The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (57 page)

On August 7, Glisan advised the board finance committee that Raptor I “was almost completely utilized,” Raptor II wasn’t yet ready for action, and that a new Raptor—called Bobcat—was needed to increase “available capacity.” In swift order, LJM2 collected its third $41 million.

As Enron saw it, the beauty of the Raptors was that they wouldn’t just lock in gains on winners—they could also bury the losses on losers. Indeed, one of the reasons the Raptors were so useful is that the traders were refusing to bury losses like those on Kevin McConville’s disastrous investment portfolio, according to a former Global Finance executive. So the bad assets were stashed in the Raptors instead. Though some of them had already been written down, the Raptors insulated Enron from having to book even bigger charges. Dave Delainey used to call them “the critter deals.”

On September 1, an Enron lawyer named Stuart Zisman, who had been reviewing the Raptor project, wrote a memo sharply questioning this strategy: “Our original understanding of this transaction was that all types of assets/securities would be introduced into this structure (including both those that are viewed favorably and those that are viewed as being poor investments). As it turns out, we have discovered that a majority of the investments being introduced into the Raptor Structure are bad ones. This is disconcerting [because] . . . it might lead one to believe that the financial books at Enron are being ‘cooked’ in order to eliminate a drag on earnings that would otherwise occur under fair value accounting. . . .” Of course, that’s precisely what was happening. After receiving the memo, Mark Haedicke, a senior Enron attorney, called Zisman to his office and scolded him for using “inflammatory” language.

Zisman was right, though. The Raptors were absorbing much of Enron’s “nuclear waste”—and, by the fall of 2000, with the collapse of the tech-stock craze, even the high fliers in the portfolio were starting to deteriorate. Enron’s stock price was slipping, too. This meant that one of the Raptors—Talon—was running out of credit capacity. The situation was getting worrisome. Causey ordered his accountants to monitor the numbers closely.

And still, there was another: the last Raptor, called Porcupine, was created in late September, and this one was even more bizarrely conceived than the rest. Porcupine was created to lock in a single large Enron investment—a $370 million Enron gain that was tied to the price of shares in the New Power Company, Lou Pai’s residential energy spinoff, in which Enron had a 75 percent stake.

But instead of being funded with Enron stock, this Raptor held warrants in New Power—the very investment that it was supposed to hedge. This meant that if the price of New Power fell, Porcupine’s obligation to Enron would grow at the same time that its ability to pay on the hedge was dropping. Thus, “this extraordinarily fragile structure” (as the special board report later described it) was “the derivatives equivalent of doubling down on a bet.” Porcupine could survive only if New Power shares, which were about to go public, climbed in the aftermarket.

But they didn’t. On October 5, one week after Porcupine got the New Power stock, the company went public at $21 per share. It was up $6 a share in the first day of trading, but within a week, New Power had fallen back below its offering price—and at year-end was below $10. This produced what one investigator called “a double-whammy effect” on Porcupine. Its obligation to Enron soared while its only real asset to pay the obligation plummeted. Of course, by then, LJM2 had recouped its stake in Porcupine, investing $30 million, then pocketing $39.5 million one week later.

 • • • 

By October 2000, Andy Fastow was entering the homestretch on what was turning out to be a lovely year. Back in February, he promised the Enron board that his Global Finance division would be a profit center—just like trading and the pipelines. Among his “key responsibilities,” Fastow declared, was to contribute to Enron’s earnings targets. He’d even given the board a projection of the profits his group could generate—$140 million.

Now, in early fall, he’d already blown that number away. In 2000 alone, the Raptors alone shielded Enron from more than $500 million in losses. In their brief lifespan, they allowed Enron to avoid booking an astonishing $1 billion worth of losses—effectively
tripling
the profits Enron reported to investors during that period. Not even Tim Belden could make such a claim.

If the Raptors were good to Enron, they were even better to Fastow. After barely a year in operation, LJM2 was already reaping impressive returns for its investors—including Fastow himself. Millions were flowing into his pocket in partnership distributions and management fees.

In fact, Fastow’s partnership was doing so well that he was ready to ask the board to launch LJM3. He’d already started hitting up the banks, advising Chase’s Rick Walker that he was preparing to launch the new fund “at Skilling’s request”—and wanted to know about the bank’s participation. LJM3, of course, was the fund he’d once described as his ticket out of Enron. Lay and Skilling didn’t know that was his goal; they’d already given their approval for his third exemption from Enron’s code of ethics. But he’d talked about raising a billion dollars for LJM3—and if he could pull that off, who could blame him for walking away?

The Enron board was holding its October meeting in Palm Beach, Florida, at an opulent Italian Renaissance-style hotel called the Breakers. Fastow’s discussion of LJM3 was the featured item in his report to the October 6 meeting of the finance committee. Fastow displayed a chart showing the growth in Enron’s off-balance-sheet assets. Since 1997, when he’d moved to corporate, Enron’s balance-sheet assets had grown by 50 percent, while its off-balance-sheet assets had doubled. All this had resulted in a business of mind-boggling complexity. By then, Enron had generated 3,000 separate corporate entities, more than 800 of them in offshore jurisdictions like the Cayman Islands. Enron’s corporate tax return for 2000 ran to 13 volumes.

But such details weren’t of concern to the Enron board. In Palm Beach, Fastow didn’t hand out any LJM documents or approval sheets to the directors, as he routinely did on Enron deals—and none of the board members demanded any. He didn’t mention the proposed size of LJM3 or discuss the returns or his personal compensation from his first two private partnerships. But he did explain how Enron had “largely mitigated” his conflict—and would do so in the future. Enron’s management or board could ask him to resign from LJM whenever it wanted, Enron had “no obligation to transact with LJM,” and the audit committee reviewed LJM annually.

Among Fastow’s list of reasons as to why his conflict was “largely mitigated,” two involved Skilling. The CFO told the board that Skilling was among the executives who had to “approve all Enron-LJM transactions.” The sec-
ond: “Review of A. Fastow economic interest in Enron and LJM presented to J. Skilling.” The minutes of the committee meeting, taken by Rebecca Carter—who was dating Skilling—reflect that he was present during the discussion (as was Ken Lay). Carter’s handwritten notes from the meeting even show that Skilling spoke up in support of Fastow’s proposal, explaining that Enron needed LJM3 “to get accounting treatment” and that “third-party transactions would take much longer to do.”

But Skilling, who later publicly discussed these matters in congressional hearings, claimed that he might have been absent during the part of Fastow’s presentation that cited his role in reviewing LJM transactions because of a power failure at the hotel that resulted in people running in and out of the meeting room. He added that he never heard Fastow’s presentation that cited his oversight responsibilities for LJM, nor did he ever see the board minutes. In fact, Skilling later insisted: “I was not required to approve those transactions.”

And, indeed, Skilling didn’t sign many LJM approval sheets, even though they contained a line specifically for his signature. Even when he did sign, he said later, he merely signed if Causey and Buy had already done so, without giving the deal any independent assessment. In other words—contrary to what the board was told—he wasn’t accepting any oversight responsibility at all.

And as for his review of Fastow’s economic interest in LJM? Skilling was fuzzy about those details, too. But he did say that at some point, he sat down to discuss this subject with his CFO. Skilling had always been oddly squeamish when it came to personnel matters, and this time, by his own description, he let Fastow set the terms for the discussion. As Skilling described it, Fastow presented him with a one-page handwritten sheet, offering a back-of-the-envelope calculation comparing, over a five-year period, his probable compensation from the partnership with his likely take from his job as CFO of Enron. The figures, Fastow said, reflected assumptions that his Enron stock would appreciate at 15 percent and that LJM would earn a 25 percent return.

“You know, you’re not going to make 25 percent,” Skilling told Fastow. It would surely be much lower than that.

“I know,” Fastow said, smiling. “I’m being conservative.”

By Fastow’s calculation, Skilling said later, the CFO expected his LJM proceeds to total “something on the order of $5 million.” In fact, Fastow had already pocketed several times that amount. But Skilling never asked Fastow directly what he had already made—and he never asked him for any kind of documentation. Skilling left the meeting, he later said, convinced that his CFO’s outside compensation would be modest and that Andy Fastow’s personal interests would remain aligned with those of Enron.

 • • • 

Nineteen days later, Andy Fastow returned to Palm Beach, this time for the first annual meeting of LJM investors. This gathering was held at an even jazzier venue—the Ritz-Carlton—with Fastow the master of his domain, presiding over the event with a deep sense of satisfaction.

Among those listed as being in attendance was an eight-member contingent from LJM, including four of the beneficiaries of the secret Southampton deal: Michael Kopper, Kathy Lynn, Michael Hinds, and Anne Yaeger. LJM’s lawyers were there, from Kirkland & Ellis, and its accountants, from PricewaterhouseCoopers. And there were the limited partners, including bankers from Chase and, of course, Merrill Lynch.

Fastow had good news for his guests. LJM was capitalizing on Enron’s need to “deconsolidate assets” and “create structures which accelerate projected earnings and cash flow,” he explained in materials handed out to the investors. “This leads to opportunities for LJM.”

And how LJM had seized those opportunities! To Skilling, Fastow projected 25 percent returns. In front of his investors, he told a different story: he was projecting an annualized net return of 69 percent. And the individual investment details were even more extraordinary. LJM had racked up a 194 percent return on something called Yosemite. On the first three Raptors, he was showing returns of 156 percent, 248 percent, and
2,500 percent
! On the fourth Raptor, Fastow had forecast another 125 percent. All were deals with Enron.

Happy as they were to be making money, the LJM2 investors in attendance—several of them Enron bankers—couldn’t help but wonder:
was LJM ripping off Enron? How could Fastow get away with this? Did Skilling know what was going on?
As usual, Fastow had anticipated the need to head off skepticism. His guest speaker for the end of the day was none other than . . . Jeff Skilling!

Enron’s president had spent the day in New York, talking to the rating agencies. He had wanted to fly directly to Dallas for an SMU homecoming party with college friends the following afternoon. But Fastow insisted that he make an appearance at the LJM meeting.

When Skilling arrived, the LJM investors had already received copies of Fastow’s 44-page presentation, detailing the partnership’s extravagant returns. Skilling insisted to the SEC, many months later, that he’d never seen the document—
a 2,500 percent return, negotiating a deal against Enron?
—and that if he had, he’d have gone ballistic. Instead, Skilling popped in for his 30-minute appearance and reassured his CFO’s investors that Enron stood squarely behind Andy Fastow and everything he was doing at LJM.

“LJM,” Jeff Skilling told them, “is very important to Enron.”

On December 13, 2000, Enron announced the inevitable: Jeff Skilling would succeed Ken Lay as Enron’s CEO. The official transfer of power was set to take place in February. “I’m glad to see that Ken Lay has had the presence of mind to allow Jeff, who’s really been running this show for a couple of years anyway, to go ahead and take over,” Merrill Lynch analyst Donato Eassey told the
New York Times
, summing up the consensus view. In the analyst community, there were rumors that Skilling had forced Lay’s hand by hinting that he had another job offer. Indeed, earlier in the year, Skilling renegotiated his contract with a trigger: If he was not named CEO by the end of 2000, he could leave the company and collect a payout of over $20 million. Lay himself was also rumored to be moving up—to Washington, where he would join the cabinet of the incoming Bush adminstration. But that rumor turned out not to be true.

By all appearances, Skilling was on top of the world.
BusinessWeek
celebrated his new position with a worshipful cover story, featuring Skilling precisely as he wanted the world to see him, dressed in ultracool black, electricity sizzling through his body.
Worth
magazine described him as “hypersmart” and “hyperconfident”—and named him America’s second-best CEO (just behind Microsoft’s Steve Ballmer) before he’d even been on the job three months. Merrill Lynch’s Rick Gordon e-mailed Skilling to tell him that David Komansky, the firm’s CEO, was searching for “potential new board members”—and wanted to “get together” with him.

Besides, these were the Enron glory days. Remember 1999, when the stock had returned 58 percent? In 2000 it did even better, returning a startling 89 percent, a gain that generated huge payouts to all the top executives, thanks to the company’s performance-unit plan. In addition to his salary and his stock-based compensation, Skilling got a $7.5 million payout. Lay got a total of $10.6 million in cash. Other executives, including Cliff Baxter, Andy Fastow, Rick Causey, and Rick Buy, also got seven-figure payouts. The numbers the company was hitting were just as eye-popping. Revenues topped $100 billion, twice what they were in 1999. Earnings hit $1.3 billion—up 25 percent from the previous year on a per-share basis. (That is, before a $287 million onetime write-off—the result of Azurix’s Buenos Aires disaster.)

On the conference call to announce the results, Skilling couldn’t stop using words like “outstanding,” “fantastic,” and “tremendous.” The 2001 analysts meet-
ing, held, as always, in late January, was every bit the love fest it was the previous year, when the company unveiled its broadband strategy. The crowning moment came when Skilling presented his analysis of the value of Enron stock. The pipelines, by his analysis, were worth a mere $6 a share. EES, he said, was worth $23 a share. The wholesale business was worth $57 a share. And broadband was worth $40 a share. In the world according to Skilling, Enron stock was really worth $126 per share—more than 50 percent above its current level. The day of the meeting, the stock closed at $82, up 3 percent. Enron “management did not let the optimists down,” noted Goldman Sachs analyst David Fleischer, who reiterated his $110 price target on the stock.

A month later, Skilling and Lay held one of their regular employee meet-
ings. They took the opportunity to announce Enron’s new vision. Clearly, the World’s Leading Energy Company was no longer grand enough. The management committee had held a half-dozen meetings to brainstorm. The American executives loved the World’s Coolest Company, but many of Enron’s foreign employees didn’t know what it meant. Instead, they chose the World’s Leading Company.

Later in the meeting, Skilling explained how one measured the World’s Leading Company—not that there was ever any doubt. “When we talk about becoming the ‘World’s Leading Company,’ the target I think we all ought to have in mind is how do we become the company with the highest market value of any company in the world,” he said. At that time, those honors belonged to General Electric, which had a market value of $400 billion—almost six times larger than Enron’s.

Skilling had another thought as well. “Got to change my license plate from WLEC to WLC,” he said. Everyone laughed.

 • • • 

Skilling later insisted that, appearances to the contrary, he never wanted to be the CEO. The trigger, he claimed, was not the naked power play that it appeared to be. Rather, he said it was Lay’s idea—Lay realized that Skilling was restless. Even so, Skilling half expected that Lay would do to him what he’d done to Kinder four years earlier. But as it became clear that Lay had every intention of turning over the job to him, Skilling felt he had no choice but to accept the position. “Drive and ego, control and power,” says a former Enron executive who was close to Skilling. “You want the next job. Then, on the other hand, you want a life.” In this friend’s view, Skilling was genuinely conflicted, but he wasn’t able to walk away from the prestige of being Enron’s chief executive.

Skilling had a variety of reasons for why he didn’t want the job. He felt the board was always going to be in Lay’s back pocket. After taking a trip to Africa with his brother Mark and his son Jeffrey, he realized he wanted to spend more time with his children. That trip was the first vacation he ever had where he was not eager to return to work at Enron. And, he confided to his inner circle, he wasn’t having fun anymore. “I hate what I’m doing,” he told people.

For all of Skilling’s public bravado about how great everything was at Enron, he spent most of his time dealing with a host of serious problems, the part of the job he had always despised. Part of him was caught up in maintaining the illusion that Enron was, indeed, the World’s Leading Company. But it seems likely that another part of him was being forced to confront the darker reality. Holding those two conflicting notions in his head at the same time—at a minimum, it had to be exhausting.

Take the underperforming international assets. Although Skilling had disbanded the international team, he had yet to unload the assets. Enron had placed its hopes on Project Summer—the $7 billion deal with the Mideast investor that fell through at the last minute. After the buyer went away, Skilling put Baxter in charge of selling the assets piecemeal. He told investors that Enron would sell $2 billion to $4 billion of international projects by the end of 2001. But there were no takers.

Dabhol had also resurfaced as a nightmare. By this point, Enron had almost $900 million invested in it, but Maharashtra stopped footing Dabhol’s bills. Indian officials were complaining loudly about the high cost of Dabhol’s power and the resulting “exorbitant profitability” to Enron. By the spring of 2001, Dabhol was dark and silent, construction had been halted on Phase II, and Enron had launched arbitration proceedings.

Ken Lay personally chaired the Dabhol task force, and Ben Glisan served as the Global Finance liaison. Rebecca Mark—who believed the problem was that Enron, having fired all the international executives, didn’t have anyone left who understood the business—offered herself up as a savior, calling Lay to volunteer to salvage the situation. After Skilling told Lay that he would quit if Mark came back, Lay wouldn’t even return her calls.

The problem was both incredibly simple and impossible to fix: the MSEB said it did not need and could not afford the expensive power that Dabhol produced, there was no one else to buy it, and the project would run out of cash by the summer. (“Plant of questionable value,” Glisan noted.) Skilling joked to one fund manager that his preferred solution would be to confiscate Air India planes when they landed at JFK International Airport. Lay later told India’s prime minister that he would settle for $2.3 billion, an amount that he called “exceptionally reasonable.” Publicly, however, Enron insisted that Dabhol would not have a material effect on its finances.

Skilling could blame Rebecca Mark for the problems with the international assets. But he had no one to blame but himself for broadband. The market for tech and telecom stocks was melting down—there wasn’t going to be anyone left to trade with. The content business remained a joke. And the broadband team, with its huge overhead, had run out of ways to create earnings.
This
was a business worth $36 billion?

Enron had negotiated the sale of Portland General to Sierra Pacific for $2.1 billion. It was supposed to be a sure thing. But as a result of the new California laws triggered by the state’s energy crisis, Sierra Pacific was barred from sell-
ing generating plants it needed to unload in order to fund the acquisition. It took until April for Enron to announce what everyone already suspected: the deal was off.

California was troublesome in other ways. Questions were swirling about how much money Enron’s traders were making, and on Wall Street, there were just as many questions about how much money EES was losing in the state. Skilling insisted that Enron was fully “reserved” for any California problems, but he refused to disclose any details, insisting it was competitive information. On the year-end conference call, he said, “Now, for Enron, the situation in California had little impact on fourth-quarter results. Let me repeat that. For Enron, the situation in California had little impact on fourth-quarter results.”

Six months later, the folly of Enron’s California stance was underscored when its longtime investor, CalPERS, halted ongoing negotiations to amend JEDI II, meaning that JEDI II would have less money to extend to Enron. “This action is a direct result of the continuing power crisis in California and the threat of a backlash, which could lead to the reregulation of the energy industry,” explained a Global Finance executive in an e-mail. “More pressure,” replied Rick Buy succinctly.

And Andy Fastow’s team had its own cancer in the making. Their clever concoction, the Raptors, had immediately gone sour. In late 2000, as the assets in the SPEs declined, the Raptors owed Enron money. But the New Power warrants that Porcupine was supposed to use to repay Enron had virtually collapsed. And the assets in the first Raptor had declined so dramatically that Enron needed its stock to continue to climb dramatically to cover the losses. But the stock had stalled. Since two Raptors couldn’t pay what they owed, Enron would have to declare losses—which defeated the very purpose of the vehicles.

Naturally, Rick Causey and his in-house accountants tried to come up with a solution that avoided that dire possibility. They first argued that under a “probabalistic” analysis—the chief probability being that Enron’s stock would climb—there was no need to declare losses. Andersen refused to go along with that, arguing that Enron’s stock price was what the market said it was. (Enron was not a fan of the market when it meant taking losses.) Next, Enron argued all the Raptors could, in essence, be viewed in the aggregate—meaning that the healthy vehicles could use their excess credit capacity to support the sick ones. Under that scenario there would be no need to declare losses.

This solution should never have passed muster under any circumstances. The Raptors had already contorted the rules of accounting. This made a complete mockery of them. Indeed, Andersen refused to go along—or rather, Carl Bass refused to go along. He insisted that there was no rational basis for LJM to agree to use some SPEs to prop up others.“Heads I win, tails you lose,” as Bass described it. (Of course Fastow had already gotten his money out, so it made no difference to him.)

As year-end approached, both Enron and Arthur Andersen were desperate. And so, David Duncan, with the support of his immediate superiors in the Houston office—Mike Odom, the practice director, and Mike Lowther, the head of the firm’s energy practice on the audit side—agreed to “bridge” the Raptors through the end of the year. Without telling Bass, they cross-collateralized the four Raptors for 45 days, enabling Enron to avoid reporting $500 million in losses. (LJM2 was paid $50,000 for its trouble.) Of course, the fix didn’t really fix anything. It only pushed the problem further off and added another tangle to the fragile web of accounting deception.

 • • • 

On February 5, 14 senior Arthur Andersen partners, including eight based in
Houston—David Duncan among them—held a meeting to discuss whether to retain Enron as a client. Andersen has insisted this was a routine meeting, but the topics seemed to be anything but routine. At the meeting, there was “significant discussion” about LJM, about Fastow’s conflicts, and about whether Enron ever got any competing bids for assets that were sold to LJM, as a memo documenting the meeting noted. The Andersen accountants called Enron’s use of mark-to-market accounting “intelligent gambling.” The high-level group fretted over “Enron’s dependence on transaction execution to meet financial objectives.”

But they also noted that it “would not be unforeseeable that fees could reach a $100 million per year amount.” They concluded that despite the rising fees, they could maintain their independence—so they would keep the account. They decided to tell Enron’s board to establish a special committee to monitor the fairness of the LJM transactions. In fact, Duncan never made that request. One week later, Enron’s board met, but Duncan and a second Andersen partner in attendance never breathed a word about their concerns. Instead, Duncan reassured the board that Andersen’s “opinion on the Company’s internal controls . . . would be unqualified.”

Arthur Andersen reached another decision, too. In late February, Andersen CEO Joseph Berardino paid a visit to Houston, where he met with Causey and Duncan. The visit was a courtesy call, but perhaps inevitably, the subject of Carl Bass came up. Causey was angry that Bass had refused to sign off on Project Braveheart and the Raptors. Duncan scribbled notes: “Carl. Too technical. Client satisfaction involved in Blockbuster.” Other notes conveyed Causey’s feelings about Bass: “negative view of Carl” and “Some push by client to get Carl out of engagement team.”

About a week later, the firm removed Bass from any further direct dealings with Enron. When Bass found out what had happened, he wrote a three-page e-mail to his boss, John Stewart. “You should at least have a version of what I know about this Enron ‘thing’ from me,” Bass began. He denied harboring “some caustic and inappropriate slant” in dealing with Causey or Enron. In questioning transactions like Project Braveheart, he was doing his job—upholding accounting standards and protecting both the firm and the client. Bass also complained that Duncan’s group had allowed Enron to know “all that goes on within our walls” instead of keeping his internal advice private. He recalled a meeting where a low-level Enron employee “introduced herself to me by saying she had heard my name a lot—‘So you are the one that will not let us do something.’ ”