Who Killed Enron

Enron was supposed to be the next new thing, a New Economy company with substance to it. Unlike flaky Internet start-ups that substituted ethereal yardsticks like "eyeballs" and "stickiness" for revenues and profits, Enron had real businesses, real assets, real revenues and what seemed to be real profits. It owned natural-gas pipelines and electricity-generating plants and water companies. Not only would it do well, it would improve the planet by substituting the efficient hand of the market for the clumsy hand of government regulation.

And it seemed to work. From humble beginnings as a natural-gas company, Enron rose in a mere 15 years to No. 7 on the Fortune 500, doing $100 billion of business in 2000. Along the way, Enron became one of America's most admired companies, and a perennial favorite on "best places to work" lists. The guys running the show were hailed as magicians with newfound secrets that would change the future of business.

But Enron turned out to be another bubble. Unlike a Pets.com or a Webvan, whose implosions did little damage outside of costing dice-rolling speculators some money and techies some jobs, the Enron bubble exploded like a grenade. Today Enron is a smoking ruin, the biggest corporate bankruptcy in American history. A year ago the stock market valued Enron at more than $60 billion. Its stock has since lost 99 percent of its value--and still seems overpriced. Stockholders and lenders are out tens of billions of dollars. Many of Enron's 20,000 employees lost their retirement savings when the company collapsed. About 5,000 of them, from computer jocks in Houston to newsprint recyclers in New Jersey, lost their jobs, too. By contrast, chairman Ken Lay made $205 million in stock-option profits in the past four years alone, and other big hitters and board members made out, too. What's especially galling is that a handful of executives and outsiders made millions by investing in off-balance-sheet deals with Enron that played a large role in destroying the company.

The collateral damage keeps spreading. Prominent among the wounded is Arthur Andersen, Enron's outside auditor, which admitted last week that some employees destroyed documents. Andersen's reputation has been tarnished to the point that the Big Five accounting firms might shrink to the Big Four. Wall Street's credibility has been shattered. Utilities deregulation, for which Enron was the poster boy, is now on the back burner. The spectacle of impoverished, unemployed Enronites has thrown a harsh spotlight on the risks of 401(k) accounts stuffed with company stock. Confidence in financial markets has been shaken--and rightly so. With the action in Afghanistan slowing down, Enron shock waves have finally reached Washington, raising the specter of another 'Gate. L'affaire Enron is becoming a classic Washington scandal: criminal probes, investigations of destroyed documents, pols being asked what they knew about Enron and when they knew it. There's no sex, alas--but there sure is lots of money.

Life would be simple if we could blame the whole thing on Enron chairman Lay. Or on George W. Bush, who goes way back with Lay, among the biggest individual contributors to Bush's presidential and Texas gubernatorial campaigns. But Enron isn't that simple. It's something far more scary: a wholesale systemic failure. The multilayered system of checks and balances that is supposed to keep a company from running amok completely broke down. Executives of public companies have legal and moral responsibilities to produce honest books and records--but at Enron, they didn't do that. Outside auditors are supposed to make sure that a company's financial reports not only meet the letter of accounting rules but also give investors and lenders a fair and accurate picture of what's going on--but Arthur Andersen failed that test. To protect themselves, lenders are supposed to make sure borrowers are creditworthy--but Enron's lenders were as clueless as everyone else. Wall Street analysts are supposed to dig through company numbers to divine what's really happening--but almost none of them managed to do that. Regulators didn't regulate. Enron's board of directors didn't direct.

Why did all these people look the other way for so long? Money talks. Or, with Enron, shouts. The company put lots of money in pockets of the people and institutions that were supposed to police it. Enron's incessant dealmaking generated huge fees for Wall Street investment banking houses. And guess what? Wall Street loved Enron, with most analysts rating its stock and bonds as the greatest thing since money was invented, at least until they finally heard Enron's death rattle. Even when it became clear last fall that Enron was engaging in creative bookkeeping, almost no analysts recommended selling the stock, says Chuck Hill, who tracks analyst recommendations for First Call/Thompson Financial. "They should have thrown in the towel a lot earlier," he said. Enron paid huge fees--$52 million in 2000--to Arthur Andersen for auditing and consulting services. Andersen allowed it to get away with accounting that was, at best, aggressive and, at worst, criminal. If Andersen had stood on principle, Enron would doubtless have changed accountants. Enron famously made heavy political contributions. Pols got peanuts compared with what Wall Street and Andersen got, but it was enough to help Enron run roughshod over regulators at the national and state levels.

With so many dollar signs floating around and the company's stock soaring, no one was interested in bad news--a problem that's hardly limited to Enron. "A lot of people don't want to hear the straight truth," says Thomas Donaldson, a business-ethics professor at the University of Pennsylvania's Wharton School. "Investors don't want the CEO to say something negative that will drop the stock, even for the short term. There's a culture of puffery, a culture of winking." The winking stopped last year when regulators and the financial markets finally reined in Enron--at least five years after its big-time financial shenanigans had begun.

Enron started out innocently enough, born of a mildly innovative 1985 deal to combine two boring businesses: an Omaha-based natural-gas-pipeline company called InterNorth and a Texas pipeline company called Houston Natural Gas. Ken Lay, a soft-spoken statesman kind of guy with a Ph.D. in economics, found a hyperaggressive financial whiz named Jeff Skilling working in McKinsey & Co.'s energy practice in Houston. They had a brilliant insight. Instead of just delivering gas to customers at a modest profit, Enron could use newly deregulated pipelines to match buyers and sellers. In other words, Enron became a gas trader, as well as a gas company. Because trading was much more fun and much more lucrative than building pipes and drilling wells and selling gas at regulated, low-profit prices, Enron morphed into a trading company with a utility attached to it.

And make no mistake, these guys were deregulation's True Believers. At a dinner I had with Skilling in the late 1990s, he was like a religious zealot who couldn't stop repeating his favorite mantra as the solution to all the world's problems. There are rolling blackouts in the Midwest? Deregulate. Some energy companies look like they're price gouging? Deregulate more. And if salad dressing had dripped onto my tie?... You get the picture.

With Lay and Skilling in charge, Enron's revenues and profits climbed sharply. People from all over the country clamored to join Enron and its crusade. TV monitors in the Enron Building in downtown Houston displayed the stock price. Employees could get pumped up by inspirational elevator messages on the way to work. In the best dot-com tradition, employees were treated to subsidized Starbucks, an on-site gym and lavish company outings. Enron wasn't just a business, it was a lifestyle that rewarded foam-mouthed aggression. "There's nothing wrong with ambition, but there was simply a warped culture at the top," says John Allario, 38, who worked six years in Enron's business-development department before losing his job in the collapse. "They wanted to climb to the top of the mountain and pound their chest and crush anyone or anything that got in the way."

The most important measure of Enron's growth was its rising stock price. It was the oil that made the Enron machine run smoothly. After faltering in 1997, Enron shares went on a run in late 1998, doubling, then doubling again. Enron stock options were making employees rich and helped the company attract the best and brightest. Not wanting to miss out on a sure thing, Enronites stuffed company shares into their 401(k) plans. The company required most employees to have a chunk of their 401(k)s in Enron stock--but many employees had far more stock than Enron required, and far less in diversified investments, such as mutual funds.

But what made Enron successful--innovation and daring--got the company into trouble when it decided in its arrogance that it could "financialize" almost anything. Rather than sticking to natural gas and electricity, which it understood, Enron in the mid- and late-'90s branched into whatever struck its fancy: water, coal, fiber-optic capacity, weather derivatives (whatever those are) and newsprint. It bought and sold properties, and traded up a storm. But many of its businesses tied up lots of capital while earning very little or running in the red. In the late 1990s, by my count, Enron lost about $2 billion on telecom capacity, $2 billion in water investments, $2 billion in a Brazilian utility and $1 billion on a controversial electricity plant in India. Enron's debt was soaring. If these harsh truths became obvious to outsiders, Enron's stock price would get clobbered--and a rising stock price was the company's be-all and end-all. Worse, what few people knew was that Enron had engaged in billions of dollars of off-balance-sheet deals that would come back to haunt the company if its stock price fell.

And it was in those too-clever-by-half financial structures that Enron sowed the seeds of its undoing. Before we proceed to the story of Enron's final days, let's get out our trusty lightsabers and take an accounting trip, one made more lively by some Enron financial techie's fondness for "Star Wars."

Our case involves something called JEDI, as in Jedi knight. JEDI stands for Joint Energy Development Investments, which was an investment partnership between Enron and the California Public Employees Retirement System, known as Calpers. Enron and Calpers invested $250 million each into the partnership in 1993. JEDI prospered--the Force must have been with it--as Enron deftly bought and sold energy stocks, power plants and other investments, earning a 23 percent annual return for Calpers. Very nice. So Calpers welcomed Enron's offer in late 1997 to do a sequel. They ramped up JEDI II, with each side putting up $500 million. But first, Calpers wanted to cash in its JEDI I stake, worth $383 million. Enron obliged. Instead of liquidating the partnership, Enron went looking for someone to ante up $383 million to take Calpers's place. That would keep JEDI I off Enron's balance sheet and its profit-and-loss statement. Making JEDI I part of Enron would have cut the company's reported profits sharply, and increased its reported debt by more than $500 million.

To solve this problem, Enron ginned up Chewco Investments--as in Chewbacca the Wookiee. Chewco was a partnership of Enron executives and some undisclosed outsiders. Chewco didn't have $383 million sitting around. So Enron lent it $132 million and guaranteed a $240 million loan. This left about $11.5 million for Chewco to come up with. Not a whole lot, given the size of the deal. But $11.5 million was an important number. Why? Because it was more than 3 percent of Chewco's capital. And what's magical about that number? Clearly you're not an accountant. If outsiders put up at least 3 percent of the capital, accountants are allowed to keep the deal off the parent company's books. But Enron couldn't even get this right. It turns out that Enron had provided collateral for about half of Chewco's $11.5 million investment. This meant Chewco had only about 1.5 percent at risk, not 3 percent. So JEDI and Chewco should have been treated as part of Enron by Arthur Andersen from late 1997 on. But they weren't. In congressional testimony last month, Andersen chief executive Joseph Berardino admitted the accounting was wrong, but said it wasn't Andersen's fault because no one told his firm about the collateral Enron had provided. What Berardino didn't say then (and he wouldn't talk to us) is that even if Chewco had met the 3 percent rule, the result would still be outrageously misleading. Keeping JEDI and Chewco off the books inflated Enron's 1997 profits by 75 percent. And the move inflated profits for three more years, for a total of $396 million. Did keeping JEDI and Chewco off Enron's books when their impact was so great "present fairly" Enron's financial situation, as Andersen certified? Not to me. But I'm only an English major.

Now, to the death spiral. Enron had started 2001 in great shape. Its stock was $83, close to its previous high of $90. CEO Jeff Skilling said in January that the stock was really worth $126. But rather than heading north, Enron stock started falling as the year wore on. The continuous decline in Internet and telecom issues helped drag it down, as did falling natural-gas prices. What some Enron insiders knew--but outsiders didn't--is that the falling stock price was going to cause trouble, big time. That's because Enron was going to have to fork over lots of money, or give ruinous amounts of stock, to institutions that had lent billions to Enron's off-balance-sheet entities. The commitment to provide that stock made the off-balance-sheet entities creditworthy, because it reassured lenders about getting their money back.

Skilling quit unexpectedly in August, triggering speculation that something was amiss (he said he wanted to spend more time with his family). Skilling wouldn't talk to NEWSWEEK, but his spokesman said that Skilling "left believing the company was in very good shape." Asked if Skilling felt any responsibility for Enron's failure, his spokesman said he believes that "what happened to Enron is a tragedy. He does not understand the reasons for it."

The reasons, actually, are sort of obvious. The end began on Oct. 16, when Enron held a conference call to discuss its third-quarter profits. Or, more accurately, losses. Buried in its release was the fact that Enron's net worth had mysteriously shrunk by $1.2 billion. That was because of a complex off-balance-sheet deal involving four partnerships called Raptor, but Enron didn't explain that.

For the first time, Enron found itself fielding lots of hostile questions from its formerly docile constituency on Wall Street. Meanwhile, The Wall Street Journal had been picking away at the Enron facade, revealing, among other things, that Enron's chief financial officer, Andrew Fastow, had made more than $30 million in fees for running some of the supposedly independent partnerships. That, plus the losses and the vanished $1.2 billion of net worth, started a Wall Street uproar. This went virtually unnoticed in Washington, where all eyes were on Afghanistan. But a few days later the Securities and Exchange Commission informed Enron that it had begun an informal investigation. Enron did what comes naturally to any large company in trouble--it ran for a lawyer: University of Texas Law School Dean William Powers Jr. It put Powers on its board and named him to chair a special board committee to deal with the SEC, and to investigate. Powers hired William McLucas, a former head of the SEC's enforcement division and a partner at the Washington law firm of Wilmer, Cutler & Pickering. McLucas assembled a legal task force and hired accountants from Deloitte & Touche to dig into the books.

Guess what? Inside a month, McLucas & Co. found unpleasant truths that Enron's board (and presumably Andersen) had ignored or overlooked for years. Then again, McLucas didn't have a vested interest in ignoring them. McLucas's conclusion: Enron's profits had been grossly overstated and its debts understated for five years.

On Nov. 8, Enron issued a report, clearly crafted by McLucas, saying that its numbers dating back to 1997 could no longer be relied on. About 10 days later, it issued its third-quarter report, containing additional damaging information. The end was nearing. As a trading company, Enron needed huge amounts of credit to carry inventory (and, as we've seen, to cover losses) and also needed the confidence of trading partners. With Enron's numbers hinky, its credit failing, a cash crisis clearly on the horizon, Enron's beloved free market did it in. Creditors fled, trading partners fled, money gushed out the door. After an aborted attempt to sell out to crosstown rival Dynegy Inc., which walked away from the deal at the last moment, Enron was out of cash, out of credit, out of luck and out of time. It filed for bankruptcy on Dec. 2. And it may well never emerge from it. Its energy-trading business is still very valuable, but the bankruptcy is looking messy, even by bankruptcy standards.

Former Enron employees can't stop shaking their heads over the sorry saga. "There was a time not so long ago when we all thought Ken Lay was just the most wonderful person in the world," says Shane Yelverton, who had worked as a senior administrative assistant in Enron's engineering department. "But now we're hearing all this stuff: that he was selling off stock, even while he was telling us not to sell our stock. It's disgusting."

Charles Prestwood is more than disgusted. A pipeline operator who had been with Enron since day one, he retired in October 2000 with $1.3 million of Enron stock in his 401(k). Now, he's watching pennies. "All those dreams are gone now," he says. "I've lost everything I had. I'm just barely surviving."

Remember John Allario, the former Enron employee who so elegantly described the corporate culture in Enron's heyday? He's getting a measure of revenge. Invoking his former CEO's last name, he started a Web site, laydoff.com, that peddles i got lay'd by enron T shirts. "We've sold about 450 so far," Allario said last week. "It's my way of showing the company that its former employees whom they left in the lurch are still creative, and that we have something to offer."

The Enron fallout promises to be severe and far-reaching. With a criminal investigation underway, some of the Enron players face the prospect of spending time in the big house. The only question about Arthur Andersen is how much the partners will have to pay to settle this mess, and whether the company can survive as an independent entity. The accounting profession is wishing it were once again faceless and colorless, instead of being in the harsh spotlight. Financial conglomerates like JP Morgan Chase and Citigroup are going to be scrutinized over their multiple and often conflicting roles at Enron: lenders, trading partners, investors, advisers, investment bankers.

Small investors, understandably, are frightened when a giant, well-regarded company collapses overnight. The obvious lesson: don't keep too many eggs in one investment basket, especially in the company you work for. Utilities deregulation has suffered a severe blow: if a huge company like Enron can disappear overnight, how can you trust new market players to provide you with essentials like electricity, gas and water? And maybe it's time to change the name of the Houston Astros' home park, Enron Field, to House of Cards.

The bottom line: Enron wanted to change the world. It did. But not quite the way that it had in mind.

--Kenneth Lay and Jeffrey Skilling, in a letter to shareholders that boasted of the company's vast opportunities for growth

"Even an effective internal control system can provide only reasonable assurance with respect to the preparation of reliable financial statements and safeguarding of assets."
--On management's responsibility for reporting financial information to shareholders

"In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Enron Corp."
--Arthur Andersen, on its audit of the company's balance sheet and statements of income

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