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

by Bethany McLean

  • • •

  While Lay was hobnobbing in Washington, Rick Causey was huddling with Enron’s accountants in Houston, haggling over just how far the company could go in sugarcoating its bad third-quarter earnings news.

  From the moment they decided to terminate the Raptors, Enron executives desperately wanted to avoid a restatement, which would mean the company was formally admitting mistakes, confessing to the world that its previous financial statements were wrong. Restatements triggered big stock declines, SEC inquiries, and shareholder lawsuits. It was far better instead to simply take a charge in the current quarter, something more akin to reporting that things hadn’t gone quite the way they’d expected.

  The balance-sheet error, of course, was a mistake. But Enron argued—incredibly—that this $1.2 billion balance-sheet error wasn’t “material” under accounting rules, because it amounted to only about 8.5 percent of Enron’s total net worth. David Duncan went along; Andersen didn’t want to admit the screwup either. Enron reported the charge as a simple equity reduction.

  The income-statement charges were harder to fudge. Enron was preparing to report a $544 million hit ($710 million pretax) for the Raptors’ termination. There was another $287 million for write-downs of overvalued assets at Azurix and $180 million for restructuring charges at broadband, which included the cost of layoffs and belated acknowledgement that the much-hyped content business really wasn’t worth much after all. The grand total was $1.01 billion after-tax, enough to throw Enron’s quarterly earnings deeply into the loss column. Andersen had already agreed that this wouldn’t require a restatement either, even though the Raptors, now being eliminated, had inflated Enron’s reported earnings for four previous quarters.

  The issue now was that Enron wanted to report these problems as nonrecurring charges, one-of-a-kind events that didn’t really reflect on the underlying performance of the company’s businesses. This too had big Wall Street implications. Analysts tended to discount nonrecurring charges and focus instead on operating earnings.

  For precisely that reason, the accounting treatment on this front was rife with opportunity for abuse. And Enron was a habitual abuser: historically, it had treated routine business losses as nonrecurring charges, and booked onetime gains as operating profits. In the Braveheart deal, for example, Enron booked its dubious monetization of the Blockbuster contract as operating income; now, it wanted to call its write-down of the content business a nonrecurring loss. Similarly, while Enron wanted to treat the Raptors’ termination as a nonrecurring event, it certainly hadn’t hesitated to treat the $1 billion in income they contributed as operating profits.

  Even for Arthur Andersen, this was going too far. David Duncan, uncharacteristically, was putting up a fight. With each new emerging problem, Duncan became more immersed in Enron than ever. He was so busy he even had to skip the big Arthur Andersen shindig in New Orleans, where his face was flashed on giant video screens in recognition of his status as one of the firm’s stars. His sterling work on the huge Enron account had just earned him a partnership bonus worth about $150,000.

  After seeing Causey’s first draft of Enron’s earnings release on Friday, October 12, Duncan alerted various Andersen partners and an in-house attorney named Nancy Temple. One partner quickly e-mailed back: “I agree with your comment about the nonrecurring wording which seems inappropriate given in one quarter they have multiple ‘nonrecurring’ items.”

  On Sunday, Duncan spoke to Causey, telling him that Andersen had “strong concerns that the presentation of the charges as nonrecurring could be misconstrued or misunderstood by investors” and that the SEC might well view it as “materially misleading.” In a memo Duncan later wrote documenting the events, he also recalled advising Causey to “consider changing the presentation.” Duncan’s old friend was noncommittal. “Rick acknowledged my advice,” Duncan wrote.

  Causey spent half his workday Monday in meetings with Ken Lay and others, prepping for the critical conference call that would immediately follow the earnings release. When he saw Duncan again that night, Causey told him he had discussed his concerns internally and that the earnings release had gone through “normal legal review.” Joined by other Andersen partners—some by conference call from Chicago—Duncan argued with Causey late into the night.

  Ultimately, though, it was Enron’s call, and the client wanted nonrecurring. The release didn’t even make it to the PR department until 5:30 A.M.—not long before it was to go out on the newswires, ahead of the market’s opening bell.

  • • •

  • • •

  For those who didn’t know any better, it would have been easy to conclude from Enron’s third-quarter earnings release, issued Tuesday, October 16, that nothing was seriously amiss. The headline actually seemed reassuring: ENRON REPORTS RECURRING THIRD QUARTER EARNINGS OF $0.43 PER DILUTED SHARE; REPORTS NONRECURRING CHARGES OF $1.01 BILLION AFTER-TAX; REAFFIRMS RECURRING EARNINGS ESTIMATES OF $1.80 FOR 2001 AND $2.15 FOR 2002; AND EXPANDS FINANCIAL REPORTING.

  What followed was classic Enron—an attempt to hide what was really going on by stretching the rules, twisting the language, and playing games. Instead of talking about quarterly earnings, as Enron’s earnings releases usually did, this one focused on “recurring earnings.” “Our 26 percent increase in recurring earnings per diluted share shows the very strong results of our core wholesale and retail energy business and our natural-gas pipelines,” Lay was quoted as saying in the press release.

  The billion-dollar nonrecurring charge was noted in the third paragraph, along with the $618 million net loss for the quarter. That was quickly explained away as a matter of housecleaning. The nonrecurring charges were described as “asset impairments” involving Azurix; “restructuring costs” at broadband; and $544 million “related to losses associated with certain investments, principally Enron’s interest in the New Power Company, broadband and technology investments, and early termination during the third quarter of certain structured-

  finance arrangements with a previously disclosed entity.” It was a massive obfuscation, calculated to hide the awkward fact that the now-terminated Raptors had hidden Enron losses. Even more astonishing, the release didn’t even mention the separate $1.2 billion cut in shareholders’ equity—which wouldn’t show up on the accompanying financial statements since Enron never released its updated balance sheet until well after the quarterly-earnings statements.

  In the 9 A.M. conference call, Ken Lay walked a carefully prepared line. First, he focused on the strong “recurring operating performance.” When he turned to the “nonrecurring charges of slightly over $1 billion,” Lay stuck to the script, again attributing most of the charge to “early termination” of “certain structured-finance arrangements with a previously disclosed entity.” Then he noted, for the first time, the giant balance-sheet hit: “In connection with the early termination, shareholders’ equity will be reduced by approximately $1.2 billion with a corresponding significant reduction in the number of diluted shares outstanding.” In other words, Lay was tying the equity cut to the purported housecleaning decision to terminate the Raptors. In fact, they were unrelated.

  Now, Lay insisted, all of Enron’s problems were on the table. “If we thought we had any other impaired assets, it would be in this list today.” Enron stock actually climbed a bit through the day, closing near $34.

  But Fastow knew trouble was on the way. “Well, you probably saw the earnings release and some of the interviews already,” he wrote in an e-mail to a family member. “Needless to say, things have been a little busy around here. I wouldn’t be surprised to see the LJM article appear tomorrow as part of the earnings story.”

  • • •

  Sure enough, Enron’s financial dealings with Andy Fastow were finally placed on public display the next day in the long-awaited story in the Wall Street Journal. Using the billion-dollar charge as their peg, Emshwiller and Smith did two things Enron had long feared: they cited the big third-quarter
loss as evidence that Enron’s business was, in truth, perilous, and they showcased the sordid details of Enron’s relationship with Fastow’s partnerships, raising “vexing conflict-of-interest questions.”

  This time LJM was front and center. The page-one story quoted from the offering memo’s discussion about how Fastow’s involvement would help LJM2 cash in on its deals with Enron—and noted that the company had embraced an arrangement that could provide “potentially huge financial rewards for Mr. Fastow.” Lay was described as having insisted in an interview that the arrangement didn’t really present any conflicts. Equally damning, Charles LeMaistre, chairman of the board’s compensation committee, told the Journal he viewed the arrangement as a supplemental form of compensation that helped keep Fastow, the valued CFO, at Enron. “We try to make sure that all executives at Enron are sufficiently well paid to meet what the market would offer.”

  After reading the Journal, Merrill banker Schuyler Tilney e-mailed a colleague: “Not a great article, but frankly could have been worse.”

  Fastow had a different reaction. Later that day, he e-mailed Ben Glisan with a simple message—“5:00 pm get drunk with Andy.”

  This story was just the beginning. The next day, Thursday, October 18, the Journal focused on the $1.2 billion hit to shareholder equity, highlighting its link to Fastow’s partnership and Enron’s failure to disclose “the big equity reduction” in its earnings release. Asked why Enron had hidden the cut, PR man Palmer was left to insist that it was “just a balance-sheet issue,” immaterial for disclosure purposes.

  Peter Fastow e-mailed his brother that morning. “Jana and I read the WSJ article with great revulsion,” he wrote. “We know, without a doubt, that there was nothing inappropriate with your involvement in LJM while serving as an officer of Enron. We support you 100%. Anyway, we both found the content of the article to be extremely suspect. If you were really making millions from LJM, there is no way you’d let your brother continue to drive a 7 year old Toyota Camry. We both wish there was something we could do to help you combat this attempt at character assassination.”

  The third shot arrived on Friday, headlined: “Enron CFO’s Partnership Had Millions in Profit.” Noting that LJM2 reaped more than $7 million in management fees in 2000, this story drove home the central nature of the conflict. Though the reporters didn’t know precisely how much Fastow had personally cleared, it was obvious that he’d pocketed millions doing business with Enron.

  “There I go, making money again,” Andy e-mailed his brother. “That is even allowed in Russia and China today. The saga continues.”

  As Fastow circled the wagons, some of his banker friends rushed to display their loyalty. CSFB’s Osmar Abib sent Fastow the dismissive research note that Curt Launer, his firm’s Enron-friendly analyst, wrote in response to the Journal stories. (“In our view, the so-called ‘LJM Partnerships’ were fully disclosed in ENE’s financial statements and were subject to appropriate scrutiny by ENE’s board, outside auditors and outside legal counsel . . . we continue to rate it Strong Buy.”) “Thought you would appreciate the support,” Abib wrote. “Hang in there.”

  Enron’s stock, meanwhile, had fallen more than 20 percent during the week, to $26, and was approaching levels not seen since 1997. On Tuesday, after the earnings call, Moody’s announced it was placing the company’s long-term debt on “review” for a possible ratings downgrade.

  There was yet another ominous development that week: after reading the Journal’s first story on Wednesday, SEC officials began an informal inquiry into Enron’s dealings with Fastow’s partnerships. Strange as it might seem, it wasn’t unusual for the agency to begin a securities probe on the basis of a media report. The SEC was short staffed and overwhelmed; its staff hadn’t conducted a routine review of Enron’s annual financial filings since 1997.

  In a letter sent by the SEC’s district office in Fort Worth, the agency informed the company that it wanted to “determine the nature and amount of the interests, profits, and losses of Enron and Mr. Fastow in the Related Party transactions.” Among other items, it wanted “an accounting of Mr. Fastow’s interests in each Related Party transaction, and showing his profits or losses with regard to the individual transaction.”

  Though the inquiry was short of a full-fledged investigation, it was still very bad news. On Monday, October 22, when Enron announced the informal probe—five days after getting the letter—its stock sank another 20 percent, to $20.65.

  • • •

  At this point, Lay believed he was the only one who could keep Enron together long enough to turn the ship around—and there were others telling him that as well. Lay responded to Enron’s growing problems like a politician under fire: he began polling his constituents. First, he conducted his own in-house sampling—called the Lay It On the Line survey—which revealed the unsurprising news that Enron employees were very concerned about their stock. Then he hired a political consultant—a high-profile Republican pollster named Frank Luntz—to conduct focus groups at Enron.

  Luntz’s report, which landed on Lay’s desk two days after the letter from the SEC, made brutally clear that the CEO’s exalted notions of Enron’s culture were a delusion. “Instability and chaos” were defining features at Enron, Luntz said. Far from reveling in their freedom, employees complained bitterly about senior management’s “lack of corporate vision”: “there appears to be no long-term thinking, strategy, or game plan.” Enron’s constant reorganizations—six in just the previous 18 months—were a running joke. The PRC was viewed not as a meritocracy but as “punishment.” Only deal makers got ahead; “no one in the corporate leadership truly cares about those charged with executing the deals and making them actually produce profit.” Enron’s lack of discipline wasn’t something noble that nurtured creativity; it was destructive and demoralizing. Commented one Enron employee: “We’re a major corporation still acting like a dot-com start-up.”

  But what Lay seems to have taken away from the exercise was Luntz’s belief that Lay alone had the “credibility, confidence, and trust” to deal with Enron’s crisis. “Ken is your most powerful weapon. A personal commitment from Ken Lay will go further than [from] the entire executive team combined,” Luntz wrote. “Employees want to see Ken Lay’s face. They want to hear from him and be led by him.”

  So Lay tried to lead. On Monday, October 22, he convened a meeting at the Hyatt of Enron’s best and brightest—not just members of the management committee but all the company’s managing directors, about 80 people in all. Andy Fastow wasn’t there; he’d been instructed not to attend.

  The meeting was cast as part of Enron’s new open communication in the post-Skilling era. The discussion quickly turned to Fastow’s partnerships. The board and senior management were behind Andy, he said; the managing directors needed to be supportive too. Enron had done nothing wrong, Lay insisted, “but knowing what we do now, we would never do it again.”

  “I’m in the terrible position of having to disagree with you,” said Vince Kaminski from the audience.

  Lay encouraged the risk-management wizard to speak his mind, so Kaminski stepped up to the microphone. Enron should never have gotten involved in Fastow’s private partnerships, Kaminski said. “The Raptors were not only improper,” he declared. “They were terminally stupid.” The company’s murky dealings had caused a crisis, Kaminski said. “The only fighting chance Enron has is to come clean.”

  Lay looked stunned; this was getting out of hand. “Enough, Vince,” Whalley interrupted, and he led Kaminski from the podium.

  • • •

  Later that same day, a few hours after the managing directors meeting, Enron’s board met. Unsure whether he was officially persona non grata, Andy asked a board secretary to “double-check that Ken wants me to attend.” He didn’t.

  Among the directors, there was much concern about the impending rating review by Moody’s, which had advised the company that it would be focusing on three issues: negative cash flo
w from operations, slow progress in the promised asset sales, and the likelihood of more write-offs involving Dabhol, Azurix, broadband, and California.

  The most pressing discussion was about Fastow. It was now painfully obvious that the media knew more about Andy’s partnerships than the Enron board did. The directors struggled to recall just what they had been told about the money Fastow made from the partnerships. The minutes noted: “Mr. Lay asked for a discussion regarding if the members of the Board had any recollection of information regarding the financial returns by Mr. Andrew S. Fastow in conjunction with certain financial arrangements.”

  In fact, the board had requested that information earlier. Back in October 2000 in Palm Beach, when Fastow won approval for LJM3, the directors actually asked the compensation committee to check on the CFO’s compensation from the partnerships. The committee chair, LeMaistre, even made a feeble attempt to carry out the request. Initially, he asked Mary Joyce, an Enron compensation executive, to give him information on the outside income for all of Enron’s top management. LeMaistre later explained that to avoid spreading office gos-

  sip he didn’t ask specifically about Fastow. When Joyce said she didn’t have the information, he asked her to let him know when she did. Six months later, he asked again. When no information arrived, LeMaistre simply dropped the matter.

  Now the board belatedly resolved to do the obvious: ask Fastow directly.

  • • •

  Andy Fastow was up early the next day, Tuesday, October 23. At 6:36 A.M., he

  e-mailed his office: “Mickey LeMaistre called and asked that I have a conference call today at 4 P.M. with him and John Duncan. I’m not sure who is supposed to arrange it. Could you coordinate?”

  Fastow then headed into the office, for an 8:30 A.M. analysts conference call. Determined to reclaim the initiative, Lay scheduled the call to address “investor concerns.” The executive team carefully prepared for the session with Enron’s outside accountants and lawyers. Vinson & Elkins partner Ron Astin displayed a Q&A script he’d marked up to the group—Lay, Fastow, Koenig, Causey, and Buy were all in the room. Included in the talking points was that Fastow had come up with the idea for LJM and presented it to the Enron board. “This is wrong!” Fastow screamed; LJM was Skilling’s idea.