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

by Bethany McLean

  Unlike other Enron problems, though, this one wasn’t buried. Mark’s humiliation played out in full public view, as a kind of reverse story line to the Enron tale, served up by the business press as a stark contrast to Skilling’s string of seeming successes. “Their respective fates stand as testimony to the effectiveness of their competing business strategies,” declared Rebecca Smith and Aaron Lucchetti in the Wall Street Journal. Skilling himself seemed practically gleeful when Azurix failed, even though he served on Azurix’s board. In a videotaped interview he gave for a case study at the University of Virginia, he said, “Azurix was in some ways—and this is going to sound terrible—probably good, because it resolved the discussion. It was absolutely clear it was not the direction to go.”

  Many people at both Azurix and Enron came to the dark view that Mark had been set up by Skilling. “He wanted to give her some rope to hang herself,” says a former senior RAC official. “His objective was to see her fail,” adds another high-ranking executive. Mark herself later complained that she’d been abandoned by Enron and hung out to dry. But Mark also avoided seeing what was clear to everyone else: that she had mismanaged Azurix terribly, turning a difficult situation into an impossible one. Skilling’s failings as a businessman and a manager remained hidden for another year. With Azurix, Mark’s failings were on vivid display, for anyone to see.

  • • •

  Rebecca Mark later told friends that she almost backed out of Azurix several times before it got off the ground. It bothered her that there had been two dissenting votes on the Enron board for the Wessex acquisition; it made her wonder how committed the board really was to her new business. It bothered her even more when she heard Lay announce that Enron would not give Azurix any additional capital after it completed the Wessex deal.

  In fact, Mark’s longtime deputy, Joe Sutton, who took over at Enron International after she’d left, advised her against launching Azurix. At Enron, he told her, there was “no goodwill” toward her new venture. But she pushed aside the doubts and forged ahead with the kind of single-minded determination that had always characterized her. The global water business, she told herself, played to her strengths. With the capital it was committing to the Wessex acquisition, Enron had too much skin in the game, she believed, to abandon Azurix. Besides, it wasn’t in her nature to walk away from a challenge.

  What was it that made Rebecca Mark—and, for that matter, the executives who signed up with her—believe that they could build a water company from scratch? And not just any water company but, as she put it early on, “the global leader in the water industry.” A lot of it was hubris, the same kind of hubris that preceded every new Enron venture. Neither Mark nor Enron had any experience in the water business nor any real sense of how it worked. They also thought they saw a huge opportunity. Water was a big business, with some $300 billion in global revenues. But it was veering toward crisis, and they believed that Azurix could both profit from the crisis and help alleviate it. The World Bank estimated that a billion people around the globe had poor access to clean drinking water and three billion lacked sanitary sewage facilities; there were predictions that shortages would become increasingly common. Both water and wastewater treatment facilities were often old and outmoded and badly needed to be upgraded or replaced. Mark and her team cited studies that suggested that $600 billion would need to be invested in global water and wastewater infrastructure in just the next decade, hundreds of billions in the United States alone.

  All around the globe, water utilities operated as small local businesses, usually run by municipal governments. A small chorus of experts were saying that the world’s water woes would not be solved until the industry was privatized because municipalities lacked the money and the expertise to provide solutions on their own. Mark quickly joined the chorus. “The only way to bring capital to solve the problem is to place it in private hands and increase accountability,” she told the trade publication Global Water Reporter in March 1999.

  The two biggest players in the industry, Vivendi and Suez Lyonnaise des Eaux, both French companies (France had privatized its water sector decades ago), made substantial amounts of money by operating municipal water systems for local governments. Surely, as privatization efforts around the world gained momentum, Mark and her team at Azurix would be able to grab a large chunk of the business.

  Her plan of action was not much more than a carbon copy of what she’d done at Enron International. She’d jet off to one continent or another, meet government officials, persuade them that privatization was the answer to their water troubles, and cut deals to buy water utilities, wastewater treatment facilities, the rights to operate a municipal system—whatever she could pry loose. Where would she get the capital to do all these deals, especially now that Enron wasn’t going to provide it? Her audacious plan was to acquire companies quickly and use their cash to build the business. She also assumed that Azurix would go public and that she could tap its stock, which she was sure would be high-flying, as currency to do even more deals. The key was to move fast—“in a time frame that would wow everybody,” as a former Azurix official later put it. Unfortunately, this person adds, “She picked an industry that is the antithesis of moving fast.”

  In fact, although privatization of the water business was on the horizon, it was already proving to be a slow, drawn-out affair. Privatizing municipal water systems cuts against the grain; for most people, water is a sacred entitlement, and there is an inherent resistance to the idea of having a private company profiting from selling people water. Water is also regulated at the local level, which makes the politics much different and much closer to the bone. “Unless you give it five years, it’s not going to work,” one former Azurix executive warned early on. But that kind of time horizon just wasn’t Enron’s style.

  Mark’s other miscalculation was underestimating the French. Vivendi and Suez had been in the business since the days of Napoleon III, who put the French water industry into private hands. What made Azurix think it could outsmart them? Why did Azurix executives believe that the industry giants would simply play dead and yield their territory to an arrogant newcomer? And what made Azurix think a municipality would choose it over a company with far more experience?

  None of these potential stumbling blocks deterred Azurix’s grand plans. Early in 1998, well before the Wessex purchase, Enron had thought about getting into the water business by putting together a venture with a fast-growing California company called USFilter, a provider of water equipment and services and the largest American company in the business. But when CEO Richard Heckmann met informally with Mark and other Enron executives, he was baffled by what he heard. Mark told him that Azurix, once it attained scale, would eventually be able to move water from one area to another; in essence, Azurix would make a market in water, just as Enron did in natural gas and electricity.

  “If they can do what they’re saying, then it really is a new economy and I don’t get it,” he said afterward. Mark, he thought, was either brilliant or crazy. He recalls thinking that “if Azurix is this far off base, then Enron has to be off base, too.” (In March 1999, Vivendi announced that it would buy USFilter for over $6 billion. Heckman says that at the party to celebrate the close of the deal, J. P. Morgan and Salomon Smith Barney—USFilter’s bankers—displayed a huge chart showing the company’s history. In the upper left-hand corner was a sinking ship. On the ship’s bow, it read “Enron.”)

  Does it need to be said that Mark and Enron also miscalculated the value of the Wessex purchase? Overpaying for acquisitions was practically an Enron trademark. Wessex was a heavily regulated, publicly traded utility. Though its stock had run up 20 percent over the previous year or so, Enron’s $2.4 billion offer, cobbled together by Mark and Cliff Baxter, still represented a 28 percent premium for Wessex’s investors.

  But the rich price wasn’t the real problem. While Wessex gave Mark her entrée into the water business, it just wasn’t a good vehicle around which to build
a fast-moving, fast-growing company with global water know-how. Though it was one of the most profitable utilities in the United Kingdom—Wessex made $232 million in operating profits on just $436 million in revenues the year before Enron bought it—government regulators were considering the imposition of rate cuts, which could dramatically reduce profits. Wessex was also supposed to provide Mark with the water expertise she lacked. But what did utility executives in the south of England really know about managing water systems in the third world? As it turned out, not much.

  There’s one more reason why Azurix was in trouble from the start, and it had to do with the way cash-strapped Enron had financed the $2.4 billion Wessex purchase. Enron did not use much of its own cash, nor did it use stock to buy Wessex. A chunk of the money—$800 million—came from new debt (which went on Azurix’s balance sheet, not Enron’s). Mostly, Enron relied on sleight of hand, cooking up a deal intended to create the appearance that Azurix would have no immediate—or even long-term—impact on Enron. Fastow and his Global Finance team created an off-balance-sheet vehicle called Marlin, similar to the Osprey/Whitewing off-balance-sheet partnership. In late 1998, Marlin sold over $1 billion of debt plus $125 million of equity certificates—basically, stock that paid a fixed return—to institutional investors. Marlin, in turn, used that money to buy a 50 percent stake in a new entity called Atlantic Water Trust. Enron, which contributed Azurix to the trust, owned the other 50 percent of Atlantic Water Trust, meaning that it owned 50 percent of Azurix. Then, some $900 million of the money Fastow had raised was paid back right back to Enron. The remainder went into a trust to help pay interest to the Marlin investors.

  Why would investors be willing to buy the Marlin debt? Because once again, Enron promised that if Azurix couldn’t pay it would make up the difference by issuing stock or buying back the debt itself. As was the case with Osprey, investors got extra protection: if Enron’s debt rating fell below investment grade and its stock fell below $37.84, the company would be obliged to pay off all the Marlin debt at once. Once again, even though Marlin was sold to investors as Enron’s responsibility, the rating agencies treated Marlin as off-balance-sheet debt, not as Enron’s obligation. Nor was there anything secretive about this transaction: it was disclosed in Azurix’s public documents. To CFO Magazine, Fastow even boasted about the innovative contingent equity structure he used to finance Azurix.

  Marlin had both near-term consequences and long-term repercussions. It created a Chinese box of debt—debt that resided neither on Azurix’s balance sheet nor on Enron’s but that one or the other nevertheless had to pay. Although Azurix (which soon had plenty of its own debt) was ostensibly independent, the Marlin investors were in the game to collect interest on what they saw as an Enron obligation. The fact that the money was going to Azurix was largely immaterial to them. Indeed, they cared so little about Azurix that even though they had the right to appoint half of Azurix’s board, they never bothered; all of the outside directors on Azurix’s board were Enron appointees, including Ken Lay, Jeff Skilling, and Pug Winokur.

  Yet to a surprising degree, Enron wasn’t all that invested in Azurix’s success, either. The company had taken so much money out already—in addition to the $900 million in Marlin money, two executives say that Enron also kept $330 million it reaped from the sale of one of Wessex’s assets—that it fooled itself into thinking that even if Azurix failed, it would have no appreciable effect on Enron. This turned out to be a terrible miscalculation.

  Given these facts, though, is it any wonder that some people came to believe that the entire expensive episode had all been a grand conspiracy to do Mark in? Her new company was barely off the ground, and Enron had already sucked out over $1 billion in cash while loading it up with debt. Instead of being freed from Enron, Rebecca Mark remained tethered to it. And instead of getting away from Jeff Skilling, she now had to deal with him on the Azurix board.

  • • •

  On the other hand, Mark took a bad situation and made it worse at every turn. For instance: you would think that a company that didn’t have a great deal of cash would hoard what it had. But most of Mark’s business career had been at Enron, where the mantra had always been “spend today.” Like Enron, Azurix was a high-cost operation. (One executive recalls meeting with Lay while deciding whether to accept an offer to work at Azurix. “I’ve decided that budgets and management oversight is the wrong way to go,” Lay told this person. “You spend so much time looking over shoulders.”) Although Azurix was a start-up, Mark paid herself the same base salary she’d made at Enron—$710,000—and hired Enron executives, which meant she inherited their rich Enron contracts. They included Amanda Martin, who was named president of the North American business and paid $400,000 a year. (Martin also got an additional $350,000 just for transferring her contract to Azurix.) CFO Rod Gray, who also came from Enron, was paid $430,000 a year. They, along with other executives, all got long-term, guaranteed contracts. As befitted an Enron company, Azurix had all the trappings of success. In the year before Enron bought Wessex, its general overhead was $29 million. By the end of 1999, Azurix was spending $118 million on overhead. Mark, for example, continued to use Enron’s corporate jets that year. “Many of us said ‘You can’t do that,’ to her, but when it finally sank in, it was too late,” says a former Azurix executive.

  Mark quickly hired an army of developers—a corporate staff of over 70—to seek out water deals. “How are you going to do anything without people?” she said at the time. But others had a different view of the buildup. It was “a monster hooked on to the side of Wessex,” recalls Chris Wasden, a former Azurix executive. Early on, new people were showing up almost every day. Naturally, they weren’t the standard gray-haired engineers who dominated the water industry. Mark, like Skilling, believed that talent outweighed experience, and in Enron’s world, talent meant thirty-somethings with MBAs from all the best business schools. What did it matter that they didn’t know a thing about water? They were smart; they would figure it out. “What am I going to do, hire a $50,000 water engineer from Detroit?” she’d ask.

  Azurix people worked hard, and no one worked harder than Mark herself. She was always in her stilettos, always urging her employees to get deals done, and always, always, courting people. “She could talk up to ambassadors and down to rednecks,” says one former Azurix executive admiringly. But to what end? The rap on Mark when she ran Enron’s international business was that she was so intent on landing the deal—any deal—that she didn’t fully consider whether the deal made sense.

  At Azurix, the search for deals had a more desperate quality; after all, the company needed to do deals. That was the story it had sold investors. But the competition was brutal and prices were sky-high; and Azurix was behind from day one. Yet Mark never lost that sense of boundless optimism, her unshakable belief that she could make the company work. “We spent millions chasing things with little likelihood of success,” says one executive, who remembers jumping on a plane and flying to Guam for a dinner meeting. Others would tear out of the office at a moment’s notice and spend three weeks investigating deals in far-flung places.

  Almost immediately Azurix needed more money. Mark, with the help of Skilling, Lay, and Fastow, tried first to raise several billion dollars from private-equity firms, even approaching Chase Manhattan about helping the company find partners. But that effort went nowhere; this was the era when people put $20 million into an Internet start-up and took $200 million out six months later. Nobody wanted to tie up billions in a heavy-asset company like Azurix. So instead, Mark told the investment bankers at Merrill Lynch that she wanted to take the company public. Indeed, she had to take Azurix public; otherwise the company would soon be out of cash.

  It was a very risky move, especially in a stock market that had zero patience. After a public offering, the brand-new company would be naked, forced to reveal itself four times a year, like every other publicly traded corporation. It would have no Enron shield to hide behind
and no room for even small stumbles. Azurix had yet to complete a single deal aside from the original Wessex purchase. To some people inside Azurix, it was obvious that the company wasn’t ready to go public. “Enron took the pie out of the oven way too soon. It wasn’t cooked in the middle,” says a former Azurix employee. Amanda Martin says she even went to Jeff Skilling to tell him that Azurix wasn’t ready to go public. “I don’t care,” she says Skilling replied; Enron was determined to see Azurix fund itself.

  One thing Mark never lost was her ability to sell snow to Eskimos—as she proved again during the IPO process. As she met with potential investors in advance of the IPO, Mark made extravagant projections, projections that were unprecedented in the water industry. Azurix was going to earn a 20 percent return on equity, double the industry average. With all the acquisitions she planned, operating profits, she claimed, would skyrocket, from $300 million to $800 million in 12 to 18 months. Azurix’s profit margins would far outstrip those of its older, stodgier competitors. Azurix, she said, would revolutionize the water business, just as Enron had done in natural gas and electricity.

  But how? How was Azurix ever going to be able to grow that fast? By doing deals, that’s how! Indeed, Azurix’s prospectus listed dozens of possibilities, from Tunisia to Ecuador to Illinois. Here, though, was a problem even Mark’s vaunted salesmanship couldn’t overcome: Azurix still hadn’t done any deals, and investors were hardly going to flock to the stock until she could prove that her deal-oriented strategy would work. Its one ongoing business, Wessex, was hardly enough to inspire a big commitment from the investment community. By the time Mark and her team launched the Azurix road show—the grueling multicity tour in which the top executives and the investment bankers make presentations to rooms full of institutional investors—the situation was getting desperate. Azurix needed to compete a deal—fast.