The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (19 page)

His top executives were also dismayed at the way he and his family openly fed at the Enron trough. “If you’re the CEO of a public company, it isn’t yours,” says a former executive, but Lay seemed oblivious of such distinctions. Over the years, he seemed to have cultivated a powerful sense of personal entitlement. Not only did he use the company’s fleet of airplanes for his private use; so did his children. Enron employees called the planes the Lay family taxi, so frequently did family members use them. Linda Lay used an Enron plane to visit her daughter Robyn in France. Another time an Enron jet was dispatched to Monaco to deliver Robyn’s bed.

An even bigger issue was nepotism. Ken and Linda Lay had five children between them; four of the five worked at either Enron or Azurix, a water company Enron started in 1998. Enron employees were encouraged to make their travel plans through Lay/Wittenberg Travel Agency in the Park, which was 50 percent owned by Lay’s sister Sharon. In fact, Lay himself initially owned a minority interest in the travel agency, which he sold after being warned about the impropriety. Early on, following the advice of an Enron lawyer, Lay agreed to put Enron’s multimillion-dollar travel account out to bid. On one occasion, according to two people involved in the process, when an overzealous Enron administrator hired an outside consultant to oversee the bidding process, Lay’s sister actually lost. So she was then given an opportunity to match the low bid. Travel Agency in the Park retained Enron’s account as long as Ken Lay remained at Enron. In just two years, 1997 and 1998, Sharon Lay’s agency earned $4.5 million in commissions thanks to Enron.

And then there was Lay’s son, Mark, who was one of Skilling’s first employees. After leaving Enron, he eventually joined a small company called Bruin Interests, which had contracts to store natural gas in facilities owned by Enron. In late 1994, lawsuits were filed alleging that Bruin’s executive team, including Mark Lay, had embezzled more than $1 million from a bankrupt company that Bruin had bought earlier that year. According to the
New York Times
, the U.S. attorney decided not to pursue the criminal case, but Mark Lay paid nearly $315,000 to settle a related civil suit. (He later told the
Times
that he “trusted the wrong people and ended up in a transaction that everybody decided was wrong.”) While some of this was still going on, Enron decided to do a deal with another small company that Mark Lay had gotten involved with. Enron agreed to reimburse over $1 million of this company’s expenses; as part of the deal, Mark got a three-year contract with Enron guaranteeing him almost $1 million in salary and bonuses, plus 20,000 Enron options.

•  •  •

 • • • 

Ken Lay’s increasing distance from Enron didn’t matter very much to the executives under him. After all, Rich Kinder was running the show.

Kinder had mellowed a bit since his early days as chief operating officer. Though he still presided over a brutal weekly divisional meeting every Monday morning, he no longer reduced employees to tears, as he once had. Even so, he remained a demanding boss. Once, during a performance review, he told an employee that she’d done a great job, but then only gave her 2 on a scale of 1 to 5. Why, she asked, hadn’t he given her a 1—which stood for excellent? “Nobody’s excellent,” Kinder responded.

Unlike Lay, Kinder was an utterly practical businessman who saw his job as solving problems and making sure Enron delivered on the earnings targets it promised to Wall Street. Every year, he created a list of Enron’s top ten problems—its alligators—and spent the rest of the year working relentlessly to kill the alligators. He understood the innards of Enron’s various businesses, even the new one Skilling was building. And he commanded respect from Enron’s top executives in a way that Lay never did. “Lay was not a good manager,” says one former executive flatly. “Kinder was a good manager.”

Although they got along, there was always some underlying tension between the two men. Lay seemed to look down his nose at Kinder, according his talents limited value, and viewing him as having too many rough edges. “Ken was the visionary, and Rich was the deep-down operator, who would go beat up people,” says a former high-ranking executive. “It was like the patrician who has to hire the Mafia.”
Kinder seemed to resent Lay’s condescension. The Enron CEO failed to appreciate that it was the company president—and his willingness to roll up his sleeves—who made his grandiose lifestyle possible. “There are lots of visionaries,” says one longtime friend of Kinder’s. “There are very few people who can actually run a company.”

Kinder had another issue: he badly wanted to be Enron’s CEO. In the early 1990s, Lay had promised to hand over the top job to Kinder but had second thoughts, and concluded that he wasn’t ready to give up his position. At the time, Kinder agreed to stay on as his number two, but in his next employment contract, he negotiated a provision stating that if he and Enron were “unable to agree upon an acceptable employment position,” Kinder could leave the company, and his outstanding loan would be forgiven. Though it wasn’t spelled out any further, both Lay and Kinder understood what the language meant: that at some point in the not-too-distant future, Lay would make Kinder the CEO of Enron. From Kinder’s perspective, that was the only “acceptable employment position.” And, according to Enron executives close to both men, Lay had assured Kinder that would happen when his own contract expired at the end of 1996.

In the aftermath of the Enron bankruptcy, there are many in and around the company who embraced the theory that it might have been avoided if Lay had kept his promise and made Kinder CEO. Many former Enron executives believe that he tempered the company’s natural aggressiveness and brought a sense of discipline it badly needed. He was also the one person at the top of Enron who looked skeptically at things, consistently asking, “Are we smoking our own dope? Are we drinking our own whiskey?” After Kinder left, this theory goes, the inmates were running the asylum.

But to view Kinder simply as the white knight who got away is to ignore a more complicated reality. In truth, some of the seeds of Enron’s downfall were sown on Kinder’s watch. It wasn’t just Ken Lay and the board who signed off on Skilling’s use of mark-to-market accounting; so did Kinder. And if Kinder ever actually confronted Lay about his own blind spots, it doesn’t appear to have produced tangible results.

Kinder was also every bit as focused as Lay and other Enron executives on making Wall Street happy, thus ensuring that the stock would go up. Analysts and investors, many of whom viewed Lay as useless (“Ask a candid question, get a canned answer,” says one), vastly preferred dealing with Kinder. He was the one who told them what numbers to expect and the one who delivered on that promise. He knew how to sell the Enron story, which he did (along with Lay and other Enron executives) at extravagant ski retreats Enron threw for analysts and big institutional shareholders.

Kinder was also the one who told Enron’s division heads the earnings they were
really
expected to deliver each quarter. Invariably, Kinder would accuse them of “sandbagging” him with lowball estimates and force them to stretch. “That’s bullshit,” he would say. “My grandmother could make $50 million. You can make $60 million.” For this, the Enron COO made no apologies; he believed in setting the bar high and forcing people to jump over it.

But given the kind of company Enron was, the bar was hard to jump over consistently. And thus did Enron begin turning to aggressive accounting tactics, tactics that planted those dangerous seeds. The things Enron did in those early years were not illegal, nor did they push the boundaries anywhere near as far as it did later in the decade. But they did help mask certain unpleasant financial realities, and they pushed the company into accounting’s gray zone. Kinder, though, had a sense of where the limits were—and he knew how to maintain control. Had he stayed, Enron’s highs would never have been as high. But the lows would never have been as low.

 • • • 

Fifteen percent a year. That’s what Enron was promising investors: that its earnings per share would grow at a clip of 15 percent a year.

That was an admittedly aggressive target, but if Enron could deliver, the company would be handsomely rewarded. Companies that grow at double-digit rates are classified by investors as growth companies, and they tend to have higher stock valuations than slower-growing companies. This was never truer than during the bull market of the 1990s, an era when growth companies were the only kind of companies investors wanted to buy. Internet stocks were growth companies, of course, and so were big technology companies like Microsoft and Cisco and Sun Microsystems. Every company, it seemed, was striving to become known as a growth company. The problem is that whenever a growth company disappoints Wall Street—when it announces earnings that don’t meet the aggressive target it has set for itself—the punishment is usually severe. As rapidly as growth stocks can run up when the news is good, they can spiral downward just as quickly when the news is bad.

At Enron, as at many companies in the 1990s, a big incentive for achieving double-digit earnings growth was that it would make its executives rich. With so much of their compensation tied up in stock options, Enron executives cared deeply about seeing the stock rise as rapidly as possible: a rising stock had the potential to make them millionaires. For Kinder and Lay, it was even more explicit: it was written into their employment agreements. In early 1994, the Enron board awarded the two men enormous options packages: 1.2 million options for Lay and another million for Kinder. The vast majority of the options—80 percent—did not vest until the year 2000, meaning that the two men would not be able to cash in the options until then. But there was another provision: if Enron delivered at least 15 percent annual growth, a third of their options would vest each year. That one clause was worth millions to each man.

But how was Enron going to hit that growth target? It wasn’t easy. Despite Skilling’s traders and Mark’s international deal makers, it was still an energy company, with an energy company’s issues. The pipeline division had become solidly profitable, but it was never going to be a fast-growing part of the company. In 1993, the pipeline division made pretax profits of $382 million; the next year, pipeline’s profits rose to $403 million—for a growth rate of just over 5 percent. Enron had a division called Enron Oil and Gas, its exploration and production arm. That part of the business was downright turbulent, with profits plunging one year, skyrocketing the next. Volatile earnings may reflect the way many businesses work, but they’re not rewarded by Wall Street, which values consistency above all else. Skilling’s ECT was generating the kind of fast-
growing earnings Enron wanted, but that brought its own set of pressures: every time Skilling’s group found a new profit center, competitors would quickly copy it, and the easy profits would vanish. And though Teesside was generating big profits, many of Mark’s international deals were not yet money-makers. Theoretically, the vast bulk of international profits would come once her power plants and pipelines were up and running.

One way Enron managed its earnings, even then, was by reworking its long-term supply contracts—which would then allow it to post additional earnings, thanks to mark-to-market accounting. The company also sold assets and made other “nonrecurring” moves to meet its earnings targets. But it didn’t always label these as nonrecurring events; Enron simply declared them part of its ongoing operations. For instance, between 1994 and 1996, Enron reduced its stake in Teesside from 50 percent to 28 percent and folded the gains it reaped from selling the stake into its earnings. Back in 1989, Enron had raised needed cash by sell-
ing a minority stake in Enron Oil and Gas through a public offering; six years later, the company sold more Oil and Gas shares to the public, generating an additional $367 million in pretax profits.

Were these transactions hidden from the investing public? No. Enron’s brass didn’t go out of their way to point them out, but for anyone willing to wade through the company’s financial documents, the numbers were clear. From time to time, an analyst would ask some tough questions or a reporter would write a story that raised what would seem now to be obvious objections to Enron’s modus operandi. In 1993, Toni Mack published a story in
Forbes
entitled “Hidden Risks,” in which she questioned the use of mark-to-market accounting in Skilling’s business. “If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income,” an Enron competitor told Mack. A few years later, a journalist named Harry Hurt III wrote an article in
Fortune
about, as he put it, Enron’s “allegedly byzantine methods of managing earnings.” Hurt noted that when you stripped a few of the onetime gains out of Enron’s seemingly healthy 1995 earnings, including the profit Enron recorded for selling shares of Enron Oil and Gas, 1995 hadn’t been such a good year after all. Without those gains, Enron’s profits actually
fell.
But stories like that were soon forgotten.

There’s another tactic Enron used during the Kinder years that deserves special attention; in retrospect, it was a harbinger of things to come. In 1994, Enron created a spin-off company called Enron Global Power and Pipelines (EPP). Its stated purpose was to purchase Rebecca Mark’s assets from Enron, thereby taking them off Enron’s balance sheet and freeing capital for Enron to reinvest. (For instance, Enron planned to sell EPP 50 percent of Dabhol.) There is nothing remotely illegal about this; in fact, Coca-Cola spun off its bottling system for much the same reason. But there was also a second benefit: by selling assets to EPP, Enron could realize profits at once, which would help it hit its earnings targets instead of waiting for them to drift in over the years. In a sense, it was analogous to Skilling’s use of mark-to-market accounting for ECT.

Here was the rub, though. Enron couldn’t simply sell the international projects outright. Why? Because the various agreements it had with its lenders and partners often required it to maintain a majority ownership of the assets. Yet under accounting rules, if Enron were deemed to control EPP, it would not be allowed to realize profits when it sold stakes in the assets to EPP. It was a classic catch-22, difficult even for clever accountants and lawyers to get around. Nevertheless, Enron and its accountants at Arthur Andersen (and its lawyers at the blue-chip Houston firm of Vinson & Elkins) managed to find a way. Enron, they decided, would retain slightly more than 50 percent of the assets, but it would set up an oversight committee consisting of three directors who would independently approve every transaction. Astonishingly, Arthur Andersen agreed that this would mean Enron didn’t control EPP and could therefore book profits when it sold assets to EPP. It was, all in all, a remarkably sleazy solution. For their work, Arthur Andersen was paid $750,000 and V&E $1.2 million. Oh, and the chairman of EPP? That was Rich Kinder.