The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (35 page)

Then, of course, he began to see what happened to the stocks of Internet companies. He also had a second reason for changing his mind: Enron’s traders had gotten enthused about the idea of trading bandwidth—capacity on the fiber-optic networks that Enron and others were building. It made at least theoretical sense: Internet data moved along fiber networks that crisscrossed the coun-
try, just like natural gas and electricity. Why couldn’t Enron trade bandwidth capacity in the same way it traded natural gas?

Suddenly, Hirko’s little telecom business was starting to look like a knock-
off of the power-trading business—only better. According to Skilling’s back-
of-the-envelope calculation—“horseshoes and hand grenades,” he liked to call it—Enron’s market value would increase by $20 for every dollar the company invested in a broadband venture. Thus, a $1 billion investment would add $20 billion in market capitalization. Whether the business would bring in cash or profits (and how long that might take)—those were different issues. If broadband could quickly get him another $20 billion in market cap, he was all for it. “I’ve always believed there’s no such thing as a free lunch,” he later told associates, “but this looks like a free lunch. I’ve never seen economics like these numbers.”

In the summer of 1999, Skilling flew west and met with the employees of the new division in the lobby of their start-up offices above the beer vats at a popular restaurant in a historic building in downtown Portland. (Internet companies all had to have funky quarters; it was part of the ethos.) Skilling told Hirko’s staff that he had great news: they were about to become a core business for Enron. This meant two things. First, Enron was prepared to spend up to $1 billion to build the business. Second, it meant that its center of gravity would inevitably shift to Houston. “We’re all going to make a lot of money together,” Skilling happily declared.

But the Enron president didn’t get the exultant reaction he’d expected. Hirko’s troops were looking for an even quicker payoff. They had stakes in the broadband subsidiary and had been hoping Skilling was going to announce that Enron planned to spin them off through one of those hot tech IPOs. Skilling’s announcement meant they’d end up with shares of
Enron
stock instead. There was another issue, too: none of them wanted to move to Houston.

Back in Texas, however, the word quickly spread: broadband was Skilling’s new “it” business. The klieg-light syndrome immediately kicked in. Tracy Smith, the Portland division’s marketing director, recalls arriving in Houston, where she began spending much of her time, and finding dozens of new employees, none of whom had any experience in technology or telecommunications. “Whole groups from other business units, with 20 people, would transfer in,” says Smith. “You’d ask them what they were going to do, and they’d say, ‘I don’t know.’ It was their job to figure out what they should do. They’d come up with minibusiness plans.”

The Portland staff soon grew to 300. Enron moved them from their cool offices above the brewery to more expensive digs in a downtown office tower. But because so much of the business was being conducted in Houston, many of the employees didn’t spend much time in their new offices. An Enron jet began a regular shuttle service to Texas, leaving Oregon Monday morning and returning Friday afternoon.

There was another big sign of how much Skilling was making broadband his own. In mid-1999, he asked Ken Rice to leave his top job at ECT—which had been renamed Enron North America—and run this new business instead. Worried that the engineers and the rest of the Portland staff would bolt, Skilling also wanted to keep Hirko on in Portland, with an informal arrangement that he and Rice serve as co-CEOs.

Rice wasn’t enthusiastic about the idea. A skilled deal maker for many years, Rice by then was 41 years old. He was rich, and he was tired, and he was in the throes of a midlife crisis. His relationship with Amanda Martin, which was finally over, had taken a toll. Martin and her husband had divorced in 1997, and that year Rice had filed to end his own marriage, too. But he delayed the suit after discovering that his wife was pregnant with their fourth child, and the Rices later reconciled. In the midst of it all, he’d entered counseling and begun taking antidepressants. Unwilling to keep working long hours, he’d also found other distractions: he was planning a vacation home in Telluride, Colorado; he’d started cutting out early to spend time with his kids; and he’d developed a fascination with racing Ferraris and expensive motorcycles. These were his passions now, not Enron.

Rice didn’t like the awkward co-CEO arrangement either. But Skilling pleaded with him. So much was at stake: he was desperate to plant a trusted ECT hand in this new broadband business. Skilling promised to make Rice an offer he couldn’t refuse. “You know I’m going to take care of you,” he told Rice. “Just make it work.”

Rice finally relented—and Skilling did take care of him. The following February, his amended contract was approved by the Enron board. Rice received a base salary of $420,000. He would get a cash bonus of $1.75 million. And he received a stunning package of almost 1.8 million stock options, which he’d be free to cash in unusually early. Some 346,154 of the options would vest immediately, another 771,154 in just a year, and 425,000 more in just two years.

Running Enron’s broadband business would add tens of millions to his fortune. Still, Rice came to regret having given in to Skilling’s pleas. Accepting the job, he later privately confided, “was probably the biggest mistake I could have made.”

 • • • 

It didn’t take the new broadband employees long to learn what it meant to work for Enron. Dozens of them who lived out of town were put up in corporate apartments, at $3,500 a month each. A midlevel salesman on a business trip to Los Angeles rented the penthouse suite at one of the most expensive hotels in town. Small tech companies were acquired, consultants were retained, reports were commissioned, parties were thrown. “No expense was spared,” recalls Tracy Smith. “It was just the Enron culture.”

Because she was new to Enron, Smith was struck by things that most Enron employees had long since taken for granted. The abrasive, cutthroat culture. The condescension toward anyone who didn’t work at Enron. And always, the obsession with the stock price at every level of the company. “Everywhere you looked, the stock ticker was going,” said Smith. “In the lobby of the building. In the lobby on your floor. It was on the screen of your computer. Everybody was focused on the stock price. You couldn’t get away from it. When the stock wasn’t doing well, the mood changed.”

By late 1999, Skilling thought Enron had the makings of a hot new business. Its foundation would be the sophisticated cross-country fiber-optic system it was building; they dubbed it the Enron Intelligent Network. Enron claimed that its system would transform the Internet by providing bandwidth and switching capacity to distribute TV-quality video and other content rapidly and at a reasonable price. And it had other plans, too. It would create a market in bandwidth trading, which it believed it could launch, then take to critical mass in the span of just two years. Finally, Enron had a team working to develop content, to figure out how to send high-quality entertainment and other video over the Internet with no delay.

In late 1999, Skilling began making plans to unveil this vision to Wall Street. He had laid the groundwork with a flurry of press releases, announcing an assortment of minor acquisitions, alliances, and developments. In December, Enron announced that it had executed the first bandwidth forward trade, with Global Crossing. “This is Day One of a potentially enormous market,” Skilling told a Houston reporter.

The big splash was to come at Enron’s analysts’ meeting, scheduled for January 2000. The business was set to debut with a brand new name. Up until then, the business had been known as Enron Communications. The new name was Enron Broadband. It conveyed exactly the right message. “Wall Street was into broadband,” says marketing director Smith, recalling the thought process be-
hind the new name, “and if we put broadband into our name, that would mean everything.”

And for a little while, it did.

Enron’s top executives may well have believed their own rhetoric about the company’s two big new businesses—that they would one day be huge and successful and generate billions in real profits. And that, in turn, might allow the company to wean itself from the machinations it so depended on to book earnings and impress Wall Street. But in the here and now, EES and broadband had exactly the opposite effect: because they chewed up so much capital while generating so little cash, their existence made the company even more dependent on Andy Fastow.

In his two years as corporate-finance czar, Fastow had employed creative forms of financial chicanery to dress up Enron’s financial statements. He’d also figured out how to use his power—and his closest associates—to secretly line his own pockets. Now he established new ways to accomplish both of those ends, on a far larger scale, at once.

His mechanism was a private equity fund—a series of funds, actually—that Fastow named LJM and that he ran even while serving as Enron’s CFO. The name signaled how important they were to him. His earlier entities, JEDI and Chewco, were named after
Star Wars
characters; the letters
LJM
were the first initials of Andy’s wife and two sons: Lea, Jeffrey, and Matthew.

Fastow, you’ll recall, had long harbored the desire to set up a fund that could invest in Enron deals. But over the years, whenever he had broached the idea, he’d been shot down—and with good reason. A special fund open only to certain favored employees would surely be enormously divisive, and having the CFO himself running it would create an obvious conflict of interest. When Enron wanted to sell an asset to the fund, Fastow would be in the position of negotiating with himself.

But by the late 1990s, Enron was making such frequent use of SPEs that finding the necessary outside equity investors was becoming nearly impossible. There were only so many trusted Friends of Enron, after all. So Fastow began promoting the idea of setting up a big standing private equity fund—a sort of permanent Friend of Enron—that would raise enough cash from institutional investors to provide the all-important 3 percent independent equity for dozens of Enron deals. This was an elegant solution, Fastow argued. It would avoid the messiness of having to find new investors every time. It would allow Enron to close deals faster than ever. It would even save money on banking fees. And, Fastow argued to Skilling, it wouldn’t distract from his regular duties at Enron.

By August 1998—just five months after becoming CFO—Fastow was actively exploring the idea with investment bankers at Merrill Lynch. Enron’s key Merrill contact was a Houston investment banker named Schuyler Tilney, whose wife Beth was an Enron executive and a Ken Lay confidante; the Fastows and Tilneys were good friends. As Fastow initially presented the fund idea to the Merrill bankers, Enron would contribute half the equity, just as it had with JEDI, in the form of company stock. But unlike JEDI, where CalPERS was the only outside partner, this fund would solicit dozens of private investors, all of whom would be expected to contribute cash. Despite the Fastow-Tilney friendship, though, Merrill didn’t bite. In an e-mail report back to New York after the meeting, one Merrill banker wrote: “. . . we just listened to Andy and . . . we all—at least I did—got headaches trying to analyze an Enron stock contribution from an investor’s viewpoint and what kind of commitment it really was given that Enron can ‘manufacture’ stock—even Schuyler observed that we were probably asking investors to consider ‘an unnatural act.’ ”

Fastow pushed ahead anyway. By May 1999, he was floating the idea with Enron’s accountants at Arthur Andersen. Even they thought it was a bad idea—though they kept this view to themselves. In a May 28 e-mail to colleagues, Benjamin Neuhausen, a member of the elite Professional Standards Group at Andersen, wrote: “Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view. Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme?”

David Duncan, Andersen’s Enron relationship partner, expressed similar skepticism, writing back: “. . . on your point 1 (i.e. the whole thing is a bad idea), I really couldn’t agree more.” Duncan said that he would insist that the plan be approved by Enron’s CEO, general counsel, and board—and he expressed hope that would put an end to it. (“None of this communication has yet to occur and this thing could get killed when it does.”) It was clear, however, that Fastow wasn’t going to give up easily. Noted Duncan: “This thing is still very much in the brainstorming stage, but Andy wants to move through it very quickly to get all this done, if possible, this quarter. Andy is convinced that this is such a win-win that everyone will buy in. We’ll see.”

Through Duncan, the accountants were setting in motion a game of dodging responsibility. They privately agreed the idea was terrible but were expecting Lay and Skilling—or, surely, the board—to kill it. For their part, the board and management would later point to Andersen’s silence in justifying their conclusion that Fastow’s scheme was perfectly okay.

Fastow finally brought his idea to life by seizing an opportunity to prove just how handy such a fund could be. The occasion involved a $10 million investment Enron’s fledging broadband unit had made back in March 1998 in a tech start-up called Rhythms NetConnections, one of the first high-speed Internet providers. Enron had bought 5.4 million pre-IPO shares at $1.85 per share. On April 7, 1999, a year later, at the height of the Internet frenzy, Rhythms went public at $21 and promptly skyrocketed to $69 by the end of the day. By May, Enron’s $10 million investment was worth about $300 million.

Skilling convened a meeting of ten Enron executives to discuss the dilemma this presented. As ever, Enron needed an earnings boost, so it wanted to book the entire gain right away. But if it did so, Skilling complained, Enron would get no credit in its stock price from Wall Street because it would be booking the windfall as a onetime gain. “We need to figure out how to make it a recurring item on our income statement,” he told the group.

Then Skilling turned to the broader issue: even after Enron booked the Rhythms gain, it couldn’t just unload the stock. To get the pre-IPO shares, it had signed a lockup provision preventing it from selling until November. Who could say where the price would be in November? Skilling was eager to find a way to lock in the gain, to hedge against the very real possibility that Rhythms shares would drop sharply before the lockup expired, which, under mark-to-market accounting, would then require the company to book a
loss.

The meeting ended with everyone scratching his head; by conventional methods, what Skilling wanted to do was impossible. Buying some kind of traditional hedge, such as a put option—an obligation to buy the volatile Rhythms shares at a set price—from a legitimate third party would be prohibitively expensive. Besides, Rhythms was so thinly traded and Enron’s position so large—it controlled about half the shares available in the market—that it would be exceedingly difficult for any buyer to unload. No outside buyer would assume such enormous economic risk.

Into the breach stepped Fastow, who let it be known that he was willing to create a new SPE to hedge the Rhythms position for Enron, but
he
needed to control it. Here’s how it would work: Fastow would start his first fund, LJM1 (also known as LJM Cayman), with $1 million of his own money. An additional $15 million would be contributed by two big outside investors. LJM1 would then set up a subsidiary, called LJM Swap Sub. Swap Sub would sell a put option on the entire Rhythms stake to Enron, giving Enron the right to force Swap Sub to buy the Rhythms stock from Enron in June 2004 at $56 a share. To compensate Fastow and his partners for taking this extraordinary risk, Enron would arrange the transfer of 3.4 million shares of its own stock, worth about $276 million, to LJM, which then moved almost half the holding (as well as several million dollars in cash) into Swap Sub. LJM also gave Enron notes for $64 million, which helped Enron by adding to its reported cash flow.

In essence, Enron was using the value of its own stock to buy the hedge. This meant that it wasn’t truly hedging its risk at all. If Rhythms fell, the only way it could pay off the hedge was by using Enron stock. But if the shares dropped, Swap Sub would have no way of making good on its obligation to Enron. Like so many of Enron’s questionable transactions, the Rhythms deals was rooted in the fundamental belief that Enron stock would never fall. The entire arrangement was an accounting artifice, protecting Enron from having to book an accounting loss but doing nothing to protect it from an actual economic loss.

Fastow and Kopper, in fact, were quite proud of the structure they’d created for the Rhythms hedge, so much so that they later tried to sell the concept to at least one other Houston energy company, El Paso. They thought El Paso might want to do a deal with LJM. After listening to the two men explain the complex structure, the El Paso executive, a former investment banker himself, scratched his head. The accountants would never approve it, he said.

Sure they will, Fastow and Kopper told him. “We can get you an opinion letter.”

“How do you determine valuation?” he asked.

Fastow and Kopper grinned. “It’s whatever you want it to be,” one of them replied.

 • • • 

In early June, as Fastow was hatching this scheme, Rick Buy phoned Vince Kaminski, head of Enron’s Research Group, for help in pricing the Rhythms options. Kaminski’s 50-member group was part of RAC, a team of high-powered quant jocks who built Enron’s complex derivatives-pricing models. The Polish-born Kaminski was a former Salomon Brothers vice president with an MBA and a doctorate in mathematical economics who read daily newspapers in five different languages. He was universally respected for his raw brainpower—at Enron, no small compliment—and equally renowned for his bluntness.

Buy was calling Kaminski with Jeff Skilling in his office. The chief risk officer was vague about what was really up, but Skilling told Kaminski the project was urgent. A short while later, Skilling appeared in Kaminski’s office—an exceedingly rare event—to try to explain the transaction. When Kaminski later presented the problem to members of his group, everyone in the room laughed; that kind of put option, they all knew, would be impossible to buy on Wall Street. Still, they did what they were told and came up with a price.

The next day, Kaminski told Buy that his group had produced a number but that he viewed the idea of transferring Enron shares to an outside partnership as foolish. In fact, Kaminski declared, “This is so stupid that only Andrew Fastow could have come up with it.” That’s when Buy told him that Fastow
had
come up with the idea—and that the CFO was planning to run the partnership himself. Now Kaminski was even more certain the idea was stupid. What about the conflict of interest? After hearing more about the structure, Kaminski returned the following week with more arguments. The hedge simply wouldn’t work. And the payout cheated Enron shareholders in favor of Fastow, Kaminski said; it’s “heads the partnership wins, tails Enron loses.” After all, Enron was funding the hedge almost entirely with its own shares, giving LJM virtually no exposure. Buy listened with his usual sense of grim anxiety, then told Kaminski he would try to stop the deal. “The next time Fastow is going to run a racket,” the Enron risk officer nervously joked, “I want to be part of it.”

At 10
A
.
M
.
on the morning of Friday, June 18, Skilling and Fastow walked over to Ken Lay’s office for a discussion of the deal that would give birth to LJM. Fastow’s role in the new private partnership would require an exemption from Enron’s code of ethics, which barred employees from profiting from any company that did business with Enron but allowed the CEO to waive the provision if the arrangement “does not adversely affect the best interests of the Company.” Lay agreed to grant the waiver but wanted the board of directors to ratify his decision.

Ten days later, LJM was brought before a special meeting of the Enron directors; most participated by phone. As Fastow explained it, his personal involvement in the new partnership was an act of altruism, an unfortunate but necessary ingredient to attract outside investors to LJM and essential to Enron’s goal of hedging the Rhythms investment. Fastow insisted that LJM would provide the hedge “at no cost to Enron.” And in materials that had been sent to the directors, he insisted that, even though he would serve as LJM’s general partner, he would personally receive “no current or future (appreciated) value” from the Enron stock it held; if Enron’s shares continued to rise, those gains would all go to his limited partners.

Fastow did note, however, that he would receive a $500,000 annual management fee plus more than half the returns on any other assets in LJM. Fastow also told the board that PricewaterhouseCoopers would be issuing a fairness opinion affirming that the deal was fair to Enron. (Fastow neglected to mention that the firm was also being paid by LJM to work on the deal.) With nary a dissenting vote—or even any discussion of how to monitor the conflict—the directors passed a resolution exempting Enron’s CFO from the company’s code of ethics. Even with several other items on the agenda, the meeting was over in just an hour.

Neither David Duncan, Enron’s auditor, nor Rick Buy made any attempt to get in the way, despite their muttered complaints to outraged colleagues. Buy later told Vince Kaminski the project had too much momentum for him to stop it. And in fact, Fastow had clearly viewed the board approval as a mere formality. He had teed up the entire transaction before the board even met—and closed it two days after the vote.

As for Kaminski, in the aftermath of his objections to LJM’s first deal, his entire group was removed from RAC and placed in Enron North America, where it was no longer in a position to stand in the way of anything Andy Fastow wanted to do.

 • • • 

As it turns out, the finances of LJM1 and Swap Sub soon moved in Fastow’s favor. The increase in Enron’s shares meant that Fastow’s new partnership was sitting in a sizable gain.