The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (38 page)

Yet about two years after the sale, with Cuiabá in far worse shape, Enron bought back LJM’s stake, handing the CFO’s partnership a $3 million profit. Skilling later insisted that Enron’s Brazilian staff had made misrepresentations to LJM that obligated Enron to buy back the fund’s interest.

But at the time (according to a later investigation), Fastow told a subordinate that Enron had made a secret handshake agreement with LJM1 that guaranteed repurchase of the Cuiabá interest, even if its value declined. Indeed, it wasn’t even all that much of a secret: a June 1999 e-mail from an Enron accountant named Kent Castleman described LJM as a “short-term equity warehouse” for the Cuiabá stake. Kopper later disclosed that the buyback provision had even been included in drafts of the original Cuiabá sale documents. One thing was certain: the deal provided yet another windfall for LJM’s investors. When the transaction was completed, the fund’s general partner (by then Michael Kopper) received $7.3 million. LJM1’s limited partners, CSFB and Royal Bank of Scotland (which had acquired NatWest), got $2.7 million apiece.

Another example: On December 21, LJM2 bought a 75 percent interest in an Enron power plant being built in Poland, the country’s first independent power project. Fastow’s fund invested $30 million in equity and debt in the plant, which allowed Enron to book $16 million in fourth-quarter profits. The company had agreed that it would try to find a buyer for LJM2’s interest after the quarter closed, but when the plant malfunctioned during a test, Enron couldn’t find one. So, just three months after selling to LJM2, Enron, through two different subsidiaries, bought it back for $32 million.

For a price, LJM2 made all sorts of accommodations to Enron, even backdating documents. The legal documents on one LJM2 transaction showed that the fund bought a set of financial instruments from Enron on December 29 and sold them to another Enron-related entity the very next day—in time to remove them from Enron’s balance sheet in the company’s 1999 financial statements. But investigators later found that the deal didn’t actually occur until two months later. Fastow had originally demanded that LJM2 be paid $1 million for its troubles. But he dropped his price to $100,000 after complaints from Enron treasurer Jeff McMahon.

In another late-December deal, LJM2 paid $26.3 million ($1 million in cash, the rest in a note) for an offshore natural-gas gathering system. According to an LJM internal memo, the deal allowed Enron to book $2.5 million in earnings and another $25 million in cash flow on a related gas contract when “no other 3rd party would take . . . the exposure in the timeframe that LJM did.” Enron bought back the interest three months later, giving LJM a $500,000 profit.

 • • • 

As the pace of LJM’s deal making accelerated, Fastow made little effort to dampen the conflicts of interest he and other LJM officials faced. On the contrary: he positively embraced the conflicts and flaunted them inside Enron. For instance, under an agreement Fastow struck with Causey, Enron employees were allowed to work full time for LJM while keeping their Enron benefits and even remaining in their Enron offices. The arrangement institutionalized their divided loyalties: LJM was to pay Kopper’s bonus while Enron would cover his base salary, Kathy Lynn would get her salary and bonus from LJM and her benefits from Enron, and the salary and bonus for Anne Yaeger would be divided between LJM and Enron. The LJM executives sat next to colleagues who were sometimes negotiating with them on behalf of Enron. At times, it was unclear who was negotiating for Enron and who was negotiating for LJM.

Fastow himself had no compunction about pressuring Enron finance executives—officials who reported to him in his capacity as Enron’s CFO—to cut more generous deals for LJM. In at least 13 transactions with LJM, Enron employees who reported either directly or indirectly to Fastow found themselves on the other side of the table from their boss. Time and again, he told Enron negotiators they were bargaining too hard against LJM, that they needed to wrap up a deal, even if it meant giving the partnership more generous terms. Notorious for beating up bankers, Fastow proved just as nasty to Enron employees negotiating against LJM. Crossing Fastow, they knew, could cost them a large part of their year-end bonuses.

Fastow’s partnership made out handsomely. Almost all of LJM2’s deals—21 of 23—were related to Enron. Excluding five assets LJM2 held at the time of Enron’s collapse, the fund made money on all but one of them, generating $85.3 million in profits. Of the 16 Enron-related assets that LJM2 sold profitably, 14 went straight back to Enron (or a related entity), most in a matter of months, even when their value had dropped.

This pattern spurred rumors that Skilling and Fastow had made a secret deal to guarantee that LJM2 wouldn’t lose money. Government officials later charged in court papers that Fastow had forged just such an arrangement with Causey, called the Global Galactic agreement. Under the accord, the government alleges, if LJM lost any money in its deals with Enron, the company promised to make it up later. Many Enron hands believe that Causey wouldn’t do anything this significant without Skilling’s blessing. Though all the principals involved (including Skilling) have denied the existence of such a pact, Causey’s calendar shows a 30-minute meeting with Fastow at 9
A
.
M
.
on September 6, 2000. It bears the notation “Global Galactic deal.”

It’s safe to conclude that LJM’s investors were led to believe that Fastow had received certain, shall we say, commitments. An executive at the Royal Bank of Scotland, an LJM lender, returned from a meeting with Enron executives with written notes of their informal assurances: “Enron’s senior management are consistent in strongly representing verbally that Enron will do everything in their power to protect the investors and lenders involved.” In an e-mail to his colleagues, a Citigroup executive later described a similar assurance offered from the LJM side: “LJM2 principals argue that Enron would make the Fund whole should it suffer losses because the vehicles that the Fund invests in are critically important to Enron’s ability to manage its earnings.”

Enron’s court-appointed bankruptcy examiner later noted that there was “no evidence of any effort to determine and use fair market values” for the sale of assets to LJM2 or their subsequent repurchase by Enron. “LJM2’s function in the Enron related transactions was as a lender,” he added. “Its ‘investments’ were more like loans than arm’s length sales to third parties. . . .” Many of the transactions, he concluded, “had no valid business purpose from Enron’s perspective, other than to achieve desired financial statement reporting.” A lengthy investigation by outside lawyers hired by Enron’s board concluded that LJM’s investments simply were never at risk: “As a matter of economic substance, it is not clear that anything was really being bought or sold.”

As for the controls, they were a joke. None of those who were supposed to be providing oversight of Fastow’s conflict took the responsibility seriously. Causey and Buy were supposed to be reviewing all transactions with the partnership, but some of the deals were never even submitted to them. And when he did review LJM transactions, Causey—whose fiftieth-floor office was next door to Fastow’s—later explained, he viewed his job as merely making sure that the appropriate people had “signed off”; never mind that
he
was the appropriate person. Buy, who was also supposed to provide oversight, said he limited his involvement to assessing Enron’s risk; he later complained to Vince Kaminski that he was getting so many approval sheets to sign on LJM deals at his New Hampshire summer home that he’d had to buy a new fax machine. Some LJM2 deals went through without any approval sheets being generated; in other cases, required signatures from Enron executives were never obtained or the approval documents were prepared after the deal had closed.

In February 2000, the board audit committee conducted its first annual review of LJM transactions. It received a single sheet of paper titled “LJM Investment Activity 1999” listing eight partnership transactions; two others (including Cuiabá) weren’t even included. Causey described the deals and assured the directors that all the transactions had been negotiated on “an arms-length basis.” The discussion lasted 15 minutes. A few months later, the board’s finance committee took its turn, listening to Fastow discuss how much his fund was doing for Enron. When one director asked why Enron’s CFO was spending so much time on an outside partnership—
didn’t he have enough to do?—
Fastow replied that he had hired employees to run the fund and it was now occupying only about three hours of his time a week. Anticipating the subject of his compensation, Fastow told the finance committee that LJM2 was projecting that its investors would receive an annual return of a relatively modest 17.95 percent. What Fastow didn’t mention was that
on that very day,
the Enron investors in his Southampton partnership were receiving wire transfers divvying up more than $12 million—with the Fastow Family Foundation alone receiving a return on its investment of
17,765 percent.

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Even with the existence of LJM2, Enron was still having trouble making its numbers as 1999 came to a close. Though investors and outside observers didn’t realize it, the company was having a tough year. It was spending a fortune on EES and broadband and seeding an assortment of Skilling’s other new ventures. And trading was having a mixed year.

There was so much at stake. Enron’s shares were climbing again—they rose 55 percent in 1999—and salaries and bonuses were soaring. Every high-level Enron executive held options worth millions. There was even a long-term incentive plan to provide yet another payoff built on Enron’s share price: if the company’s stock performance between 1997 and 2001 ranked among the top six companies in the Standard & Poor’s index, everyone in upper management would get a special cash bonus.

So as Enron headed into December and as the company’s finance executives realized the company was still short of its earnings targets, it undertook two deals that were egregious even by Enron’s standards. Both involved Merrill Lynch; it wasn’t lost on anyone that Merrill was helping Fastow raise money for LJM2.

In the first transaction, Merrill agreed to participate in an energy trade with Enron that would generate $50 million in fourth-quarter profits. The government later called the transaction fraudulent. The deal was initiated by Cliff Baxter, who had become CEO of Enron North America earlier that year.

As originally conceived, the deal involved two commodity trades between Enron and Merrill in something called heat-rate swaps. The paired trades were perfect mirror images of one another, but they had different accounting treatments. As a result, Enron would book the profits it needed immediately on the first trade while deferring a loss on the mirror-image trade until later. Merrill was to make $8.5 million from the transaction. But Arthur Andersen refused to approve the accounting because neither party had any true risk in the deal.

The problem was solved by setting up a second set of trades, where the paired deals were different enough to justify the separate accounting treatments—or were, at least, as long as Enron and Merrill didn’t cancel both trades at the same time. To get Merrill to go along with this arrangement for booking profits, Baxter had agreed to double the bank’s fee to $17 million.

The key Merrill advocates were the usual suspects: Schuyler Tilney and Rob Furst, the firm’s top Enron contacts. They explained to a firm committee reviewing the deal that it presented no risk to Merrill and that they had extracted the oversize $17 million profit because Enron was desperate to hit its Wall Street targets. One Merrill executive, according to a later SEC complaint in the matter, expressed reservations:
wasn’t this earnings manipulation?
Merrill, responded a senior executive, has “17 million reasons” for doing the deal.

After Merrill executives insisted on speaking to Causey, Enron’s accounting chief explained that the company needed the trade’s earnings to hit its numbers; millions in executive bonuses were riding on it, Causey added. At Merrill’s request (according to the SEC), Causey agreed to sign a warranty letter prepared by Merrill stating that Arthur Andersen had approved the deal and that Merrill Lynch had played no part in its accounting. Causey faxed the signed letter back to Merrill on December 31, literally only hours before the clock ran out on the fourth quarter. For its part, Arthur Andersen said that Enron would have to restate the numbers if the trades were later unwound.

Sure enough, less than two months later, Enron told Merrill it wanted to unwind the trade early. The SEC later charged that this early unwinding had been part of an “understanding” between Enron and Merrill all along. Still, there was squabbling over the arrangements. Enron wanted Merrill to forgo its fee, which wasn’t due until the fall; Merrill wanted the entire $17 million. Tilney wrote his Merrill colleagues for guidance: “. . . they knew what we were making at the time and we were clearly helping them make earnings for the quarter and year (which had great value in their stock price, not to mention personal compensation). What would you think was a fair number . . . ?” Ultimately, they agreed to split the difference: in June, Enron paid Merrill $8.5 million for its help in manufacturing earnings. Arthur Andersen never followed through on its threat to force Enron to restate the $50 million if the trades were later unwound.

 • • • 

The second deal was cooked up to solve a familiar Enron problem: assets it couldn’t sell. In this case, Enron was trying to unload a trio of 3,600-ton floating power plants, turbines placed on barges destined for a lagoon off the Nigerian coast. These barges, still under construction, were supposed to provide electricity for Nigeria’s national grid.

In mid-December, Enron treasurer Jeff McMahon contacted Furst about buying an interest in the barge project. According to the SEC, Enron wanted to sell so it could book another $12 million in earnings and $28 million in cash flow. The proposed deal would work like this: if Merrill would take the stake in the barges off its hands by year-end, Enron would arrange a profitable buyback later. Merrill would get a $250,000 up-front fee, a 15 percent annual rate of return on a $7 million equity investment (Enron would finance $21 million in interest-free debt), and an oral guarantee that Enron would “facilitate” Merrill’s “exit from the transaction” by June 30, 2000. Merrill’s internal deal memo captured the essential dynamic: “Enron has strongly requested ML to enter into this transaction. Enron has paid ML approximately $40 million in fees in 1999 and is expected to do so again in 2000.”