Conspiracy of Fools (11 page)

Eventually the accountants and lawyers left the room, and Fastow broke into laughter. The three percent rule struck him as hilarious.

“Who comes up with these ridiculous rules?” he laughed. “This is such bullshit! Your gardener could hold the three percent! I could get my brother to do it!”

Fastow set to putting Cactus together. With it, Enron pooled loan commitments to gas producers in exchange for a deal on their production payments, placed them in the Cactus special-purpose entity, and sold stakes to heavy-hitting institutional investors. Cactus investors would then resell the gas back to Enron, which in turn would use it to meet its obligations under the long-term supply contracts with customers. It was the Gas Bank in its final form; outsiders provided cash, producers received financing, customers obtained gas at a reliable price—all with Enron in the middle, profiting handsomely.

Or so it seemed. But a problem emerged. The accounting for the two sides of the transaction—buying production payments and selling fixed-price contracts—followed different rules. Enron could be forced to report a loss simply because it couldn’t count the two parts of the deal in the same way. Skilling thought the result absurd: how could things of the same value be worth different amounts?

The issue came to a head at a meeting between Skilling’s team, the accountants from Arthur Andersen, advisers from Bankers Trust, and lawyers from Vinson & Elkins. Steve Goddard, an Andersen partner, brought along a number of other accountants, including a young graduate from Texas A&M named David Duncan, who was working on the Cactus deals.

Skilling took the floor. He wanted his group’s accounting to shift from the old oil-and-gas rules to mark-to-market, a method commonly used by trading houses. It allowed a company to record the value of a transaction at the beginning; any changes over time—caused by anything from flawed assumptions to variations in market value—would be recorded as a profit or a loss. If a brokerage owned a stock that went up in price, it reported a profit—even if it didn’t sell the stock. If the value went down, it reported a loss. That was the beauty of mark-to-market, Skilling said. It reflected market reality.

“Wait,” Goddard said. “But this is an oil-and-gas transaction. You need to use oil-and-gas accounting.”

Around and around they went. The auditors with Andersen’s energy group were far more familiar with old-line oil-and-gas accounting; this new stuff was hard to get their heads around. Everyone became frustrated.

“You guys are just stupid,” Lou Pai finally railed in exasperation. “You’re fucking stupid!”

Skilling pushed Goddard to check with Andersen’s top accounting experts in Chicago; after that, he flew there to see them and to present his arguments in person. A few weeks later, Goddard dropped by Skilling’s office.

“Well, I talked to Chicago,” he said. “They agree mark-to-market is the appropriate treatment.”

Skilling clapped his hands. “Great!”

“Well, I still don’t feel up to speed on this. But they like it, and they think it’s the right way to go.”

“Okay,” Skilling said.

Goddard hesitated. “But they don’t think we can do this unilaterally.”

“What do you mean?”

“We’ve got to go to the SEC with this,” Goddard said. “This is a change in accounting methodology, so we’ve got to convince the SEC to approve it.”

Skilling flopped back in his chair.
The
SEC. The Securities and Exchange Commission.
All we have to do is convince the government to reverse course
.

Skilling was silent for a moment, then sat up.

“Okay,” he said. “Let’s go convince the SEC.”

“This is the stupidest accounting I’ve ever heard of. It’s just crazy.”

As he spoke, David Woytek stared across a conference table at Jack
Tompkins, Enron’s chief financial officer. It was June 1991, and Woytek, the accountant who investigated the Valhalla oil-trading scandal, was attending a monthly meeting of Enron’s top financial executives. Now chief financial officer of Enron’s liquid-fuels division, Woytek had just heard George Posey, Skilling’s finance chief, explain the new accounting his team was pushing.

“Mark-to-market makes much more sense for what we’re doing,” Posey replied.

“Mark-to-market is all fine and good, but that’s not what you’re describing,” Woytek shot back.

“We’re describing mark-to-market.”

“No, you’re not. You’re saying you want to recognize revenues from twenty-year contracts in the first year. I don’t know what that is, but
that’s
not mark-to-market.”

Posey held up a hand. “We’re talking mark-to-market,” he said. “It’s the accounting the investment banks use.”

That wasn’t the same thing, Woytek argued. Those institutions were valuing their portfolios based on current, actively traded markets. If they owned stock in Exxon and Exxon’s share price rose two dollars, then the value of their investment went up. There was logic to it; the market was independently assessing the value. If an investment bank needed cash, the stock could be sold at the price recorded on its books. But
this
was different, he said. They were making estimates about the total revenues a contract would produce, and then reporting the whole thing right away. There was no independent judgment involved. It wasn’t mark-to-market; it was mark-to-guess.

“How can you book twenty years of revenue in the first year?” Woytek asked. “That goes against everything I was ever taught in accounting. You never recognize revenue in advance, only when title passes from one owner to the next. And title doesn’t pass on this until you deliver the gas, over the next twenty years.”

There were other problems, Woytek said. The strange accounting idea would make the profits from Skilling’s division unpredictable from one year to the next. If it sold fifty contracts in the first year—requiring gas deliveries over, say, five years—and recognized all future revenues up front, the next year it would start out at zero, with no revenues. In fact, it would start out at less than zero, since it would have already presumably done business with its stable of customers. So the second year, it would have to sell as many contracts as in the first year—and then more—just to beat its first year’s earnings. Year after year, it would be the same thing, forever. An investment bank using mark-to-market just needed market prices to rise to grow profits; but Skilling’s group was almost guaranteed to someday hit a wall.

Worse, the reported earnings would be huge, but the cash wouldn’t finish trickling in for years. Earnings without cash are anathema to investors; how would the company explain it?

“We’ve always sold long-term contracts, and we always took into earnings the amount of gas we delivered each month,” Woytek said. “Why should this be different?”

Posey didn’t back down. Woytek, he said, was looking at this from the old oil-and-gas method, which was affected by fluctuating energy prices. But Gas Services was matching its purchases and sales, and then marking to market the entire position. It made sense, Posey argued.

Woytek smiled. There were other reasons to use this accounting idea that nobody was mentioning. He had already heard that as part of his compensation, Skilling received an ownership stake in his division. When the division’s earnings went up, the value of that stake would, too. If that division started booking twenty years of contracts in a single year, its earnings would go through the roof.

And then—even if those profits came from fancy accounting—Jeff Skilling would be one very rich man.

The following month, on July 26, Jack Tompkins was sitting at his desk when a call came in from the SEC. It was Jack Albert from the agency’s office of the chief accoutant, calling about the Skilling accounting proposal. Tompkins asked Albert to hold for a moment and patched in Posey from Skilling’s group.

“I’ve kept very close contact with this, but George has been the one carrying the ball,” Tompkins explained.

Albert acknowledged Posey, and then started. “The bottom line is that we don’t believe you can make a case with the preferability to change at this time,” he said. “I know this is not the best news to give you.”

The Enron executives spoke simultaneously for a second. What was the issue?

“The reasons vary,” Albert replied. “But at the present time we think accounting for oil and gas is locked into this historical cost model.”

Posey was almost speechless. Because Enron had an oil-and-gas business, it should use oil-and-gas accounting—
even for its finance division?
“Let me just maybe understand your point a little better,” he said. “This doesn’t include our oil-and-gas exploration company.”

“I understand that.”

“Okay,” Posey continued. So one division’s accounting should be dictated by another division’s business?

“This is a dramatic change for anyone in the oil-and-gas business,” Albert responded. “I don’t think you really have anyone analogous to Enron Gas Services out there.”

Tompkins jumped in, trying to play conciliator. “We certainly don’t want to be argumentative,” he said. “The more information we can get why and what we can do sometime down in the future as far as—”

Albert interrupted. “I think you’ve made an excellent point right there with ‘sometime down in the future.’ We think it is premature at this time.”

The call ended, and Posey rushed to Skilling’s office. He found him at his desk, engrossed in work.

“The SEC turned us down,” Posey announced.

Skilling sank in his chair.
“What?
That’s stupid.”

Furious, Skilling threw questions at Posey and learned the details of the call with the SEC. He phoned Tompkins, warning that he was coming up. Minutes later, in Tompkins’s office, Skilling could barely contain himself.

“What the hell happened?”

Tompkins shrugged. “They turned us down.”

“Did you give them the reasons that was the wrong thing to do?” Skilling barked. “Did you talk to them?”

“About how this compares with other companies, and I explained that other companies use it.”

“Did you explain why this is important?”

“I think our application was very clear about that.”

Skilling fumed in silence, then turned on his heel and stormed out. Back in his office, he called Steve Goddard from Andersen.

“Is this normal?” Skilling asked. “Mark-to-market makes all the sense in the world. Why wouldn’t they just automatically do this?”

“Well,” Goddard replied, “they are very conservative, and this is a big change.”

“It’s
not
a big change,” Skilling shot back. Lots of investment banks used the accounting, he said. It was ridiculous that competing companies would be forced to treat the same deals differently. The whole thing had been mishandled, Skilling said. Andersen needed to fix it.

“We can’t just send a letter and say, ‘Oh, we want to switch to mark-to-market,’ ” Skilling said. “We need a full-blown presentation about why it’s the right thing.”

Goddard agreed to call the SEC and set up a meeting. Skilling said he would make the presentation himself, but asked Andersen to be there ready to answer any questions on the technical accounting issues. Goddard said he would give the job to Rick Causey.

It was the assignment that set Causey on the path to becoming a power in his own right at Enron.

On September 17, 1991, SEC staffers gathered in a conference room at the agency’s Washington headquarters. Already the place was packed, with people standing along the walls or sitting on the carpet, eager to hear the presentation from Enron and Andersen. After all, it wasn’t every day a big company lobbied to fundamentally change the way it reported revenues and profits. This was as close to a financial wonk’s version of Woodstock as there could be.

With the place filled, Skilling and his team were escorted into the room. Goddard walked to the front of the assembled group, gave a few greetings, and introduced Skilling, who strode to an overhead projector.

“Thank you, Steve,” he said. “As Steve suggested, our business is changing radically. What has traditionally been a very fixed structure is now turning into a traded commodity. And with that, the accounting has to change.”

Skilling placed a series of transparencies on the projector, describing the history of his unit and the growth of the natural gas trading market. But it was the eighteenth transparency that captivated the room. It showed two gas portfolios—one with matched purchases and sales handled the way Enron did business, and another with a long-term supply contract satisfied by buying fuel in the open market. At first, since short-term prices were lower than long-term prices, such a deal might look good. But of course, Skilling said, the approach was reckless, since the company taking the position could be forced to sell gas at a loss if prices climbed. It was the kind of shortsighted strategy—lending long-term and buying short-term—that blew up the savings-and-loan industry, he said.

A new transparency appeared, showing how the two portfolios would be reported under the traditional, accrual accounting and the mark-to-market approach. With mark-to-market, the matched portfolio was worth the current value of all the cash it would generate over its life; the mismatched, dangerous portfolio was worth less. But with accrual accounting, the matched portfolio showed a loss while the dangerous portfolio showed big profits. Worse, traditional accounting provided benefits to companies that sold winning positions while holding on to losers.

Skilling glanced at the assembled faces. “Accrual accounting lets you pretty much create the outcome you want, by keeping the bad stuff and selling the good,” he said. “Mark-to-market doesn’t let you do this”

An SEC staffer sitting in front of Skilling stopped taking notes. He was from the financial-institutions group, and Skilling’s words had sounded a familiar chord.

“That’s gains trading,” the staffer said. “That’s what our banks do all the time.”

“Of course they do,” Skilling said. “Under accrual accounting, it’s a no-brainer. It’s a simple, easy way to report profits, but they don’t reflect reality.”

“Wait a minute,” the staffer continued. “Let me get this right. You’re
asking
to go to mark-to-market?”