Conspiracy of Fools

by Kurt Eichenwald

  This was no secret, Levitt implied. Regulators knew, executives knew. The market was punishing companies with real numbers, while competitors were rewarded for playing games.

  The honest executives “know how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud,” Levitt said. “A gray area where the accounting is being perverted; where managers are cutting corners; and where earnings reports reflect the desires of management rather than the underlying financial performance.”

  It was a moment virtually unparalleled in the sixty-five-year history of the SEC. A chairman for the agency was announcing that the success of untold numbers of corporations was the result of dreams, not dollars. But the warning went unheard. The day after the speech, the Dow Jones Industrial Average closed above 8,000. Over the next two years, it would climb almost another four thousand points—the unprecedented price increase later derided as the bubble.

  And the stock price of Enron, Andersen’s biggest client, went right along for the ride. Without question.

  CHAPTER 8

  MORNING IN HOUSTON BROUGHT only darkness and flooding. Ominous pitch-black clouds of Tropical Storm Frances had rolled in overnight from the Gulf of Mexico, dumping sheets of water. Swollen bayous around the city spilled into the streets, trapping cars and buses in swirling torrents.

  Just past eight that Friday morning in September 1998, Michael Jakubik, the Bankers Trust deal maker from London, walked out of the St. Regis hotel and into the deluge. Not a good start. Not today, when he was interviewing with Jeff Skilling and Andy Fastow about joining Enron.

  It had been more than a month since McMahon pitched the idea of making him Enron’s investment czar, responsible for managing billions of dollars in holdings—setting up equity funds, selling assets, everything. Even though it meant moving his family from London, the opportunity seemed too enticing, one that could lead to even bigger things in the private-equity business. That is, if Enron hired him.

  Jakubik approached a couple of taxis before finding a driver willing to brave the weather. About twenty minutes later, the cab pulled up to corporate headquarters. Jakubik hustled in through the pelting rain and was directed to the fiftieth floor. Upstairs, it was empty and dark, with rain drumming on the floor-to-ceiling windows. Lightning flashed outside, and a sharp clap of thunder shook the room. A door opened, and a small man emerged, making his way through the shadows toward his visitor.

  “Mike?” the man said.

  “Yeah?”

  A few steps closer. A hand thrust out.

  “Jeff Skilling.”

  They sat on either side of Skilling’s desk, talking. Jakubik was awed. Here was the guy, the oracle of corporate strategy, speaking to him like a peer.

  “So of course, in this job, you’ll come to my weekly staff meetings,” Skilling said.

  Wow. “All right.”

  Skilling turned on the charm, jabbering about Houston and his family. But he asked nothing. It struck Jakubik as an oddly nonchalant stance toward a candidate for what would be one of the most powerful positions at the company.

  “I leave it up to the guys to judge brainpower and whether you’re appropriate for the job,” Skilling said. “If they’re fine with you, I’m fine with you.”

  He leaned in. “But I am eager for your questions.”

  “Okay. Why do you think this job’s important?”

  Skilling shrugged. “I trust Jeff and Andy, and they tell me this is important. That’s good enough for me.”

  The telephone rang. Skilling grabbed it. “Hello?”

  A pause. “No, let me pass you to the operator.”

  Jakubik stifled a smile. With no one else on the floor, the oracle was now the receptionist.

  For fifteen minutes, Jakubik tossed questions at Skilling, but the answers were perfunctory. His would-be boss seemed distracted, even indifferent. Whenever the phone rang, he snatched it up. Not one call was for him.

  Okay, Jakubik said. This job will involve stepping on a lot of toes. Every asset, every business that needs to be sold was purchased or built by somebody in the building.

  “Everybody’s going to claim I’m selling the company’s crown jewel,” Jakubik continued. “So I’m worried about coming here, only to find nothing can be sold.”

  Skilling shook his head. “That’s not how Enron works,” he said. “If Andy and Jeff say we need liquidity, then we’ll do it. They tell me to do it, I’ll do it.” Jakubik nodded. Okay, good enough.

  Suddenly Skilling stood, signaling an end to the interview. The two walked back to reception and said their goodbyes.

  “Stay dry,” Skilling said.

  About that time, Fastow was in his office, hanging up his raincoat in a hidden closet. He walked to his desk, rubber duck boots still sloshing, and told his secretary to send Jakubik back whenever Skilling was done.

  Jakubik arrived minutes later. Fastow spun toward him on his desk chair. “Sorry about the water,” Fastow said wryly. “So how’d it go with Skilling?”

  I have no idea. Why didn’t the guy ask me anything?

  “I think it went fine,” Jakubik said.

  Fastow nodded. “Okay, good.” He paused. “So what’s it gonna take to get you here?”

  “Well, I’d like to hear how you see the job.”

  Fastow leaned back. “This company has to do a better job of financing our merchant investments. They’re a drag on the balance sheet.” He laid out the same concerns McMahon had described weeks before. Enron needed to set up equity funds, sell assets, create new sources of cash.

  “I haven’t worked with you,” Fastow said. “But everyone who has says you’re the right guy. We need someone with your talents who understands private equity.”

  Jakubik said nothing. This was flattering.

  “We’re going to be looking to you,” Fastow continued. “You’re empowered. You’ll be the guy to make these calls. You’re going to be running this thing.”

  He paused. “So, what’s it gonna take to get you here?”

  “This is a copy of an address given a few weeks ago by Arthur Levitt from the SEC,” David Duncan said.

  Duncan passed a pile of stapled printouts down the boardroom table to the directors on Enron’s audit committee. It was about 4:30 on the afternoon of October 12, a day of scheduled board meetings. Duncan had just finished discussing Andersen’s view of Enron’s accounting practices. It seemed the right time to bring the Levitt accounting speech to the attention of the directors.

  “This speech is really the official notice of an SEC initiative to take a tougher view of corporate accounting practices,” Duncan said. “It is very detailed, and everyone would be well served to read it.”

  Causey, sitting nearby, motioned for a slide to go up on the screen. “Levitt Speech: Five Popular Earnings Management Practices,” it read. Underneath the heading was a list of five abusive tactics Levitt had criticized.

  “I would like to address each one of these,” Causey said. Levitt’s tough talk wasn’t aimed at anything Enron was doing, he said. The company had no giant restructuring charges, and it didn’t use creative acquisition accounting—two of the biggest sins Levitt had singled out.

  On the other hand, Levitt had also attacked accounting abuses that Enron would have to guard against. One was the premature booking of revenue—a temptation that, happily, Enron had not succumbed to, Causey said.

  “We do recognize a good portion of our revenue quickly, under mark-to-market accounting,” Causey said. “But, as you remember, the SEC approved our approach a number of years ago. So that is not a concern.”

  Last, materiality. Levitt had warned companies not to abuse the practice that allowed them to avoid reporting accounting errors that affect less than a defined percentage of income. Causey glanced at Duncan.

  “Now, we have had a dispute with Andersen about the proper accounting for a contract that we acquired as part of Portland General,”
Causey said. “We’ve disagreed on the accounting, and that disagreement has not been resolved.”

  However, the net effect was not reported to investors, Causey said, because Andersen had made the determination that the numbers were not material.

  Duncan jumped in. “I think that judgment is valid.”

  The directors listened, content with what they heard. Whomever Levitt was criticizing, they certainly weren’t like Enron.

  Later that night, at 8:15, the board gathered in the fiftieth-floor conference room for its regular meeting. They still had not recovered from their heated debate over the water business. Some directors worried there was no overarching strategy for the decisions being made at Enron. Lay had heard the grumbling and decided to address it head-on.

  About forty minutes into the meeting, Lay glanced around the circular table. “There have been a lot of concerns, expressed by a number of you in recent meetings, about the state of the company,” he said.

  He nodded toward Skilling. “Jeff has prepared a presentation to lay out where we’ve been, where we are, and where we’re going.”

  “Thank you, Ken,” Skilling said. A slide, showing the Enron logo, clicked up on the screen. “At our last board meeting, a number of you expressed some concerns about a number of areas,” he began.

  Click. The concerns. A loss of focus. Too rapid an expansion in international. Too many acquisitions of regulated businesses. Worries about the balance sheet and liquidity. Too many diverse activities in individual business units—what Skilling called “conglomeration.”

  But Enron’s performance had been stellar, Skilling said, rushing through the slides. By diversifying its business interests, the company had seen its stock dramatically outperform other energy companies. The trading business in particular was in a unique position to generate profits.

  Another slide. “For our international effort, we have developed an excellent platform network in both the Southern Cone in Latin America and in India,” he said. “We are going to have strong earnings and cash flow as these projects move toward completion.”

  The new business would make things even better. The company had a lot of upside—potentially increasing its stock price by twenty dollars a share—because of its strong entry in the telecom and water businesses.

  “Our key concern, of course, is of a liquidity meltdown, and the impact that would have both on our balance sheet and on our trading capabilities,” he said.

  That concern, he said, was mitigated by unexpected strengths—momentum in retail, a shakeout in power trading, and general stability in the wholesale business.

  The presentation was impressive. The directors asked questions; Skilling and Lay fielded them deftly. It sure sounded like management knew what it was doing and where it was headed. Maybe those worries had been for nothing.

  After going late into the evening, the directors reconvened at eight the next morning. After the first hour, Pug Winokur, the finance chairman, took the floor. His committee had approved a range of issues, he said.

  Fifteen pages of resolutions were distributed. They included authorizations for Enron to sell debt, preferred stock, and other securities and changes to policies on corporate guarantees. The resolutions ranged over so many issues there wasn’t time to discuss every detail. Nothing was mentioned about a paragraph on page 14, giving authority to Enron’s CFO to issue guarantees of up to ten million dollars without approval.

  No one knew that for years, Enron had struggled in its structured deals, trying to find investors willing to cough up far less than that amount. If Fastow could use an Enron guarantee—assuring potential investors who provided the three percent that they would get their money back—that hunt might not be so difficult anymore.

  The directors had just handed Fastow a loaded pistol. It would not be long before he pulled the trigger.

  Just past 2:15 on the afternoon of October 27, a yellow cab snaked through Park Avenue traffic in midtown Manhattan. In the back, Skilling sat beside Fastow, gazing through the car window at pedestrians. To his agitated mind, their faces were frozen in fear, dark circles defining their eyes. The elite of the financial world worked here, and Skilling thought they had good reason to be terrified.

  A global economic depression was on the way; Skilling was sure of it. Russia had defaulted. The Asian financial crisis was still digging into world economies. The Fed had been forced to engineer a bailout of Long-Term Capital Management LP, a hedge fund, on concern its collapse would trigger a market meltdown. Skilling feared the gathering financial storm would swamp Enron itself. Banks were ruthlessly tightening credit. If they shut off the spigot to Enron, the consequences could be dire.

  So he had ordered Fastow to fly to Paris, Düsseldorf, Brussels, and London, seeking reassurances from the banks. Now the time had come for meetings with Enron’s New York lenders, and Skilling wanted to attend these himself; any banks planning to call Enron’s loans would be more likely to listen to the company’s number two than to its CFO.

  The taxi pulled in front of the fifty-three-story headquarters of Chase Manhattan Bank. Within minutes, Skilling and Fastow were upstairs, in an office near a trading floor. A short man with gray hair and a chunky gold ring on one finger bounded toward them. It was Jimmy Lee, Chase’s colorful chief of global investment banking.

  “Gentlemen, good to see you,” he boomed.

  After the pleasantries, Skilling got to the point.

  “Listen, guys, I’ve got no illusions,” he said. “There’s probably a liquidity crunch on the way, and you might have to start making choices among your borrowers.”

  Skilling braced himself, then asked the question. “So I need to know, if you have a problem, where does Enron stand? Will you continue to support us?”

  Lee smiled. “Jeff, we like Enron,” he said. “This is exactly the kind of business we want to do long term.”

  Skilling listened as other bankers in the room praised the company—and Fastow. He always kept them up on events, always gave them plenty of feedback. He made the bank comfortable.

  Afterward, as the two Enron executives left the building, walking to Park Avenue, Skilling was exultant. This was how it was supposed to be; any doubts he had harbored about appointing Fastow as CFO evaporated.

  “You know, Andy,” he said, “they could be putting the screws to us right now, and instead they’re telling us how much they want to work with us.”

  Fastow nodded, smiling broadly.

  “This is what makes the difference, Andy,” Skilling continued. “When times are tough, if we’re doing a good job with our bankers, that makes all the difference.”

  Skilling slapped Fastow on the back. “Keep up the good work, man,” he said.

  A week later, a group of Chase bankers held a lengthy meeting about Enron. There was a lot to talk about. The bank had committed $750 million in two credit lines to different Enron-related entities. They had made large commitments for the Elektro acquisition.

  But some of the best deals weren’t quite so straightforward. For example, in the past year, Chase had arranged what looked like $650 million in gas trades involving Enron and a Jersey company called Mahonia. But in reality, Mahonia was a front for Chase itself. No gas changed hands; money simply circled from Chase to Mahonia to Enron, then back again, with the equivalent of interest. The transactions were effectively loans dressed up to look like energy trades. That let Enron report the borrowings as cash flow and trading liabilities. Chase bankers knew Enron loved the deals, because they could use them to hide debt.

  With all this business, Enron was at the top of the heap at Chase. The bank ranked corporate customers based on a color code, with “blue” clients having the richest potential for bringing in future fees. And Enron, the bankers agreed, was the bluest of the blue.

  After the meeting wrapped up, one banker, Matt Lyness, approached George Serice, a colleague. Lyness was stunned by the numbers he just saw—in “Enron shock,” Serice joked. Chase couldn’t be the only
bank putting together off-balance-sheet deals with Enron, Lyness mused to Serice.

  “Just how much in off-balance-sheet commitments do these guys have?” he wondered.

  Serice was coy. “You don’t want to know,” he replied.

  Should Enron try to raise its triple-B-plus credit rating to an A level?

  Skilling had pushed the question for years. For most companies the answer would be obvious: yes. An A rating was insurance against defections by trading partners in wobbly markets. Trading was Enron’s profit center. There was good reason to go all-out and protect the crown jewel.

  But, somehow, nobody on the board seemed to worry much about Enron’s credit rating. The complacency rested on the assumption that Enron had grown so powerful in the energy markets that trading partners would have nowhere else to turn. Besides, raising the rating would have a price. Enron would have to cut billions in its debt levels and limit its financing choices. Its light-speed growth would slow. All to ward off some unseen, theoretical future threat. It was, some directors and managers thought, like spending millions of dollars for insurance against being hit by an asteroid.

  Skilling raised the question with Pug Winokur.

  “Tell me, Jeff,” Winokur responded, “what business are we losing because of our credit rating?”

  Skilling shrugged. “None.”

  “So what business would an A rating bring in?”

  “None.”

  Winokur smiled. “So why do we need it?”

  The logic seemed strong. It wasn’t like Enron was in danger. Skilling dropped the idea.

  Ken Rice walked briskly into a conference room down from his office. Kevin Hannon, his co-chief executive in Enron’s wholesale-trading division, was there waiting.

  The two men were getting together for the task that everybody hated—putting together their budget for the coming year, reporting not only current performance but projected profits for 1999. And there was no doubt that whatever numbers they wrote down, they had to be larger than the ones reported this year. That’s what Enron told Wall Street was coming, and that’s what wholesale trading had to deliver.