How a Titan Came Undone
Enron's collapse stunned the world. But it was inevitable from Day 1. Here's why
BY JULIAN E. BARNES, MEGAN BARNETT, AND CHRISTOPHER H. SCHMITT
USNews.com
Money & Business 3/18/02
High above the Atlantic, cruising stateside in his sleek Falcon jet, Ken Lay had reason to be pleased. It was October 1987, and his two-year-old company was looking to sell a chunk of its oil and gas unit to raise cash to pay off a pile of debt. The Enron CEO had been to England, Scotland, and Switzerland to pitch investors there on buying a piece of the action, and the roadshow had gone well. The corporate jet swooped into Gander, Newfoundland, to refuel. There, Lay's mood soon darkened. An aide told him that a brewing scandal–speculative activity in the company's New York crude-oil trading operation–was about to explode. "You could just see the blood drain out of his face," recalls an executive on the trip. "It was catastrophic." Lay peeled off and headed to New York for damage control. The episode would ultimately cost Enron up to $150 million and threaten its very existence.
The crisis would prove prophetic. To most people, Enron's implosion late last year was sudden and startling, accompanied by revelations that executives used secret partnerships to hide huge debt, wildly inflate profits, and line their pockets. But a closer look shows that the collapse of the nation's seventh-largest company was virtually preordained. Over the years, Enron made a steady series of moves–financial, ethical, and cultural–toward what would become its abyss, so that when failure finally came, the last few strides weren't long ones. Before there were partnerships like Raptor and Chewco, there were warnings about cooking the books. Before that, an "old economy" pipeline psychology had yielded to a best-and-brightest "new economy" ethic, where the fact of doing deals came to rival whatever the deal itself might be. At the start, just as at the end, was an all-consuming obsession with debt. Enron didn't lurch into crisis. It began a march there in 1985, on the very day it was born.
As business scandals go, Enron doesn't top the list. The savings and loan collapse in the 1980s cost taxpayers about three times the $67 billion that Enron torpedoed in investor wealth. The Enron debacle doesn't mean capitalism is broken. Nor does it fully discredit a devil-take-the-hindmost management style. Still, Enron stands as the signature scandal of the new economy, reinforcing the notion that, for all the progress made since the robber barons of the late 1800s, fair and open markets remain more an ideal than a reality.
Seen in one light, Enron is about a band of pretty smart people who thought they had found a way to defy the laws of business physics and who created a culture that couldn't recognize that those laws were, in fact, immutable. The courts will decide whether any of those people broke the law. But for now, the only crime that is certain to have been committed is that of hubris.
Past as prologue
In Texas horse country, when there's no hitching post handy, a rider hobbles his horse, tying its legs, so it can't move. When Enron was created, through Omaha-based InterNorth Inc.'s takeover of Houston Natural Gas Corp., the company hobbled itself. As told by Enron executives afterward, the $2.3 billion deal was carefully crafted to exploit a shifting energy landscape. That may be. But the Enron that crashed and burned may be more the result of a huge misunderstanding–or at least a shotgun wedding. Minneapolis corporate raider Irwin Jacobs had taken a big position in InterNorth, and the company was panicked that Jacobs was moving to take it over. Scrambling for a more suitable partner, InterNorth approached Lay, the Missouri-bred son of a Baptist preacher who cast himself as a benevolent, civic-minded leader. There was another side to the soft-spoken executive, however. Just a year after Enron was created, he was the fifth-highest-paid CEO in America, a man who had no trouble steering his employees to his sister's travel agency and, according to an executive who fielded complaints, browbeat Enron suppliers into doing the same. Near the end, Lay would emphatically encourage nervous employees to buy more Enron stock even as he was dumping $20 million of his own shares.
When Lay ran Houston Natural Gas, it was common practice for companies to fend off would-be raiders like Jacobs by piling on debt to make themselves unattractive. Except in this case, Jacobs says, he had no intention of making an InterNorth play. On the contrary, he wanted someone else to swallow the company for a premium, while he would make a tidy little profit on his investment. "I never had any intention of taking it over," Jacobs says. "People are reaching for the stars if they believe that." InterNorth paid a huge premium for Houston Natural Gas, and today, it's hard to understate the importance of the $5 billion in debt that resulted. With debt payments draining as much as $50 million a month from the company, Enron quickly sold off billions' worth of assets, beginning its Icarus-like flight toward the asset-light firm that immolated itself last year. And because the debt load was so oppressive, it forced the company into financing projects with borrowings kept off the balance sheet it presented to Wall Street and the world.
Jacobs was also the spur for an early shareholder controversy. After the takeover, Jacobs's InterNorth shares meant he held stock in the new Enron. That made Enron executives so queasy they decided to pay him $240 million in "greenmail"–a premium over a stock's current value–to get him to go away. Shareholders were outraged. But there was another twist. The main source of funds for the deal was a raid on $230 million in "excess" worker retirement funds–money invested for worker retirements but above federal minimums. Thus, Enron used worker pension money to prop up the company, years before it did the same thing another way.
Just as the merger would presage Enron's obsession with debt, the oil-trading scandal that Lay confronted when his jet touched down in Newfoundland foretold some of the more devastating consequences of the company's seeming inability to deal with trouble. Enron executives have been reluctant to discuss the episode. But documents unearthed in a little-noticed lawsuit show that Enron first learned of problems in January 1987, when a New York bank tipped off the company that employees of its oil unit had opened an account that was showing unusual activity, including multimillion-dollar payments to an Enron trader.
Under questioning, oil traders said that Enron executives had asked them to manipulate earnings by moving revenue from one year to another. Enron investigators had also learned that bank statements were doctored and that the account was opened with forged documents. "I was waiting for Lay to fire them on the spot," says one participant in a meeting. To the contrary, Enron executives expressed faith in the head of the trading unit, Louis Borget. "I have complete confidence in your business judgment . . . and personal integrity," Enron's then President John "Mick" Seidl wrote to Borget. "Please keep making us millions." Two months later, at a meeting of Enron's audit committee, Lay weighed in. "I've decided we're not going to discharge the people involved in this, because the company needs those earnings," Lay said, according to two participants in the meeting.
Instead, internal investigators demanded heightened controls. But as with the partnerships a decade later, the controls were never put in place. Unchecked oil trading opened up a terrifying exposure of at least 80 million barrels and may have cost Enron up to $150 million. The fraud went beyond trading, because the bank account discovered earlier was actually part of a scam to inflate profits and divert funds to Borget and trader Thomas Mastroeni. In 1990, the pair pleaded guilty to defrauding Enron. And it turns out that Enron's auditing firm, Arthur Andersen, had warned in 1984 that the oil trading needed more oversight. The risk "could exceed the levels senior management is willing to assume," Andersen said. Enron portrayed itself as a victim of rogue trading, but in truth, it had plenty of notice before the worst damage was done.
Enter the whiz kids
In September 2000, Enron dissolved, with no fanfare, a subsidiary called the Gas Bank that it had created 11 years before. While it had been years since any business had passed through the Gas Bank, its creation represented a critical juncture in Enron history. For one thing, it would prompt Jeff Skilling to join the company. More important, the Gas Bank paved the way for Enron to adopt unusually aggressive accounting practices and develop a series of innovations that transformed its culture from one of Texas collegiality to cutthroat trader.
Gerald Bennett, the man in charge of Enron's intrastate pipelines in 1989, didn't have much use for management consultants. So when a McKinsey & Co. consultant named Skilling came to see him, the pipeline man had something different in mind. Enron's problem was that for a fluid market for natural gas, the industry needed long-term supply contracts. But because prices were volatile, contracts were typically available only for 30-day spot deals. Producers were unwilling to commit to the long term, always believing the price could go up.
Enron needed to find a way to bridge this gap between what the producers and big gas users wanted. Bennett and Skilling discussed ways to pool lots of gas-supply contracts in a bank, then sell long-term deals to utilities. Bennett says the Gas Bank was his idea, but it was Skilling who got the credit. Not long after the Gas Bank fired up, Richard Kinder, Enron's president, asked Skilling to join the company to run the new project. Skilling was torn. He had just been made a director of McKinsey, one of the youngest ever. But he was tired of being only an adviser. Skilling negotiated hard, demanding that Kinder give him power. The final talks, when Enron set its future course, were June 11, 1990. Kinder was in his office; Skilling was at the hospital, where his wife had just given birth to their son. In August, Skilling joined Enron full time and almost immediately made a name for himself as an arrogant jerk. He had little patience for those he considered less gifted than himself, but he reserved his venom, associates say, for those who disagreed with him. In Skilling's world, dissenters weren't just mistaken; they were liars. And Skilling told them so.
The art of the deal
In the late 1980s, the business of independent oil and gas production was intensely competitive, and the boom-and-bust energy cycle weeded out all but the pluckiest entrepreneurs. But big companies like Enron were much more forgiving, places where the promise of entrepreneurial riches was traded away for stability. There was a modicum of teamwork, and people worked hard–but not too hard. Back-office workers and secretaries left at 5 p.m., and many executives packed up soon after. The new whiz kids thought Enron was soft. A more ruthless atmosphere, they thought, would make the company more money. So Skilling set about turning the place upside down.
The Gas Bank led the way. Because it called for Enron to write long-term contracts, the company could start accounting for those contracts differently. Traditional accounting would book revenue from a long-term contract when it came in. But Skilling wanted Enron to book all anticipated revenue immediately. The practice is known as mark-to-market–or, more colloquially, counting your chickens before they hatch. Whatever the term, it was the third time in five years that Enron had significantly changed its accounting.
Tallying all expected profits immediately would mean a huge earnings kick for a company obsessed with debt. But it would also put Enron on a treadmill: To keep growing, it would have to book bigger and bigger deals every quarter. The result, in hindsight, was predictable: a shift from developing economically sound partnerships to doing deals at all costs. "The focus wasn't on maintaining relationships and serving customers," says a former Enron official. "The quality of the deals deteriorated." The turning point, some say, was a deal involving a British power facility that earned Enron brass big bonuses. Yet, says one executive, the deal was "a disaster" that forced Enron to cough up $400 million when gas prices moved the wrong way.
The new accounting made workers eligible for fatter payoffs. Enron employees once were urged to work together on deals. But the new arrangements created an incentive to cut out colleagues, because bringing them in meant carving more slices in the bonus pie. "It was a very intense and urgent form of accounting," says Dan Ryser, a former employee who worked with Skilling. "The culture became less team oriented and more individual. It would have been OK if everyone played fair. But it didn't work out that way."
Ryser was a pipeline man from InterNorth, but he shared his boss's vision. Or at least he thought he did. One Friday afternoon, making small talk in Skilling's office, Ryser said he had to leave early to coach his kids in a soccer tournament. "This is one thing I do to get my mind off work," Ryser said to Skilling. "What do you do to take your mind off the business?" Replied Skilling: "I never do anything to get my mind off the business." A few weeks later, Ryser found himself back in Skilling's office, being told he wasn't pushing his people hard enough. The marketplace didn't like the Enron deals, Ryser countered. Nonsense, Skilling said; he transferred Ryser back to the pipeline division.
Fastow to the rescue
The truth was that Ryser was right. The initial Gas Bank plan hadn't persuaded gas producers to sell Enron their reserves. To entice the producers, the company needed to offer them money upfront for gas that would be delivered later. But where to get the cash?
Enter Andy Fastow. The finance whiz came to Enron from Continental Bank in Chicago, at the behest of his wife, who was from a prominent Houston family. Fastow would chat with employees about art exhibits and his favorite jogging routes. But he also came to be seen as a petty tyrant, a bully who demanded that deals be done to improve short-term profits even at the expense of long-term benefits. Soon after he arrived, Fastow began impressing Skilling's deputies with his ability to concoct sophisticated financial instruments. In 1991, to revitalize the Gas Bank, Fastow began creating a number of partnerships. The first series was called Cactus. (Like that of the first Gas Bank plan, the origin of Cactus is controversial: New York businessman Bernard Glatzer, who sued Enron over the issue, claims Enron took the idea from him.)
The Cactus ventures eventually took in money from banks and gave it to energy producers in return for a portion of their existing gas reserves. That gave the producers money upfront and Enron gas over time. But since Cactus owned the reserves in the ground even if the energy producers went bust, Enron would still have the gas. The term of art here is "special purpose vehicles." They served two ends: moving debt from Enron's books to the partnerships and transferring risk from Enron to the banks that invested in them. Eventually, Enron would grow addicted to these arrangements because they hid debt. But Enron let the risk-shifting feature of the partnerships lapse. Although they were presented to the board as a way to relieve Enron of risk, later partnership deals were backed by promises of Enron stock. That meant that, if something went wrong, Enron would be left holding the bag.
Backstopping the partnership deals with Enron stock had a subtle, corrosive effect. When Enron wasn't guaranteeing specific returns, outside partners needed to look hard at the quality of the venture. With the new Enron guarantees, quality became less important, so there was less outside scrutiny. "It sort of took away that discipline," says Robert M. Chiste, a former Enron executive. Later, losses on bad projects buried in partnerships would erase hundreds of millions in profits.
Rank and yank
As the partnerships proliferated, Skilling found that he needed more financial experts. He began recruiting talent from elite colleges and business schools, luring graduates with $20,000 signing bonuses and annual bonuses of up to 100 percent. And he began to hire more traders, people who could deal in natural gas and a variety of other commodities.
Skilling also inspired the paradox of making Enron more relaxed yet more competitive. He adopted an all-casual dress code, but the jeans and tennis shoes couldn't relieve the tension that hid underneath. Employees started staying later, first until 6 p.m., then 11 p.m., even into the next morning. Part of the pressure resulted from Skilling's new employee-evaluation policy. Workers called it "rank and yank." Employees were evaluated in groups, with each rated on a scale of 1 to 5. The goal was to remove the bottom 20 percent of each group every year.
At first, some thought the program was a good way to cull deadwood. One manager posted signs with a red circle and slash over a happy face, telling her employees that Enron was about working hard, not being happy. But many later chafed under the system, seeing the reviews as a tool for managers to reward loyalists and punish dissenters. "What a cutthroat system," says J. C. Nickens, a Houston attorney representing about a dozen Enron officers. "If you were a 5, you were on your way out; if you were a 1, you got the biggest bonus." The system encouraged a "yes" culture, in which employees were reluctant to question their bosses–a fear that many would later come to regret.
Around the mid-1990s, Enron began pushing the envelope in other ways. Fixated on finding new sources of cash, Enron looked to its natural-gas storage business. Long-term contracts called for a flow of payments from customers to Enron over time. Enron used a formula to calculate the current value of future payments. Then it used that shimmery number as collateral to borrow money. Risky perhaps, but Enron made it even more so by borrowing more than it judged the contracts to be worth. It also appeared that, while borrowing against the value of the contracts, Enron was counting it as income. "There was concern that Enron was cooking the books," says energy consultant Jim Harrington.
Suspicion began to spread. In late 1994, James Alexander became an executive in Enron's Global Power & Pipelines affiliate. He soon heard rumblings about shaky accounting involving unsuccessful bids for international projects. Around May 1995, he warned Lay. "The response was in a medicinal calm voice, 'Gee, I guess I'll have to talk with Rich Kinder about that,' " says Alexander, who quit only months later. "The only way you can keep accounting games going," he says, "is to make them bigger and bigger."
For lots of reasons, the first player into a new energy market can score hugely. But over time, competitors catch on, and profit margins shrink. So Skilling began looking for new pastures. In 1996, he set his sights on electricity. Enron would do for power, he promised, what it had done for natural gas.
Out with the old
The push into electricity only added to the pressures percolating inside Enron. Earlier in 1996, Lay predicted that Enron's profits would double by 2000. He instituted a stock-option plan that promised to double employee salaries after eight years. Fresh off a $2.1 billion takeover of Portland General Corp., an electric utility, Lay said his goal was nothing less than to make Enron the "world's greatest energy company."
No executive in the stable of senior managers was more prepared to help Lay reach that lofty goal than Skilling, then head of the company's finance and trading unit. But there was an obstacle to Skilling's ambition: president and chief operating officer Kinder. A 16-year company veteran, Kinder was an "asset guy," more adept at running Enron's older businesses than at playing a visionary role in the company's new endeavors. Kinder stirred strong passions at Enron; those who felt strongly about him typically felt the opposite of Skilling. Some mistrusted him. One former executive says he was "great at finding ways to meet earnings estimates" and "willing to take shortcuts." Others say he never would have let Enron take the path it did. "With Kinder, you always had to show him the money," says another former executive. "You had to show him strong project economics or he wouldn't do the deal."
Kinder's departure from Enron, in December 1996, was pivotal. The promotion of Skilling as his replacement, says one employee, "was really the turning point, when the image of the asset as albatross was created." Another former executive says Kinder's departure was Enron's biggest mistake. "He held a lid on all the egoism," he says. Skilling, by contrast, did not seek to control his lieutenants so closely.
May the force be with you
Above Jeremy Blachman's desk at Enron sits a fuzzy Chewbacca head a foot and a half high, a reminder that the past can indeed come back to haunt. The bust was a "deal toy"–a keepsake to mark a battle over a partnership called Chewco that Enron entered into in late 1997. Named for the woolly Star Wars character, Chewco is believed to have been the first of a number of partnerships in which Enron executives schemed to improperly inflate earnings and hide debt. Enron created Chewco to buy out its partner in another venture called JEDI, which was legally kept off the books. For JEDI to remain off the balance sheet, however, Chewco had to meet certain accounting requirements. But Enron skirted the already weak rules required to keep Chewco off its books. Chewco was responsible for overstating Enron's profits by $405 million and understating debt of $2.6 billion. Lay says he didn't know about Chewco. But within the company, Chewco's existence was widely known. Frank Karbarz, a former manager on Enron's credit desk, says: "People knew, but no one had the time to sit there and follow the trail to find out what was really there."
Because Enron needed to close the deal by year's end, Chewco was a rush job. Enron's executive committee presented the Chewco proposal to the board of directors–including Lay–on November 5. But Fastow left out a few key details. He failed to mention that there was virtually no outside equity in Chewco, which he maintained was not affiliated with Enron. Nor did he reveal that one of his protégés, Michael Kopper, would manage the partnership. The board approved the deal. Enron's law firm, Vinson & Elkins, quickly prepared the requisite documents. Arthur Andersen, which claims that Enron withheld critical information, billed the company $80,000 for its review of the transaction. It was the beginning of the end. When it collapsed, Enron's off-balance-sheet financing stood at an estimated $17 billion.
Living large
1998, Lay & Co. had convinced Houston, its employees, and Wall Street that Enron was in a class by itself. At a two-week orientation for new recruits, top executives took turns pumping their respective divisions, trying to woo the best and brightest. By the end of the two weeks, Enron's newest elite had practically overdosed on confidence. "Every day, I would walk into work thinking, 'Where can I add value today?' " recalls Karbarz. "This was a cosmopolitan, global company with unlimited possibilities." Executives stoked the fire. "These were privileged, smart, cocky kids, and we nurtured them," says one former Enron executive. "We put them on pedestals so they would develop a sense of superiority."
Enron opened the faucet on expenses. After one deal was closed, six analysts were flown to Telluride, Colo., for a weekend of skiing, with gifts of pricey parkas, gloves, massages, and facials. Senior executive Lou Pai signed off on the use of a corporate jet for his assistant and a dozen of her friends to fly to Jamaica for a week, according to a former executive assistant. Salespeople in the pulp and paper business took clients to the Texas Motor Speedway in Fort Worth, where they wheeled around in Ferraris, for a genuine, hands-on Grand Prix experience. Energy Services teams returning from closing deals strolled down a red carpet rolled out in an airplane hangar, to be handed $300 bottles of Cristal champagne. Administrative assistants ordered $300 planters for their cubicles and expensed everything from lunches with friends to mileage to the company's extravagant Christmas party.
As Enron pushed out in new directions–wind power, water, high-speed Internet, paper, metals, data storage, advertising–it became a different company almost every quarter. Entrepreneurship was encouraged; innovation was the mantra. Mike Horning, a former Enron manager, remembers the day he sat down at the round table in Skilling's office and pitched him an idea to create a market in advertising contracts. Armed with a half-dozen PowerPoint slides, he ticked off statistics showing why the media market was ripe for Enron. Skilling was thrilled. In just 20 minutes, a whole new operation, Enron Media Services, was born.
The quarter-by-quarter scramble to post ever better numbers became all consuming. "You lived an entire life in a 90-day cycle," says Phyllis Anzalone, a former director of Enron Energy Services. Enron traders, meanwhile, were encouraged to use "prudence reserves," to essentially put aside some revenue until another quarter when it might be needed. Long-term energy contracts were evaluated using an adjustable curve to forecast energy prices. When a quarter looked tight, analysts were told to simply adjust the curve in Enron's favor.
As if the music weren't playing fast enough, Enron found another way to quicken the pace. As is common in corporate America, Enron executives got stock options, which they were able to cash in over time. But Enron added a sweetener: If profits and the stock price went up enough, the schedule for those options would be sharply accelerated. The plan gave executives even more incentive to push the envelope. "It's just another case," says Glenn Matthys, an Enron manager who was laid off after the collapse, "of people getting too damn greedy."
The greatest pressures probably were in Fastow's finance group, although Chewco's apparent success lifted some of the weight. In 1999, Fastow constructed two partnerships called LJM Cayman and LJM2 that readily passed through the board, the lawyers, and the accountants. They were followed by four more, known as the Raptors. "You do it once, it works, and you do it again," says Anzalone. "It doesn't take long for the lines to blur between what's legal and what's not."
And employees knew it. One analyst in Fastow's global finance group recalls his epiphany, while on a recruiting trip for the company. "Students would ask me what I was doing at Enron, and when it came down to it, I was removing numbers from our balance sheet and inflating earnings," he says. "Personally, I'm extremely disappointed in what I did."
Today, after perhaps the most spectacular failure in American business history, "disappointment" doesn't even begin to describe the devastating sense of betrayal by investors who lost billions of dollars and employees who lost jobs and most or all of their savings. It is a fitting irony that just as Enron's earliest days foreshadowed its collapse, the recovery effort will now attempt a full-circle return to the company's roots. After years of furiously unloading assets and building intellectual and informational capital, the Enron of the future–if there is indeed such a thing–will be a steady, slow-growing, asset-laden energy company. "Our reorganized business will be dedicated primarily to the movement of natural gas and the generation of electricity," said Jeff McMahon, president and chief operating officer. Interim CEO Stephen Cooper hopes a reorganization plan will be in place sometime in the next few months. In a logical attempt to shake off the polluted image of Enron, the company will be renamed. Most, if not all, of the board members will be replaced. Its unoccupied downtown skyscraper is on the block for $200 million, and Cooper plans to lease the other and move his demoralized army somewhere else.
If Enron emerges from its bankruptcy proceedings as the energy company it was back in 1985, it may not be so far-fetched. After all, U2 just won a Grammy, George Bush is in the White House, and E. T. is coming to the big screen. If the Eighties are back in Hollywood and Washington, there's no telling what could happen in Houston. |
