The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (54 page)

But neither nCube nor CIBC really wanted to invest in Braveheart—and neither apparently believed that it had any money at risk. According to government filings, nCube and CIBC were in the deal as a favor to Enron—a favor that Enron had promised to repay with the quick return of their capital plus a tidy profit for their troubles. Officials at nCube say that EBS executives promised they’d repay their investment in early 2001, with a profit of $100,000. Eventually, this promised profit grew to $200,000, because Enron asked nCube to stay in the deal for another quarter.

Officials at CIBC say they had a similar handshake agreement, the government charges. At the time, CIBC was falling over itself to please Enron. After investing $15 million in LJM2 and lending Enron hundreds of millions of dollars, it had finally made the leap onto Andy Fastow’s coveted list of Tier 1 banks. Just a few months earlier, CIBC Houston banker Billy Bauch had written the Enron CFO a note of thanks “for the opportunity to work with Enron & LJM over the last year,” adding, “To be named one of your Tier One banks is a noteworthy achievement for us, and we are sincerely humbled by your confidence.” Bauch ended with a friendly word on the Fastow family’s plans to build a huge new residence in River Oaks: “I trust that the house is coming together and will not cause you too much fiscal pain.”

One CIBC banker later reassured nervous colleagues by telling them that Fastow had “given his strongest possible assurance that the risk won’t be realized.” A second banker elaborated in an e-mail quoted in government court filings: “Unfortunately, there can be no documented means of guaranteeing the equity. . . . We have a general understanding with Enron that any equity loss is a very bad thing. They have been told that if we sustain any equity losses, we will no longer do these types of transaction[s] with them. Not many other institutions are willing to take such risks so it is important to Enron to keep us happy. . . . We have done many ‘trust me’ equity transactions over the last 3 years and have sustained no losses to date.” According to a government filing, this same banker, whose name was not disclosed, once remarked that someday Fastow would be “led away in handcuffs.”

Such guarantees, of course, would mean that the equity investments weren’t truly at risk and that Enron therefore couldn’t legally report the revenues. But it did. According to the government, an Enron finance executive told CIBC officials point-blank that he couldn’t put EBS’s commitment on paper because it would “blow the accounting treatment” for the deal.

Kevin Howard and Mike Krautz, the EBS finance executives who headed Project Braveheart, deny they had any unwritten agreement, even though federal authorities say it was described in draft deal documents and e-mails. A memo Howard later prepared for Rice, for example, contains a passage titled CIBC Exit Strategy and notes “that by the end of 2001, Enron would need to replace CIBC with “ ‘true’ outside equity, ie without ENE support.” (The situation is complicated by the fact that neither CIBC nor nCube got back their money before Enron’s collapse.)

The government also charges that the handshake arrangements with nCube and CIBC were hidden from the Arthur Andersen auditors who reviewed Project Braveheart. But if the firm were really doing its job, that shouldn’t have mattered; even without that information, the auditors had more than enough to know that signing off on Project Braveheart required an incredible stretch of accounting rules. It was obvious that the deal was largely worthless. And even if it hadn’t been, Enron was using assumptions to value the contract that were truly fanciful; it was the broadband equivalent of monkeying with a pricing curve on a long-term electricity contract. To book the profits it needed, Enron had to assume that by the year 2010 the company’s content business would be operating in 82 cities, that 32 percent of the households in those markets would be using DSL lines, that 70 percent of DSL customers using video-on-demand would subscribe to the Enron-Blockbuster service—and that Enron would control 50 percent of the video-on-demand market. (This last figure came from “research” conducted by EBS and McKinsey.)

A top Andersen accountant named Carl Bass was upset with Enron’s plans to book profits from Project Braveheart. Bass was an old-fashioned Andersen hand, an acerbic, skeptical veteran who was highly regarded inside the firm for his technical expertise. In late 1999, Bass was appointed to Andersen’s Professional Standards Group (PSG), which was supposed to offer independent rulings on particularly tricky accounting issues. At Duncan’s request, Bass was spending much of his time on Enron issues, since the company was by far the riskiest accounting client Andersen had. But Duncan came to regret seeking Bass’s involvement, for Bass quickly became the leading in-house critic of Enron’s financial maneuvers. A typical Bass comment was one he made in an August 2001 e-mail about an Enron deal: “Help me out here,” he wrote. “How do you sell an asset and generate operating cash flow?”

To Bass, the accounting treatment for Project Braveheart defied common sense. “. . . I was told that they were going to have some $50 million gain on the sale of this venture interest immediately after the contract was signed and the venture was entered into. Furthermore, the other venture partner was not contributing anything,” he wrote in an e-mail. “In effect, this was a very risky transaction. . . .” But as Bass also noted, Duncan and his team “did not follow our advice on this.” The only concession Andersen was able to wring out of En-
ron was a promise that the company would obtain an independent appraisal of the value of the Blockbuster contract. But Enron never bothered to get the appraisal—and Andersen approved the deal anyway.

For Enron, all the machinations produced the desired result: EBS booked the revenue it needed to meet Wall Street’s expectations. Kevin Howard, EBS’s vice president for finance, had originally intended to book just $20 million on the Braveheart deal. But as the end of the year approached, EBS’s earnings hole kept growing—in late November, COO Hannon calculated that the business was $100 million behind budget—and so did the amount the company needed to milk from Braveheart. In the end, EBS claimed a $53 million gain on Braveheart for the fourth quarter, representing 84 percent of the broadband division’s revenues. Broadband closed 2000 reporting a loss of just $60 million for the year, meeting Enron’s promise to analysts.

Everyone in broadband, of course, was acutely attuned to the stakes involved in pleasing the market. (“EBS has released key metrics to the analysts on Wall Street and must now deliver on those metrics,” explained a 91-page internal document detailing broadband’s “strategic vision,” completed in November 2000. “Each group within EBS must learn to focus on these and make certain EBS meets or exceeds them to keep Wall Street interested in the proper valuations of Enron. This is now a very important part of the daily routine of EBS going forward.”) And though they knew full well that they had met their numbers only by using smoke and mirrors, more than a few regarded the illusion they were creating as a genuine accomplishment. That, after all, was what Enron valued. That’s what got them bonuses and promotions.

Indeed, at the Enron Broadband Christmas party, members of the finance group put together a PowerPoint presentation that celebrated, in mockumentary style, their earnings “achievement.” “Since this is the largest earnings deal for EBS in the 4th quarter with over $50 million in earnings, the Blockbuster Team are now heroes. Congratulations,” it began.

A series of slides then recast popular films to portray the exploits of several of the EBS executives who’d worked on the Blockbuster deal. One of them was called “Mike Krautz and The Search for the Holy Monetization.” “Mike scours the globe in search of the holy mark-to-market—I mean monetization,” the narrative read. “This monetization is supposed to bring everlasting life, but Mike soon discovers that his immortality lasts for only one quarter.”

Another slide offered up a variation on
Thelma & Louise
, starring two EBS employees: “After Kevin tells them that they are responsible for unwinding the Blockbuster deal next quarter, the two decide to make a run for the border. In the end, they both drive over a cliff, choosing the more attractive exit strategy.”

Blockbuster’s inability to obtain first-run videos inspired the casting of Kevin Howard as Forrest Gump (“A monetization effort is like a box of chocolates, you never know what you’re going to get”), with a buddy who “has all kinds of content—‘kids’ movies, action movies, animal movies, home movies, shrimp movies, just no hit movies.’ ”

And finally, the presentation portrayed the Arthur Andersen accountants who had objected to the deal as “The Grinch Who Stole VOD,” starring “Arthur Andersen as the Grinch and Enron’s Accounting Team as the Who’s in Whoville,” in “the story of how the mean, heartless auditors tried to ruin the deal for Little ConnieLeeWho:

One Deal, Two Deal, Red Deal, No Deal

You cannot do it without GAAP.

You cannot do it because it’s crap.

You cannot do it for 25. What the hell, let’s go for 65.

After the party was over, EBS’s alarmed general counsel, Kristina Mordaunt—the same Kristina Mordaunt who had hit the $1 million jackpot in the Southampton investment with Andy Fastow—reportedly instructed Howard to destroy all copies of the presentation.

 • • • 

Two months after booking $53 million in profits from Project Braveheart, Enron announced it was ending its 20-year deal with Blockbuster. Enron publicly blamed Blockbuster, saying the video giant had failed to provide the “quantity and quality” of movies the project needed. Here’s the most amazing part, though: Enron’s spin machine, which had shamelessly hyped the Blockbuster deal to the analysts, now labored to dismiss the significance of its implosion—
and the analysts bought it!
ENRON
EXPANDING
ENTERTAINMENT
ON
-
DEMAND
SERVICE
;
TERMINATES
EXCLUSIVE
RELATIONSHIP
WITH
BLOCKBUSTER
INC
.,
blared the Enron press release. The company cast the venture’s failure as a kind of liberation, reasoning that it was now free “to initiate discussions with various content providers” for movies, games, television programming, and music.

Blockbuster was less sanguine. Enron, which had signed a noncompete agree-
ment, was openly seeking new partners, a process it had secretly begun even before the contract was formally terminated. As Blockbuster saw it, it had always made clear that lining up content from the studios would take time; it had actually signed a second major studio deal (with Universal) in early 2001. Yet Enron was blaming the venture’s breakup on the video chain. The two sides took their dispute into secret arbitration. Enron settled a few months later by paying Blockbuster $5 million.

One person who took particular note of the dissolution of the Blockbuster deal was Carl Bass at Arthur Andersen. “One would think,” he e-mailed a colleague, “there should be a loss reported.” But that was hardly Enron’s style. Instead of writing down the value of the deal, the company’s finance executives reasoned that its broadband content business was worth
more
without Blockbuster, since it wouldn’t have to share the proceeds. (As the bankruptcy examiner wryly noted: “Apparently, Enron’s intention ‘to initiate discussions’ was even more valuable than its ‘exclusive relationship with Blockbuster.’ ”) EBS booked an additional $58 million from Braveheart—more than two-thirds of its reported revenues for the first quarter of 2001. Thus was one last quarter saved. Blockbuster executives say they were astounded to find out months later that Enron had booked $111 million in profits on their unprofitable venture.

David Cox and his deal-making colleagues kept hustling. They vowed to develop more “killer apps.” They promised to sign three more Blockbuster-like deals before year-end. (The World Wrestling Federation and the NFL were their top targets.) The company’s lobbyists began laying plans to force the cable business to accept content distribution deals by demanding so-called open access to cable systems. But it was all for naught. “We were trying very hard to pump blood into this patient, and we ran out of blood,” says an EBS vice president.

Inevitably, as broadband’s inflated promise stood revealed, many in and out of Enron pointed the finger at Skilling’s old lieutenant, Ken Rice. Much was riding on broadband’s success but Rice had never risen to the challenge. He just didn’t have it in him any longer to work the kind of hours an exceedingly ambitious start-up required. Like many Enron deal makers, Rice also hated managing—and it showed. An internal EBS document noted that the organization was characterized by “chaos” and “a perception of ‘inability to get things done.’ ” Rice occasionally appeared in a T-shirt, biker jacket, and jeans; he seemed uninterested and distracted. “The last couple of years, a lot of us got lazy,” he later acknowledged to friends. Rice felt trapped by broadband’s enormous expectations. He was managing a business that had spent more than a billion dollars but hadn’t produced a penny in real profits.

The government later charged, however, that there was one area where Rice had played the broadband game like a master—pumping and dumping Enron’s stock. Government filings say that Rice was repeatedly warned that EBS was spending far too much and making far too little and that just days before the company’s January 25, 2001, meeting with analysts, an outside consultant Rice hired had advised him that prospects for the year remained poor.

But that didn’t stop Rice from presenting a remarkably upbeat forecast to Wall Street. In his presentation, the government noted, “Rice stated, among other things, that EBS’s strategy was right on target; EBS’s content delivery business had an outstanding year; Blockbuster was EBS’s ‘anchor tenant’ with a 20-year deal” and that broadband was even further along than Enron had expected. Rice announced that he was anticipating an annual loss for 2001 of just $65 million, even though, according to the government, he’d received an internal estimate just three days earlier projecting broadband’s losses as totaling $149 million for the first quarter alone.