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

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The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron Page 18

by Bethany McLean


  growing earnings Enron wanted, but that brought its own set of pressures: every time Skilling’s group found a new profit center, competitors would quickly copy it, and the easy profits would vanish. And though Teesside was generating big profits, many of Mark’s international deals were not yet money-makers. Theoretically, the vast bulk of international profits would come once her power plants and pipelines were up and running.

  One way Enron managed its earnings, even then, was by reworking its long-term supply contracts—which would then allow it to post additional earnings, thanks to mark-to-market accounting. The company also sold assets and made other “nonrecurring” moves to meet its earnings targets. But it didn’t always label these as nonrecurring events; Enron simply declared them part of its ongoing operations. For instance, between 1994 and 1996, Enron reduced its stake in Teesside from 50 percent to 28 percent and folded the gains it reaped from selling the stake into its earnings. Back in 1989, Enron had raised needed cash by sell-

  ing a minority stake in Enron Oil and Gas through a public offering; six years later, the company sold more Oil and Gas shares to the public, generating an additional $367 million in pretax profits.

  Were these transactions hidden from the investing public? No. Enron’s brass didn’t go out of their way to point them out, but for anyone willing to wade through the company’s financial documents, the numbers were clear. From time to time, an analyst would ask some tough questions or a reporter would write a story that raised what would seem now to be obvious objections to Enron’s modus operandi. In 1993, Toni Mack published a story in Forbes entitled “Hidden Risks,” in which she questioned the use of mark-to-market accounting in Skilling’s business. “If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income,” an Enron competitor told Mack. A few years later, a journalist named Harry Hurt III wrote an article in Fortune about, as he put it, Enron’s “allegedly byzantine methods of managing earnings.” Hurt noted that when you stripped a few of the onetime gains out of Enron’s seemingly healthy 1995 earnings, including the profit Enron recorded for selling shares of Enron Oil and Gas, 1995 hadn’t been such a good year after all. Without those gains, Enron’s profits actually fell. But stories like that were soon forgotten.

  There’s another tactic Enron used during the Kinder years that deserves special attention; in retrospect, it was a harbinger of things to come. In 1994, Enron created a spin-off company called Enron Global Power and Pipelines (EPP). Its stated purpose was to purchase Rebecca Mark’s assets from Enron, thereby taking them off Enron’s balance sheet and freeing capital for Enron to reinvest. (For instance, Enron planned to sell EPP 50 percent of Dabhol.) There is nothing remotely illegal about this; in fact, Coca-Cola spun off its bottling system for much the same reason. But there was also a second benefit: by selling assets to EPP, Enron could realize profits at once, which would help it hit its earnings targets instead of waiting for them to drift in over the years. In a sense, it was analogous to Skilling’s use of mark-to-market accounting for ECT.

  Here was the rub, though. Enron couldn’t simply sell the international projects outright. Why? Because the various agreements it had with its lenders and partners often required it to maintain a majority ownership of the assets. Yet under accounting rules, if Enron were deemed to control EPP, it would not be allowed to realize profits when it sold stakes in the assets to EPP. It was a classic catch-22, difficult even for clever accountants and lawyers to get around. Nevertheless, Enron and its accountants at Arthur Andersen (and its lawyers at the blue-chip Houston firm of Vinson & Elkins) managed to find a way. Enron, they decided, would retain slightly more than 50 percent of the assets, but it would set up an oversight committee consisting of three directors who would independently approve every transaction. Astonishingly, Arthur Andersen agreed that this would mean Enron didn’t control EPP and could therefore book profits when it sold assets to EPP. It was, all in all, a remarkably sleazy solution. For their work, Arthur Andersen was paid $750,000 and V&E $1.2 million. Oh, and the chairman of EPP? That was Rich Kinder.

  In November 1994, EPP sold stock to the public at a price of $24 a share, raising a total of $225 million, money that bolstered Enron’s 1994 earnings. Of course, in substance, Enron absolutely controlled EPP, which the EPP offering document flatly stated. That same document also said that the relationship with Enron “may result in conflicts of interest” when EPP and Enron’s interests diverged. Indeed, it did. Not only was Kinder the chairman of EPP; its CEO was Rod Gray, a managing director of Enron. After the public offering, Gray’s stake in Enron continued to be larger than his stake in EPP, and Enron continued to pay part of his salary. (The rationale was this was a good thing because Gray would have an inside scoop on the assets.) The CFO was Jim Alexander, who had been one of Enron’s investment bankers at Drexel Burnham.

  But EPP didn’t work out as planned, partly because certain projects weren’t completed and partly because Jim Alexander, who quickly became the fly in the ointment, complained that Enron was pressuring EPP to overpay for assets, particularly the troubled Dominican Republic power plant. Alexander even met with Lay to complain about the rampant conflicts. He also says he told Lay that there were problems with the accounting in Enron’s international business, including the compensation system and Enron’s practice of “snowballing” development expenses for projects that had ground to a halt. Lay said he’d have Kinder look into it and ushered Alexander out.

  Alexander also complained to other Enron executives. They, however, told Lay that he was overreacting and that the conflicts were being well monitored. They also felt Enron’s internal accounting issues were none of his business. Alexander worked for EPP, after all.

  Weeks later, EPP entered into a cost-sharing agreement with Enron, which meant, among other things, that EPP’s accountants now worked for Enron. Alexander left EPP as did several other EPP officials, all in the same week. Alexander says today: “They were people who couldn’t take no for an answer. They couldn’t even take no from reality.” Once Alexander departed, Enron sold a 50 percent interest in the troubled plant in the Dominican Republic to EPP.

  In August 1997, Enron announced that it would buy back EPP. Several former executives contend that the problem wasn’t that the gatekeeper didn’t work, but that it worked too well. EPP wasn’t paying enough for the assets it bought, and the process was viewed as more trouble than it was worth. There had to be a better way—and soon there was.

  Enron ultimately paid about $35 a share for EPP, which represented about a 14 percent annual return to EPP shareholders. It was a premium price, but Enron wanted Wall Street to think that its investments were stellar. But the buyback wasn’t Kinder’s doing; he was gone by then.

  • • •

  • • •

  There was one part of the business that Ken Lay always kept to himself: the care and feeding of Enron’s board of directors. Over time, most of the old board members he’d inherited from InterNorth had been replaced with people Lay handpicked. Charls Walker joined in 1985. So did Charles LeMaistre, the president of the famous Houston cancer hospital, M. D. Anderson. In 1993, Lay added Wendy Gramm, who had just finished a stint as chairman of the Commodities Futures Trading Commission (CFTC) and was married to Texas Senator Phil Gramm. (Several notables declined to join Enron’s board, including former commerce secretary Robert Mosbacher, one of Lay’s old Houston friends, who decided against it after asking some associates in the energy business about the wisdom of Enron’s strategy. And despite two separate invitations from Lay, Robert Rubin, Bill Clinton’s former treasury secretary and later the chairman of the Citigroup executive committee, also turned down a chance to sit on Enron’s board.)

  The board had its share of conflicts, all of which received withering scrutiny after Enron’s bankruptcy. Enron employed Walker’s lobbying firm. Just after Wendy Gramm stepped down from the CFTC, that agency approved an exemption that limited the regulatory s
crutiny of Enron’s energy-derivatives trading business, a process she had set in motion. (At the time, both Enron and Gramm denied any kind of mutual back-scratching.) Enron donated hundreds of thousands to the M. D. Anderson Cancer Center. It gave a $72,000-a-year consulting contract to Lord Wakeham. Several directors did business with Enron. And John Urquhart actually owned 0.1 percent of Enron Power’s phantom equity through a consulting arrangement he had with the international business. Enron bought him out in 1993 for over $1 million but also gave him a fresh batch of options on Enron stock. In 1994, for instance, he earned $596,354 consulting for Enron and reaped another $931,000 through his options.

  But Enron was hardly the only board in America rife with conflict, and in any case, the real problem with the board wasn’t merely the conflicts. It was that just about every member of the board seemed to believe that Ken Lay walked on water. The Great Man persona he presented to the world at large was also what the Enron directors saw. Walker later described Lay as a “unique individual”—“charitable work, leadership in the community, leadership in the Republican Party, a preacher’s son.” To their way of thinking, Ken Lay was the one indispensable person at Enron.

  The flavor of the board meetings only reinforced the notion that all was perfect at Enron. The day before the board met, the Enron jets would pick up the directors and fly them to Houston, where they would sometimes head to the Lays’ condominium for a cocktail party. The meetings themselves were clubby affairs, with soothing conversation and long dinners, “more like a family gathering than a board meeting,” recalls a former director. Enron executives would deliver what Walker recalls as “very, very well-rehearsed” presentations. (Indeed, throughout the years, few, including the accountants, ever hinted that anything fell short of perfection.) Lay would share his vision with the group. And the outcome was never in doubt. “Whatever Ken wanted them to okay, they did,” says a former executive. Which goes a long way toward explaining what happened next.

  Kinder had been operating under the belief that he would be elevated to CEO at the end of 1996. In the interim, though, Lay had begun to sour on his number two. He still believed that Kinder lacked the appropriate polish. He had hoped Kinder would “grow into the job,” he later told several Enron executives, but in Lay’s opinion that hadn’t happened. And of course Bill Clinton was headed toward a second term as president, which meant that Lay’s dream of becoming treasury secretary would have to wait at least four more years.

  In 1995, as Ron Burns was preparing to leave the company, Lay asked whether Kinder was the cause of his departure. Burns thought it was a strange question, and it made him wonder if Lay was looking for reasons to hold back Kinder. Then, in the fall of 1996, as the time approached for Kinder to take over as CEO, Lay went to at least one other top executive and said that he planned to tell the board the executive wouldn’t support Kinder—and he wanted to be sure this person would back Lay up if asked.

  Finally, there was this: in the fall of 1996, Lay heard that Kinder, who had recently divorced his University of Missouri college sweetheart, was romantically involved with Nancy McNeil, Lay’s trusted assistant (and by then an Enron vice president) who had also recently been divorced. Lay was dismayed, to say the least: he grilled another Enron executive about whether the relationship had been going on before their respective marriages had broken up. And he was furious that his number two had a pipeline into his office. “I’ve lost Nancy’s loyalty,” he declared.

  Whatever lingering relationship Kinder and Lay still had pretty much dissolved with this discovery. Lay was voicing moral outrage; never mind that he’d had an affair with his own secretary or that both Kinder and McNeil denied persistent rumors that their relationship had begun before both were divorced.

  The climactic board meeting—the one in which Kinder expected to be promoted—was held in New York in mid-November. Early on the morning of the meeting, one of the directors saw Kinder arrive at the hotel accompanied by McNeil. During the meeting, as the board discussed Kinder’s qualifications to be CEO, the romance was brought up. According to Walker, two of the directors said that they couldn’t support Kinder: he lacked Lay’s character. (When asked why Kinder’s affair was different from Lay’s, one director says: “Some people would make the point that it was his own secretary, versus the boss’s secretary.”) After the meeting, Lay told Kinder that he had asked the board to promote Kinder to CEO but that the directors had refused to accept his recommendation.

  Here’s a telling comment on the way Lay was perceived in the upper ranks of Enron: very few of the company’s senior executives believed him. People at the top of Enron believed that Lay was hiding behind the board because he didn’t want Kinder to be CEO but lacked the guts to tell him so directly. As one executive put it, “Any time there was a tough issue, Ken would blame it on the board.” Certainly that’s what Kinder believed. After getting the news, Kinder angrily told one senior executive: “Ken fucked me! He fucked me. He’s blaming it on the board. That’s bullshit!”

  On Tuesday, November 26, 1996, Enron announced that Lay had agreed to a new five-year term as chairman and CEO and that Kinder was leaving. Lay got a new contract guaranteeing him a base salary of $990,000 in 1996, rising to $1.2 million the next year. And even though Enron’s earnings only grew 11.6 percent that year, the failure to hit the 15 percent earnings target didn’t cost Lay. The board simply amended the compensation provision to include “at least double-digit earnings per share growth annually,” instead of 15 percent. In addition, Lay got a new grant of 1,275,000 options. There was again a provision that would enable Lay to cash them in quickly. But this time, it wasn’t tied to earnings: Enron’s stock simply had to outperform the S&P 500. Those options alone would later be worth as much as $90 million.

  In typical Enron fashion, Kinder was well taken care of, too. He got $2.5 million in cash, and forgiveness of an outstanding loan of almost $4 million. He also took $109,472 in unused vacation pay. Despite the earnings failure, most of his options vested, too. Kinder quickly sold over 1 million shares of Enron stock, worth $40 million.

  On his way out the door, Kinder took one other thing, the most important of all. He cut a deal to buy Enron’s interest in something called Enron Liquids Pipeline for about $40 million in cash. There was no fairness-opinion done, and Enron sought no competing bids (though it had had the stake on the block for some time). “He knew that system [the liquids pipeline] better than anybody else and he cut one hell of a deal when he left,” says a former executive.

  That he did. Within a matter of months Kinder had joined up with his old University of Missouri classmate Bill Morgan to form a company called Kinder Morgan. The assets he bought from Enron were the foundation of the company; they included interests in two natural-gas liquids pipelines, one carbon dioxide pipeline and a rail-to-barge coal-transfer terminal. They were the sorts of assets Enron didn’t put much value in anymore, but Kinder, says one friend, “always loved those assets.”

  By early 1998, Kinder Morgan had a market value of over $1 billion. Since 2001 Kinder has been on Forbes’s list of the 400 richest in America. By mid-2003, Kinder Morgan’s stock was worth over $7 billion. Nancy McNeil left Enron around the same time Kinder did; the two soon married. Their philanthrophic activities soon rivaled those of Ken and Linda Lay; for instance, the Kinders gave $3 million to the DePelchin Children’s Center. To this day, Kinder refuses to allow Kinder Morgan to own a corporate jet; though he leases a hundred hours of airtime on a private jet each year, he pays for it out of his own pocket.

  For his part, Lay told the senior staff that he was not planning to replace Kinder, and the company announced that starting on January 1, 1997, Lay would assume Kinder’s old title of president while continuing as CEO and chairman of the board.

  One former board member says that “it was one of the saddest days for Enron when Rich Kinder left.” And that director wasn’t the only one who felt that way. Though long gone from the company, John Wing still
held millions in Enron stock. When he learned that Kinder was leaving, he sold most of his shares.

  CHAPTER 8

  A Recipe for Disaster

  Early in December 1996, just days after Kinder’s resignation was announced, Ken Lay had lunch with Ron Burns in a private room at the River Oaks Country Club, Houston’s most exclusive enclave. After leaving Enron to become president of the Omaha-based Union Pacific Railroad, Burns endured a rocky stint that lasted only 15 months. He’d orchestrated a graceful exit when Union Pacific merged with another railroad. He had been out of work about a month when Lay invited him to Houston.

  “I’d love to have you back,” Lay told Burns, adding that if Burns were willing to return to Enron, Lay would restore the stock options and other benefits he’d forfeited; it would be as if he’d never left. Lay didn’t specify what job he had in mind for Burns, but that wasn’t unusual. Even after all these years, Lay still had a habit of hiring people he liked, then figuring out what to do with them later. Burns, for his part, told Lay that there was only one position he’d consider:

  Kinder’s old job. He also told him that if he became Enron’s president, his first order of business would be to rein in the company’s two warring superstars, Skilling and Mark. “If you’re willing to deal with them,” Burns told Lay, “I’ll talk.” Lay was noncommittal, and the negotiations went no further. But that evening, Burns bumped into some old friends from ECT at a Houston restaurant and over dinner and a few drinks casually mentioned that he’d met with Lay earlier in the day.

 

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