The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron
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But the analysts didn’t appreciate any of this—in part because they were so terribly credulous, in part because they were simply misled. Enron had built its claims about the broadband business on the promise of its own high-speed network, with sophisticated technology driven by powerful new software that no one could match. In a press release back in April 1999, Enron started publicly claiming that its new system provided “virtually unlimited bandwidth” and “built-in intelligence” that would give businesses access to “a powerful new breed of Internet services.” At the time, Enron had portrayed this network as “lit, tested, and ready.” In fact, it wasn’t close to operating on a commercial scale, and much of the promised technology never made it out of the lab.
For all of these reasons, Skilling’s claims about the broadband business’s value went well beyond mere hubris or even Internet-era hype, so common at the time. It was an act of staggering recklessness. “Jeff declared it a success when his own management team said it’s not there yet,” recalls a senior Enron executive. “You were creating another pressure cooker.”
“Enron Broadband was a reasonably decent concept with reasonably decent technology,” adds a former Enron managing director who worked in the business. “Given six years to develop the technology and the business plan, without making representations about a $29 billion market value, it had a decent shot of doing something unique. Demanding first-quarter results in a start-up communications business is really what led to some of the things that were done. They put out the projection, and then you’ve got to do some questionable things to make it happen.”
In many ways, broadband stands as the logical evolution of the accumulating problems that ultimately brought down Enron. What Enron was trying to accomplish was bold, even inspirational. It looked dazzling in a hotel ballroom, presented to analysts by Skilling on PowerPoint slides. But in the real world, it ran headlong into the reality of a thousand technical, economic, competitive, and logistical roadblocks that keep any business plan—especially one so exceedingly ambitious—from unfolding perfectly. That was the problem with thinking about an elegant idea as profits in the bank (or at least on the income statement) from the moment it was conceived. The real world just doesn’t work that way.
Although it ended in a welter of criminal charges, Enron Broadband didn’t start out as deliberate fraud. Though few who worked there thought broadband was really worth what Skilling claimed, there were plenty among his minions who were convinced it would all work out in the end. If broadband’s promises and valuation were miles ahead of reality, well, they would ultimately catch up. As Enron people saw it, this was how they always did things. “Our company was running downhill, with our arms pinwheeling, as fast as we can,” says one former executive. “You get to a point where your legs can’t keep up with your body. But we all believed we’d get to the bottom of the hill before we collapsed.”
Skilling seemed oblivious of the practical challenges of turning his latest grand vision into reality and utterly unconcerned with the enormous pressures he’d created. What he saw was that the failure of Azurix and the contraction of the international business posed a threat to Enron’s market capitalization, and he simply could not—would not—allow that to happen, no matter what. Broadband seemed as if it could work, and the payoff was off the charts. With the announcement of the broadband initiative, he later exulted, “We could get the market cap fixed. We had it fixed.”
All this meant that Enron couldn’t ever back away from Skilling’s profit predictions, at least not without causing the stock to crater. Which left the broadband executives facing a nightmarish scenario. They would have to somehow manage to build an entirely new industry from scratch in an incredibly short time against astonishing odds. And in the meantime, they would have to resort to creating a portrait of a reality that simply didn’t exist.
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How big were the obstacles facing the new broadband division? They were enormous. Take trading first. Without question, the idea of trading bandwidth capacity had appeal. At the time, purchasing bandwidth was an inflexible, expensive proposition, requiring business customers to lease a special dedicated line—usually for a year or more—with far more capacity than they needed. One former Enron broadband trading executive says: “It’s like going to Sam’s Club and asking for a single pack of gum.”
Enron believed that broadband trading would make it possible for customers to buy only the bandwidth capacity they needed when they needed it. Businesses that required lots of bandwidth during a daytime peak period, for example, could sell their nighttime and weekend capacity for residential use. This kind of trading would be more efficient than laying new lines and, in theory, bring prices down as well.
But as a practical matter, the kind of real-time switching Enron envisioned was impossible. Transferring high-capacity bandwidth meant sending workers out to change connections by hand, a process that took days—if it was possible to switch them at all. Two companies that leased lines had no way of hooking up to use each other’s bandwidth. For all practical purposes, when it came to high-capacity bandwidth, the information superhighway was like a series of parallel roads that never intersected.
Enron claimed to be rolling out the capability to change that, through its Enron Intelligent Network. This network, with its powerful new operating software, was the foundation for all of Enron’s broadband promises, including instantaneous electronic switching. Enron had claimed back in 1999 that its network offered a “highly reliable pay-for-what-you-need, bandwidth-on-demand way to deliver data.” Enron’s idea was to connect customers through a few dozen pooling points in key cities around the country, which would act much like transfer hubs in the gas-pipeline business. As a practical matter, this capability to deliver real-time bandwidth-on-demand was what made trading useful and attractive—and critical to Enron’s prediction, in its 1999 annual report, that the “robust merchant operation” it was building would allow the bandwidth-trading market to “reach critical mass” by 2001.
In fact, the Enron network couldn’t provide bandwidth-on-demand and never would. The switching capability was still under development, as were other advanced features of Enron’s system. Yet Enron continued to portray most of its key components as present-day reality. During 2000, according to the government, top broadband executives regularly discussed among themselves the Enron network’s inability to do much of what the company claimed. Still, Enron kept issuing fresh press releases boasting about network capabilities that didn’t exist.
There was another problem with developing bandwidth trading: the owners of the existing big broadband networks, mostly telephone companies, were largely uninterested in hooking into Enron’s nascent system. They were already in the driver’s seat; as they saw it, turning bandwidth into a tradable commodity could only cut into their profits.
The second part of Enron’s master plan, assembling and delivering content for home viewing, was every bit as audacious and problematic. Enron was promis-
ing to establish a profitable new entertainment business by streaming programming for consumers, such as on-demand movies and sports events, over its global broadband network. The company would make money by charging consumers on a pay-per-view basis.
Never mind that Enron had no experience with this sort of thing; “video on de-
mand” was full of gnarly problems that stymied even veteran entertainment com-
panies. Most homes didn’t even have the high-speed broadband telephone lines that Enron was planning to use for on-demand video. Those that did were con-
nected to computers; the Enron plan called for video to be streamed into tele-
vision sets. Providing such digital-TV video required a new kind of set-top box that would cost $500 apiece (while the boxes were under development, one of them burst into flames). And, not least, Enron was competing with the cable-television industry, a modern cabal if ever there was one, which had a giant built-in advan-
tage:
it already had wires and boxes in millions of American homes.
Attempting even one of these plans would have been an enormous undertaking for any company, requiring a tremendous commitment of resources, time, and talent. To try to do them all at once, without any previous experience, virtually overnight? It was crazy.
Nonetheless, Enron Broadband Services—EBS, it was called internally—exuded the company’s version of brash cool. Its offices were vintage dot-com, with whiteboards that hung floor to ceiling and funky indirect lighting. Ken Rice’s imprint was evident, too: he had placed a huge gleaming-red Hellcat motorcycle, custom-built in Louisiana for $30,000, outside the elevators of EBS’s executive floor. It was inscribed with the words BANDWIDTH HOG.
In February 2000, star performers from other Enron businesses had been officially urged to sign on at broadband at a special internal job fair held at a hotel near Enron’s headquarters. EBS’s head count gradually climbed to 600, then 900, then over a thousand, eventually spilling onto three floors in the Houston tower and in more space in Portland. Eager newcomers kept piling in, then charging off to spend money exploring new ideas. In no time at all, EBS was churning through money at a burn rate of $500 million a year.
By the summer of 2000, the co-CEO experiment had failed. Joe Hirko, the former utility company CFO who had remained in Portland, left Enron in late July; since the January 20 analysts meeting that sent shares soaring, he’d cashed in $35 million worth of Enron stock. Hirko’s departure left Ken Rice fully in charge. Rice’s top deputy at broadband was his number-two man at wholesale, chief operating officer Kevin Hannon.
While EBS was never what Enron claimed, certainly much of the work being done was real. Teams of engineers were struggling with the technology, trying to crack the code on the networking problems, testing video-streaming, spending hundreds of millions on hardware, and cobbling together the promised 15,000-mile fiber network, which Enron had pledged to extend to Europe (where it was putting yet another hundred employees). The traders were developing standard contracts, trying to drum up trading partners, and courting the phone companies. EBS’s mergers-and-acquisitions team gobbled up software companies that might help the business along. Broadband even had its own venture-capital division, investing in start-ups and public tech stocks.
Considerable effort was also devoted to giving Wall Street the impression of rapid and dramatic progress. Enron sent out dozens of press releases, trumpeting every new partnership, equipment purchase, and video event. (“Enron to broadcast international cricket tournament live via the Internet.”) The company made a point of creating the impression that its bandwidth-trading business was moving quickly toward critical mass—from 3 trades in the first quarter of 2000 to 236 in the fourth.
In fact, the trading really wasn’t much more than a demonstration project. EBS’s main trading partners were other companies that had followed Enron into the game and were just as eager to launch a market. But their activity served no commercial purpose for actual bandwidth users and generated no real profits. In practical terms, the continued lack of instantaneous switching rendered most bandwidth trading pointless.
There was another problem, too. Enron was hardly the only company trying to build a huge network of high-speed fiber-optic cable. During the Internet bubble, dozens of start-ups had sprung to life with this exact goal, and dozens of well-established companies had committed their own billions to building fiber-optic networks. As a result, there was a tremendous glut of fiber capacity, far outstripping the meager demand. Once the Internet bubble popped in the spring of 2000, prices plummeted. Soon enough, the entire telecom industry was in meltdown.
Though he’d committed $1 billion to laying thousands of miles of fiber, Skilling quietly slowed the build in 2000. He figured he’d lease or trade for whatever additional city-to-city links he needed, then cobble them together through Enron’s pooling points, with EBS’s own fiber, to assemble a virtual network.
While this decision saved money, it upset many of the Portland engineers, who saw the fiber network as the centerpiece of their efforts. Enron had spent millions on the expensive equipment needed to activate the network—to light it, as they say in the business—but it no longer made sense to do so. So Enron left much of its fiber dark and stuck the networking gear in a company warehouse. The equipment was helpful in one way, though: broadband job prospects were often given a tour of the warehouse stuffed with hardware to impress them with the size of Enron’s commitment to broadband. (Enron was less forthcoming with local tax officials, who later indicted the company for dodging $1 million in county property taxes by submitting declarations that the warehouse contained about $500 worth of furniture and fixtures instead of computer and telecommunications gear worth more than $20 million.)
The biggest pressure of all, though, was the lack of time. In hyping the business, Enron told Wall Street that EBS would lose no more than $60 million for all of 2000. This meant that the division had to begin showing quarterly results right away.
It was an utterly impossible goal; Enron Broadband wasn’t close to being ready to generate real income. But everyone at broadband knew that didn’t matter: they had to deliver the number Skilling had promised. And if EBS executives couldn’t come up with real earnings and revenues, they’d have to figure out a way to gin them up. Instead of focusing on building the business, they had to start playing accounting games. Here’s what they did:
First quarter 2000: EBS announces $59 million in revenues. It gets almost the entire amount by exchanging surplus strands of fiber on its own network for strands built by competitors that expand its reach. This helps to build out EBS’s virtual network, and it also taps into an accounting oddity that Enron is happy to exploit: the fiber Enron is selling can be accounted for as an immediate gain, while the fiber it is purchasing can be depreciated over 20 years. Though no cash changes hands, this produces an instant boost to the bottom line for both parties. These deals, popular among many telcom companies desperate to show revenue growth, become known in the industry as fiber swaps.
Second quarter: Ken Rice orders his deal makers to try to sell some of Enron’s dark fiber so it can book the ensuing gain to the quarter’s earnings. But the deal makers can’t find any takers, so they turn to Enron’s buyer of convenience—Andy Fastow’s LJM2. Broadband just wants LJM2 to warehouse the fiber until the quarter is past and it can find a buyer. Fastow, of course, plays hardball with his own company: he wants the cap on his rate of return raised from 18 percent to 25 percent if EBS can’t resell the fiber in two years. As the deadline starts closing in, two EBS finance executives, Mike Krautz and Larry Lawyer, find themselves in the deeply uncomfortable position of haggling on behalf of Enron—with Enron’s CFO on the other side of the table. “Krautz, you cocksucker!” Fastow barks at one point over the speakerphone, seeking to bludgeon the Enron negotiators. Rice is finally brought in but winds up in a shouting match with Fastow. In the end, Fastow agrees to do the deal (called Project Backbone!) just before the quarter closes. He pays $100 million for the fiber—$30 million in cash and a $70 million note. Ken Lay personally signs the LJM2
approval sheets. And EBS books a $53 million pretax gain on the sale on its way to a loss of just $8 million for the quarter. (Enron finds a buyer for the dark fiber just a few months later.)
Third quarter: To make its numbers this quarter, EBS captures a huge gain on an investment in a tech start-up called Avici Systems, which makes high-speed routers. Several months before, in return for committing to purchase $25 million in hardware, EBS was allowed to buy almost a million coveted pre-IPO shares of the company. After Avici goes public in July, its stock skyrockets to $162.50, giving Enron a gain of more than $150 million on its $15 million investment. Enron uses one of its special-purpose entities to lock in its gain. (It can’t sell the shares outright because of a 180-day lock-up provision.) Then EBS transfers its stake into a special-purpose entity, allowing it to book $35 million in third-quarter profits.
&
nbsp; Then came the fourth quarter. . . .
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There was no getting around it: by the end of 2000, things at the broadband division were starting to feel desperate. EBS’s costs and head count had continued to soar; there were 24 people in the public-relations department alone. It was further bloated with refugees from Enron’s hobbled water and international businesses. Everyone scrambled to come up with minibusiness plans. One came up with the idea of developing a risk-management system for movie studios to allow them to recover their losses if expensive new productions flopped. (Hollywood wasn’t interested.) Another explored the idea of starting a futures trading market for film revenues.
The switching technology for the Enron Intelligent Network remained under development, and with bandwidth prices in free fall, the traders were fighting an uphill battle to build a market. The division still had virtually no cash coming in the door.
To make its numbers for the fourth quarter, Enron resorted to a positively breathtaking scheme, a truly brazen feat of accounting duplicity. Enron Broadband ended its year by booking $53 million in earnings on a deal that was well on its way toward collapse and hadn’t produced a single penny of profit.
It involved the content business—developing video entertainment programming for streaming into homes. The content team was led by a flamboyant Enron deal maker named David Cox, one of the more unusual characters at Enron. Far from being the typical high-achieving MBA, Cox was a high school dropout and former commercial fisherman who had started out at Enron in the basement graphics department. While working on projects for Skilling, he’d managed to convince the Enron executive to have the company bankroll his own printing business—and give him Enron’s printing work.
Cox later returned to Enron and was running its paper-trading venture when Rice tapped him to head the broadband content sales team. “You could take David and drop him in the middle of the desert naked, and within a day, he’d figure out a way to make money,” Rice liked to say of Cox. The EBS deal chief, who had a reputation as a loose cannon, had clearly absorbed the Enron ethos. “No one in the world can package this like we do because of all the financial engineering,” he explained, in an interview with a Fortune writer. The company philosophy, he noted, was: “No shots, no ducks. Nobody gets rewarded for saving money. They get rewarded for making money.”