The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (6 page)

On Monday, Lay won Jack Bowen’s blessing for his departure, and in June 1984, at the age of 42, Ken Lay became chairman and chief executive officer of Houston Natural Gas. After her husband assumed his big new job, Linda Lay exulted to a friend: “It’s fun to be the king.” HNG would serve as the foundation for building Enron.

From the moment he walked in the door, Lay operated on one theory: get big fast. His core belief, as ever, was that deregulation—
real
deregulation—was coming soon. And when it did, he believed, the price of the commodity would reflect true market demand and the companies with the best pipeline networks would be the ones calling the shots. In just his first six months, Lay spent $1.2 billion on two pricey acquisitions that dramatically extended HNG’s pipeline system into the growth markets of California and Florida. (The Florida pipeline had been owned by Lay’s old company, Florida Gas.) He even talked to his old friend, Jack Bowen, about a deal with Transco. At the same time he unloaded $625 million in holdings outside the core pipeline business, including coal-mining properties and a fleet of barges.

Then came a bit of luck. In April 1985 Lay got a call out of the blue from a man named Sam Segnar, the CEO of InterNorth, a big Omaha pipeline company. Because Lay was in Europe at the time courting investors, John Wing, his old deputy from Florida Gas—who had just hired on as HNG’s chief strategy officer—handled the call. Segnar wanted to pitch the idea of InterNorth’s buying HNG. But it quickly became apparent that Segnar was too eager for his own good.

InterNorth, three times the size of HNG, had long been one of the most respected operators in the pipeline business. Among its 20,000 miles of pipeline was a genuine prize: Northern Natural, the major north-south line feeding gas from Texas into Iowa, Minnesota, and much of the rest of the Midwest. For decades, InterNorth had assumed a role in Omaha much like that of HNG in Houston. It was the caretaker of civic causes—the number one corporate citizen. Like HNG it had been run for years by a beloved figure, Bill Strauss. Under Strauss, InterNorth was a quiet, steady company with low debt and terrific cash flow that paid executives modest salaries and carefully watched expenses.

But in 1981 Strauss had turned the company over to Segnar, a charmless personality who upset many in frugal Omaha with a series of ham-handed moves. He purchased a company jet, bought a corporate ranch in Colorado, and closed the fifteenth-floor corporate dining room to all but a few top executives, who were served by white-gloved waiters. Worst of all, Segnar made a string of bad diversification investments. InterNorth was also powerfully motivated by the fact that Irwin Jacobs, a corporate raider, was buying up its shares. Jacobs’s looming presence sent Segnar into a panic. He persuaded the board that the only way to make InterNorth “sharkproof” was to make the company bigger and dramatically increase its debt. Buying HNG would accomplish both goals.

Lay and Segnar turned over negotiations to Wing and Rocco LoChiano, Segnar’s top deputy. They met at the St. Regis Hotel in Houston and quickly started talking price. At the time, HNG was trading at about $45 per share. LoChiano figured HNG was worth perhaps $60, $65 tops. But Wing, a canny negotiator, took advantage of InterNorth’s desperation to strike a deal, and quickly brought the price up to $70 a share. And that wasn’t all. Wing demanded that the smaller company’s younger management team ultimately end up in charge. Amazingly, LoChiano and Segnar agreed: Lay would replace Segnar, then 57, as CEO and chairman of the combined company after just 18 months. “I think I get this,” LoChiano told Wing over a cup of coffee. “We’re the rich old ugly guy with all the money, and you’re the good-looking blonde.” Wing laughed. “Yeah, that’s right,” he replied.

Just 11 days after the first phone call, the two CEOs won approval for the $2.3-billion deal from their respective boards. From a business standpoint, HNG InterNorth, as it was called, seemed an elegant combination: with 37,500 miles of pipeline, the new $12 billion company would have the largest gas-distribution system in the country, running from border to border, coast to coast. It would have access to the three fastest growing gas markets: California, Texas, and Florida. And it had some $5 billion in debt, surely more than enough to put it safely beyond the reach of raiders like Irwin Jacobs. As for Ken Lay, he wound up with a personal windfall: a $3 million profit from converting his stock and options in the wake of the merger.

Mergers that sound good on paper often wind up facing a far harsher reality. Such was the case with HNG InterNorth. There were two fundamental issues. The first was that almost immediately after the transaction closed, the InterNorth directors came down with a bad case of buyer’s remorse. As the implications of the deal sunk in, they began to realize that even though their company was the acquirer, they had pretty much given away the store to the Texans. Why, they now wondered, did HNG come before InterNorth in the new name when InterNorth had been the acquirer? Why was Segnar so quick to agree to give the CEO job to Lay in 18 months? Did it have anything to do with promises of a fat severance package? (Segnar ended up walking away with $2 million.) Why did HNG have almost as many seats (8) on the new board as InterNorth (12)? The more they thought about how they’d been snookered, the madder they got, but they were far angrier at their man, Segnar, than at Ken Lay, whose company had done the snookering.

Among the old-line InterNorth directors, the biggest fear of all was that the Texans were planning to move the company’s headquarters to Houston, even though everyone concerned, including Lay, had repeatedly promised that the company would remain in Omaha “for the forseeable future.” This wasn’t just a matter of jobs (though 2,200 were at stake); it was also a question of civic pride. It quickly became evident that the promises really weren’t worth much. Houston, after all, was the center of the U.S. energy business. Once the merger went through, the issue became so heated that the board created a special committee to study the matter. The committee retained the management-consulting firm, McKinsey & Company, to make a recommendation.

The McKinsey consultants, who included Lay’s old friend John Sawhill and a young partner named Jeff Skilling, were scheduled to unveil their recommendation to the board on November 11, 1985, a frosty day in Omaha, at the Marriott Hotel. They were indeed going to advise the company to move to Houston. But the meeting quickly took a different turn, and the consultants were told to wait outside. Hours later, Segnar stepped out of the board meeting with tears in his eyes. He shook Sawhill’s hand. “I’m leaving InterNorth,” he told the consultant.

Afterward, all parties claimed that Segnar had voluntarily resigned. In truth, the meeting had been a bloodbath, and he hadn’t really had a choice. Convinced that Segnar had made a series of secret side deals with Lay to betray Omaha, the old InterNorth directors demanded his head. Of course, since the board didn’t have another CEO candidate, it also meant that Ken Lay would become chief executive immediately, instead of having to wait the agreed-upon 18 months.

As a counterweight to Lay, the board brought back Bill Strauss as nonexecutive chairman and some even tried to mount a bid to reclaim the company for the River City. But the effort quickly fizzled when Strauss refused to lead the charge and quit after just four months, giving Lay the chairman’s title, too. It wouldn’t have succeeded in any case, for Lay had quietly won control of the board. A father-son pair of old InterNorth directors, Arthur and Robert Belfer, had lined up behind Lay. Two new directors, appointed after the merger by agreement between both sides, also turned out to be Texas partisans.

Over the next three years, the Omaha bloc was purged, and Lay started packing the board with his own directors, including a powerful Washington lobbyist named Charls Walker—Pinkney Walker’s brother—and an old Pentagon friend named Herbert (Pug) Winokur. John Duncan, the HNG director who had hired Lay, became head of the executive committee. And the corporate headquarters? The directors resolved to split the difference, maintaining an executive headquarters in Omaha and an operating headquarters in Houston. But that arrangement obviously couldn’t last long, and it didn’t. In July 1986 Lay announced that the company’s corporate headquarters would relocate to Houston, to a silver-skinned downtown skyscraper at 1400 Smith Street.

In Omaha, this decision was bitterly resented for years to come.

 • • • 

There was a second issue looming, of far more consequence than the question of where to put the company’s headquarters. It was this: all the good things Ken Lay assumed would happen once the HNG-InterNorth merger took place simply weren’t happening. For the moment, Lay’s get big fast strategy was only bringing bigger problems.

Irwin Jacobs? Even though the new company was now drowning in debt, the raider and an investor group allied with him still wouldn’t go away. Lay wound up having to shell out about $350 million—a modest premium to the market price—to buy out the group’s 16.5 percent stake. There wasn’t enough cash in the corporate coffers to pay the greenmail, so Lay had to tap the company’s pension plan for the money.

Deregulation? All of a sudden, there was a glut of gas on the market, prompting prices to plunge to levels no one had ever imagined. That only multiplied the company’s take-or-pay problem. Lay’s new business had more than $1 billion in take-or-pay liabilities.

Lay seemed unable to assemble a coherent management team amid bitter political infighting involving not just the old HNG and InterNorth executives but also the pipeline businesses he’d acquired the year before and a handful of well-paid friends that Lay had hired from outside.

Lay even ran into trouble coming up with a trendy new name for the company. After four months of research, the New York consulting firm Lay had hired had settled on Enteron in time for the merged business’s first annual meeting, in the spring of 1986. But then the
Wall Street Journal
reported that Enteron was a term for the alimentary canal (the digestive tract), turning the name into a laughingstock. Though it meant reprinting 75,000 covers that had already been printed for the new annual report, the board convened an emergency meeting and went with a runner-up on the list: Enron.

Oh, and just for good measure, Lay had to battle the government of Peru, which nationalized the company’s Peruvian production assets just a month after he’d become CEO. That alone produced a $218 million charge to earnings.

In early 1986 Enron reported a loss of $14 million for its first year. Lay announced a series of cost-cutting measures and job cuts. He froze pay for top executives and started selling off assets to cut debt, including 50 percent of the Florida pipeline he purchased just two years earlier.

Enron’s financial situation had grown so dire that by January 1987 Moody’s had downgraded its credit rating to junk status. One former executive recalls that during this period there was even worry about meeting payroll. “The company was in deep shit,” Bruce Stram, then vice president of corporate planning, says.

What Ken Lay and Enron desperately needed was a fresh source of profits—while there was still time.

Not every part of the old InterNorth wound up being relocated to Houston; at least one small division stayed right where it was. That unit was InterNorth’s oil-trading business, which had its offices in a suburb of New York City, in a small town called Valhalla, about an hour’s drive from Wall Street. Enron Oil, as it was renamed, wasn’t anything like the rest of the company’s gritty industrial operations. It was “the flashy part” of the business, as one employee later put it.

After the merger, Enron tucked Enron Oil away in a division that was a hodgepodge of businesses with little in common other than that they all made some of their money outside the United States. In Enron’s financial reports, earnings from the oil-trading operation weren’t broken out separately, and Enron didn’t talk up its oil trading to Wall Street analysts or investors. But that only heightened the importance of the operation internally. The traders were a kind of secret weapon in the ongoing struggle to improve Enron’s financial appearance. For unlike most of the rest of Enron, oil trading actually made money. Internal financial reports often bragged about the profits the traders were producing.

In more than location, the oil traders were closer to the freewheeling world of Wall Street than to the slow-moving, capital-intensive, risk-averse world of natural gas pipelines. Oil trading was about
trading,
not about oil. It was pure speculation: the oil traders came to work every day and made bets on the direction of crude oil prices. Enron’s top brass knew very little about how the trading operation worked, and, if truth be told, they didn’t much care. Oil trading looked like fast easy money, and that’s all that mattered.

Of course, easy money is rarely as easy as it looks; such was the case with Enron’s oil trading division. By the time Ken Lay and his minions in Houston realized something was horribly wrong—more accurately, by the time they were willing to face up to what they should have seen all along—the oil traders had come within a whisker of bankrupting the company. And Wall Street had its first indication that Enron and its leader didn’t always play by the rules that were supposed to apply to publicly held corporations. Although it took place a long time ago, it seems obvious now that the Enron Oil scandal was the canary in the coal mine.

•  •  •

 • • • 

The man who created Enron Oil was named Louis Borget. Within Enron, he was a shadowy figure who divulged as little as possible about the details of his operation and kept a wary distance from Houston. To most Enron employees—even most of the top executives—he was little more than a voice at the other end of the telephone line, cryptically telling them that everything was just fine.

Borget was born in 1938 in New York, the son of an abusive, alcoholic father. According to court documents, he shined shoes to make money for his family at the age of nine. A brilliant student, he graduated from high school by the time he was 16. From there, he joined the army, where he learned to speak fluent Russian, then put himself through night school at New York University. In 1964, he took a job with Texaco, where he slowly rose through the ranks, becoming special assistant to the chairman and later running a small division. But after 17 years with Texaco, he abruptly left the oil giant, signing on with a company called Gulf States Oil and Refining, which wanted him to set up an oil-trading division. Three years after that, in January 1984, InterNorth came calling, asking him to set up
its
oil-trading subsidiary and offering him a lucrative package, which included Wall Street–style bonuses based on whatever profits he brought in. By the time of the InterNorth-HNG merger, Borget’s operation was about a year and a half old.

Back then, oil trading was the hot new thing, both on Wall Street and in the oil patch. The big oil companies had long traded contracts promising to deliver oil in the future. This was a way to lock in a profit and mitigate the risk that oil prices would rise or fall. But the business had been limited by a couple of factors. For one thing, there was no standard contract for oil, which meant that the details of every trade had to be hammered out separately. And second, these contracts, by definition, meant that a cargo of oil would be delivered (or received)
at a certain time in the future. Because there was so little trading—so little liquidity, as they say in the business—there was little opportunity and a lot of risk for those who didn’t actually want to take possession of the oil. These factors tended to keep most speculators away.

In 1983 the New York Mercantile Exchange began to trade crude oil futures, in effect, a standard version of these contracts. Yes, the contract still theoretically came with the obligation to deliver, or receive, oil in some future month. But now that there was a standard contract, it could be traded many times over before anyone had to receive any oil. (If, indeed, oil was received at all: many times, the contracts were settled financially.) Suddenly oil looked a lot like other commodities, such as soybeans or pork bellies, or a financial instrument, like a stock or a bond. Suddenly, you could speculate in the stuff.

As a general rule, trading begets more trading. As a market becomes liquid—meaning that it’s easier to find a willing buyer or seller—it attracts more participants. That further increases the liquidity, which further attracts new participants. Fueled by this so-called virtuous circle, the oil-trading business exploded in the mid-1980s. Texaco and the other major oil companies were no longer content to trade merely as a price hedge. Now they hoped to make money purely on the act of trading. It wasn’t long before they all had trading desks. And it wasn’t just the energy industry that piled in. Wall Street firms like Drexel Burnham Lambert (whose most famous employee was Michael Milken) and Goldman Sachs jumped into the business. So did many less reputable players, sketchy fly-by-nighters who saw a chance to make quick profits. By some accounts, those early years in the oil-trading business were wild and woolly. There were all kinds of little scams being run, even by the reputable trading firms. Yet there was also a seemingly limitless opportunity to make money.

Borget, for his part, loved playing the role of a big-time oil trader. He kept Dom Pérignon and caviar in the office refrigerator for afternoon toasts. He and his traders dressed casually—Borget would even wear jeans—before the term business casual was widespread. They all drove company cars and ate daily catered lunches. A former trader named David Ralph Hogin recalls that Borget drove a Mercedes; when Hogin asked for a Mercedes, too, he was told that “Lou’s the only one who has a Mercedes. Would you settle for a Cadillac?” Enron Oil’s offices in Valhalla were sleek and modern and sheathed in glass, a far cry from the more modest quarters favored by energy industry executives. Borget himself could be charming, but he also could be intimidating; he had an odd combination of corporate polish and a trader’s swagger. “He was very intelligent, very imposing, sophisticated, and slick,” recalls someone who knew him then. Traders were loyal to him; they liked both his unflappability and his steadfastness in sticking by his trading decisions.

“We were the golden-haired boys in the Enron fold,” recalls Hogin. In 1985, the year of the InterNorth-HNG merger, Borget’s group made $10 million. The following year—a year when Enron’s ongoing business lost money—the oil traders made $28 million for the company. That year their bonus pool was $9.4 million, to be split among just a handful of traders. (Borget kept the lion’s share for himself.) And there was every expectation that Borget and his crew would keep pumping profits into the company. As Borget himself put it reassuringly, in a 1986 report he prepared for the Enron board: oil trading “as done by professionals in the industry today, using the sophisticated tools available, can generate substantial earnings with virtually no fixed investment and relatively low risk. . . .” In other words, it was the perfect modern business.

Or was it?

 • • • 

The first sign that Enron Oil might not be what it appeared came in early 1987. On the morning of January 23, David Woytek, the head of Enron’s internal audit department, received a startling phone call from someone at the Apple Bank in New York. An Enron account had been opened by a man named Tom Mastroeni. Mastroeni was a nervous yes-man who served as the treasurer of Enron Oil. Wire transfers amounting to about $5 million had been flowing in from a bank in the Channel Islands, and over $2 million had flowed out to an account in Mastroeni’s name. Alarmed, Woytek immediately called Enron’s general counsel, Rich Kinder, who was rapidly becoming Ken Lay’s most trusted lieutenant.

Kinder told Woytek to track down Borget’s nominal superiors, John Harding and Steve Sulentic, who oversaw Enron Oil from Houston. While Woytek tried to track down the two men, his deputy, John Beard, made another frightening discovery: the Apple Bank account could not be found anywhere on Enron’s books. To the auditors, this reeked of disaster. Beard jotted his worst fears in his notes: “misstatement of records, deliberate manipulation of records, impact on financials for the year ending 12/31/86.”

But according to internal documents, court testimony, and notes detailing these events, Sulentic and Harding had an explanation for the whole thing. The Apple Bank account was part of a tactic Borget had used to “move some profits from 1986 into 1987 through legitimate transactions,” Woytek noted in a memo; Borget had done so because “Enron management had requested” it. Nor was this the first time that Borget had shifted profits. Since 1985, the oil trader had been setting up prearranged deals with other entities—they had names like Isla, Southwest, and Petropol—that in essence allowed Enron Oil to generate a loss on one contract then have the loss cancelled out by a second contract that would generate a gain in the same amount. Using this technique, Borget had repeatedly moved income from one quarter to another. In his memo, which he sent to Lay and other Enron executives, Woytek described this as the creation of “fictitious losses.”

Harding now insists that whatever happened was not profit shifting, just the “prepayment of expenses,” and that he believed Borget’s actions were perfectly legal. But in testimony given over a decade ago, Borget said that Harding asked him to shift profits, originally for tax reasons. He also said that Harding approved bonuses as if the shifted profits from Enron Oil had remained in the year in which they were earned. For his part, Sulentic later testified that Enron Oil and other subsidiaries were “routinely instructed by Enron senior management to shift profits from month to month and year to year.”

It was easy enough to understand why Enron would want to do this: like every public company, it hoped to show Wall Street that it could produce steadily increasing earnings, which is what the stock market rewards. Indeed, lawyers later charged that Enron used the profit shifting for precisely that purpose. But it also had a more pressing reason: Enron’s ability to get bank loans absolutely depended on its ability to show earnings. Under the terms of its long-term bank debt, Enron was required to produce a certain amount of income every quarter, at least 1.2 times the interest on its debt. What’s more, because Enron was so strapped for cash, it constantly needed new loans to pay back maturing loans. In 1986, for instance, Enron had over $1 billion in commercial paper—short-term loans that mature quickly—that needed to be refinanced. With all its mid-1980s problems, Enron was constantly on the verge of being in violation of its loan agreements. As Lay put it in an Enron annual report about that time: “The present business climate provides no margin for error.”

Later, in court testimony, Borget described Enron Oil as “the swing entry to meet objectives each month.” Extra earnings in one quarter didn’t do Enron much good—unless the income could somehow be deferred to help the company meet its targets in the next quarter. It was all very logical, really. Profit shifting can be done legally—though even then it amounts to earnings manipulation. What subsequent events showed was that no one wanted to dig deeply enough to see if Borget and Mastroeni were staying on the right side of the law.

 • • • 

On February 2 Borget and Mastroeni were summoned to Houston. They met in
the office of a man named Mick Seidl, an old Ken Lay buddy who had followed Lay from Florida Gas to Enron and served as his number two. Woytek and Beard, the internal auditors, were there, as were a number of Enron’s senior executives, including Kinder, Harding, and Sulentic. (Some people remember Lay being present; Harding says he wasn’t there.) Sulentic defended the transactions. In a memo he wrote summarizing his views, he argued that Enron Oil’s Apple Bank account, and its transactions with Isla, Southwest, and Petropol “represents a sincere effort on their [Borget and Mastroeni’s] part to accomplish the objective of a transfer of profitability from 1986 to 1987.” He did concede that the methods Borget and Mastroeni had used were “not acceptable,” but he didn’t recommend any sort of punishment, not even a public admission of what had happened.

Next up was Mastroeni. While admitting that he had diverted funds to his personal account, he insisted that it was merely part of the profit-shifting tactic and that he had always intended to repay the money. He presented bank statements, however, that the auditors knew had been doctored, because they had gotten the original documents from Apple Bank. What was Mastroeni’s explanation? He and Borget had paid a bonus to a trader and didn’t want to have to explain it to corporate executives. Stunningly, most of the Enron executives in the room appeared to accept Mastroeni’s explanation. Mastroeni wasn’t even reprimanded. Neither was Borget. Says an Arthur Andersen accountant who was involved, “No one pounded the table and said these guys are crooks. They thought they had the golden goose, and the golden goose just stole a little money out of their petty cash.”

Still, the internal auditors continued to dig. They discovered a $7,800 deposit into the Apple Bank account from the sale of Borget’s company car. There were payments totalling $106,500 to an M. Yass. Was this a play on “My ass?” Not at all! Borget said he was an English broker who had faciliated the bonus to the Enron trader; Mastroeni claimed he was a Lebanese national. They searched directories of trading organizations looking for the names Isla, Southwest, and Petropol and came up empty-handed. They went to Valhalla but didn’t get very far. Finally, they got the word: they were to return to Texas and turn the investigation over to Enron’s accountants at Arthur Andersen. “Fieldwork . . . not completed based on advise [
sic
] from Houston,” jotted Beard at the time. There was no doubt by then what the auditors thought of the Enron Oil operation. “They were a bunch of scam artists,” one of them said years later.