Infectious Greed

by Frank Partnoy

  In a filing with securities regulators on November 8, 2001,62 Enron restated its financial statements, saying that its profits had been overstated by almost $600 million over four years. The culprits were JEDI, Chewco, and the LJM partnerships, which Enron had used to inflate its profits. Under the scrutiny of the special committee investigating Enron’s partnership deals, Enron finally was forced to disclose some of its hidden losses. The media gasped at the numbers; but, even as revised downward, Enron’s net income was substantial and its debt manageable. Even the restated numbers showed a profitable company, which should have easily survived.

  However, the restatement made it clear that Enron’s investment-grade credit rating was undeserved, and should be lowered a notch or two. Such a downgrade would kill Enron, because it would make it impossible for its traders to borrow money. The sluggish rating agencies were under pressure to respond, or else risk permanently soiling their own reputations. Enron had paid substantial fees directly to the credit-rating agencies for almost two decades, and agency officials didn’t want their downgrade to send Enron into bankruptcy. Nevertheless, the officials were worried about maintaining some credibility, so that regulators would not punish them or, even worse, open the market for credit ratings to competition. Based on historical data, the lowest investment-grade rating suggested that the probability of Enron defaulting on its debts within the next twelve months was just 0.33 percent.63 That probability was too low for Moody’s, which finally began planning to downgrade Enron to a rating of below investment grade.

  Moody’s would have downgraded Enron then, had it not been for entreaties from Dynegy, one of Enron’s competitors—and Dynegy’s investment bankers, including Richard Fuld, the chief executive of Lehman Brothers.64 On November 9, Dynegy told Moody’s it would agree to merge with Enron if Moody’s would maintain an investment-grade rating on Enron’s debt. The ostensible rationale was that, if the merger were completed, Enron would be financially stronger and would be more likely to be able to repay its debts. (In reality, the rating agencies soon would be downgrading Dynegy, too.) Less than an hour before Moody’s was planning to announce it was downgrading Enron to sub-investment grade, Moody’s capitulated and agreed to give Enron’s debt the lowest possible investment-grade rating. With that concession, Charles Watson, the CEO of Dynegy, agreed that day to a merger with a desperate Ken Lay. At this point, Enron was hanging by a thread.

  Ten days later, on November 19, Enron again restated its third-quarter earnings, and its stock fell to the lowest level in a decade. Enron extended by a few weeks the deadline on the $690 million of debt that would have been triggered by a downgrade, but the extension didn’t inspire the firm’s investors. Enron’s stock price fell to $3.

  The last straw for the credit-rating agencies was the revelation about derivatives deals Enron had used to dress up its financial statements, including $8 billion of prepaid swaps with J. P. Morgan Chase and Citigroup, and several deals designed to generate last-minute accounting profits at the end of the year. In the prepaid swaps, the banks paid money up front to Enron, in exchange for Enron’s promise to repay that money over time. The banks used Special Purpose Entities to do the deals—J. P. Morgan Chase used Mahonia, the Jersey company Chase had created years earlier. Enron and its accountants had argued that there were sufficient technical differences between the prepaid swaps and traditional loans that Enron could keep the swaps off its balance sheet.

  When U.S. Senate investigators later uncovered the details about Enron’s prepaid swaps, the politicians professed outrage. Senator Carl Levin interrogated officials from J. P. Morgan Chase, demanding that they accept responsibility for the prepaid swaps. He said, “They were just simply loans from these two banks that were covered up through a series of transactions. These were phony prepays. They were not real.”65

  These deals might have been phony, but they were both common and, arguably, legal. Numerous companies used prepaid swaps to borrow money off balance sheet, and prepaid swaps—like FELINE PRIDES and other structured finance deals—were part of mainstream corporate life, even though few investors had heard of them. Yes, these deals did not fit economic reality, but in a world governed by accounting standards, economic reality was barely relevant.

  J. P. Morgan Chase had pitched prepaid swaps with the understanding that they would be used to avoid liabilities. In a November 1998 e-mail, a Chase employee stated, “Enron loves these deals because they are able to hide funded debt from their equity analysts . . . they can bury it in their trading liabilities.” A Chase pitch book described the deal as “Balance sheet ‘friendly’” and said, “Attractive accounting impact by converting funded debt to deferred revenue or long-term trade payable.” Chase also noted that, from a tax perspective, the transaction would be treated as a loan. When one Chase employee expressed surprise that Enron had billions of dollars of prepaid swaps, another employee wrote in response, “Shut up and delete the e-mail.”

  J. P. Morgan Chase vigorously defended the prepaid swaps, and a spokesperson said, “If they were being marketed to other companies, it’s because they were perfectly legal transactions in accordance with generally accepted accounting principles.” In fact, J. P. Morgan Chase also marketed prepaid swaps to numerous companies, including Equitable Resources, Kerr-McGee, PG&E, Devon Energy, Dominion Resources, Duke Energy, and Phillips Petroleum.66

  Citigroup was equally active in prepaid swaps, marketing them to Williams, El Paso, Mirant, Dynegy, American Electric Power, Reliant Energy, and others.67 Enron did $4.8 billion of prepaid swaps with Citigroup. In one deal, called “Roosevelt,” Enron orally promised to repay $500 million Citigroup had advanced to Enron as part of a natural-gas swap; Enron later honored the oral promise, making the transaction appear to be a loan.68 Congressional investigators later uncovered e-mails from Citigroup showing that Enron had “agreed to prepay” and warning, “The papers cannot stipulate that as it would require recategorizing the prepaid as simple debt.”69 Given that Enron had disguised $8 billion of “loans” as cash flow from operations, the company had much more debt than the rating agencies had imagined when they gave Enron an investment-grade rating. Enron’s bankruptcy examiner would later discover more than $25 billion of debt.

  Enron also engaged in numerous other structured finance deals in addition to its infamous SPEs, none of which the credit-rating agencies had managed to uncover. For example, in December 1999, Enron had been desperate to sell its interest in some Nigerian barges that were mounted with electricity generators. Enron had planned to sell the interest to an Asian investor, but when that deal fell through, Jeffrey McMahon, a senior Enron executive, tried to find another buyer, so that Enron could recognize a profit from the sale before the end of the firm’s 1999 reporting year. McMahon approached Merrill Lynch, which reportedly agreed to “buy” Enron’s interest in the barges after Andy Fastow orally promised that, by June 2000, Enron would “make sure Merrill Lynch was relieved of its interest.”70 It was illegal for Enron to “park” securities with a bank—booking a gain—even though it planned to repurchase the securities later; and, as promised, LJM2 repurchased Merrill Lynch’s interest in the barges in June 2000. But Enron had never committed in writing to repurchase the interest, and Merrill defended the deal as a “real transaction, with real risk.” Merrill said it “would never knowingly engage in a transaction that threatened our reputation.”71 This Nigerian barge deal was one of many similar transactions.

  As the rating agencies learned the facts, they finally decided that Enron was not the investment-grade company they had imagined. The agencies delivered the death blow to Enron on November 28, downgrading its debt to below investment grade. Enron’s stock price dropped from $3 to $1 within a few minutes of the downgrade—the largest one-day percentage decline in the company’s history. There was no other important news that day, except the fact that Moody’s, Standard & Poor’s, and Fitch/IBCA were lowering their ratings on Enron’s debt. Now that Enron was sub-investment grade, i
t was locked out of the capital markets and could no longer sustain a trading operation. With the stroke of a pen, the rating agencies had put Enron out of its misery.

  The rating agencies apparently were unaware that Dynegy, Enron’s prospective merger partner—also barely above investment grade—had done similar off-balance-sheet deals with Citigroup, including one, called Project Alpha, in which Dynegy paid an incredible $33 million in fees to Citigroup and Vinson & Elkins, also Enron’s law firm, in order to inflate its own reported cash flow. Dynegy had booked mark-to-market profits on its derivatives trades, but had not yet received cash. Most experts believed that, although companies could use derivatives to manipulate their recorded income or debt, they could not use them to affect operating cash flow—the key variable in assessing the profitability of a company. Dynegy proved the experts wrong. Project Alpha enabled Dynegy to report it had received more operating cash, even though the deal did not affect Dynegy’s actual operations.72

  Dynegy described some aspects of Project Alpha in its annual report, but not in enough detail for anyone to understand. Later, when investors were trying to understand why Dynegy also collapsed, instead of explaining the details about Project Alpha, they simply pointed to Enron as the paradigmatic example of an energy company engaged in complex financial deals.

  In November 2001, Dynegy’s complex deals were not yet public, and the company sought to avoid being dragged down by Enron. After Dynegy’s officers learned the credit-rating agencies had downgraded Enron, they immediately terminated the merger. Without a partner, Enron had to suspend all payments, except those necessary to maintain its core operations. Enron’s credit was no longer good, and it could not find any more sources of money. Having lived just above the cusp of investment grade for more than a decade, Enron was about to die just below it.

  For Matt McGrath,73 a natural-gas derivatives trader at Enron, the last few days of Enron’s life were a surprise. Like many traders, McGrath had earned huge profits for Enron during 2001; but, given the firm’s trajectory, he had assumed a big bonus was unlikely. Bonuses for a given year typically weren’t paid until January or February of the next year, and McGrath wasn’t sure he would remain employed at Enron until then. Enron didn’t look like it would survive for much longer, and McGrath—like many traders—had begun looking for work elsewhere.

  When the credit-rating agencies downgraded Enron, all trading halted, and the high-tech trading floor became lifeless. Frenetic traders, with as many as nine computer screens stacked in front of them, took a break. A visitor to Enron’s trading floor would have seen a line of casually dressed young men and women, leaning back in their black-leather chairs, watching daytime television. There were few jokes or eating contests—not even ogling. The traders’ telephone turrets, with dozens of direct lines, were silent. No one was tossing Nerf footballs or listening to AC/DC.

  During Friday morning, some of the employees who worked on the fourth floor—two floors below the traders—decided to liven up the place and ordered several kegs of beer, to celebrate what might be their last day at the firm. The kegs were delivered around ten A.M., Styrofoam cups were passed around, and the traders from the sixth floor made multiple trips downstairs and back up. McGrath had just returned to the sixth floor when an attractive woman, with an Ally Sheedy haircut, stopped behind him and whispered, “Hey, I need you to come to meet me in a conference room. I’ll call you with directions. Wait by the phone.” McGrath was a little tipsy, but he recognized the woman as an employee from Enron’s human-resources department. He wondered if he was about to be fired.

  A few minutes letter, a phone line buzzed. The woman said, “Come down the hallway behind the trading floor. Knock on the last door on the left. If I come and open the door, you’re at the right place.” McGrath went to the hallway, and walked past the glassed office of John Lavorato, the senior trader known as Lavo. He had never been farther down this particular hallway, which was light and airy, with glass doors and windows throughout—except for one closed door made of dark wood, on the left, at the end of the hallway. The door appeared to lead to the only private room on the trading floor. McGrath had never seen it before.

  When the door opened, McGrath saw that the room was empty except for a twenty-foot oval conference table made of hickory and surrounded with black-leather chairs. The table was empty except for two pieces of paper. The woman told him to read them, and sign. One was a confidentiality agreement, requiring that McGrath not disclose any information he knew about Enron. The other was a check with more zeros than McGrath had ever seen. He quickly signed the agreement, took the check, and rushed to the bank.

  When he returned, he told the other traders what had happened. For the next several hours, the remaining traders sat by their phones and waited.

  Enron had decided to pay $55 million in advance bonuses to a handful of energy-derivatives traders who had had a spectacular year in 2001. Enron called the payments “retention bonuses,” and required that the traders remain at the firm for a few months. Indeed, Enron needed its top traders to stay at the firm, under contract if possible, so it could sell its trading business to another firm as an ongoing concern. Without the traders, Enron’s trading business was virtually worthless.

  Few people understood that these “retention bonuses” were the same amounts that Enron ordinarily would have paid the traders a few months later, as their year-end performance bonuses. The difference was that Enron was paying them early—ostensibly to get the traders to stay—but, in reality, because Enron was about to run out of money. The huge payments—such as $5 million for John Lavorato and $8 million for John Arnold, the trader who reportedly made $750 million of profits for Enron in 2001—were well deserved. During 2001, these traders had generated record profits for Enron, of several billion dollars, and had kept the company alive as it plunged into a series of ill-advised and conflicted investments. However, it wasn’t clear whether Enron legally could pay $55 million of bonuses and then file for bankruptcy. Such last-minute payments typically were not permissible. That was one reason why the traders were running so quickly to the bank with their checks.

  Anyone who doubted the supremacy of the derivatives trader in modern financial markets needed only to take a peek inside Enron on November 30. The company’s stock had plunged from $90 a share to pennies. Thousands of employees were out of work. Thousands more had watched helplessly as their retirement plans evaporated; they couldn’t sell their Enron shares during October and November because Enron was changing pension-fund administrators and had locked employees out of their plans.74 And yet, that Friday afternoon, one by one, a few top derivatives traders were called into secret meetings where they received seven-figure bonus checks in exchange for agreeing to stay at the firm just three months longer (and for agreeing to keep quiet about what they knew).

  December 2—two days later—was a busy Sunday for Enron: the company filed for bankruptcy protection, fired 4,000 employees, sued Dynegy for $10 billion for breaching its merger agreement, and procured $1.5 billion more in financing from J. P. Morgan Chase and Citigroup, so it could attempt to sustain a skeleton operation. Incredibly, Enron’s two big banks continued to lend the firm more money, even in bankruptcy.

  Ultimately, Enron sold its trading operations to Union Bank of Switzerland. According to some of the licensing agreements associated with this venture, UBS received all of Enron’s assets (including a long list of hardware and software) and did not assume any liabilities. The price for the deal: zero. UBS paid nothing for Enron’s trading operations, one British pound less than what ING (International Netherlanden Groep) had paid for Barings Bank six years earlier.

  The collapse of Enron led to numerous lawsuits, government investigations, and criminal prosecutions. But the question remained: were the direct participants really responsible for Enron’s collapse?

  Ken Lay, who finally stepped down in January 2002, benefited financially from Enron’s schemes; in all, he sold $144 million of Enron sto
ck. Lay also received loans from Enron, and public records from Texas indicated that several members of Lay’s family had purchased million-dollar homes during late 2000 and 2001. (Texas has a homestead exemption, which protects homes from being taken as part of the penalty in a criminal prosecution—however, as of early 2003, it was unlikely that prosecutors would be able to sustain charges against Lay or any members of his family.) Although Lay was not directly involved in the deals that ruined Enron, he helped to fashion the firm’s trading-focused culture. Especially after August 2001, when he learned the details of Enron’s partnerships, he should have been more engaged in Enron’s business, and more forthcoming with investors. But even then, Ken Lay really did not seem to understand what was happening at his company.

  Jeff Skilling also benefited from Enron’s schemes—selling $76 million of stock—and some people questioned whether Skilling’s reasons for resigning on August 14, 2001, were truly “personal.” However, Skilling had been CEO for only six months when he resigned, and it seems unlikely that he would have learned much startling new information during that time that would lead him to resign. Moreover, Skilling had effectively been running Enron for several years before he became CEO, and he was a reasonably hands-on person during this period. Instead, it seemed more likely that Skilling was telling the truth when he testified before Congress that, after several months of scrutinizing Enron’s dealings, he still believed that Enron’s financial statements had been accurate, and that accounting rules had permitted the various off-balance-sheet transactions. He clearly was right about Enron’s trading profits, which were substantial when he resigned. Indeed, there was a strong argument that Skilling was correct about the SPEs, too, and that, although Enron’s practices made little economic sense, they were, nevertheless, perfectly legal.