Conspiracy of Fools

by Kurt Eichenwald

  Martin found Enron a delight. Skilling and his vision for the industry captivated her. The staid old pipeline company was, in Skilling’s group, more like a Wall Street deal factory, attracting young, smart people on the make. Martin and the rest became Skilling’s youthful acolytes, eager to shatter the constraints of the old world.

  From the start, Martin formed a close bond with Andy Fastow and relished his seeming lack of pretension. He would schmooze with colleagues into the wee hours. And on weekends, when Martin sometimes brought her young son to work, Fastow thought nothing of getting down on the floor to horse around with the boy. True, Fastow had a dark side—yelling when things didn’t go his way, shoving a banker in the heat of negotiations—but Martin viewed those outbursts as standard fare in a high-pressure profession.

  But if Fastow the sour deal maker put Martin off, Andy the bubbly games player was always a delight. Just the other day, Fastow’s wicked sense of humor had taken one of Enron’s outside lawyers down a peg. All week, the lawyer had been bragging about the deal he had struck on a Jaguar. The jabbering only stopped when the lawyer was told that he had a call from the police. The lawyer had purchased a stolen car, the caller informed him, faxing over the evidence to prove it. Only then did everyone listening to the escapade collapse in laughter; the lawyer had been taken in by one of Fastow’s elaborate practical jokes.

  Tonight, Martin was confident that Fastow the fun loving would be waiting inside. As she rang the front bell, a truck pulled up and a delivery man climbed out, carrying a large object to the Fastows’ entryway. Lea opened the door, greeting Martin as the delivery man arrived. He set down a giant, hideous bust of Elvis Presley.

  “Mrs. Fastow?” he said. “We’re delivering that bust you ordered.”

  “I’m sorry?” Lea said, looking mortified. “That’s not mine. We never ordered it.”

  “No,” the delivery man said. “It’s for you. It’s all paid up. Where do you want it?”

  Lea glanced around at her guests as her husband walked over to see what was going on. Martin had already figured it out: the Jaguar lawyer was getting his revenge, right in the middle of Fastow’s holiday party. She shook with laughter. God, she loved working for this place.

  The tall, patrician man walked casually through the lobby of the Enron building toward the elevators. He was dressed in a finely tailored, top-of-the-line suit and a muted tie. It was the kind of look that seemed calculated to attract notice, but the man paid no attention to the stares set off by his arrival. As someone with one of the world’s most recognizable faces, James Baker III, the former Secretary of State in the Bush Administration, was pretty much used to them, particularly in his hometown of Houston. After being ushered through security, Baker headed to the fiftieth floor, where a beaming Ken Lay waited, eager to hear the thoughts of Enron’s newest consultant.

  “Jim, thanks for coming to see us today,” Lay said, pumping Baker’s hand. “Well, Ken, it’s an honor.”

  It was early 1993, not long after Bill Clinton’s inauguration as President. While Lay had been disappointed by Bush’s defeat, he also viewed it as an opportunity to attract top-flight talent to Enron. Baker—and Lay’s old friend Robert Mosbacher, the former Commerce Secretary—were offered consulting contracts to lend their international expertise to Enron’s overseas power projects.

  The deals were signed on February 22, 1993, and Baker and Mosbacher soon began examining company projects. One caught Baker’s attention: the Indian power plant that Rebecca Mark had contracted to build. Constructing the plant in Dabhol, about a hundred miles south of Bombay on the rocky coast of the Arabian Sea, struck Baker as tricky business. Enron had made efforts to protect its interests, winning agreements from the Maharashtra State Electricity Board to purchase virtually all of the plant’s power, securing guarantees from the state and national governments, bringing in contractors involved in the construction as part owners. But Baker saw dangers that appeared to have escaped Enron’s attention.

  He dashed off a one-and-a-half-page memo, raising red flags. Enron, he cautioned, seemed to be assuming that the politicians negotiating the deal would be around to enforce it; the company was betting on a single horse, without forging alliances with other political factions. Worse, the company had failed to give locals a sense of ownership in the plant, say, by bringing in an Indian company as a corporate partner. It would be a serious error, he warned, to underestimate the potency of Indian nationalism and its potential to harm the deal.

  Baker sent the memo to Enron’s officers, who promptly filed it away and largely forgot about it.

  The hunt had lasted almost three years. But now, having found Enron, Christopher Bower was ready to bring down the big game.

  Bower, founder of the Pacific Corporate Group in La Jolla, California, held one of the country’s most intriguing jobs—helping Calpers, the giant retirement system for government employees in California, invest more than two billion dollars in private deals. With that kind of money jangling in his pocket, Bower was welcome in most any corporate or Wall Street office and had heard hundreds of investment ideas. But time and again, he and his team of eleven professionals found the proposals unexciting.

  Then, paydirt. Bower came to Houston, meeting with Fastow and his finance executives, and pushed a simple idea. Enron wanted to finance gas producers through off-books entities but needed outside money to meet the accounting rules. The Cactus deals had been fine but required Enron to wander around, tin cup in hand, scaring up investors. Calpers was ready to fill the gap. It could provide cash custom-fit for Enron’s needs, up to half of a $500 million fund. Enron, already cash starved, could use its own stock to finance the other half.

  “This is an approach that would give you guys a real leg up on your competitors,” Bower said.

  “It’s great,” Fastow replied. “It’s exactly the kind of deal Enron wants to do.”

  Months of work ensued. Then, on May 17, 1993, Skilling, Fastow, and Amanda Martin appeared in the glass-and-mahogany corporate boardroom before the executive committee of Enron’s directors. John Duncan called the meeting to order and asked Lay to open things up.

  “We have several items,” Lay said. “But the primary purpose of our meeting is to consider a joint venture with Calpers that Andy and his team have been working on.”

  The broad outlines of the deal were left for Kinder to describe. It all sounded too good to be true. What, one of the directors asked, were the potential profits?

  Fastow studied a sheaf of papers. “We’ve done a detailed analysis of the estimated impact this would have on our financial reporting for the next few years.”

  He laid out the numbers and the directors’ eyes lit up. The potential was huge. With little additional debate, the directors unanimously approved the concept. The joint venture was named JEDI—ostensibly for Joint Energy Development Investments, but in truth as a tip of the hat to Fastow’s affection for Star Wars.

  The project would soon be well known within Enron. It would take almost a decade for it to become infamous.

  Just blocks from Enron’s headquarters, on the twenty-third floor of Two Shell Plaza, Toni Mack was going through her mail. A reporter at Forbes, Mack had written for years about the travails of the energy industry, early on spotting Lay’s efforts to solve the take-or-pay problems. Long ago she had decided Enron was about the only company putting together a crackerjack strategy for deregulation, and always made sure to keep an eye on its business.

  Sitting at her steel-case desk, Mack picked up a long envelope stamped with a logo she recognized. Enron. Probably the company’s annual report to shareholders for the prior year, 1992. She tore open the envelope and pulled out the document. A splash of colors danced across the cover in an illustration depicting Enron’s impact on the world.

  Mack grabbed a highlighter and began reading. On page fifty she saw a summary of Enron’s accounting policies. The usual boilerplate, until she reached the seventh entry: Enron accounts for its pric
e-risk management activities under the mark-to-market method of accounting.

  “Huh?” Mack said aloud.

  In the next two paragraphs Enron spelled out its methods for counting profits in Skilling’s division. Mack’s highlighter marked almost every word. What the heck does that mean?

  Mack hit the phones, calling sources in the industry. But the more questions she asked, the more puzzled she became. While the accounting was mark-to-market, it wasn’t being handled the old-fashioned way, with trading prices dictating values; instead, Enron was using its own projections to fold anticipated income from decades-long contracts into the current year. It struck her as horribly aggressive. What if the other party to the contract went bankrupt? What if energy taxes changed? If, oh, natural gas was outlawed? This newfangled accounting seemed highly risky, and Mack thought investors needed to know about it.

  Mack’s article appeared in the May 24, 1993, issue of Forbes. While acknowledging Enron’s business successes, the piece focused on its accounting risk—the potential for unexpected events to erode previously reported profits. She pointed out that with profits of each contract reported the first year, Enron needed to sign up increasing numbers of contracts each year to keep growing.

  Mack believed she had untangled the threads of a complicated corporate tale. But Wall Street analysts—many at firms already lapping up banking fees from Enron—issued reports saying mark-to-market made no difference. None confronted the substance of Mack’s analysis.

  Days later, Mack received a hand-delivered letter from Ken Lay. How could Mack criticize mark-to-market, he asked, when the SEC and Arthur Andersen had approved the approach? Mack wrote back, appealing to Lay’s sense of history. The take-or-pay debacle proved the industry’s shortcomings in making long-term assumptions; imagine, she wrote, how bad that episode would have been if gas companies had been forced to reverse previously reported profits.

  But Lay—and Skilling—were unmoved. The risks Forbes was warning about were imaginary, they told colleagues. Mack, they insisted, just didn’t get it.

  Could Enron use mark-to-market accounting in a business that, at this point, had no real market?

  That was the question bedeviling executives in Skilling’s group. By mid-1993, Enron had a division running that seemed to fit no place: clean fuels, which manufactured methanol and MTBE, a gasoline additive. Skilling thought the business made no sense and put Enron in danger of losing big money. But maybe, he thought, if he could re-create Enron’s approach to the gas business in clean fuels, there were dollars to be made.

  To get the ball rolling, Skilling tapped Ken Rice, a top-notch marketer in his division. Skilling knew Rice’s zest for salesmanship and figured he was just what the business needed—an executive who produced results.

  Skilling summoned Rice to his office. The young executive walked in and flopped down on a chair. Tall and fit with a cap of brown hair, he wore his usual outfit—jeans, a faded shirt, and boots. Skilling bluntly broke the news that he wanted Rice to take over clean fuels.

  “You’re kidding, right?” Rice said. “I don’t know anything about this business.”

  It didn’t matter, Skilling said. The division was a disaster, but it had a couple of valuable contracts. “If we can create a market and renegotiate those contracts,” he said, “maybe we can get mark-to-market earnings on them.”

  At that point the fuels group was making profits the old-fashioned way: it made stuff and sold it at a profit. The plants were connected by pipeline to the factories that used the fuels—hardly an arrangement, Rice thought, conducive to creating a market. But if Enron could switch the accounting, big profits from the contracts could be booked right away.

  Rice took a few days to think about it, then accepted Skilling’s request. By his first day on the new job, he had devised his strategy. He would build a market for the fuels. Then, once the traders had some traction, he would consult Andersen and propose switching to mark-to-market accounting. It seemed logical, similar to the path set by the original foray into gas trading.

  Within days Rice figured he had it backward, at least as far as his bosses were concerned. Rick Causey, Skilling’s top accounting guru, assigned a controller to Rice, and she arrived with marching orders. The controller brought copies of the unit’s big contracts into Rice’s office and laid them out on his desk.

  “Let’s talk about how we can make these mark-to-market,” she said.

  Rice didn’t get it. How could plants servicing two customers through direct pipelines be a market? The controller assured him it could be handled.

  Just shift the corporate entity that signed the contracts and persuade customers to agree to allow the fuels to come from any source. True, it was an artifice—why would Enron get MTBE anyplace other than the plant connected directly to the customer? But with the changes, the controller said, Enron could argue it had established a rudimentary marketplace.

  “But we’ll still have only two big contracts,” Rice said. “How many will we need to be considered a market?”

  The controller shrugged. “All we need to show is two or three independent deals. Causey says that will be enough to get Arthur Andersen’s approval.”

  That’s all? A little renegotiating, and suddenly Enron had hundreds of millions in new profits—on the same deals? Still, Rice figured the accountants knew what they were doing. “All right,” he said. “Let’s get on it”

  Storm clouds and tendrils of mist drifted across the summit of Arrowhead Mountain in Edwards, Colorado, tempering the summer heat. On the golf course below, Ken Lay was climbing into a cart, ready to ride out to the driving range. It was early on August 14, 1993, and Lay had just arrived at the Country Club of the Rockies following a ten-minute flight from his Aspen vacation home on one of Enron’s Hawker jets. He was eager to get in a few practice swings; after all, it wasn’t every day he teed off in front of the White House press corps alongside the President.

  Weeks before, Lay had received a call from the White House inviting him to join President Clinton in a game. Lay figured Clinton was inviting an assortment of business executives, maybe to spend the time seeking support on some economic issue. But days ago, his assistant had checked for final details and learned that only three people were joining Clinton. Lay would be the sole businessman. The others were Lay’s friend Gerald Ford, the former President, and Jack Nicklaus, the pro golfer. For someone like Lay, a sometime golfer, the lineup was unnerving.

  As Lay’s small white cart approached the driving range, he saw Ford hitting a few warm-up balls. The cart circled to a stop and Lay hopped out. The former President set the head of his club on the ground and smiled.

  “Jerry, nice to see you,” Lay said. “Looks like we’re going to have an interesting foursome today.”

  “That’s an understatement,” Ford replied with a smile. “Thanks for agreeing to play, Ken.”

  After a few minutes of conversation, the two men hit some practice balls. Another cart came around, carrying Nicklaus, and everyone exchanged greetings.

  The first sign of Clinton’s arrival was the sudden emergence of reporters. He showed up on a cart driven by the course’s golf pro and spoke a few kind words to Ford before turning to Lay and clasping his hand.

  “Ken, I’m delighted you could join us,” Clinton said.

  “Well,” Lay said, glancing around at the famous men, “it certainly looks like it’s going to be interesting.”

  They climbed into two carts and rode out to the first tee, Clinton and Nicklaus in the lead, Ford and Lay following. The four men teed up, but only two balls made it on the fairway—one from Nicklaus and one from Lay. The presidents’ had both veered off: the Democratic President’s ball to the left, the Republican’s to the right.

  After nine holes riding with Ford, Clinton invited Lay to accompany him in his cart. The two men spent time discussing their lives, their thoughts, and their games as the press corps snapped photos.

  The game ended hours later, and
all the players went on their way. Any thoughts that the defeat of President Bush would significantly blunt Enron’s influence at the White House had evaporated with the first swing of a club.

  Skilling threw his arms up in disgust.

  “Why wouldn’t they do this?” he shouted. “It makes all the sense in the world!”

  Two of Skilling’s lieutenants had just delivered the bad news: the electric utilities had no desire to hitch themselves to his latest idea. Since 1994, Skilling had been trying to build on Enron’s success in gas by expanding into electricity. It was an audacious, if logical, move. While the folks at Enron could spout chapter and verse about gas, they didn’t know much about electricity trading. But that business dwarfed the gas industry, with transactions totaling close to $100 billion a year. Baby steps toward deregulation were forcing utilities to open their transmission lines to anyone, and Skilling wanted Enron to jump in with both feet.

  He tossed the trading business to Lou Pai; the first transactions began in June. He pulled Rice back from clean fuels and put him in charge of negotiating long-term power contracts with the utilities.

  Then it struck him—the Idea. Enron should form a consortium with, say, half a dozen electric utilities. Skilling hated owning assets, so the utilities would be responsible for building and operating the power plants. Enron would stick with what it did best—marketing and trading the power that the plants produced. It seemed breathtaking in its simplicity and moneymaking promise.

  Skilling summoned Cliff Baxter, an investment banker who had joined Enron years before. The two had become close friends, despite Baxter’s penchant for challenging Skilling’s views, a cocksureness that few others in the building dared display. This time was no different.