The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (22 page)

Now it was Skilling’s turn to be furious. More determined than ever to unload EOG, Skilling sent Baxter to negotiate with Hoglund directly. After weeks of bitter talks, Hoglund won EOG’s independence. Enron would sell the bulk of its stake in EOG, mostly back to the company. In return, Enron would get $600 million in cash and EOG’s holdings in China and India. At the time of the deal, EOG stock was valued at about $22 a share. When the brutal negotiations were finally over, Baxter, who was largely outmaneuvered by Hoglund, sent his crusty adversary a huge bouquet of flowers, accompanied by a conciliatory note: “Forrest: We finally got the right deal done.” Hoglund sent Baxter a droll response: “Dear Cliff: There’s no question we finally got the right deal done. But what you need to understand is that I’m from the Midwest, and I think this means we’re engaged.”

After the EOG spinoff was complete, Hoglund retired, turning the company over to his second in command. Sure enough, by the end of 2000, EOG’s stock had risen to $54 a share, more than twice the value at which Enron had sold it. In his eagerness to unload Enron’s EOG stake, Skilling had left more than $1 billion on the table.

 • • • 

Don’t think for a minute that Skilling had forgotten about Rebecca Mark—or that she had forgotten about him. Mark was furious about Skilling’s promotion. It meant that Ken Lay had lied to her: he had said that he wasn’t going to replace Kinder anytime soon.

With Skilling in charge, Mark’s charmed career at Enron was not likely to be charmed much longer. Skilling had long been her chief in-house critic, disdainful and suspicious of her deals and her operation. But as long as they’d been equals, she’d been able to fend him off. Now that Skilling was her boss, she darkly suspected that her days at Enron were numbered. In this, she was completely right. Over the next two years, the two became locked in the business equivalent of guerilla warfare. It was a war Rebecca Mark never really had a chance to win.

In later years, the media explained the divide between Skilling and Mark as a fundamental difference of business philosophy: Skilling believed Enron’s future lay in what came to be known as his asset-light strategy, driven by brainpower not physical infrastructure. As Mark herself liked to put it: “Oh, Jeff just hates assets.” And of course Mark’s division was nothing but hard assets.

But that was never quite right. Physical assets were always the foundation for Skilling’s own business success. Enron’s pipeline system revealed the secrets for making a fortune trading natural gas; the Portland General acquisition provided entrée into the new world of electricity trading. Later Skilling bought paper mills so Enron could start trading pulp and paper, and a billion-dollar fiber network launched broadband trading. Skilling thought he had it down to a formula: En-
ron would buy the infrastructure needed to crack the code, build a new trading business—and then unload the assets when everybody else started to pile in. During his tenure at the top of Enron, the company spent billions on physical assets.

His problem with Mark’s overseas plants and pipelines was that he simply didn’t believe her deals made sense. There was no particular strategy driving her empire-building; she would strike deals in any country that would have her and for just about any kind of power or energy project. “When they found a deal, they did a deal,” recalls a former Enron executive. “It was buckshot all over the globe.” Mark used to speak nobly about helping the world’s underdeveloped nations. But, as this same executive pointed out, “bringing technology and light to people in darkened states is not a business.” Skilling believed that Mark’s projects could be justified only if their returns were extraordinarily high, because the risks she was taking in volatile emerging markets were enormous. And in his opinion, the returns just weren’t there.

Not that he had any way of knowing for sure. That was another of his beefs: her international deals routinely sidestepped internal corporate review. Skilling complained it was impossible to get good numbers from Mark. Even as her peer, back when he’d been running ECT, Skilling had argued that his own risk-control group should be charged with reviewing her deals. Intent on maintaining her autonomy, and suspicious of Skilling’s motives, Mark had beaten back the effort. But Skilling had managed to make other incursions. In 1993, he took over responsibility for all North American power plants, which had been part of Wing’s old empire. Soon he was given responsibility for England as well.

Then there was the matter of compensation. Nothing bugged the executives at ECT more than knowing that Mark and her developers were paid huge bonuses without regard for how their deals turned out. Mark, for example, received bonuses of $1 million to $2 million, even for some small Enron International projects. As the ECT side saw it, this provided a mindless incentive for the developers to keep building—and gin up a rosy projection to justify it.

Valid as the criticism was, it contained a large element of hypocrisy. After all, ECT’s traders and originators were also richly rewarded up front based largely on their own long-term profit projections, which could be every bit as rosy. And unlike the traders, the international developers often put in years of work on a project before getting a bonus at all. One former Enron executive says: “It was basically prima donnas accusing other prima donnas of being a bigger prima donna.”

Still, bringing Mark to heel was not going to be easy; her projects had enormous momentum. Nonetheless, Skilling began the process of slowly clipping her wings. His first big move after becoming president was to pitch Lay on the idea of giving him responsibility for all of Enron’s operations in western Europe. His reasoning was that Enron’s plants could be used as a platform for building a regional trading and marketing business, in essence, a foundation for a global ECT. Besides, the plant developers needed ECT’s trading and risk-management expertise. Hadn’t the J-Block disaster proven as much?

Mark objected bitterly and lobbied Lay to let her keep that part of her empire. The fight came to a head at an Enron off-site meeting in San Antonio, where Lay convened a meeting with the principals. Mark made the case that her people knew Europe and Enron’s projects there best; she viewed Skilling’s proposal as a brazen power grab. “As soon as we build something,” she said, “you want to take it away!” When it became clear that Lay was siding with Skilling, Mark and her deputy, a former military man named Joe Sutton, got up and stormed out of the meeting.

Mark later described the resulting encounter with Lay to friends. “I’ve never had anyone walk out on me in my whole business career,” he told her.

“Ken,” Mark responded, “all you want is what Jeff wants.”

To the outside world, Rebecca Mark was still riding high.
Fortune
put her on its list of the 50 most powerful women in American business. Media profiles gushed that she had a shot at eventually replacing Lay as CEO.

But Mark knew the battle was lost. She was desperate for a way out of the company and away from Skilling. She was contemplating quitting when another idea landed in her lap: selling Enron International to Shell. Skilling agreed to consider it, as long as Cliff Baxter served as lead negotiator. Discussions went on for months. Lay, in the summer of 1997, sat down for lunch with a top Shell executive. A price tag was even batted around: as much as $3 billion for a 50 percent stake. But there was never a formal offer on the table. A Shell negotiator says the company was worried about the cultural fit, among other things. Mark blamed Baxter and Skilling for mismanaging the negotiations.

During that same period, something truly curious happened. During the summer of 1997, Mark invited Skilling to spend a week with her touring development prospects in South America, and he accepted. She had employed this tactic before, with board members. She’d taken them overseas, wined them and dined them with high-ranking officials, given them tours of the projects, and explained the good they might do someday. It worked like magic.

Amazingly, her tour had the same effect on Skilling. He came back eager to pour money into the continent’s southern cone. Of course, he used the classic Skilling rationale: if Enron could build a critical mass of infrastructure in South America, it could leverage those assets into a big new trading business. “South America—awesome story,” he gushed at an Enron employee meeting in May 1999. “. . . South America may be our strongest network in the world. . . .” Skilling was so jazzed about his visit he even bought a beach house in Brazil with an executive from Enron’s South American operations. The transformation was so dramatic that rumors started flying that the ever-beguiling Mark had—literally and figuratively—seduced him. (Both have denied any personal involvement.)

Nevertheless, Skilling continued to make Mark’s life miserable, gradually stripping Enron International of its independence. By May 1998, she’d finally had enough. Mark handed her post as CEO of Enron International to Joe Sutton while remaining EI’s chairman. She also became an Enron vice chairman, a title known internally as “the ejector seat” because it was viewed as the first step out the door.

And yet when you look back on the two years the two battled for control of Enron International, one striking fact stands out above all else: in all that time, Rebecca Mark kept striking deals and building power plants. And Skilling, for all his talk about how poor her assets were and how unreliable her numbers, never shut off the flow of Enron’s cash—and never shut down her deals.

Skilling later explained that it was politically impossible for him to stop Enron International dead in its tracks. In addition to Lay’s favor, Mark had strong support from the board. “I should have thrown myself under the truck on some of them,” Skilling later told friends. “But what would it have accomplished? I didn’t feel like I was in a position to stop it.” But the irony remains: Skilling, who today blames Mark for spending Enron into bankruptcy, signed off on many of her projects.

 • • • 

Enron being Enron, Mark got a rich new contract when she left her job running International, with a $710,000 salary and 450,000 additional stock options. (In 1998 and 1999, Enron also forgave over $1.6 million in loans.) And Mark being Mark, though she’d been relegated to the sidelines, she didn’t stay there for long. Just a month after her appointment as vice chairman, she proposed to the board that it allow her to lead Enron into a business it was already contemplating: the business of water.

Mark wanted to buy a British water utility, called Wessex, as the opening move in building a new Enron subsidiary that she would run. The cost would be $2.4 billion. Water was a treacherous game, dominated by the French giants Vivendi and Suez Lyonnaise des Eaux. The politics of water were complicated, the profit margins razor thin. The companies that succeeded in the business understood how to keep costs to a minimum, not exactly Enron’s strength.

But Mark made a compelling case. “The world’s running out of water,” she declared. The water business was going to be deregulated—right up Enron’s alley. It was an unparalleled opportunity, she insisted. Mulling over the issue, the directors wondered what their fellow board member, Jeff Skilling, thought about the idea.

“If it works,” he said coolly, “it could be a good business.” What Skilling thought to himself but didn’t say aloud was that approving this deal would get Rebecca Mark out of his way, once and for all. The price of the acquisition was steep (as Skilling figured it, she was overpaying by about $200 million), but that never bothered him. Besides, under the terms of her deal, she’d have to raise all additional capital on her own. If she failed, well, that would be her problem. For all these reasons, it seemed to Skilling that it was worth doing, regardless of whether it made sense for the company.

Even with Skilling’s blessing, not all the directors were convinced. When it came time to vote, two directors voted against the acquisition, the only time in recent memory that an Enron board vote was not unanimous. Still, it went through, and Rebecca Mark was back in business.

She originally wanted to call her new company WaterMark. Instead, she chose Azurix, a name that was devised by a brand consultant. It would only take a few years before Mark’s new company, with its fancy new name, would provide the first visible crack in Enron’s facade.

It is utterly beyond question that in reshaping Enron after he was named its president, Skilling turned it into a place where financial deception became almost
inevitable.

In no small part, that’s because there were so many other kinds of decep-
tion taking place. Skilling created a freewheeling culture that he touted as innovative—but didn’t rein in the excesses that came with it. He preached the gospel of intellectual capital, claiming that it was critically important to give smart people the resources and freedom to let creativity flourish, but looked the other way when this became a license for wastefulness and self-indulgence. He bragged about Enron’s sophisticated controls but undermined them at every turn. He was openly scornful of steady, asset-based businesses that grew slowly but generated cash—then swept them away to make room for a series of ever-bigger, ever-riskier bets that brought in almost no cash at all.

Worst of all, Skilling created impossible expectations and unbearable internal pressures by holding Enron out to Wall Street as something that it simply wasn’t. He created a wild, out-of-control experiment yet presented it as a well-oiled machine that generated steadily growing profits. He offered the world a powerful, even charismatic, vision of the new Enron. But the Enron Skilling was describing—and which by 1998 Wall Street and the press were once again lapping up—wasn’t even close to reality.

 • • • 

Consider the issue of risk. It would be hard to think of a more important concept for Enron than managing risk. Traders risked losing money every time they made a trade. Signing long-term contracts to provide gas and electricity required understanding all kinds of risks—pricing, delivery, credit, and so on—and knowing how to hedge those risks. Figuring out whether a deal was worth doing was nothing if not an exercise in calculating risk: did the size of the potential return justify the risk of all the things that could go wrong? That’s a question that every executive at every company has to be willing to tackle. A company that lacked the ability to manage risk properly simply had no business doing the kinds of deals Enron did on a daily basis.

When reporters and analysts inquired about the company’s risk-management abilities, Skilling had a ready answer: he pointed to Enron’s Risk Assessment and Control department, known inside the company as RAC. Though Skilling had had small risk-management teams at ECT, he set up RAC as a stand-alone unit in 1996. Skilling knew Wall Street wanted to see a strong system of internal controls and after he was named president, he made RAC a centerpiece of management presentations to Wall Street analysts, investors, and credit-rating agencies. RAC was the part of the company that had the analytical skills—and presumably the authority—to prevent Enron from doing anything stupid. Skilling imposed a requirement that RAC had to review virtually all Enron deals—even international ones—and he bragged constantly about the sophisticated oversight that RAC provided, which he portrayed as sacred. “Only two things at Enron are not subject to negotiation: the firm’s personnel evaluation policy and its company-wide risk-management program,” Skilling told a corporate-finance journal.

On paper, RAC sounded terrific. Its mission was to assess the economic, financial, credit, and political risk in every Enron deal of more than $500,000. Its analysts pored over numbers, challenged assumptions, tested models, checked price curves, and monitored portfolios. It employed former bankers, accountants, statistical wizards, and MBAs—a crack team of experts in every aspect of a commercial transaction. RAC had resources, too: by the late 1990s, a $30 million budget, access to a $600 million computer system, and 150 professionals. Most of all, as Enron described it, RAC had independence and clout. The formal mechanism for expressing its findings was a document called a deal-approval sheet—or DASH. The DASH, which contained space for signatures of everyone who needed to approve the project, summarized the deal, the range of projected returns, and the risks that it presented. Later iterations of the form included a box for RAC’s recommendation: it could approve the transaction or it could tell management “do not proceed.”

The top man at RAC was Rick Buy, who had joined Skilling at ECT in 1994 after years as a vice president in the energy department at Bankers Trust. Buy was named the company’s chief risk officer in 1998 and promoted to senior vice president of Enron in early 1999, at the age of 46. Skilling described Buy as Enron’s “top cop” and frequently pointed out that he reported regularly to the audit committee of the Enron board. No one flat-out declared that RAC had veto power over a deal. But this was, after all, Enron’s
control
group. The implication was clear: if Buy thought a deal was too risky, Enron wouldn’t do it.

Thanks to RAC, Enron was able to portray itself as a company that could safely take on
more
risk than other companies, precisely because it had the right controls in place. As Buy himself once put it: “You won’t make money these days without taking on risk. We want to take on risk—a lot of risk—subject to prescribed limitations and insight into the associated outcomes. If the outcomes are palatable, we’ve got an appetite.” Indeed, Enron claimed that its risk systems were so good that there was no need to slow the frantic pace of deal making. “We move fast around here; things
cook,
” Buy explained in a promotional videotape for Arthur Andersen, Enron’s auditing firm. “I mean, it’s a high-stress, high-pressure, fast-moving place. You don’t want anyone . . . that’s going to slow you down or bog you down or not be value-added. . . .”

Wall Street was dazzled. “We rely heavily on Enron’s risk-management ability,” Todd Shipman, an analyst with the Standard & Poor’s credit-rating agency, told
Fortune.
“You can’t overemphasize how important that is. It’s the underpinning to everything. . . . It gives you a nice, warm, fuzzy feeling. . . . Even though they’re taking more risk, their market presence and risk-management skills allow them to get away with it. . . . Enron has such extraordinary risk-management capabilities that we look at them differently.” Rick Walker, managing director in the Houston office of Chase Manhattan Bank, added: “Rick has figured out how to profit from risk. Consequently, Enron has become a company defined by the way in which it handles risk.”

But how much of the RAC story reflected the reality of life inside Enron? It was certainly true that RAC had substantial resources and talented analysts. But the part about RAC being a serious force within the company, able to stop bad deals dead in their tracks: that part wasn’t even close to the truth. And everyone in the company knew it. “RAC was a hurdle, a speed bump, but not an obstacle,” says a former Enron managing director. “If a deal had overwhelming commercial support, it got done. I treated them like dogs, and they couldn’t do anything about me. The process was there, sure, but the support wasn’t. If RAC had complained about me and I got paid $100,000 less bonus, I would have changed. Never happened. I told my guys to fuck ’em.” A former RAC vice president agrees: “We didn’t approve shit,” he says.

RAC’s ineffectiveness was largely a reflection of the executive Skilling picked to run it. Rick Buy was a pleasant, paunchy man with glasses—a soft-spoken sort, uncomfortable with confrontation. When his analysts raised issues with a deal, Buy would dutifully take them up the chain of command. But in a head-to-head with the company’s senior traders and originators, it was no contest, as those on both sides of the table recognized. “RAC existed to keep analysts happy, to keep the story alive,” says one veteran originator. “Buy was a decent guy but not smart enough or strong enough to be in that position.” A former senior Enron executive says: “Rick’s the right guy to evaluate the risk. He’s not the right guy to stand down the guys who want their deals done. They’d ram it down his throat.”

It is business wisdom that many of a company’s best deals are the ones it doesn’t do. That was never the belief at Enron, a place that was defined by deal making. “The corporate culture was such that you never said no to a deal,” says a Buy friend who worked in corporate finance. “It was ‘how do you make a deal work?’ ” Buy, she adds, “didn’t want to be seen as someone saying no to a deal.” In fact, Buy later insisted that saying no wasn’t even part of his job description. He eventually told his staff that RAC’s charge was simply to describe a transaction, analyze its risks and possible returns, and tell senior management: “you guys make your mind up.”

There were times when frustrated RAC executives refused to sign off on a bad deal, but Buy would overrule them. In 1998, John Hopley, who served for four years as one of Buy’s top deputies, opposed a deal promoted by ECT executives in Europe, who wanted to invest about $20 million in a British company named Techboard, which made fiberboard for kitchen cabinets. Hopley opposed the deal because the company was in the British equivalent of bankruptcy and even the originators’ projected returns—which assumed the company would be able to navigate its way out of the mess—were small. He refused to sign the DASH. So Buy signed it instead. Three months after signing the agreement, the company went into liquidation, and Enron wrote off its entire $20 million investment. “Rick and the group were under a tremendous amount of pressure,” says a former RAC executive. But Buy, he adds, “was not as forceful as he could have been in laying down the law.”

According to RAC employees, the deal makers were often allowed to set absurdly optimistic assumptions for the complex models that spat out the likelihood of various outcomes for a transaction. “Every attempt was made to really strong-arm RAC with regard to the assumptions,” says one RAC vice president. After completing its analysis, RAC had to circulate its draft comments for the DASH on a given transaction—and the deal makers actually had the right to
edit
them. When RAC employees complained, they were told to negotiate what they would say in the DASH with the deal makers. “In many instances,” says the vice president, “the actual drafting of the language was done with an originator at the same table, very much suggesting the language that should go in there.”

Often, entire deals went to RAC just a few days before the close of the quarter, leaving little time to scrutinize transactions involving hundreds of millions of dollars, and putting enormous pressure on RAC to sign off, because the company needed the deals to hit its numbers. “The mentality was to do whatever they can to go over, under, and right through us; that was the objective,” says one RAC veteran.

The performance-review process was another way the deal makers beat RAC into submission. Incredibly, traders and originators sat on panels that ranked the same RAC executives who reviewed their transactions. Everyone was supposed to act honorably, but there were clear opportunities for retaliation (“he doesn’t cooperate; he’s hard to deal with”), and Buy wasn’t able to protect them. “If you really pissed off an originator, that came up in the PRC,” says a RAC vice president. “Those guys could really tag you and tag you hard. You could get knocked down from the first or second group to the third or fourth group,” for some RAC executives, enough to make a six-figure difference in their annual bonus. And some originators didn’t hesitate to use this very threat as a club during negotiations with RAC, warning the deal analyst: “This deal’s going to get done whether you like it or not. If your name’s not attached to it, it’s going to look bad for you.”

Buy agonized constantly over his situation. One Enron originator remembers him complaining over lunch in early 1999 that “he had a real problem with the job: he felt like he didn’t matter. I said, ‘Quit!’ ” the dealmaker recalled. “He said, ‘I have to stay because I’m making a ton of money.’ ” Buy’s cash compensation hit $400,000 in 1999, but his big money loomed from stock options, and he’d need to stick around for a couple of more years for most of them to vest. (In 2001, Buy unloaded Enron shares worth $4.3 million.)

Did Skilling realize how ineffectual Buy was? In fact, he did. He used to tell associates that Buy wasn’t strong enough to stand up to the deal makers; when Skilling left Enron, he even told Ken Lay to replace Buy with someone tougher and more aggressive. But if he understood that, why didn’t Skilling replace Buy himself? In private meetings with those who raised this issue, Skilling argued he could personally make up for Buy’s weakness because he was so aggressive in challenging deals himself.

This was one of Skilling’s delusions, though. In fact, in his own way, Skilling was as big a problem as Buy. He personally approved some deals even when he was openly skeptical, especially if they were backed by one of his trusted deputies. “I don’t like this deal. I
hate
this deal!” Skilling would announce in a meeting. Then he’d look over at the senior deal maker backing the transaction and tell him he was getting a pass: “If you really want to do it, this is your silver bullet, but I’m going to hold you responsible.” After recounting how the scene too often played out, one RAC executive slowly shook his head: “There were a lot of silver bullets.”

After Enron fell, Skilling continued to defend his system, blaming RAC’s weakness on Buy for failing to use the power he’d been given. But Amanda Martin, the former Enron executive who once presided over the ECT deal makers, believes that Skilling’s selection of a “meek” chief risk officer was no accident: “If Buy had said, ‘I will not sign off—I will go to the board,’ Jeff would have caved and killed the deal.” As Martin sees it, Buy’s refusal to press the issue allowed Skilling to maintain that he always respected the integrity of RAC. If Buy had gone to the board, she says, “He would not have had the plausible deniability he wanted. Jeff played chicken, and he never got run off the road.”

 • • • 

So much of the culture Skilling instilled at Enron was just like RAC: it sounded great in theory, but the reality was something else entirely. Skilling used to say that a culture that supported innovation, as Enron’s did, needed to be willing to accept failure: “I’ll take a smart, thoughtful guy who fails over a person who is successful,” he declared in one interview. But what company can afford to hang on to executives who fail too often? At Enron, though, there was virtually no consequence for cutting a bad deal. Skilling might say he was going to hold deal makers responsible, but he rarely did, and the deal makers all knew it. On the contrary, by the time it was clear that the deal had gone south, the originator would have gotten his bonus and moved on.