Titanic:2 – 06- Collision with the Iceberg

In the beginning of 2001, George W Bush, a republican and Ken Lay`s friend was elected as the 43rd president of the United States. There had been rumors of Lay becoming the Secretary of Energy in the Bush administration. Ken strongly opposed regulation of prices in the state of california and had Pat Wood appointed as the chairman of Federal Energy Regulatory Committee (FERC). The FERC, for a long time, kept quiet on the issue of price regulation in California but ebbed due to increasing democratic pressures. The whole crisis was also given a political spotlight as the then Governor of California was Gary Davis, a Democrat. He later lost to Republican Arnold Schwarzenegger. The golden egg of Enron was lost.

Throughout the summer of 2001, Enron stock began to fall. There were questions being raised both inside and outside of Enron. Jeff Skilling was seen increasingly despondent. There were rumors that Ken Lay is leaving Enron to join Bush Administration. But something unexpected happened. It was Jeff Skilling who resigned on August 14, 2001. It was unnatural for a Fortune 500 CEO to resign out of the blue. The reasons were stated as strictly personal. The media on wall street was baffled. Ken Lay took over as CEO on August 16, 2001.

A day after Jeff resigned, a controversial letter was sent to Key lay by its Executive VP Sherron Watkins. The letter was titled “Has Enron become a risky place to work?” Sherron was put in-charge of managing assets by Andy Fastow, the CFO. She had discovered the fraudulent partnerships of Andy which were hiding Enron`s debts. Andy had gambled Enron`s future on the assumption that Enron’s stock would never fall which was kept as a collateral to the investment made in his partnerships. She also described Cliff Baxter`s repeated display of concern to Jeff about cooking books.

The SEC began an investigation on Enron when the WSJ published a report on Andy`s disguised partnerships. The analysts began to worry that billions that were accounted as profits under M2M were actually loses. Enron’s accounting firm , Arthur Andersen had already begun shedding its Enron files. On october 23rd,  they shredded around 1 ton of paper. In October and November combined, Lay cashed in $26 million of his stock. In a turnaround, Andy Fastow was fired too when the board discovered that he had made $45 million through his LJM partnerships. Crippling throughout the November and October of 2001, Enron finally filed Bankruptcy in December. Over 30000 employees lost their jobs losing their medical insurance and pension funds.

The SEC enquiry also raised questions on the banks that were involved with Fastow in his LJM partnerships. It was believed that he could not have done that without Skilling and Lay being consistently acquiesced. He was named the crook and was the first to be penalised. He later plead guilty to conspiracy to commit wire fraud. He forfeited $23 million in assets. His sentenced was reduced to 10 years in exchange of testimony against Enron`s other executives which led to Skilling`s indictment in 2004. Lay also joined this league, however his attorney still maintain that he acted in his most ethical faith. America`s oldest accounting firm Arthur Andersen fell along with Enron and 29000 people lost their jobs.

The Titanic was lost in the midst of the deep ocean……

 

Titanic:2 – 05 – Troubled Waters

In the year 1997, Enron had merged with Portland General Electric (PGE). The merger helped Enron to get into electricity business. PGE had a wide array of plants – hydro-power and thermal which produced electricity and sold it to commercial distributors which would in turn sell this to consumers.  Enron soon instilled greed in this industry through the famous California Electricity Crisis in 2001 which rendered so many industry veterans perplexed.

The state of California had its wholesale i.e. producers` market deregulated. Enron leveraged this little loophole. The traders at Enron would clandestinely shut their (PGE`s) power plants terming them as ‘under-maintenance’ which would in turn increase the demand of electricity. The distributors, thus, had to buy electricity at a higher price, but, they could not sell the same at higher prices to the end user (as there was a regulation; the prices were capped by the government). Running  into losses, they had to shut down their operations every now and then. The electricity in California was being controlled by these Enron traders sitting in Houston. They sold electricity nearly at 10 times the average price.  Greed engulfed them; the shut-downs became so prominent, thanks to the never stopping maintenance going at the power plants,  that it became the major part of Arnold Schwarzenegger`s campaign when he ran for the Governor of California (he later won).

Enron made a lot of money out the the California crises. Interestingly, it was not enough to cover the humongous losses it was undergoing from its other businesses. To fix this Jeff and Ken had bought in a Knight – Andy Fastow. Andy joined Enron in the year 1998 as its CFO and was given the task of hiding its loses. He meticulously formed his private partnerships, around 100 in number, – LJM, JEDI, RAPTORS etc – which would invest in Enron`s assets. He successfully got 96 US Banks to pour money in these partnerships to indirectly invest in the red inked assets. The collateral was Enron`s stock which was soaring at the exchanges. This little arrangement helped disguise Enron`s losses; all the debt was being pumped to Fastow`s partnerships. To the outer world, there was cash-flow at Enron.

People soon began to raise questions. One of them was John Olson, at Merrill Lynch, who became a personal enemy of Andy Fastow. An immediate warning was issued to Merrill to replace him with an analyst who ‘loves us’ and gives a strong BUY recommendation otherwise Enron wont do business with them. John Olson was later fired and Merrill got 2 Investment Banking projects from Enron worth 50 Million USD. One Investor quoted Enron as ‘a black box of faith.’ I guess, he was right.

In March 2001, Bethany McLean, then an editor with Fortune magazine,  did a controversial story titled ‘Is Enron Stock Overpriced?’ She raised questions like How exactly Enron made money? How come the numbers don’t add up?  Jeff sent Fastow with a team over to Fortune to bully her but she was determined and got Fastow to personally plead her to not to make him look bad. She also went on to write a book about the whole Enron scandal after the bankruptcy.

Jeff had become increasingly weary during the later part of 2001. He knew the iceberg was about to strike them really hard. His despondency translated into his action and words. He called an analyst an ‘asshole’ when the question ‘Why Enron as a financial services company does not publish a Balance Sheet?’ was raised. It caused a stir on Wall Street that a Fortune 500 CEO openly called an investor an asshole. The Enron caption ‘Ask Why’ was mockingly converted to ‘Ask Why, Asshole.’ 

Titanic:2 – 04 – The Treasure Island

In the year 1997, Enron entered Wall Street and captured the hearts of Analysts which gave it a ‘Strong Buy’ recommendation. Inevitably, the Enron stock soared. The elevators in Enron offices now had tickers of Enron stock. Its stock price was as important as their lives for the people at Enron, specially its executives; their stock options were now worth millions. Jeff Skilling was a critical component in perpetuating this public image of Enron. There was a famous buzz on Wall street – Let`s run this by Jeff – when anyone had any questions about Enron. Analysts really believed what Jeff told them.

To the outside world, Enron was a very stable place. It became the largest contributor to the George W Bush`s election campaign. Every year they would host an odyssey of ceremonies including the famous Enron Prize for Distinguished Public Service. Fortune kept Enron at the top of America`s most innovative companies; and they did so much to retain the spot.

The dot-com gaga motivated Jeff to steer Enron to get into Internet Bandwidth trading. So when you go to sleep, you could trade your unused bandwidth to some office across the Atlantic. They decided to trade Weather forecasts. They got into a deal with Blockbuster to sell Video on Demand (VOD) on stock exchanges – the stock price rose to 35% in 2 days after the announcement. The pity was that none of these deals really materialized into profits, the blockbuster one was not even implemented.  But thanks of M2M, the profits were booked instantly and the executives, including Jeff, were paid millions in bonuses.

The year 2000 was catastrophic for Wall Street. American economy was in a slump. The dot-com bubble had bust. However, it proved even better for Enron. Investors, loosing their faith in cyber stocks, vouched for Enron. The ship which was sailing comfortably in the storm further raised faith in its crew. Enron became as the ‘next big thing’ on Wall Street. But who knew that within a year it will have to file a bankruptcy; the dream would be short lived. And soon the inevitable happened, Enron`s public image began to take a hit; questions were being raised, greed surfaced explicitly both on and off the Wall Street.

This is what happened next. Just when Enron was about to go Bankrupt, Enron`s executives en-cashed their stock options worth: Ken Lay – 300 Million USD; Jeff Skilling – 200 Million USD; Ken Rice – 53 Million USD; Cliff Baxter – 35 Million USD. It was soon after the Bankruptcy that the Investigators were able to solve the Enron hoax which is covered in the next article.

Titanic:2 – 03 – The Journey

Key Lay championed the smooth departure of Titanic 2 in the year 1985. Enron Oil Corporation was formed with the merger of Northern Natural Gas and Houston Natural Gas in Houston, Texas. He had surmised that Energy market, Natural Gas industry in particular, will be deregulated sooner or later – which eventually happened in the year 1989. Till then all Lay wanted to do was to prepare for the curtain-raiser – build a rapport in the market. Enron Oil was in the business of trading of oil – oil-in and oil-out, with, of course, cutting a margin for itself in between.

Ken Lay`s deep political connections and wit helped him to maneuver his ship without turbulence. Although, in 1987, just after 2 years of inception some shock waves were felt but again it did not seem to bother him much. Two of Enron`s traders – Louis Borget and Tom Mastroeni – in its Valhalla, New York office had gone rogue. They were gambling far above their limits, manipulating earnings, and were shredding trading evidence; as Enron`s auditors at Arthur Anderson had suspected. Lay was also apprised of the embezzlement of Enron`s money to an offshore account under the name M. Yass which on a careful look spells as My Ass. Ken was not bothered at all.

The money that was taken from Enron was a fraction of what the two rogue traders had made for Ken. This was in fact what made him decide to not let them go. He placed the loss Enron would undergo if he fired them over what loss it was undergoing in keeping them. The margin was too big for him to ignore. Filled by greed, he encouraged them to take such risks. A telex was sent to New York by Lay which said “Please keep making us millions.”  This was enough for anyone to understand that greed undermined everything at Enron and what kind of place it would be in future – A place filled with lust for money.

US government finally deregulated the energy market in the year 1989 and it was time for Ken to make his moves. He bought Jeff Skilling on board in the year 1992. Enron was now Enron Inc. and has become a place for ideas that were out of the box, needless to say ideas which were greedy.  And Skilling had the greediest ideas of all. He perpetuated the transformation of energy into financial instruments that could be traded in the form stocks and bonds. Thus Enron would become a stock market for natural gas. By 2001, Enron had become the largest buyer and seller of Natural Gas in the US.  However, this metamorphosis of Enron into a behemoth had some dirty secrets. Secrets that eventually shattered Enron leaving it with nothing but disgrace.

One of the secrets was Mark-to-Market (M2M) accounting practice which Jeff Skilling strongly believed in and pioneered. M2M helps one to book profits right away. As soon as the deal is negotiated, its profits are booked instantly. For example, signing a contract to build a power plant, the proponents of M2M would say that we are going to sell energy power at the rate of $X per unit 2 years from now after this plant is built. The catch here is that they will book the profits of this contract on the very day it is signed. Ironically, nobody can prove that they are wrong in their hypothesis. This M2M was extremely exploited by Enron, Skilling in particular. They took risks and they booked profits.

One such risk was Dabhole – A power plant that Enron fantasized to built in Gujarat, India. In INDIA, which was not a stable place to invest back then. Inevitably, Dabhole proved to be a catastrophe years later. However, its profits were booked right on the day its was executed; Enron`s executives, including Skilling and Lay, cashed in millions in bonuses. Thanks of M2M. To them, the idea was everything; you  have an idea, you book the profits from it. And Such risks were day to day phenomenon at Enron. It was deeply integrated into Enron`s culture. They took their hiring very seriously – they were known to hire bad-ass and smartest people from top US schools who would eventually become bullish traders. Money kept flowing in, at least on papers, even when they made losses. To the outside world Enron`s profits were what Enron said. Nobody questioned them. Enron was the smartest kid on the block.

When people got bored with Ideas, Enron dazzled them with new ones. One such idea was Enron Energy Services (EES). EES. a subsidy of Enron Inc. headed by its mysterious CEO Lou Pai, provided direct energy services to homes and business. It was nothing more than a hoax to cash profits. Lou Pai retired with $200 million in bonus from EES in the year 2000. With eggs like trading of weather, internet bandwidth on stock market in their basket, Enron was consistently ranked as the most innovative american company by Fortune magazine. Enron was a quintessential example of the american dream. Even the Wall street could not ignore its charm. Tat is when things took a turn for them. The iceberg was somewhere in the vicinity.

Titanic:2 – 02 – The Crew

Kenneth Lay

Ken founded Enron in the year 1985 through a merger of Northern Natural Gas Company and Houston Natural Gas. He was always on his toes to get the energy market deregulated so that his company – Enron – could capitalize from new competitive markets. He kept campaigning in Washington for this cause along with other  Energy-Industry Industrialists. He is also known to be very close to the famous Bush family. To the extent that George W Bush Sr. helped Enron with government subsidies in initial years and promoted Ken Lay as the deregulation ambassador. He brought Jeff Skilling on board and had known all along what was happening under his nose.

Jeffery Skilling

Jeff became CEO of Enron in the year 1991.  Until 1992, energy was traded by Enron in physical quantity – gas in and gas out on daily basis – in a deregulated market. However, Jeff had other things in mind. He perpetuated the idea of Enron becoming a stock market for Natural Gas – transforming energy into financial instruments which could be traded in stocks and bonds. Enron had always valued new ideas and Jeff supposedly came out with biggest ideas of all.  He pioneered trading of Internet Bandwidth and even Weather in stock markets in his later years at Enron.  No wonder why he was known as the ‘Smartest guy in the Room’ at Enron. In his interview at Harvard Business School, he was asked “Are you smart.” Jeff`s answer to this rhetorical question was “Oh yeah, I am fucking smart.”

Andy Fastow

Andy was hired by Jeff to command the ship as the Chief Financial Officer (CFO). He was brought in the year 1998 when Wall Street was dazzling whole of america prior to the famous dot-com bust.  His main job was to keep up with the share price of Enron. He designed a complex network of partnership firms that would do business with Enron and at the same time hide its losses. Needless to say that this was a clear case of Conflict of Interest. He meticulously disguised Enron`s debts and made a fortune for himself  in the whole process. He was the first one to be convicted in the trial. His imprisonment term was reduced to 10 years after he agreed to testify against other Enron executives – Skilling and Lay.

Another executive Lou Pai made $250 million after stepping down as a CEO of Enron Energy Services (EES) (A subsidy of Enron). He sort of had been smart enough to make the exit well before the bankruptcy and fled to Hawaii. Kenneth Rice was another big name with Enron who was convicted. However, there was one who had questioned Skilling all along. His name was Cliff Baxter. He was an Air Force veteran and committed suicide in the year 2002 after the bankruptcy.  

Titanic:2 – 01 – The Premise

Nothing better than the Titanic can describe how something flamboyant and lavish can precipitously fall to become a misery. Titanic, on its very first journey, left the shores  with huge pomp and show. But who would have had the slightest hint of it never making it to the other side?

The same could be related to Enron – the 7th largest american corporation of its time with $70 billion in revenues.  Enron was all about a dream that was cherished by its CEO Kenneth Lay. However, this dream had some under-surfaced presumptions – money and greed. These presumptions got deeply engraved in the culture at Enron – its tangible or intangible vision, its employees, and even in its office buildings.

Enron best describes the dark shadow of American dream. It is a story of how an american corporation drained out $65 billion, which it took 16 years to make after incorporation in 1985,  in 24 days at the time of its bankruptcy in December, 2001.  The sinking ship of Enron took with it their auditors – Arthur Anderson – as well. The term Big Four which we get to hear so much was actually Big Five until the collapse of Arthur Anderson – such was degree of the affairs.

This bankruptcy left Americans with a deep shock. Fraudulent trading strategies of Enron such as ‘Death Star, Fat Boy, Ricochet,’ etc are a common business jargon now. A Famous US Senator Tom Daschle once, while stating his opposition over pending of a certain legislation act commented that “I don`t want to Enron the people of America.”

I will try to explain the whole Enron phenomenon through a series of articles within the category of Titanic:2 because the Enron story is very exhaustive to pen down in one place without avoiding esoteric literature and business jargon.  I will also try to cover the aftermaths of this crisis and what changes were made by the US authorities, such as Sarbanes-Oxley Act, to deter something like Enron to happen again.