Infectious Greed

by Frank Partnoy

  Borget and Mastroeni’s scheme presaged the financing structures Enron would use a decade later. The men had set up four Panamanian companies known by the acronym “SPIT” to enter into trades with Enron, much as Andy Fastow later would set up several partnerships to do business with Enron. Borget and Mastroeni used the SPIT companies to hide huge volumes of Enron’s trades and to redirect funds to themselves. The SPIT companies paid inflated fees to a London broker called Rigoil (a rather unfortunate name, given the rigged nature of the trades), which kicked back a portion of the fees to Borget and Mastroeni.8 In all, the two men diverted more than $5 million from Enron to themselves and related parties.9

  But the real damage was done when Enron officials tried to unwind the eighty million barrels of oil positions. The losses from those trades were around $140 million, wiping out the year’s profits and nearly destroying the firm.10

  In 1987, financial frauds were still being prosecuted with a vengeance, and a tough young federal prosecutor named James B. Comey got the case (fifteen years later, Comey would be the U.S. attorney in Manhattan, the lead federal prosecutor charged with investigating the unprecedented number of financial frauds). Comey obtained convictions, although Borget was sentenced to just one year in prison, and Mastroeni to two years’ probation and 400 hours of community service.11

  Enron’s reputation was sullied, but only briefly. Yes, the company’s first three years of financial reports had been false, but Enron was in good company, with Bankers Trust and Merrill Lynch, which had lost even more money during 1987 from their own trading scandals. Investors shrugged off these losses, blaming them on a few rogue traders. Enron’s core energy business seemed sound, and Ken Lay even found a silver lining in the scandal, saying, “We put in place probably the best risk management and control system, not just in our business, but in any industry.” Until 2001, it appeared that Ken Lay genuinely had, as he said, “learned a lot” from the experience.12

  In addition to a control system, Lay obviously needed some new talent and, within a few months in 1990, he got it, making the two most significant hires of his career: Jeffrey Skilling and Andrew Fastow. Skilling left McKinsey, at the age of 36, to run a new finance division at Enron. Fastow, just out of Northwestern’s M.B.A. program, quit his job at Continental Bank in Chicago, where he had been using some of the new structured-finance techniques that were spreading through the markets. Skilling had plans to revolutionize Enron by focusing on new markets for energy products, and by demonstrating that a modern corporation could be based on intellectual capital instead of physical assets.13 Fastow knew less about energy, but was eager to use his creativity and expertise in structured finance. Skilling and Fastow also became friends, and soon would join Ken Lay’s inner circle.

  Skilling and Fastow developed relationships with dozens of commercial and investment banks, and met regularly with bankers. During the early 1990s, when Bankers Trust, First Boston, or Salomon Brothers invented a new product, it wasn’t long before Enron learned about it. Enron developed especially close relationships with commercial banks, such as Citibank, J. P. Morgan, and Chase Manhattan, which were aggressively pitching investment-banking-type deals, now that regulators were permitting them to do so.

  Like most oil companies, Enron created partnerships—with the assistance of major banks, accounting firms, and law firms—to do its major projects, such as oil wells and pipelines.14 These partnerships—not Enron—borrowed money, purchased assets, and entered into leases and other contracts. There were numerous reasons for Enron to use partnerships instead of doing deals directly. By using partnerships (or other legal entities, such as trusts or corporations), Enron could create non-recourse financing—meaning that the company could borrow money for a project based solely on the assets of the partnership; investors in the partnership could not hold Enron responsible for the partnership’s debts. Moreover, so long as Enron controlled no more than 50 percent of the partnerships, accounting rules did not require that Enron consolidate the partnerships’ assets and liabilities; in other words, any debts belonged to the partnerships, not to Enron, and they would appear only in a footnote to Enron’s financial statements, not on its balance sheet. By keeping debt off its books, Enron would appear healthier, and the all-important credit-rating agencies would give Enron a higher rating.

  Enron also began using offshore Special Purpose Entities to do various over-the-counter derivatives deals, including swaps, that enabled Enron to borrow money without recording the debt. For example, in 1992 Enron and Chase Manhattan did a swap using a company called Mahonia, which had been incorporated in 1986 in the island of Jersey, a regulatory haven in Europe. Chase effectively controlled Mahonia, so in reality Enron was doing the swap with Chase (the legal independence of Mahonia potentially protected Chase from liability, an issue that would be hotly disputed beginning in 2001). At first, Enron used Mahonia to do deals that reduced its taxes. After several years, Enron also borrowed billions of dollars in prepaid swaps with Mahonia, organized by Chase and—after Chase’s merger with J. P. Morgan—J. P. Morgan Chase (more on these prepaid swaps later).

  As Enron’s deals became more complex, Skilling and Fastow took over responsibility from Lay. Skilling traveled the world to sell investors on Enron’s new concepts, and Fastow stayed in Houston to deal with the nuts and bolts of various financial issues. Meanwhile, Lay developed connections among business and political leaders. Lay chaired the 1992 Republican National Convention in Houston and sat with George H. W. Bush in the presidential box.15 After Bush lost the election in 1992, Lay maintained strong ties to the Bush family, hiring two of Bush’s former cabinet ministers and his former director of operations. Bush’s sons lobbied on behalf of Enron: Neil and Marvin in Kuwait and George W. in Argentina. 16 Lay also rewarded Wendy Gramm, Bush’s chair of the Commodity Futures Trading Commission, with a position on Enron’s board, just weeks after she had pushed through the regulatory exemption for over-the-counter derivatives, which were becoming an important part of Enron’s business.

  By 1993, Enron was an active participant in derivatives markets, along with just about every other company, investment fund, and governmental entity in the United States. As Gibson Greetings was buying complex swaps from Bankers Trust, Orange County was buying structured notes from Merrill Lynch, and John Meriwether was soliciting investors in Long-Term Capital Management, Enron was arranging the complex deal that the public would seize on as the cause of Enron’s demise. It was called the Joint Energy Development Investments Limited Partnership, or JEDI. Enron’s equal partner in JEDI was the California Public Employees’ Retirement System, known as CalPERS. Enron and CalPERS each invested $250 million, and they shared control.

  As with its other partnerships, Enron excluded JEDI from its financial statements. Again, the well-accepted rationale was that, because Enron controlled only 50 percent of JEDI, accounting rules did not require that Enron consolidate JEDI’s assets and liabilities. Instead, some of JEDI’s numbers were included in a footnote to Enron’s annual report.

  According to efficient-market theory, it shouldn’t have mattered where JEDI appeared in Enron’s annual report. As long as it was disclosed somewhere, the value of JEDI—positive or negative—should have been reflected in Enron’s stock price. In other words, Enron’s executives didn’t need to feel any qualms about burying JEDI in a footnote, because sophisticated investors would spot the disclosure and buy or sell Enron stock until its price was accurate. Thus, efficient-market theory reinforced a culture of following the bare letter of the law in complex financial transactions. Doing more simply wasn’t necessary.

  For efficient-market theorists, Enron was a poster child: a profitable, flexible, and efficient firm operating in new, unregulated markets. On December 9, 1997, economist Myron Scholes, then at Long-Term Capital Management, delivered a lecture in Stockholm, Sweden, after he received the Alfred Nobel Memorial Prize in Economic Sciences for his work in options pricing. He singled out two companies—General
Electric and Enron—as having the ability to outcompete existing financial firms, and noted, “Financial products are becoming so specialized that, for the most part, it would be prohibitively expensive to trade them in organized markets.” According to Scholes, Enron’s trading of unregulated over-the-counter energy derivatives was a new model that someday would replace the organized securities exchanges.

  Enron was every bit as sophisticated and aggressive as General Electric, and both companies were expanding outside the United States during the mid-1990s, just as financial risks were spreading to Mexico, East Asia, and beyond. Enron borrowed billions of dollars to fund overseas ventures ranging from a Brazilian electric plant to a United Kingdom water company.17 (Ultimately, Enron would lose much of that money.)

  The daisy-chain deals overseas were just as complex as the structured transactions developing in the United States. For example, in 1996, Enron Europe, with the help of Goldman Sachs and J. P. Morgan, sold a stake in a power plant to an entity called Thornbeam, which sold the stake to a Dutch company called Strategic Money Management, which then issued AAA-rated notes, backed by the power plant’s assets, to a leading bank.18 Andy Fastow also created a complex structured transaction in which Enron used a partnership called Marlin to put money into the Atlantic Water Trust, one of Enron’s many subsidiaries, which in turn invested in Azurix, a subsidiary that owned a majority of the facilities of a United Kingdom water company known as Wessex. In an interview with CFO Magazine, Fastow boasted about the deal: “What we did is we set up a trust, issued Enron Corp. shares into the trust, and then the trust went to the capital markets and raised debt against the shares in the trust, using the shares in the trust as collateral.”19 In other words, instead of borrowing money, Enron was using its own shares to pay for its overseas investments, a controversial practice contrary to the spirit of accounting rules, even though it was quite common and, arguably, within the letter of the law. No worries for Enron, though, Fastow assured CFO Magazine’s readers: “We have disclosures about it in the footnotes, which help our investors and the rating agencies understand all of this.”

  The legal changes of 1994 and 1995—including restrictions on securities lawsuits, incentives for companies to compensate executives with stock options, and various forms of deregulation—enticed Enron executives to take advantage of accounting rules, and contributed to the company’s developing mercenary culture. In 1994, Enron created an entity called Enron Capital LLC, incorporated in the regulatory haven of the Turks and Caicos, to deal in financial markets without complying with U.S. securities laws.20 In 1996, the Federal Energy Regulatory Commission began deregulating energy markets, in response to lobbying from Ken Lay and other energy firms. The more Enron did deals in the shadow of the law, the less legal rules seemed to matter. At the same time, most Enron executives received substantial numbers of stock options, which rewarded them for pushing short-term accounting profits. The options grants ranged from five percent of annual base salary to hundreds of thousands of options for top executives, far more than their counterparts at Cendant, Waste Management, Sunbeam, and Rite Aid. In all, Enron’s executives would make more than a billion dollars from these options.

  Enron’s risk-management manual explicitly encouraged employees to adhere to the letter of accounting rules, even if they were contrary to economic reality. It stated: “Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Risk management strategies are therefore directed at accounting rather than economic performance.” In other words, Enron managers were encouraged to focus on the accounting effect of their decisions more than their real economic impact. This was true even when Enron was dealing with issues of risk, where real economic impact should have mattered more to the company than accounting disclosures.

  As Enron’s board of directors became more international, to reflect the company’s new global businesses, it became less effective in monitoring Enron’s management. Lord John Wakeham, former leader of the British House of Commons, and minister of energy, previously had permitted Enron to build England’s largest power plant at Teesside, and now received even more money as a consultant to Enron than as a board member—both at the same time.21 The five-member audit committee of Enron’s board of directors was hardly full of watchdogs, either. Ronnie C. Chan, chairman of the Hang Lung Group in Hong Kong, and Paulo V. Ferraz Pereira, a senior officer of Group Bozano in Brazil, lived outside the United States and had little experience with U.S. accounting. Wendy Gramm, the former chair of the Commodity Futures Trading Commission, was conflicted as a direct beneficiary of Enron’s political and charitable largesse. Her free-market policy group in Washington, D.C., received $50,000 from Enron and another $10,000 from a foundation set up by Ken Lay. Her husband, Texas senator Phil Gramm, received $97,350 of aggregate donations from Enron, plus additional funds raised by Mark Brickell, the J. P. Morgan lobbyist, one of Wendy Gramm’s comrades.22 (Not surprisingly, the newspaper Barron’s called the Gramms “Mr. and Mrs. Enron.”) John Mendelsohn, president of the Anderson Cancer Center at the University of Texas, benefited indirectly from Enron’s $1.6 million of donations to the Center.

  That left the chair of the audit committee, Robert K. Jaedicke, a respected emeritus professor of accounting at Stanford. In spite of his accounting expertise, Jaedicke did not grasp the complex disclosure issues presented by the managers he was supposed to oversee and control. Jaedicke also made nearly $1 million from Enron stock—a lot of money for an accounting professor, even one who had been the dean at Stanford Business School during the 1980s.

  Enron’s anything-goes atmosphere was ideal for Jeff Skilling and Andy Fastow. Skilling was promoted to president and chief operating officer, and became Ken Lay’s clear No. 2 man in 1997. After Fastow raised more than $5 billion for Enron in 1996, in dozens of financings, Lay promoted him to senior vice president of finance, where he became the youngest member of Lay’s inner circle, at the age of 35. Incredibly, Enron—now a large multinational firm—still did not have a chief financial officer, so Lay quickly created the position and put Fastow in it.

  With Skilling and Fastow at the helm, Lay disengaged even more, turning to his social and political circles, and lobbying his friend, Texas governor George W. Bush. When Lay and Skilling were together, it often was merely for public appearances: for example, they posed for photographs while playing basketball with members of the Houston Rockets, who periodically stopped by Enron’s headquarters during the lunch hour to play on a special court set up in the street in front of Enron’s building.

  Meanwhile, Enron was changing its face. In 1997, Jeff Skilling unveiled a major new advertising campaign, complete with television advertising during the Super Bowl and a newly redesigned corporate logo (the one that later became known as the “crooked E”). Skilling described the ad campaign as the beginning of a process “to take Enron from being one of the least well-known large companies, to joining McDonald’s, Coca-Cola and American Express as one of the most recognized names in the world.”23 Enron even purchased the rights to name the Houston Astros’ baseball stadium, which became Enron Field.

  As the Internet IPO market began its boom, Enron strived to look like a dot.com, and began betting its future on technology and the Internet. Television monitors scattered throughout Enron’s headquarters in downtown Houston flashed the company’s stock price. Inspirational messages played inside the elevators. There was an on-site gym, and even a subsidized Starbucks coffee shop. Enron was named one of the best companies to work for in the United States. The retirement plan was generous, especially given that the stock price was rising. Every year, young executives received big bonuses and more stock options. And every year, the number of new Porsches and BMWs in the Enron garage multiplied.

  Enron’s board increased the incentives for executives to bet sha
reholders’ money on speculative ventures by granting huge numbers of stock options. In 1998, Enron granted almost 16 million options to its employees and executives.24 In 1999 and 2000, those grants more than doubled, to roughly five percent of Enron’s outstanding shares. By Enron’s own estimate, these options would have reduced Enron’s earnings by almost ten percent if their cost had been reflected in Enron’s financial statements. 25 (Fortunately for Enron, Congress had defeated the proposal to include stock options as an expense.) Moreover, because options were a one-way bet, unlike stock, they created incentives for the options holders to take risks that shareholders might not support, and to reduce dividend payments, which benefited only holders of stock, not options.

  In addition to granting these options, Enron entered into derivatives deals to ensure that it would have adequate shares to cover the options by agreeing to purchase its own shares in the future. These forward purchases of its own shares were like a cash repurchase of shares in the open market, except that they didn’t require any cash. Moreover, because these forward purchases involved over-the-counter derivatives, not actual securities, they did not need to be disclosed in Enron’s financial statements. By agreeing to buy its own shares in the future, Enron—and its executives—had made a huge, secret bet on Enron stock, without using any of Enron’s precious cash.

  Unfortunately, beginning in 1997, Enron lost most of the risky bets it made, costing the firm billions of dollars. First, Enron bet on the Internet by setting up a venture-capital firm to invest in Internet-related companies, and by putting its own trading operations on an Internet platform. Second, Enron expanded its trading from natural-gas and electricity derivatives—its primary areas of expertise—to new products such as fiber-optic capacity for telecommunications and even derivatives based on the weather. Third, Enron permitted employees to create and invest in new partnerships that did business with Enron, and to use these partnerships to manipulate Enron’s financial statements. For Enron, these deals were three strikes.