Same with the changes in personnel management. Enron employed a system where every job description was assigned a certain number of points, which could be used to “purchase” an office with a bigger window or a better chair. Not in Skilling’s group. There would be no job descriptions; he didn’t want anyone locked in to some predetermined list of duties.
With every step and every idea, Skilling won legions of enemies among Enron’s administrators. He reduced the company’s dozens of titles to just four in his division—associate, manager, director, and vice president. Seniority-based compensation was chucked out, too; instead, pay would be based solely on annual performance.
Skilling thought he was on his way to building a perfect meritocracy, where smart, gifted—and richly compensated—people would be pitted against one another in an endless battle for dominance, creating a free flow of ideas that could push the business past its competitors.
As his dream office space was being constructed on the thirty-ninth floor, Skilling started scouring around for talent. Gene Humphrey, Skilling’s first hire, was brought in from Citibank to head the effort providing financing to gas developers; Lou Pai, a former SEC economist, jumped from Enron’s marketing organization. George Posey, from the corporate division, was assigned to handle accounting and finance. Within a month, Skilling had filled almost every important position—except one.
The last piece Skilling needed on his game board was an expert in a form of finance known as securitization. In such deals an institution pools similar loans, and then sells interests in them to outside investors. That gives the institution new money, which can then be used to make new loans. Better still, loans sold in a securitization can be removed from the company’s balance sheet, since the risk of ownership has been shifted to the outside investors. With his plans to push loans into the gas market, Skilling knew a securitization expert could give his fledgling business access to an almost endless supply of capital.
The only question was, could he find somebody creative enough for the job?
The telephone rang in the Chicago office of Andrew Fastow, a young senior director with Continental Bank, on a morning in early October. On the line was Jonathan Crystal, a corporate recruiter from the Houston office of Spencer Stuart, one of the world’s largest executive search firms.
“There’s an opportunity available that I think you will find very interesting,” Crystal said.
Spencer Stuart had been hired by Skilling to track down his securitization expert, and Fastow, a twenty-eight-year-old banker, seemed to fit the bill. In the last few years, Fastow had specialized in such financings, working on some high-profile, complex deals. The second son of a buyer for drugstores and a homemaker, Fastow had grown up in New Providence, New Jersey. His family was comfortable, though hardly wealthy. But Fastow, who graduated summa cum laude in 1984 from Tufts University, soon came to be more familiar with the world of the well-heeled. He married his college sweetheart, Lea—an heiress to the Weingarten fortune, earned with grocery stores—and set off for Chicago to launch his business career. While working, he earned his MBA at the Kellogg School and eventually found his niche at Continental Bank.
Andy worked hard, but his personal style could be grating, even pompous. He was the type to take a stand in quicksand, making demands with shouts and temper tantrums, at times costing him more in reputation than he gained in deal points. Even a simple cab ride had once transformed into a fracas, with a hotheaded driver ultimately punching Fastow in the face in a dispute over seventy cents.
Still, the Fastows were restless. For months they had considered moving to Houston if the right jobs came along, but the idea seemed like a long shot. New York and Chicago were the hot spots for securitization; Houston wasn’t even on the industry’s map. But with this call from Crystal, suddenly it seemed like that might be changing.
Fastow listened as Crystal gave the rundown on the position. Enron needed someone who knew about securitization to join their new finance business; it sounded, Crystal said, like a great fit.
For a moment Fastow said nothing.
“Who,” he finally asked, “is Enron?”
On the morning of October 3, a Wednesday, Lou Rieger, head of Spencer Stuart’s Houston office, called Skilling. “We’ve found a good candidate,” Rieger said. “There’s a guy who wants to move to Houston. He’s been working at Continental Bank in Chicago.”
“You’re kidding me. He wants to move to Houston?” Skilling asked. “Send over his résumé. Let me look at it”
Minutes later, at 9:36, the fax machine near Skilling’s office hummed to life, and three pages of paper scrolled into a tray. His assistant, Sherri Reinartz, brought it in. Skilling flipped through the pages, reading quickly.
“Andrew S. Fastow.”
Education. “Kellogg, Tufts.”
Experience. “Continental Bank … Sold first security backed solely by senior LBO debt … named 1989 ‘Deal of the Year’ … directly responsible for pre-tax profit contribution of $12.8 million … structured and arranged leveraged buyouts … proficient in Chinese …”
“Holy shit,” Skilling said. The perfect guy.
He picked up the phone and dialed Rieger’s office.
“Lou, hey, home run,” Skilling said. “This guy is dead-on what we’re looking for.”
Fastow traveled to Houston later that month to visit a company that still made no sense to him. His world was one of esoteric deals, derivatives, wealthy bankers with business degrees. But from what he could tell, Enron worked in pipelines—expensive, dirty pipelines. It sounded like nothing more than a big step down.
Fastow arrived at the building early that morning and rode up to the thirty-ninth floor, where he asked for Skilling. A receptionist placed a call, and a minute later an energetic man in his late thirties—a little nerdy-looking, with steely eyes—came bounding toward him.
“Andy? Jeff Skilling”
“Good to meet you,” Fastow replied, shaking hands.
Skilling smiled as he glanced around the room. “Well, welcome to Enron. Follow me, we’ll go talk.”
Fastow trailed Skilling to a bullpen that housed most of the department’s professionals and support staff. The place bristled with energy, the staccato rhythms of computer keyboards punctuating a low hum of activity. Fastow had expected the place to be sleepy and dull. But here, no one dawdled or wandered about. There was work to be done, and Team Skilling seemed thrilled by the challenge.
The two men walked into Skilling’s glass-encased office and took seats at the table. Fastow didn’t smile and was a little standoffish; he still didn’t understand what role he could play in this corporation.
“So,” Fastow said, an edge of condescension in his voice, “what are you guys doing here?”
Skilling launched into his now-familiar speech about the irrationality of the natural-gas business and how his team was building a marketplace balanced between buyers and sellers. It was all about gathering risks and spreading them around, so that no one player got stuck if the music stopped. That’s where securitization came in; the division couldn’t be constrained by Enron’s capital or its balance sheet. New investors meant new money, new money meant more business, and more business was sure to mean more profit.
As Skilling spoke, Fastow’s eyes lit up. This wasn’t some company trying to hire a showcase executive it couldn’t use; for someone with his background, Enron’s new venture was right on the center of the fairway.
“Wait a minute,” Fastow interrupted. “Why is this going on at a pipeline company? What you’re talking about is finance and almost banking activities.”
“Having the pipelines gives us a jump, a place to start, and a knowledge of the business we can use.”
Made sense. Still, Fastow had trouble accepting that a corporation in such an old-line industry could harbor cutting-edge visions. Maybe this was all some fad.
“Is this company really going to stand behind this?” he asked. “Are they really commi
tted?”
“Talk to Kinder,” Skilling replied. “He gets it. He knows this is the future, and he’s committed to it.”
Fastow sat back. This was all coming too fast, and this guy Skilling seemed to be at the center of it all. Fastow had already heard that Skilling abandoned a lucrative career at McKinsey to take on this new business. That stumped him more than anything.
“You walked away from McKinsey?”
“I did,” Skilling replied.
Fastow didn’t know how else to put it. “Why?”
Skilling smiled and turned up his hands. “Hey,” he said, “how often do you get a chance to change the world?”
The interview clinched it. The conversation transformed into a free-flowing exchange of ideas as Fastow brainstormed about how Enron could utilize securitizations. In about an hour, Fastow pushed the thinking further than anyone in the building had ever dreamed. Skilling was enthralled.
Afterward, Skilling telephoned Lou Rieger, telling him that Enron was very interested. Not long after, Fastow called the Spencer Stuart Houston office, too, equally enthusiastic. But there was a problem. If they were going to move, his wife also needed a job in Houston. Rieger phoned Skilling, telling him about the roadblock.
“Fine. Send me her résumé,” Skilling said. “I’ll see if we can find something for her here.”
The résumé arrived that same day by fax. Skilling read it through quickly; her background seemed perfect for Enron’s treasury department. In no time, both Fastows were offered jobs at Enron, with Andy’s paying a salary of seventy-five thousand dollars, a signing bonus of twenty thousand, and a guaranteed bonus for the following year of at least twenty-five thousand.
On December 3, 1990, Andy Fastow returned to Enron as a newly minted employee, one who would play a far greater role in its history than anyone could have possibly imagined.
The slime ball zipped across the room, splatting against a window before slowly oozing down the glass. Fastow grabbed another one of the green globs, going into a slow windup.
“Heads up!” he yelled, heaving the ball past his colleagues in the bullpen.
Skilling and his team kept talking, ignoring the mess from another typical late-night session at Enron Finance. No longer was Fastow the zipped-up banker he had been at his job interview; instead, he had emerged as a prankster, adept at lending the frequent after-hours discussions the feel of a college bull session. The bottom left-hand drawer of his desk had become known as the toy store; Skilling’s children always made a beeline there whenever they visited. Throughout the day—and into the night—the place descended into toy chaos; footballs flew, slime balls splatted, and Nerf-gun wars raged.
The mischievousness was all part of the division’s character, one that quickly made the thirty-ninth floor a central attraction for other employees. The executives there often spoke with messianic fervor about the new order they hoped to create: they were going to take power away from the monopolies, finance the dying gas industry, create markets that had never existed before.
The early years were a time of discovery, and Skilling’s division evolved into an idea factory. One of the earliest changes was a reorganization. The separation of Enron Finance, which worked with producers, from Enron Gas Marketing, which arranged long-term contracts, was simply illogical; both were different ends of the same business. So in January 1991, the two were melded into Enron Gas Services, with Skilling its top executive.
The business also evolved. Buying reserves outright made no sense; in order to get the gas it needed, Enron was paying for intangible things it didn’t want, like drilling opportunities and exploratory potential. But writing a contract to purchase the gas would limit securitization efforts; most producers were in lousy financial shape, and investors wouldn’t be eager to buy interests in contracts struck with businesses on the brink of bankruptcy.
The remedy was found in century-old laws, which created something called a production payment. In essence, the production payment was nothing more than the gas that a company could pump out of the ground; if a wildcatter sold production payments to Enron, then the company owned the fuel. It didn’t matter if the wildcatter went bankrupt, as several did; Enron’s ownership of the gas production would survive any challenge from the producer’s creditors.
With a solid asset available, Fastow went into action. The first securitization idea, named Cactus, was hatched in 1991, utilizing an accounting device called a special-purpose entity—the critical piece of such financings. Essentially, Enron could legally use special-purpose entities to transfer risks and debt off its books by selling interests in them to independent investors. The vehicle was like a sponge that soaked up the acquired gas before Enron tore it into bits for sale to investors.
But the rules governing what constituted an off-books special-purpose entity—and what instead would just be another part of the company itself—were detailed.
So in 1991, Fastow and his team met with lawyers from the Houston firm of Vinson & Elkins and accountants from Arthur Andersen. The rules, recited by a young Andersen accountant named Rick Causey, were fairly simple. First, loan sales to the special-purpose entity had to be real, with ownership transferring to outside investors. Enron couldn’t agree to compensate investors for losses; doing so meant the company retained the risk of ownership, and the loans would have to stay on its books. Plus, Enron could not control the entity; strategic decisions had to be made by third parties. The independent investors also had to invest at least three percent of the entity’s capital.
Eventually the accountants and lawyers left the room, and Fastow broke into laughter. The three percent rule struck him as hilarious.
“Who comes up with these ridiculous rules?” he laughed. “This is such bullshit! Your gardener could hold the three percent! I could get my brother to do it!”
Fastow set to putting Cactus together. With it, Enron pooled loan commitments to gas producers in exchange for a deal on their production payments, placed them in the Cactus special-purpose entity, and sold stakes to heavy-hitting institutional investors. Cactus investors would then resell the gas back to Enron, which in turn would use it to meet its obligations under the long-term supply contracts with customers. It was the Gas Bank in its final form; outsiders provided cash, producers received financing, customers obtained gas at a reliable price—all with Enron in the middle, profiting handsomely.
Or so it seemed. But a problem emerged. The accounting for the two sides of the transaction—buying production payments and selling fixed-price contracts—followed different rules. Enron could be forced to report a loss simply because it couldn’t count the two parts of the deal in the same way. Skilling thought the result absurd: how could things of the same value be worth different amounts?
The issue came to a head at a meeting between Skilling’s team, the accountants from Arthur Andersen, advisers from Bankers Trust, and lawyers from Vinson & Elkins. Steve Goddard, an Andersen partner, brought along a number of other accountants, including a young graduate from Texas A&M named David Duncan, who was working on the Cactus deals.
Skilling took the floor. He wanted his group’s accounting to shift from the old oil-and-gas rules to mark-to-market, a method commonly used by trading houses. It allowed a company to record the value of a transaction at the beginning; any changes over time—caused by anything from flawed assumptions to variations in market value—would be recorded as a profit or a loss. If a brokerage owned a stock that went up in price, it reported a profit—even if it didn’t sell the stock. If the value went down, it reported a loss. That was the beauty of mark-to-market, Skilling said. It reflected market reality.
“Wait,” Goddard said. “But this is an oil-and-gas transaction. You need to use oil-and-gas accounting.”
Around and around they went. The auditors with Andersen’s energy group were far more familiar with old-line oil-and-gas accounting; this new stuff was hard to get their heads around. Everyone became frustrated.
“Yo
u guys are just stupid,” Lou Pai finally railed in exasperation. “You’re fucking stupid!”
Skilling pushed Goddard to check with Andersen’s top accounting experts in Chicago; after that, he flew there to see them and to present his arguments in person. A few weeks later, Goddard dropped by Skilling’s office.
“Well, I talked to Chicago,” he said. “They agree mark-to-market is the appropriate treatment.”
Skilling clapped his hands. “Great!”
“Well, I still don’t feel up to speed on this. But they like it, and they think it’s the right way to go.”
“Okay,” Skilling said.
Goddard hesitated. “But they don’t think we can do this unilaterally.”
“What do you mean?”
“We’ve got to go to the SEC with this,” Goddard said. “This is a change in accounting methodology, so we’ve got to convince the SEC to approve it.”
Skilling flopped back in his chair. The SEC. The Securities and Exchange Commission. All we have to do is convince the government to reverse course.
Skilling was silent for a moment, then sat up.
“Okay,” he said. “Let’s go convince the SEC.”
“This is the stupidest accounting I’ve ever heard of. It’s just crazy.”
As he spoke, David Woytek stared across a conference table at Jack Tompkins, Enron’s chief financial officer. It was June 1991, and Woytek, the accountant who investigated the Valhalla oil-trading scandal, was attending a monthly meeting of Enron’s top financial executives. Now chief financial officer of Enron’s liquid-fuels division, Woytek had just heard George Posey, Skilling’s finance chief, explain the new accounting his team was pushing.
“Mark-to-market makes much more sense for what we’re doing,” Posey replied.
“Mark-to-market is all fine and good, but that’s not what you’re describing,” Woytek shot back.
“We’re describing mark-to-market.”
Conspiracy of Fools Page 8
