The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

But the government refused to let the pipelines out of their expensive take-or-pay commitments. This put pipeline companies between a rock and a hard place: stuck with huge volumes of gas at prices they could no longer pass on to customers. As a result, many of the companies became technically insolvent, and a few went bankrupt. Some form of relief was obviously needed—from Washington, the gas producers, or the courts. Over time, the companies pursued all three avenues: lobbying, negotiating, and litigating. Orchestrating it all took years and proved expensive. It wasn’t until the late 1980s and early 1990s that the crisis finally ended and the natural-gas business, including the pipeline industry, was largely deregulated.

  But though the beginning of this crisis was bad for the industry, it was certainly good for Ken Lay. With his Ph.D. in economics, his Washington experience, and his long advocacy of deregulation, Lay seemed like just the right man for the new age. With the industry in paralysis, he began helping Transco work through its take-or-pay problem by setting up a fledgling spot market for natural gas, where producers who let Transco out of its take-or-pay obligation could sell directly to their customers, paying Transco just to move the gas. Thoughtful and articulate, Lay was in demand at industry conferences and Capitol Hill hearings. “Ken isn’t bound by tradition,” declared John Sawhill, head of the global energy practice for the consulting firm, McKinsey & Company. Even Wall Street viewed him as a major asset. The Houston Chronicle wrote in 1983, “Some analysts attribute the strength of Transco’s stock price to Lay’s credibility and his bold and unique accomplishments.”

  If Lay had stayed at Transco, he probably would have become CEO in 1989, when Bowen planned to retire. But as it turned out, he didn’t have to wait nearly that long to become a chief executive. In the summer of 1984, opportunity came knocking, and he eagerly answered the call. It came in the form of a meeting with a man named John Duncan, who had helped put together the old conglomerate Gulf & Western, and was a key board member of a midsize pipeline company called Houston Natural Gas (HNG).

  Lay and Duncan had gotten to know each other a few months earlier, when HNG had been trying to repel a takeover attempt by a corporate raider and Transco had offered to act as a white knight—a friendly alternative acquirer. Ultimately, Transco’s help wasn’t needed, but Lay had clearly made an impression. In their meeting, which took place over breakfast on a Saturday morning, Duncan popped the question: would Lay consider becoming CEO of HNG? He didn’t require a lot of convincing. “By Sunday morning,” Lay later recalled, “it was sounding kind of interesting.”

  Houston Natural Gas had a special place in the city. Though smaller than many local rivals—annual revenues were $3 billion—it had for years assumed the role of the “hometown oil company.” Part of that was its heritage: the company dated back to 1926, and it had long been the prime gas supplier to the huge industrial plants on the Texas coast. Part of it was due to Robert Herring, its longtime chairman, who was active in every important civic project and charitable event in town. Herring’s wife, Joanne, was an international socialite, and the couple’s home in exclusive River Oaks—one of America’s wealthiest neighborhoods—became Houston’s preeminent salon, a place where oilmen mixed with international royalty. Herring had died of cancer in October 1981; HNG, though still profitable, hadn’t been quite the same since. His successor, 60-year-old M. D. Matthews, was a nondescript caretaker type. Even after the takeover attempt was repulsed, HNG’s modest debt made it a juicy target for corporate raiders. And the takeover battle had left the HNG board convinced that it needed stronger leadership.

  On Monday, Lay won Jack Bowen’s blessing for his departure, and in June 1984, at the age of 42, Ken Lay became chairman and chief executive officer of Houston Natural Gas. After her husband assumed his big new job, Linda Lay exulted to a friend: “It’s fun to be the king.” HNG would serve as the foundation for building Enron.

  From the moment he walked in the door, Lay operated on one theory: get big fast. His core belief, as ever, was that deregulation—real deregulation—was coming soon. And when it did, he believed, the price of the commodity would reflect true market demand and the companies with the best pipeline networks would be the ones calling the shots. In just his first six months, Lay spent $1.2 billion on two pricey acquisitions that dramatically extended HNG’s pipeline system into the growth markets of California and Florida. (The Florida pipeline had been owned by Lay’s old company, Florida Gas.) He even talked to his old friend, Jack Bowen, about a deal with Transco. At the same time he unloaded $625 million in holdings outside the core pipeline business, including coal-mining properties and a fleet of barges.

  Then came a bit of luck. In April 1985 Lay got a call out of the blue from a man named Sam Segnar, the CEO of InterNorth, a big Omaha pipeline company. Because Lay was in Europe at the time courting investors, John Wing, his old deputy from Florida Gas—who had just hired on as HNG’s chief strategy officer—handled the call. Segnar wanted to pitch the idea of InterNorth’s buying HNG. But it quickly became apparent that Segnar was too eager for his own good.

  InterNorth, three times the size of HNG, had long been one of the most respected operators in the pipeline business. Among its 20,000 miles of pipeline was a genuine prize: Northern Natural, the major north-south line feeding gas from Texas into Iowa, Minnesota, and much of the rest of the Midwest. For decades, InterNorth had assumed a role in Omaha much like that of HNG in Houston. It was the caretaker of civic causes—the number one corporate citizen. Like HNG it had been run for years by a beloved figure, Bill Strauss. Under Strauss, InterNorth was a quiet, steady company with low debt and terrific cash flow that paid executives modest salaries and carefully watched expenses.

  But in 1981 Strauss had turned the company over to Segnar, a charmless personality who upset many in frugal Omaha with a series of ham-handed moves. He purchased a company jet, bought a corporate ranch in Colorado, and closed the fifteenth-floor corporate dining room to all but a few top executives, who were served by white-gloved waiters. Worst of all, Segnar made a string of bad diversification investments. InterNorth was also powerfully motivated by the fact that Irwin Jacobs, a corporate raider, was buying up its shares. Jacobs’s looming presence sent Segnar into a panic. He persuaded the board that the only way to make InterNorth “sharkproof” was to make the company bigger and dramatically increase its debt. Buying HNG would accomplish both goals.

  Lay and Segnar turned over negotiations to Wing and Rocco LoChiano, Segnar’s top deputy. They met at the St. Regis Hotel in Houston and quickly started talking price. At the time, HNG was trading at about $45 per share. LoChiano figured HNG was worth perhaps $60, $65 tops. But Wing, a canny negotiator, took advantage of InterNorth’s desperation to strike a deal, and quickly brought the price up to $70 a share. And that wasn’t all. Wing demanded that the smaller company’s younger management team ultimately end up in charge. Amazingly, LoChiano and Segnar agreed: Lay would replace Segnar, then 57, as CEO and chairman of the combined company after just 18 months. “I think I get this,” LoChiano told Wing over a cup of coffee. “We’re the rich old ugly guy with all the money, and you’re the good-looking blonde.” Wing laughed. “Yeah, that’s right,” he replied.

  Just 11 days after the first phone call, the two CEOs won approval for the $2.3-billion deal from their respective boards. From a business standpoint, HNG InterNorth, as it was called, seemed an elegant combination: with 37,500 miles of pipeline, the new $12 billion company would have the largest gas-distribution system in the country, running from border to border, coast to coast. It would have access to the three fastest growing gas markets: California, Texas, and Florida. And it had some $5 billion in debt, surely more than enough to put it safely beyond the reach of raiders like Irwin Jacobs. As for Ken Lay, he wound up with a personal windfall: a $3 million profit from converting his stock and options in the wake of the merger.

  Mergers that sound good on paper often wind up facing a far harsher reality. Such was the case with HNG InterNort
h. There were two fundamental issues. The first was that almost immediately after the transaction closed, the InterNorth directors came down with a bad case of buyer’s remorse. As the implications of the deal sunk in, they began to realize that even though their company was the acquirer, they had pretty much given away the store to the Texans. Why, they now wondered, did HNG come before InterNorth in the new name when InterNorth had been the acquirer? Why was Segnar so quick to agree to give the CEO job to Lay in 18 months? Did it have anything to do with promises of a fat severance package? (Segnar ended up walking away with $2 million.) Why did HNG have almost as many seats (8) on the new board as InterNorth (12)? The more they thought about how they’d been snookered, the madder they got, but they were far angrier at their man, Segnar, than at Ken Lay, whose company had done the snookering.

  Among the old-line InterNorth directors, the biggest fear of all was that the Texans were planning to move the company’s headquarters to Houston, even though everyone concerned, including Lay, had repeatedly promised that the company would remain in Omaha “for the forseeable future.” This wasn’t just a matter of jobs (though 2,200 were at stake); it was also a question of civic pride. It quickly became evident that the promises really weren’t worth much. Houston, after all, was the center of the U.S. energy business. Once the merger went through, the issue became so heated that the board created a special committee to study the matter. The committee retained the management-consulting firm, McKinsey & Company, to make a recommendation.

  The McKinsey consultants, who included Lay’s old friend John Sawhill and a young partner named Jeff Skilling, were scheduled to unveil their recommendation to the board on November 11, 1985, a frosty day in Omaha, at the Marriott Hotel. They were indeed going to advise the company to move to Houston. But the meeting quickly took a different turn, and the consultants were told to wait outside. Hours later, Segnar stepped out of the board meeting with tears in his eyes. He shook Sawhill’s hand. “I’m leaving InterNorth,” he told the consultant.

  Afterward, all parties claimed that Segnar had voluntarily resigned. In truth, the meeting had been a bloodbath, and he hadn’t really had a choice. Convinced that Segnar had made a series of secret side deals with Lay to betray Omaha, the old InterNorth directors demanded his head. Of course, since the board didn’t have another CEO candidate, it also meant that Ken Lay would become chief executive immediately, instead of having to wait the agreed-upon 18 months.

  As a counterweight to Lay, the board brought back Bill Strauss as nonexecutive chairman and some even tried to mount a bid to reclaim the company for the River City. But the effort quickly fizzled when Strauss refused to lead the charge and quit after just four months, giving Lay the chairman’s title, too. It wouldn’t have succeeded in any case, for Lay had quietly won control of the board. A father-son pair of old InterNorth directors, Arthur and Robert Belfer, had lined up behind Lay. Two new directors, appointed after the merger by agreement between both sides, also turned out to be Texas partisans.

  Over the next three years, the Omaha bloc was purged, and Lay started packing the board with his own directors, including a powerful Washington lobbyist named Charls Walker—Pinkney Walker’s brother—and an old Pentagon friend named Herbert (Pug) Winokur. John Duncan, the HNG director who had hired Lay, became head of the executive committee. And the corporate headquarters? The directors resolved to split the difference, maintaining an executive headquarters in Omaha and an operating headquarters in Houston. But that arrangement obviously couldn’t last long, and it didn’t. In July 1986 Lay announced that the company’s corporate headquarters would relocate to Houston, to a silver-skinned downtown skyscraper at 1400 Smith Street.

  In Omaha, this decision was bitterly resented for years to come.

  • • •

  There was a second issue looming, of far more consequence than the question of where to put the company’s headquarters. It was this: all the good things Ken Lay assumed would happen once the HNG-InterNorth merger took place simply weren’t happening. For the moment, Lay’s get big fast strategy was only bringing bigger problems.

  Irwin Jacobs? Even though the new company was now drowning in debt, the raider and an investor group allied with him still wouldn’t go away. Lay wound up having to shell out about $350 million—a modest premium to the market price—to buy out the group’s 16.5 percent stake. There wasn’t enough cash in the corporate coffers to pay the greenmail, so Lay had to tap the company’s pension plan for the money.

  Deregulation? All of a sudden, there was a glut of gas on the market, prompting prices to plunge to levels no one had ever imagined. That only multiplied the company’s take-or-pay problem. Lay’s new business had more than $1 billion in take-or-pay liabilities.

  Lay seemed unable to assemble a coherent management team amid bitter political infighting involving not just the old HNG and InterNorth executives but also the pipeline businesses he’d acquired the year before and a handful of well-paid friends that Lay had hired from outside.

  Lay even ran into trouble coming up with a trendy new name for the company. After four months of research, the New York consulting firm Lay had hired had settled on Enteron in time for the merged business’s first annual meeting, in the spring of 1986. But then the Wall Street Journal reported that Enteron was a term for the alimentary canal (the digestive tract), turning the name into a laughingstock. Though it meant reprinting 75,000 covers that had already been printed for the new annual report, the board convened an emergency meeting and went with a runner-up on the list: Enron.

  Oh, and just for good measure, Lay had to battle the government of Peru, which nationalized the company’s Peruvian production assets just a month after he’d become CEO. That alone produced a $218 million charge to earnings.

  In early 1986 Enron reported a loss of $14 million for its first year. Lay announced a series of cost-cutting measures and job cuts. He froze pay for top executives and started selling off assets to cut debt, including 50 percent of the Florida pipeline he purchased just two years earlier.

  Enron’s financial situation had grown so dire that by January 1987 Moody’s had downgraded its credit rating to junk status. One former executive recalls that during this period there was even worry about meeting payroll. “The company was in deep shit,” Bruce Stram, then vice president of corporate planning, says.

  What Ken Lay and Enron desperately needed was a fresh source of profits—while there was still time.

  CHAPTER 2

  “Please Keep Making Us Millions”

  Not every part of the old InterNorth wound up being relocated to Houston; at least one small division stayed right where it was. That unit was InterNorth’s oil-trading business, which had its offices in a suburb of New York City, in a small town called Valhalla, about an hour’s drive from Wall Street. Enron Oil, as it was renamed, wasn’t anything like the rest of the company’s gritty industrial operations. It was “the flashy part” of the business, as one employee later put it.

  After the merger, Enron tucked Enron Oil away in a division that was a hodgepodge of businesses with little in common other than that they all made some of their money outside the United States. In Enron’s financial reports, earnings from the oil-trading operation weren’t broken out separately, and Enron didn’t talk up its oil trading to Wall Street analysts or investors. But that only heightened the importance of the operation internally. The traders were a kind of secret weapon in the ongoing struggle to improve Enron’s financial appearance. For unlike most of the rest of Enron, oil trading actually made money. Internal financial reports often bragged about the profits the traders were producing.

  In more than location, the oil traders were closer to the freewheeling world of Wall Street than to the slow-moving, capital-intensive, risk-averse world of natural gas pipelines. Oil trading was about trading, not about oil. It was pure speculation: the oil traders came to work every day and made bets on the direction of crude oil prices. Enron’s top brass knew very little
about how the trading operation worked, and, if truth be told, they didn’t much care. Oil trading looked like fast easy money, and that’s all that mattered.

  Of course, easy money is rarely as easy as it looks; such was the case with Enron’s oil trading division. By the time Ken Lay and his minions in Houston realized something was horribly wrong—more accurately, by the time they were willing to face up to what they should have seen all along—the oil traders had come within a whisker of bankrupting the company. And Wall Street had its first indication that Enron and its leader didn’t always play by the rules that were supposed to apply to publicly held corporations. Although it took place a long time ago, it seems obvious now that the Enron Oil scandal was the canary in the coal mine.

  • • •

  • • •

  The man who created Enron Oil was named Louis Borget. Within Enron, he was a shadowy figure who divulged as little as possible about the details of his operation and kept a wary distance from Houston. To most Enron employees—even most of the top executives—he was little more than a voice at the other end of the telephone line, cryptically telling them that everything was just fine.

  Borget was born in 1938 in New York, the son of an abusive, alcoholic father. According to court documents, he shined shoes to make money for his family at the age of nine. A brilliant student, he graduated from high school by the time he was 16. From there, he joined the army, where he learned to speak fluent Russian, then put himself through night school at New York University. In 1964, he took a job with Texaco, where he slowly rose through the ranks, becoming special assistant to the chairman and later running a small division. But after 17 years with Texaco, he abruptly left the oil giant, signing on with a company called Gulf States Oil and Refining, which wanted him to set up an oil-trading division. Three years after that, in January 1984, InterNorth came calling, asking him to set up its oil-trading subsidiary and offering him a lucrative package, which included Wall Street–style bonuses based on whatever profits he brought in. By the time of the InterNorth-HNG merger, Borget’s operation was about a year and a half old.