Fastow launched into the history of his funds, lauding his own work on the Rhythms hedge as a stroke of genius.
“Because LJM1 was so successful with Rhythms, we started LJM2,” Fastow continued. “And LJM2 allowed us to hedge even more investments, through the Raptors.”
The lawyers and accountants were always filled in on every detail, he said. “Nobody’s hiding anything from anybody,” he said. “Everything is just an open kimono.”
Open kimono. Mintz hated that phrase. Too many people at Enron said it. He had never heard it anyplace else.
“That’s why Enron’s comfortable,” Fastow said. “They’re comfortable it’s me and Michael. They know we wouldn’t do anything that wasn’t in Enron’s interest.”
But, he went on, Enron didn’t have to rely on their integrity alone. Plenty of controls were in place, from Enron’s right to refuse to do a deal, to the requirements for a sign-off from Causey and Buy. Plus, Fastow said, the company disclosed everything in its annual proxy sent to shareholders. It was all there, in the section on related-party transactions. Mintz nodded silently; these were the disclosures he knew Kopper was working to remove.
Fastow looked at Mintz sternly. “Now, the money I make from LJM doesn’t have to be disclosed,” he said.
In case Mintz wanted to know more, he named the lawyers who had worked on the LJM disclosures the prior year. “Our approach in the past,” Fastow said, “has been to try to keep our disclosures as innocuous as possible.”
Mintz wrote down the words “keep innocuous.”
The meeting ended after forty-five minutes. Mintz headed to the elevator, eager to put together a plan of how to substantiate everything Fastow had just told him. He didn’t want to leave anything to chance.
Rick Buy was behind his desk, acting aloof. It was two days later, October 25, and Mintz was questioning him about LJM. Buy struck Mintz as torn: convinced the deals were good for Enron while plagued by doubts about the wisdom of using the funds.
Buy explained that a lot of the analysis on the LJM deals was handled by Dave Gorte, in Risk Assessment and Control. For a few minutes, he discussed the economics of the transactions. He paused, glancing away.
“I don’t know,” he said. “What a great deal Andy’s got for himself here.” He looked back at Mintz. “In fact, he’s sort of talked to me about going over there, joining LJM. I may do it. I don’t know.”
Mintz sat motionless. Buy, one of the people charged with reviewing the fairness of LJM deals, had been approached about working there? Just making the offer deepened the conflict. Wasn’t anybody bothered by all of this?
Jeff McMahon couldn’t stop laughing.
It was the next morning at 10:30. Mintz had just walked into McMahon’s office for a briefing about his experiences with LJM during his time as treasurer. McMahon communicated his thoughts fast, breaking into laughter before Mintz said a word. Mintz understood immediately. McMahon hadn’t joined the cult. He could skip the political niceties.
“Jeff,” Mintz said, “what the fuck is this LJM stuffall about?”
McMahon broke up again. “Well, you’ve got your hands full now that you’ve gone over to the dark side.”
“What do you mean?”
“Fastow, Kopper, and that group. Never a dull moment.” McMahon sighed. “It’s a real conflict. And fucking Andy is so blind he doesn’t even recognize he’s got a problem. People are afraid to talk about it.”
He paused. He wasn’t laughing anymore. “Andy knows he’s got everybody by the balls,” he said. “Buy just rubber-stamps those deals, and Andy rolls right over him. Andy’s trying to get our bankers to invest with him and holding out a threat that they might lose Enron business if they don’t. And Causey’s in a big dilemma because, at the end of the day, he’s responsible for the financial statements, and LJM helps make the numbers.”
It was, in short, a disaster waiting to happen. And McMahon blamed Skilling for the whole problem.
“I think Skilling’s just afraid to get rid of assets,” he said. “He wants it both ways. So here we have LJM, and it’s the perfect situation. We can sell it to them and later, if we want, maybe buy those assets back.”
McMahon gave Mintz a brief course on the intricacies of the relevant accounting rules. “What you’ve got to understand here is, with these deals, now Enron is just a holding company,” McMahon said. “We’re not an operating company anymore. We just take investments and sell them.”
In just thirty minutes, Mintz’s worst fears had been validated. He had been in his new job for ten days.
Later that day, outside a meeting room at the Ritz-Carlton in Palm Beach, Florida, Skilling was shouting. He was in town for the LJM2 investor conference and was set to be introduced for his presentation in a few minutes.
He had arrived about an hour before and had found an executive from New Power there to make his own presentation. Enron and New Power were in the middle of a dispute, and Skilling decided to take care of it right there and then. After the initial blowup, things calmed down as the two men began negotiating an agreement.
In the midst of the bargaining, the door opened. Time for Skilling’s talk. He walked to the front of the room and for twenty minutes described Enron’s accomplishments and expectations. After a few questions, he headed out the door and returned to the airport. He missed hearing Fastow brag about LJM2’s stellar performance over the past year.
The numbers were staggering. LJM2 projected returns of 69 percent, exclusively from transactions tied to Enron. If any real third party had cut deals with Enron that generated profits like that, company executives would have hung their heads. But Fastow beamed as he reviewed the results. After all, the third party walking away with the cash was his fund.
The breakdown of investments showed that big payoffs came from a handful of deals. For most of the others, the returns were almost run-of-the-mill. The fiber purchase from Broadband, for example, was expected to yield 18 percent. But the Raptors were off the charts. Projected returns for Raptor I were 193 percent. Raptor II, 278 percent. And Raptor III? A nice, round 2,500 percent.
His investors had put up $437 million. They could expect profits of almost $345 million. Soon.
The next day, October 27, Mintz saw Dave Gorte, the analyst who Buy said examined the LJM2 deals. Gorte seemed almost laid-back about the process.
“When things go into LJM, the prices aren’t wildly out of line with the market or anything,” Gorte said. “But these are tough transactions to review, because we’re moving so many assets off the balance sheet.”
“Do we care about whether a particular sale is the best option?” Mintz asked.
Gorte shook his head. “No. We probably should. But we just look at whether the deal is fair on its own. We don’t necessarily compare it with other deals.”
Mintz took a mental note. Gorte was unknowingly contradicting Fastow’s assurances that LJM2 was never anything other than the buyer of last resort.
“But a third party would take too long,” Gorte continued. “We just want to get comfortable that the deal passes the smell test.”
Mintz asked how the assumptions from finance that were used to justify the deals were reviewed. “We don’t usually test the assumptions,” Gorte said. “But we need to.”
Mintz left the meeting convinced that McMahon was right. The vaunted review of LJM2 deals was a rubber stamp.
What did the accountants think about this?
In his interviews, Mintz was hearing lots of things that made him question how the numbers were being counted; Enron, he had heard, was even buying back assets it had sold to LJM2. That alone might suggest the sales should never have been counted as revenue. Still, he couldn’t shake the notion that his lack of accounting experience was creating unnecessary doubt. Maybe the accountants could explain why LJM made sense.
So he visited Causey on October 30. For a few minutes, Mintz ran down the list of people he had spoken with in his efforts to understand LJM. �
��Now, obviously, you’re a very important person in this process,” Mintz said. “But I want a better understanding of your role.”
Causey described briefly how he reviewed the transactions. Then he gave them a ringing endorsement.
“This is a win-win for the company,” he said. “We sell assets to LJM; we’re not going to buy the assets back. So we get them off our balance sheet.”
Not buy assets back? But Mintz had just learned that assets were repurchased. He mentioned what he heard.
“I don’t know anything about that,” Causey replied.
A eureka moment. It suddenly struck Mintz as so obvious. The executives entrusted with reviewing all of the LJM transactions—Causey, Buy, the board—approached their duties casually, giving everything just the onceover. They seemed to figure that somebody else was doing the tough analysis. But no one was.
“Where does Andersen stand on this?” Mintz asked.
“We’ve got to manage Arthur Andersen in the process,” Causey said. “They don’t love it, but they don’t see anything wrong with it.”
He shrugged. “So long as we keep making the disclosures they require, they’ll sign off on it.”
The lawyers working with the trading group returned to Portland on November 3, ready for more interviews. Sanders surveyed the traders assembled in a conference room.
“Now, about those strategies we discussed,” he said to the traders. “We’re not doing those anymore, right, guys?”
Belden looked sheepish. “Yeah, we’re not.”
The calming air of twilight had arrived, and Skilling watched as the woods darkened behind Rebecca Carter’s house. The two were on the back deck, enjoying cigarettes while Skilling talked about his desire to get out of Enron. “Why can’t I leave now?” he asked.
There were plenty of good people who could take over. The biggest problems were under control, he said. Azurix, International—even California. But Carter disagreed.
“You can’t leave now, Jeff,” she said. “The company needs you too much. Ken is getting ready to leave, there’s nobody to step into your shoes. You have to stay.”
Skilling puffed on his cigarette. All right, he wouldn’t leave. Not yet.
———
“What the hell happened? I thought we had everything worked out!”
It was November 5, and Joe Berardino, the Andersen managing partner who had been working with Levitt on the industry compromise on consulting, was calling the SEC from Europe. He had played diplomat for weeks and thought an agreement had been struck. But at the last minute, Levitt had gambled badly, telling the other firms that the compromise was not open for debate, take it or leave it. They left it.
The proposal had been pretty much half a loaf for everybody. Some of the most lucrative consulting deals would still be allowed, but the size of the payments for non-audit services would have to be disclosed. The firms could even continue handling internal audits, so long as no company used them for more than forty percent of the work.
The sticking point proved to be the part Levitt considered the most important. The compromise required accounting firms to be independent, both in fact and in appearance. Three of the five big firms weren’t willing to accept the “appearance” standard, believing it was too vague.
With word of the breakdown, Berardino started his diplomacy again, pushing until a majority of the industry accepted the appearance provision. Meanwhile, Levitt hit the phones. Eventually everyone agreed to a deal except Philip Laskaway, chairman of Ernst & Young.
Levitt called Laskaway, urging him to join his colleagues. The Ernst & Young general counsel, who was also on the line, argued against the proposal.
Tired and frustrated, Levitt lost his patience. “Be quiet!” he shouted at the general counsel. The call went silent.
“Philip, do I have your support or not?” he asked.
There was a pause of several seconds. “I think it’s in the best interest of the profession to get a deal done,” Laskaway said. “You have our support.”
On November 15, Levitt stood in his conference room surrounded by agency staff. The final rules on auditor independence had just been adopted by the commission. He raised a plastic glass filled with champagne.
“This is a great achievement,” he told the troops. “Everyone here has so much to be proud of.”
He went around the room, singling out people for their contributions to the effort. Levitt felt happy, but not fully content. The rules were not as good as he had hoped. They didn’t completely fix the problem. But the accounting industry’s argument that the SEC hadn’t been able to produce a smoking gun—a case that showed unequivocally that a firm’s lack of independence had allowed a client to go too far—had won the day.
As he sipped his champagne, Levitt was torn. He believed the markets had just been made better. But in his heart he knew the era of accounting scandals was not over. Not by a long shot.
There was something wrong at Enron. Jim Chanos, the New York short seller, was willing to bet money on it.
Over a little more than a month, Chanos and his analysts had examined Enron’s filings and discovered plenty. Despite its aggressive accounting, Enron had only a seven percent return on its invested capital—a sign of lots of bad business decisions. That was so low that, given what he calculated as Enron’s cost of capital, Chanos wasn’t even sure if Enron was earning money at all.
But the truly bizarre mother lode turned up in Enron’s third-quarter filing. The company was doing deals with entities that Enron said were run by some senior officer it didn’t identify. Chanos and his staff reviewed everything they could about the deals but couldn’t decipher the impact that they had on Enron’s reported financials.
Still, Chanos saw enough. In November, his firm began making its big bet that Enron’s stock price would fall.
In Portland, Christian Yoder visited Stephen Hall, the lawyer he hired from Stoel Rives. Yoder was beginning to fear Enron’s top management had no idea about the trading problems in California. Something needed to be done to get their attention. Hall had been assigned to understand the trading strategies; that was the opening he seized.
“Steve, I want you to write down everything you’ve got,” he said. “I need it for upper management.”
The examination of Enron Energy Services, or EES, that was begun the previous April by Wanda Curry and her team of accountants had turned up a financial house of horrors. The division had a small trading desk to hedge price risks on the long-term contracts it offered customers, but Lou Pai had allowed the desk to take a speculative bet on power prices. While wholesale set up positions to profit if prices rose, retail was betting they would fall. And retail was wrong, leaving it with huge losses.
But the troubles in EES weren’t limited to trading. Customer deals were a disaster, too. The full values of contracts were reported under mark-to-market accounting, using what the accountants found to be wildly optimistic assumptions. An analysis of just thirteen contracts showed a discrepancy of $200 million between the reported earnings and what Curry believed were their actual value.
Chaos and disorganization ruled the day in EES. That fall, an employee discovered trays full of envelopes under a desk. Inside were checks—hundreds and hundreds of checks—from utility companies trying to pay their bills to Enron. All told, the slips of paper being treated like EES garbage had a value of about ten million dollars.
The division couldn’t even cash its checks properly.
Jim Derrick, Enron’s general counsel, templed his fingers in front of his mouth, contemplating the words he was hearing. It was November 20, and the lawyers from the wholesale division—Richard Sanders and Mark Haedicke—were in Derrick’s office, spelling out everything they had learned about the California trading schemes.
Sanders listed the sophomoric names that the traders gave the strategies, without detailing the nitty-gritty of how they worked. Derrick listened silently until Sanders finished.
“What sort o
f causes of action do you think people can bring against us because of these?” he asked.
“Potentially antitrust violations,” Sanders said. “Some of the strategies I’m not too worried about. But I am worried about the congestion-management strategies.”
Derrick thought about that for a moment. “Do we have the right lawyers to defend us in the lawsuits?” he asked.
The first complaint would be filed nine days later. But even then, Derrick never mentioned anything to Lay or Skilling about what he had learned.
On the afternoon of November 27, Mintz was at his desk when the phone rang. Fastow’s name flashed on caller ID. “Hey, Andy.”
“Jordan, hey. Just wanted to let you know the board approved LJM3.”
Mintz scribbled “LJM3” in his schedule. Another one? He didn’t know that board approval had come weeks ago.
“Kirkland & Ellis is working on the private-placement memorandum,” Fastow continued. “Call them, they’ll give you a copy to look at. But basically, it’s out the door.”
Mintz drew an asterisk next to the name “LJM3.” He would have to move fast.
Later that day, Mintz was leaning on his desk, his eyes gliding across the words in the LJM3 offering documents. On page 2, he stopped. That can’t be right. He read the sentence again. Fastow was telling investors that they would profit from his access to proprietary deal-flow data from Enron. In effect, he was putting Enron’s inside information up for sale. Mintz grabbed a copy of the LJM2 memorandum and discovered the same bold claim. Any Enron investors who saw this would go nuts; it was their confidential corporate information that Fastow was selling.
Mintz rubbed his face. Plenty of lawyers had reviewed this. It must be okay. After all, it was all being disclosed, right up front. But, still …
How are we getting away with this? How can they ever be comfortable saying it?
At five on the afternoon of December 5, Governor Gray Davis stood beside a fifty-six-foot Christmas tree towering above the Capitol’s rotunda floor. He looked out at the eager faces of the festive holiday crowd. The First Lady, Sharon Davis, took the hand of seven-year-old David Almberg and helped him push a small button. Power flowed to the four thousand lights strung around the white fir tree.
Conspiracy of Fools Page 51
