The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (53 page)

The biggest pressure of all, though, was the lack of time. In hyping the business, Enron told Wall Street that EBS would lose no more than $60 million for all of 2000. This meant that the division had to begin showing quarterly results right away.

It was an utterly impossible goal; Enron Broadband wasn’t close to being ready to generate real income. But everyone at broadband knew that didn’t matter: they had to deliver the number Skilling had promised. And if EBS executives couldn’t come up with real earnings and revenues, they’d have to figure out a way to gin them up. Instead of focusing on building the business, they had to start playing accounting games. Here’s what they did:

First quarter 2000:
EBS announces $59 million in revenues. It gets almost the entire amount by exchanging surplus strands of fiber on its own network for strands built by competitors that expand its reach. This helps to build out EBS’s virtual network, and it also taps into an accounting oddity that Enron is happy to exploit: the fiber Enron is selling can be accounted for as an immediate gain, while the fiber it is purchasing can be depreciated over 20 years. Though no cash changes hands, this produces an instant boost to the bottom line for both parties. These deals, popular among many telcom companies desperate to show revenue growth, become known in the industry as fiber swaps.

Second quarter:
Ken Rice orders his deal makers to try to sell some of Enron’s dark fiber so it can book the ensuing gain to the quarter’s earnings. But the deal makers can’t find any takers, so they turn to Enron’s buyer of convenience—Andy Fastow’s LJM2. Broadband just wants LJM2 to warehouse the fiber until the quarter is past and it can find a buyer. Fastow, of course, plays hardball with his own company: he wants the cap on his rate of return raised from 18 percent to 25 percent if EBS can’t resell the fiber in two years. As the deadline starts closing in, two EBS finance executives, Mike Krautz and Larry Lawyer, find themselves in the deeply uncomfortable position of haggling on behalf of Enron—with Enron’s CFO on the other side of the table. “Krautz, you cocksucker!” Fastow barks at one point over the speakerphone, seeking to bludgeon the Enron negotiators. Rice is finally brought in but winds up in a shouting match with Fastow. In the end, Fastow agrees to do the deal (called Project Backbone!) just before the quarter closes. He pays $100 million for the fiber—$30 million in cash and a $70 million note. Ken Lay personally signs the LJM2
approval sheets. And EBS books a $53 million pretax gain on the sale on its way to a loss of just $8 million for the quarter. (Enron finds a buyer for the dark fiber just a few months later.)

Third quarter:
To make its numbers this quarter, EBS captures a huge gain on an investment in a tech start-up called Avici Systems, which makes high-speed routers. Several months before, in return for committing to purchase $25 million in hardware, EBS was allowed to buy almost a million coveted pre-IPO shares of the company. After Avici goes public in July, its stock skyrockets to $162.50, giving Enron a gain of more than $150 million on its $15 million investment. Enron uses one of its special-purpose entities to lock in its gain. (It can’t sell the shares outright because of a 180-day lock-up provision.) Then EBS transfers its stake into a special-purpose entity, allowing it to book $35 million in third-quarter profits.

Then came the fourth quarter. . . .

 • • • 

There was no getting around it: by the end of 2000, things at the broadband division were starting to feel desperate. EBS’s costs and head count had continued to soar; there were 24 people in the public-relations department alone. It was further bloated with refugees from Enron’s hobbled water and international businesses. Everyone scrambled to come up with minibusiness plans. One came up with the idea of developing a risk-management system for movie studios to allow them to recover their losses if expensive new productions flopped. (Hollywood wasn’t interested.) Another explored the idea of starting a futures trading market for film revenues.

The switching technology for the Enron Intelligent Network remained under development, and with bandwidth prices in free fall, the traders were fighting an uphill battle to build a market. The division still had virtually no cash coming in the door.

To make its numbers for the fourth quarter, Enron resorted to a positively breathtaking scheme, a truly brazen feat of accounting duplicity. Enron Broadband ended its year by booking $53 million in earnings on a deal that was well on its way toward collapse and hadn’t produced a single penny of profit.

It involved the content business—developing video entertainment programming for streaming into homes. The content team was led by a flamboyant Enron deal maker named David Cox, one of the more unusual characters at Enron. Far from being the typical high-achieving MBA, Cox was a high school dropout and former commercial fisherman who had started out at Enron in the basement graphics department. While working on projects for Skilling, he’d managed to convince the Enron executive to have the company bankroll his own printing business—and give him Enron’s printing work.

Cox later returned to Enron and was running its paper-trading venture when Rice tapped him to head the broadband content sales team. “You could take David and drop him in the middle of the desert naked, and within a day, he’d figure out a way to make money,” Rice liked to say of Cox. The EBS deal chief, who had a reputation as a loose cannon, had clearly absorbed the Enron ethos. “No one in the world can package this like we do because of all the financial engineering,” he explained, in an interview with a
Fortune
writer. The company philosophy, he noted, was: “No shots, no ducks. Nobody gets rewarded for saving money. They get rewarded for
making
money.”

Back in April, Cox had landed an exclusive 20-year agreement with Blockbuster, the nation’s biggest video-rental chain, to collaborate on a new video-on-demand service. Under the agreement’s terms, Blockbuster would use its Hollywood clout to obtain licenses for films and other content while Enron would be responsible for figuring out how to stream it into homes.

In Blockbuster’s first meeting with the Houston energy company, Cox—acutely conscious of his company’s extravagant promises for broadband—told the Blockbuster negotiators: “I want to do a
really
big deal.” The movie chain had wanted to explore the video-on-demand business—though it had already concluded that VOD was far too expensive and technically difficult to turn a profit for years. Enron, however, offered a deal too good to refuse: Blockbuster’s job was to line up the movie studios to provide content and allow use of its name and stores to market the venture; Enron would do pretty much everything else and pick up the costs as well. Enron would receive about $1 for every movie sold; all the rest of the proceeds (after certain expenses) would go to Blockbuster.

As Blockbuster executives saw it, they couldn’t lose. “Basically, the deal was: we brand it, and they pay for it,” recalls one. They did wonder about Enron’s motives for bankrolling a venture that would take years to establish and seemed certain to lose money even longer; but they figured the respected energy giant would write off the red ink as a loss leader toward building the broadband business for the long haul.

Blockbuster also warned that it would be tough to line up the movie studios, which were wary of any new distribution channels they didn’t control. In fact, just nine days before the deal was to be publicly unveiled, Blockbuster CEO John Antioco flew to Houston to have dinner with Lay, Rice, and Cox, where he told them the video chain had concluded it would be easier to line up the studios
before
going public with the deal. Blockbuster wanted to delay the announcement. But Enron was desperate for broadband to make a splash; Lay told Antioco they should go ahead. “I can help you crack the studios,” Lay said. “I’ve got a lot of influence.”

When the deal was announced in July, the hype that accompanied it was impressive even by Enron standards. “For the first time, customers will be able to choose from a large library of movies through their TV screens and enjoy VHS-quality or better with VCR-like control (pause, rewind, stop),” boasted the Enron press release. Ken Lay declared: “With Blockbuster’s extensive customer base and content, and Enron’s network delivery application . . . we have put together the ‘killer app’ for the entertainment industry.” Blockbuster CEO Antioco pronounced the arrangement “the ultimate ‘bricks, clicks, and flicks’ strategy.”

The two companies said they planned to introduce the service in “multiple U.S. cities” by year-end and roll it out to other markets, both in the United States and abroad, during 2001. On cue, the analysts swooned. “Signing a company like Blockbuster is a reassuring signal of the validity of their strategy,” declared PaineWebber’s Ronald Barone. He promptly raised his Enron rating, citing the “ongoing valuation upside” Enron Broadband offered.

Does it need to be said that there was almost nothing to back up the hype? As the court-appointed bankruptcy examiner later dryly put it, “This agreement reflected nothing more than an aspiration.” Almost immediately, problems arose that made it obvious the dream the two companies shared was unlikely ever to become reality.

The first big stumbling block was that Enron quickly became impatient with the slow pace of lining up the studios; after several months, Blockbuster had signed up only one. Cox began camping out in Beverly Hills, trying to negotiate studio deals on his own. Blockbuster executives got wind of this, and when Blockbuster’s general counsel Ed Stead ran into Cox in Los Angeles, he bluntly advised him: “If you’re going around us, we’re going to feed you to the fishes.”

Enron, meanwhile, was having trouble delivering on its own promises. A big piece of the challenge for video-on-demand was solving what’s known as the last-mile problem—getting the content from Enron’s network into people’s homes. That required negotiating agreements with the phone companies that provided local DSL service across the country. Enron executives, according to a Blockbuster official, had assured the video chain they had the phone companies “in our pocket”—and under the terms of the deal, Blockbuster had the right to walk away if Enron hadn’t gotten them all on board by December.

When it became apparent that wasn’t going to happen—and Blockbuster threatened to terminate the venture—Enron negotiated an extension on the requirement until March. Even then, according to government filings, it was so clear the venture was doomed that one lawyer who worked on the extension wrote a memo predicting that the partnership would enter a “termination scenario” in two months anyway.

Still, Enron somehow managed to introduce the service in four cities by year-end—which it promptly announced in yet another press release. Ken Rice, who had vowed to shave his head if the trial began on time, paid off his bet by showing up at a meeting of the Blockbuster project team with a female barber, who shaved his head clean to wild cheers. Ken Lay dropped in to offer his congratulations—and to enjoy the show.

What nobody mentioned was that the trial wasn’t exactly what Enron and Blockbuster had promised. Originally, the companies had planned trials in four cities—Seattle; Portland, Oregon; New York; and a Salt Lake City suburb called American Fork. But without all the phone companies on board, Enron was reduced to conducting testing in three of the cities using tiny providers. Only about 300 households were involved; in Seattle, the test was limited to just three apartment buildings. Much of the testing didn’t even use standard DSL equipment.

Though Enron had boasted of allowing customers to choose from “a large library of movies,” the trial offered a feeble collection of offerings. The standard fee was $5 a film—Enron’s share was just $1.20—but many of the customers in the test markets weren’t even charged. Even then, few used the service; each household watched an average of just 1.8 videos a month—half of what Enron expected. Broadband executives sat in meetings poring over reports on the pilot’s comically pathetic results:
The Care Bears Movie:
seven purchases—$8.40. When Cox excitedly reported his movie proceeds at one gathering, another executive handed him a $5 bill and said, “I just doubled your revenue.”

Just because the Blockbuster deal was doomed didn’t mean Enron couldn’t figure out some way to monetize it. Enron finance executives had been work-
ing to monetize the Blockbuster deal practically from the moment it was announced. The scheme they devised was called Project Braveheart—named for an Academy Award–winning Mel Gibson movie depicting a rebellion by thirteenth-century Scots.

Here’s how it worked: even before the pilot program was begun, EBS calculated a value for the entire 20-year Blockbuster deal, based on projections—wildly speculative, of course—about future DSL use, customer video purchases, the speed of the rollout, market share, expenses, and other factors. Then, through a series of transactions, it sold most of its interest in the Blockbuster contract to an outside buyer. EBS then began booking profits up front.

What outsiders would buy into this arrangement? Friendly ones. In the first step of the transaction, the broadband division formed a joint venture, called EBS Content Systems, with two partners. One was a vendor involved in the Blockbuster trial called nCube—a tiny video-on-demand equipment company privately owned by Oracle CEO Larry Ellison. The other was an investment vehicle called Thunderbird, owned by Whitewing, the Enron-controlled special-
purpose entity. As ever, to justify off-balance-sheet accounting treatment, nCube and Thunderbird had to contribute a total of at least 3 percent of the venture’s equity, that investment had to be at risk, and the outside investors had to control the joint venture. To meet the 3 percent requirement, nCube chipped in $2 million and Thunderbird $7.1 million. EBS contributed its Blockbuster contract.

EBS Content Systems then sold almost all profit rights in the Blockbuster deal for $115 million to a
second
investment vehicle, called Hawaii 125–0 (a play on the old
Hawaii 5–0
television show and one of the accounting rules governing such transactions, known as FAS 125). Hawaii 125–0, in turn, was funded with $115.2 million from the Canadian Imperial Bank of Commerce in Toronto. CIBC was supposed to get 93 percent of the Blockbuster deal’s cash flow for the next ten years.