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

by Bethany McLean

  First, Enron’s earnings for the third quarter were actually worse than previously reported—a loss of $664 million—and things also looked bleaker than expected for the fourth quarter. Enron attributed its latest problems to “a reduced level of transaction activity by trading counterparties.” In other words, the trading business was drying up.

  Then there were fresh surprises on the SPE front. The assets inside Whitewing had dropped far below the amount of its obligations; this meant Enron might have to take a new $700 million charge to earnings. Enron also revealed that a ratings downgrade one week earlier had triggered an obligation to repay $690 million in debt in an off-balance-sheet vehicle called Rawhide. For some reasons, this SPE—the creation of Michael Kopper and Ben Glisan—had been rigged to explode if S&P cut Enron to one step above junk grade. No one appeared to have even known about the problem until the default notice arrived. Now Enron had eight days to come up with the money.

  And cash, the company also revealed, was in desperately short supply. Despite the $2 billion that had arrived on November 13, Enron had only $1.2 billion left. Counting the money it had in hand before getting the $2 billion, that meant Enron had burned through at least a billion dollars in six days and $2 billion in less than a month. Clearly Enron no longer had ample liquidity.

  Watson went ballistic. He fired off a letter to Lay: “We have not been consulted in a timely manner regarding developments since November 9. We were not briefed in advance on the issues in your 10-Q. Our team had to make repeated phone calls to your finance and accounting officials in an attempt to obtain information. Some of the most significant information in the Q was never shown to us at all.” Watson added: “We believe that Enron is going to have to do a far better job of communicating with us and with the marketplace for this transaction to reach a successful conclusion.”

  Watson also gave Lay a call, telling him: “You and I need to go to lunch, buddy.” The Dynegy CEO was now harboring serious doubts about the deal. With this latest revelation, Enron was back on the ropes. Where had the $2 billion gone? Incredibly, Enron didn’t seem to know. Enron quickly negotiated some extra time on the $690 million Rawhide debt, but the company would now need billions more. Where would it come from?

  Watson was also embarrassed by the Enron disclosure. To the reporters who called Dynegy for comment, it was obvious that his team hadn’t known this news was coming—and that’s how they would cast it in their stories. It wasn’t just bad faith; the news made Dynegy look foolish. Watson’s company was using its credibility to prop up Enron’s; now Enron’s behavior was damaging Dynegy.

  “I’m not used to people lying to me,” Watson told Lay during a two-hour lunch in a private room at the downtown Coronado Club. “You guys need to get your act together, or this deal’s not going to close.” Suddenly all of Dynegy’s “conservative” assumptions didn’t look so conservative after all. By week’s end, Enron’s shares had fallen to $4.71. Goldman Sachs had downgraded both merger partners, but Dynegy’s stock was down only 7 percent; apparently Wall Street now assumed that Watson would find a way out of the deal.

  In addition, Watson was discovering that the Enron culture wasn’t such a good fit after all. After getting a peek at Lay’s new G-5 jet, he told a colleague, “I nearly had a heart attack.” He kept learning about Enron executives who made twice what their Dynegy counterparts made. And as Enron started planning for layoffs, he heard about the company’s extravagant severance plan: two weeks’ pay for each year of service—plus another two weeks for each $10,000 of base pay. It wasn’t hard to see where some of Enron’s money went.

  In the week after the merger was announced, Watson went on an East Coast swing to pitch the deal to analysts and investors. He took Whalley and Horton along with him. Everywhere they went, the Enron executives came under attack. They finally left the road show early and went home. “These people are hated worse than I thought,” Watson later said.

  The list of those suing the company grew to include Enron’s own employees, who had seen much of their retirement-plan savings disappear. They claimed Enron’s top executives had misled them about the riskiness of Enron shares and locked them into their plummeting holdings for a month while the com-

  pany changed plan administrators. Between the company’s savings and stock-ownership plans—60 percent of the total assets in both consisted of Enron stock— 20,000 Enron employees lost about $2 billion in 2001.

  Some, however, did manage to get some of their savings out. During November, as Enron was spiraling downward, scores of current and retired executives who had participated in the company’s deferred-compensation program—which set aside earnings in exchange for tax breaks—clamored for their money. Formal requests for such accelerated distributions were submitted by 211 plan participants. Some 126—personally approved by Whalley—received $53 million in cash. The rest are likely to get virtually nothing.

  In the chaos of late November, everyone was maneuvering for position, elbowing for money that Enron didn’t have. Jordan Mintz, for instance, was working on Thanksgiving Day when a call came in from a Lehman Brothers lawyer who’d been threatening to go to court to force immediate repayment on a $120 million Enron debt. “I just faxed you a draft complaint,” he said. “You might want to take a look at it.” Back off, Mintz finally told him. “You want to be the one to throw Enron into bankruptcy?” He didn’t—Lehman was also serving as Dynegy’s financial adviser.

  • • •

  Dynegy’s deal team had responded to the startling Enron 10-Q by intensify-

  ing its diligence, fueled by rage. “We were ripshit,” recalls one Dynegy adviser. Watson’s side began to suspect that this was yet another Enron scam. Says an

  executive involved in the deal: “They thought they could just get our money and keep their game going.”

  Given all the anger, it was hard to see how the deal could still work. But Watson agreed to try, on one condition: Ken Lay had to go—immediately. Watson had concluded he needed his own team running Enron, right away. This was an audacious proposal; an acquirer usually keeps its hands off the target until the acquisition closes. Any change would require the agreement of the Enron board, which had long been in Lay’s pocket. But Watson felt he had no choice. Without a different team in place, he figured, Enron would be dead and buried long before the deal could close.

  Watson wasn’t just after Lay’s head; he wanted to replace Jim Derrick, the general counsel, and appoint a new CFO, too. He planned to bring in a cash-management team to get a handle on the finances and a divestiture team to start selling assets.

  To replace Lay, Watson tapped a respected Houston executive named Joe Foster. Foster was a true heavyweight; he had served as chairman of Tenneco, then started his own oil and gas company, called Newfield Exploration, where he remained board chairman. The two men knew each other partly from working together on the board at Baker Hughes, where Foster had served as interim chairman and CEO. As Watson envisioned it, Foster would hold the same posts at Enron until the sale closed.

  With a new executive team as a starting demand, Watson dispatched his CFO and investment bankers over the Thanksgiving weekend to a resort in Westchester County, New York, where everyone met to see if the deal—and Enron—could be saved. Enron sent its top executives: Lay, Whalley, and McMahon. Watson remained at his new vacation home in Cabo San Lucas, Mexico, monitoring events by phone. His number two, Bergstrom, stayed away, too.

  By Sunday, it looked as if the pieces might come together. A little after 10 P.M., Lay convened a conference-call meeting to update his board. Because of the severe drop in the price of Enron shares, it had been clear that the deal would need to be recut just two weeks after it was struck. This also was extraordinary. The new exchange ratio—0.12 Dynegy share for each Enron share—valued Lay’s company at about $4 billion, less than half the previous price. The board unanimously approved the new terms.

  But the deal wasn’t yet done, not by a long shot. To maintain
an investment-rade rating, Enron needed new capital. The idea was that J. P. Mor-

  gan Chase, Citi, and Dynegy would each put up a third of the money. And that would be enough only if the company could reschedule all of the debt that was supposed to be paid off by the end of 2002. The banks would also need to convert much of their debt to equity. But after initially talking about big dollars—“We’re in for a billion,” Chase’s Jimmy Lee proclaimed at one point—the banks danced away from making giant commitments even though closing the deal was supposed to bring them a giant payday. In addition to the $15 million advisory fee each had already received, J. P. Morgan Chase and Citi were due to get an additional $45 million apiece from Enron.

  Finally, there was the issue of replacing Lay. The Enron CEO had dutifully explained the demand to his board. It made no decision that Sunday night.

  On Monday, talks continued in Houston. Lay told his board that he thought the deal could still be saved. Now the rating agencies started expressing doubts. They noticed that the banks, for all their talk, weren’t putting up the big money. They were worried about the deterioration of the trading business, which had generated almost all of Enron’s reported profits. With Enron’s crushing debt load, they didn’t see how the company could borrow any more on its own. And without a big infusion of extra cash, they didn’t see how Enron could pay off the $9 billion in debt coming due. Still, reluctant to provide the death blow, the rating agencies agreed to hold off on an immediate downgrade.

  Then came the clincher: Lay wasn’t going to leave. Enron was prepared to take Joe Foster on but only as an interim vice chairman. Watson called Foster to apologize; he thought Enron had already committed to make the move. “I’m embarrassed,” Watson told him. “You shouldn’t be embarrassed,” Foster responded. “But good luck, buddy, because you’re going to need it.”

  Talks among Dynegy, the banks, and the credit agencies continued late into the night on Tuesday, even after Watson went to bed telling his board and advisers that he’d pretty much made up his mind. The banks weren’t stepping up the way Enron needed, he reasoned, thus making the repayment of all the debt impossible. It just wasn’t going to work. And he’d also had a bellyful of Enron. He didn’t trust any of its numbers, and he didn’t want anything to do with its culture. “At the end,” he later told friends, “you couldn’t give it to me.”

  The next morning, Wednesday, November 28, as Watson waited, the rating agencies made the first move. S&P downgraded Enron two notches, deep into junk-company territory, citing its “loss of confidence that the Dynegy merger will be consummated.” Moody’s and Fitch soon followed. The downgrades immediately triggered $3.9 billion in Enron debt.

  Watson placed a call to Lay to tell him the Dynegy board was terminating the deal. “I’m disappointed this didn’t work out; I wish you the best of luck,” Watson said. “I’m disappointed, too,” Lay responded. “I’ll go on to our other alternatives.”

  Enron Online shut down that morning. Enron shares closed the day at 61 cents.

  • • •

  At six o’clock that evening in Houston, Ken Lay met with the Enron board. He announced the demise of the deal with Dynegy and explained that it was likely to produce a court battle over the ownership of Enron’s Northern Natural Gas pipeline, to which Dynegy was laying claim. A financial consultant offered the board a discussion “on alternatives to bankruptcy.” Even now, for all its problems, the trading business remained Enron’s great hope—or at least that’s how Enron’s board saw it. The adviser noted that his firm had contacted a number of prospects who might be interested in “financing or purchasing an interest.” Treasurer Ray Bowen, who had quickly moved to more closely monitor the company’s liquidity, noted that Enron’s cash stood at $514 million.

  Then Charles LeMaistre moved for approval of a new Enron Corp. Bonus Plan. This special fund, board minutes noted, would set aside $55 million “for the purposes of retaining key people given the uncertainty surrounding the Company’s business and the need to maximize the value of the Company.” The funds, which required the recipients to remain with the company for just 90 days, would be distributed to more than 500 employees. The biggest payments, of course, went to trading executives: Lavorato got $5 million, Louise Kitchen $2 million, and Jim Fallon $1.5 million.

  There was one other piece of business. With the end of the Dynegy deal and Enron’s fate uncertain, Ken Lay offered to fall on his sword. He “advised the Board that they continued to have the right to choose another chief executive officer for the Company and indicated that the Board should take whatever action is determined to be in the best interest of the Company,” according to the minutes. “He stated the importance of the Board and the chief executive being very aligned going forward and stated his willingness to serve in that capacity.”

  With that, Lay left the room so the board could talk in private. A few minutes later, the directors adjourned, without taking any further action.

  • • •

  For four days, Enron lingered painfully in the land of the undead, and Ken Lay remained in open denial. “As you have heard,” Lay advised employees, “Dynegy is terminating the merger agreement today. Among other things, this means we are now free to pursue other alternatives—which we are actively doing.”

  In the meantime, there would be some layoffs “to establish a more solid footing for the rest of Enron,” Lay advised. “Although there are no guarantees, you should know that we are still in this fight and remain absolutely committed to protecting the value of the ongoing businesses of Enron. . . . Even six or so weeks ago, none of us could have imagined that we would be where we are today. We will not recover in six weeks what we have lost, but we will work to stabilize and rebuild this great company. As always I appreciate the extraordinary contributions each of you make. Thank you, Ken.”

  But as Enron’s cash rapidly dwindled, others harbored few illusions. Enron’s debt—both on the balance sheet and off—totaled a staggering $38 billion. On December 1, retail chief Dave Delainey responded to a former Enron executive who had e-mailed him with suggestions for making improvements at EES. “Dick, thanks for your e-mail,” Delainey wrote. “I don’t think I disagree with any of the points you made. . . . Unfortunately, a lot of these changes in thinking, sales and cost structure are too little too late. It is highly unlikely at this point that EES will exist beyond next week.”

  As Enron spiraled toward bankruptcy, its banks labored to minimize their losses. Marc Shapiro, the J. P. Morgan Chase executive, e-mailed two bank colleagues about his efforts to recover money from Enron before it was too late: “On several occasions during the week of November 26, I called Ken Lay, CEO of Enron, to request the return of excess collateral that Enron was holding for our account. My first call was midday on Wednesday, November 28. I requested return of about $50 mm, representing collateral held by Enron in excess of what we owed them. I next called late in the day on 11/29 to inquire about the status, and I indicated that they now owed us about $100 mm. Ken said that they were reviewing their cash position, and he did not know if they would have sufficient cash to pay. I called again at midday on Friday, only to be told that a decision would not be made until the end of day. Ken called on Friday afternoon to say that they did not have sufficient cash to return our collateral or anyone else’s.”

  • • •

  Sunday, December 2, was the day it finally happened. Electronically, at 2 A. M., Enron’s lawyers filed the largest bankruptcy case in U.S. history. The Chapter 11 papers had been rushed together. Just days before, everyone was focused on

  the Dynegy deal. Once that collapsed, bankruptcy was really Enron’s only

  alternative.

  After the papers were filed, a six-man contingent from Enron flew to New York on Sunday afternoon for a routine court hearing on “initial orders,” which would allow the bankrupt company the ability to conduct ordinary business, like paying employees and vendors. But this bankruptcy was obviously anything but routine. The
courthouse was jammed with lawyers and press. Ken Lay flew up with the group—he felt it was the right thing to do—but it was decided that his presence in the courtroom would only turn the occasion into more of a circus.

  The Enron contingent included CFO Jeff McMahon, Enron Wholesale general counsel Mark Haedicke, and associate counsel Richard Sanders. An adviser from the Blackstone Group and a Weil Gotshal lawyer were there, too. Lay was still in denial, a posture he maintained indefinitely. “We were the quickest ones in,” he told the group, “and we’ll be the quickest ones out.”

  They traveled on the crown jewel of the Enron air fleet, the $45 million G-5 corporate jet, whose interior design was personally selected by Lay. After the jet reached cruising altitude, Lay rose from his leather chair to serve everyone sandwiches and fruit, as he had so many times before. They stayed in New York’s plush Four Seasons Hotel. Heading back to Houston, Sanders was sickened by the opulence of it all, the money Enron still spent freely when the company had just gone broke.

  “We should have flown up on Southwest Airlines,” he said, “and stayed at the Ramada Inn.”

  CHAPTER 23

  The Pursuit of Justice

  Enron’s shocking collapse triggered an intense and angry search for answers: How could this have happened? Who was to blame?

  Virtually everyone who played a part in the debacle came under the microscope of public and legal scrutiny: executives, accountants, bankers, analysts, lawyers, company directors. But for a time, precious few were willing to admit that they bore any responsibility for the biggest corporate scandal in American history. Wasn’t anybody sorry?

  The after-the-fact rationalizations were strikingly similar to the mind-set that produced the Enron disaster in the first place. The arguments were narrow and rules-based, legalistic in the hairsplitting sense of the word. Some were even arguably true—in the way that Enron itself defined truth. The larger message was that the wealth and power enjoyed by those at the top of the heap in corporate America demand no sense of broader responsibility. To accept those arguments is to embrace the notion that ethical behavior requires nothing more than avoiding the explicitly illegal, that refusing to see the bad things happening in front of you makes you innocent, and that telling the truth is the same thing as making sure that no one can prove you lied.