The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (58 page)

John Stewart was furious. “I thought it was unprofessional for Enron to make such a request,” he later said. Stewart, who had been at the Professional Standards Group since 1980, also said he viewed Bass’s removal as a defining moment. It was a request no client had ever made before, and one the firm should never have granted. “We should have been more independent,” Stewart later said.

 • • • 

The bull market was over. It ended in the spring of 2000. The dot-coms were in free fall; many were soon out of business. The telecoms were in similar straits. Where investors had once cheered the market’s every move, now they grew angry as their savings dwindled and they realized they had gotten caught up in a classic bubble.

As stocks sank, the game changed. Momentum investors were selling instead of buying. Skeptical voices that had been ignored during the great bull run were suddenly getting a hearing. And companies that hit or beat their earnings target could no longer be assured of a rising stock price. Investors were newly curious about how companies had arrived at those earnings. They were digging deeper and asking questions. In the bull market, investors always saw the glass as half full; now, for the first time in years, they were seeing it as half empty.

For all his brilliance, Skilling never seemed to understand this new dynamic. After peaking in August 2000 at $90 a share, Enron stock had sunk as low as $65 that fall, largely because of worries about California. It gained much of that back—helped, as ever, by the analyst meeting in January—but it never really jolted upward again the way Skilling thought it should. It was certainly not climbing inexorably towards $126 a share. Skilling was, if anything, more obsessed with the stock than ever; in the words of one of his executives, he had “morphed into more of a stock promoter than a businessman.” He kept thinking that as long as Enron made its numbers, the stock would start climbing again. But he was wrong.

It was short sellers who first asked tough questions about Enron. Their interest was sparked by the tremendous run-up in the stock, which can suggest that a company is overvalued. It was fueled by the hype about broadband and the collapse of Azurix.

And it was also triggered by Enron’s use of mark-to-market accounting, which had been largely ignored since Toni Mack and Harry Hurt III pointed out its dangers in the mid-1990s. On September 20, 2000, Jonathan Weil, a reporter in the Dallas bureau of the
Texas Journal
, a regional supplement to the
Wall Street Journal
, published a story that focused on the degree to which all the energy trading companies relied on mark-to-market accounting. Weil noted that outsiders had no way of knowing the assumptions that companies like Enron, Dynegy, and El Paso used to book their earnings. He also pointed out that a hefty portion of those earnings was not cash. Weil’s story ran only in Texas; inexplicably, his editors chose not to run it in the national edition. But at his desk in New York, a man named Jim Chanos came across the story.

Chanos and his hedge fund, Kynikos Associates, are not well known the way that giant mutual fund complexes like Fidelity and Vanguard are. Hedge funds cater to institutions and wealthy individuals—Chanos’s fund requires a minimum investment of $1 million—and they don’t advertise. But to the Wall Street cognoscenti, Chanos is very well known indeed. Kynikos has been around for almost 20 years—an aeon in hedge-fund terms—and is one of the few funds focusing exclusively on short selling to have survived the long bull market. Chanos is always on the lookout for overvalued stocks, but more than that, he’s a kind of financial sleuth, who scours balance sheets and financial documents searching for clues that something might be awry inside a company. Although he doesn’t get them all right—in 1995, Chanos was run over shorting AOL—his batting average in recent years is high. Today, he manages over $1 billion.

Like Skilling, Chanos is from a midwestern family—his father ran a chain of dry cleaners in Milwaukee—and like Skilling, he was always interested in the market. When he was young, his father would take out books from the library on the market for him to read. Unlike Skilling, Chanos was conservative with his money and didn’t invest on his own until college, when he bought shares of oil stocks and airlines—companies that were in the Dow Jones industrial average or the S&P 500. He attended Yale, where he began as a premed major but soon became fascinated by economics, accounting, and a book called
The Contrarian Investor
, which stresses fundamental analysis and the importance of ignoring the crowd. After graduation in 1980, Chanos began working as a numbers cruncher for a small investment-banking firm. His epiphany came when he did an analysis showing that a client about to issue equity should actually be buying back stock instead. “You cannot mention that,” yelled his boss. “We are in the business to promote the sale of equity.”

And so Chanos moved out of investment banking and into a small research firm. His life changed forever when he began looking into a company called Baldwin United. Baldwin, which had been formed from the merger of a piano maker and an insurance company that sold annuities, was one of the hottest stocks of that era. After months of dogged research, Chanos realized that the high-flying Baldwin was, in essence, a giant Ponzi scheme that raised money secretly through subsidiaries, turned the money over to the parent to support its enormous capital consumption, and used aggressive mark-to-market assumptions on its portfolio of annuities to create fabulous earnings growth. When it comes to stock-market frauds, history does repeat itself.

In August 1982, the 24-year-old Chanos put out a sell report on Baldwin United. The report was extremely controversial, for Baldwin, just like Enron, had wide and vocal support among the analysts. Merrill Lynch and many of the other firms made hefty commissions pushing Baldwin’s annuities on its retail customers. Chanos’s work was denounced up and down Wall Street. But by the fall of 1983, Baldwin had filed for bankruptcy, and the scandal had burst into the open. In 1985, Wall Street firms settled with the annuity holders for $140 million. That same year, Chanos founded Kynikos, named after a sect of ancient Greek philosophers that believed the key to life was self-discipline and independence of thought.

After Chanos saw Jonathan Weil’s story in the fall of 2000, he flipped open Enron’s 1999 10-K. He read: “The market prices used to value these transactions reflect management’s best estimates.” He thought: “A license to print money.” He began talking to Enron’s competitors, Wall Street analysts, and virtually anyone else he thought might have information on the company—though not to the company itself, which he viewed as a waste of time. (“You can call the analysts and get the company party line,” he says.)

The more Chanos poked around, the more he felt that the Enron story didn’t make sense. Chanos had made a fortune researching—then shorting—telecom stocks. He knew how much trouble they were in. How could Enron’s broad-
band unit be doing so well when the rest of the industry was on life support?
“We know telecom cold,” he says. “And here’s Enron bleating about this great opportunity.”

Enron’s return on invested capital was abysmally low, around 7 percent—and that figure didn’t even include the billions upon billions of off-balance-sheet debt. “They were chewing up capital,” says Chanos. He was struck by a three-paragraph disclosure in Enron’s third-quarter 2000 filing about its dealings with a related party. No matter how many times he read it, he still couldn’t understand what it said. He showed it to derivatives specialists, corporate lawyers, and other experts; they couldn’t figure it out either. Chanos thought: “They must be trying to hide something.” And then there were the insider sales. Lay was consistently selling about 2,500 shares a day. Skilling was also selling in big chunks.

Chanos and the others who shorted Enron’s stock didn’t have any special information that wasn’t available to the bulls. “As soon as anyone looked, they could see the stuff we saw,” says Chanos today. At first, he adds, “We didn’t think it was some great hidden fraud. We just thought it was a bad business.” By November 2000, he had begun taking a big short position in Enron stock.

Because of Chanos’s record, reporters call his office regularly, looking for story ideas. A few weeks after Enron’s 2001 analysts conference, Chanos and Doug Millett, Kynikos’s chief operating officer, told
Fortune
writer Bethany McLean (co-author of this book) that they were skeptical of Enron. Millett, a gregarious former Yale football player, laughingly described Enron as “a hedge fund sitting on top of a pipeline.” After pointing out how low Enron’s return on invested capital was, he added, “Would you put your money in a hedge fund earning a 7 percent return?” Chanos said, “Read the 10-K and see if you can figure out how they’re making money.” The two men also noted that Enron was a speculative trading shop, which meant that, at an absolute minimum, its outsize price-to-earnings multiple made no sense. “You don’t give these things a 50 multiple even if it’s the Goldman Sachs of the energy business,” said Chanos.

Chanos was right: when you took the time to pore through Enron’s financial documents, it wasn’t hard to find scratches on its shiny surface. While Enron’s reported earnings were growing smoothly, the business didn’t seem to be generating much cash—and you can’t run a business without cash. In fact, Enron had
negative
cash from its operations in the first nine months of 2000. (It was impossible to analyze the full year because Enron released an income statement only when it announced earnings—not a balance sheet or a cash-flow statement. Only when the report was filed with the SEC a month or so later could anyone really dig through the numbers. This soon became a huge issue.)

There were other warning signs. Enron’s debt was climbing rapidly—$3.9 billion of debt was added on the balance sheet in the first nine months of 2000 alone—which didn’t make sense if the business was as profitable as Enron was claiming. It was also clear that Enron was selling assets and booking the proceeds as recurring earnings. In fact, publicly filed documents showed that nearly 40 percent of Enron’s earnings in 1998 and 1999 came from gains on sales of assets rather than from ongoing operations.

McLean soon realized that there was growing skepticism toward Enron in the investment community, though few were willing to express it on the record. “It’s hard to believe they’re not taking losses in California [on EES], but they’ll cover it up somehow. Enron is especially good at that,” said one portfolio manager under the cover of anonymity. “The last two years, about half the quarters they’ve had some kind of issue, but no one on Wall Street will challenge them.” Another portfolio manager said: “Volatility and pricing are going to go down in California. How can you pull the same numbers out of trading?”

Commerzbank analyst Andre Meade, one of the few who had a hold rating on the stock, worried that Enron was “liquidating its asset base and booking it as recurring revenue.” Another analyst, Robert Winters, then at Bear Stearns, wrote in a report dated January 26, 2001, that “the ability to develop a somewhat predictable model of this business for the future is mostly an exercise in futility.” Yet another analyst when asked about Enron’s accounting said: “You don’t have a clue, I don’t have a clue, and I’m not sure they have a clue. Enron,” he added, “is a big black box.”

On February 14 at 10
A
.
M
.,
McLean and Skilling spoke for about 20 minutes. Skilling, who had been CEO for all of two weeks, was not in a good mood. “Enron is
not
a black box,” he said emphatically. “It is very simple to model.” Enron was a “logistics company,” not a trading company, he insisted. Off-balance-sheet debt? Virtually all of it, he said, related to international assets, and Enron was not on the hook to pay it back in any case. With every question McLean asked, Skilling became increasingly agitated. “I can see where you’re going,” he said finally and then went on almost a stream-of-consciousness rant. “I would really appreciate it if you would sit down with our finance and accounting teams. It is unfair to us and unethical [if you don’t take the time to understand our busi-
ness] . . . we are doing it purely right . . . people who raise questions are people who have not gone through our business in detail . . . people who don’t understand want to throw rocks at us . . . we have explicit answers, but people want to throw rocks at us . . . anyone who is successful, people would like to take them down based on ignorance.” With that, he hung up the phone.

Mark Palmer, Enron’s head of PR, promptly called back, offering to come to New York the next day with Enron’s CFO, Andy Fastow. “We want to make sure we’ve answered all of your questions completely and accurately,” he said. With Mark Koenig, Enron’s head of investor relations, in tow, they flew to New York the next morning, arriving at
Fortune
around ten. The three Enron executives were shepherded into a small, windowless conference room, where they sat down with McLean and two
Fortune
editors.

Fastow’s explanation of Enron’s business did not exactly provide the promised clarity. On the contrary. Here’s how Fastow explained Enron’s business model: “We create optionality. Enron is so much more valuable—hence our stock price—because we have so much more optionality embedded in our network than anyone else.” Fastow then compared Enron to Toyota; Enron, too, was an “assembler” rather than a “manufacturer.” “Our disclosure is more complete than anyone’s,” Fastow insisted. A moment later, he seemed to say precisely the opposite: “We don’t want to tell anyone where we’re making money.” Like Skilling, Fastow insisted that Enron did not make its money speculat-
ing. “It’s not trading, it’s optimization,” he said. The proof? Enron’s earnings record in the wholesale business. “We have for 20 straight quarters exceeded the previous one. There’s not a trading company in the world that has that kind of consistency.”

When McLean asked Fastow about the related-party transactions, he replied, “One of our senior executives runs that fund. It’s confidential who it is.” (In fact, a line in Enron’s 1999 proxy statement disclosed that the senior executive was Fastow.) Why did Enron need to do business with the related party? “We’re always looking to hedge risks, to sell risks,” Fastow replied. “We want to sell, but we don’t want the information to get into the market . . . it adds to our optionality.” And “we strip out the price risk, we strip out the interest-rate risk, we strip out all the risks. What’s left may not be something that we want. We want the contract, but we don’t want the power plant. We’re not investing for the whole thing—we wanted the optionality. Once we’ve gotten that piece, we want to sell off the other pieces.”