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

by Bethany McLean

  Back in April, Cox had landed an exclusive 20-year agreement with Blockbuster, the nation’s biggest video-rental chain, to collaborate on a new video-on-demand service. Under the agreement’s terms, Blockbuster would use its Hollywood clout to obtain licenses for films and other content while Enron would be responsible for figuring out how to stream it into homes.

  In Blockbuster’s first meeting with the Houston energy company, Cox—acutely conscious of his company’s extravagant promises for broadband—told the Blockbuster negotiators: “I want to do a really big deal.” The movie chain had wanted to explore the video-on-demand business—though it had already concluded that VOD was far too expensive and technically difficult to turn a profit for years. Enron, however, offered a deal too good to refuse: Blockbuster’s job was to line up the movie studios to provide content and allow use of its name and stores to market the venture; Enron would do pretty much everything else and pick up the costs as well. Enron would receive about $1 for every movie sold; all the rest of the proceeds (after certain expenses) would go to Blockbuster.

  As Blockbuster executives saw it, they couldn’t lose. “Basically, the deal was: we brand it, and they pay for it,” recalls one. They did wonder about Enron’s motives for bankrolling a venture that would take years to establish and seemed certain to lose money even longer; but they figured the respected energy giant would write off the red ink as a loss leader toward building the broadband business for the long haul.

  Blockbuster also warned that it would be tough to line up the movie studios, which were wary of any new distribution channels they didn’t control. In fact, just nine days before the deal was to be publicly unveiled, Blockbuster CEO John Antioco flew to Houston to have dinner with Lay, Rice, and Cox, where he told them the video chain had concluded it would be easier to line up the studios before going public with the deal. Blockbuster wanted to delay the announcement. But Enron was desperate for broadband to make a splash; Lay told Antioco they should go ahead. “I can help you crack the studios,” Lay said. “I’ve got a lot of influence.”

  When the deal was announced in July, the hype that accompanied it was impressive even by Enron standards. “For the first time, customers will be able to choose from a large library of movies through their TV screens and enjoy VHS-quality or better with VCR-like control (pause, rewind, stop),” boasted the Enron press release. Ken Lay declared: “With Blockbuster’s extensive customer base and content, and Enron’s network delivery application . . . we have put together the ‘killer app’ for the entertainment industry.” Blockbuster CEO Antioco pronounced the arrangement “the ultimate ‘bricks, clicks, and flicks’ strategy.”

  The two companies said they planned to introduce the service in “multiple U.S. cities” by year-end and roll it out to other markets, both in the United States and abroad, during 2001. On cue, the analysts swooned. “Signing a company like Blockbuster is a reassuring signal of the validity of their strategy,” declared PaineWebber’s Ronald Barone. He promptly raised his Enron rating, citing the “ongoing valuation upside” Enron Broadband offered.

  Does it need to be said that there was almost nothing to back up the hype? As the court-appointed bankruptcy examiner later dryly put it, “This agreement reflected nothing more than an aspiration.” Almost immediately, problems arose that made it obvious the dream the two companies shared was unlikely ever to become reality.

  The first big stumbling block was that Enron quickly became impatient with the slow pace of lining up the studios; after several months, Blockbuster had signed up only one. Cox began camping out in Beverly Hills, trying to negotiate studio deals on his own. Blockbuster executives got wind of this, and when Blockbuster’s general counsel Ed Stead ran into Cox in Los Angeles, he bluntly advised him: “If you’re going around us, we’re going to feed you to the fishes.”

  Enron, meanwhile, was having trouble delivering on its own promises. A big piece of the challenge for video-on-demand was solving what’s known as the last-mile problem—getting the content from Enron’s network into people’s homes. That required negotiating agreements with the phone companies that provided local DSL service across the country. Enron executives, according to a Blockbuster official, had assured the video chain they had the phone companies “in our pocket”—and under the terms of the deal, Blockbuster had the right to walk away if Enron hadn’t gotten them all on board by December.

  When it became apparent that wasn’t going to happen—and Blockbuster threatened to terminate the venture—Enron negotiated an extension on the requirement until March. Even then, according to government filings, it was so clear the venture was doomed that one lawyer who worked on the extension wrote a memo predicting that the partnership would enter a “termination scenario” in two months anyway.

  Still, Enron somehow managed to introduce the service in four cities by year-end—which it promptly announced in yet another press release. Ken Rice, who had vowed to shave his head if the trial began on time, paid off his bet by showing up at a meeting of the Blockbuster project team with a female barber, who shaved his head clean to wild cheers. Ken Lay dropped in to offer his congratulations—and to enjoy the show.

  What nobody mentioned was that the trial wasn’t exactly what Enron and Blockbuster had promised. Originally, the companies had planned trials in four cities—Seattle; Portland, Oregon; New York; and a Salt Lake City suburb called American Fork. But without all the phone companies on board, Enron was reduced to conducting testing in three of the cities using tiny providers. Only about 300 households were involved; in Seattle, the test was limited to just three apartment buildings. Much of the testing didn’t even use standard DSL equipment.

  Though Enron had boasted of allowing customers to choose from “a large library of movies,” the trial offered a feeble collection of offerings. The standard fee was $5 a film—Enron’s share was just $1.20—but many of the customers in the test markets weren’t even charged. Even then, few used the service; each household watched an average of just 1.8 videos a month—half of what Enron expected. Broadband executives sat in meetings poring over reports on the pilot’s comically pathetic results: The Care Bears Movie: seven purchases—$8.40. When Cox excitedly reported his movie proceeds at one gathering, another executive handed him a $5 bill and said, “I just doubled your revenue.”

  Just because the Blockbuster deal was doomed didn’t mean Enron couldn’t figure out some way to monetize it. Enron finance executives had been work-

  ing to monetize the Blockbuster deal practically from the moment it was announced. The scheme they devised was called Project Braveheart—named for an Academy Award–winning Mel Gibson movie depicting a rebellion by thirteenth-century Scots.

  Here’s how it worked: even before the pilot program was begun, EBS calculated a value for the entire 20-year Blockbuster deal, based on projections—wildly speculative, of course—about future DSL use, customer video purchases, the speed of the rollout, market share, expenses, and other factors. Then, through a series of transactions, it sold most of its interest in the Blockbuster contract to an outside buyer. EBS then began booking profits up front.

  What outsiders would buy into this arrangement? Friendly ones. In the first step of the transaction, the broadband division formed a joint venture, called EBS Content Systems, with two partners. One was a vendor involved in the Blockbuster trial called nCube—a tiny video-on-demand equipment company privately owned by Oracle CEO Larry Ellison. The other was an investment vehicle called Thunderbird, owned by Whitewing, the Enron-controlled special-

  purpose entity. As ever, to justify off-balance-sheet accounting treatment, nCube and Thunderbird had to contribute a total of at least 3 percent of the venture’s equity, that investment had to be at risk, and the outside investors had to control the joint venture. To meet the 3 percent requirement, nCube chipped in $2 million and Thunderbird $7.1 million. EBS contributed its Blockbuster contract.

  EBS Content Systems then sold almost all profit rights in the
Blockbuster deal for $115 million to a second investment vehicle, called Hawaii 125–0 (a play on the old Hawaii 5–0 television show and one of the accounting rules governing such transactions, known as FAS 125). Hawaii 125–0, in turn, was funded with $115.2 million from the Canadian Imperial Bank of Commerce in Toronto. CIBC was supposed to get 93 percent of the Blockbuster deal’s cash flow for the next ten years.

  But neither nCube nor CIBC really wanted to invest in Braveheart—and neither apparently believed that it had any money at risk. According to government filings, nCube and CIBC were in the deal as a favor to Enron—a favor that Enron had promised to repay with the quick return of their capital plus a tidy profit for their troubles. Officials at nCube say that EBS executives promised they’d repay their investment in early 2001, with a profit of $100,000. Eventually, this promised profit grew to $200,000, because Enron asked nCube to stay in the deal for another quarter.

  Officials at CIBC say they had a similar handshake agreement, the government charges. At the time, CIBC was falling over itself to please Enron. After investing $15 million in LJM2 and lending Enron hundreds of millions of dollars, it had finally made the leap onto Andy Fastow’s coveted list of Tier 1 banks. Just a few months earlier, CIBC Houston banker Billy Bauch had written the Enron CFO a note of thanks “for the opportunity to work with Enron & LJM over the last year,” adding, “To be named one of your Tier One banks is a noteworthy achievement for us, and we are sincerely humbled by your confidence.” Bauch ended with a friendly word on the Fastow family’s plans to build a huge new residence in River Oaks: “I trust that the house is coming together and will not cause you too much fiscal pain.”

  One CIBC banker later reassured nervous colleagues by telling them that Fastow had “given his strongest possible assurance that the risk won’t be realized.” A second banker elaborated in an e-mail quoted in government court filings: “Unfortunately, there can be no documented means of guaranteeing the equity. . . . We have a general understanding with Enron that any equity loss is a very bad thing. They have been told that if we sustain any equity losses, we will no longer do these types of transaction[s] with them. Not many other institutions are willing to take such risks so it is important to Enron to keep us happy. . . . We have done many ‘trust me’ equity transactions over the last 3 years and have sustained no losses to date.” According to a government filing, this same banker, whose name was not disclosed, once remarked that someday Fastow would be “led away in handcuffs.”

  Such guarantees, of course, would mean that the equity investments weren’t truly at risk and that Enron therefore couldn’t legally report the revenues. But it did. According to the government, an Enron finance executive told CIBC officials point-blank that he couldn’t put EBS’s commitment on paper because it would “blow the accounting treatment” for the deal.

  Kevin Howard and Mike Krautz, the EBS finance executives who headed Project Braveheart, deny they had any unwritten agreement, even though federal authorities say it was described in draft deal documents and e-mails. A memo Howard later prepared for Rice, for example, contains a passage titled CIBC Exit Strategy and notes “that by the end of 2001, Enron would need to replace CIBC with “ ‘true’ outside equity, ie without ENE support.” (The situation is complicated by the fact that neither CIBC nor nCube got back their money before Enron’s collapse.)

  The government also charges that the handshake arrangements with nCube and CIBC were hidden from the Arthur Andersen auditors who reviewed Project Braveheart. But if the firm were really doing its job, that shouldn’t have mattered; even without that information, the auditors had more than enough to know that signing off on Project Braveheart required an incredible stretch of accounting rules. It was obvious that the deal was largely worthless. And even if it hadn’t been, Enron was using assumptions to value the contract that were truly fanciful; it was the broadband equivalent of monkeying with a pricing curve on a long-term electricity contract. To book the profits it needed, Enron had to assume that by the year 2010 the company’s content business would be operating in 82 cities, that 32 percent of the households in those markets would be using DSL lines, that 70 percent of DSL customers using video-on-demand would subscribe to the Enron-Blockbuster service—and that Enron would control 50 percent of the video-on-demand market. (This last figure came from “research” conducted by EBS and McKinsey.)

  A top Andersen accountant named Carl Bass was upset with Enron’s plans to book profits from Project Braveheart. Bass was an old-fashioned Andersen hand, an acerbic, skeptical veteran who was highly regarded inside the firm for his technical expertise. In late 1999, Bass was appointed to Andersen’s Professional Standards Group (PSG), which was supposed to offer independent rulings on particularly tricky accounting issues. At Duncan’s request, Bass was spending much of his time on Enron issues, since the company was by far the riskiest accounting client Andersen had. But Duncan came to regret seeking Bass’s involvement, for Bass quickly became the leading in-house critic of Enron’s financial maneuvers. A typical Bass comment was one he made in an August 2001 e-mail about an Enron deal: “Help me out here,” he wrote. “How do you sell an asset and generate operating cash flow?”

  To Bass, the accounting treatment for Project Braveheart defied common sense. “. . . I was told that they were going to have some $50 million gain on the sale of this venture interest immediately after the contract was signed and the venture was entered into. Furthermore, the other venture partner was not contributing anything,” he wrote in an e-mail. “In effect, this was a very risky transaction. . . .” But as Bass also noted, Duncan and his team “did not follow our advice on this.” The only concession Andersen was able to wring out of En-

  ron was a promise that the company would obtain an independent appraisal of the value of the Blockbuster contract. But Enron never bothered to get the appraisal—and Andersen approved the deal anyway.

  For Enron, all the machinations produced the desired result: EBS booked the revenue it needed to meet Wall Street’s expectations. Kevin Howard, EBS’s vice president for finance, had originally intended to book just $20 million on the Braveheart deal. But as the end of the year approached, EBS’s earnings hole kept growing—in late November, COO Hannon calculated that the business was $100 million behind budget—and so did the amount the company needed to milk from Braveheart. In the end, EBS claimed a $53 million gain on Braveheart for the fourth quarter, representing 84 percent of the broadband division’s revenues. Broadband closed 2000 reporting a loss of just $60 million for the year, meeting Enron’s promise to analysts.

  Everyone in broadband, of course, was acutely attuned to the stakes involved in pleasing the market. (“EBS has released key metrics to the analysts on Wall Street and must now deliver on those metrics,” explained a 91-page internal document detailing broadband’s “strategic vision,” completed in November 2000. “Each group within EBS must learn to focus on these and make certain EBS meets or exceeds them to keep Wall Street interested in the proper valuations of Enron. This is now a very important part of the daily routine of EBS going forward.”) And though they knew full well that they had met their numbers only by using smoke and mirrors, more than a few regarded the illusion they were creating as a genuine accomplishment. That, after all, was what Enron valued. That’s what got them bonuses and promotions.

  Indeed, at the Enron Broadband Christmas party, members of the finance group put together a PowerPoint presentation that celebrated, in mockumentary style, their earnings “achievement.” “Since this is the largest earnings deal for EBS in the 4th quarter with over $50 million in earnings, the Blockbuster Team are now heroes. Congratulations,” it began.

  A series of slides then recast popular films to portray the exploits of several of the EBS executives who’d worked on the Blockbuster deal. One of them was called “Mike Krautz and The Search for the Holy Monetization.” “Mike scours the globe in search of the holy mark-to-market—I mean monetization,” the narrative read. “T
his monetization is supposed to bring everlasting life, but Mike soon discovers that his immortality lasts for only one quarter.”

  Another slide offered up a variation on Thelma & Louise, starring two EBS employees: “After Kevin tells them that they are responsible for unwinding the Blockbuster deal next quarter, the two decide to make a run for the border. In the end, they both drive over a cliff, choosing the more attractive exit strategy.”

  Blockbuster’s inability to obtain first-run videos inspired the casting of Kevin Howard as Forrest Gump (“A monetization effort is like a box of chocolates, you never know what you’re going to get”), with a buddy who “has all kinds of content—‘kids’ movies, action movies, animal movies, home movies, shrimp movies, just no hit movies.’ ”

  And finally, the presentation portrayed the Arthur Andersen accountants who had objected to the deal as “The Grinch Who Stole VOD,” starring “Arthur Andersen as the Grinch and Enron’s Accounting Team as the Who’s in Whoville,” in “the story of how the mean, heartless auditors tried to ruin the deal for Little ConnieLeeWho:

  One Deal, Two Deal, Red Deal, No Deal

  You cannot do it without GAAP.

  You cannot do it because it’s crap.

  You cannot do it for 25. What the hell, let’s go for 65.

  After the party was over, EBS’s alarmed general counsel, Kristina Mordaunt—the same Kristina Mordaunt who had hit the $1 million jackpot in the Southampton investment with Andy Fastow—reportedly instructed Howard to destroy all copies of the presentation.