Infectious Greed

by Frank Partnoy

  Andy Fastow benefited directly from Enron’s schemes, selling $30 million of stock, and making another $45 million from the LJM partnerships in two years. In July 2001, Fastow made an undisclosed amount from selling his interests in the LJM partnerships to Michael Kopper, just after Kopper resigned from Enron.75 Fastow told board members he had spent only a fraction of his time working on the LJM partnerships, but it seemed that he had spent a great deal of time engineering the partnerships’ deals with Enron. According to several sources, Lay, Skilling, and Enron’s board members were stunned when they learned how much money Fastow had made from the partnerships.76 But many financial institutions permitted their employees to engage in deals with related partnerships—the involvement of ninety-six employees from Merrill Lynch as investors in LJM2 was not unusual, by Wall Street standards—and Fastow was nowhere near the highest-compensated person at Enron. If Enron’s board hadn’t agreed to compensate him from the LJM partnerships, Fastow could have quit Enron and made nearly as much money somewhere else. Most important, Fastow’s compensation didn’t prove that the SPE deals were illegal, or that Fastow possessed criminal intent. Fastow was indicted for various schemes related to the SPEs, and the allegations of kickbacks were damning. But as for the vast majority of the SPEs Fastow created, he arguably was playing within the rules of a game whose very structure and purpose had been corrupted.

  Some of the highest-paid senior executives at Enron were less known, but more directly involved in the company’s most spectacular failures. Lou Pai, who ran two ruinous businesses—Enron Energy Services, the firm’s retail energy flop, and NewPower Holdings, one of Enron’s failed dot.coms—sold $270 million worth of Enron stock. Thomas White, the vice chairman of Enron Energy Services—who then became secretary of the army—made $5.5 million a year, and sold $12 million of stock during the months before Enron’s bankruptcy. Ken Harrison, the former CEO of Portland General, who also was on the board of Rhythms NetConnections, sold $78 million of stock.77 In terms of Enron’s failed business operations, these three men deserved just as much blame as Lay and Skilling.

  After Enron’s bankruptcy filing, Jack Welch, former CEO of General Electric, blamed the firm’s trading culture for the losses, comparing Enron to the Kidder Peabody scandal involving Joseph Jett, which occurred under his watch: “I think what happened was they got into a culture they didn’t understand, and culture counts. When I got into one I didn’t understand, we screwed it up. We were lucky it was small enough. We sold it and got out. And got out alive. But it could have eaten us up if it were a bigger thing. This thing at Enron got bigger than the core business and it ate them up.”78

  But Welch had it backwards. The problem at Enron wasn’t the trading culture; Enron had been a trading firm since the beginning, and it was a profitable one. Welch had the wrong image in his mind when he spoke of moving “from people in overalls and wrenches who ran pipelines and utilities to a trading business where people wore suspenders and had $10 million salaries.” Enron’s traders didn’t make $10 million, and they certainly didn’t wear suspenders. John Arnold, the 27-year-old who made $750 million for Enron and was the highest-paid trader, at $8 million, was by all accounts a calm, low-key math whiz who was simply a better trader than his peers—he arguably deserved a bigger bonus. No, the people who were most to blame for Enron’s collapse weren’t the traders. Instead, it was the corporate executives who had run Enron’s non-trading businesses, all of which were utter failures. They were the ones running off with the serious money.

  Enron’s bankers and lawyers had not exactly behaved admirably, but it was difficult to pin much blame on them. Enron paid several hundred million dollars in fees to banks for work on various financial aspects of its business, including fees for derivatives transactions and loans masquerading as prepaid swaps, and yet none of those firms pointed out to investors any of the derivatives problems at Enron.79 Enron’s bankers faced serious conflicts of interest, and many were even investors in Enron’s partnerships. Recall, also, that as late as October 2001, sixteen of seventeen securities analysts covering Enron rated it a strong buy or buy.80 Enron paid more than ten million dollars in legal fees to its primary outside firm, which previously had employed Enron’s general counsel, yet that firm failed to correct or disclose the problems related to derivatives and Special Purpose Entities. But the bankers and lawyers weren’t accountants, and it was difficult to hold them responsible for accounting mistakes. The deals they had structured had a financial and legal justification, even if they were dubious from an accounting perspective.

  Arthur Andersen was responsible for auditing Enron’s financial statements and assessing Enron management’s internal controls on derivatives trading. Most people blamed Andersen for Enron’s collapse, and even Andersen’s top auditors seriously considered the fact that they might be responsible for Enron’s malfeasance, when they met in January 2001 to discuss Enron’s account. They discussed these risks but, ultimately, decided that Enron was a large enough client that it was worth the downside.

  However, the case against Andersen was a difficult one, too. When Andersen signed Enron’s 2000 annual report, it expressed approval, in general terms, of Enron’s system of internal controls from 1998 through 2000.81 Andersen certainly could have done a better job of independently verifying Enron’s valuations of complex trades; but most of the information relevant to Enron’s questionable deals was contained in Enron’s financial statements, even if it was hard to understand. (In Enron’s 2000 annual report, it stated that the firm’s derivatives-related assets and liabilities had increased five-fold during one year alone,82 a flashing red light to anyone reading the report.) Although Andersen was convicted of obstruction of justice, it would have been much more difficult to convict the firm of securities fraud. The strongest argument that Andersen was to blame for Enron’s collapse was one few commentators had made: Andersen had been willing to opine that Enron’s internal controls were adequate when it was obvious, based on Enron’s financial statements alone, that the firm was spinning out of control.

  Investors, prosecutors, plaintiffs’ lawyers, and members of Congress have blamed the various direct participants in Enron’s collapse. But, in reality, it was difficult to assign blame to any of these people, even though several, including Skilling and Fastow, were convicted of crimes (Lay died before his sentencing, and a judge vacated his conviction). Instead, it was the parties outside Enron that were most to blame: the credit-rating agencies that had propped up Enron’s credit rating and then pulled out the carpet at the end; the investors who had not scrutinized Enron’s public filings; and the legislators and regulators who not only had passed the rules Enron used to rationalize its dealings, but then stood by for years while those rules distorted the dominant corporate and financial culture so much that Enron’s dealings, which should have been reprehensible, became permissible.

  Enron was the culmination of the decade’s key developments in financial markets. First, Enron’s financial instruments were so complex—and so many of its deals were so explicitly designed to skirt legal rules—that few people understood the company, and even its accountants and bankers did not have an accurate picture of Enron’s finances. Second, control and ownership of Enron were so far separated that shareholders and the board of directors could not stop, or even effectively monitor, the self-interested activities of Enron’s managers. Third, the markets Enron participated in—including both the energy and derivatives markets—were mostly deregulated; no corporate executive, accountant, or banker perceived a substantial risk of punishment for misleading investors, in part because prosecutors hadn’t been punishing complex financial fraud, but also because their activities arguably complied with the letter of the law.

  Enron reinvented the U.S. corporation, trading every commodity imaginable, not just natural gas, but also electric power, plastics, metals, bandwidth, pollution, and even complex bets on the weather. Enron moved this trading to the Internet, where traders completed more
than a million on-line transactions. In 2001, Enron was worth more than AT&T, and its top officers were prosperous, prominent members of the Houston community. The firm’s lower-level employees were wealthy, too; Enron awarded them so many stock options that many already were millionaires, and most others expected to be millionaires soon, given Enron’s soaring stock price. It didn’t even seem like hubris when an enormous banner was put up at the firm’s headquarters, proclaiming Enron “The World’s Greatest Energy Company on the Way to Becoming the World’s Greatest Company.”

  Then—poof—Enron was gone. It was only a few weeks from the time of Ken Lay’s October 23 conference call, when Enron seemed to face only a minor crisis, until the company filed for bankruptcy protection.

  Enron’s focus on markets resurrected an important question Ronald Coase, the Nobel Prize-winning economist, had first posed fifty years earlier: markets or companies?83 According to Coase, markets and companies were alternative ways of doing business—you could buy a widget in the market or you could produce it in a company—and rational economic actors would choose whichever method was cheaper and more efficient. Someone had to make the widget, but that person didn’t necessarily need to operate within a corporate structure. In other words, companies existed only when it was cheaper to provide a service or produce a good within a company than in the market.

  The dominant belief during the 1990s was that markets would dominate companies, which were no longer able to change at the pace and scale required in the new economy. Enron was the definitive representation of this belief.

  But for Enron, the victory of markets over companies was a Pyrrhic one. Enron was destroyed, in part, because it became too costly for it to engage in its own businesses within a corporate structure. The costs of a company, compared to the costs of the market, included not only a building, computers, and paper clips, but also the very real agency costs associated with human behavior.84 At Enron, there were too many conflicts of interest within those agency relationships, too many temptations for personal profit, and too many ways to use other corporate entities—such as partnerships and Special Purpose Entities—to hide details from shareholders. These were all costs of putting so much activity within a single corporate structure. In the end, Enron was evidence that the answer to Ronald Coase’s question, increasingly, was markets, although that answer was the death knell for companies such as Enron.

  Although some of Enron’s businesses were profitable, the fact that they were housed within a large and costly corporate structure marked Enron for doom. Ironically, this conclusion was precisely what Jeff Skilling had been preaching, in substance, since he had joined Enron in 1990. Skilling had argued that Enron should strip itself of hard assets and focus, instead, on making money as a market intermediary, profiting from individuals and institutions that traded in organized markets, rather than from producing the items those traders might buy or sell. To the extent that it focused on markets—including acting as a market intermediary trading energy derivatives—Enron was a success. To the extent that it abandoned markets—dealing in opaque disclosures and Related Party transactions in other businesses—Enron was a failure.

  During the months after Enron’s demise, numerous shareholders of other companies would decide that the corporate structure was too costly for their other businesses, primarily due to the costs associated with monitoring complex financial transactions. Those companies—Global Crossing, WorldCom, Adelphia, Tyco, and so on—would fail, just as Enron had. Other companies would nearly fail. The next era of markets would be defined by an effort to untangle the web of conflicted relationships within various corporate structures, and to hunt for—and avoid—companies, like Enron, that simply cost too much to justify their existence.

  As time passed, investors learned that Enron—which many journalists had labeled the biggest business story of the decade—was merely the first public notice of a much bigger story about how much the playing field of investing had changed. During Enron’s life, it had evolved from a bricks-and-mortar firm into the perfect design for modern markets: an agile firm focused on technology and trading, with finances too complex to describe in the traditional language of finance. Perhaps it was fitting that Enron’s officials became the scapegoats for investors seeking an explanation of why their double-digit returns were ending. But Enron was not merely about a few bad guys, and anyone who believed it was would miss the important connections between Enron’s collapse and the even bigger bankruptcies that were about to follow it.

  11

  HOT POTATO

  Just as the interest rate hikes of early 1994 had uncovered hundreds of derivatives bets at major institutions, the collapse of Enron exposed widespread risks and deceitful practices at the world’s leading corporations. Any investor who read a newspaper in 2002 knew about financial scandals at companies ranging from Adelphia to WorldCom, from Anadarko to Xerox.

  By the end of 2002, the surfeit of information about complex dealings and surprise losses became, for many investors, like financial white noise. On average, one company restated its financials every day. There was a billion-dollar collapse every few weeks. Congressional inquiries into the Enron, Global Crossing, and WorldCom scandals were televised incessantly.

  At first, public officials blamed corporate executives and accounting firms. Jeffrey Skilling of Enron was publicly assailed, while other former CEOs, including Bernard Ebbers of WorldCom, invoked their Fifth Amendment right against self-incrimination. Arthur Andersen was convicted of obstructing justice, PricewaterhouseCoopers was charged with violating rules requiring auditor independence, and Congress established new penalties for top corporate executives and additional oversight of accounting firms. Over time, the emphasis shifted from CEOs and accountants to Wall Street, as it became clear that major banks—especially Citigroup and J. P. Morgan Chase—were intimately involved in the various schemes.

  The range of financial malfeasance and manipulation was vast. Energy companies, such as Dynegy, El Paso, and Williams, did the same complex financial deals Andy Fastow had engineered at Enron. Telecommunications firms, such as Global Crossing and WorldCom, fell into bankruptcy after it became clear they, too, had been cooking their books. Financial firms were victims as well as aiders-and-abettors. PNC Financial, a major bank, settled SEC charges that it abused off-balance-sheet deals and recklessly overstated its 2001 earnings by more than half. A rogue trader at Allfirst Financial, a large Irish bank, lost $750 million in a flurry of derivatives trading that put Nick Leeson of Barings to shame. And so on, and so on.

  These firms were closely connected, and Enron was at or near the center of the web. During the previous decade, the financial world had become even more incestuous than Hollywood, with its “six degrees of Kevin Bacon” (one degree was being in a movie with Kevin Bacon, two degrees was being in a movie with someone who was in a movie with him). In 2001, “two degrees of Enron” was more than sufficient to link most major corporations and financial firms. Enron did dubious deals directly with Global Crossing, WorldCom, and many other firms. Enron officials marketed earnings-management strategies to other companies, ranging from AT&T to major utility companies. Enron also did deals with Citigroup, J. P. Morgan Chase, Merrill Lynch, and other prestigious banks; those banks, in turn, transacted with nearly every public company.

  The top energy and telecommunications firms did the most notorious transactions, including questionable round-trip swaps with each other, many of which were arranged by Wall Street’s top banks and blessed by Big Five accounting firms. Some of these swaps merely inflated the companies’ revenues, without affecting the bottom line; others puffed up profits. Like Enron’s partnership transactions, many of these deals were arguably legal, but they were contrary to economic reality and common sense, and when investors learned about them, they dumped the companies’ stocks, without regard for whether the practices could be defended in court.

  As with the prior financial scandals, substantial losses were related to over-th
e-counter derivatives. There were prepaid swaps, in which a company received an up-front payment resembling a loan from a bank, but did not record its future obligation to repay the bank as a liability. There were swaps of Indefeasible Rights of Use, or IRUs, long-term rights to use bandwidth on a telecommunications company’s fiber-optic network, which were similar to the long-term energy derivatives Enron traded—and just as ripe for abuse. And there were more Special Purpose Entities, created by Wall Street banks.

  As news of the various corporate fiascos spread, there was more evidence of the inefficiency of stock markets, where individual investors played, especially as compared to the markets for bonds and derivatives, where more sophisticated institutions dominated trading. Invariably, when bad news appeared about a company, that company’s bonds and derivatives were hit first, as financial institutions quickly sold their holdings and bet against the company. In contrast, stock markets reacted only gradually, in a kind of slow-motion crash, as individual investors sluggishly realized they should sell. For example, on the day Enron CEO Jeffrey Skilling resigned, the price of Enron’s stock—supported by individual investors—barely moved, even though the resignation was obviously awful news. In contrast, the cost of a derivatives contract insuring against a default by Enron spiked by 18 percent that day.1 The stock markets eventually caught up with the derivatives markets and by August 2002 had lost more than a quarter of their value, destroying more than $7 trillion of wealth built during the 1990s—roughly $70,000 of losses for each U.S. household.2