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

by Bethany McLean

  When Enron’s 2000 proxy was filed in late March, it contained no information about Fastow’s pay. Mintz, relying on lawyers from Enron and Vinson & Elkins, had used a loophole to avoid disclosing what Fastow was earning. Because not all transactions between LJM2 and Enron had officially settled, the lawyers maintained that they couldn’t calculate Fastow’s income yet. Never mind that Fastow had received millions in partnership management fees and distributions.

  The last thing Mintz wanted, though, was for Fastow to relax. And so he sent another memo, this time directly to Fastow, the next day, telling him that the lack of disclosure likely couldn’t continue and that “the decision not to disclose in this instance was a close call; arguably, the more conservative approach would have been to disclose the amount of your interest.”

  In early May, Skilling gave Fastow an additional responsibility: he became head of corporate development—incredibly, this was the group in charge of finding buyers for projects Enron wanted to unload. This new conflict didn’t bother Fastow any more than any of the old ones. In a staff meeting, Fastow said bluntly, “We’re going to start selling a shit load of assets to LJM.” For Mintz, that was the last straw. Looking for more ammunition, Mintz sent a letter to a lawyer he knew in the Washington office of Fried Frank Harris Shriver & Jacobson, a tony New York law firm. Mintz was referred to an SEC expert at the firm, to whom he sent a huge pile of Enron and LJM documents, seeking his opinion on the adequacy of the company’s public disclosures. (Fried Frank later opined that Enron should “consider supplementing the prior disclosures . . . especially on such points as the purpose of the specific transactions entered into and the ‘bottom-line’ financial impact on the Company and the LJM Partners.”)

  Mintz also took another, far more drastic step. He resolved to take his concerns directly to Skilling. Buy warned him against doing so. “Jeff is very fond of Andy,” Enron’s chief risk officer said. “ I wouldn’t stick my neck out.” But Mintz did exactly that. Because Skilling had not signed many of the LJM2 documents, Mintz, on May 22, sent him a memo in a “personal and confidential” envelope. The memo informed Skilling that Mintz had a batch of LJM approval forms awaiting Skilling’s signature and that he would “arrange to get on your schedule” so the CEO could sign them. Mintz hoped that the forms would alert Skilling to the “dysfunctionality” involving LJM2 and hoped the ensuing conversation with the CEO would make him reconsider whether Fastow’s partnership was really such a great idea.

  To this day, the fate of Mintz’s memo remains a mystery. Mintz insists that after he got no response, his secretary called Skilling’s office three times over a two-week period trying to set up a meeting. The lack of response was later viewed as deliberate, an attempt by Skilling to maintain his distance from the messy details of LJM. But Skilling and his assistant, Sherri Sera, have both denied to investigators ever receiving the memo or Mintz’s calls. “I would have met with Jordan in an instant,” Skilling has said. “Why didn’t Jordan come up and talk to me?”

  Though Mintz didn’t know it, things were already changing. Skilling told confidants that he was beginning to worry that Fastow was spending far more than three hours a week on LJM2. “We used to talk about Enron most of the time, and now we’re spending most of the time talking about LJM and the balance sheet,” he complained. And the criticism from the investment community was intensifying. It was becoming quite clear that the existence of LJM2 was not helping Enron’s stock. If nothing else got Skilling’s attention, that certainly did.

  And so, on a Friday afternoon that spring, Skilling called Fastow into his office. LJM was taking up too much of the CFO’s time, Skilling said. Now, Fastow had to make a choice. “Do you want to be CFO of Enron,” Skilling asked, “or do you want to run LJM?” Fastow asked for the weekend to think about it. On Monday, he gave Skilling the answer: “I want to be the CFO of Enron.”

  Mintz later described the moment Fastow told him that he had decided to sell his interest as “melodramatic.” “I created LJM,” Fastow said. He seemed almost heartbroken at the thought of giving it up and giving up as well his dreams of LJM3. “I’m really sad I’ve got to divorce myself.” Fastow said that the partnership agreement gave him free rein to sell his interest to anyone of his choosing. A Fastow deputy kept Credit Suisse First Boston informed about his analysis of a suitable purchase price.

  In late July, Fastow sold his interest in the two LJM funds. The buyer was none other than Michael Kopper, whom Fastow had persuaded to leave Enron to take over the partnership. Causey, the government later alleged, assured Kopper that the deal would be lucrative, because Enron would continue to do plenty of business with LJM to meet its financial reporting goals.

  Kopper paid Fastow a total of $16.35 million. Of that amount, $15.5 million was cash; the rest came in the form of Kopper’s house, valued at $850,000, which he turned over to Fastow. (Fastow planned to give the house to his parents.)

  Where did Kopper get the cash? He got a loan from Citigroup, which, according to the government, noted in a memo that the loan should be approved because “many [Enron] transactions will continue to flow through LJM.” According to the terms of the loan, though, Kopper had to repay at least $8 million by the end of 2001. That too was easy. When LJM1 sold its Cuiabá stake back to Enron, Kopper, as the new general partner, was entitled to a distribution of $7.3 million. He apparently used the proceeds to repay Citi. (Kopper’s total take from Chewco and the LJM partnership amounted to $33.5 million.)

  Naturally, Kopper also was paid to leave Enron. Under the terms of his separation agreement he received $905,000. In addition, his departure was termed an involuntary termination, which meant that all of Kopper’s options and restricted stock vested. On his way out the door, Kopper asked to be able to stay in his Enron office, and he wanted all of the legal and accounting expenses he incurred in connection with the LJM purchase to be paid for by Enron. Though his request to keep his office was denied, Enron agreed to pick up the tab for Kopper’s expenses. (He kept his Enron cell phone, too.) In late August, Global Finance held a going-away party for Kopper at the Ruggles Grill. The charge was $4,815.76. Enron paid, of course.

  Few at Enron knew that it was Michael Kopper to whom Fastow had sold his interest in LJM. Enron’s shareholders weren’t told. The directors say they weren’t told, either, but they didn’t ask. Nor did the board ever ask how much Fastow had made from selling his interest. As far as the board and management were concerned, Fastow’s exit from the partnership had brought an easy end to any problems anyone might have with the company’s involvement in LJM.

  • • •

  On May 6, Enron’s “mindnumbingly complex” financial disclosures became one of the subjects of a skeptical report written by Mark Roberts, a well-respected short seller and researcher who runs a firm called Off Wall Street Consulting.

  Roberts dug deeply into Enron’s financial report for 2000, which had been released in late March. He noted Enron’s increased reliance on trading and the seeming cluelessness of the Street analysts who were recommending the stock. He scrutinized the related-party transactions and noted that none of the “numerous industry experts and analysts” he asked were able to explain the footnotes to him. He also noted other oddities revealed in that filing, such as the information that Enron had received $2.4 billion in proceeds from securitizations, and that Enron, by using swaps, appeared to be retaining an unknowable amount of risk. “These are, in effect, sales with recourse to Enron,” Roberts wrote.

  One of Roberts’s most devastating revelations had to do with Enron’s cash flow. In 2000, Enron reported an unprecedented $4.8 billion in operating cash flow. Roberts noted that almost $2 billion of it was from customer deposits—because energy prices were so high, Enron’s counterparties had to provide more collateral. But this money didn’t really belong to Enron. If prices fell, it would have to be returned to the counterparties. Roberts also noted that another $1 billion in cash flow had come from a onetime sale of inventory.
(Although Roberts didn’t know it, another $1.5 billion in cash flow was the result of prepay transactions.) In other words, much of the $4.8 billion in cash flow wasn’t cash flow at all. It was merely the illusion of cash flow.

  Though most of the mainstream business press was unaware of Roberts’ report, it was widely circulated among hedge-fund managers and other large institutional investors. A reporter named Peter Eavis, who wrote for the popular online financial site, TheStreet.com, followed up on Roberts’s research and began writing a string of negative stories about Enron. Slowly, the heat was being turned up.

  • • •

  There was yet another disaster brewing: broadband. All through the winter and into the spring, even as telecom and Internet companies were collapsing, Skilling continued to insist that Enron Broadband Services was right on track. On March 23, when he conducted that conference call to assure Wall Street that Enron would hit its earnings targets, he claimed that the broadband trading business was “absolutely developing, it is ahead of plan.” He also said he was “very optimistic” about the content business. Falling prices, Skilling insisted, were helping Enron gain access to network capability at lower prices, decreasing the required capital expenditures.

  A few weeks later, Skilling gave a presentation at a Salomon Smith Barney investment conference in Manhattan and insisted, yet again, that collapsing prices would be good for Enron’s broadband traders. Chanos attended the conference; it was the one time he saw Skilling in person. As he listened to him explain why collapsing prices were good, Chanos thought, “Are you crazy? There won’t be anybody left for you to trade with!”

  Inside Enron, the mismatch between rhetoric and reality was becoming increasingly stark. In fact, EBS quietly spent much of the first quarter redeploying people out of the division. In late March, Peter Eavis wrote a story for TheStreet .com citing the redeployments as evidence that EBS might be underperforming. That day, the stock fell over 8 percent. Two days later, CBS MarketWatch, another online financial site, quoted Skilling as saying that the rumors of broadband job cuts were “absolutely not true”; Enron’s PR department said the redeployments were “standard daily practice” and went so far as to say there were sixty job openings in broadband.

  In late March, one EBS employee sent an anonymous letter to Fortune. “When Jeff Skilling says that it is ‘absolutely not true’ that there are job cuts in Broadband Services, he is not telling the truth. There have been job cuts of about 30%. These are ‘redeployments,’ which means that the person has 45 days to find a job elsewhere at Enron or they are terminated. Unfortunately, the other parts of Enron are also ‘redeploying’ people so that you are being laid off. I asked my boss who is a senior person in Enron Broadband Services about Mr. Skilling’s quote. He said that he could not believe that Jeff had said this to the media. He said that he was in the meeting with Jeff where these decisions were made and that the job cuts might have been twice as large except for the need to maintain the perception that the Broadband Services business unit was being successful. I am sorry that I can’t provide my name, but I don’t want to be redeployed also. Employees at Enron know what the truth is. All you need to do is ask them.”

  During the next few months, EBS had its last gasp. A handful of executives argued that Enron needed to either acquire another company—in other words, buy a real business—or shut down EBS. Several people pushed the idea of acquiring PSI Net, an Internet service provider. (It later declared bankruptcy.) Skilling and Rice opposed the deal. Then, the Enron team briefly toyed with the idea of buying WorldCom, but they quickly realized that the combined debt made the deal impossible. With that, executives who had options elsewhere at Enron began to flee.

  During this period, Skilling’s moods seemed to swing wildly. In Portland, where dozens of people were redeployed, Skilling gave a mid-March speech telling them that the industry was in a meltdown. Yet that spring, Skilling also gave a pep talk to the broadband troops in Houston. Some 50 to 100 broadband employees stood around him as he spoke. “We are perfectly positioned in broadband,” Skilling insisted. “This is just like gas.” One executive recalls, “I could look around and see people saying, ‘This is bullshit.’ People thought he was nuts. Everyone was tired of hearing him say everything was just perfect.”

  • • •

  Throughout 2001, as Enron was besieged by business issues, Skilling was also besieged by internal political issues. It was now obvious that his longtime lieutenants, like Rice and Pai, were costing the company more than they were contributing. The long-simmering resentment that Enron’s young guns felt toward them was getting uglier. Yet Skilling—who took such pride in Enron’s kill-or-be-killed culture—was reluctant to take any action.

  When Skilling became CEO, it was assumed that one of his first tasks would be to replace himself as the company’s chief operating officer. There was no way that Skilling could choose one of his old compadres to succeed him as COO. They didn’t really want the job—but even if they had, Whalley and the other top traders had made it clear that there was only one acceptable candidate. That was Whalley himself. But Rice, who had been threatening to leave for some time, told Skilling that he was definitely gone if Whalley became COO.

  For his part, Skilling didn’t believe that Whalley was ready for the COO job. His stone-cold brilliance notwithstanding, Whalley was rough around the edges, and he knew little of the company beyond the trading organization. Some argued that he was “reckless” and pointed to such disasters as the metals deal. Executives in Enron’s other divisions were panicked at the possibility that Whalley would be chosen. There was a perception that he was not encouraging to women, Louise Kitchen notwithstanding, and Skilling was worried about reinforcing the widespread view that Enron’s culture was a macho one.

  Yet Skilling knew that he no longer had the blind loyalty of Enron’s traders, the major source of the company’s profits. Whalley did. So Skilling dithered. To one insider, it appeared that he was hoping something would give and the decision would magically take care of itself. By letting the situation simmer, says one former executive, “Jeff was tightening the noose around his own neck.”

  By early 2001, Pai and Rice were largely no-shows, yet they continued to hold important titles and take down millions in compensation. Rice and Pai were both in charge of deeply troubled businesses. The wholesale traders’ profits were hiding EES losses. The traders thought this was a grave injustice, and their resentment soon hardened into outright viciousness. One former executive from the trading side, asked to describe Ken Rice, replied: “Scumbag motherfucker.” Another trader says, “We sat around asking, why Pai? Why Rice? As motivating as everything at Enron was, to see people like that getting paid . . .” He paused for a moment, then added, “We had no respect for their intellectual capital.” In an effort to defuse the rage, Whalley used to tell his crew that the huge compensation the two were reaping should be rightfully thought of as founder’s pay, their reward for having worked so hard in the early years to make Enron what it had become. The traders didn’t want to hear it.

  Finally, in 2001, the old guard started to leave. The first to go was Cliff Baxter. Baxter had always been a bundle of resentments, and it had only gotten worse over time. He viewed himself in rivalry with Fastow, and he saw the CFO’s close relationship with Skilling as usurping his own position with the boss. He was also upset with Fastow’s LJM deals. He would rage about Fastow, “He’s a goddamn master criminal!” Baxter had also been humiliated by his treatment as head of Enron North America, where he complained about his lack of authority.

  Baxter’s last assignment at Enron was to sell the international assets after Project Summer fell through. It was an impossible task. The market for overseas assets was deteriorating; buyers simply couldn’t be found. Baxter always had an odd arrangement with Skilling—he could work the hours that he chose, which often meant twenty-hour days followed by vacation time. But by the end of 2000, the widespread perception was that Baxter wasn’t wo
rking anymore. Certainly, his heart wasn’t in it.

  And so, in late April, the two men agreed that Baxter would leave. The press release announcing Baxter’s departure went out on May 2, noting that he was leaving to spend more time with his family. At the end of May, all the top Enron executives and their spouses—including Andy and Lea Fastow—attended a farewell dinner held in Baxter’s honor.

  There was no press release announcing Lou Pai’s departure. He was largely a no-show in his last Enron job, running the Xcelerator. Pai had an office the size of Ken Lay’s on the fiftieth floor. Xcelerator was on the fifth floor. If he came in at all, he showed up at ten and was gone by two. He spent far more time at his ranch in Colorado. The new breed of traders had once respected Pai, but now they grew angrier and angrier at his sinecure. Skilling could no longer look the other way. In June, he called Pai to tell him it was time to go.

  Pai had continued unloading his shares. Just between May 18 and May 25, 2001, he sold almost a million shares. When he had finally parted with his last share, Pai had sold over $250 million worth of Enron stock—more than anybody else at the company.

  And then there was Ken Rice, who had always been considered Skilling’s golden boy. This was the most delicate of the three, because Rice was still running what was supposed to be a successful business, Enron Broadband Services.

  Back in 2000, one of Whalley’s deputies infiltrated the broadband ranks. His name was Jim Fallon, and he was a hard-nosed nuclear engineer who had become a CPA, worked at PricewaterhouseCoopers, gotten an MBA from Columbia, and joined Enron as an associate in 1993. On the trading floor Fallon had a variety of nicknames. One called him the Janitor, because he had a reputation for being able to clean up messes. Another called him J. Edgar Fallon. The rumor on the trading floor was that before he made the move to broadband, he sent a young associate down to the broadband offices late at night to snoop around people’s desks and see what information he could pick up. “You always know where Fallon is standing,” says another trader. “Behind you with a knife.”