“No, you’re not. You’re saying you want to recognize revenues from twenty-year contracts in the first year. I don’t know what that is, but that’s not mark-to-market.”
Posey held up a hand. “We’re talking mark-to-market,” he said. “It’s the accounting the investment banks use.”
That wasn’t the same thing, Woytek argued. Those institutions were valuing their portfolios based on current, actively traded markets. If they owned stock in Exxon and Exxon’s share price rose two dollars, then the value of their investment went up. There was logic to it; the market was independently assessing the value. If an investment bank needed cash, the stock could be sold at the price recorded on its books. But this was different, he said. They were making estimates about the total revenues a contract would produce, and then reporting the whole thing right away. There was no independent judgment involved. It wasn’t mark-to-market; it was mark-to-guess.
“How can you book twenty years of revenue in the first year?” Woytek asked. “That goes against everything I was ever taught in accounting. You never recognize revenue in advance, only when title passes from one owner to the next. And title doesn’t pass on this until you deliver the gas, over the next twenty years.”
There were other problems, Woytek said. The strange accounting idea would make the profits from Skilling’s division unpredictable from one year to the next. If it sold fifty contracts in the first year—requiring gas deliveries over, say, five years—and recognized all future revenues up front, the next year it would start out at zero, with no revenues. In fact, it would start out at less than zero, since it would have already presumably done business with its stable of customers. So the second year, it would have to sell as many contracts as in the first year—and then more—just to beat its first year’s earnings. Year after year, it would be the same thing, forever. An investment bank using mark-to-market just needed market prices to rise to grow profits; but Skilling’s group was almost guaranteed to someday hit a wall.
Worse, the reported earnings would be huge, but the cash wouldn’t finish trickling in for years. Earnings without cash are anathema to investors; how would the company explain it?
“We’ve always sold long-term contracts, and we always took into earnings the amount of gas we delivered each month,” Woytek said. “Why should this be different?”
Posey didn’t back down. Woytek, he said, was looking at this from the old oil-and-gas method, which was affected by fluctuating energy prices. But Gas Services was matching its purchases and sales, and then marking to market the entire position. It made sense, Posey argued.
Woytek smiled. There were other reasons to use this accounting idea that nobody was mentioning. He had already heard that as part of his compensation, Skilling received an ownership stake in his division. When the division’s earnings went up, the value of that stake would, too. If that division started booking twenty years of contracts in a single year, its earnings would go through the roof.
And then—even if those profits came from fancy accounting—Jeff Skilling would be one very rich man.
The following month, on July 26, Jack Tompkins was sitting at his desk when a call came in from the SEC. It was Jack Albert from the agency’s office of the chief accoutant, calling about the Skilling accounting proposal. Tompkins asked Albert to hold for a moment and patched in Posey from Skilling’s group.
“I’ve kept very close contact with this, but George has been the one carrying the ball,” Tompkins explained.
Albert acknowledged Posey, and then started. “The bottom line is that we don’t believe you can make a case with the preferability to change at this time,” he said. “I know this is not the best news to give you.”
The Enron executives spoke simultaneously for a second. What was the issue?
“The reasons vary,” Albert replied. “But at the present time we think accounting for oil and gas is locked into this historical cost model.”
Posey was almost speechless. Because Enron had an oil-and-gas business, it should use oil-and-gas accounting—even for its finance division? “Let me just maybe understand your point a little better,” he said. “This doesn’t include our oil-and-gas exploration company.”
“I understand that.”
“Okay,” Posey continued. So one division’s accounting should be dictated by another division’s business?
“This is a dramatic change for anyone in the oil-and-gas business,” Albert responded. “I don’t think you really have anyone analogous to Enron Gas Services out there.”
Tompkins jumped in, trying to play conciliator. “We certainly don’t want to be argumentative,” he said. “The more information we can get why and what we can do sometime down in the future as far as—”
Albert interrupted. “I think you’ve made an excellent point right there with ‘sometime down in the future.’ We think it is premature at this time.”
The call ended, and Posey rushed to Skilling’s office. He found him at his desk, engrossed in work.
“The SEC turned us down,” Posey announced.
Skilling sank in his chair. “What? That’s stupid.”
Furious, Skilling threw questions at Posey and learned the details of the call with the SEC. He phoned Tompkins, warning that he was coming up. Minutes later, in Tompkins’s office, Skilling could barely contain himself.
“What the hell happened?”
Tompkins shrugged. “They turned us down.”
“Did you give them the reasons that was the wrong thing to do?” Skilling barked. “Did you talk to them?”
“About how this compares with other companies, and I explained that other companies use it.”
“Did you explain why this is important?”
“I think our application was very clear about that.”
Skilling fumed in silence, then turned on his heel and stormed out. Back in his office, he called Steve Goddard from Andersen.
“Is this normal?” Skilling asked. “Mark-to-market makes all the sense in the world. Why wouldn’t they just automatically do this?”
“Well,” Goddard replied, “they are very conservative, and this is a big change.”
“It’s not a big change,” Skilling shot back. Lots of investment banks used the accounting, he said. It was ridiculous that competing companies would be forced to treat the same deals differently. The whole thing had been mishandled, Skilling said. Andersen needed to fix it.
“We can’t just send a letter and say, ‘Oh, we want to switch to mark-to-market,’ ” Skilling said. “We need a full-blown presentation about why it’s the right thing.”
Goddard agreed to call the SEC and set up a meeting. Skilling said he would make the presentation himself, but asked Andersen to be there ready to answer any questions on the technical accounting issues. Goddard said he would give the job to Rick Causey.
It was the assignment that set Causey on the path to becoming a power in his own right at Enron.
On September 17, 1991, SEC staffers gathered in a conference room at the agency’s Washington headquarters. Already the place was packed, with people standing along the walls or sitting on the carpet, eager to hear the presentation from Enron and Andersen. After all, it wasn’t every day a big company lobbied to fundamentally change the way it reported revenues and profits. This was as close to a financial wonk’s version of Woodstock as there could be.
With the place filled, Skilling and his team were escorted into the room. Goddard walked to the front of the assembled group, gave a few greetings, and introduced Skilling, who strode to an overhead projector.
“Thank you, Steve,” he said. “As Steve suggested, our business is changing radically. What has traditionally been a very fixed structure is now turning into a traded commodity. And with that, the accounting has to change.”
Skilling placed a series of transparencies on the projector, describing the history of his unit and the growth of the natural gas trading market. But it was the eighteenth transparency that captivated the room.
It showed two gas portfolios—one with matched purchases and sales handled the way Enron did business, and another with a long-term supply contract satisfied by buying fuel in the open market. At first, since short-term prices were lower than long-term prices, such a deal might look good. But of course, Skilling said, the approach was reckless, since the company taking the position could be forced to sell gas at a loss if prices climbed. It was the kind of shortsighted strategy—lending long-term and buying short-term—that blew up the savings-and-loan industry, he said.
A new transparency appeared, showing how the two portfolios would be reported under the traditional, accrual accounting and the mark-to-market approach. With mark-to-market, the matched portfolio was worth the current value of all the cash it would generate over its life; the mismatched, dangerous portfolio was worth less. But with accrual accounting, the matched portfolio showed a loss while the dangerous portfolio showed big profits. Worse, traditional accounting provided benefits to companies that sold winning positions while holding on to losers.
Skilling glanced at the assembled faces. “Accrual accounting lets you pretty much create the outcome you want, by keeping the bad stuff and selling the good,” he said. “Mark-to-market doesn’t let you do this”
An SEC staffer sitting in front of Skilling stopped taking notes. He was from the financial-institutions group, and Skilling’s words had sounded a familiar chord.
“That’s gains trading,” the staffer said. “That’s what our banks do all the time.”
“Of course they do,” Skilling said. “Under accrual accounting, it’s a no-brainer. It’s a simple, easy way to report profits, but they don’t reflect reality.”
“Wait a minute,” the staffer continued. “Let me get this right. You’re asking to go to mark-to-market?”
“Yeah, we’re asking to go to mark-to-market.”
A pause. “Why?”
“Because,” Skilling said, “we think it’s a more accurate reflection of what is going on in the business.”
The staffer shook his head. “We’ve been trying to get the banks to go to mark-to-market accounting for years.”
“Well …,” Skilling began.
“I think this makes all the sense in the world,” the staffer interrupted, gathering his notes as he stood. “Sorry, I’ve gotta go.”
Skilling smiled as the staffer headed out of the room. “Well,” he said, “I think he gets it.”
The SEC ruminated over the idea for months, calling Enron periodically for more material—copies of Skilling’s presentation, information about other market participants. More meetings were held in Washington to review details.
Finally, on January 30, 1992, a call came to Skilling from Jack Tompkins. “Jeff, I just got a letter from the SEC, and they’ve agreed with our accounting change.”
“Really?”
“Yeah, they put some conditions in place, but they signed off on the idea.”
Skilling hurried upstairs to see the two-page letter. Posey was already there and handed Skilling a copy. Reading it, Skilling broke into a smile.
“Thank God,” he said. “There’s some logic in the world after all.”
After a round of congratulations, Skilling and Posey headed to their offices, now on the thirty-third floor. Skilling walked into the bullpen and called for everyone’s attention.
“We got mark-to-market!” he crowed.
The announcement elicited a burst of congratulatory chatter from the Enron executives. At last, their business was ready to take off. “Folks,” Posey announced, “I’m going out and getting us all some beer to celebrate.”
Still, there were loose ends. In its letter the SEC said it would allow Enron to use mark-to-market accounting beginning in January 1992. Days later, Tompkins wrote back, informing the SEC that Enron would be applying the new accounting treatment for 1991, although he said that the effect on earnings would not be material.
As far as the executives at Enron were concerned, they had no choice. They needed the profits they would gain from collapsing the estimated lifetime revenues of their gas contracts into a single year. Without them, under traditional accounting the company could miss the earnings targets Wall Street was projecting for the year just ended.
Accounting techniques—approved by the nation’s top securities regulator—now allowed Enron to report fast-growing profits. But the related cash would not finish flowing in for years. With high earnings and low cash, about the worst thing Enron could do at that moment was start throwing money into another risky business.
Rebecca Mark pushed open the door to a conference room for a group of dignitaries from India. The delegation, led by the country’s Power Secretary, Srinivas Rajgopal, had been in America almost a week and had flown to Houston on this day in May 1992 specifically to meet with her. The thirty-seven-year-old onetime Missouri farm girl had made a name for herself helping Enron build power plants in several countries—just what the Indian delegation wanted.
The meeting this day came at a time of transition for both India and Mark. After decades of shunning foreign investment, the Indian government had begun aggressively seeking overseas capital; in particular, it needed power plants to overcome chronic energy shortfalls that often paralyzed the country’s factories.
Enron had almost no track record in the developing world, but Mark wanted to change that. An attractive woman with a wave of blond hair that illuminated her face, Mark had just lost an internal political battle. Despite her work on a number of plant projects—including one constructed in Massachusetts while she attended Harvard Business School and a hugely successful plant in Teesside, England—she had drawn the short straw when the company split its power business into three units. The lucrative deals in Europe and the United States were divvied up to others. Mark and her team handled what was left—the riskier developing world. India was right in her bailiwick.
The Indian delegation took their seats and quickly got to the point. Rajgopal said that Enron had come to his attention because of its plant in Teesside. India needed such a project, he said. Mark listened, with reservations. She knew India mostly relied on high-polluting, coal-fired power plants, a business she wanted nothing to do with.
“I must tell you,” she said, “we don’t do coal, we do gas. We have some ethical issues about coal.”
“We understand that,” Rajgopal said. “That is why we’re here. We want you to bring gas into India.”
Ludicrous. India had no reserves, no infrastructure of a gas industry. Gas would have to be imported, but that seemed unlikely, she told her guests. A pipeline through Pakistan was too risky, and the only other alternative—shipped liquid natural gas, or LNG—was pricey. Plus, the investments required—gas field drilling, liquefaction technology, ports—meant that to justify the costs, an LNG plant would have to be huge, at least two thousand megawatts.
“The size would drive up the cost of electricity,” Mark said. “In my view, you can’t afford LNG.”
Rajgopal shook his head. “We think we can.”
Mark still was dubious. The cost of electricity would be almost double that from a coal plant, she said. How could India possibly handle that?
“We’re very power short,” Rajgopal responded. “Our industries need power. We want to look at LNG.”
The government was willing to make whatever commitments were necessary to ensure such a project worked, Rajgopal said. Mark sat back in her chair. These were determined people. Could this be the break her team needed?
It was almost a magical moment. After losing the internal battles, her group might well be stumbling into the lead role on one of the world’s biggest projects. It would cost billions. And it would shower cash on Mark and her team. Enron effectively paid the power-plant developers a percentage of their deals, based on estimates of the money they would bring in. The larger the project, the more electricity it produced, and—consequently—the bigger the bonuses, often running into millions. Enron would invest the cash, and the in
ternational team would get rich.
“Okay,” Mark said. “We’ll take a look at it.”
With that, the fuse was lit. Enron would soon be pursuing wildly contradictory strategies. One brought in huge earnings but little cash, and depended on Enron’s credit rating to survive. The other would devour cash while producing next to no earnings for years, potentially putting the credit rating at risk.
Enron was on a collision course with itself.
CHAPTER 3
ROWS OF LUXURY CARS lined Wroxton Road near Andy Fastow’s house in the upscale neighborhood of Southampton Place. It was a weekend evening in December 1992, the night of the Fastows’ holiday party for Enron’s executives and bankers. Already the crowded street was forcing latecomers to park more than a block away; the crisp evening air whipped by as they scurried back, past historic bungalows and Victorian-style lampposts that battled feebly against the darkness. From the Fastows’ front walk, new arrivals could see a huge crowd through the shutters on the Georgian home’s first-floor windows.
Just inside, Lea Fastow stood near a staircase in the entry hallway, playing hostess to perfection. She greeted new arrivals personally, dispensing warm smiles and cheerful words. Framed artwork and delicate knickknacks lent the house a sumptuous air of class. Many of the guests complimented Lea on her decorating skills, already the stuff of legend around the office. Andy wandered from room to room, chatting up the revelers.
The mood was relaxed and celebratory, capping a fantastically successful year. Gas Services had taken off; following the accounting change, the division had blown through its projected numbers, the bottom line rising in an unswerving, near-vertical climb. After years of stumbling from one embarrassment to the next, Enron now inspired awe and fear in competitors, thanks largely to the cocksure, bubbly young people packed shoulder to shoulder at Fastow’s house. That evening everyone felt successful, smart, and richer than they had ever dreamed.
One late arrival, Amanda Martin, headed up the Fastows’ front walk, watching the festivities with a sense of wonder. A lawyer by training, Martin, thirty-six, was blond and attractive, but it was her smarts that wowed Enron executives. Although her job was to clear away legal land mines in Enron’s deals, she never hesitated to challenge transactions she thought wrongheaded; her pointed questions, raised in her lilting Afrikaner accent, could deflate the most arrogant of deal makers.
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