The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (7 page)

For the next few months, the Arthur Andersen team took up the investigation, but they didn’t get much further than the internal auditors did. The Enron executives were terrified of offending Borget. Before the accountants went to Valhalla to interview Borget, Seidl sent the head oil trader a memo detailing Andersen’s concerns so that he would be better prepared to address them. After one conference call among Arthur Andersen, Seidl, and Borget, Seidl sent a telex to Borget. “Lou,” it read. “Thank you for your perservance [
sic
]. [Y]ou understand your business better than anyone alive. Your answers to Arthur Andersen were clear, straightforward, and rock solid—superb. I have complete confidence in your business judgment and ability and your personal integrity.” Then he added, “Please keep making us millions. . . .”

In late April, Arthur Andersen discussed its findings with the audit committee of the board. The accountants told the board that they “were unable to verify ownership or any other details” regarding Enron Oil’s supposed trading partners. They noted that the Apple Bank transactions had no purpose beyond shifting profits. And they’d found a few other troubling things. For instance, Enron Oil was supposed to have strict controls to prevent the possibility of large losses; its open position in the market was never supposed to exceed 8 million barrels, and if losses reached $4 million, the traders were required to liquidate the position. Yet when the Arthur Andersen auditors had tried to check whether Enron Oil was complying with the policy, they later reported, they discovered that Borget and Mastroeni had made a practice of “destroying daily position reports.”

Still, Andersen refused to opine on the legality of what had come to be known internally as Borget and Mastroeni’s “unusual transactions,” claiming that it was beyond their professional competence. Nor were the auditors willing to say whether the profit shifting had a material effect on Enron’s financial statements. Both things would require the company to disclose the transactions to the Securities and Exchange Commission, restate its earnings, and face possible sanctions from the IRS. Instead, the auditors said, they were relying on Enron itself to make those determinations. And Enron did. Arthur Andersen noted that the firm had received a letter from Rich Kinder and another Enron lawyer concluding that “the unusual transactions would not have a material effect on the financial statements . . . and that no disclosure of these transactions is necessary.”

And that, stunningly enough, was that. According to the minutes of that same board meeting, “Dr. Jaedicke called upon management for a matter that involved Enron Oil Corporation that was investigated by the company and subsequently investigated by Arthur Andersen. . . . After a full discussion, management recommended the person involved be kept on the payroll but relieved of financial responsibility and a new chief financial officer of Enron Oil Corporation be appointed. The committee agreed with reservations. . . .”

“Management,” says Woytek, was Lay—who openly said at the board meeting that the traders made too much money to let them go. And the new watchdog chief financial officer was none other than Steve Sulentic, who, once he moved to Valhalla, reported to Borget. “Dr. Jaedicke” referred to Dr. Robert Jaedicke, then the dean of the Graduate School of Business at Stanford and the head of Enron’s audit committee.

Two months later, what lawyers later called a “whitewash” was completed when an Enron lawyer wrote a memo—which Kinder eventually sent to the board—concluding that the profit-shifting deals were “legitimate common transactions in the oil trading business” and that they did not “lack economic substance.” In other words, there was no reason to report the transactions to the outside world. It was an absurd position to take, given that an in-house auditor had called the transactions “fictitious.” But not terribly surprising. As one lawyer on the Enron side remarked many years later, “Enron knew they were crooks. But they thought they were profitable crooks.”

 • • • 

As it turned out, Borget and Mastroeni weren’t engaging in criminal acts just for the good of the company. They were stealing from Enron as well. They were keeping two sets of books, one that was sent to Houston and one that tracked the real activities of Enron Oil. They were paying exorbitant commissions to the brokers who handled their sham transactions and demanding kickbacks. The so-called counterparties—Isla and Southwest and Petropol—weren’t legitimate trading entities. They were creations of Borget and Mastroeni, phony companies they set up in the Channel Islands. Mastroeni’s Apple Bank account was indeed one of the places he and Borget were hiding money they had skimmed from the company. In total, the two men and the other brokers stole some $3.8 million from Enron. And with Ken Lay and the other Houston executives so willing to look the other way, they would have gotten away with it, too, except that they made the one mistake Enron couldn’t abide. They stopped making money.

Back in Houston there had always been a few executives who were skeptical of the oil traders. One was Mike Muckleroy, the head of Enron’s liquid-fuels division and a former naval officer. An experienced commodities trader, Muckleroy had begun to hear rumors in mid-1986 that Enron Oil was making massive bets on the direction of oil prices. One thing that had long seemed obvious to Muckleroy was that Enron Oil had to be ignoring the trading limits that were supposed to prevent the traders from huge losses. Nothing else made sense. After all, the limits didn’t just keep losses under control; they also had the inevitable effect of limiting gains as well. To Muckleroy, it just didn’t seem possible that the Enron’s oil traders could be racking up their eye-popping profits without exceeding their trading limits. He took his worries to Seidl, who scoffed and replied that Muckleroy must be jealous of Borget’s bonus.

The rumors wouldn’t go away. At least a half dozen times, Muckleroy says, he pressed his concerns with Seidl. Finally, Seidl sent him to Lay. But the Enron CEO was no more interested in looking into it than Seidl had been; he told Muckleroy that he was being paranoid. “What do I have to do to get you to understand that this could do devastating damage to our company?” Muckleroy asked Lay. Then, in the summer of 1987, Muckleroy began to hear from friends in the business, as he later recalled, “that we were huge on the wrong side of a trade.” But so unconcerned were the Enron brass that at the company’s mid-August board meeting, the Enron board
increased
Borget’s trading limits by 50 percent. One skeptical Enron executive who attended that meeting returned to his office and told a colleague: “The Enron board believes in alchemy.”

It wasn’t until October that the truth began to come out—and then only because there was simply no way to hide it any longer. On October 9, 1987, Seidl met Borget for lunch at the Pierre hotel in Manhattan. It was supposed to be a social lunch; Seidl’s wife was upstairs in her room, waiting to join them. But as soon as Borget explained the situation to Seidl, he immediately called his wife and told her to stay put. He spent the rest of the lunch trying to absorb what Borget was telling him. For months, Borget had been betting that the price of oil was headed down, and for months, the market had stubbornly gone against him. As his losses had mounted, he had continually doubled down, ratcheting up the bet in the hope of recouping everything when prices ultimately turned in his direction. Finally, Borget had dug a hole so deep—and so potentially catastrophic—that there was virtually no hope of ever fully recovering. Borget was confessing because he had no choice.

This time, Seidl understood the gravity of the situation. He called Houston immediately after the lunch and, in a panicked tone, declared that as a result of Borget’s trading losses, Enron was “less than worthless.” Within two hours, he was on a plane to Newfoundland to meet Lay, who was returning from Europe and had to stop there to have his jet refueled. In Houston, Muckleroy was on his way back from lunch when he was confronted by an ashen Rich Kinder, who had just talked to Seidl. Muckleroy hopped on the next plane to New York to see if there was any way he could salvage the situation.

Muckleroy quickly discovered that things were far worse than anyone realized. Enron Oil was short over 84 million barrels. The position was so huge that it amounted to roughly three months’ output of the gigantic North Sea oil field off the coast of England. If Enron were forced to cover its position, it would have been on the hook for well over $1 billion. “Less than worthless” was exactly the right description: when you added $1 billion-plus to Enron’s $4 billion in debt, the company’s total debts outstripped its net worth. And, of course, given how strapped the company was for cash, there was simply no way it could cover its trading losses without filing for bankruptcy.

But Enron got lucky. Exactly the right person had gone to Valhalla to take charge of the problem. Experienced commodities trader that he was, Muckleroy took one look at Enron Oil’s books and sat Mastroeni down. “Unfortunately, I’ve had to kill people in my past,” he told the terrified treasurer, “and I sleep like a baby.” He demanded to see the real books. At eight the next morning, Mastroeni produced them. Muckleroy told Borget to leave the premises and asked Enron’s security officer to change the locks on the doors. Then he went to work.

For the next three weeks, he and a small team of traders worked 18- to 20-hour days. His goal was to shrink the size of the position so that when the company finally had to settle up, the loss would at least be manageable. His only hope was to bluff his way out of his dilemma; if other traders knew what trouble Enron Oil was in, they were likely to bid the price of oil even higher, then demand payment. To fool them, Muckleroy pretended that Enron had crude oil in hand; he even bought some to sell into the market. The bluff bought him time. Within a few days, oil prices began to decline. Or at least they fell enough that Muckleroy and his team were able to close down Enron Oil’s positions, reducing the damage to the company to around $140 million. That still hurt, but it was no longer life-threatening. “If the market moved up three more dollars Enron would have gone belly up,” Muckleroy later said. “Lay and Seidl never understood that.”

After almost a year of pretending in the face of overwhelming evidence that nothing was awry at Enron Oil, Ken Lay and the other Enron executives now had to pretend the opposite: that they were shocked—
shocked!
—by the actions of these rogue traders. The company announced that it would take an $85 million after-tax charge to 1987 earnings and blamed it on “losses from unauthorized trading activities by two employees in its international crude oil trading subsidiary.” As rumors of the fiasco had trickled out, Enron’s stock began to fall; by the time of the October announcement it was down 30 percent. But now Lay insisted to Wall Street analysts that this was a freak event that would have no long-term effect: “I would not want anyone to think at any time in the future this kind of activity would affect our other businesses,” he said.

At an all-employee meeting in late October, Lay told the crowd that he had been blindsided by Borget. “If anyone could say that I knew, let them stand up,” he said. Two people had to physically prevent Muckleroy from standing. At a board meeting held to discuss the loss, Lay again denied any responsibility, according to one person who was there. Lay also played dumb with Enron’s bankers, who were infuriated when they learned of the trading losses. As well they should have been. For at the same time the scandal was unfolding internally, Enron was in the midst of raising money from its banks. The deal closed just before Enron announced the $85 million charge but well after the company knew about the problem. “Everyone went apeshit,” recalls one banker. “They felt like they were lied to.” Well, they
had
been lied to.

The most ironic part of the aftermath was a massive suit Enron filed against Borget, Mastroeni, and a handful of others alleging a conspiracy to “defraud” Enron through what it now called “sham trades” with entities like Isla, Southwest, and Petropol, among others. Nobody at Enron was calling trades with these entities “unusual transactions” anymore. Defense lawyers for other trading companies argued that Enron was merely playing the victim to cover up its own complicity. “Any honest competent management, confronted with the conduct of Borget and Mastroeni, as revealed to Enron’s senior management in January 1987, would have fired these gentlemen without delay,” wrote one lawyer. (The suits were eventually settled.)

There were also investigations by both the SEC and the U.S. attorney’s office, but it seems that Enron got lucky once again. The investigations focused on the phony transactions Borget and Mastroeni had concocted to shift profits from quarter to quarter, transactions that several Enron executives had encouraged and that several others, including Ken Lay, had condoned after the fact. Yet for reasons that mystify many lawyers involved in the case, the government chose not to prosecute the company. In early 1988 Enron restated its financials for the previous three and a half years, blaming “unauthorized activities . . . designed to shift income.”

In addition to charging both Borget and Mastroeni with fraud and personal income tax violations, the U.S. attorney charged Borget with “aiding and assisting the filing of a false corporate income tax return” by hiding income with “sham transactions.” But, said the government, “there is no indication that Enron knew the information supplied by Borget and contained in the consolidated tax return was false.” Of course, anyone who poked around could have found plenty of indications. In early 1990 Borget pled guilty to three felonies and was sentenced to a year in jail and five years’ probation. (When reached by telephone, he said, “My memory is fading, and I don’t have much to say about an episode that is painful.”) A month later, Mastroeni pled guilty to two felonies. He received a suspended sentence and got two years’ probation. But by then, the Enron Oil scandal had long been forgotten.

 • • • 

 • • • 

Inside Enron, there was a second, less public kind of aftermath: the scandal marked the rise of Rich Kinder as a force inside the company. Mick Seidl had become the company’s number two man largely on the strength of his friendship with Lay. He had much in common with Lay: he was a former academic with a Ph.D. in economics and a former government policy maker who had worked with Lay at the Interior Department in the early 1970s. But Seidl also shared other tendencies with Lay. He had a terrible time making decisions that might anger somebody. And he was far more interested in the glamour of being a
corporate executive than in the hard work of making the company profitable.
He wanted to be Mr. Outside, but Enron already had a Mr. Outside: Ken Lay himself.