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

by Bethany McLean

  • • •

  Two months after booking $53 million in profits from Project Braveheart, Enron announced it was ending its 20-year deal with Blockbuster. Enron publicly blamed Blockbuster, saying the video giant had failed to provide the “quantity and quality” of movies the project needed. Here’s the most amazing part, though: Enron’s spin machine, which had shamelessly hyped the Blockbuster deal to the analysts, now labored to dismiss the significance of its implosion—and the analysts bought it! ENRON EXPANDING ENTERTAINMENT ON-DEMAND SERVICE; TERMINATES EXCLUSIVE RELATIONSHIP WITH BLOCKBUSTER INC., blared the Enron press release. The company cast the venture’s failure as a kind of liberation, reasoning that it was now free “to initiate discussions with various content providers” for movies, games, television programming, and music.

  Blockbuster was less sanguine. Enron, which had signed a noncompete agree-

  ment, was openly seeking new partners, a process it had secretly begun even before the contract was formally terminated. As Blockbuster saw it, it had always made clear that lining up content from the studios would take time; it had actually signed a second major studio deal (with Universal) in early 2001. Yet Enron was blaming the venture’s breakup on the video chain. The two sides took their dispute into secret arbitration. Enron settled a few months later by paying Blockbuster $5 million.

  One person who took particular note of the dissolution of the Blockbuster deal was Carl Bass at Arthur Andersen. “One would think,” he e-mailed a colleague, “there should be a loss reported.” But that was hardly Enron’s style. Instead of writing down the value of the deal, the company’s finance executives reasoned that its broadband content business was worth more without Blockbuster, since it wouldn’t have to share the proceeds. (As the bankruptcy examiner wryly noted: “Apparently, Enron’s intention ‘to initiate discussions’ was even more valuable than its ‘exclusive relationship with Blockbuster.’ ”) EBS booked an additional $58 million from Braveheart—more than two-thirds of its reported revenues for the first quarter of 2001. Thus was one last quarter saved. Blockbuster executives say they were astounded to find out months later that Enron had booked $111 million in profits on their unprofitable venture.

  David Cox and his deal-making colleagues kept hustling. They vowed to develop more “killer apps.” They promised to sign three more Blockbuster-like deals before year-end. (The World Wrestling Federation and the NFL were their top targets.) The company’s lobbyists began laying plans to force the cable business to accept content distribution deals by demanding so-called open access to cable systems. But it was all for naught. “We were trying very hard to pump blood into this patient, and we ran out of blood,” says an EBS vice president.

  Inevitably, as broadband’s inflated promise stood revealed, many in and out of Enron pointed the finger at Skilling’s old lieutenant, Ken Rice. Much was riding on broadband’s success but Rice had never risen to the challenge. He just didn’t have it in him any longer to work the kind of hours an exceedingly ambitious start-up required. Like many Enron deal makers, Rice also hated managing—and it showed. An internal EBS document noted that the organization was characterized by “chaos” and “a perception of ‘inability to get things done.’ ” Rice occasionally appeared in a T-shirt, biker jacket, and jeans; he seemed uninterested and distracted. “The last couple of years, a lot of us got lazy,” he later acknowledged to friends. Rice felt trapped by broadband’s enormous expectations. He was managing a business that had spent more than a billion dollars but hadn’t produced a penny in real profits.

  The government later charged, however, that there was one area where Rice had played the broadband game like a master—pumping and dumping Enron’s stock. Government filings say that Rice was repeatedly warned that EBS was spending far too much and making far too little and that just days before the company’s January 25, 2001, meeting with analysts, an outside consultant Rice hired had advised him that prospects for the year remained poor.

  But that didn’t stop Rice from presenting a remarkably upbeat forecast to Wall Street. In his presentation, the government noted, “Rice stated, among other things, that EBS’s strategy was right on target; EBS’s content delivery business had an outstanding year; Blockbuster was EBS’s ‘anchor tenant’ with a 20-year deal” and that broadband was even further along than Enron had expected. Rice announced that he was anticipating an annual loss for 2001 of just $65 million, even though, according to the government, he’d received an internal estimate just three days earlier projecting broadband’s losses as totaling $149 million for the first quarter alone.

  Then there was the critical question of just how much the broadband business was really worth. Before the 2001 analysts meeting, an EBS team prepared a valuation of the content business, placing its worth at about $8 billion. According to government filings, Rice sent the group back to come up with a higher number, saying he wouldn’t give the analysts a figure that was less than the $18 billion he’d fed them a year ago. Rice got just what he wanted: a valuation of $21 billion, which he then offered up to Wall Street. All of broadband, he told the analysts in 2001, was now worth $36 billion—an increase of more than 20 percent from its value just one year earlier. Rice, noted the government, also failed to disclose that the Blockbuster deal was in danger of cancelation—and that Enron, through the Braveheart deal, had already sold most of any future profits it might generate.

  Inside Enron, there were, as always, plenty of rationalizations for this behavior. For instance, there were many valid methods for estimating a value for EBS—one of which really did generate a figure of $36 billion—and that Rice regularly received conflicting reports about the business’s state of affairs. Those who defend Skilling and Rice excuse the giddy claims made for the business, in press releases and analysts meetings, as a combination of excessive optimism and puffery—typical for the Internet era. And after all, the Wall Street analysts didn’t have to accept any of it. “If they’re going to send everyone to jail that was optimistic in 1999 about broadband,” Skilling later railed to friends, “they would have to incarcerate half of San Jose.”

  As the government saw it, Rice’s behavior belied his insistence that his only crime was excessive optimism. It was during his time running the broadband business—between February 2000 and February 2001—that Rice cashed in a big chunk of his giant Enron stake, unloading shares and options valued at some $53 million.

  • • •

  In February 2001, Rick Causey convened a routine budget meeting with the top number crunchers from the company’s operating divisions. The group of about 15 managers gathered in Enron’s cavernous fiftieth-floor boardroom, which is darkly paneled with rare woods and dominated by a huge table.

  Causey was in an upbeat mood. Everything was looking great, he announced to the team. The traders had made so much money in California that all Enron would have to do was reverse some of the giant reserves it had squirreled away from that late-2000 windfall and it could pretty much count on making its numbers for the entire year. “From an accounting standpoint,” he declared, “this will be our easiest year ever. We’ve got 2001 in the bag.”

  When the session ended, a woman named Wanda Curry asked to have a private word with Causey. A long-time Enron accountant—she’d served as chief accounting officer of Enron Wholesale, among other assignments—Curry had been working for months on a special project. Now she and Causey sat back down in the leather boardroom chairs, waiting until everyone drifted out. “Rick,” Curry finally began, “we’ve got some serious problems at EES.”

  With a small team, Curry had been digging for months into things at the retail division—and the situation was plenty ugly. There were huge, unacknowledged, speculative trading losses. Records were in chaos. The division’s exposure to credit risk was far greater than anyone imagined. And finally, there was the matter of EES’s contracts. Deals for which the company had booked $20 million in profits were actually $70 million underwater. Curry showed him a one-page doc
ument she’d prepared to try to calculate the size of the entire disaster: though she’d completed only a fraction of her audit, her calculations already showed that EES was in the hole by at least $500 million.

  Wanda Curry had previously run afoul of Cliff Baxter when she’d worked at Enron Wholesale. She had joined Andersen in objecting to his plans to book the questionable back-to-back energy trade with Merrill Lynch in the closing days of 1999. As a result, the trade had been reconfigured, and Curry had been transferred out of the division. She had been burrowing into EES’s affairs since April 2000, when Causey asked her to look into complaints from Arthur Andersen about the division’s poor controls.

  After assembling a team of eight accountants, Curry soon discovered she’d stepped into a quagmire. The first issue was trading. At Lou Pai’s insistence, EES maintained its own trading desk and made up its own sets of pricing curves, some of which were different from the ones used by Enron’s own wholesale traders. Unlike the wholesale traders, the EES traders really were supposed to use trading purely as a hedging device.

  The contracts it signed with its large business customers committed EES to supplying natural gas and electricity at preset prices. It was a prime responsibility of the EES trading desk to hedge this price risk, to, in effect, ensure that the contracts would not cost the company money even if the price of power rose. Trading, though, was in Pai’s blood, and instead of hedging, he made a huge speculative bet. At the same time that Tim Belden and the wholesale traders were betting that power prices would rise, Pai was betting they would drop and that when they did, EES would reap a windfall. As it turned out, Belden made the right bet and Pai the wrong one. When California electricity prices soared in late 2000, EES incurred staggering losses.

  Enron’s corrosive culture quickly kicked in. The wholesale traders not only took pleasure in watching Pai flounder; they even participated in EES trades—on the other side. They brazenly pushed the EES desk off the wholesale floor and gleefully outtraded them on a regular basis. This only fueled the contempt that Whalley’s new generation of wholesale traders harbored for old-timers like Pai as well as for the company’s other divisions. One executive who worked in both Wholesale and EES says: “Retail is Wholesale times ten in complexity, and they had Wholesale divided by ten in talent.”

  The second issue Curry and her team uncovered was the EES contracts themselves. Her group had planned to dig into 90 EES deals that made up 80 percent of the business—“deep dives,” she called them. By the time Curry met with Causey, her group had scrutinized just 13 but had already uncovered a gap of at least $200 million between the numbers EES had reported as earnings and the far starker reality. Of the 13 contracts, all of which EES had claimed were profitable at the time of signing, every one was now millions of dollars underwater.

  Part of the problem was that EES hadn’t done much more than guess at the energy loads its customers would require. Part of it was those faulty price curves, with their excessively optimistic assumptions. Part of it was the failure to hedge. And part of it was that EES hadn’t recognized the enormous credit risk it faced in California. When the California energy crisis threw Pacific Gas & Electric into bankruptcy, the utility owed Enron hundreds of million of dollars. Much of that money was owed to EES.

  As Curry began uncovering problems—and word filtered up from other sources—Rick Buy also became deeply concerned. “Is there light at the end of the tunnel?” he fretted. “Can we come out of this?” Buy established a special EES RAC task force, charged with a list of projects he labeled Points of Light. Eventually he assigned two dozen staffers to the effort, noting in an e-mail: “This is a huge commitment of staff from RAC and will strain us no end, but it is necessary.” He noted that it would require “commitment of Skilling to fund the overage to the RAC budget, which I am under huge pressure to reduce, not increase.”

  All who were involved in these inquiries had their work cut out for them. That fall, an EES employee stumbled across trays containing hundreds of envelopes crammed under the trading desk. They turned out to contain uncashed checks from utility companies, about $10 million worth.

  The management disarray was so bad that Skilling later received an e-mail from an Enron employee whose sister managed new buildings in Texas for J. P. Morgan Chase, an EES client. The bank was building a call center in San Antonio, and the city’s electric utility, she noted, “wants to charge us a $50,000 deposit for new power because 11 out of the last 12 payments made by Enron have been late, and late fees have been paid. . . .”

  Curry, meanwhile, kept discovering more land mines—and kept bringing them to Buy’s attention. In January 2001, Buy e-mailed her, Whalley, and other executives to voice his dismay. Subject: “Another $40 million”:

  I go away for a day and come back to yet another $40 million of PGE exposure. I guess the lesson is to not go away. Where does this end? Please inform all “deal doers” at EES that they better have RAC review their deals . . . in detail before they sign. This is more out of control than anything else we have at Enron.

  Skilling, who had promised huge things for EES, recognized belatedly that its problems started with the business’s top management. Though Skilling was loath to admit it, Ken Rice wasn’t the only executive who had let him down. So had Lou Pai.

  In fact, Pai had virtually disappeared from EES. Vice Chairman Tom White remained the business’s front man, pressing the flesh with high-level customers and acting as a cheerleader with staff. Pai didn’t even show up for most of EES’s quarterly staff meetings. By mid-2000, he was rarely even in the office.

  For years Pai had maintained a secret relationship with a woman named Melanie Fewell, a former exotic dancer. Fewell and Pai had had a child together, and Pai had divorced his wife and married the ex-stripper. He bought a ranch outside of Houston, where they kept and bred top-dollar dressage horses, including a legendary Appaloosa named Pay-N-Go, who put in an appearance at the New York memorial service for Paul McCartney’s wife Linda. With partners, Pai also bought himself a huge ranch—77,500 acres—in southern Colorado, where he could comfortably retreat into seclusion. The property included a 14,047-foot-high peak, which the locals dubbed Mount Pai. Pai flew there regularly on an Enron jet, which he reportedly summoned from its hangar at Houston Intercontinental to an airport near his home in suburban Sugar Land, so he wouldn’t have to make the 20-mile drive.

  Now, Pai’s sexual and mercenary appetites fed one another. While EES ran out of control, Pai was cashing out. The canny trader had shrewdly hung on to every Enron stock option he’d received during his years at Enron. He tried to cash out his phantom-equity stake in EES, but the dollar buyout was so huge that Skilling persuaded him to take company stock instead. Those shares soon soared, and Pai began selling large blocks, just as Enron’s shares were heading toward their peak. Pai later explained that he sold his stock to settle his divorce.

  That same year, while still head of EES, Pai had begun spending time on a new opportunity for a personal windfall: the New Power Company, Enron’s second crack at the residential side of the retail energy market. Enron had spun off the business with an IPO in October 2000. Pai, who served as chairman, was given two million shares of New Power and bought another 463,000 at a pre-IPO price of about $11. When the stock climbed right after going public at $21 a share, his stake was briefly worth more than $66 million. (It soon plunged below the offering price.)

  All this, of course, left even less time for EES. The Young Turks in retail had been grumbling about Pai’s absentee management for years—especially given his enormous pay packages. They weren’t the only ones: Cliff Baxter, who’d never liked Pai, was upset as well. Pai was robbing the company, Baxter declared. By early 2001, Skilling had reluctantly resolved to make a move. Fittingly, when Skilling called down to EES to break the news to Pai, he wasn’t there. He called back from his ranch in Colorado, and Skilling told him it was time for him to go.

  Even then, Pai got one last big payoff. In moving Pai ou
t of EES, Skilling gave him a new job as chairman and CEO of the newly formed Enron Xcelerator—“to drive the formation and development of new businesses at Enron.” Though it wasn’t much more than a part-time job, Pai nonetheless got phantom equity along with a $1 million bonus. Pai’s deputy, Tom White, also left EES, to join the George W. Bush administration as secretary of the army. He sold his Enron stock for $14 million and began building a multimillion-dollar beachfront home in Naples, Florida, after paying $6.5 million for the property.

  • • •

  The man who replaced Pai that February was Dave Delainey. An ambitious, talented, young Canadian who’d run the wholesale origination business, Delainey was a Skilling favorite and Greg Whalley’s foremost rival. He saw the tough EES assignment as his best opportunity to leapfrog Whalley for one of Enron’s top jobs.

  But that was before he realized just how bad things were. “This is a disaster,” Delainey told an Enron consultant after he’d been there a few months. “They didn’t know what their receivables were. They didn’t know what they billed.” He suddenly wasn’t thinking about leapfrogging Whalley; he was worried mainly about surviving the experience.

  The big question was what to do about the losses—both from the speculative trading and from the grossly overvalued contracts that Curry’s group uncovered. Under mark-to-market accounting, all this was supposed to be booked immediately. But Enron wasn’t about to book a loss that would likely total more than $500 million—especially in EES.

  The retail division had just started reporting profits in the fourth quarter of 1999, and Skilling boasted regularly to analysts about the business’s rapid progress. To show a loss now would be catastrophic, especially if it got out that Enron’s vaunted trading and risk-management teams had lost their grip on the operations of an entire division. “If at any point they said EES was losing money, that would have been the nail in the coffin,” says a veteran Enron executive. “It would show they didn’t know what was going on. It went to the heart of what the company claimed as its core business acumen—trading and risk management.”