The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (66 page)

 • • • 

From the moment he took over as CEO, Ken Lay touted Enron’s stock. He convened investor meetings. He gave media interviews. And he regularly preached to the most easily converted—Enron’s own employees. In an August 27 e-mail, Lay declared that these efforts “should result in a significantly higher stock price.” In an employee Internet chat on September 26, he reported that Enron’s third quarter was “looking great.” He added: “My personal belief is that Enron stock is an incredible bargain at current prices and we will look back a couple of years from now and see the great opportunity that we currently have.” He urged employees to “talk up the stock.” Enron is “fundamentally sound,” he said. “The balance sheet is strong. Our financial liquidity has never been stronger.” The flogging worked: in the week before Enron’s earnings announcement, Enron’s shares climbed back over $35.

Lay, of course, didn’t reveal that in the previous two months, he had secretly cashed in $20 million of his own stock by drawing down his company credit line, then repaying it with Enron shares—part of the $78 million Lay had pocketed this way over the previous 12 months. While he later attributed this to his personal liquidity crisis, day-to-day life in the Lay household was continuing much as it always had.

Linda’s son Beau worried about whether the impending sale of one of Lay’s three multimillion-dollar Aspen homes would require the three couples he’d invited up for a long ski vacation to change their plans. No need, Linda Lay replied. Ken’s daughter Liz checked in with her dad to ask whether she and her husband should make commercial reservations back from Aspen after the Christmas holidays. Lay’s secretary e-mailed back: “Ken said to advise you that he’ll plan to arrange a plane to bring you and others back on Jan 1.” The traditional all-family dinner was planned for mid-October at the River Oaks Country Club. Dress would “remain casual to casual/chic, as usual,” Linda advised. A photographer would be on hand “to help us take a few very special group photographs,” with “very simple nonscary Halloween costumes for the wee ones to put on over their casual attire.”

It was business as usual at Enron, too. After a board meeting, Ken and Linda Lay took a tour of the sleek new Enron building nearing completion. Enron was laying plans for a giant employee Christmas bash—a million-dollar extravaganza at Enron Field. The company donated $1 million to emergency relief efforts after September 11. Lay’s calendar remained busy, not just with Enron executive meetings but with calls to governors, CEO forums, and charitable events. On October 10, he flew to Washington for dinner and a speech at the Library of Congress by former secretary of state Henry Kissinger, an Enron consultant.

 • • • 

While Lay was hobnobbing in Washington, Rick Causey was huddling with Enron’s accountants in Houston, haggling over just how far the company could go in sugarcoating its bad third-quarter earnings news.

From the moment they decided to terminate the Raptors, Enron executives desperately wanted to avoid a restatement, which would mean the company was formally admitting mistakes, confessing to the world that its previous financial statements were wrong. Restatements triggered big stock declines, SEC inquiries, and shareholder lawsuits. It was far better instead to simply take a charge in the current quarter, something more akin to reporting that things hadn’t gone quite the way they’d expected.

The balance-sheet error, of course,
was
a mistake. But Enron argued—incredibly—that this $1.2 billion balance-sheet error wasn’t “material” under accounting rules, because it amounted to only about 8.5 percent of Enron’s total net worth. David Duncan went along; Andersen didn’t want to admit the screwup either. Enron reported the charge as a simple equity reduction.

The income-statement charges were harder to fudge. Enron was preparing to report a $544 million hit ($710 million pretax) for the Raptors’ termination. There was another $287 million for write-downs of overvalued assets at Azurix and $180 million for restructuring charges at broadband, which included the cost of layoffs and belated acknowledgement that the much-hyped content business really wasn’t worth much after all. The grand total was $1.01 billion after-tax, enough to throw Enron’s quarterly earnings deeply into the loss column. Andersen had already agreed that this wouldn’t require a restatement either, even though the Raptors, now being eliminated, had inflated Enron’s reported earnings for four previous quarters.

The issue now was that Enron wanted to report these problems as nonrecurring charges, one-of-a-kind events that didn’t really reflect on the underlying performance of the company’s businesses. This too had big Wall Street implications. Analysts tended to discount nonrecurring charges and focus instead on operating earnings.

For precisely that reason, the accounting treatment on this front was rife with opportunity for abuse. And Enron was a habitual abuser: historically, it had treated routine business losses as nonrecurring charges, and booked onetime gains as operating profits. In the Braveheart deal, for example, Enron booked its dubious monetization of the Blockbuster contract as operating income; now, it wanted to call its write-down of the content business a nonrecurring loss. Similarly, while Enron wanted to treat the Raptors’ termination as a nonrecurring event, it certainly hadn’t hesitated to treat the $1 billion in income they contributed as operating profits.

Even for Arthur Andersen, this was going too far. David Duncan, uncharacteristically, was putting up a fight. With each new emerging problem, Duncan became more immersed in Enron than ever. He was so busy he even had to skip the big Arthur Andersen shindig in New Orleans, where his face was flashed on giant video screens in recognition of his status as one of the firm’s stars. His sterling work on the huge Enron account had just earned him a partnership bonus worth about $150,000.

After seeing Causey’s first draft of Enron’s earnings release on Friday, October 12, Duncan alerted various Andersen partners and an in-house attorney named Nancy Temple. One partner quickly e-mailed back: “I agree with your comment about the nonrecurring wording which seems inappropriate given in one quarter they have multiple ‘nonrecurring’ items.”

On Sunday, Duncan spoke to Causey, telling him that Andersen had “strong concerns that the presentation of the charges as nonrecurring could be misconstrued or misunderstood by investors” and that the SEC might well view it as “materially misleading.” In a memo Duncan later wrote documenting the events, he also recalled advising Causey to “consider changing the presentation.” Duncan’s old friend was noncommittal. “Rick acknowledged my advice,” Duncan wrote.

Causey spent half his workday Monday in meetings with Ken Lay and others, prepping for the critical conference call that would immediately follow the earnings release. When he saw Duncan again that night, Causey told him he had discussed his concerns internally and that the earnings release had gone through “normal legal review.” Joined by other Andersen partners—some by conference call from Chicago—Duncan argued with Causey late into the night.

Ultimately, though, it was Enron’s call, and the client wanted nonrecurring. The release didn’t even make it to the PR department until 5:30
A
.
M
.
—not long before it was to go out on the newswires, ahead of the market’s opening bell.

 • • • 

 • • • 

For those who didn’t know any better, it would have been easy to conclude from Enron’s third-quarter earnings release, issued Tuesday, October 16, that nothing was seriously amiss. The headline actually seemed reassuring:
ENRON
REPORTS
RECURRING
THIRD
QUARTER
EARNINGS
OF
$
0.43
PER
DILUTED
SHARE
;
REPORTS
NONRECURRING
CHARGES
OF
$1.01
BILLION
AFTER
-
TAX
;
REAFFIRMS
RECURRING
EARNINGS
ESTIMATES
OF
$1.80
FOR
2001
AND
$2.15
FOR
2002
;
AND
EXPANDS
FINANCIAL
REPORTING
.

What followed was classic Enron—an attempt to hide what was really going on by stretching the rules, twisting the language, and playing games. Instead of talking about quarterly earnings, as Enron’s earnings releases usually did, this one focused on “recurring earnings.” “Our 26 percent increase in recurring earnings per diluted share shows the very strong results of our core wholesale and retail energy business and our natural-gas pipelines,” Lay was quoted as saying in the press release.

The billion-dollar nonrecurring charge was noted in the third paragraph, along with the $618 million net loss for the quarter. That was quickly explained away as a matter of housecleaning. The nonrecurring charges were described as “asset impairments” involving Azurix; “restructuring costs” at broadband; and $544 million “related to losses associated with certain investments, principally Enron’s interest in the New Power Company, broadband and technology investments, and early termination during the third quarter of certain structured-
finance arrangements with a previously disclosed entity.” It was a massive obfuscation, calculated to hide the awkward fact that the now-terminated Raptors had hidden Enron losses. Even more astonishing, the release didn’t even
mention
the separate $1.2 billion cut in shareholders’ equity—which wouldn’t show up on the accompanying financial statements since Enron never released its updated balance sheet until well after the quarterly-earnings statements.

In the 9
A
.
M
.
conference call, Ken Lay walked a carefully prepared line. First, he focused on the strong “recurring operating performance.” When he turned to the “nonrecurring charges of slightly over $1 billion,” Lay stuck to the script, again attributing most of the charge to “early termination” of “certain structured-finance arrangements with a previously disclosed entity.” Then he noted, for the first time, the giant balance-sheet hit: “In connection with the early termination, shareholders’ equity will be reduced by approximately $1.2 billion with a corresponding significant reduction in the number of diluted shares outstanding.” In other words, Lay was tying the equity cut to the purported housecleaning decision to terminate the Raptors. In fact, they were unrelated.

Now, Lay insisted, all of Enron’s problems were on the table. “If we thought we had any other impaired assets, it would be in this list today.” Enron stock actually climbed a bit through the day, closing near $34.

But Fastow knew trouble was on the way. “Well, you probably saw the earnings release and some of the interviews already,” he wrote in an e-mail to a family member. “Needless to say, things have been a little busy around here. I wouldn’t be surprised to see the LJM article appear tomorrow as part of the earnings story.”

 • • • 

Sure enough, Enron’s financial dealings with Andy Fastow were finally placed on public display the next day in the long-awaited story in the
Wall Street Journal
. Using the billion-dollar charge as their peg, Emshwiller and Smith did two things Enron had long feared: they cited the big third-quarter loss as evidence that Enron’s business was, in truth, perilous, and they showcased the sordid details of Enron’s relationship with Fastow’s partnerships, raising “vexing conflict-of-interest questions.”

This time LJM was front and center. The page-one story quoted from the offering memo’s discussion about how Fastow’s involvement would help LJM2 cash in on its deals with Enron—and noted that the company had embraced an arrangement that could provide “potentially huge financial rewards for Mr. Fastow.” Lay was described as having insisted in an interview that the arrangement didn’t really present any conflicts. Equally damning, Charles LeMaistre, chairman of the board’s compensation committee, told the
Journal
he viewed the arrangement as a supplemental form of compensation that helped keep Fastow, the valued CFO, at Enron. “We try to make sure that all executives at Enron are sufficiently well paid to meet what the market would offer.”

After reading the
Journal
, Merrill banker Schuyler Tilney e-mailed a colleague: “Not a great article, but frankly could have been worse.”

Fastow had a different reaction. Later that day, he e-mailed Ben Glisan with a simple message—“5:00 pm get drunk with Andy.”

This story was just the beginning. The next day, Thursday, October 18, the
Journal
focused on the $1.2 billion hit to shareholder equity, highlighting
its
link to Fastow’s partnership and Enron’s failure to disclose “the big equity reduction” in its earnings release. Asked why Enron had hidden the cut, PR man Palmer was left to insist that it was “just a balance-sheet issue,” immaterial for disclosure purposes.

Peter Fastow e-mailed his brother that morning. “Jana and I read the WSJ article with great revulsion,” he wrote. “We know, without a doubt, that there was nothing inappropriate with your involvement in LJM while serving as an officer of Enron. We support you 100%. Anyway, we both found the content of the article to be extremely suspect. If you were really making millions from LJM, there is no way you’d let your brother continue to drive a 7 year old Toyota Camry. We both wish there was something we could do to help you combat this attempt at character assassination.”

The third shot arrived on Friday, headlined: “Enron CFO’s Partnership Had Millions in Profit.” Noting that LJM2 reaped more than $7 million in management fees in 2000, this story drove home the central nature of the conflict. Though the reporters didn’t know precisely how much Fastow had personally cleared, it was obvious that he’d pocketed millions doing business with Enron.