Conspiracy of Fools

by Kurt Eichenwald

  Since launching the inquiry, the partners, Dilg and Hendrick, had spoken to executives involved in the Raptors, including Fastow, Causey, and Duncan. Repeatedly, they heard all was well, the accounting was proper.

  Now, on September 13, the lawyers were days from giving their unofficial blessing to the structures. But before they did, they sat down again with Ron Astin, their partner who had worked on a number of Fastow deals.

  There were issues that had always bothered him, Astin said. He had never believed the LJMl/Rhythms transaction had been given adequate consideration by the company.

  “LJM just seemed like a gift to Fastow,” he said.

  As Astin described it, there was plenty to make him uncomfortable with the setup. “I heard rumors that it was unlikely Fastow would lose money on the LJM transactions with the company. There was talk of a handshake deal, and that made me uneasy.”

  If true, this alone would have been enough for Enron’s dealings with LJM to be improper, maybe even illegal. But everyone at Enron denied it. Whatever the rumors, Vinson & Elkins hadn’t been able to prove them.

  The next morning, Shannon Adlong, David Duncan’s secretary, finished collecting copies of his file memos about the Raptors. She attached them to an e-mail, then shipped them to the Andersen accountants who had been involved in the transactions. For the first time they would see everything that Duncan and his team had done.

  That morning in Chicago, John Stewart reviewed the Raptor memos with growing horror. Repeatedly, Duncan’s memos said that Stewart and Carl Bass had agreed with his decisions when the exact opposite was true! Ideas that they rejected—such as the effect of allowing the Raptors to provide guarantees for each other’s obligations—were presented as approved. There were plenty other shenanigans, such as the way Enron sold the Raptors stock at a discount, then turned around and allowed the entities to place price collars on them. That was just plain unallowable.

  Andersen’s official representation in these memos of the firm’s opinion was false. This had to be fixed.

  The September 11 attacks sent Glisan into a panic—about Enron. In the weeks since Skilling’s resignation, he had been muttering to colleagues that a financial storm might be brewing. Now, as smoke rose over the ruins of the World Trade Center, the first thunderclaps sounded.

  Most markets around the globe had closed in the wake of the terrorist attacks, but a critical one remained open—for commercial paper, the short-term loans that every company depended on to finance daily operations. On Wednesday, Glisan learned the horrible news that Enron’s paper had no buyers. As it paid back short-term loans, new ones weren’t replacing them. Cash was running out of the company. It was a crisis that could blow up into a calamity.

  Glisan summoned his staff to his office. His happy-go-lucky demeanor was gone; instead, he scowled. His eyes roamed the room, latching on to the faces of the stunned lawyers and financiers, barking orders at them.

  “Do we need to pull down the revolvers, or do we just wait?” Glisan snapped. The revolving credit lines, set up with the banks, would provide Enron with a flood of cash.

  The answers were equivocal. Jordan Mintz began offering a few thoughts, but Glisan broke him off.

  “I don’t need bullshit, Jordan!” he screamed. “I need some goddamn answers from you!”

  Glisan finally calmed down. This was no time to panic. He consulted Fastow, and the two weighed the situation. Pulling down the revolvers might signal Enron was in trouble, they decided. Better to hold off.

  Enron was skating on the edge of the financial cliff, but the gambit worked. Within a day, its commercial paper found buyers. It required some fancy footwork—acting disorganized, postponing payments—but the company weathered the threat with investors none the wiser.

  They weren’t the only ones in the dark. Ken Lay was told nothing of the crisis. And neither was Enron’s board.

  During the commercial-paper crisis, certain payments went out, no matter what.

  As part of the Chewco buyout, Kopper had demanded an additional $2.6 million to cover the taxes owed. That, he insisted, was part of the original deal, since Enron had given a tax-indemnification agreement. The argument infuriated Mintz; there was no way, he knew, that Kopper was that dim. The agreement covered cash shortfalls, in the event of a mismatch at Chewco between the amount of taxes owed and its cash on hand. Ultimately, the agreement made clear, the taxes were Chewco’s to pay. Mintz raged about the demand, telling Fastow it should not be paid.

  But Fastow disregarded his lawyer, with good reason; that tax money was already earmarked as part of Kopper’s payment to Fastow for the purchase of LJM2.

  The very week Enron was juggling its obligations, it cut a check for Michael Kopper’s taxes. The amount was $2.6 million; Fastow authorized the payment personally.

  Whalley wanted to know more. The business consumed a lot of cash, and with all the market jitters, he needed to understand how much money Enron had readily available.

  He set up a meeting with Fastow and Glisan. When they got together, the two finance executives turned over reports they had just delivered to the finance committee. Whalley skimmed through until one entry stopped him short.

  Thirty-six billion in debt? That couldn’t be right.

  He pointed at the number. “What is this?” he said.

  “In essence,” Fastow said, “that’s all of the money that we owe, on and off balance sheet.”

  Whalley stared at him. “All of this is debt?” he said, disbelief in his voice. Well, Fastow replied, some of it was nonrecourse debt, meaning that the obligations would be owed from projects rather than from Enron itself.

  “So,” Whalley said, “if everything goes well, we owe thirty-six billion dollars.”

  Fastow nodded.

  Why was he just hearing this? How could the directors have seen these numbers and thought nothing of them?

  “This is a lot of debt,” Whalley said. “We need more equity.”

  Enron’s share price had been in the rafters for months, and it hadn’t occurred to anyone to issue stock and use the proceeds to pay down debt? What a lost opportunity.

  Fastow seemed eager to agree. “Yeah,” he said, “I think we need more equity.”

  That same week, Causey and Glisan came back to Whalley with their verdict on unwinding a single Raptor: it couldn’t be done, not without a huge cost. If the Raptor providing the hedge for New Power was taken down, all of the structures would collapse.

  “To close this whole thing out, it’s going to cost us about $800 million,” Causey said. “Those are the total amounts we’re going to have to write off.”

  Instead of taking the losses, Enron should try something else, Causey began. The retail unit had a business that could be shifted into the Raptors. Then those entities could sign a note agreeing to pay Enron for the business later, and that could recapitalize—

  “Wait,” Whalley interrupted. “Guys, have we lost the money or not? Are the values there or are they gone?”

  Causey bristled. “Well, the values are gone, but—”

  “Then close it up!” Whalley barked. “What is the issue here? Write the thing off, and get on with it.”

  That day, Whalley went to see Lay to fill him in on what he had discovered. “Ken,” Whalley said as he walked into Lay’s office, “I’ve been taking a look at the Raptors, and I think we’ve got a serious problem.”

  Lay stared at his new president. “Raptors?”

  Whalley explained them, and the hedges they provided. Lay remembered. These were some of the vehicles that Sherron Watkins had spoken to him about a month before.

  There were serious capitalization problems, Whalley said. Worse, he simply didn’t think the Raptors were effective. How could something intended to hedge Enron’s risk instead keep requiring so much fresh capital from the company?

  “This is probably something we’re going to need to address,” Whalley said. “We might need to make a decision before the end of the third q
uarter.”

  All right, Lay said. Just let him know.

  Causey dropped by to see Lay soon afterward, complaining about what Whalley wanted to do.

  For years, Causey’s task had been to find creative ways that Enron—using superior accounting knowledge—could report superior results. Now Whalley scotches that and issues orders to take a loss? What kind of approach was that? Where was the creativity?

  “There is a problem with the Raptors,” Causey said, “but it’s all about capitalization.”

  Until now, Enron had been shifting stock from one pocket to the other to keep the hedges going, he said. That wouldn’t work now with the stock in the doldrums. Instead, if Enron parked good assets in the Raptors—like that retail business—then the hedges could still work. Plus, the business didn’t trade on the open market. There wouldn’t be any more sudden collapses in value.

  The dispute was obvious. Clearly, Lay thought, his management team was moving at cross-purposes. He would have to call a meeting and get everybody on the same track.

  At nine on the morning of September 19, more than half a dozen Enron executives gathered in Lay’s office, itching for a fight over the future of the Raptors. With Fastow’s muted support, Causey pushed again for saving the entities by shifting a business into them. But Whalley was unbending. Enron shouldn’t throw good money after bad, he said. Losses were losses; nothing would make them come back.

  Dave Delainey, the head of the retail group, agreed. “Why commit a business to this?” he asked. “Why take something that could have big value in the future and waste it trying to hedge something that’s already lost value?”

  Causey was not persuaded. “If you can avoid taking write-offs, you ought to avoid taking them,” he said.

  Lay sat back. “Well, apparently, that was the argument we used when we recapitalized last time,” he said. “And here we are, facing the same problem. And who knows whether we’ll have the same problem six months from now.”

  The time had come for Enron to cut its losses, Lay decided. “I want us to be on a good, solid foundation and be able to tell the Street that we are not going to have these recurring problems,” Lay said.

  The Raptors, all of them, would be shut down. And ultimately help topple Enron.

  The two Vinson & Elkins partners handling the Watkins investigation scheduled an appointment with Lay for late on September 21. At the appointed time, the lawyers—Joe Dilg and Max Hendrick—arrived at Lay’s office accompanied by Jim Derrick, Enron’s general counsel.

  Dilg kicked off the discussion. These were preliminary findings, he said, and Enron needed to tell the lawyers if they wanted to proceed further. Then Hendrick began explaining that everyone identified by Watkins had been interviewed. “None supported her. None thought there was a problem with the accounting or with these transactions.”

  They had also gone back to Andersen—in particular, to Duncan and his team. “They looked at everything again,” Hendricks said, “and concluded there was no problem.”

  Even Watkins, they said, was concerned primarily about public reaction to the transactions rather than about accounting-rules violations. For about forty-five minutes, Lay tossed questions at the lawyers. He liked what he heard.

  “All right,” Lay said. “Begin writing up your report. But I’d like you to go back to Sherron Watkins and tell her your findings, and see if she’s got anything else to add.”

  The lawyers headed out to finish their work, and that was that. If everyone was still comfortable after a second look, Lay figured there wasn’t anything to worry about.

  ———

  At about the same time, Andersen convened an emergency conference call to review the problems the firm had discovered with the Raptors—and the Raptor memos. The revelations were dynamite that, if not defused, could rip another hole in Andersen’s reputation. A core group of accountants from Houston and Chicago was brought in on the calls. This, they knew, would take weeks to repair.

  Palmer was on the phone with Fastow. Since September 11, the Journal’s interest in Enron had seemed to dwindle—no surprise, since the paper’s main offices in Manhattan had been rendered uninhabitable in the attack. But now Emshwiller and Smith were back, asking again about LJM. Palmer couldn’t hold them off any longer; he needed Fastow’s help.

  “Andy,” he said, “the Journal wants to talk about these LJM structures, about what their purpose was.”

  “And what do you think we ought to do?” Fastow asked.

  The answer was clear. “We ought to talk about them.”

  Fastow’s voice almost exploded through the phone.

  “Are you crazy!” he bellowed. “That is the dumbest thing I’ve ever heard. I told you, it’s a slippery slope!”

  Palmer held the phone away from his ear as Fastow screamed. “Well, Andy,” he said, “we’ve disclosed them, you’re not in them anymore. We should explain them.”

  Fastow’s rage built up. “It’s complicated, they won’t understand, they’ll write terrible stories, and I don’t want to go into detail about LJM.”

  “Why not?” Palmer shot back. What is Fastow’s problem?

  “Slippery slope, Mark!” Fastow shouted, whistling on each s. “We’re not going there!” Fastow shouted a few more words, then fell silent.

  But only for a second.

  “I cannot believe,” Fastow finally yelled, “that Enron has a PR guy who would come up with a strategy that is this stupid! I will not speak to The Wall Street Journal!”

  Before Palmer could respond, Fastow hung up.

  Palmer turned to fill in his boss, Steve Kean, who sat just a few feet away. Before he could say a word, Kean’s phone rang. Palmer saw on the caller ID that it was Fastow.

  “Oh,” Palmer said, “Fastow’s going to yell at you about this LJM thing.”

  Kean answered. Fastow instantly lit into him.

  ———

  Later that same day, Palmer was back on the line with the Journal, trying to broker some sort of compromise.

  “Guys, you need to help me,” Palmer said. “They’d like a better sense of what you want to talk about.”

  It would help, he suggested, if they sent prepared questions, so that Enron could understand what the reporters wanted. The reporters didn’t like the idea, but agreed.

  Lay had a chance to slow his sales of Enron stock. He had just received ten million dollars from Enron, a bonus for returning as CEO. With the stock price still falling, Lay kept being hit with demands for cash from his banks, which he met by drawing down on his credit line at Enron. Now, with his new load of money, he had something to forestall future sales. So on September 21, two days after receiving another demand from Bank of America, Lay turned over the entire ten million dollars to the bank.

  It was a onetime opportunity. All he could do from there was hold on to his Enron stock and wait for a rebound.

  On the morning of September 22, a Saturday, Stephen Cutler was pushing his infant son in a baby carriage down a dirt path. Cutler, a forty-year-old lawyer, was acting director of the SEC’s enforcement division and had been with the agency for two years, starting under Levitt. But these days, he was getting accustomed to the new boss, Harvey Pitt.

  Pitt had been confirmed in August and had swept into the agency like a whirlwind. He had taken charge of its response to the September 11 attacks, working to get the markets reopened quickly. Days before, he had given the green light to an enforcement initiative known as a 21(a) report, providing guidelines to companies on the cooperation expected by the SEC if executives discover wrongdoing. But today that was far from Cutler’s mind as he walked in the September breeze with his new son.

  A buzz sounded. It was Cutler’s BlackBerry, his portable communications system. He pushed the stroller to the side of the path and pulled out the device. It was an e-mail from Harvey Pitt, labeled “Draft 21a”

  “Here, I’ve taken a crack at drafting this,” the message read. Below that, a first version of an extended r
eport, listing all the steps of cooperation required from companies. Cutler read the document in astonishment. It was good, very good. But this was the chairman knocking out a preliminary report. That was what staff was for. If Cutler had done it, his staff would have thought he was crazy.

  Decidedly, Cutler thought, Pitt was cut from a different cloth than Levitt.

  ———

  Accountants crowded the fourth-floor office of Michael Odom, an Andersen practice director in Houston. The mood in the room was tense as the accountants on the Enron engagement team spoke by speakerphone with PSG members in Chicago, debating the accounting used for the Raptors.

  There was a knock at the door. It was Carl Bass, the accountant booted months before from dealings with Enron.

  “What can I do for you guys?” Bass asked.

  Bass had been summoned to the meeting on John Stewart’s insistence. Not only was Bass one of Andersen’s smartest accountants; he had also been intimately involved in many of Enron’s transactions—often protesting them. His views were among those misrepresented in Duncan’s memos.

  Bass took a seat as someone explained the situation. A schedule of assets and liabilities was passed to him. He reviewed it quickly, and his eyes fixed at a number on the first page. A loss of $993 million.

  His mouth gaped. A billion dollars? Enron had a billion dollars’ worth of unrecognized losses? Wait a minute! Another number. An equity charge of $1.2 billion. They had overstated shareholders’ equity. How did that happen?

  He looked at Duncan, whose face was crinkled with stress. “What is this equity charge about?” Bass asked.

  Duncan waved a hand. “Don’t worry about that. It’s not material. It was just a mistake.”

  Not material. That was the argument being pushed by Enron and now embraced by Duncan.

  Listening intently to the accountants’ recital of events, it didn’t take long for Bass to realize that Duncan and his crew had ignored his advice months before. And now their cockiness had come back to bite them.

  Bass spoke up. “Look, you guys, just so we’re clear here,” he said. “What you did is exactly what I told you not to do back in December when you called me on this.”