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

by Bethany McLean

  Fastow, you’ll recall, had long harbored the desire to set up a fund that could invest in Enron deals. But over the years, whenever he had broached the idea, he’d been shot down—and with good reason. A special fund open only to certain favored employees would surely be enormously divisive, and having the CFO himself running it would create an obvious conflict of interest. When Enron wanted to sell an asset to the fund, Fastow would be in the position of negotiating with himself.

  But by the late 1990s, Enron was making such frequent use of SPEs that finding the necessary outside equity investors was becoming nearly impossible. There were only so many trusted Friends of Enron, after all. So Fastow began promoting the idea of setting up a big standing private equity fund—a sort of permanent Friend of Enron—that would raise enough cash from institutional investors to provide the all-important 3 percent independent equity for dozens of Enron deals. This was an elegant solution, Fastow argued. It would avoid the messiness of having to find new investors every time. It would allow Enron to close deals faster than ever. It would even save money on banking fees. And, Fastow argued to Skilling, it wouldn’t distract from his regular duties at Enron.

  By August 1998—just five months after becoming CFO—Fastow was actively exploring the idea with investment bankers at Merrill Lynch. Enron’s key Merrill contact was a Houston investment banker named Schuyler Tilney, whose wife Beth was an Enron executive and a Ken Lay confidante; the Fastows and Tilneys were good friends. As Fastow initially presented the fund idea to the Merrill bankers, Enron would contribute half the equity, just as it had with JEDI, in the form of company stock. But unlike JEDI, where CalPERS was the only outside partner, this fund would solicit dozens of private investors, all of whom would be expected to contribute cash. Despite the Fastow-Tilney friendship, though, Merrill didn’t bite. In an e-mail report back to New York after the meeting, one Merrill banker wrote: “. . . we just listened to Andy and . . . we all—at least I did—got headaches trying to analyze an Enron stock contribution from an investor’s viewpoint and what kind of commitment it really was given that Enron can ‘manufacture’ stock—even Schuyler observed that we were probably asking investors to consider ‘an unnatural act.’ ”

  Fastow pushed ahead anyway. By May 1999, he was floating the idea with Enron’s accountants at Arthur Andersen. Even they thought it was a bad idea—though they kept this view to themselves. In a May 28 e-mail to colleagues, Benjamin Neuhausen, a member of the elite Professional Standards Group at Andersen, wrote: “Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view. Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme?”

  David Duncan, Andersen’s Enron relationship partner, expressed similar skepticism, writing back: “. . . on your point 1 (i.e. the whole thing is a bad idea), I really couldn’t agree more.” Duncan said that he would insist that the plan be approved by Enron’s CEO, general counsel, and board—and he expressed hope that would put an end to it. (“None of this communication has yet to occur and this thing could get killed when it does.”) It was clear, however, that Fastow wasn’t going to give up easily. Noted Duncan: “This thing is still very much in the brainstorming stage, but Andy wants to move through it very quickly to get all this done, if possible, this quarter. Andy is convinced that this is such a win-win that everyone will buy in. We’ll see.”

  Through Duncan, the accountants were setting in motion a game of dodging responsibility. They privately agreed the idea was terrible but were expecting Lay and Skilling—or, surely, the board—to kill it. For their part, the board and management would later point to Andersen’s silence in justifying their conclusion that Fastow’s scheme was perfectly okay.

  Fastow finally brought his idea to life by seizing an opportunity to prove just how handy such a fund could be. The occasion involved a $10 million investment Enron’s fledging broadband unit had made back in March 1998 in a tech start-up called Rhythms NetConnections, one of the first high-speed Internet providers. Enron had bought 5.4 million pre-IPO shares at $1.85 per share. On April 7, 1999, a year later, at the height of the Internet frenzy, Rhythms went public at $21 and promptly skyrocketed to $69 by the end of the day. By May, Enron’s $10 million investment was worth about $300 million.

  Skilling convened a meeting of ten Enron executives to discuss the dilemma this presented. As ever, Enron needed an earnings boost, so it wanted to book the entire gain right away. But if it did so, Skilling complained, Enron would get no credit in its stock price from Wall Street because it would be booking the windfall as a onetime gain. “We need to figure out how to make it a recurring item on our income statement,” he told the group.

  Then Skilling turned to the broader issue: even after Enron booked the Rhythms gain, it couldn’t just unload the stock. To get the pre-IPO shares, it had signed a lockup provision preventing it from selling until November. Who could say where the price would be in November? Skilling was eager to find a way to lock in the gain, to hedge against the very real possibility that Rhythms shares would drop sharply before the lockup expired, which, under mark-to-market accounting, would then require the company to book a loss.

  The meeting ended with everyone scratching his head; by conventional methods, what Skilling wanted to do was impossible. Buying some kind of traditional hedge, such as a put option—an obligation to buy the volatile Rhythms shares at a set price—from a legitimate third party would be prohibitively expensive. Besides, Rhythms was so thinly traded and Enron’s position so large—it controlled about half the shares available in the market—that it would be exceedingly difficult for any buyer to unload. No outside buyer would assume such enormous economic risk.

  Into the breach stepped Fastow, who let it be known that he was willing to create a new SPE to hedge the Rhythms position for Enron, but he needed to control it. Here’s how it would work: Fastow would start his first fund, LJM1 (also known as LJM Cayman), with $1 million of his own money. An additional $15 million would be contributed by two big outside investors. LJM1 would then set up a subsidiary, called LJM Swap Sub. Swap Sub would sell a put option on the entire Rhythms stake to Enron, giving Enron the right to force Swap Sub to buy the Rhythms stock from Enron in June 2004 at $56 a share. To compensate Fastow and his partners for taking this extraordinary risk, Enron would arrange the transfer of 3.4 million shares of its own stock, worth about $276 million, to LJM, which then moved almost half the holding (as well as several million dollars in cash) into Swap Sub. LJM also gave Enron notes for $64 million, which helped Enron by adding to its reported cash flow.

  In essence, Enron was using the value of its own stock to buy the hedge. This meant that it wasn’t truly hedging its risk at all. If Rhythms fell, the only way it could pay off the hedge was by using Enron stock. But if the shares dropped, Swap Sub would have no way of making good on its obligation to Enron. Like so many of Enron’s questionable transactions, the Rhythms deals was rooted in the fundamental belief that Enron stock would never fall. The entire arrangement was an accounting artifice, protecting Enron from having to book an accounting loss but doing nothing to protect it from an actual economic loss.

  Fastow and Kopper, in fact, were quite proud of the structure they’d created for the Rhythms hedge, so much so that they later tried to sell the concept to at least one other Houston energy company, El Paso. They thought El Paso might want to do a deal with LJM. After listening to the two men explain the complex structure, the El Paso executive, a former investment banker himself, scratched his head. The accountants would never approve it, he said.

  Sure they will, Fastow and Kopper told him. “We can get you an opinion letter.”

  “How do you determine valuation?” he asked.

  Fastow and Kopper grinned. “It’s whatever you want it to be,” one of them replied.

  • • •

  In early June, as Fastow was hatching this scheme, Rick Buy phoned Vince Kaminski, head of E
nron’s Research Group, for help in pricing the Rhythms options. Kaminski’s 50-member group was part of RAC, a team of high-powered quant jocks who built Enron’s complex derivatives-pricing models. The Polish-born Kaminski was a former Salomon Brothers vice president with an MBA and a doctorate in mathematical economics who read daily newspapers in five different languages. He was universally respected for his raw brainpower—at Enron, no small compliment—and equally renowned for his bluntness.

  Buy was calling Kaminski with Jeff Skilling in his office. The chief risk officer was vague about what was really up, but Skilling told Kaminski the project was urgent. A short while later, Skilling appeared in Kaminski’s office—an exceedingly rare event—to try to explain the transaction. When Kaminski later presented the problem to members of his group, everyone in the room laughed; that kind of put option, they all knew, would be impossible to buy on Wall Street. Still, they did what they were told and came up with a price.

  The next day, Kaminski told Buy that his group had produced a number but that he viewed the idea of transferring Enron shares to an outside partnership as foolish. In fact, Kaminski declared, “This is so stupid that only Andrew Fastow could have come up with it.” That’s when Buy told him that Fastow had come up with the idea—and that the CFO was planning to run the partnership himself. Now Kaminski was even more certain the idea was stupid. What about the conflict of interest? After hearing more about the structure, Kaminski returned the following week with more arguments. The hedge simply wouldn’t work. And the payout cheated Enron shareholders in favor of Fastow, Kaminski said; it’s “heads the partnership wins, tails Enron loses.” After all, Enron was funding the hedge almost entirely with its own shares, giving LJM virtually no exposure. Buy listened with his usual sense of grim anxiety, then told Kaminski he would try to stop the deal. “The next time Fastow is going to run a racket,” the Enron risk officer nervously joked, “I want to be part of it.”

  At 10 A.M. on the morning of Friday, June 18, Skilling and Fastow walked over to Ken Lay’s office for a discussion of the deal that would give birth to LJM. Fastow’s role in the new private partnership would require an exemption from Enron’s code of ethics, which barred employees from profiting from any company that did business with Enron but allowed the CEO to waive the provision if the arrangement “does not adversely affect the best interests of the Company.” Lay agreed to grant the waiver but wanted the board of directors to ratify his decision.

  Ten days later, LJM was brought before a special meeting of the Enron directors; most participated by phone. As Fastow explained it, his personal involvement in the new partnership was an act of altruism, an unfortunate but necessary ingredient to attract outside investors to LJM and essential to Enron’s goal of hedging the Rhythms investment. Fastow insisted that LJM would provide the hedge “at no cost to Enron.” And in materials that had been sent to the directors, he insisted that, even though he would serve as LJM’s general partner, he would personally receive “no current or future (appreciated) value” from the Enron stock it held; if Enron’s shares continued to rise, those gains would all go to his limited partners.

  Fastow did note, however, that he would receive a $500,000 annual management fee plus more than half the returns on any other assets in LJM. Fastow also told the board that PricewaterhouseCoopers would be issuing a fairness opinion affirming that the deal was fair to Enron. (Fastow neglected to mention that the firm was also being paid by LJM to work on the deal.) With nary a dissenting vote—or even any discussion of how to monitor the conflict—the directors passed a resolution exempting Enron’s CFO from the company’s code of ethics. Even with several other items on the agenda, the meeting was over in just an hour.

  Neither David Duncan, Enron’s auditor, nor Rick Buy made any attempt to get in the way, despite their muttered complaints to outraged colleagues. Buy later told Vince Kaminski the project had too much momentum for him to stop it. And in fact, Fastow had clearly viewed the board approval as a mere formality. He had teed up the entire transaction before the board even met—and closed it two days after the vote.

  As for Kaminski, in the aftermath of his objections to LJM’s first deal, his entire group was removed from RAC and placed in Enron North America, where it was no longer in a position to stand in the way of anything Andy Fastow wanted to do.

  • • •

  As it turns out, the finances of LJM1 and Swap Sub soon moved in Fastow’s favor. The increase in Enron’s shares meant that Fastow’s new partnership was sitting in a sizable gain.

  Fastow’s happy limited partners were two of his Tier 1 banks: Credit Suisse First Boston, which had invested through an entity established in the Cayman Islands named ERNB (the initials stood for Enron’s Rhythms Net Bet), and Greenwich NatWest, a British bank that had named its Cayman Islands subsidiary Campsie Limited. Each had sunk $7.5 million into the venture—and as the size of the gain became clear, Fastow agreed to a series of complex transactions that guaranteed each a profit of more than $20 million.

  NatWest was represented by a colorful trio of United States-based Brits from the structured-finance department: Gary Mulgrew, Giles Darby, and David Bermingham. The three men’s exploits had been chronicled in a British novel by a former colleague named Robert Kelsey, The Pursuit of Happiness: Overpaid, Oversexed and Over There, that told how they courted an especially aggressive Houston energy giant named Hardon. In the book, the bankers schmoozed the company’s officials “and made sure they got what they wanted. And what they wanted was usually a round of golf, a nice dinner, and a visit to a local strip club.”

  In late 1999, as the NatWest bankers were working up proposals to extract the bank’s profits from LJM, they began turning their attention to Swap Sub as well, allegedly with an eye toward lining their own pockets. Detailed federal court filings, including lengthy e-mail excerpts, offer a vivid account of what government prosecutors later charged was an elaborate fraud.

  For months, the limited partners had officially written off their stake in the Swap Sub as worthless; that’s because they assumed that after it had paid off the put option, there would be nothing left in the entity. But Enron’s stock had risen so fast that it covered the put option with millions left over, and no one at the bank seemed to have noticed. In late January, Bermingham e-mailed his NatWest colleague Darby that he had been studying the bank’s stake in Swap Sub and realized that “there is quite some value there now. The trick will be in capturing it. I have a couple of ideas but it may be good if I don’t share them with anyone until we know our fate!!!” The three men had reason to be worried about their future: two bigger banks were in a bidding war to gobble up NatWest’s parent.

  By February 19, the government charges, the three were at work on a PowerPoint presentation for a meeting with Fastow where they would present ideas on how they could restructure Swap Sub—and split the spoils. “For your info,” Bermingham e-mailed Darby and Mulgrew, “our minimum profit per these slides would be $8m, rising to $17m for the middle bit, and then finally up to around $30m. Everybody wins.” The following day, Bermingham wrote Mulgrew that they would do well to assure Fastow a hefty payout. “If I knew there was a realistic way to ‘lock in’ the $40m and give him $25m, we would also jump all over it I guess, since it would give us $15m. . . . I will be the first to be delighted if he has found a way to lock it in and steal a large portion himself.” Bermingham added: “We should be able to appeal to his greed.”

  The three men were soon covering their tracks with their colleagues. Responding to a query from another NatWest banker, Bermingham claimed that he and his two colleagues were traveling to Houston to do a deal and their boss was “in the loop” but that he should “not speak to anyone” about the matter and “just act dumb please.” Then he wrote his coconspirators: “This is an attempt to head the obvious off at the pass and keep the lid on the thing. Large numbers of people are asking what we are up to. I hate lies.”

  On February 22, the three British banke
rs arrived in Houston. Fastow had scheduled plenty of time for them: a leisurely dinner that evening and four more hours the next day. According to the government, the bankers sat down with the Enron CFO and offered a slide presentation laying out several illicit scenarios. One involved selling Swap Sub’s Enron shares for cash, then buying them back a few days later (presumably to get around the prohibition on Fastow’s profiting from the Enron stock). But that wouldn’t work, the bankers’ slide presentation noted: “Problem is that it is too obvious (to both Enron and LPs) what is happening (ie, robbery of LPs), so probably not attractive.”

  By the time the bankers left Houston on February 24, they had allegedly come up with a plan. Working hand in glove, Fastow, Kopper, and the trio from NatWest would orchestrate the bank’s sale of its valuable interest in Swap Sub for a relative pittance, then secretly transfer most of the stake to themselves and split millions. When he got back to New York, Mulgrew told his boss, according to the government, that Fastow had informed him that Enron was willing to pay NatWest $1 million for its Swap Sub stake. Mulgrew added that this sum was all the stake was worth and urged his boss to accept the modest return. Mulgrew got the go-ahead.

  Over the next two months, the government charges, Fastow, Kopper, and their bank collaborators operated on two levels: openly generating the paperwork and winning the approvals needed to complete the official transactions with their respective employers and simultaneously carrying out the covert maneuvers needed to divert the deal’s riches to themselves.

  A key part of the machinations was ensuring that Enron would unwind Swap Sub on generous terms. Fastow took care of that. By spring, Enron was ready to liquidate its position. The lockup had expired; the Rhythms shares had started to fall (the company was heading toward bankruptcy). It took Enron several months to unload its Rhythms position.

  But the Enron shares held by Swap Sub had soared to $70, up from $56. Fastow proposed to Causey that Enron pay Swap Sub $30 million for the return of the remaining shares. Mike DeVille, an Enron finance executive who worked for Causey, thought Fastow’s partnership was “making a killing.” Investigators also later concluded that Enron substantially overpaid in the deal. Neither Rick Buy’s RAC nor any outside accountants reviewed the terms. Fastow told Causey the $30 million was going to the limited partners: $10 million to CSFB and $20 million to NatWest. In fact, while CSFB was indeed getting $10 million, NatWest’s share was only $1 million.