both can be manipulated. But what Enron did is they used mark-to-market to increase their, their recorded earnings they could produce. They used special vehicles that their CFO had set up in order to sell at investments to that vehicle and be able to record of the gain on the investment they had sold. What was effectively a captive, a captive vehicle, and they used a whole host of other techniques. And so what it really shows is the way in which accounting laws can be manipulated without breaking the law in order to increase the metric that a company wants to increase.