Infectious Greed

by Frank Partnoy

  After October 2001, Enron’s trading operation finally floundered, as banks refused to extend them credit. When Enron sold its derivatives-trading business to UBS, the Swiss bank, Enron kept the billions of dollars of derivatives its traders already had purchased. John Lavorato, having received a $5 million bonus for 2001, left to run the trading operation at UBS, where he would be just as successful as he had been at Enron. The derivatives profits lingered at Enron even after its bankruptcy, when all of its derivatives traders were gone. The derivatives Enron retained after Lavo and his colleagues departed steadily paid off; and, by July 2002, the bankrupt company was awash in an incredible $6 billion of cash, according to a reporter at the New York Times—a reminder that although the company had died, its heart had been healthy throughout.

  Unfortunately, even these massive trading profits weren’t enough, and Enron ultimately was forced into bankruptcy. Even given the extensive media coverage, it was difficult to capture the breathless pace of the firm’s collapse. From an insider’s perspective, the last few days were a blur.

  October 23, 2001, was a relatively quiet day throughout most of Houston. Harris County officials announced the successful test of a new $25 million electronic voting system for the upcoming elections. At Enron Field, the Houston Astros were interviewing candidates to replace Larry Dierker, the baseball manager who had resigned the previous week after leading the team to four National League Central Division titles in five years.

  It had been just six weeks to the day since the terrorist attacks of September 11, and the 1.8 million residents of Houston were numb to bad news. A Texas National Guard office was closed after an officer discovered white powder on a stack of papers, but few people were alarmed and the powder tested negative for anthrax. The Union of Concerned Scientists released a long-awaited report projecting a seven-degree temperature increase in fifty years, but after another 100-degree summer, no one really believed Houston could get any hotter.

  Meanwhile, at 1400 Smith Street, Enron’s headquarters, all hell was breaking loose. For Ken Lay, it was the beginning of the end.

  Lay spent much of the morning on a conference call with investors and analysts, trying to explain some recent troubles. During a previous Enron conference call, months earlier, investors had asked some heated questions about Enron’s finances, and Jeff Skilling had responded to one analyst, Richard Grubman of Highfields Capital Management, by saying, “Well, thank you very much, we appreciate that. Asshole.” Skilling had resigned in August, citing personal reasons. Now, Ken Lay was the target.

  For many of the listeners, Enron had been a solidly performing investment. During 2000, as high-flying Internet stocks had lost almost all of their value, Enron’s stock had stayed in a range of more than double its 1999 price. Enron hit its all-time high of $90.56 in August 2000, and closed the year at $80.

  Then, the California energy crisis struck and, by summer 2001, Enron’s stock price had been cut in half. California officials blamed Enron for everything from price gouging to manipulating the price of electricity. Just before Skilling resigned, he was mobbed by angry protestors, one of whom hit him in the face with a pie. Many investors assumed that California was the primary reason for the decline in Enron’s stock price. California regulators had taken over some electricity contracts, and fewer people were trading electricity, all of which should have meant lower profits for Enron. Investors did not know that Enron was having a record year trading natural-gas and electricity derivatives, notwithstanding the problems in California. During the summer, several analysts finally focused on the cryptic disclosures in Enron’s annual report about its dealings with various “Related Parties.” They noticed disclosures, from months earlier, that Fastow and his partnerships were the Related Parties, and that Fastow was paid based on how the LJM partnerships performed. Anyone who closely read Enron’s public filings from 2000 and 2001 would have spotted the description of Fastow’s involvement and compensation.

  The analysts were furious, and demanded that Enron remove Fastow from the partnerships and end the firm’s relationships with LJM and LJM2. Lay asked Vinson & Elkins, the firm’s primary outside legal counsel, to investigate these issues; and, in an October 15, 2001, letter to Enron’s general counsel, the law firm wrote, “The facts disclosed through our preliminary investigation do not, in our judgment, warrant a further widespread investigation by independent counsel and auditors.” According to its lawyers, Enron’s actions were legal.

  The next day—Tuesday, October 16—Enron announced that it was removing Fastow from the LJM partnerships, and taking a $35 million charge related to “early termination” of its dealings with those partnerships. The firm also announced a $1.01 billion one-time charge to reflect losses in its broadband, retail-electricity, and water investments. These announcements were portrayed as terrible news, which undoubtedly would cause Enron’s stock price to plummet.

  Instead, Enron’s stock price went up about two percent that day. Sophisticated investors didn’t seem to care much about Enron’s announcement of a billion-dollar charge. Enron’s stock price didn’t budge on Wednesday, either, and trading was calm. By this time, at the latest, the price of Enron stock should have reflected all of the information related to the LJM partnerships and the billion-dollar charge. The information was out, and markets usually don’t take very long to react to news. In an efficient market, a few minutes is a lifetime, and most news is reflected in stock prices within seconds. But in Enron’s case, the markets didn’t react immediately to the news; instead there was a two-day calm before the storm.

  Finally, on Thursday, October 18, Enron’s stock price began spiraling down, out of control. On Thursday, trading volumes in Enron’s stock doubled, and the price dropped to $29. On Friday, volumes tripled, and the stock dropped $3 more. On Monday, 36.4 million shares traded—more than any other stock that day, more than double Friday’s volume, and more than any other single day in Enron’s history—leaving Enron’s closing price at around $20, a quarter of its value nine months earlier.

  What accounted for the frenzied trading and nosedive in price? Enron gave investors a partial answer on Monday, when it disclosed an “informal inquiry” by the Securities and Exchange Commission into transactions between Enron and the LJM partnerships. Investors shuddered at the words “informal inquiry.” If the SEC started digging, who knew what they might find? Ken Lay began calling in his political chits. Enron officials had meetings with Vice President Dick Cheney’s staff, and Lay called his good friend, Commerce Secretary Donald Evans (although both men later claimed they did not discuss any of Enron’s problems).

  But none of this helped, and Lay had no choice but to arrange the October 23 conference call. As the call began, the participants asked what Lay was going to do about the fact that the stock price, which months earlier had fallen from $90 to a plateau of $35, was now falling off a cliff.

  The stock analysts listening in on the call had issued buy recommendations on Enron stock, and were even more upset than the investors. (In October 2001, sixteen of seventeen securities analysts covering Enron called it a strong buy or buy.)53 Given recent allegations about conflicts of interest among analysts—specifically, that they were making unjustified buy recommendations in exchange for lucrative investment-banking business for their firms—they wanted to be sure they got accurate information about companies they were covering. No one had questioned the analysts’ conflicts as stocks were rising, even though they consistently rated nearly every stock a buy. But now that prices were falling, investors and regulators were raising eyebrows. Now, analysts were subject to greater scrutiny—a few had even been fired, and New York attorney general Eliot Spitzer had begun investigating various analysts and their firms. He was about to file an affidavit describing incriminating e-mails from Merrill Lynch. The analysts wanted to be sure they were making an accurate call on Enron.

  In fact, the analysts’ ratings finally looked like they made some sense. Enron might not really have bee
n a strong buy at $80 just a few months earlier, but at $20 it seemed to be reasonably valued.

  During the call, Lay admitted that having a chief financial officer run partnerships that did business with Enron was an “inherent conflict of interest.” But he defended Enron, saying the company had set up procedures, which officials rigorously followed, to ensure that shareholder interests weren’t compromised. He said, “There was a Chinese Wall between LJM and Enron,” and noted that Enron was not obligated to do deals with the partnerships. Indeed, Lay said, the partnerships only did deals when it was in Enron’s best interests.

  From the analysts’ perspective, the phrase “Chinese Wall” was the last straw. Wall Street investment banks had defended themselves for years with “Chinese Walls” between businesses that were subject to conflicts of interest. For example, analysts were not supposed to talk to investment bankers about confidential information. “Bringing someone over the wall” was supposed to be a significant event, when a person finally was entitled to learn secrets associated with a company or transaction. In reality, “Chinese Walls” were about eighteen inches high; bankers often compared them to the miniature Stonehenge in the movie This Is Spinal Tap.

  Lay’s use of the “Chinese Wall” defense raised suspicions about other partnerships and investments. Analysts asked about arrangements with Whitewing, Atlantic Water Trust, and other SPEs Enron partially owned. Enron officials assured listeners that the company had access to enough capital to carry out normal operations, although they warned of the risk that the credit-rating agencies might downgrade Enron’s debt. Any mention of credit ratings always created a hush among the crowd, and the explanations of these commitments in particular were cryptic, and seemed to involve several triggering events. When pressed, Lay finally told callers he was limited in what he could say about the LJM partnerships because of the SEC inquiry.

  Having earlier demanded Andrew Fastow’s resignation from the partnerships, the analysts listening to Lay began demanding Fastow’s head. David Fleischer, an analyst from Goldman Sachs, said Enron’s credibility was seriously in question, and called on Lay to do everything in his power to explain to investors that Enron’s dealings were “aboveboard.” He said, “I, for one, find the disclosure is not complete enough for me to understand and explain all the intricacies of all those transactions.” Jeff Dietert, an analyst from Simmons & Co. International in Houston, said, “I had hoped to get a little bit more out of the call.” For many others, that was an understatement.

  As the call ended, it appeared that Ken Lay was not being entirely truthful with the investing community. Lay said he and his board of directors continued to have “the highest faith and confidence” in Fastow, the CFO. For the skeptical analysts, these words sounded like the kiss of death. No one expected Fastow to survive the year at Enron. In fact, Lay fired Fastow the next day.

  Meanwhile, at the Houston offices of accounting firm Arthur Andersen, October 23 was even more frantic. Enron was Andersen’s most important client in Houston, and had paid Andersen $52 million in fees in 2000 alone—more than half of which was for consulting, not audit, advice. The ties between the firms were very close, and many Enron employees—including Richard Causey, the lead audit supervisor—had spent time working at Andersen. As one former risk manager at Enron put it, “You couldn’t swing a dead cat without hitting a manager from Andersen.”

  The focus of Andersen’s work for Enron had changed markedly in recent years. A decade earlier, Andersen had performed only audit work for Enron, and not much else. Because Andersen had been independent, and had not relied on Enron to pay it for any other services, investors believed that Andersen would scrutinize Enron’s financial statements very carefully. Even if they couldn’t trust Enron, at least they could trust Andersen.

  But Andersen had become less independent during the past few years, as it had expanded the consulting services it provided to corporate clients, including Enron. By 2000, the audit business was dying, and dreadfully boring. An annual audit required thousands of hours of tedious work. Consulting—especially consulting for an innovative company such as Enron—was glitzy and arguably more profitable.

  While Ken Lay was spinning a tangled web during his conference call, employees at Andersen had powered-up the firm’s shredders. David Duncan, the lead Andersen partner on Enron’s audits, called a meeting to organize an “expedited effort to dispose of Enron-related documents.” The document destruction quickly became document carnage, and continued until November 9, when Duncan’s assistant finally issued a memorandum directing Andersen secretaries to “stop the shredding.” During that short time, Andersen deleted thousands of e-mail messages and disposed of garbage bags’ worth of shredded documents.

  Andersen later would attempt to distance itself from Duncan, issuing a statement that the shredding “was undertaken without any consultation with others in the firm.” Duncan must have anticipated that he would be left without friends in upper management, because he took at least six boxes of documents home before Andersen fired him on January 15, 2002. Those boxes contained important documents the investigators otherwise might not have seen.54 Ultimately, prosecutors decided that Duncan’s story would be useful in bringing a case against Andersen, and they appreciated the helpful documents, so they offered Duncan a deal: if he agreed to testify against Andersen at trial, he could plead guilty to obstruction of justice, and prosecutors would recommend a lenient sentence, perhaps with no jail time at all. After lengthy deliberations, a Houston jury convicted Andersen of obstructing justice, in part based on Duncan’s testimony, in which he admitted to committing a crime.

  On October 31, Ken Lay asked William Powers Jr., the dean of the University of Texas Law School—a well-known and respected figure in the legal profession—to join Enron’s board and to oversee a special committee investigating Enron’s losses. Powers then hired William McLucas, a former head of the SEC’s enforcement division, and a dogged prosecutor with an impressive track record of victories.

  Lay also continued to call in favors owed by various Bush administration officials. He had just raised more than $100,000 for Bush’s election campaign as one of 214 so-called “Pioneers,” and had been an adviser to Bush during the transition after the election as well.55 In October and November, Lay called Treasury Secretary Paul O’Neill, Commerce Secretary Don Evans, Federal Reserve Chairman Alan Greenspan, and Robert McTeer, president of the Dallas Federal Reserve. Enron President Greg Whalley made several calls to Peter Fisher, the undersecretary of Domestic Finance, who had been involved in the private bailout of Long-Term Capital Management.56 But none of these men would agree to help Enron; and, on November 6, the stock price fell below $10 per share.

  During this time, the key issue in Enron’s survival was its investment-grade credit rating. Enron had noted, in its most recent annual report, that “continued investment grade status is critical to the success of its wholesale business as well as its ability to maintain adequate liquidity.” 57 A downgrade would be a double whammy for Enron. First, most financial institutions would refuse to extend additional loans to Enron because of the low rating. It wasn’t merely that its cost of borrowing would increase; with a sub-investment-grade rating, Enron simply would not be able to borrow enough money at any rate.

  Second, many of Enron’s loans had credit-rating triggers, so that even though payment might not be due on its debt for several years, the terms of the debt specified that payments would be accelerated, following a downgrade to below investment grade. Specifically, if the credit-rating agencies downgraded Enron to below investment grade, Enron immediately would owe $690 million, and its various partnerships immediately would owe $3.9 billion.58 Given Enron’s deteriorating financial situation, it would not be able to cover these obligations—which meant that Enron’s fate was in the hands of the credit-rating agencies.

  In early 2000, Moody’s supposedly had “exhaustively” reviewed Enron’s off-balance-sheet activities and made a decision to change
Enron’s rating, based on what it found: it had upgraded Enron one notch, to Baa1.59 (The lowest investment-grade rating on Moody’s scale was two notches lower, at Baa3.) Moody’s didn’t raise the issue of credit-rating triggers, which were not unique to Enron. Although companies—including Enron—typically did not disclose these triggers in their financial filings, the credit-rating agencies were aware of them. Moreover, all three rating agencies had closely followed Enron throughout the tumult of the California energy crisis, Jeff Skilling’s resignation, the revelations about Andy Fastow, Enron’s public announcement of a billion-dollar-plus charge, and Ken Lay’s firing of Andy Fastow after the hellish conference call on October 23. And yet, with Enron’s stock price down from $80 to below $10, all three agencies still gave Enron’s debt an investment-grade rating.60

  In early November, Citigroup and J. P. Morgan Chase each agreed to give Enron an additional $1 billion in secured loans. The banks were in a tough spot, having loaned $8 billion to Enron through prepaid-swap deals, all of which were now in jeopardy. They committed to put more money into Enron, just as they had with Long-Term Capital Management.

  Citigroup’s co-chairman, Robert Rubin, who had been the Treasury secretary during the Mexico bailout and the collapse of Long-Term Capital Management, called Peter Fisher at the U.S. Treasury Department, to request that Fisher ask the credit-rating agencies to find an “alternative” to downgrading Enron. Rubin reportedly began the call by saying, “This may not be the best idea, but . . .”61 Fisher declined.