Infectious Greed (59 page)

As the call ended, it appeared that Ken Lay was not being entirely truthful with the investing community. Lay said he and his board of directors continued to have “the highest faith and confidence” in Fastow, the CFO. For the skeptical analysts, these words sounded like the kiss of death. No one expected Fastow to survive the year at Enron. In fact, Lay fired Fastow the next day.

 

 

M
eanwhile, at the Houston offices of accounting firm Arthur Andersen, October 23 was even more frantic. Enron was Andersen's most important client in Houston, and had paid Andersen $52 million in fees in 2000 alone—more than half of which was for consulting, not audit, advice. The ties between the firms were very close, and many Enron employees—including Richard Causey, the lead audit supervisor—had spent time working at Andersen. As one former risk manager at Enron put it, “You couldn't swing a dead cat without hitting a manager from Andersen.”

The focus of Andersen's work for Enron had changed markedly in recent years. A decade earlier, Andersen had performed only audit work for Enron, and not much else. Because Andersen had been independent, and had not relied on Enron to pay it for any other services, investors believed that Andersen would scrutinize Enron's financial statements very carefully. Even if they couldn't trust Enron, at least they could trust Andersen.

But Andersen had become less independent during the past few years, as it had expanded the consulting services it provided to corporate clients, including Enron. By 2000, the audit business was dying, and dreadfully boring. An annual audit required thousands of hours of tedious work. Consulting—especially consulting for an innovative company such as Enron—was glitzy and arguably more profitable.

While Ken Lay was spinning a tangled web during his conference call,
employees at Andersen had powered-up the firm's shredders. David Duncan, the lead Andersen partner on Enron's audits, called a meeting to organize an “expedited effort to dispose of Enron-related documents.” The document destruction quickly became document carnage, and continued until November 9, when Duncan's assistant finally issued a memorandum directing Andersen secretaries to “stop the shredding.” During that short time, Andersen deleted thousands of e-mail messages and disposed of garbage bags' worth of shredded documents.

Andersen later would attempt to distance itself from Duncan, issuing a statement that the shredding “was undertaken without any consultation with others in the firm.” Duncan must have anticipated that he would be left without friends in upper management, because he took at least six boxes of documents home before Andersen fired him on January 15, 2002. Those boxes contained important documents the investigators otherwise might not have seen.
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Ultimately, prosecutors decided that Duncan's story would be useful in bringing a case against Andersen, and they appreciated the helpful documents, so they offered Duncan a deal: if he agreed to testify against Andersen at trial, he could plead guilty to obstruction of justice, and prosecutors would recommend a lenient sentence, perhaps with no jail time at all. After lengthy deliberations, a Houston jury convicted Andersen of obstructing justice, in part based on Duncan's testimony, in which he admitted to committing a crime.

On October 31, Ken Lay asked William Powers Jr., the dean of the University of Texas Law School—a well-known and respected figure in the legal profession—to join Enron's board and to oversee a special committee investigating Enron's losses. Powers then hired William McLucas, a former head of the SEC's enforcement division, and a dogged prosecutor with an impressive track record of victories.

Lay also continued to call in favors owed by various Bush administration officials. He had just raised more than $100,000 for Bush's election campaign as one of 214 so-called “Pioneers,” and had been an adviser to Bush during the transition after the election as well.
⁵⁵
In October and November, Lay called Treasury Secretary Paul O'Neill, Commerce Secretary Don Evans, Federal Reserve Chairman Alan Greenspan, and Robert McTeer, president of the Dallas Federal Reserve. Enron President Greg Whalley made several calls to Peter Fisher, the undersecretary of Domestic Finance, who had been involved in the private bailout of Long-Term Capital Management.
⁵⁶
But none of these men would agree
to help Enron; and, on November 6, the stock price fell below $10 per share.

During this time, the key issue in Enron's survival was its investment-grade credit rating. Enron had noted, in its most recent annual report, that “continued investment grade status is critical to the success of its wholesale business as well as its ability to maintain adequate liquidity.”
⁵⁷
A downgrade would be a double whammy for Enron. First, most financial institutions would refuse to extend additional loans to Enron because of the low rating. It wasn't merely that its cost of borrowing would increase; with a sub-investment-grade rating, Enron simply would not be able to borrow enough money at any rate.

Second, many of Enron's loans had credit-rating
triggers,
so that even though payment might not be due on its debt for several years, the terms of the debt specified that payments would be accelerated, following a downgrade to below investment grade. Specifically, if the credit-rating agencies downgraded Enron to below investment grade, Enron
immediately
would owe $690 million, and its various partnerships
immediately
would owe $3.9 billion.
⁵⁸
Given Enron's deteriorating financial situation, it would not be able to cover these obligations—which meant that Enron's fate was in the hands of the credit-rating agencies.

In early 2000, Moody's supposedly had “exhaustively” reviewed Enron's off-balance-sheet activities and made a decision to change Enron's rating, based on what it found: it had
upgraded
Enron one notch, to Baa1.
⁵⁹
(The lowest investment-grade rating on Moody's scale was two notches lower, at Baa3.) Moody's didn't raise the issue of credit-rating triggers, which were not unique to Enron. Although companies—including Enron—typically did not disclose these triggers in their financial filings, the credit-rating agencies were aware of them. Moreover, all three rating agencies had closely followed Enron throughout the tumult of the California energy crisis, Jeff Skilling's resignation, the revelations about Andy Fastow, Enron's public announcement of a billion-dollar-plus charge, and Ken Lay's firing of Andy Fastow after the hellish conference call on October 23. And yet, with Enron's stock price down from $80 to below $10, all three agencies still gave Enron's debt an investment-grade rating.
⁶⁰

In early November, Citigroup and J. P. Morgan Chase each agreed to give Enron an additional $1 billion in secured loans. The banks were in a tough spot, having loaned $8 billion to Enron through prepaid-swap deals, all of which were now in jeopardy. They committed to put more
money into Enron, just as they had with Long-Term Capital Management.

Citigroup's co-chairman, Robert Rubin, who had been the Treasury secretary during the Mexico bailout and the collapse of Long-Term Capital Management, called Peter Fisher at the U.S. Treasury Department, to request that Fisher ask the credit-rating agencies to find an “alternative” to downgrading Enron. Rubin reportedly began the call by saying, “This may not be the best idea, but . . .”
⁶¹
Fisher declined.

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.
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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.