Infectious Greed

by Frank Partnoy

  The abrupt boom and bust caused alarm bells to ring at the Securities and Exchange Commission. But interestingly, there were no sudden increases in reported profits to match the increase in stock price beginning in October 1999. Instead, MicroStrategy actually reported lower net income during the last quarter of 1999—when its stock price shot up—than in the previous quarter. Before then, net income had been increasing slowly and smoothly since 1997. In other words, MicroStrategy’s stock price was being driven by factors other than simple accounting fraud. Aggressive analysts were a likely possibility, but such a theory was outside Arthur Levitt’s box.

  Instead, the SEC brought a simple case, arguing that MicroStrategy had been manipulating its financial statements, typically at the end of a quarter. Some of the violations were very minor. For example, MicroStrategy recognized $17.5 million of revenue from one contract for the quarter ended September 30, 1999, even though the contract was not signed until the early hours of October 1. A $5 million contract signed on January 3, 2000, was booked in the quarter ended December 31, 1999. A $1 million contract signed on April 2, 1999, was booked in the quarter ended March 31, 1999. These were minor instances of earnings management. In 2000, the SEC would have found similar problems at just about any company.

  The SEC found some evidence supporting more serious allegations. Like Cendant, MicroStrategy was booking revenue upfront for service contracts that involved payments over time. In aggregate, the accounting manipulation led MicroStrategy to report gains, when in reality it was losing money throughout 1998 and 1999. The SEC enforcement attorneys had seen all this before, and the case moved quickly. By December 14, 2000, the top officers settled the case by agreeing to pay fines of $350,000 each.

  Done this way, the MicroStrategy investigation, like other instances of accounting fraud at technology firms, became an easy case. MicroStrategy’s officers were lightly punished, but the SEC forced them to undertake some reforms, and it could claim yet another victory in the fight against corporate fraud. The case became another “win” to be presented to Congress when it considered the SEC’s funding requests. In a related strategy, the SEC ran a series of nationwide Internet fraud “sweeps,” in which it brought enforcement actions against people who used the Internet in various fraudulent schemes.

  However, as the SEC brought more simple, easy-to-prove cases, it sent two signals to corporate executives. First, blatant accounting fraud would be punished, but only lightly. The officers of MicroStrategy, like those of other technology companies involved in similar schemes, were not charged criminally, did not go to jail, and the fines they paid were insignificant compared to the fluctuations of their stock-options positions. Second, more complex fraud would likely go unpunished. Arthur Levitt had mentioned only the easiest and most common methods of fudging numbers, methods corporate executives had been using for decades. Noticeably absent from the list were schemes involving the more complex financial instruments that chairman Levitt had repeatedly ignored during his term. Sophisticated companies were using various types of swaps, as well as Special Purpose Entities and new financial instruments called credit derivatives, to take undisclosed risks and hide losses. By sending the message that the SEC was policing a handful of straightforward accounting schemes, the SEC—perhaps inadvertently—sent a message to more sophisticated firms that they could manipulate their financial statements, as long as they did it in a way that was sufficiently complex.

  These more complex schemes would haunt the financial markets after the collapses of Enron and Global Crossing. But there was a hint of additional complexities in the MicroStrategy case, buried in a section of the SEC’s charges labeled “Other Accounting Issues.” MicroStrategy had recognized $5 million of revenue from a deal with Sybase, Inc., in which the companies essentially swapped $5 million of software. Was it illegal for a company to record revenue from such a swap? The SEC asserted that MicroStrategy should not have recorded any revenue until it either actually used the software or sold it to another party. But how would those rules apply to other swaps, such as an agreement to deliver natural gas over a several-year period, or an agreement to exchange fiber-optic capacity over several years? In the future, such hidden arrangements would cause much greater damage to shareholders than simple accounting fraud.

  Corporate executives profited from the technology boom in other ways, too. In particular, CEOs in “old-economy” businesses began buying technology companies in an attempt to increase the growth rate of their earnings. AT&T, WorldCom, Global Crossing, and others made massive investments in telecommunications infrastructure. Industrial companies—such as Enron—began shifting to an Internet platform, in an attempt to persuade investors that they, too, deserved the lofty valuations of Internet companies. Companies such as Enron also set up venture-capital subsidiaries, which they used to invest in start-up companies, just like Frank Quattrone at CS First Boston. For example, both Enron and WorldCom were major early investors in Rhythms NetConnections, which did an IPO with Salomon Brothers on April 6, 1999. One of the “lucky” investors who received shares at a price of $21 in the IPO was Bernard J. Ebbers, the CEO of WorldCom. The stock went up 229 percent the first day. WorldCom had invested $30 million and owned 8.6 percent of the company; Enron had a similar stake.78

  During his last years as SEC chair, Arthur Levitt tried to repair the damage done earlier, primarily by attacking accounting fraud. The SEC passed several well-intentioned measures during that time. In 1998, the SEC began requiring that financial filings be written in plain English and even published a “Plain English Handbook” on its website to help companies with grammar rules. In 1999, the SEC passed rules requiring additional disclosure and prohibiting corporate executives from intentionally misstating financial results, even if the misstatements were small—or immaterial—relative to the size of the company. Companies had been omitting disclosures that involved less than five percent of their revenues or earnings, calling them immaterial, but the SEC stated that “exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.” In 2000, the SEC established Regulation FD, for “Fair Disclosure,” which prohibited companies from selectively disclosing information to securities analysts.79 According to this rule, known as “Reg FD,” if managers wanted to disclose material information, they needed to disclose it to everyone, at the same time.

  These changes were cosmetic at best, and financial statements did not become more readable or accurate, because the punishments for violating the SEC’s rules were insubstantial. Corporate executives either ignored the full-disclosure rule—Reg FD—or used it as an excuse to avoid disclosing information. Moreover, Reg FD made illegal the one positive role securities analysts potentially had played: gathering hard-to-get information from companies. Not surprisingly, the quality of information about companies began to decline.

  Arthur Levitt’s last act as SEC chair was to oversee the passage of the Commodity Futures Modernization Act in 2000. Among other things, this law made clear that over-the-counter derivatives were exempt from regulation. It specifically included an exception for the trading of energy derivatives, a provision strongly supported by Senator Phil Gramm, whose wife Wendy had initially deregulated swaps in 1993 and had continued to serve as a member of Enron’s board of directors since then.

  Anyone who imagined that members of Congress, or their staffs, drafted laws regarding derivatives would have been surprised to peek inside the offices of the House Agriculture Committee during the time Congress was considering the CFMA. Instead of seeing members of Congress at work, you would have seen Mark Brickell, the lobbyist from ISDA, writing important pieces of the legislation. The legislative process has sometimes been compared to sausage-making; in the case of derivatives, the sausage makers were actually writing the law. The role of Congress was simply to look over the shoulders of the finance lobby, and nod.

  Without any serious oversight, the financial markets entered a period of frenzy. The
animal spirits became ubiquitous. It was as if the bartender, instead of announcing “last call,” had begun giving free drinks. Until March 2000, there was a boisterous party in the financial markets. Unfortunately for most individual investors, they were the last ones to arrive, long after the securities analysts, bankers, accountants, and corporate executives already had drunk their fill. Soon, as President George W. Bush would later remark, the hangover would begin.

  The first splitting headache for investors would be Enron, which had been the darling of financial markets as it grew from a modest oil-and-gas company into a global energy-and-technology behemoth. In its collapse, Enron would change the way investors thought about financial markets, although often not for the right reasons. The details of Enron’s collapse were not widely understood, and investors’ knee-jerk reaction to Enron was more like an alcoholic’s vow never to binge again than any rational decision about the merits of Enron as an investment. Nevertheless, the fall of Enron—more than the various international crises or the bursting of the dot.com bubble—was the key signal that the market merry-making of the 1990s had ended.

  10

  THE WORLD’S GREATEST COMPANY

  By now, most people have heard the basic story of Enron; how three radically different characters—the professorial founder Kenneth Lay, the free-market consultant Jeffrey Skilling, and the brash financial whiz Andrew Fastow—converted a small, natural-gas producer into the seventh-largest company in the United States, on the way generating fabulous wealth for Enron shareholders, employees, and especially insiders, who cashed out more than $1.2 billion. Most people also know about Enron’s spectacular fall into bankruptcy, the thousands of layoffs, the imploded retirement plans, the controversy surrounding political contributions, and even the details of Enron executives’ personal lives, such as Cliff Baxter’s suicide and Rebecca Mark’s alleged sexual exploits.1

  But the basic story is unsatisfying, because by focusing on just a few transactions and people, it ignores crucial details and fails to place Enron in perspective. Was Enron a unique surprise, a “perfect storm” of financial misdealings that, although it was devastating for Enron shareholders and employees, did not matter much to the general health of financial markets? Or was Enron the tip of an iceberg of financial risk and greed, a sign of serious sickness among public corporations? To answer these questions, it was necessary to understand where Enron fit within the major changes in financial markets since the 1980s.

  Simply put, two decades ago, Enron could not have happened. Enron was made possible by the spread of financial innovation, loss of control, and deregulation in financial markets. Enron’s managers—with the assistance of accountants at Arthur Andersen and several Wall Street banks—used complex financial instruments and engineering to manipulate earnings and avoid regulation. Enron’s shareholders lost control of the firm’s managers, who in turn lost control of employees, especially financial officers and traders. And Enron operated in newly deregulated energy and derivatives markets, where participants were constrained only by the morals of the marketplace. By 2001, modern financial markets had changed so radically that Enron was playing on an entirely new field, in a new body designed for a new sport.

  Enron’s officers combined the risky strategies of Wall Street bankers with the deceitful practices of corporate CEOs in ways investors previously had not imagined. Even after more than a year of intense media scrutiny, congressional hearings, and other government investigations, most of the firm’s dealings remained unpenetrated. A special committee appointed to decipher Enron’s collapse spent several months reviewing documents and interviewing key parties, but its two-hundred-page report covered just a few of Enron’s thousands of partnerships and was filled with caveats about its own incompleteness. The U.S. Congress held dozens of hearings, but barely scratched the surface. Incredibly, after Enron’s bankruptcy, the firm’s own officials were unable to grasp enough detail to issue an annual report; even with the help of a new team of accountants from PricewaterhouseCoopers, they simply could not add up the firm’s assets and liabilities.

  A close analysis of the dealings at Enron leads to three key conclusions, each counter to the prevailing wisdom about the company. First, Enron was, in reality, a derivatives-trading firm, not an energy firm, and it took on much more risk than anyone realized. By the end, Enron was even more volatile than a highly leveraged Wall Street investment bank, although few investors realized it.

  Second, Enron’s core business of derivatives trading was actually highly profitable, so profitable, in fact, that Enron almost certainly would have survived if key parties had understood the details of its business. Instead, in late 2001, Enron was hoist with its own petard, collapsing—not because it wasn’t making money—but because institutional investors and credit-rating agencies abandoned the company when they learned that Enron’s executives had been using derivatives to hide the risky nature of their business.

  Third, Enron, arguably, was following the letter of the law in nearly all of its dealings, including deals involving off-balance-sheet partnerships and now-infamous Special Purpose Entities. These deals, which blatantly advantaged a few Enron employees at the expense of shareholders, nevertheless were disclosed in Enron’s financial statements, and although these disclosures were garbled and opaque, anyone reading them carefully would have understood the basics of Enron’s self-dealing or, at a minimum, would have been warned to ask more questions before buying the stock. To the extent Enron, its accountants, and bankers were aggressive in transactions designed to inflate profits or hide losses, they certainly weren’t alone. Dozens of other companies were doing precisely the same kinds of deals—some with Enron—and all had strong arguments that their deals were legal, even if they violated common sense.

  In sum, relative to many of its peers, Enron was a profitable, well-run, and law-abiding firm. That does not mean Enron was a model of corporate behavior; it obviously was not. But it does explain how Enron could have happened. Although the media seized on Enron as the business scandal of the decade, the truth was that Enron was no worse than Bankers Trust, Orange County, Cendant, Long-Term Capital Management, CS First Boston, Merrill Lynch, and many other firms to follow, including Global Crossing and WorldCom, which collapsed soon after Enron. Enron’s dealings were not illegal; they were alegal; and Enron was a big story, not in itself, but as a symbol of how fifteen years of changes in law and culture had converted reprehensible actions into behavior that was outside the law and, therefore, seemed perfectly appropriate, given the circumstances.

  After Ken Lay received a Ph.D. in economics from the University of Houston’s night school,2 he quickly climbed the executive ladder in the energy industry, switching among various firms and specializing in “bricks-and-mortar” projects, such as the conversion of a trans-gulf Louisiana-to-Florida natural-gas pipeline. In 1985, Lay—with the assistance of Michael Milken’s firm, Drexel Burnham Lambert—arranged for Omaha-based InterNorth, one of the largest natural-gas companies in the world, to acquire Lay’s firm, Houston Natural Gas, for $2.3 billion. 3 It was a medium-sized merger by 1980s standards, but, for Ken Lay, it was the greatest opportunity of his career. He was selected to run the merged company, which was to be called Enteron. Fortunately, at the last minute, someone noticed that “Enteron” meant “intestine,” and the name was quickly abridged to Enron, which—as a spokeswoman said—“has no meaning other than what we make it mean.”4

  To help move Enron from bricks and mortar to the more exciting and lucrative business of trading energy products, Lay turned to Jeffrey Skilling, a partner at the prestigious consulting firm, McKinsey & Company. Skilling was more urbane than Lay, with an M.B.A. from Harvard and experience at a London investment bank; and he provided excellent advice about how Enron could create and profit from new energy markets. Both men were zealots for deregulation and free markets, and they became close friends. Lay also relied on Michael Milken of Drexel, who provided merger advice and helped Enron sell $180 mi
llion of junk bonds. Enron became the biggest client of Drexel’s eight-person Houston office.5

  As Andy Krieger, the currency-options trader, was beginning his career at Salomon Brothers, Enron was setting up an oil-trading business, called Enron Oil, in Valhalla, New York. From 1985 to 1987, the two men who ran the operation—Louis J. Borget and Thomas Mastroeni—reported nearly as much profit from oil trading as Krieger reported from currency options. When Charlie Sanford of Bankers Trust hired Krieger and gave him hundreds of millions of dollars to use trading, Ken Lay did the same thing with Borget and Mastroeni. The limit on their trading—twelve million barrels of oil—was about a third of the value of Krieger’s limit, a huge amount, given that Enron was a medium-sized energy firm, not a Wall Street bank.

  For Ken Lay, trading was a dream business compared to the dirty and dull pipeline projects of his past, and an entrée into the upper echelon of corporate America. He rewarded his energy traders with a total of $12.5 million in performance bonuses in 1985 and 1986, not much below Andy Krieger’s pay during the same time.6

  A few months before Charlie Sanford learned the bad news about Krieger’s trading profits, Ken Lay discovered a problem of his own at Enron Oil. As the stock market was crashing in October 1987, Lay learned that Borget and Mastroeni had positions of more than eighty million barrels of oil, almost seven times their limit. These positions represented roughly three months of output from the entire North Sea oil province, far more than Lay had imagined Enron Oil would trade.7 Lay also learned that the two men had been bilking Enron for millions of dollars.