Infectious Greed (54 page)

As the Internet IPO market began its boom, Enron strived to look like a
dot.com
, and began betting its future on technology and the Internet. Television monitors scattered throughout Enron's headquarters in downtown Houston flashed the company's stock price. Inspirational messages played inside the elevators. There was an on-site gym, and even a subsidized Starbucks coffee shop. Enron was named one of the best companies to work for in the United States. The retirement plan was generous, especially given that the stock price was rising. Every year, young executives received big bonuses and more stock options. And every year, the number of new Porsches and BMWs in the Enron garage multiplied.

Enron's board increased the incentives for executives to bet shareholders' money on speculative ventures by granting huge numbers of stock options. In 1998, Enron granted almost 16 million options to its employees and executives.
²⁴
In 1999 and 2000, those grants more than doubled, to roughly five percent of Enron's outstanding shares. By Enron's own estimate, these options would have reduced Enron's earnings by almost ten percent if their cost had been reflected in Enron's financial statements.
²⁵
(Fortunately for Enron, Congress had defeated the proposal to include stock options as an expense.) Moreover, because options were a one-way bet, unlike stock, they created incentives for the options holders to take risks that shareholders might not support, and to reduce dividend payments, which benefited only holders of stock, not options.

In addition to granting these options, Enron entered into derivatives deals to ensure that it would have adequate shares to cover the options by agreeing to purchase its own shares in the future. These
forward purchases
of its own shares were like a cash repurchase of shares in the open market, except that they didn't require any cash. Moreover, because
these forward purchases involved over-the-counter derivatives, not actual securities, they did not need to be disclosed in Enron's financial statements. By agreeing to buy its own shares in the future, Enron—and its executives—had made a huge, secret bet on Enron stock, without using any of Enron's precious cash.

Unfortunately, beginning in 1997, Enron lost most of the risky bets it made, costing the firm billions of dollars. First, Enron bet on the Internet by setting up a venture-capital firm to invest in Internet-related companies, and by putting its own trading operations on an Internet platform. Second, Enron expanded its trading from natural-gas and electricity derivatives—its primary areas of expertise—to new products such as fiber-optic capacity for telecommunications and even derivatives based on the weather. Third, Enron permitted employees to create and invest in new partnerships that did business with Enron, and to use these partnerships to manipulate Enron's financial statements. For Enron, these deals were three strikes.

The great paradox of Enron was that, notwithstanding these awful decisions, Enron's core business—natural-gas and electricity derivatives trading—generated enough money to offset its other failed efforts, including billions of dollars in profits during Enron's last years. By August 1999, Enron had withdrawn entirely from oil and natural-gas production. Instead, Enron made money by exchanging billions of dollars of long-term natural-gas and electricity derivatives, in which it committed to buy or sell energy products of various types for up to ten or more years. Enron's traders routinely took speculative positions that were much riskier than those Louis Borget and Thomas Mastroeni had taken at Enron Oil more than a decade earlier. In the developing energy markets, Enron's traders were in basically the same position Andy Krieger had been in years earlier: there were no organized exchanges for trading long-term energy contracts, and Enron traders could make huge sums trading with relatively less sophisticated market participants and taking advantage of market inefficiencies. Enron shareholders supposedly didn't need to worry too much about the risks of these trading operations, because Ken Lay had learned his lesson about trading risks with Enron Oil, and had committed to improved controls.

From the managers' perspective, the problem with Enron's derivatives trading was that even successful trading firms were not highly valued in the market. Investors generally believed that markets were efficient, and that trading made big money only when traders took on substantial risks.
Simply put, investors didn't value firms that took on substantial trading risks. Whereas a trading firm might have a price/earnings ratio of 10 or perhaps 15, a typical technology firm had a P/E ratio of 60 or more. To maximize its stock price, Enron executives needed to make it appear to investors that earnings were increasing because of the firm's successes in a range of technology businesses, not because of profits from its core business of derivatives trading. To the extent Enron appeared to be a technology firm, not a trading firm, its stock price would rise, and the executives' options would be worth more money.

As Enron shifted to new technology businesses, while hiding its derivatives trading, the perception of the firm's technology investments and the reality of its trading business were in intractable conflict. As a technology firm, Enron needed to borrow billions of dollars to pay for new investments and infrastructure. But as a trading firm, it needed to keep debt low, to maintain a high credit rating. This conflict eventually would tear Enron apart.

 

 

I
n the late 1990s, Enron Capital, the company's venture-capital fund, began investing in start-up technology companies, just as Frank Quattrone's fund at CS First Boston had bought shares of his clients' start-up companies before they did IPOs. For example, in March 1998, Enron invested $10 million in Rhythms NetConnections, an Internet service provider and a potential competitor of Netscape, the company whose IPO had marked the beginning of the Internet boom.

Enron's point man for Rhythms NetConnections was Ken L. Harrison, the former CEO of Portland General, an energy company Enron had just acquired. Harrison had just joined Enron's board and, after Enron invested in Rhythms NetConnections, he joined that board, too. Harrison was an ideal overseer, given that he had been named as a defendant several years earlier in a major financial-fraud case related to Bonneville Pacific, an energy company in which Portland General owned a substantial stake. Bonneville Pacific had raised several hundred million dollars, allegedly manipulated its earnings by using off-balance-sheet vehicles, and then declared bankruptcy—the same things Enron later would do. Portland General had settled the litigation while Ken Harrison was CEO. Given that both Ken Lay and Ken Harrison had been through painful financial scandals, it seemed likely that Enron would be safe from any similar scheme related to Rhythms NetConnections.

Enron originally had purchased shares of Rhythms NetConnections for less than $2. On April 6, 1999, Rhythms NetConnections did its IPO with Salomon Brothers, offering shares to the public for $21. At the end of the first day of trading, the stock was at $69, a big jump even for a late-1990s IPO. Enron had made 35 times its money on a $10 million investment—the same payoff as betting on a single number on a roulette wheel—and suddenly it had a $300 million gain, which represented almost half of its earnings from the previous year. (WorldCom and its CEO, Bernard J. Ebbers, made even more money from the IPO
²⁶
—more on that in the next chapter.)

The huge paper gain put Enron in an awkward situation. Enron couldn't realize the gain right away, because as an insider of Rhythms NetConnections, it was prohibited from selling the shares during a lockup period of 180 days. But even if Enron could have sold the shares, it wouldn't have wanted to do so. Why? A $300 million gain on a speculative Internet stock was not the kind of steady growth from technology investments Enron wanted to show investors. Securities analysts and credit-rating agencies wanted to see increases in income from operations, not one-time speculative gains. Solid earnings would help Enron's share price, but a several-hundred-million-dollar roulette win would not.

Andy Fastow, having sharpened his creative skills in structured finance with JEDI and other deals, had the solution. The road map came from a deal he had just done in 1997 to buy out CalPERS, the original investor in JEDI (CalPERS insisted that Enron buy its share of JEDI before it would do JEDI II, a sequel). Recall that Enron had kept JEDI off its balance sheet because CalPERS—an independent party—owned and controlled half of it. Fastow proposed replacing CalPERS with a newly created partnership called Chewco Investments L.P. (named after Chewbacca, the furry Wookie from the movie
Star Wars,
a foolish choice, given that Chewco and JEDI—names derived from the same movie—were supposed to be independent). Chewco would own and control 50 percent of JEDI, so that Enron could keep JEDI off its books.

The machinations of the JEDI-Chewco deal were widely publicized, but the rationale for the deal was not. For more than a decade, creative financiers had been dealing with the recurring problem of finding an independent source of funding, so that a company could move liabilities off the balance sheet. The problem generally arose in the context of leases, and by 1997 it applied to nearly every financial asset. Enron's attempt to find an independent investor in Chewco was an object lesson
in how apparently obscure legal rules were causing new financial products to mutate in wild and unanticipated ways. The solution to the problem involved the Special Purpose Entity.

In the 1980s, airlines often entered into long-term leases for their airplanes, instead of borrowing money to buy them. If the other party to the lease bore a substantial amount of risk with respect to the value of the leased planes, it didn't seem fair to require the airline to record the entire value of the planes as an asset and the entire value of the amount it owed on the lease as a liability. Instead, the lease would remain “off balance sheet.”

But what if the outside party bore little risk, so that the airline essentially owned the airplanes even though it technically had entered into a lease? If accountants permitted
any
lease to be off balance sheet, companies would start doing leases in droves, and investors would never know what companies actually owned and owed. To provide some guidance to leasing companies, the Emerging Issues Task Force of the Financial Accounting Standards Board—the same board that unsuccessfully proposed that companies count the value of stock options as an expense—issued an opinion called EITF 90-15, which said, essentially, that companies could move leases off their books if outsiders bore at least three percent of the residual risk of the lease.

This accounting opinion came to be known as the
three percent rule,
and companies began applying the opinion to transactions other than leases, arguing, for example, that companies did not need to record their dealings with a partnership if an outsider owned more than three percent. Some creative financiers argued that if the rationale applied to an
existing
partnership, a company also should be able to create a
new
partnership, sell an outside interest of three percent, and then remove the related assets and liabilities from its books.

The Securities and Exchange Commission was uncomfortable with three percent as a one-size-fits-all bright line. Why not five percent? Or why not a higher percentage for risky deals, and a lower percentage for less volatile ones? Notwithstanding these concerns, the SEC's Office of the Chief Accountant wrote a guidance letter in 1991, sanctioning the three percent rule, but noting that “a greater investment may be necessary depending on the facts and circumstances.”

With that mixed blessing, the three percent rule became like law, even though there was no real law or even any clear pronouncement by securities regulators supporting it. Instead, parties relied on letters from private
law firms opining that it was appropriate in a given deal to remove assets and liabilities from a company's balance sheet, citing EITF 90-15 and the 1991 SEC guidance letter. The three percent rule was an unsteady foundation for trillions of dollars of structured transactions, but that was precisely what it supported. For companies eager to use newly created SPEs to repackage and sell off mortgages, car loans, and numerous other financial interests, the three percent rule was plenty of justification for moving debts off their balance sheets. A typical SPE closely tracked the rule, with 97 percent debt and three percent stock. The three percent stock was supposed to be owned by an independent, outside party, although frequently it was held by a charitable trust or other entity related to the parties doing the deal. As SPEs became more common, financial firms pushed the envelope on the definition of “independent, outside investment.”

Chewco's “outside” investors were not really independent of Enron, but they arguably satisfied the rules. Enron cobbled together a three percent investment from Barclays Bank and some partnerships related to an Enron employee, Michael Kopper, and his domestic partner. The investment was not really at risk, because Enron put up cash collateral to guarantee repayment. And the investment was not really independent, because Michael Kopper worked for Enron. But in the new financial-market culture, reality didn't matter. The key question was whether the deal technically satisfied the rules. Technically, Barclays and the partnerships controlled Chewco. And technically, their money was labeled an outside “equity” investment, even though it was not really at risk.

With these arrangements, Enron could at least argue that Chewco had an outside investor with control. This argument might seem a thin reed, but it was entirely reasonable given how other companies were using supposedly “outside” investors in SPEs. Moreover, it wasn't up to Enron to decide whether a deal satisfied the SPE rules. That was the job of Enron's auditor, Arthur Andersen. Andersen's decision to approve of the accounting treatment for JEDI and Chewco was mired in controversy, and Andersen later claimed it would have made a different decision if Enron had disclosed key details regarding the collateral for the Barclays loan and the role of Michael Kopper and his domestic partner. But at that time, Andersen advised Enron that Chewco qualified as an SPE and, based on this advice, Enron continued to exclude JEDI from its financial statements, reporting its 50 percent ownership only in a footnote.