The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (14 page)

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The day would come when the trading operation became enormous, when it posted the biggest profits in the company and when virtually all business activity at Enron revolved around the giant trading floor. But in those early years, it
wasn’t like that at all. In the beginning, the traders were their own small division, trying to build a business from scratch.

Their transformation from a support group to a powerful profit center was cemented by a key Skilling decision. Pai had originally been in charge of the financial traders, which then made up a small portion of the trading business. Skilling expanded his purview to include all the traders who actually handled the logistics of moving natural gas through pipelines for physical delivery. This meant they were now responsible for getting the gas to customers as well as using financial instruments to manage the price risk from the long-term sales contracts that Enron’s marketers were negotiating. This gave Pai and his traders a wealth of intelligence about what was going on in the marketplace, information no other company’s trading desk could match.

The traders became critical inside Enron. In effect, trading sat in the middle of the gas-sale transaction, between two groups of commercial deal makers. On one side were Skilling’s gas bankers, busy offering financing deals to producers to lock up long-term supply. This group was headed by Gene Humphrey, Skilling’s first hire, who had come from Citibank. On the other side were the marketers, who made big deals with utilities and industrial buyers of natural gas. Both kinds of deal makers were called originators, but in the early years, it was the marketing originators who got all the glory. Whenever ECT signed a long-term contract with a customer, it could immediately declare the profits for the entire deal on its income statement, thanks to mark-to-market accounting. In addition, Ken Lay’s strategic goal was to create new markets for natural gas, and that’s precisely what these originators did with their deals.

From the moment Enron Gas Marketing was put under his aegis, Skilling began pushing the originators to do something spectacular, to pull off a deal the likes of which no one had ever seen before in the natural-gas industry. The Holy Grail was a big deal with a power-plant developer, someone who would agree to build a plant that would buy gigantic amounts of gas.

And in January 1992, the Grail was found: Enron announced that it had agreed to provide the entire gas supply for a new 1,000-megawatt plant in upstate New York. Enron convinced the plant developer, Sithe Energies, to use natural gas instead of coal, but that wasn’t what made it so important. As big as the Brooklyn Union deal had been three years earlier, the Sithe contract was of a different scale entirely. Enron would supply Sithe with 195 million cubic feet of gas per day for 20 years, an extraordinary amount for an unheard-of term. The estimated value of the gas: $3.5 billion to $4 billion. As Skilling saw it, this was his group’s “bell-cow transaction,” the one that made everybody stand up and pay attention. Both inside and outside the company, people were agog at what Skilling had pulled off.

The Sithe deal had ramifications that went well beyond its sheer size. For years, Sithe helped Enron meet its aggressive profit targets. Using mark-to-
market accounting, Enron began booking profits even before the plant started operating. It kept booking profits from Sithe well into the late 1990s by restructuring the deal on multiple occasions when the company was scrambling to meet its quarterly projections. Later, the deal’s complex machinations backfired, producing a huge liability that Enron never fully disclosed. But that was far in the future.

The Sithe deal was the ultimate proof that Skilling’s big idea was working. He had said that his new creation would allow Enron to land giant deals, and now the company had one in hand. He had said that Enron could supply huge amounts of gas on a long-term contract, and now he’d committed to do just that. To make Sithe work, Enron bought gas from dozens of locations and laid miles of fresh pipeline into the plant from Canada. And the traders were suddenly engaged in seeing to it that the Sithe supply never faltered and the price risk was managed; indeed Sithe jump-started the trading operation like nothing that had come before it. “In the beginning, we needed physical supply to trade,” says Amanda Martin, who began working for Skilling in 1992. “We had to originate transactions to give the traders something to play with.” It was a logistical triumph, proof that Enron could deliver on a huge long-term gas supply commitment.

The lead originator on the Sithe deal was a man named Kenneth Duane Rice, who soon became one of Skilling’s closest deputies. Among Skilling’s confidants, Rice stood out as conspicuously normal. A veterinarian’s son from the prairie town of Broken Bow, Nebraska, Rice was a wrestler at the University of Nebraska, where he earned a degree in electrical engineering. Fifteen years later, he retained the clean-cut good looks, wholesome manner, and boyish charm of a college jock. Rice’s father was a frugal and demanding man who made Rice earn his spending money by yanking nails from old boards on the family farm and helping out with midnight cesareans. Never an avid student, Rice later joked that “it was easier to get a degree than tell my dad I wasn’t going to go to college.” Rice married his college sweetheart, a future pediatrician, six months after going to work as an engineer at InterNorth. He later earned an MBA at Creighton University in Omaha, then moved to Houston and started selling spot-market gas to industrial customers. It became clear that he was a natural salesman.

Because of its size and importance, the Sithe deal also served as the bell cow for Rice’s career. It brought hefty bonuses, lots of options, and big promotions. But even more than that, by vaulting Rice into Skilling’s inner circle, Sithe put Rice in a position to make tens of millions more. He went on to cut more big deals, assume top jobs in ECT, and run Enron’s high-stakes (and ill-fated) broadband venture.

Sithe made Skilling a big winner, too. In 1992, ECT’s net income more than doubled, to $122 million, making it the second-biggest contributor to En-
ron’s bottom line. When the year was over, Enron bought out 30 percent of his phantom-equity stake in ECT for $4.7 million in cash and stock. That meant that the company was now valuing Skilling’s two-year-old “start-up” at a staggering $650 million.

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Is it a surprise to learn that even as the originators were landing long-term supply contracts, they were increasingly coming into conflict with Pai’s traders? Perhaps not. There is a natural tension in any such business over how to divide the spoils. But given the ethos Skilling was instilling at ECT and that Lou Pai was running the trading desk, bitter conflict was inevitable. There was simply too much money at stake.

The traders’ power stemmed from a simple fact: they had a great deal of say in deciding just how profitable an originator’s deal would be. That’s because the deal’s profits didn’t depend just on the terms of the sale. Every bit as important was the spread between the agreed-on sale price for the gas and what it would cost Enron to supply that gas. Yes, the finance group was negotiating agreements with gas producers to buy some of what was needed, but the trading desk had to round up a lot more.

With each big new origination deal, more and more of the burden for meeting the demand—and hedging the price risk—fell to the traders. For short-term deals, the New York Mercantile Exchange prices provided a benchmark. But there was no NYMEX futures market beyond 18 months. Prices for 20-year deals like Sithe were set by deploying models and plotting curves, models and curves that were, at best, educated guesswork and, thanks to Pai’s clout, set at the discretion of the trading desk.

There was some justification for the traders’ power in setting prices. Long after the originators had gotten their big bonuses and moved on to other deals, the traders were still going to have bear the risk that the contract would become unprofitable. (It was impossible to fully hedge a deal like Sithe.) They needed to build in some cushion so that they could increase their chances of making money even if prices changed over time, as they surely would.

But the disputes that took place between the traders and the originators over how to price a deal went far beyond normal corporate infighting. They turned into pitched battles over how much each camp—traders, marketers, and finance—got to claim from a deal’s profits. One executive likened the process to what happened when a village woodsman hauled in a big kill. “At Enron, you had hunters, skinners, and hangers-on. You’d get a big carcass that the organization would dive all over and strip of all the value—skin, bones, and meat.”

If it meant more money for him and his group, Pai was more than willing to cheat his ECT brethren. One former trading executive recalls that when finance executives approached him on the trading floor to obtain prices for selling the gas they’d acquired from a producer, Pai, behind his back, would secretly signal thumbs-down, meaning that the trader should quote a below-market price. And when a marketing originator came to the trader to get a price for
buying
gas, Pai would give a thumbs-up, to quote an above-market price. The effect of this would be to steal some of the expected profit spread for the trading desk from the deal makers. “The line is you show them the same price you’d show anybody else that called on the phone or better,” says the trading executive. “If you’re showing them a worse price than you show Morgan Stanley, you’re screwing them. Lou took me aside on more than one occasion for not taking enough money out of the transaction for the trading desk.” Of all the corrosive things Lou Pai did at Enron, nothing did more to emphasize the mercenary nature of life at Enron and undermine any vestige of teamwork. But Skilling, ever the believer in creative tension, didn’t see a problem.

The battles between the traders and the deal makers were also aggravated by cultural differences. The origination teams cultivated personal relationships with customers and hammered out deals with them over many months. The traders did business by phone and computer in a matter of seconds. The originators viewed the traders as bloodless mercenaries, who, as one prominent member of the group put it, “would sell their mom for a buck.” The traders viewed the originators as dinosaurs, destined for extinction; they believed they were bringing harsh economic efficiency to what had long been a good-old-boy business.

This conflict climaxed every six months, the result of another innovation Skilling had imported from his consulting days: an elaborate peer-review system. At McKinsey, Skilling had served on the powerful committee that assessed the performance of all consultants worldwide. One of the first things he did upon joining Enron was set up a similar system, officially called the Performance Review Committee (PRC).

Early on, when ECT was still small, the PRC seemed a useful innovation. It swept out obvious deadwood and identified and rewarded up-and-comers. But over time, its goals were distorted, and the PRC had more to do with manipulating the system than with honestly evaluating talent. Employees called it “rank-and-yank.”

Twice a year, every ECT employee (except Skilling), from managing director down to secretary, underwent individual review. It began with extensive written “feedback reports” from bosses and colleagues that assessed their performance on five sets of criteria. The real action took place at a string of marathon sessions held at local hotels, where panels would debate and rank each employee on a scale of 1 to 5—1 being the best and 5 the worst—while the individual’s photo was projected on a screen in front of the group. Most of the ranking categories involved collaborative qualities, such as “teamwork/interpersonal” and “communication/setting direction.” What really counted, though, was the bottom line. “If they were making money and being total jerks to people, we’d always forgive them for that,” says one early ECT executive. “They might be a 5 in teamwork, but if they were a 1 in earnings, they were a 1. If you weren’t doing deals, we had trouble valuing your contribution to the company.”

Still, it wasn’t all just about money. It was also about friendship. Executives simply refused to tell the truth about weak members of their team with whom they were friendly, knowing that all the other executives in the room were doing the exact same thing. Rather than reflecting a true meritocracy, the PRC became a perversion of it. “People manipulated the system,” recalls a former top executive. “It became a question of who could argue better, who could debate better, and, in some cases, who could shout the loudest.” Sometimes managers would purposely sabotage one candidate in order to ensure room at a higher level for one of their favorites.

For individual employees, the stakes were large. Those rated a 1 got huge bonuses. A ranking of 2 or 3 could cost a vice president a six-figure sum. And those at the bottom were supposed to be fired if they didn’t improve their ranking at the next PRC. Because Skilling insisted that the ranking be distributed along a curve, at least 10 percent of the workforce had to be placed in the bottom group, marked for execution.

Predictably, the sessions got ugly. Because traders and deal makers with the same title were rated together, by representatives of both groups, the PRC became a place to duke out their mutual grievances and debate their relative worth. “A trader could go out and generate $5 million of earnings in a day,” noted one early ECT hire. “The numbers can be huge. A lot of the controversy stemmed around the fact that for originators to generate the same type of earnings, the effort is ten times greater.”

And so the argument went: should a hot trading hand be more richly rewarded than a gas-supply deal that had taken nine months to negotiate? Why should effort matter as much as profits? Every single ranking had to be unanimous, encouraging horse-trading and the occasional filibuster. The entire process consumed huge amounts of time for everyone involved. Sessions for executives, where the debate got the hottest, sometimes ran from 8
A
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until after midnight. As Skilling and his defenders saw it, the PRC produced the best of Enron, rewarding brains, innovation, and dedication. But many thought it brought out the worst of Enron: ruthlessness, selfishness, and greed.