Infectious Greed

by Frank Partnoy

  The Rhythms NetConnections deal was just one of dozens of transactions Enron entered into with LJM and LJM2. They were deals involving various assets, debt, stock, loans, and derivatives, including put and call options. Many of these trades also were sweetheart deals for investors in the LJM partnerships. For example, in 1999, when Enron purchased a portfolio of corporate loans and repackaged them in a Collateralized Loan Obligation—a deal similar to the Collateralized Bond Obligations pioneered by First Boston and Salomon Brothers—Enron could not find a buyer for the riskiest securities in the deal, so it sold those securities to LJM2. When the transaction later deteriorated, Enron repurchased those securities at their full value .37

  Several of Fastow’s employees also became involved in the LJM transactions. Ben Glisan, Enron’s treasurer, and Kristina Mordaunt, an Enron lawyer who worked for Fastow, each invested $5,800 in a partnership called Southampton Place—after an exclusive Houston neighborhood. Southampton Place was involved in several dubious deals with the LJM partnerships: it bought CS First Boston and National Westminster’s stakes in LJM and repaid some of LJM2’s loans, using Enron’s backing and even a new subsidiary of Southampton Place, called Southampton K (“K” for Michael Kopper).38 Southampton Place made so much money that, within a year, it paid Glisan and Mordaunt each $1 million for their shares.39 Their annualized return was more than 16,000 percent. With those returns, it wasn’t hard to find “outside” investors.

  The last step in the evolution of Fastow’s structured finance deals involved four partnerships appropriately named “Raptors,” for the highly evolved species of dinosaur that appeared in the movie Jurassic Park (Enron’s officers apparently had decided to switch from Star Wars). There were four Raptors, which were used in various daisy-chain deals with LJM2. The myriad Raptor deals involved various types of complex derivatives and were almost incomprehensible; they were a major reason Enron was unable to produce an annual report for 2001. To give an example, one Raptor deal involved Enron lending money to Kafus Industries Ltd., a Vancouver paper-products company, in exchange for shares of Kafus, which Enron sold to SE Thunderbird LP, which was controlled by Blue Heron I LLC, which was controlled by Whitewing Associates LP, which was controlled by Whitewing Management LLC, which was controlled by Egret I LLC, all of which were listed among more than 3,000 affiliated firms in Enron’s annual report filed in 2001—but without enough detail to enable an investor to figure out what Enron was doing.40

  The Raptors satisfied the three percent rule with a neat trick: by having LJM2 act as their “outside” investor. It was a diabolical and intricate scheme. First, Enron invested in the Raptors by contributing derivatives based on Enron shares—or, in the case of Raptor III, shares of The New Power Company, a technology stock Enron had purchased before its IPO in October 2000. Then, LJM2 “invested” $30 million, in each Raptor, in exchange for a promise to repay the $30 million, plus $11 million of interest. Next, the Raptors sold a put option to Enron, giving Enron the right to sell its shares to the Raptors. Enron paid each Raptor $41 million for this put option, which the Raptors then forwarded to LJM2, thereby satisfying the Raptor’s obligation to repay the $30 million plus interest. The initial $30 million “investment” by LJM2 remained within the Raptor.

  In other words, the LJM2 “investors” were not investors at all; they had no money at risk and were simply temporary placeholders to satisfy the three percent rule. Their $30 million made a quick round-trip through Enron, picking up an extra $11 million along the way. For their willingness to “lend” $30 million to LJM2, they made $11 million—a 35 percent return—virtually overnight.

  The accounting treatment of the Raptors was a hotly debated topic within Arthur Andersen. One Andersen partner, Carl Bass, said the Raptors had “no substance,” and argued that Enron should be required to report the transactions. Enron’s chief accountant, Richard A. Causey, complained about Bass, and Andersen removed him from Enron’s account in March 2001.41 Enron and Andersen ultimately decided that the $30 million “outside” investment remaining in the Raptors satisfied the SPE rules.

  Enron used the Raptors to inflate the value of its own assets by selling a small portion of those assets to a Raptor at an artificially high price, and then revaluing the lion’s share of the assets Enron still held, at that high price. As with the other partnerships, Enron disclosed some details about these deals in the footnotes to its financial statements, albeit in a convoluted way. For example, anyone who cared to scrutinize page 49, footnote 16, of Enron’s annual report for 2000 would find the following two sentences: “In 2000, Enron sold a portion of its dark fiber inventory to the Related Party in exchange for $30 million cash and a $70 million note receivable that was subsequently repaid. Enron recognized gross margin of $67 million on the sale.”42 Anyone who thought carefully about these sentences would be very worried about the nature of Enron’s Related Party deals, and would be skeptical of whether Enron really was making money in its new telecommunications business.

  The Related Party was LJM2, although it wasn’t necessary to know that detail to be worried. The evident bottom line was that Enron had sold something called “dark fiber” for $100 million—$30 million in cash, plus $70 million in a note that would be paid over time—and made $67 million on the sale. In other words, Enron had sold something it valued at $33 million for triple its value. And it had sold that something to a Related Party.

  Dark fiber referred to telecommunications rights Enron had begun trading as part of its foray into the broadband business. In this business, Enron traded the right to transmit data through various fiber-optic cables, more than 40 million miles of which various companies had installed in the United States.43 Only a small percentage of these cables were lit—meaning they could transmit the light waves required to carry Internet data; the vast majority of cables were still awaiting upgrades, and were “dark.” As one might expect, the rights to transmit over dark fiber were very difficult to value.

  It was difficult to triple the value of a short-term investment in any business, especially telecommunications, which was struggling at the time. It was apparent that Enron had sold dark fiber at an incredibly inflated price. The inevitable conclusion was either that Enron had found a chump to buy some of its assets, or that Enron was engaging in some dubious, undisclosed side deal with LJM2.

  Andy Fastow and LJM2 certainly were not chumps. Instead, LJM2 was persuaded to pay an inflated price for the dark fiber, because Enron entered into a make whole derivative deal with LJM2: protecting it from a loss by agreeing to pay LJM2’s investors with additional Enron stock. In other words, when the dark fiber inevitably declined from its inflated value, the LJM2 investors wouldn’t care, because Enron would make them whole.

  This meant that Enron retained the economic risk associated with the dark fiber. As the value of dark fiber plunged during 2000, Enron would be obligated to deliver more stock to LJM2, offsetting Enron’s illusory gain from the original sale of dark fiber to LJM2. Yet, because LJM2 was an SPE—like Chewco and JEDI—Enron would not have to report the loss on its make-whole derivatives contract—that remained hidden inside LJM2. Instead, Enron would report only the gain from its purported sale of dark fiber to LJM2 at the inflated price. Thus, Enron and LJM2 became a financial hall of mirrors, where Enron looked profitable regardless of which way investors looked.

  In all, Enron committed to deliver almost $4 billion worth of its own stock in make-whole derivatives deals.44 With the stock price near its highs, these obligations amounted to just a few percent of Enron’s outstanding shares. But if Enron’s stock price fell, the obligations would increase, substantially diluting the holdings of Enron’s shareholders by requiring Enron to give more shares to its partnerships. Because the deals were unregulated derivatives with SPEs, Enron would not need to report the details of these transactions in its financial statements.45

  Enron’s sale of dark fiber to LJM2 also magically generated the appearance of a fair market price, which Enr
on then could use in valuing any remaining dark fiber it held. Enron could pretend that the sale to LJM2 was just like any other sale in the market. LJM2 had, in a sense, “validated” a higher price for the dark fiber in Enron’s inventory, and Enron could then use that inflated price to make its assets appear more valuable.

  Suppose Enron sold one unit of dark fiber to LJM2 for $30—triple its actual value—using this scheme. Now, Enron had an argument that each remaining unit of dark fiber also was worth $30. If Enron’s assets were difficult to value—as dark fiber was—Enron could inflate the value of its assets in reliance on the “market” prices established by the deals between Enron and LJM2.

  Legally, the valuation might be defensible. Economically, the valuation was preposterous, and Enron, eventually, would need to recognize a loss to offset the false profit it had booked. Until then, as Enron’s risk-management manual had instructed, accounting numbers were more important than economic reality.

  The inflated value of the dark-fiber deal between Enron and LJM2 would be the basis for a much larger, $500 million dark-fiber swap between Enron and Qwest Communications, the dominant telephone company in the western part of the United States.46 During the second quarter of 2001, Enron had been negotiating to sell its dark-fiber capacity to a real company—not one of its Related Party partnerships—so that it could really avoid a loss on its foolish telecommunications investments. However, talks with Qwest and Global Crossing had broken down. Late during the third quarter of 2001, Qwest finally became desperate for a deal that would generate some reported revenue. On September 10, Qwest had reduced its profit forecast by half a billion dollars and, by the end of September, it was obvious that it wouldn’t meet that lower estimate, either.

  On September 30, 2001—the last day of the quarter—Enron and Qwest agreed to the swap. Qwest would buy $308 million of Enron’s dark-fiber capacity, including lines running from Salt Lake City to New Orleans. Enron would buy some of Qwest’s lines for $196 million. It was unclear why Qwest—which had just announced plans to fire 4,000 employees—needed the new 5,500 miles of dormant capacity, especially in New Orleans, far away from its primary customers. But it was absolutely plain why Qwest was doing the deal: it booked $86 million of the amount Enron paid as revenue in the third quarter. Enron recorded the revenue from its sale of dark fiber, just as it had done on the previous deal with LJM2. It was all eerily similar to MicroStrategy’s swap a few years earlier.

  Arthur Andersen, which audited both Enron and Qwest, blessed this accounting treatment, and both Enron and Qwest marked to market the value of their positions, recording an accounting profit even though they were not receiving any cash. It appeared that both companies were planning to record the expenses related to these deals in later quarters, but neither would survive for long enough to know for sure. (In late 2002, Qwest would admit to other swaps and reduce its reported profit even more.) The Enron-Qwest swap illustrated the accounting professor’s admonition that profit is an opinion, but cash is a fact.

  Accounting numbers were especially important at EnronOnline and Enron Energy Services, two Enron businesses that appeared to generate revenues and profits but, in reality, were losing money. EnronOnline was Enron’s Internet platform for computerized trading of virtually any commodity. Compared to Enron’s SPE schemes, which were abstrusely disclosed, EnronOnline was transparent. Nothing at EnronOnline was off balance sheet; indeed, the point of EnronOnline was that everything was on balance sheet, including “revenues” that arguably didn’t belong.

  The idea of EnronOnline was simple: Enron would set up a website for trading various commodities and derivatives, and its clients would use it. Enron would use the website to match buyers and sellers, just like an exchange, except that the transactions would take place on-line with Enron. It was like eBay for commodities, except that Enron would act as counterparty to each trade.

  Enron booked many of EnronOnline’s trades as revenue, even though the money paid by buyers went directly to sellers. It was this “revenue” that propelled Enron to seventh on the Fortune 500 list of top U.S. companies, which was based on revenue, even though most experts agreed that revenue was a poor measure of the true size of a company (profit or share value were better). Without EnronOnline’s sham revenues, Enron would have been perceived to be a much smaller company.

  EnronOnline was the brainchild of Louise Kitchen, a junior Enron executive who had worked after hours developing the Internet platform with key employees in Enron’s commercial, legal, and technical departments. Kitchen’s secretive approach to EnronOnline made sense given the mercenary culture at Enron, where an aggressive manager might try to steal a good idea, and where top employees such as Kitchen were encouraged to pursue new business lines on their own. Kitchen even protected herself by obtaining patents for the trading system—in her name.

  Just a few weeks before she was ready to launch EnronOnline, Kitchen finally told Jeff Skilling about it. He was enthralled, and immediately took credit for the idea, launching EnronOnline on November 29, 1999. A year and a half later, when the site had completed its one millionth transaction, Skilling would proudly proclaim: “With the power of the Internet, we believe the potential for extending our business model to new markets is limitless.”

  Like much of Enron’s dealings, EnronOnline functioned outside the scope of U.S. financial regulation. EnronOnline was exempt under U.S. law because all of its trades were judged to be “bilateral contracts” between the two parties trading on Enron’s website, and such over-the-counter derivatives were unregulated, thanks to the new law passed by Congress in December 2000, with Senator Phil Gramm’s involvement, cementing the derivatives exemption Wendy Gramm had pushed through in 1993. It was a sign of Enron’s political influence that U.S. legal rules permitted the firm to set up an unregulated website to trade energy derivatives when prosecutors were bringing cases against other firms doing precisely the same thing with other financial instruments. (Recall from Chapter 6 that, in 2002, federal regulators shut down just such a website set up by Mitchell Vazquez, the former Bankers Trust salesman who had covered Gibson Greetings.)

  The theory behind EnronOnline was that trading networks based on long-term relationships among a small number of market participants were too costly. Instead, EnronOnline was an open, transparent market, which—it was argued—would be cheaper and fairer than alternatives. Any member of the network could offer to buy and sell any amount of any trade at any time, and all trades would be posted on the website.

  Unfortunately, the theory was flawed. Trading networks often failed because they were transparent. Numerous studies showed that electronic trading networks were more expensive than exchanges run by human beings, and sophisticated investors—given the choice—frequently chose less automated systems. For example, the clean and computerized Tokyo Stock Exchange had higher trading costs than the loud and frenetic New York Stock Exchange and, in both markets, when sophisticated investors wanted to sell large blocks of shares, they typically did it privately, through a Wall Street bank, not with the stock exchange. Notwithstanding the advances in computer technology and artificial intelligence, trading networks seemed to work best when real people were directly involved. Even eBay, the Internet auction site, allowed for human interaction.

  Moreover, even if EnronOnline succeeded, and lowered the costs of transacting, it was unclear why it would generate profit for Enron. If anything, it would sabotage Enron’s other profitable trading operations by commoditizing Enron’s businesses. Enron might capture more trading “revenues,” but its profits from trading would decline.

  Nevertheless, EnronOnline sounded good, and investors and securities analysts seemed to like the idea. Enron’s employees stressed EnronOnline’s flexibility. A presentation by EnronOnline manager Mike McConnell began with Charles Darwin’s quote: “It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.”

  EnronOnline could have used more
strength and intelligence. Without much serious thought, Enron first used the EnronOnline model for natural-gas trading, and then copied it to cover the trading of virtually any commodity. It was simply a matter of creating another link on the website. First, traders branched out from oil to steel to plastics, commodities that already were traded on various exchanges in Chicago. In these cases, the only significant advantage of EnronOnline over the exchanges was its ability to avoid U.S. regulations. Not surprisingly, EnronOnline’s revenues increased, but its profits narrowed. In response, traders began searching out more exotic markets to trade—retail energy services, fiber-optic bandwidth, and, finally, weather derivatives—which they hoped would have higher margins.

  Ironically, on-line bets on the weather (which the media later mocked as a sign of Enron’s murky dealings) were one of the few successes of EnronOnline. Weather derivatives—essentially, bets on changes in the weather over a period of time—already were traded in the over-the-counter markets among private parties. These contracts might have seemed like lunacy at first, but they actually fulfilled an important economic function. Many businesses—such as farming, leisure, insurance, and travel—faced risks based on the weather. Weather derivatives allowed parties to hedge risks they previously had not been able to hedge.

  Trading in weather-related contracts had not become standardized in any way, and Enron was a leader in creating a standardized trading platform. The contracts were based on the minimum or maximum temperature, the inches of rainfall or snowfall, the amount of streamflow or storm activity, or the level of perceived temperature (wind chill or heat index). With Enron, if you wanted to bet that the temperature in Houston on August 1 would be above 100 degrees, you could do so.