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

by Bethany McLean

  Only a few months after Enron booked this gain from selling part of EES, the company finally threw in the towel on its residential energy campaign. Lay and Skilling acted partly on the recommendation of a newly hired consumer-marketing expert named Jim Badum, a veteran of Pepsi and Taco Bell. Just three months after coming to Enron, Badum, with Pai in agreement, told them that the company “needed to slow things down.” States simply weren’t deregulating fast enough, and Enron was spending so much on landing customers that none of the early ventures had a prayer of turning a profit. “They wanted to go into the markets and hope the markets would get better,” says Badum. “We said, ‘Maybe it’s time to take a wait-and-see approach in these states.’ ” Lay, who had relished his role as populist crusader, seemed crushed. “This is the last thing I expected from this meeting,” he said, pushing his chair back from the table. Says Badum, “When it came to the simple realities of the consumer business, Enron simply didn’t get it.”

  Reluctantly, Enron stopped signing up new residential accounts in California and returned its hard-won customers back to the hands of the “monopolist” utilities in most of the states with pilot deregulation programs. And it returned its customers—all 300 of them—in Peterborough, New Hampshire, too.

  • • •

  Not that Enron was about to back away from EES—how could it, after Skilling and Lay had touted it to Wall Street and the company had sold a piece of the division to some highly reputable investors? No, Enron would just have to shift strategies, that’s all. Instead of targeting homes, it would target businesses, from hospitals to fast-food chains to big corporations with scores of office sites around the country. And instead of just selling them power, it would subcontract to take care of all of their energy needs.

  Can you see how this would be an alluring notion for a big company that spends tens of million of dollars each year to light, heat, and cool its offices?

  Just as consultants had cropped up to handle the complicated computer needs of large corporations, saving them money in the process, Enron was promising to do the same with energy. Its ability to lock in prices on the trading floor would eliminate the worry that volatile energy costs would blow a hole in a company’s budget.

  In addition, Enron was promising to use its energy know-how to make efficiency improvements that would save even more money. “That was the pitch,” recalls an early EES executive: “ ‘You go focus on building your widget, and we’ll worry about the energy side of the business. We’re the energy experts.’ ” Depending on the size and term of the contract—some ran as long as 15 years—EES was promising savings of anywhere from 5 percent to 15 percent.

  The more perplexing question is why this would be an alluring idea for Enron. The commodity part of this new business—providing electricity and gas at a discount to customers—was often a money-loser at the retail level because most states were still refusing to deregulate retail energy. That meant the only way Enron could cut the cost of energy for a customer was to buy electricity from a local utility and resell it at a loss.

  Amazingly, Enron was willing to do this because it remained convinced—despite much evidence to the contrary—that the states would soon open up their markets and the company would begin making money at the tail end of long-term contracts. When it started its retail push, back in 1996, Enron had forecast that half the U.S. retail markets would be open by 2001. Then by early 2000, it pushed back its projection of hitting that mark to 2004. In fact, by 2001 only a quarter of the U.S. power market had opened up and the deregulation effort had ground to a standstill.

  What’s more, this new thrust by EES was taking Enron somewhere it didn’t belong. A business like the one EES was launching requires attention to detail, devotion to customer service, and a willingness to understand—and care about—the nitty-gritty of a company’s energy issues. Enron was promising, for instance, to make energy-efficiency improvements, many of which would require big up-front expenditures. But what did Enron executives know about energy efficiency? Nothing. Enron was promising to run the cooling and heating systems, hire the energy-maintenance staff, change the lightbulbs, and pay the bills. Enron had never shown that it could manage that sort of operation.

  Pricing energy costs for customers was especially tricky. In a typical long-term EES deal with a large corporation, Enron had to establish models with multiyear tariff curves—predictions about how dozens of factors would affect electric rates—for every utility in every locale the customer had a business site. In just one of its contracts, Enron was required to manage 252 properties in 36 states. “It’s like duplicating the rate department for every single utility in the country and having to do it on the fly and keep it updated,” says an electrical engineer who worked on the EES tariff-risk desk.

  One thing Enron was good at quickly came into play, though: cutting deals. EES started out signing pure commodity contracts—selling gas or electricity to companies. When it became clear these weren’t going to generate big profits, EES started bundling the sale of power and gas with energy-management services, in what it called total energy outsource contracts. Offering big custom-

  ers millions in guaranteed savings, EES began rapidly signing up high-profile clients.

  The University of California and California State University systems signed up for four years to let Enron provide electricity and efficiency projects for their 31 campuses. (Enron had promised to provide them electricity at 5 percent below the utilities’ rate, saving a projected $16 million.) Lockheed Martin struck a four-year deal for electricity and energy infrastructure. The San Francisco Giants signed a ten-year commodity contract “totaling $60 million” for their new ballpark; Ocean Spray, a $116 million ten-year agreement; Owens Corning, a ten-year contract said to be worth $1 billion; the Simon Property Group signed up for a ten-year $1.5 billion “alliance” to manage energy needs for its malls. Chase Manhattan Bank and IBM each signed ten-year contracts. Tom White won EES the first contract for privatization of utility management at a U.S. military base. Enron even claimed the blessing of the Roman Catholic Church: a seven-year energy deal with the Archdiocese of Chicago. In 1998, Enron announced, EES had signed contracts with a total “value” of $3.8 billion. By the end of 1999, the company had signed up so many new customers that the “total contract value,” according to Enron, was a stunning $8.5 billion.

  It’s important to note, however, that this “total contract value”—the phrase Enron was using to keep score—bore no relation to either revenues or profits. The term merely represented Enron’s calculation of the cost of all the energy and infrastructure needs a customer had outsourced to EES over the life of the contract. If Enron agreed to supply $500 million worth of electricity to a large corporation over a ten-year period, that $500 million was included as part of the total value of the contract, even if Enron was likely to lose money on the sale. But the number was still useful to the company: it was a way to show growth and to dazzle Wall Street.

  In fact, this new metric had been cooked up for that very purpose. In September 1997, a high-level EES executive named Dan Leff sent out a memo proposing that Enron adopt a new term he called TCEE—total customer energy expenditure. “The overall objective of creating and deploying TCEE is to communicate, in a simple manner, the size, growth and success of EES to investment analysts, the investment community, shareholders, employees, and customers. We will endeavor to create a new index . . . where Enron is number one out of the box, as the metric is announced.” Leff proposed refining the metric for formal presentation to Skilling two weeks later. By the time it was unveiled, TCEE had been changed to TCV: Total Contract Value. Just as the new dot-coms had such uneconomic measures as “eyeballs” and “hits,” Enron now had TCV. Enron used the term so freely—in press releases, earnings announcements, and annual reports—that it made some of the company’s accountants nervous. “It was a PR message embedded in a financial disclosure,” says one former divisional EES accountant. “That even made Rick Ca
usey cringe.” It served the same purpose as the dot-com metrics: it gave Wall Street something to focus on besides profits.

  For most of 1998 and 1999, EES was still reporting losses: $119 million in pretax losses in 1998, another $68 million in 1999. Skilling, as ever, raised the bar. He’d promised the Street that the division would go “earnings-positive” by the end of 1999. Sure enough, in the fourth quarter, Enron announced a $7 million profit, and management promptly declared victory. “In 1999, we proved that Enron’s retail business works,” Lay and Skilling declared to shareholders in Enron’s annual report, written in early 2000. “Enron Energy Services achieved positive earnings in the fourth quarter, and its profitability is expanding rapidly.”

  Swallowing Enron’s story, Wall Street analysts declared victory, too. Goldman Sachs’s David Fleischer gushed: “Enron has redefined the worldwide energy marketplace with its vision for both the wholesale and retail markets.” In April, Credit Suisse First Boston’s Curt Launer calculated that EES alone was worth a staggering $19 billion, about $24 per Enron share. Four months later, he raised his valuation target on EES alone to $30 per share.

  • • •

  Back in January 1998, at a time when Skilling was intent on convincing Wall Street that EES was taking off, Enron invited the analysts who covered the company to Houston for an annual meeting with the company’s top executives. As part of the event, Enron officials gave the analysts a tour of the company’s operations, including EES. The group was escorted to the sixth floor of Enron headquarters, where they were shown what was described as the EES war room.

  There, they beheld the very picture of a sophisticated, booming business: a big open room, bustling with people, all busily working the telephones and hunched over computer terminals, seemingly cutting deals and trading energy. Giant plasma screens displayed electronic maps, which could show the sites of EES’s many contracts and prospects. Commodity prices danced across an electronic ticker. “It was impressive,” recalls analyst John Olson, who, at the time, covered the company for Merrill Lynch. “It was a veritable beehive of activity.”

  It was also a veritable sham. The war room had been rapidly fitted out explicitly to impress the analysts. Though EES was then just gearing up, Skilling and Pai had staged it all to convince their visitors that things were already hopping. On the day the analysts arrived, the room was filled with Enron employees. Many of them, though, didn’t even work on the sixth floor. They were secretaries, EES staff from other locations, and non-EES employees who had been drafted for the occasion and coached on the importance of appearing busy. One, an administrative assistant named Kim Garcia, recalls being told to bring her personal photos to make it look as if she actually worked at the desk where she was sitting; she spent most of the time talking to her girlfriends on the phone. After getting the all-clear signal, Garcia packed up her belongings and returned to her real desk on the ninth floor. The analysts had no clue they’d been hoodwinked.

  Just as Enron’s financial executives convinced themselves that their financial shenanigans stayed within the rules, it seemed, so EES executives reasoned that this deception wasn’t a problem. Eventually, EES really would use all that space. Eventually, there would be hundreds of busy employees working the phones and trading energy and the division would be every bit as fabulous as they were telling investors. It just wasn’t quite there yet. In many ways, Skilling’s little Potemkin Village stood as the perfect metaphor for EES: so much of what outsiders were led to believe about the operation was at odds with what was really going on. Listening to Skilling and Pai describe it, EES sounded like a business that made sense; that’s one reason all the analysts were so willing to buy in. But it never made sense for Enron.

  For instance: if you tell all your highly aggressive deal makers that the only thing that matters is total contract value and add to that horrible controls and an extreme urgency to get deals done quickly and a compensation system based on the projected profitability of long-term deals, you’re inevitably going to get an awful lot of bad contracts. That’s precisely what Enron did.

  Despite Skilling’s oft-stated horror at the way Rebecca Mark’s international deal makers were paid, he instituted virtually the same system at EES. The EES originators—they eventually totaled 170—got huge bonuses not on the basis of how a deal worked out over time but on how profitable it appeared on the day the contract was signed. Margaret Ceconi, a 40-year-old former GE Capital manager who joined the EES origination staff in November 2000, says headhunters were recruiting former bankers for EES sales jobs with the prospect of making $1 million or more a year.

  With that kind of incentive, EES executives used all the standard Enron tricks to make their deals look better than they were. Even though state-by-state deregulation was largely stalled, they priced contracts as if it were inevitable, thus making losing deals appear to be winners. They signed 15-year contracts that even they acknowledged would lose money for the first ten years—but included a wildly optimistic price curve that showed steep profits at the end, making up for all the losses. (Tilting the curves, this practice was called.) They underestimated the cost of and overestimated the savings from efficiency improvements. They stomped all over Rick Buy’s risk assessors.

  To make life easier for the sales force and give himself more opportunity to wheel and deal, Pai also insisted that his division have its own trading and risk-

  management staff. Shockingly, Pai’s team was allowed to establish pricing curves that were different from the ones used by the wholesale traders. In other words, dif-

  ferent parts of Enron were making different long-term pricing assumptions, then booking millions in mark-to-market profits based on those different guesses.

  Knowing how critical it was to land big-name companies that would lend credibility to EES, Enron cut some deals that looked like losers on the day the contracts were signed. Pai was perfectly fine with this state of affairs; he even encouraged it. Signing big deals fast was what counted. If any contracts turned out to be stinkers, he told his staff blithely, they could simply restructure and sell a longer-term deal later on. “We’ll just blend and extend,” is how he used to put it. One EES executive says the business’s early mantra was: “After all the marquee names, we’ll get the profitable ones.”

  EES even paid companies to sign contracts—in one case, $50 million. “We bought the business,” says an EES vice president. “It was easy to get people to do deals, if you pay them up front.” In many cases, this was structured as a prepayment on part of the savings expected over the life of the contract. Owens Corning got a $2 million promotional payment from Enron, in exchange for permission to use its brand and even its trademark Pink Panther in EES marketing materials. Enron paid Simon Property Group millions to lease its existing energy equipment. To sweeten the deal with Simon even more, Enron also agreed to provide a $4 million “equity infusion.”

  Even after it started reporting quarterly accounting profits, EES was hemorrhaging cash. After all, its operating expenses were huge, many of its deals wouldn’t make a dime for years, and it was writing multimillion-dollar checks to win contracts. Then there was the matter of making energy improvements, a huge capital expense, which included such big-ticket items as replacing chilling systems and boilers. Enron was supposed to make the money back over the life of its contracts by sharing in the savings from cutting customers’ consumption of energy.

  But it soon became apparent that many of the improvements wouldn’t pay for themselves or couldn’t be done on the rapid timetable the company had promised. Starwood, the large hotel chain, had been promised $42 million in efficiency improvements, says Ceconi. When it became clear that the spending wouldn’t pay off, Enron balked at moving forward.

  EES even pitched its deals as offering opportunities for earnings management. Tyco’s contract, for example, guaranteed 15 percent annual energy savings and provided the company “with ability to monetize,” according to an EES document; this meant Tyco had th
e option of asking for the savings in an up-front payment. The Owens Corning deal even involved an off-balance-sheet partnership. To cook up such deals for retail, Andy Fastow formed an EES Structured Finance Group.

  Ken Lay himself helped EES rope in prominent corporations. His calendar is dotted with meetings and phone calls with top executives of other companies, opening doors for the division: Larry Bossidy of Allied Signal in December 1998; Tyco’s Dennis Koslowski in May 1999; Owens Corning in July 2000. With Lay’s help, EES struck a big deal with Compaq, where he served on the board. Whenever the EES deal makers had trouble getting in to make their pitch to a prospect, they would call on Lay. “Ken can get us in,” Pai would say.

  As ever at Enron, there was always another powerful incentive for getting deals done quickly and making them appear profitable. EES needed to feed the Wall Street beast. Internally, company executives were explicit about this. A document detailing EES’s 1999 business plan, prepared that February, included this reference to Skilling’s public vow that the division would turn a profit in the fourth quarter: “Q4 EBIT Positive is Nonnegotiable.” The document added, “We have a gap—and it must be filled. . . . We must change the way we operate—NOW.”

  Sure enough, the division’s deal makers began racing to get contracts signed so that they could make the quarter. The haste caused bad deals to become that much worse, as Enron’s originators gave up negotiating points to sign contracts and as they played with the price curves and other assumptions to disguise reality. They also used those price curves and assumptions to book mark-to-market profits based on the life of the contract.