Conspiracy of Fools

by Kurt Eichenwald

  McMahon agreed.

  The bonus number was good. McMahon had feared he might pay a price for his run-ins over LJM2. But in his review on January 17, Fastow lavished him with praise, promising a hefty check in a week or so. McMahon left feeling sheepish. Apparently, he’d been worried for nothing.

  By mid-afternoon on January 20, the scores of Wall Street analysts were starting to wilt. They had been in an auditorium at the Four Seasons Hotel in Houston for Enron’s annual conference since 7:30 that morning, with few breaks. The company’s news was good, but it was all starting to blur together.

  Showtime. Skilling stood on a stage before the crowd. “I have an interesting announcement. We have renamed Enron Communications. As of today, Enron Communications Inc. is now Enron Broadband Services.”

  The rechristening was just the outward sign of an inner transformation, he declared. Already the unit was far down the high-tech path, and greater glories lay ahead.

  “We intend to be the world’s largest provider of premium broadband delivery services,” he said. “And we have a range of products for streaming of broadband services and data management.”

  More speeches followed, accompanied by plenty of videos. Hirko, Rice, and the others described what the newly empowered division was up to—the intelligent network, video streaming, bandwidth trading.

  More than an hour into the presentation, Mark Palmer, Enron’s public-relations chief, was standing in the back, watching the crowd. Almost every head was down, looking through materials as Skilling took the stage again. The door beside Palmer opened. A man dressed in blue jeans, a casual shirt, and a sports coat came inside, followed by a few other executives. It was Scott McNealy and his entourage.

  Skilling was still speaking. “We are announcing today an agreement with Sun Microsystems that’s intended to accelerate the adoption of broadband Internet services.”

  Sun would help Enron build out the Enron Intelligent Network, he said. Enron would purchase thousands of Sun servers to drive the network. And the companies would work together in marketing the network’s services.

  He motioned toward the back. “I would like to introduce Scott McNealy, the chairman and chief executive of Sun Microsystems, to provide his perspective.”

  All heads in the room popped up and craned around in unison. Palmer stifled a laugh; the analysts looked like a covey of quail reacting to a shotgun blast. The crowd burst into applause. As McNealy approached, Skilling commented that his new partner had come from his sickbed.

  McNealy climbed onto the stage and faced the crowd. “Actually, I’m feeling pretty good,” he said. “Eighteen thousand servers tend to snap me right out of it.”

  The analysts roared.

  “I even put a jacket on for this event,” McNealy said. “I almost went out and rented a tux.”

  As expected, details of the Sun relationship and other positive news sent Enron’s stock price into the stratosphere. That day it shot up $13.75, closing at a new high of $67.25 a share. And that was before McNealy even appeared. The next day was sure to be another blowout.

  In the evening, senior managers headed out to a bar in downtown Houston to celebrate. They all were there—Lay, Skilling, Rice, Pai, everybody. There were cheers and laughs as they knocked back drinks. All of them had made a fortune that day—at least on paper.

  As the night wore on, one executive approached Ken Rice, who was nursing a beer at the bar. “Wow, Ken, what a day!” the executive said. “What are you going to buy?”

  Rice just looked at the man and laughed.

  The executives were not the only ones who made money that day. Project Grayhawk had come off without a hitch; the hedge on JEDI’s Enron stock had been removed in time, then quickly slapped back on. Enron brought in eighty-five million dollars in profits, just from the increased value of its own stock. It was, by any measure, a great start for the year.

  Bonus-check day finally arrived. Sutton called McMahon up to his office to hand over the envelope. McMahon traipsed to the fiftieth floor, where Sutton had moved after becoming vice chairman. His office door was closed.

  McMahon waited several minutes, occasionally chatting with the secretary. Finally Sutton emerged, looking harried.

  “I’m sorry. I’m really, really busy,” he said. “But I wanted to give you your bonus check.”

  There were people in his office; Sutton waved for McMahon to follow him. They huddled in an oversize closet, where Sutton held out an envelope. McMahon looked inside.

  Wait a minute. A quarter of the bonus was missing.

  “Joe, this isn’t what Andy told me I was getting.”

  Sutton shrugged, raising his hands. “Well, you’re going to have to talk to Andy about that. I’m very busy.”

  Sutton left the closet, heading back into his office. McMahon headed straight down the corridor to see Fastow.

  “Andy,” he said as he walked in, “there’s a huge discrepancy in my bonus numbers.”

  Fastow looked up from his desk. “Well, I told you early on I wasn’t comfortable telling you the number before the board approved it. We had to move around some of the numbers. But it’s still a good bonus for you.”

  Next year would be better, Fastow said. McMahon stopped listening. Not much later, he saw a list with bonus figures on it. He knew what Michael Kopper was supposed to have received; Kopper had been ranked, and the rank came with a bonus range. But Kopper’s number on the bonus list was much higher than what he had been slated to get.

  It didn’t take McMahon a lot of guesswork to figure out what had happened. Fastow had wanted more money for his boy, the one who had pushed through the lucrative LJM2 deals. So he had taken it from the guy who kept causing trouble for the fund.

  Fastow had manipulated him every step of the way, putting him off until the board had acted and nothing could be changed. All for Kopper; all for LJM2. McMahon understood. Fighting against LJM2 was going to cost him.

  That was it, McMahon decided. He was going to have to leave this job. But not before he went head-on at Fastow and his precious LJM2.

  *McMahon was incorrect. The actual anticipated profit from the barge deal was twelve million dollars. The figure was corrected in all subsequent conversations.

  CHAPTER 12

  VINCE KAMINSKI WATCHED THE gathering storm clouds through the gray-tinted glass of the Dallas Street sky bridge. His footsteps clicked on the flamed granite floors as he approached the entrance of the Double Tree Hotel, just blocks from Enron. He made his way down a hallway to the Milam room, a meeting area on the hotel’s second floor.

  The first to arrive, Kaminski sat down and pulled out a pile of reports he had been putting together. For weeks, he had been pressing Rick Buy for this meeting; the topic was so sensitive that Buy insisted the meeting take place at the Double Tree, away from any curious eavesdropping.

  Kaminski was deeply troubled; in fact, he feared for Enron’s future. He had not been taken in by the giddy sense of invincibility that permeated the company; instead, he harbored an inner disquiet. Did anyone really understand all of the financial dangers Enron faced? Risk was analyzed deal by deal, as if the sum of those pieces composed the total potential hazard confronting the company. But that was myopic. They needed to analyze risk across the business, to discover hidden dangers that might be festering in Enron’s books.

  Both Buy and Kaminski knew that the idea was politically treacherous. An enterprise-wide analysis would step on lots of toes; no one would want to be accused of ignoring risks. If Buy was going to give the go-ahead, Kaminski’s course of action had to be planned carefully.

  The other participants arrived: Buy, another member of the Risk Assessment and Control Department, and a couple of Kaminski’s analysts, including a young financial whiz named Kevin Kindall. After making small talk over sandwiches and cookies, Buy looked over at Kaminski.

  “All right, Vince,” he said. “Let’s get started.”

  Kaminski passed around the ten-page report he had co
mpleted over the weekend. “What I want to discuss today is defining and implementing guidelines for enterprise-wide risk management for Enron,” he said.

  One big issue the company had to face, Kaminski said, was the mismatch between its debts and its assets. It was borrowing huge sums of money—often billions at a time—frequently for terms of just weeks or months. But then the cash was used in long-term projects, like power plants. Using short-term loans for long-term investments was a classic financial blunder that had crippled the savings-and-loan industry, and it could wreak havoc on Enron, too.

  “We have to estimate the possibility Enron could face a liquidity crisis,” Kaminski said. “Even a large trading loss—or a news report suggesting such a loss—could deny us access to short-term loans and set off such a crisis.”

  A liquidity crunch would leave Enron short of the cash it needed to stay in business. To ensure every defense against that outcome, Kaminski wanted a team analyzing everything—trading risks, merchant investments, debt management. And perhaps most important, all of the company’s assets and liabilities, on and off the books.

  “Now, asset/liability management is sensitive because it typically belongs to the CFO’s office,” Kaminski said. “We may be trespassing, but as far as I know, it is not being done by Andy or anyone in his department.”

  Buy shifted uncomfortably in his seat. He didn’t like the politics. “I don’t know, Vince. I’m not happy about this part of the project. I’m not sure you should do it.”

  Kaminski didn’t bend. “It’s too important not to do it,” he said. “It’s an essential part of this analysis.”

  He had already put together a team, Kaminski said, with Kindall hired to lead the project. But his group had no mandate to collect information around Enron; only Risk Assessment and Control did. If RAC joined, it could request the data, and Kaminski’s analysts could pore through it.

  Buy agreed to assign a RAC member to the project. But he again voiced reservations about casting so wide a net. Maybe, he said, they should just forget about assets and liabilities. Kaminski nodded, as if in agreement. In reality, he had no intention of narrowing the analysis.

  The project would take almost a year to complete. It would prove to be Enron’s last, best chance to avert the debacle that was now just twenty-two months away.

  Kopper dug in his heels. “I just don’t think Doug’s a smart guy. He’s not as good as a lot of other people.”

  Around him, an array of executives listened. They were gathered in a windowless conference room, attending the latest PRC session. Kopper was on one side of a table already littered with paper and pencils. In the center of the room stood Rocky Jones from human resources, holding a nameplate labeled “Doug McDowell.”

  Kopper was vehement in his criticism, treating the junior executive as if he were Enron’s worst mistake. McDowell’s supervisors, Bill Brown and Jeff McMahon, knew exactly what was going on. McDowell had fought hard against LJM2, refusing to pay the million-dollar fee Kopper demanded for the Yosemite deal. Now it was payback time.

  “McDowell is just not on the scale of talent that Enron should expect,” Kopper said.

  “Wait a minute, Michael,” McMahon said. “When did you work with him that gave you a problem?”

  Kopper raised his chin. “We worked on Yosemite.”

  McMahon and Brown both laughed. “Michael, that’s an LJM deal,” McMahon said.

  Recognition swept across every face in the room. That’s what this was all about. McMahon fixed his eyes on Kopper. “Michael, was the problem that LJM was paid a lower fee than you wanted?”

  Kopper’s response came fast. “No, no, nothing like that. It was the way the deal was negotiated.”

  That was enough. The other executives in the room sided with McMahon and Brown. On one side of the table, Andy Fastow watched the event unfold. Throughout the verbal sparring, he didn’t utter a single word.

  The room commandeered by Glisan was a hive of commotion as Project Raptor went into high gear. Glisan stood at the whiteboard, scribbling boxes and arrows. Ryan Siurek and Kevin Jordan, now working as Glisan’s assistants, analyzed reams of documents and data. Causey and Fastow dropped by frequently for updates.

  The plan was numbingly complex. But Glisan was sure Raptor would allow Enron to avoid future losses in its merchant investments. It would be like some elixir; with mark-to-market, Enron reported profits from investments as their values increased. With Raptor, it could avoid reporting losses if those values collapsed. What mark-to-market gave, Raptor would keep from being taken away.

  In essence, Raptor would be the Rhythms hedge writ large. It would set up an entity, Talon, to provide Enron with a commitment to make up losses in its investments, again by depending on Enron stock. The company would transfer stock to Talon, with restrictions against selling or shorting it—terms that would diminish the shares’ worth by 35 percent. In other words, if Enron gave Talon stock worth $500 million at market price, Talon would only owe Enron $325 million for it.

  For Talon to be treated as a true independent entity, it needed three percent of its capital from a third party—the perfect job for LJM2. The Fastow fund would contribute thirty million dollars to Talon, enough to treat it as separate from Enron.

  Then things got tricky. While Fastow was happy to kick in the cash, he didn’t want his investors exposed to losses. So the team devised a simplistic—and absurd—solution. Before hedging anything, Talon was first required to give forty-one million dollars—the original thirty, plus an eleven-million-dollar profit—back to LJM2. Fastow’s fund was guaranteed a massive profit before Talon took on any new risks. A baboon could make money under those terms.

  But the forty-one million dollars couldn’t be deemed as a return of the original investment; otherwise, there would be no independent cash in the deal. So Glisan had to find a way to argue that LJM2 still had thirty million dollars at risk in Talon. Semantics provided the answer. The forty-one million would be deemed a distribution of pure profit to LJM2. That would arguably still leave the fund with thirty million in Talon.

  It was all smoke and mirrors. The requirement for an independent three percent investment was designed to make sure somebody cared about the financial performance of an entity like Talon. Otherwise, the company that set it up could just dump all its low-quality assets into a special-purpose entity, making its own performance look superb. But once Fastow had locked in his profit, he couldn’t care less what deals Talon did. LJM2’s investors would still see a stellar performance, guaranteed by the forty-one-million-dollar payout.

  But the Enron shares couldn’t be sold to make the payment; Talon needed cash from someplace else. So the team went to the only source available: Enron itself. Under this last leg of the plan, Enron would pay Talon forty-one million dollars. In exchange, Talon would commit to pay Enron a sum of cash if the company’s own stock dropped in price.

  Even for a transaction that had already soared past the outer reaches of common sense, this final step was a mass of contradictions. Talon was dependent on the value of Enron stock to make good on the hedge. In other words, by setting up Talon, Enron was betting its stock price would hold steady or go up. But now it was paying Talon millions of dollars in a bet that the price would go down. And of course, Talon would be hard-pressed to honor its commitment; if Enron’s stock went down, the entity would lose its primary source of capital to compensate the company for the decline.

  Talon was nothing more than Enron itself. Enron had handed it some assets; in the event that the merchant investment lost value, Talon would hand the assets back. Enron would be better off economically by doing nothing at all—at least then it would save forty-one million dollars.

  ———

  As Glisan’s explanations about Raptor droned on, Ron Astin and Mark Spradling, lawyers from Vinson & Elkins advising on the deal, grew uncomfortable. In particular, it seemed this forty-one-million-dollar distribution to LJM2 would eliminate all of the independent equit
y in the deal.

  “Ben, wait,” Astin said. “Doesn’t that leave Talon with insufficient outside equity?”

  “Not at all,” Glisan responded. “It’s a return on capital, not a return of capital. LJM2 keeps its interest in Talon. The three percent is still satisfied.”

  Astin wasn’t convinced. Glisan’s word game just sounded too cute. Still, the lawyers had time to mull it over, maybe talk it through with Andersen. After all, they were the accountants. Not Vinson & Elkins.

  Chewco had become nothing but a headache. The entity formed years before—and now secretly owned by Michael Kopper and his domestic partner—for the purpose of buying half of the JEDI partnership had emerged as a source of endless trouble at Enron.

  Both Enron and Chewco had to prepare valuations of JEDI’s assets for establishing Enron’s profits and figuring out if Chewco was owed any money. But their conclusions were sharply at odds; Kopper argued that the Chewco assets were worth double what Enron’s analysts calculated. The disagreement broke down into bickering.

  McMahon was sick of it. Why did Chewco even exist? He still didn’t know. Maybe it would be better, he thought, to buy out Chewco and make JEDI wholly owned by Enron. He asked Bill Brown what he thought of that idea.

  “Well,” Brown replied, “buying out Chewco would mean negotiating a deal with Kopper.”

  That wasn’t a fun prospect. “Does that mean Fastow will be involved?” McMahon asked.

  Brown said yes. So McMahon cut out the middleman and went straight to Fastow with the proposal.

  A million-dollar profit seemed fair. From what McMahon could figure, the Chewco investors put up $125,000 for an investment just over a year old. They couldn’t possibly object to an annual return approaching 800 percent.

  But Fastow didn’t like the number. “I’ll take it to Michael, but he’s never going to accept that.”

  Soon after, Fastow called McMahon and Brown in for a discussion. He had been right; Kopper had refused. He proposed another deal, one that would give Chewco a ten-million-dollar profit.