Visionary's Dream Led to Risky Business
Opaque Deals, Accounting Sleight of Hand Built an Energy Giant and Ensured Its Demise
By Peter Behr and April Witt
Washington Post Staff Writers
Sunday, July 28, 2002; Page A01
[This is one of the most comprehensive articles I have read on Enron's culture and the top management's ability to conduct such sophisticated fraud...Below, I have attached some of the highlights]
washingtonpost.com
<<...For Vince Kaminski, the in-house risk-management genius, the fall of Enron Corp. began one day in June 1999. His boss told him that Enron President Jeffrey K. Skilling had an urgent task for Kaminski's team of financial analysts.
A few minutes later, Skilling surprised Kaminski by marching into his office to explain. Enron's investment in a risky Internet start-up called Rhythms NetConnections had jumped $300 million in value. Because of a securities restriction, Enron could not sell the stock immediately. But the company could and did count the paper gain as profit. Now Skilling had a way to hold on to that windfall if the tech boom collapsed and the stock dropped.
Much later, Kaminski would come to see Skilling's command as a turning point, a moment in which the course of modern American business was fundamentally altered. At the time Kaminski found Skilling's idea merely incoherent, the task patently absurd.
When Kaminski took the idea to his team -- world-class mathematicians who used arcane statistical models to analyze risk -- the room exploded in laughter.
The plan was to create a private partnership in the Cayman Islands that would protect -- or hedge -- the Rhythms investment, locking in the gain. Ordinarily, Wall Street firms would provide such insurance, for a fee. But Rhythms was such a risky stock that no company would have touched the deal for a reasonable price. And Enron needed Rhythms: The gain would amount to 30 percent of its profit for the year.
The whole thing was really just an accounting trick. The arrangement would pay Enron to cover any losses if the tech stock dropped. But Skilling proposed to bankroll the partnership with Enron stock. In essence, Enron was insuring itself. The risk was huge, Kaminski immediately realized.
If the stocks of Enron and the tech company fell precipitously at the same time, the hedge would fail and Enron would be left with heavy losses.
The deal was "so stupid that only Andrew Fastow could have come up with it," Kaminski would later say.
In fact, Fastow, Enron's chief financial officer, had come up with the maneuver, with Skilling and others. In an obvious conflict of interest, Fastow would run the partnership, sign up banks and others as investors, and invest in it himself. He stood to make millions quickly, in fees and profits, even if Enron lost money on the deal. He would call it LJM, after his wife and two children.
Stupid or not, Enron did it and kept doing more like it, making riskier and riskier bets. Enron's top executives, who fancied themselves the best of the brightest, the most sophisticated connoisseurs of business risk, finally took on more than they could handle.
Fastow's plan and Skilling's directive would sow seeds of destruction for the nation's largest energy-trading company, setting in motion one of the greatest business scandals in U.S. history...>>
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<<..."We're the world's coolest company," Skilling told the University of Virginia professors.
Lay even considered the idea of draping a giant pair of sunglasses around Enron's headquarters tower in Houston, Skilling joked.
"It was an intoxicating atmosphere," said Jeff S. Blumenthal, an Enron tax lawyer. "If you loved business and loved being challenged and working with unique, novel situations . . . it was the most wonderful place."
It wasn't just the ideas. The place was giddy with money. Enron paid employees $750 million in cash bonuses in 2000, an amount approaching the company's reported profit that year.
The princes of Enron were its dealmakers or "developers," in-house entrepreneurs who launched businesses and structured deals so they could immediately claim huge profits for the company -- and bonuses for themselves -- while saving the problems for later.
From the company's earliest days, those princes flew around the world, overpaying for power plants in India, Poland and Spain, a water plant in Britain, a pipeline in Brazil, and thousands of miles of Internet cable. Enron accumulated 50 energy plants in 15 countries. Virtually none of them were profitable.
Lou L. Pai, a Skilling favorite, set up an Enron division that sold electricity to businesses. Pai received numerous stock options as compensation. He sold $270 million worth of Enron stock in the 16 months before he left the company last year.
"The culture at Enron is all about 'me first, I want to get paid,' " Hermann said. "I used to tell people if they don't know why people are acting a certain way, go look up their compensation deal and then you'll know. There were always people wanting to do deals that didn't make sense in order to get a bonus."
Porsches replaced pickup trucks in the company parking lot as even secretaries became paper millionaires. There were mansions in Houston's posh River Oaks neighborhood, vacation homes in Aspen. Everybody went along for the company's wild ride...>>
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<<...To much of the world, Jeff Skilling looked like a genius. Between January and May 2000, the stock price had risen nearly 80 percent, to $77 a share. Enron insiders -- Lay and Skilling among them -- had cashed out more than $475 million worth of stock. Everybody was getting rich.
A High-Tech Ponzi Scheme
But Enron had created only an illusion of ever-expanding revenue and profits.
The company still needed increasing amounts of cash for its profligate new ventures and expanding energy-trading operations. Its grab bag of pipelines and plants could not produce enough money to drive the growth that Lay and Skilling demanded.
As Fastow explained in a CFO Magazine article, Enron could not keep borrowing in traditional ways without scaring lenders away and damaging its credit rating. Enron's investment-grade credit was just high enough to ensure that it could get the cash it needed to settle its energy contracts when they came due.
So Enron turned itself into a factory for financial deals that would pump up profit, protect its credit rating and drive up its stock price.
In the 1990s, banks and law firms began aggressively peddling "structured finance," complex deals in which companies set up separate affiliates or partnerships to help generate tax deductions or move assets and debts off the books. With Skilling's ascension to the presidency in 1997, Enron became increasingly dependent upon such deals to hit its financial targets.
"Skilling's participation in the LJMs and the other vehicles was probably the most important part of his job," said John Ballentine, a former president of an Enron pipeline subsidiary and a corporate vice president.
The company teamed up with the brightest minds in banking, accounting and law to create scores of secretive deals with exotic code names such as Braveheart, Backbone, Rawhide, Raptor and Yosemite.
Enron used the deals for various purposes. The LJM partnerships hedged risky stock investments such as Rhythms. An affiliate named Whitewing took billions of dollars of debt off of the company's books. In some cases, Enron "sold" money-losing foreign assets to the partnerships, added the proceeds to its quarterly financial statement and then bought the assets back in the next reporting period.
To entice banks and others to invest in the deals, Enron privately pledged millions of shares of its stock to guarantee against any losses. It was a risky gambit, exposing the company to losses if the price of its shares dropped and it could not cover its obligations...>>
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<<...As the top finance man at Enron, Fastow was responsible for Enron's overall financial stability.
He was known as an intimidating and single-minded self-promoter. He liked to say that capitalism was about survival of the fittest. He flogged his team so furiously to close deals that they often made business calls in the middle of the night. Executives who attended meetings with Fastow recall him freely putting down older colleagues or anybody he perceived as weak.
As unpopular as he was, Fastow was untouchable. Skilling was positively enamored of him. "Fastow was Skilling's favorite," Enron lawyer Jordan Mintz said later.
But even Skilling later conceded to investigators that Fastow could be a "prickly guy that would tell you everything wrong about others and everything right about himself."
Fastow was also something of a mystery. He rarely attended the quarterly briefings Enron staged for financial analysts, making him the butt of a Wall Street wisecrack: "Name Enron's CFO."
He spent much of his time as managing partner of the LJM partnerships. Although he later said he spent only three hours a week on the partnerships, colleagues complained that he was constantly working on his own deals. He jetted to New York, California, Florida and the Caribbean, hunting investors...>>
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<<...Fastow strong-armed Enron's major Wall Street banking partners, threatening to take away Enron's banking business if they did not put money into his fund, former Enron treasurer Jeffrey McMahon said later.
The banks put up a "huge outcry," but many ultimately invested, including J.P. Morgan Chase & Co., Citigroup Inc. and Merrill Lynch & Co.
"The banks complained they were being told that investing in LJM2 was a quid pro quo for future Enron business," McMahon later told investigators.
Fastow used the soft touch with people like Joe Marsh. A wealthy Floridian, Marsh had been approached in 2000 by his Merrill Lynch stock adviser about investing $1 million in LJM2. Fastow's partnership would do deals with Enron, promising gaudy annual returns of 20 percent or more.
At first, Marsh was skeptical. "It sure sounded like a conflict of interest," he said. So his broker arranged for Marsh to do a conference call with other investors and Fastow.
Fastow was knowledgeable, at ease and persuasive, Marsh said. "He said he was putting in $5 million of his own. His wife was mad at him for doing it, but he really believed in it," Marsh said. Enron's lawyers and accountants, the board, Merrill Lynch, everyone had approved it. "It got flying colors." Marsh was convinced. He put in $1.6 million.
Fastow had married into a wealthy Houston family. He wanted wealth of his own, colleagues said.
At Enron, Fastow made about $2.4 million in salary, bonus and incentives. But he had long chafed at the huge bonuses that division chiefs were getting from big power plant and pipeline deals. He wanted a similarly lucrative payday for himself. He got one from LJM1 in the spring of 2000, when Enron and the partnership ended the Rhythms transaction.
Three London bankers who have been accused in criminal fraud complaints of joining with Fastow to cheat their bank in the Rhythms deal had a pithy take on what motivated him. "We should be able to appeal to his greed," one of the bankers e-mailed another in February 2000.
Fastow's dealings with the British bankers were not revealed until much later. Fastow's secret profit from LJM1 and the Rhythms deal was staggering: a $1 million investment turned into a $22 million profit in less than a year.
A Closely Held Secret
For a while, LJM2 looked like a great deal for everyone.
From 2000 on, the LJM deals provided most of Enron's profits, though they remained invisible to outside investors.
At the end of each financial quarter, whenever Enron needed to sell a pipeline or Internet cable, or execute a helpful commodities trade, it would turn to Fastow for almost instant results.
Even inside Enron, the exact details were a closely held secret. People gossiped that Fastow was getting rich, but nobody asked how rich.
Enron's board, which twice waived the company's code of ethics to allow Fastow's dual roles, could have asked, but it did not until too late. Board members later said they were misled by Enron executives. The board set up an elaborate system for monitoring Fastow, with three committees assigned to the task. But board members put little energy into it, repeatedly failing to ask pointed questions, a Senate subcommittee later concluded.
As Enron's chief financial officer, Fastow was supposed to be the company's financial watchdog, even in the LJM transactions. But Fastow personally profited if LJM bested Enron in negotiations. Some Enron colleagues say Fastow bullied subordinates to win an advantage for LJM. He pressured one, William Brown, to close a deal on terms unfair to Enron, Brown later told investigators.
As more colleagues came to believe that Fastow was enriching himself and a few close to him, the deals became a source of envy and suspicion...>>
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<<...On July 12, 2001, in one of those routine rites of business, Skilling fielded questions from Wall Street analysts about the company's second-quarter financial results. Skilling batted away the analysts' mild queries. Enron had "outstanding" results, he said, a 40 percent increase in profit.
Finally, Skilling was asked an obscure-sounding question by Carol Coale, a securities analyst with Prudential Securities Inc. in Houston and a growing skeptic.
What about Enron's transactions with your "MLT affiliate" she asked, groping for the correct name, LJM.
Skilling mentioned there were "a couple of real minor things" with LJM, before dismissing the question: "There are no new transactions in LJM."
"He's lying to me," Coale thought. She, too, had been piecing together the sketchy clues from Enron's financial statements. She suspected that Enron was using LJM to hide big losses.
But she did not press him. People who dealt with Skilling knew not to do that. And despite her misgivings, Coale did not feel that she had enough information to advise investors to sell their Enron stock. By the end of July 2001, Lay and Skilling were on the road again, telling analysts that Enron had never been stronger.
The response was nearly unanimous: "Buy, buy, buy."
The full story of LJM remained hidden...>>
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Staff researchers Margot Williams, Lucy Shackelford, Mary Lou White and Richard Drezen contributed to this report.
© 2002 The Washington Post Company
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