Infectious Greed (55 page)

The bottom line of all these intricate dealings was simple. Enron substituted one outside investor in JEDI for another. And it kept JEDI—which
it could now continue to use to make various energy investments—off its balance sheet.

Enron's dealings in JEDI and Chewco later horrified many individual investors, but the truth was that they were arguably legal, not especially unusual, mostly disclosed, and largely irrelevant to Enron's collapse. There were enough key details about JEDI and Chewco in the footnotes to Enron's financial statements to warn off any investor who read them. And even if Enron had included JEDI in its financial statements, its reported income still would have been almost a billion dollars a year, and its reported debt would have been at reasonable levels. Indeed, after Enron later revised its financial statements to include JEDI, the effects were insubstantial compared to the magnitude of Enron's derivatives trading. To the extent that Enron's financial statements were inaccurate, the primary reason was not that Enron was violating the rules; instead, it was that the rules of the game had changed so much that companies were permitted to create a fictional accounting reality, which didn't need to comport with economic reality.

After the JEDI-Chewco deal, Fastow began developing even more complicated transactions, with strange names such as Enron Cash Co. No. 2 or, more creatively, Obi-1 Holdings LLC and Kenobe Inc., keeping with the
Star Wars
motif.
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Fastow was obviously good at structured finance. In 1999, he received a major award for excellence as a CFO, which stressed his “unique financing techniques.”
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With his new-found expertise, Fastow finally had the road map for dealing with Enron's $300 million gain on Rhythms NetConnections, and for making himself some easy money. Fastow's fingerprints were all over his newest partnership, called LJM; even the initials stood for the names of his wife and two daughters. Fastow would be directly involved in LJM, even though the securities laws would require that Enron disclose his involvement. In the Chewco deal, Michael Kopper, not Fastow, had been directly involved, because Kopper was a lower-level employee who fell outside the scope of disclosure rules.
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But Kopper and the related partnerships had made $10 million on a $125,000 “outside” investment—why should Kopper, Fastow's assistant, make all the money?
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Fastow persuaded Enron's board of directors that LJM would be of great value to Enron as a purchaser of Enron's assets, a partner with Enron in new investments, and a counterparty to derivatives agreements to help Enron hedge its risks.
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Fastow also asked the board to give him permission to keep a percentage of the profits from LJM's deals, even
though it created a blatant conflict of interest.
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The proposal sailed through Enron's hands-off board, with a minimal requirement that Enron officers review LJM's transactions. The directors later approved a second, similar partnership called LJM2 Co-Investment, L.P. They apparently never imagined that Fastow would make more than $45 million from the partnerships.
³³

The details of the two LJM partnerships were unknown to Enron's shareholders, but they were palpable among Wall Street firms, which funded the bulk of the partnerships' outside investment. LJM was a relatively small partnership, with just two outside investors putting in $7.5 million each: ERNB Ltd., a partnership set up by CS First Boston, and Campsie Limited, a partnership set up by National Westminster, a British bank.
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Fastow also invested $1 million of his own money, bringing the total amount of money raised for LJM in 1999 to $16 million.

LJM2 was more than twenty times the size of LJM, with several hundred million dollars of outside investment from a Who's Who of the financial markets: investment banks such as Merrill Lynch; commercial banks such as J. P. Morgan Chase; insurance companies such as American International Group; charitable institutions such as the John D. and Catherine T. MacArthur Foundation; retirement funds such as the Arkansas Teacher Retirement System; and even several wealthy individuals such as Leon Levy, former chairman of the Oppenheimer mutual funds, John Friedenrich, a prominent Silicon Valley lawyer, Jack Nash, a New York hedge-fund manager, and even ninety-six employees of Merrill Lynch.
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LJM used its $16 million to purchase from Enron the rights to 3.4 million Enron shares, worth $276 million. Of course, LJM didn't have $276 million in cash to pay for the shares, so it agreed to make payments over time. Enron imposed a restriction on the shares, so that LJM could not sell them for four years, and therefore deemed that the restricted shares were worth only 60 percent of their value in the market. That restriction, and the resulting discount, were a substantial windfall to LJM. Assuming LJM was willing to hold the Enron shares for four years, they would be worth 40 percent more than it had paid for them, even if Enron's share price only remained constant.

Then, Enron entered into several derivatives deals with LJM and an LJM subsidiary called “Swap Sub,” purportedly to hedge the risk of Enron's stake in Rhythms NetConnections. Enron was still barred from selling the Rhythms NetConnections stock during the six-month lockup
period, but nothing prevented it from buying a put option from Swap Sub, which would give Enron a five-year right to sell 5.4 million shares of Rhythms NetConnections if its price fell below $56 per share. Effectively, the put option—the right to sell the stock—was an insurance policy on Enron's investment.

These deals seemed to benefit both Enron and LJM. Enron unlocked some of its gains from Rhythms NetConnections. When the lockup period expired, Enron unwound the deals with Swap Sub and cancelled the put option. But, this time, Enron calculated the value of the put option assuming the shares were unrestricted, so that LJM and Swap Sub received the higher, unrestricted value; in other words, LJM made money when Enron was moving in, and when it was moving out. Although Arthur Andersen apparently allowed Enron to make this calculation based on the higher unrestricted value, which obviously took money from Enron and gave it to LJM, Andersen required that subsequent deals be done using the restricted value.
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All of these transactions were, essentially, just Enron trading with itself, because LJM's ability to pay Enron depended on the price of the rights to the 3.4 million Enron shares it originally received, and continued to hold, as its major asset. In other words, if Enron's stock price declined, so would LJM's assets, and then LJM would not be able to repay its debts to Enron. This was why accounting rules typically did not allow companies to use their own stock to influence their earnings: from an economic perspective, such deals were a sham. Nevertheless, Arthur Andersen permitted Enron to treat the LJM partnerships at arm's length, and to keep the deals with LJM off its books. Technically, Enron wasn't using its stock—it was using derivatives instead (the rights to receive its stock in the future).

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 .
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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).
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Southampton Place made so much money that, within a year, it paid Glisan and Mordaunt each $1 million for their shares.
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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.
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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.
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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.”
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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.
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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.