The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (34 page)

Despite Skilling’s oft-stated horror at the way Rebecca Mark’s international deal makers were paid, he instituted virtually the same system at EES. The EES originators—they eventually totaled 170—got huge bonuses not on the basis of how a deal worked out over time but on how profitable it
appeared
on the day the contract was signed. Margaret Ceconi, a 40-year-old former GE Capital manager who joined the EES origination staff in November 2000, says headhunters were recruiting former bankers for EES sales jobs with the prospect of making $1 million or more a year.

With that kind of incentive, EES executives used all the standard Enron tricks to make their deals look better than they were. Even though state-by-state deregulation was largely stalled, they priced contracts as if it were inevitable, thus making losing deals appear to be winners. They signed 15-year contracts that even they acknowledged would lose money for the first ten years—but included a wildly optimistic price curve that showed steep profits at the end, making up for all the losses. (Tilting the curves, this practice was called.) They underestimated the cost of and overestimated the savings from efficiency improvements. They stomped all over Rick Buy’s risk assessors.

To make life easier for the sales force and give himself more opportunity to wheel and deal, Pai also insisted that his division have its own trading and risk-
management staff. Shockingly, Pai’s team was allowed to establish pricing curves that were different from the ones used by the wholesale traders. In other words, dif-
ferent parts of Enron were making different long-term pricing assumptions, then booking millions in mark-to-market profits based on those different guesses.

Knowing how critical it was to land big-name companies that would lend credibility to EES, Enron cut some deals that looked like losers on the day the contracts were signed. Pai was perfectly fine with this state of affairs; he even encouraged it. Signing big deals fast was what counted. If any contracts turned out to be stinkers, he told his staff blithely, they could simply restructure and sell a longer-term deal later on. “We’ll just blend and extend,” is how he used to put it. One EES executive says the business’s early mantra was: “After all the marquee names, we’ll get the profitable ones.”

EES even
paid
companies to sign contracts—in one case, $50 million. “We bought the business,” says an EES vice president. “It was easy to get people to do deals, if you pay them up front.” In many cases, this was structured as a prepayment on part of the savings expected over the life of the contract. Owens Corning got a $2 million promotional payment from Enron, in exchange for permission to use its brand and even its trademark Pink Panther in EES marketing materials. Enron paid Simon Property Group millions to lease its existing energy equipment. To sweeten the deal with Simon even more, Enron also agreed to provide a $4 million “equity infusion.”

Even after it started reporting quarterly accounting profits, EES was hemorrhaging cash. After all, its operating expenses were huge, many of its deals wouldn’t make a dime for years, and it was writing multimillion-dollar checks to win contracts. Then there was the matter of making energy improvements, a huge capital expense, which included such big-ticket items as replacing chilling systems and boilers. Enron was supposed to make the money back over the life of its contracts by sharing in the savings from cutting customers’ consumption of energy.

But it soon became apparent that many of the improvements wouldn’t pay for themselves or couldn’t be done on the rapid timetable the company had promised. Starwood, the large hotel chain, had been promised $42 million in efficiency improvements, says Ceconi. When it became clear that the spending wouldn’t pay off, Enron balked at moving forward.

EES even pitched its deals as offering opportunities for earnings management. Tyco’s contract, for example, guaranteed 15 percent annual energy savings and provided the company “with ability to monetize,” according to an EES document; this meant Tyco had the option of asking for the savings in an up-front payment. The Owens Corning deal even involved an off-balance-sheet partnership. To cook up such deals for retail, Andy Fastow formed an EES Structured Finance Group.

Ken Lay himself helped EES rope in prominent corporations. His calendar is dotted with meetings and phone calls with top executives of other companies, opening doors for the division: Larry Bossidy of Allied Signal in December 1998; Tyco’s Dennis Koslowski in May 1999; Owens Corning in July 2000. With Lay’s help, EES struck a big deal with Compaq, where he served on the board. Whenever the EES deal makers had trouble getting in to make their pitch to a prospect, they would call on Lay. “Ken can get us in,” Pai would say.

As ever at Enron, there was always another powerful incentive for getting deals done quickly and making them appear profitable. EES needed to feed the Wall Street beast. Internally, company executives were explicit about this. A document detailing EES’s 1999 business plan, prepared that February, included this reference to Skilling’s public vow that the division would turn a profit in the fourth quarter: “Q4 EBIT Positive is Nonnegotiable.” The document added, “We have a gap—and it must be filled. . . . We must change the way we operate—NOW.”

Sure enough, the division’s deal makers began racing to get contracts signed so that they could make the quarter. The haste caused bad deals to become that much worse, as Enron’s originators gave up negotiating points to sign contracts and as they played with the price curves and other assumptions to disguise reality. They also used those price curves and assumptions to book mark-to-market profits based on the life of the contract.

After getting the word that EES needed to close another deal by the end of the quarter to make its numbers, one senior executive recalls persuading a customer to sign a simple commodity agreement while putting the more lucrative outsourcing agreement on hold. “I knew I had to get creative,” he says. “To get deals done, we just said, ‘Shit, we’re going to have to talk these guys into doing part of the deal, so we’ll do the second piece later.’ The quarter was riding on it.” This same executive recalls an instance where he closed a deal that had a total contract value of $500 million, only to see Enron issue a press release claiming the contract was worth $1.3
billion.
“You don’t know what to do in that case,” he said. “Do you beat on Lou Pai’s door and say, ‘What are you smoking?’ ”

EES would presumably have to pay the real cost for fulfilling its contracts someday. But the sales team, which was paid up front, wasn’t worried about what would happen five years down the road. One senior sales executive used to joke about how he’d close deals, then “throw them over the fence” to let the back-office staff worry about actually making them work. “People would say to me: ‘Hey, it’s not your problem,’ ” recalls Ceconi. “ ‘You’re not going to be around. Why do you care?’ ”

 • • • 

Here, though, may have been the biggest problem of all: once Enron had the contracts, it had to start fulfilling the terms. Partly, that meant selling power to big companies at cut-rate prices. But it also meant that Enron had to start implementing all those energy efficiencies, hiring all those maintenance workers, changing all those lightbulbs, and paying all those bills. This was a massive undertaking. At its peak EES was managing 28,000 different sites all across the United States and Europe.

Lacking that kind of management expertise, Enron decided to go out and buy it. EES made a string of acquisitions of energy-management and facilities companies, assembling a massive energy-maintenance operation, and becoming the biggest HVAC (heating, ventilation, air conditioning) contractor in the country. Even though this expertise was desperately needed, the company’s culture remained as contemptuous as ever of people who had to manage and execute; Enron’s fast trackers dismissed these acquisitions as “butt-crack businesses.” One Enron analyst scouting for new purchases even had a cap made up, reading Butt-Crack Acquisition Team.

One Enron employee assigned to the operations side spent time researching whether the company could buy financial instruments to hedge the possibility of rising labor costs. That was the Enron way of dealing with labor costs. Meanwhile, promised energy-saving projects were never started, unpaid utility bills piled up, and EES tried to wiggle out of provisions it had agreed to that were either too difficult to perform or too expensive.

Take the California public universities’ contracts, which required EES to bill the university system for energy use on each of their 31 campuses. According to David DeMauro, a Cal State administrator who helped manage the schools’ deal with EES, Enron routinely made major billing errors and submitted its bills late. In fact, says DeMauro, from the very first month that the contract went into effect, EES
never
got it right. “There were no situations,” he says, “where the bills were either on time or correct. People either didn’t get the bills or they got incorrect bills. We went all four years without receiving timely or accurate bills. We figured a company like this could do something as easy as turning out timely, accurate bills. They were never able to do so.”

“The problem was so widespread over our campuses,” says DeMauro, “we decided that our strategy would be that we would not pay Enron until they could deliver us an accurate bill. We probably went five or six months without paying Enron at all. I would guess our accounts payable was approaching $40 million or so.”

Enron never delivered the energy-efficiency projects it had promised, either, says DeMauro. The one constant in dealing with Enron, he says: “People we worked with were always making promises that weren’t kept.”

Enron also had a contract with the giant HMO Kaiser Permanente to handle utility bills for hundreds of facilities in several states. But EES habitually paid the wrong amounts and ran up late fees as well. At one point, while Enron tried to straighten the mess out, boxes of unpaid Kaiser bills stacked up in EES’s offices.

EES’s cash management was so poor that it took months to invoice customers for reimbursement of utility bills it had already paid. “We were basically paying their utility bills and giving them loans,” says an Enron managing director who studied the situation. According to EES executives, the float was costing the business more than $50 million a year.

“How are we actually going to do all this shit that we’re selling?” an EES back-office manager named Glenn Dickson recalls asking. “The approach was, ‘Let’s sell it—and we’ll figure out everything else later.’ They touted themselves as a risk-management company, but they never asked what could go wrong. It was a free-for-all—a chaotic, fucking free-for-all.”

Yet Skilling remained oblivious. At an employee meeting held in February 2000, the Enron president told the assembled staffers that “EES has turned the corner.” Then, later in the meeting, he added almost off-handedly, “The next challenge in this business is going to be execution. This stuff sells. Now we have to actually get out there and do something for the customers. That’s the easy part.” For Skilling, like everyone else at Enron, customer service was little more than an afterthought.

Arthur Andersen had been warning Enron executives about EES’s management problems. In an April 26, 1999, memo to the EES board, which included Skilling, Pai, and Fastow, the auditing firm noted “significant deficiency in the internal control structure of the company,” problems that included “few defined accounting policies and procedures . . . to ensure account balances and transactions were properly reported in a timely manner.” At year-end, according to an Enron accounting executive, EES’s Andersen auditors were so concerned they were threatening to take the extraordinary step of giving the division a “qualified” accounting opinion.

A few months later, in response to Andersen’s complaint, a special team was assigned to look into EES’s problems. Nobody at the top of Enron expected them to find anything serious.

 • • • 

And then there was the other big enchilada: broadband.

This, too, was a business that might seem, at first glance, to be a surprising choice for Jeff Skilling’s Enron, and not just because it had nothing to do with energy. For a man who liked to think of himself as on the cutting edge of American business, Skilling was pretty much a Luddite. During his years at Enron, he never learned to surf the Internet. He stubbornly refused to use e-mail; his secretary printed out the messages he received. Though he had two computer terminals on his desk, he used them only to track stock and commodity prices. “He didn’t even know how to turn them on,” his secretary told people.

But of course anyone who remembers the Internet mania of the late 1990s will understand perfectly why Skilling touted broadband as the Next Big Thing for Enron. Internet stocks had taken off; companies would go public in the morning and have a $100 share price by 4
P
.
M
.,
when the market closed. Valuations were so high they bore no relation to profits or revenues—which, for many Internet companies, were non-existent. If Skilling was going to get Enron an Internet-style valuation—and there was nothing he wanted more—he’d have to convince Wall Street that Enron was becoming, at least in part, an Internet company. He may not have known how to surf the Web, but the relationship between the Internet and the stock market was something he understood all too well.

 • • • 

The part of the company that became Enron Broadband began life as an afterthought: it was a tiny start-up inside Portland General, called FirstPoint Communications. When Skilling learned in 1996 that the Oregon utility had just launched a telecommunications business that was laying fiber-optic cable around Portland, he was distinctly unenthusiastic. He gave the business zero value, and his intention was to sell the operation or shut it down once Enron completed the Portland General acquisition.

Portland General was one of several utilities that had jumped into the tele-
com business with the idea of using their existing right-of-way to lay a fiber network—a system of glass strands that acts as an underground highway for moving Internet data at high speeds. Joe Hirko, Portland General’s CFO, had taken over the small telecom business in 1997. Following the merger, Skilling remained skeptical. But after a group of trusted Enron deputies came back excited from a scouting trip to Portland, he authorized Hirko to spend up to $20 million to expand his network.