Infectious Greed (52 page)

These changes were cosmetic at best, and financial statements did not become more readable or accurate, because the punishments for violating the SEC's rules were insubstantial. Corporate executives either ignored the full-disclosure rule—Reg FD—or used it as an excuse to
avoid disclosing information. Moreover, Reg FD made illegal the one positive role securities analysts potentially had played: gathering hard-to-get information from companies. Not surprisingly, the quality of information about companies began to decline.

Arthur Levitt's last act as SEC chair was to oversee the passage of the Commodity Futures Modernization Act in 2000. Among other things, this law made clear that over-the-counter derivatives were exempt from regulation. It specifically included an exception for the trading of energy derivatives, a provision strongly supported by Senator Phil Gramm, whose wife Wendy had initially deregulated swaps in 1993 and had continued to serve as a member of Enron's board of directors since then.

Anyone who imagined that members of Congress, or their staffs, drafted laws regarding derivatives would have been surprised to peek inside the offices of the House Agriculture Committee during the time Congress was considering the CFMA. Instead of seeing members of Congress at work, you would have seen Mark Brickell, the lobbyist from ISDA, writing important pieces of the legislation. The legislative process has sometimes been compared to sausage-making; in the case of derivatives, the sausage makers were actually writing the law. The role of Congress was simply to look over the shoulders of the finance lobby, and nod.

Without any serious oversight, the financial markets entered a period of frenzy. The animal spirits became ubiquitous. It was as if the bartender, instead of announcing “last call,” had begun giving free drinks. Until March 2000, there was a boisterous party in the financial markets. Unfortunately for most individual investors, they were the last ones to arrive, long after the securities analysts, bankers, accountants, and corporate executives already had drunk their fill. Soon, as President George W. Bush would later remark, the hangover would begin.

The first splitting headache for investors would be Enron, which had been the darling of financial markets as it grew from a modest oil-and-gas company into a global energy-and-technology behemoth. In its collapse, Enron would change the way investors thought about financial markets, although often not for the right reasons. The details of Enron's collapse were not widely understood, and investors' knee-jerk reaction to Enron was more like an alcoholic's vow never to binge again than any rational decision about the merits of Enron as an investment. Nevertheless, the fall of Enron—more than the various international crises or the bursting of the
dot.com
bubble—was the key signal that the market merry-making of the 1990s had ended.

B
y now, most people have heard the basic story of Enron; how three radically different characters—the professorial founder Kenneth Lay, the free-market consultant Jeffrey Skilling, and the brash financial whiz Andrew Fastow—converted a small, natural-gas producer into the seventh-largest company in the United States, on the way generating fabulous wealth for Enron shareholders, employees, and especially insiders, who cashed out more than $1.2 billion. Most people also know about Enron's spectacular fall into bankruptcy, the thousands of layoffs, the imploded retirement plans, the controversy surrounding political contributions, and even the details of Enron executives' personal lives, such as Cliff Baxter's suicide and Rebecca Mark's alleged sexual exploits.
¹

But the basic story is unsatisfying, because by focusing on just a few transactions and people, it ignores crucial details and fails to place Enron in perspective. Was Enron a unique surprise, a “perfect storm” of financial misdealings that, although it was devastating for Enron shareholders and employees, did not matter much to the general health of financial markets? Or was Enron the tip of an iceberg of financial risk and greed, a sign of serious sickness among public corporations? To answer these questions, it was necessary to understand where Enron fit within the major changes in financial markets since the 1980s.

Simply put, two decades ago, Enron could not have happened. Enron was made possible by the spread of financial innovation, loss of control,
and deregulation in financial markets. Enron's managers—with the assistance of accountants at Arthur Andersen and several Wall Street banks—used complex financial instruments and engineering to manipulate earnings and avoid regulation. Enron's shareholders lost control of the firm's managers, who in turn lost control of employees, especially financial officers and traders. And Enron operated in newly deregulated energy and derivatives markets, where participants were constrained only by the morals of the marketplace. By 2001, modern financial markets had changed so radically that Enron was playing on an entirely new field, in a new body designed for a new sport.

Enron's officers combined the risky strategies of Wall Street bankers with the deceitful practices of corporate CEOs in ways investors previously had not imagined. Even after more than a year of intense media scrutiny, congressional hearings, and other government investigations, most of the firm's dealings remained unpenetrated. A special committee appointed to decipher Enron's collapse spent several months reviewing documents and interviewing key parties, but its two-hundred-page report covered just a few of Enron's thousands of partnerships and was filled with caveats about its own incompleteness. The U.S. Congress held dozens of hearings, but barely scratched the surface. Incredibly, after Enron's bankruptcy, the firm's own officials were unable to grasp enough detail to issue an annual report; even with the help of a new team of accountants from PricewaterhouseCoopers, they simply could not add up the firm's assets and liabilities.

A close analysis of the dealings at Enron leads to three key conclusions, each counter to the prevailing wisdom about the company. First, Enron was, in reality, a derivatives-trading firm, not an energy firm, and it took on much more risk than anyone realized. By the end, Enron was even more volatile than a highly leveraged Wall Street investment bank, although few investors realized it.

Second, Enron's core business of derivatives trading was actually highly profitable, so profitable, in fact, that Enron almost certainly would have survived if key parties had understood the details of its business. Instead, in late 2001, Enron was hoist with its own petard, collapsing—not because it wasn't making money—but because institutional investors and credit-rating agencies abandoned the company when they learned that Enron's executives had been using derivatives to hide the risky nature of their business.

Third, Enron, arguably, was following the letter of the law in nearly
all of its dealings, including deals involving off-balance-sheet partnerships and now-infamous Special Purpose Entities. These deals, which blatantly advantaged a few Enron employees at the expense of shareholders, nevertheless were disclosed in Enron's financial statements, and although these disclosures were garbled and opaque, anyone reading them carefully would have understood the basics of Enron's self-dealing or, at a minimum, would have been warned to ask more questions before buying the stock. To the extent Enron, its accountants, and bankers were aggressive in transactions designed to inflate profits or hide losses, they certainly weren't alone. Dozens of other companies were doing precisely the same kinds of deals—some with Enron—and all had strong arguments that their deals were legal, even if they violated common sense.

In sum, relative to many of its peers, Enron was a profitable, well-run, and law-abiding firm. That does not mean Enron was a model of corporate behavior; it obviously was not. But it does explain how Enron could have happened. Although the media seized on Enron as the business scandal of the decade, the truth was that Enron was no worse than Bankers Trust, Orange County, Cendant, Long-Term Capital Management, CS First Boston, Merrill Lynch, and many other firms to follow, including Global Crossing and WorldCom, which collapsed soon after Enron. Enron's dealings were not illegal; they were
alegal;
and Enron was a big story, not in itself, but as a symbol of how fifteen years of changes in law and culture had converted reprehensible actions into behavior that was outside the law and, therefore, seemed perfectly appropriate, given the circumstances.

 

 

A
fter Ken Lay received a Ph.D. in economics from the University of Houston's night school,
²
he quickly climbed the executive ladder in the energy industry, switching among various firms and specializing in “bricks-and-mortar” projects, such as the conversion of a trans-gulf Louisiana-to-Florida natural-gas pipeline. In 1985, Lay—with the assistance of Michael Milken's firm, Drexel Burnham Lambert—arranged for Omaha-based InterNorth, one of the largest natural-gas companies in the world, to acquire Lay's firm, Houston Natural Gas, for $2.3 billion.
³
It was a medium-sized merger by 1980s standards, but, for Ken Lay, it was the greatest opportunity of his career. He was selected to run the merged company, which was to be called Enteron. Fortunately, at the last minute, someone noticed that “Enteron” meant “intestine,” and the
name was quickly abridged to Enron, which—as a spokeswoman said—“has no meaning other than what we make it mean.”
⁴

To help move Enron from bricks and mortar to the more exciting and lucrative business of trading energy products, Lay turned to Jeffrey Skilling, a partner at the prestigious consulting firm, McKinsey & Company. Skilling was more urbane than Lay, with an M.B.A. from Harvard and experience at a London investment bank; and he provided excellent advice about how Enron could create and profit from new energy markets. Both men were zealots for deregulation and free markets, and they became close friends. Lay also relied on Michael Milken of Drexel, who provided merger advice and helped Enron sell $180 million of junk bonds. Enron became the biggest client of Drexel's eight-person Houston office.
⁵

As Andy Krieger, the currency-options trader, was beginning his career at Salomon Brothers, Enron was setting up an oil-trading business, called Enron Oil, in Valhalla, New York. From 1985 to 1987, the two men who ran the operation—Louis J. Borget and Thomas Mastroeni—reported nearly as much profit from oil trading as Krieger reported from currency options. When Charlie Sanford of Bankers Trust hired Krieger and gave him hundreds of millions of dollars to use trading, Ken Lay did the same thing with Borget and Mastroeni. The limit on their trading—twelve million barrels of oil—was about a third of the value of Krieger's limit, a huge amount, given that Enron was a medium-sized energy firm, not a Wall Street bank.

For Ken Lay, trading was a dream business compared to the dirty and dull pipeline projects of his past, and an entrée into the upper echelon of corporate America. He rewarded his energy traders with a total of $12.5 million in performance bonuses in 1985 and 1986, not much below Andy Krieger's pay during the same time.
⁶

A few months before Charlie Sanford learned the bad news about Krieger's trading profits, Ken Lay discovered a problem of his own at Enron Oil. As the stock market was crashing in October 1987, Lay learned that Borget and Mastroeni had positions of more than
eighty
million barrels of oil, almost seven times their limit. These positions represented roughly three months of output from the entire North Sea oil province, far more than Lay had imagined Enron Oil would trade.
⁷
Lay also learned that the two men had been bilking Enron for millions of dollars.

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