Conspiracy of Fools

by Kurt Eichenwald

  Everyone ordered, and small talk soon dwindled out.

  “Okay,” Causey said, “so what’s up?”

  Duncan looked down at the table. It was about that Bonneville contract, he said. “Well, our thinking is—now, it’s our advice at this time,” Duncan stammered. “There are lots of really complicated issues here, and some of them are not real clear …”

  Bass and Bauer glanced at each other. What was Duncan talking about? Why was he dithering? Bass tapped his palm against the tips of his fingers.

  “Wait, time out,” he said. “Rick, we can’t support booking this as income.”

  They had consulted the firm’s top accounting experts in the Professional Standards Group, Bass said, and consulted the Houston practice. All were in agreement.

  Bass vaguely shrugged. “So that’s the answer.”

  Wait a minute, Causey argued. It was income. He rolled out his arguments, but Bass and Bauer just shook their heads. Sorry, they said. Duncan sat at the table, silent.

  Causey refused to give up. He hurried back to the office, placing calls to Andersen’s Houston managers and making his case. But despite the protests, none of them would back down.

  Well, tough. The financial statements were from Enron, not Andersen. Causey wasn’t required to take their advice. If he thought they were wrong, he could take it to the mat and report the income. And he did.

  Andersen, still certain the accounting was in error, put the item on what is known as the adjustment sheet. Under the rules, if the numbers on the sheet were high enough, the company had to report them. But Duncan, having lost the accounting issue, argued that the amount was not material when viewed a particular way. That was an audit judgment—the area where Duncan had far more control. His argument won out; the dispute was kept hidden.

  In the end, Andersen ruled that a single transaction almost doubling Enron’s annual profits—from $54 million to $105 million—would not strike investors as important.

  Joe Hirko, the chief financial officer of Portland General, sauntered into Skilling’s office in high spirits. After months of work, the merger was all done, and now Hirko was in Houston, eager to push his next great idea.

  “I wanted to lay out some ideas we’ve got for telecom,” Hirko said.

  Skilling pulled a face. Portland General, he knew, had launched a tiny telecommunications business in late 1996 called First Point Communications, with plans to lay fiber-optic cable encircling Portland for high-speed Internet communications. The whole idea made no sense to him; it just seemed like money spent for little reason. When calculating Portland General’s value, Skilling had always assumed, at best, the telecom group was worth nothing—at worst, Enron would have to shoulder the expense of shutting it down.

  Now Hirko was throwing out this grand vision of building a long-haul fiber-optic network, linking Portland and Los Angeles, ultimately spanning more than sixteen hundred miles.

  “You’ve gotta be kidding me,” Skilling sneered. “You want to get back-hoes out there and start digging holes? We’re not doing that. We’re not putting money into it.”

  “Well, Jeff, what if we could presell something like thirty fibers? Because that will pay for the project.”

  Skilling laughed. Thirty fibers was less than one-third of what Hirko was talking about putting into the ground. It was like saying he would sell a tire to pay for the car. No way in hell, he thought.

  “Okay, sure,” Skilling said. “If you can presell a third of it and pay for the whole project, have at it.”

  Approval in hand, Hirko went on his way. Weeks later, he returned, stunning Skilling with the news. He had presold the fibers and raised all the money he needed.

  “Come on!” Skilling said. “Businesses don’t work that way. Why aren’t people putting in their own fiber instead of buying it from you if the prices are this screwy?”

  Hirko shrugged. “It’s telecom.”

  The whole thing was goofy. But suddenly Skilling wasn’t so negative about his energy company spending money to join the Internet mania.

  Carl Bass skimmed through the details of the power-plant transaction, certain that Enron was pulling another fast one on the accounting. Only this time, it was following the rules. The results were just insane.

  Somebody at Enron had fallen in love with obtaining financing by selling power plants to off-books partnerships. But these weren’t sales any reasonable person might expect. Under the complex deals, Enron received cash from the partnership—all borrowed—in a “sale” of the plant. But even though the company lost control of the plant, it still retained the risks of ownership. Then, sometime in the future, Enron could swap everything around and pull back most of the ownership when it wanted.

  It was nuts, a way of allowing Enron to report cash flow where none really existed. But Bass had a hard enough time fighting the company when it abused the rules. What was he supposed to do when it was following the literal rules to an irrational end?

  Bass thought about it for a moment.

  Change the rules.

  What if, Bass wondered, he helped John Stewart, Andersen’s top accounting guru, persuade the rule makers to write a couple of revisions? It would be tough, but there was a logic to the plan. Accounting for real estate tended to be more onerous than for other assets. If the rule makers deemed such financings couldn’t be done with real estate, it would be a small step. Then, Bass figured, the big part. Power plants are attached to land. So shouldn’t they be real estate?

  It would take almost eighteen months for Bass and his colleague to execute their subterfuge. But they would be successful in shutting down—for one of the only times—an illogical Enron accounting practice.

  Causey and Enron executives cursed the real-estate rules when they were finally changed. But no one ever learned—not even Arthur Andersen—that it was two of the firm’s own accountants who had pulled it off.

  ———

  On August 26, a wire operator at Bank One glanced at a single sheet and began typing numbers into the computer.

  From Account #1883757583.

  An account in the name of Michael Kopper.

  Routing instructions. Several numbers, directing the electronic system to send the money to J. P. Morgan Chase. To Account #054-06029219.

  An account in the name of Andrew and Lea Fastow. Total funds to be wired. $481,850.

  In a flash, almost half a million dollars zipped into the federal banking system. Within seconds, it appeared at J. P. Morgan Chase, ready to be credited to the Fastows.

  The loan to Kopper for the wind-plant purchase had been repaid. In just over three months, the Fastows had received back the money they had fronted to the bogus investors in RADR, plus almost sixty-three thousand dollars in profit.

  It was just the first in a steady stream of cash they would receive from the deal for years to come.

  Ron Astin stared at the inch-thick document on his desk. It was September 4, 1997, and Enron had just sent over its latest draft of the Chewco private-placement memorandum. The document, which would be used to solicit investors, was loaded with the required arcane information so potential investors could make informed choices.

  Astin had reviewed most of the details before; the first draft had landed back in July. This would be another structured-finance deal, meaning Enron only had to raise three percent of the total capital—in this case, still a hefty chunk of change, about eleven million dollars.

  Turning the pages, Astin studied portions of the document marked in the margin with a straight black line, a designation by the word-processing program of a revision. One new entry took him aback.

  A group of Enron executives, including Fastow, would be investors in Chewco. The intertwining of Chewco and Enron had always made Astin uncomfortable, but he signed off on it. But now Fastow was trying to make it a vehicle for personal profit. That went too far.

  Astin didn’t know it, but Fastow thought he had finally found a way around the accounting problems that had killed
Alpine Investors. Chewco wasn’t buying anything from Enron; Calpers was on the other side of the table. With the Chewco structure, Fastow and a few select colleagues would post a little cash and gain control of a quarter of a billion dollars in JEDI assets. Enron knew exactly what reserves JEDI owned; at this point the partnership was just clipping coupons, receiving a reliable stream of cash. The investors would be rich, with almost no risk.

  But Enron, not Fastow, was Astin’s client. And this deal looked bad for the company. He reached for the phone.

  Four days later, on September 8, Fastow scowled as he and Kopper led a small cadre of lawyers to a conference room. He closed the door and slumped into a seat. The new Chewco documents had set off alarm bells at Vinson & Elkins, and now three lawyers—Astin, Joe Dilg, and Bob Baird—had marched over to Enron to air their concerns.

  Even before coming over, the lawyers had raised the same arguments Fastow had heard before: executives couldn’t be investors in their own companies’ structured deals. That left Fastow burning. He hadn’t invented the concept of special investments for insiders. Wall Street did it all the time. And Chewco wasn’t even buying anything from Enron, for heaven’s sake! What was the problem?

  This time Fastow wasn’t going to give up the money without a fight. His staff had called around to Wall Street firms and gathered information about their investment deals. He had also made sure to bring a few Enron lawyers along to the meeting—Mordaunt, Carol St. Clair, and Rex Rogers.

  Fastow’s expression oozed contempt as Astin spoke.

  “As we told you earlier,” Astin began, “this new provision allowing Enron employees to be investors has raised some serious concerns for us.”

  Fastow listened impassively.

  “Now, no matter what is ultimately done here, there is one absolute,” Astin continued. “Chewco cannot proceed in its current form unless Enron’s senior management specifically approves of the inclusion of this provision”

  Shaking his head, Fastow tossed up a hand. “Oh, come on, Ron. What, we have to drag in Lay and Skilling? What in the world is the big deal here?”

  “It’s a business issue, Andy. The timing and the form of this are not sound from a business perspective.”

  “It’s got nothing to do with Enron!” Fastow snapped. “We’re not negotiating with the company.”

  “That’s not the problem, Andy,” Astin said. “Look, the business units in Enron have a lot of rivalries. With your group getting special investment opportunities, that’s only going to make that problem worse.”

  Fastow said nothing.

  “But the most important element here is the substance,” Astin continued. “This may trigger Enron’s conflict-of-interest policy. And if it does, the board has to approve it. You are an executive officer, and there are serious legal issues raised by that.”

  Astin suggested that Fastow’s involvement in Chewco might even have to be disclosed in Enron’s financial statements. After several minutes, he finished up. Fastow sat silent for a second, then leaned forward in his chair.

  “You done?” he asked.

  Before Astin responded, Fastow launched his rebuttal.

  “Look, Ron, you guys are getting worked up over nothing. I mean, take a look at Wall Street. A lot of investment banks have compensation plans that let their best executives take equity interests in deals.”

  He poked his finger onto the table. “And damn it, Enron is not just some pipeline company. We’re like an investment bank. We do the same things. And if investment banks can do this, there isn’t a damn reason Enron can’t.”

  Astin sat for a moment in the ensuing silence. Fastow’s eruption had surprised him. The man clearly wasn’t weighing all the issues here.

  “Andy,” he said, “Enron isn’t an investment bank. It’s an energy company. And even if at the end of the day we decide that it’s fine from a legal and policy perspective, that doesn’t change the fact that the board and the senior management have to approve this.”

  Fastow didn’t miss the message. If he was in the deal, the board had to get involved.

  “Look, Andy,” Astin continued, “you might not be CFO of this company, but you’ve sure taken on a lot of those responsibilities. Given your position, you really need to think about how this kind of arrangement is going to affect this whole company. I know Chewco seems like a great opportunity, but you’ve got to consider Enron’s interest.”

  There was a long silence.

  “I’ll think about it,” Fastow mumbled.

  The solution was obvious. Michael Kopper.

  When Fastow got knocked out of an official role in the wind deal, Kopper had stepped into his place. He had proven reliable and trustworthy. He wasn’t an executive officer—the thing that seemed to bother the lawyers so much. If Fastow couldn’t manage Chewco without triggering problems, Kopper was the ideal substitute.

  But Astin had raised other concerns. It was clear he wasn’t going to endorse the involvement of Enron employees in Chewco unless Skilling or Lay approved. But that didn’t worry Fastow. He knew how to speak Skilling’s language.

  A few days later, Fastow walked down the wide fiftieth-floor hallway past a line of cubicles. Since Skilling’s appointment as chief operating officer, he had moved up to the top-floor executive suites. Fastow had called ahead, telling Skilling he wanted to bounce an idea off him.

  Fastow breezed into the office, and Skilling broke into a smile; he seemed more energized than he had in years. The two wandered to the seating area on one side of the room.

  “Okay,” Skilling said. “What’s up?”

  “We’ve got an idea for how we can really do some great stuff for Calpers on JEDI.”

  Skilling smiled again. God, he loved Fastow. The guy was always finding new ways to get an edge.

  “I’m intrigued,” Skilling said. “What’s the idea?”

  “You know, we could get Michael to do this. I’ve talked to him, and he’s willing to put together a deal.” Skilling nodded.

  “He’s willing to do it at a higher price than we could get if we sold it to a third party,” Fastow continued.

  “Why?”

  “Two reasons. First, he doesn’t have to do any due diligence. He knows the assets. If we try to find investors like General Electric or someplace like that, they’re going to have to go through every single one of the assets.”

  “Mm-hmm.”

  “The engineering would be very expensive, because they have to figure out the geology, that kind of stuff. But Michael trusts the geologists we’ve already used, so there wouldn’t be any money spent on that.”

  Skilling liked that idea. Enron was going to pick up the sale costs; this meant lower expenses for the company.

  “And because he’s so familiar with the assets,” Fastow said, “he’s not going to give us as high a discount rate as an investor like GE might.”

  Even better. The discount rate would be used to calculate the present value of JEDI’s future cash flows. If Kopper was willing to use a lower discount rate, that meant a higher present value—and so a higher purchase price.

  “So,” Fastow said, “would you consider that?”

  Skilling laughed. “Hey, Andy, if we can make Calpers more money that way, you bet.”

  Fastow nodded, hesitating for a second. “Listen, also, what would you think of my family investing in this? You know, the Weingartens, Lea’s family?”

  Skilling sat back and crinkled his nose. Enron putting together family investments? That felt kind of low-rent.

  “I don’t think so, Andy,” Skilling replied. “That doesn’t sound like something I want to be messing with.”

  The small pushback was all Fastow needed. “Fine, we won’t do that,” he said quickly.

  Finishing up, the two men stood. Skilling slapped Fastow on the shoulder. “Sounds great, Andy,” he said.

  Banks provide loans, money that has to be paid back, with interest. Chewco needed equity, a third-party investment at risk of be
ing lost. But equity from an independent investor meant the profits would have to be divvied up. That’s why Fastow and Kopper wanted to get the money for Chewco from banks.

  So how to finagle it so that loans looked like investments?

  A proposal was floated with Barclays Bank, which had been involved in the original financing of JEDI: The bank would “invest” several million dollars in Chewco. Then Chewco would hire Barclays as a consultant, at a cost of one million dollars a year. If the bank injected five million into Chewco, the consulting agreement would last five years; if six, then six. On October 20, Barclays’s operations committee met to discuss the idea. Every dime it put in, Barclays would get back. With its maximum potential loss at zero, Barclays thought it could classify the “investment” as a loan on its own books.

  Then the accountants nixed the advisory fee idea. Without that tit for tat, Enron lost interest in the bank’s consulting expertise. After all, what good was Barclays’s advice if it didn’t help manipulate the accounting?

  Jordan Mintz, Enron’s newest tax lawyer, plastered a fake smile on his face, trying to mask his loathing of Kopper. He barely knew the guy and couldn’t stand him.

  The Chewco deal had grown endlessly complicated, and Mintz had been brought in to review its tax consequences. As best he could tell, Enron needed to provide a tax indemnification to Chewco. Often, an entity like Chewco will be deemed to have reportable income—and be required to pay tax on it—before it actually receives the cash. So Mintz was crafting a document requiring Enron, in the event of such a timing mismatch, to advance Chewco the money. Then, when Chewco got its cash, it would repay the loan.

  While the concept was simple, the details were complex, and Mintz asked a series of questions to make sure he had everything right. “Michael,” he said, “I need to understand more about the full structure, the investors—”

  “I can’t do that,” Kopper interrupted. “Enron doesn’t have a right to know more. We’re negotiating for Chewco, but it’s behind a black curtain. You’re not supposed to know what’s there. That’s what all the parties have agreed to.”