Skilling and Delainey cooked up what seemed like a clever solution. The trading losses would be recorded but hidden—buried in the wholesale traders’ overwhelming profits, through their assumption of all of EES’s trading functions. The move was publicly cast as an overdue consolidation; it simply didn’t make sense for EES to run its own trading desk. With the trading disaster moved off its books, EES reported a $40 million profit for the first quarter of 2001.
EES sales executive Margaret Ceconi, who had gotten her undergraduate degree in accounting and worked in finance most of her career, was among those who were bewildered at how the division could have reported a profit. Why hadn’t Enron had to disclose the trading losses in EES, which informal office gossip placed at a minimum of $500 million? In late July, Ceconi e-mailed a query to the SEC, filling out a form on the agency’s Web site. Leaving her phone number but not disclosing where she worked, she posed the following hypothetical question:
A public company owns an ice cream business and a popcorn business. The popcorn business is losing money, but the ice cream business is very profitable. If you move the popcorn business into the ice cream division, under accounting rules, can you avoid reporting the popcorn business’s losses?
Two days later she was awakened at 7 A.M. by a phone call from an SEC staffer. The size of the popcorn business’s losses and the impact of moving them needs to be fully disclosed and clearly explained, the SEC officer said—otherwise it would distort the financial results of both businesses. Ceconi didn’t disclose why she was calling, and, amazingly, the SEC staffer didn’t press the matter. But Ceconi later checked Enron’s public filings; there was no disclosure of how much money EES’s trading operation had lost.
This manipulation was no secret inside Enron, though. The wholesale traders were furious. John Lavorato vented to John Arnold. As Arnold later described it in a deposition: “He would express frustration with the other divisions at Enron that were losing money and that the trading group was being looked upon to make its own budget and cover the losses of the other divisions.” Asked why EES’s trading desk was merged into wholesale, Arnold went on to say: “I had the sense that it was done because there was a large liability at EES that they were going to hide with Enron profits” from the wholesale trading business. Arnold said he had heard “rumors” that characterized the EES issue as “a billion-dollar liability,” which made him concerned about the accuracy of Enron’s financial statements.
The second problem—the overvalued contracts—was largely blustered away. In the weeks after EES’s trading group was absorbed into wholesale, Wanda Curry was shunted aside. The deep dives project she led into EES’s contracts was turned over to others and never completed. Through the time of her removal in April 2001, the losses her group had uncovered on the first 13 EES contracts had not been booked.
Delainey tried to stop the bleeding at EES, but all he could do was staunch the flow. He barred new deals in all but the handful of states that were already deregulated. He ended up-front payments to customers who signed contracts. Curves were adjusted downward, infuriating the originators, who suddenly lost their ability to make losing deals appear to be winners. He reluctantly closed a deal with J. C. Penney that arrived on his desk just days after he took over: the new curves showed it would be yet another loser. He sent his deal makers out to try to renegotiate the most egregious existing contracts.
Some things at EES didn’t change, though. Shortly after Delainey’s arrival in early 2001, EES signed a $1.3 billion, 15-year contract with Eli Lilly that had been in the works for more than a year. The agreement established a joint venture, owned by Enron and Lilly, to which Lilly would make payments for energy-
saving improvements. Enron then transferred its interest in the joint venture into—what else?—a special-purpose entity. The result? A gain of $38 million—95 percent of EES’s reported first-quarter profits.
The utter disarray of the business was impossible to overcome. After the purge of the Pai regime, a veteran trader from wholesale named Don Black was brought in to take over the trading desk. After he’d been there for a while, Black summed up his EES experience this way to a colleague: “It’s like going to work every day with your hair on fire and nothing to put it out with but a hammer.”
• • •
Inside Global Finance, Ben Glisan’s promotion to corporate treasurer in May of 2000 had been cause for celebration. Young, smart, ambitious—and intensely loyal to his boss, Andy Fastow—Glisan replaced Jeff McMahon, who had quarreled with Fastow over the propriety of LJM. Not long after the promotion was official, everyone gathered at Ruggles, a popular Houston nightspot, for a few celebratory rounds of Kamikazes. Kopper picked up the $7,123 bar tab—and promptly put it on his Enron expense account.
Along with Kopper, Glisan had become Andy Fastow’s go-to guy. He was the chief designer of the fiendishly complex structures Global Finance created, and he was the technical mastermind behind Fastow’s most audacious scheme yet to manage Enron’s earnings, which he’d devised just before he became treasurer. Emerging from months of brainstorming with other Enron executives, accountants from Arthur Andersen, and lawyers at Vinson & Elkins, Glisan had worked an accounting miracle. He called it Project Raptor.
Project Raptor was inspired by the Rhythms deal, in which LJM1 helped Enron use the value of its own shares to avoid booking losses on the decline of a high-flying investment. Glisan was deeply involved in Rhythms, and his participation, Rick Buy later recalled, made him “a hero.”
Skilling was eager to do the same sort of thing on a monster scale—to lock in the gains from the winners in Enron’s billion-dollar merchant portfolio (mostly energy and tech investments) while keeping the losers, like Kevin McConville’s investments in underperforming steel mills, off the company’s books. Vince Kaminski, Enron’s resident derivatives genius, insisted this couldn’t be done. But Fastow told Skilling what he wanted to hear: with Project Raptor, it could be done.
Glisan’s creation would allow Enron to hedge assets worth billions of dollars—that is, allow the company to lock in paper profits the company had already booked. Though Skilling, Lay, and the Enron directors who approved the plan insist they never knew it, Raptor also guaranteed Fastow’s LJM2 a mind-boggling return. It all seemed too good to be true. Project Raptor—for a time—was viewed as Global Finance’s most brilliant achievement yet.
And so in 2000, Enron rolled out four new special-purpose entities—Raptors I, II, III, and IV—with the sole purpose of avoiding the need to record mark-to-market losses on its books. Like Enron’s stake in Rhythms, many of these assets were impossible—or prohibitively expensive—to hedge in normal circumstances. A hedge, it’s important to remember, is a little like taking out insurance. For a small amount of money, you’re buying a derivative contract that commits the seller of the contract to pay you a preset price for the asset. If the price of the asset falls, the counterparty has to pay off your contract—and he takes the financial hit that you’ve avoided. If it doesn’t fall, the counterparty keeps the money you’ve paid for the contract, and that’s his profit. Conventional hedges work only for highly liquid assets, like large-cap stocks or corporate bonds, where derivatives traders can make money by writing lots of such “insurance.”
In practical terms, you can’t hedge the value of debt in a troubled steel mill or a private stake in a deep-sea drilling company, in large part because you’d never find a counterparty to take the other side of the hedge. The chance of losing a lot of money is too high. But Enron wasn’t really hedging against a true economic loss; rather, it was using the Raptors to hedge against an accounting loss. It did this through a dizzyingly complex series of derivative transactions that essentially amounted to tapping, once again, the value of its own shares. As the underperforming assets placed in the Raptors continued to decline in value, the Raptors would have to pay Enron—therefore giving Enron a gain that would offset the loss. Voilà! The company had avoided having to report
a decline on its income statement.
In truth, Enron was really just covering losses in one pocket by taking money from another pocket. As a board report put it after Enron’s bankruptcy, “In effect, Enron was hedging risk with itself.” The report added: “Were this permissible, a company with access to its outstanding stock could place itself on an ascending spiral: an increasing stock price would enable it to keep losses in its investments from public view; which, in turn, would spur further increases in stock price; which, in turn, would increase its capacity to keep losses in its investments from public view.”
But what if Enron shares fell? If that happened, the entire structure would collapse under its own weight, and Enron would finally have to book its losses. Few at Enron worried about that, though. In early 2000, when a member of Vince Kaminski’s group completed a statistical analysis concluding that there was a 25 percent probability that Enron’s stock would fall below $40, the finance group reacted with outrage.
Raptor I, also named Talon, was born on April 18, 2000. Talon’s chief asset came from Enron, through a subsidiary—Enron shares and stock contracts valued at about $537 million. But Talon was actually run by LJM2, which invested $30 million, providing the 3 percent outside equity required for off-balance-sheet treatment. Enron executives calculated that Talon had the capacity to offset almost $217 million worth of losses through the derivatives that hedged Enron assets.
In fact, it was Fastow’s partnership that was going to be cashing in. Under terms negotiated between Glisan and Kopper (Glisan representing Enron; Kopper negotiating for LJM2), Enron was required to pay LJM2 $41 million—repaying its entire $30 million investment plus a 37 percent return. And this would have to happen before the Raptor did anything. Though LJM would have all its money back up front plus an $11 million profit—and thus face no risk at all—a series of extraordinary accounting maneuvers, all approved by Arthur Andersen, maintained the fiction that LJM hadn’t withdrawn its 3 percent at-risk equity investment.
What was the rationale for the $41 million payment? Enron described it as a premium for a put option on the Raptors’ Enron stake. But as a board investigation later put it: “The transaction makes little apparent commercial sense, other than to enable Enron to transfer money to LJM2 in exchange for its participation in vehicles that would allow Enron to engage in hedging transactions.” Though the original put agreement required Enron to wait six months before it started hedging, Fastow convinced Causey to amend the terms in early August, allowing LJM2 to get its $41 million sooner. And that wasn’t all: Enron picked up the tab for LJM2’s legal and accounting costs and paid Fastow’s partnership a $250,000 annual management fee.
Much later, Enron’s top executives and directors insisted that certain key information about the Raptors—information that would have set off alarms—was deliberately withheld from them. This appears to be true. Indeed, while promoting the Raptors to the board, Causey privately confided to an Enron lawyer that he thought the structure had just a 50/50 chance of passing muster with the SEC. Still, the information they did have should have been more than enough to get those alarms ringing.
An Enron deal summary sheet on Talon, dated April 18, explicitly noted the windfall for Fastow’s partnership: “It is expected that Talon will have earnings and cash sufficient to distribute $41 million to LJM2 within six months. . . .” Skilling later insisted he had no idea his CFO’s partnership was making such returns; the line for Skilling’s signature on an attached LJM2 approval sheet was left blank. (It did, however, contain the signatures of Glisan, Buy, and Causey.)
Glisan presented the Raptors to the finance committee of Enron’s board in May. The presentation took place immediately after Fastow had finished reassuring the board that he was spending only three hours a week on LJM2. Then, with Lay and Skilling looking on, Glisan described the Raptors as a “risk-management program to enable the company to hedge the profit and loss volatility of the company’s investments.” His presentation noted that Talon would be capitalized with “excess [Enron] stock” and provide “approximately $200 million of P&L protection” to Enron.
On the subject of LJM2’s compensation, the written board presentation was brazenly deceptive. It reported that LJM2 would “be entitled to 30% annualized return plus fees.” It didn’t say that the actual compensation language provided LJM2 with a 30 percent return or an up-front $41 million—whichever was greater. It was clear, though, that the risk-management program was an accounting artifice. Taking notes on the presentation, Enron’s corporate secretary, Rebecca Carter, wrote: “Does not transfer economic risk but transfers P&L volatility.” Among the risks Glisan presented: “accounting scrutiny”—and a substantial decline in Enron stock price. Glisan also noted that “the transaction had been reviewed by Causey and Andersen.” Raptor I was quickly approved by both the finance committee and the full board.
After LJM2 got its $41 million, Talon began hedging, through $743 million in derivatives, called total return swaps, on Enron merchant investments. Investigators later concluded that many of the documents involved had been backdated. Much of it was likely a simple (if improper) matter of convenience. But in one case—the hedging of Enron’s Avici shares, the Internet company that the broadband unit had taken a stake in—the backdating was less benign. The transaction date was set as of August 3—which happened to be the very day Avici hit its high of $162.50 per share. By dating the swap with Talon on Avici then, Enron locked in the maximum possible gain on its books. By September 15, about the time the agreement actually appears to have been signed, Avici had already fallen below $100. This is precisely the sort of maneuver a normal counterparty would never allow, for it dramatically increased Talon’s liability. Indeed, according to government filings, executives working on the deal for LJM and Enron referred to the backdating as “the Enron time machine.” But LJM2, which was running the Raptor, had little reason to care. Its $41 million was already in the bank.
On June 22, the executive committee of the Enron board approved Raptor II. Named Timberwolf, this one was structured just like Talon. According to the board minutes, Fastow told the board that Timberwolf would “provide approximately $200 million of P&L protection.” The CFO said the second Raptor was needed because of simple demand—“there had been tremendous utilization by the business units of Raptor I.” In fact, as of that date, Enron hadn’t even begun hedging with Talon. After sailing through the board, the new Raptor went through the same arcane machinations as the first, orchestrating LJM2’s second $41 million payment.
On August 7, Glisan advised the board finance committee that Raptor I “was almost completely utilized,” Raptor II wasn’t yet ready for action, and that a new Raptor—called Bobcat—was needed to increase “available capacity.” In swift order, LJM2 collected its third $41 million.
As Enron saw it, the beauty of the Raptors was that they wouldn’t just lock in gains on winners—they could also bury the losses on losers. Indeed, one of the reasons the Raptors were so useful is that the traders were refusing to bury losses like those on Kevin McConville’s disastrous investment portfolio, according to a former Global Finance executive. So the bad assets were stashed in the Raptors instead. Though some of them had already been written down, the Raptors insulated Enron from having to book even bigger charges. Dave Delainey used to call them “the critter deals.”
On September 1, an Enron lawyer named Stuart Zisman, who had been reviewing the Raptor project, wrote a memo sharply questioning this strategy: “Our original understanding of this transaction was that all types of assets/securities would be introduced into this structure (including both those that are viewed favorably and those that are viewed as being poor investments). As it turns out, we have discovered that a majority of the investments being introduced into the Raptor Structure are bad ones. This is disconcerting [because] . . . it might lead one to believe that the financial books at Enron are being ‘cooked’ in order to eliminate a drag on earnings that would otherwise occur
under fair value accounting. . . .” Of course, that’s precisely what was happening. After receiving the memo, Mark Haedicke, a senior Enron attorney, called Zisman to his office and scolded him for using “inflammatory” language.
Zisman was right, though. The Raptors were absorbing much of Enron’s “nuclear waste”—and, by the fall of 2000, with the collapse of the tech-stock craze, even the high fliers in the portfolio were starting to deteriorate. Enron’s stock price was slipping, too. This meant that one of the Raptors—Talon—was running out of credit capacity. The situation was getting worrisome. Causey ordered his accountants to monitor the numbers closely.
And still, there was another: the last Raptor, called Porcupine, was created in late September, and this one was even more bizarrely conceived than the rest. Porcupine was created to lock in a single large Enron investment—a $370 million Enron gain that was tied to the price of shares in the New Power Company, Lou Pai’s residential energy spinoff, in which Enron had a 75 percent stake.
But instead of being funded with Enron stock, this Raptor held warrants in New Power—the very investment that it was supposed to hedge. This meant that if the price of New Power fell, Porcupine’s obligation to Enron would grow at the same time that its ability to pay on the hedge was dropping. Thus, “this extraordinarily fragile structure” (as the special board report later described it) was “the derivatives equivalent of doubling down on a bet.” Porcupine could survive only if New Power shares, which were about to go public, climbed in the aftermarket.
But they didn’t. On October 5, one week after Porcupine got the New Power stock, the company went public at $21 per share. It was up $6 a share in the first day of trading, but within a week, New Power had fallen back below its offering price—and at year-end was below $10. This produced what one investigator called “a double-whammy effect” on Porcupine. Its obligation to Enron soared while its only real asset to pay the obligation plummeted. Of course, by then, LJM2 had recouped its stake in Porcupine, investing $30 million, then pocketing $39.5 million one week later.
The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron Page 51
