The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (20 page)

In November 1994, EPP sold stock to the public at a price of $24 a share, raising a total of $225 million, money that bolstered Enron’s 1994 earnings. Of course, in substance, Enron
absolutely
controlled EPP, which the EPP offering document flatly stated. That same document also said that the relationship with Enron “may result in conflicts of interest” when EPP and Enron’s interests diverged. Indeed, it did. Not only was Kinder the chairman of EPP; its CEO was Rod Gray, a managing director of Enron. After the public offering, Gray’s stake in Enron continued to be larger than his stake in EPP, and Enron continued to pay part of his salary. (The rationale was this was a good thing because Gray would have an inside scoop on the assets.) The CFO was Jim Alexander, who had been one of Enron’s investment bankers at Drexel Burnham.

But EPP didn’t work out as planned, partly because certain projects weren’t completed and partly because Jim Alexander, who quickly became the fly in the ointment, complained that Enron was pressuring EPP to overpay for assets, particularly the troubled Dominican Republic power plant. Alexander even met with Lay to complain about the rampant conflicts. He also says he told Lay that there were problems with the accounting in Enron’s international business, including the compensation system and Enron’s practice of “snowballing” development expenses for projects that had ground to a halt. Lay said he’d have Kinder look into it and ushered Alexander out.

Alexander also complained to other Enron executives. They, however, told Lay that he was overreacting and that the conflicts were being well monitored. They also felt Enron’s internal accounting issues were none of his business. Alexander worked for EPP, after all.

Weeks later, EPP entered into a cost-sharing agreement with Enron, which meant, among other things, that EPP’s accountants now worked for Enron. Alexander left EPP as did several other EPP officials, all in the same week. Alexander says today: “They were people who couldn’t take no for an answer. They couldn’t even take no from reality.” Once Alexander departed, Enron sold a 50 percent interest in the troubled plant in the Dominican Republic to EPP.

In August 1997, Enron announced that it would buy back EPP. Several former executives contend that the problem wasn’t that the gatekeeper didn’t work, but that it worked too well. EPP wasn’t paying enough for the assets it bought, and the process was viewed as more trouble than it was worth. There had to be a better way—and soon there was.

Enron ultimately paid about $35 a share for EPP, which represented about a 14 percent annual return to EPP shareholders. It was a premium price, but Enron wanted Wall Street to think that its investments were stellar. But the buyback wasn’t Kinder’s doing; he was gone by then.

•  •  •

 • • • 

There was one part of the business that Ken Lay always kept to himself: the care and feeding of Enron’s board of directors. Over time, most of the old board members he’d inherited from InterNorth had been replaced with people Lay handpicked. Charls Walker joined in 1985. So did Charles LeMaistre, the president of the famous Houston cancer hospital, M. D. Anderson. In 1993, Lay added Wendy Gramm, who had just finished a stint as chairman of the Commodities Futures Trading Commission (CFTC) and was married to Texas Senator Phil Gramm. (Several notables declined to join Enron’s board, including former commerce secretary Robert Mosbacher, one of Lay’s old Houston friends, who decided against it after asking some associates in the energy business about the wisdom of Enron’s strategy. And despite two separate invitations from Lay, Robert Rubin, Bill Clinton’s former treasury secretary and later the chairman of the Citigroup executive committee, also turned down a chance to sit on Enron’s board.)

The board had its share of conflicts, all of which received withering scrutiny after Enron’s bankruptcy. Enron employed Walker’s lobbying firm. Just after Wendy Gramm stepped down from the CFTC, that agency approved an exemption that limited the regulatory scrutiny of Enron’s energy-derivatives trading business, a process she had set in motion. (At the time, both Enron and Gramm denied any kind of mutual back-scratching.) Enron donated hundreds of thousands to the M. D. Anderson Cancer Center. It gave a $72,000-a-year consulting contract to Lord Wakeham. Several directors did business with Enron. And John Urquhart actually owned 0.1 percent of Enron Power’s phantom equity through a consulting arrangement he had with the international business. Enron bought him out in 1993 for over $1 million but also gave him a fresh batch of options on Enron stock. In 1994, for instance, he earned $596,354 consulting for Enron and reaped another $931,000 through his options.

But Enron was hardly the only board in America rife with conflict, and in any case, the real problem with the board wasn’t merely the conflicts. It was that just about every member of the board seemed to believe that Ken Lay walked on water. The Great Man persona he presented to the world at large was also what the Enron directors saw. Walker later described Lay as a “unique individual”—“charitable work, leadership in the community, leadership in the Republican Party, a preacher’s son.” To their way of thinking, Ken Lay was the one indispensable person at Enron.

The flavor of the board meetings only reinforced the notion that all was perfect at Enron. The day before the board met, the Enron jets would pick up the directors and fly them to Houston, where they would sometimes head to the Lays’ condominium for a cocktail party. The meetings themselves were clubby affairs, with soothing conversation and long dinners, “more like a family gathering than a board meeting,” recalls a former director. Enron executives would deliver what Walker recalls as “very, very well-rehearsed” presentations. (Indeed, throughout the years, few, including the accountants, ever hinted that anything fell short of perfection.) Lay would share his vision with the group. And the outcome was never in doubt. “Whatever Ken wanted them to okay, they did,” says a former executive. Which goes a long way toward explaining what happened next.

Kinder had been operating under the belief that he would be elevated to CEO at the end of 1996. In the interim, though, Lay had begun to sour on his number two. He still believed that Kinder lacked the appropriate polish. He had hoped Kinder would “grow into the job,” he later told several Enron executives, but in Lay’s opinion that hadn’t happened. And of course Bill Clinton was headed toward a second term as president, which meant that Lay’s dream of becoming treasury secretary would have to wait at least four more years.

In 1995, as Ron Burns was preparing to leave the company, Lay asked whether Kinder was the cause of his departure. Burns thought it was a strange question, and it made him wonder if Lay was looking for reasons to hold back Kinder. Then, in the fall of 1996, as the time approached for Kinder to take over as CEO, Lay went to at least one other top executive and said that he planned to tell the board the executive wouldn’t support Kinder—and he wanted to be sure this person would back Lay up if asked.

Finally, there was this: in the fall of 1996, Lay heard that Kinder, who had recently divorced his University of Missouri college sweetheart, was romantically involved with Nancy McNeil, Lay’s trusted assistant (and by then an Enron vice president) who had also recently been divorced. Lay was dismayed, to say the least: he grilled another Enron executive about whether the relationship had been going on before their respective marriages had broken up. And he was furious that his number two had a pipeline into his office. “I’ve lost Nancy’s loyalty,” he declared.

Whatever lingering relationship Kinder and Lay still had pretty much dissolved with this discovery. Lay was voicing moral outrage; never mind that he’d had an affair with his own secretary or that both Kinder and McNeil denied persistent rumors that their relationship had begun before both were divorced.

The climactic board meeting—the one in which Kinder expected to be promoted—was held in New York in mid-November. Early on the morning of the meeting, one of the directors saw Kinder arrive at the hotel accompanied by McNeil. During the meeting, as the board discussed Kinder’s qualifications to be CEO, the romance was brought up. According to Walker, two of the directors said that they couldn’t support Kinder: he lacked Lay’s character. (When asked why Kinder’s affair was different from Lay’s, one director says: “Some people would make the point that it was his own secretary, versus the boss’s secretary.”) After the meeting, Lay told Kinder that he had asked the board to promote Kinder to CEO but that the directors had refused to accept his recommendation.

Here’s a telling comment on the way Lay was perceived in the upper ranks of Enron: very few of the company’s senior executives believed him. People at the top of Enron believed that Lay was hiding behind the board because he didn’t want Kinder to be CEO but lacked the guts to tell him so directly. As one executive put it, “Any time there was a tough issue, Ken would blame it on the board.” Certainly that’s what Kinder believed. After getting the news, Kinder angrily told one senior executive: “Ken fucked me! He fucked me. He’s blaming it on the board. That’s
bullshit!
”

On Tuesday, November 26, 1996, Enron announced that Lay had agreed to a new five-year term as chairman and CEO and that Kinder was leaving. Lay got a new contract guaranteeing him a base salary of $990,000 in 1996, rising to $1.2 million the next year. And even though Enron’s earnings only grew 11.6 percent that year, the failure to hit the 15 percent earnings target didn’t cost Lay. The board simply amended the compensation provision to include “at least double-digit earnings per share growth annually,” instead of 15 percent. In addition, Lay got a new grant of 1,275,000 options. There was again a provision that would enable Lay to cash them in quickly. But this time, it wasn’t tied to earnings: Enron’s stock simply had to outperform the S&P 500. Those options alone would later be worth as much as $90 million.

In typical Enron fashion, Kinder was well taken care of, too. He got $2.5 million in cash, and forgiveness of an outstanding loan of almost $4 million. He also took $109,472 in unused vacation pay. Despite the earnings failure, most of his options vested, too. Kinder quickly sold over 1 million shares of Enron stock, worth $40 million.

On his way out the door, Kinder took one other thing, the most important of all. He cut a deal to buy Enron’s interest in something called Enron Liquids Pipeline for about $40 million in cash. There was no fairness-opinion done, and Enron sought no competing bids (though it had had the stake on the block for some time). “He knew that system [the liquids pipeline] better than anybody else and he cut one hell of a deal when he left,” says a former executive.

That he did. Within a matter of months Kinder had joined up with his old University of Missouri classmate Bill Morgan to form a company called Kinder Morgan. The assets he bought from Enron were the foundation of the company; they included interests in two natural-gas liquids pipelines, one carbon dioxide pipeline and a rail-to-barge coal-transfer terminal. They were the sorts of assets Enron didn’t put much value in anymore, but Kinder, says one friend, “always loved those assets.”

By early 1998, Kinder Morgan had a market value of over $1 billion. Since 2001 Kinder has been on
Forbes
’s list of the 400 richest in America. By mid-2003, Kinder Morgan’s stock was worth over $7 billion. Nancy McNeil left Enron around the same time Kinder did; the two soon married. Their philanthrophic activities soon rivaled those of Ken and Linda Lay; for instance, the Kinders gave $3 million to the DePelchin Children’s Center. To this day, Kinder refuses to allow Kinder Morgan to own a corporate jet; though he leases a hundred hours of airtime on a private jet each year, he pays for it out of his own pocket.

For his part, Lay told the senior staff that he was not planning to replace Kinder, and the company announced that starting on January 1, 1997, Lay would assume Kinder’s old title of president while continuing as CEO and chairman of the board.

One former board member says that “it was one of the saddest days for Enron when Rich Kinder left.” And that director wasn’t the only one who felt that way. Though long gone from the company, John Wing still held millions in Enron stock. When he learned that Kinder was leaving, he sold most of his shares.

Early in December 1996, just days after Kinder’s resignation was announced, Ken Lay had lunch with Ron Burns in a private room at the River Oaks Country Club, Houston’s most exclusive enclave. After leaving Enron to become president of the Omaha-based Union Pacific Railroad, Burns endured a rocky stint that lasted only 15 months. He’d orchestrated a graceful exit when Union Pacific merged with another railroad. He had been out of work about a month when Lay invited him to Houston.

“I’d love to have you back,” Lay told Burns, adding that if Burns were willing to return to Enron, Lay would restore the stock options and other benefits he’d forfeited; it would be as if he’d never left. Lay didn’t specify what job he had in mind for Burns, but that wasn’t unusual. Even after all these years, Lay still had a habit of hiring people he liked, then figuring out what to do with them later. Burns, for his part, told Lay that there was only one position he’d consider:
Kinder’s old job. He also told him that if he became Enron’s president, his first order of business would be to rein in the company’s two warring superstars, Skilling and Mark. “If you’re willing to deal with them,” Burns told Lay, “I’ll talk.” Lay was noncommittal, and the negotiations went no further. But that evening, Burns bumped into some old friends from ECT at a Houston restaurant and over dinner and a few drinks casually mentioned that he’d met with Lay earlier in the day.

When Skilling heard the news, he reached a predictable conclusion: the two men had to be talking about Burns returning as president and COO of Enron. That also sparked a second worry—that his rival, Rebecca Mark, might also be trying to maneuver herself into the position.

During the time his marriage was disintegrating (the divorce was final in 1997), Skilling would tell colleagues that he felt burned out, that he even sometimes thought about calling it quits. But nobody at Enron took this seriously; Skilling had always been too driven. Just nine months earlier, Skilling had signed a new five-year contract, bumping his annual base pay to $400,000 a year and providing that Enron would work with him to find “an enhanced position and job title.” If a new job title couldn’t be agreed upon by February 1997, Skilling would be entitled to a $1 million payment.

Now that Skilling sensed that Kinder’s job was up for grabs, he knew exactly which enhanced position he wanted. Quickly, he and his forces swung into action. Skilling met with Lay and used the classic Enron tactic: he told the Enron CEO that if anyone else got the job, he’d quit. What’s more, he declared, if Lay named Rebecca Mark as president, “there will be revolution in the ranks—70 percent of the merchant business will quit the next day.” On a business trip a few days later, amid speculation that Lay might be considering Mark for the post, Skilling said to an ECT colleague, “I’ll tell you one thing. If that bitch gets it, I’m outta here.” Lou Pai also did his part to drive the message home. In a meeting with Lay, he told the Enron CEO that only Skilling could keep the traders happy.

How did Lay respond to these threats? He caved. Mark might be his fair-haired child, but he just couldn’t afford to let Skilling walk out the door. Thus, on December 10, 1996, barely two weeks after announcing that Lay would assume Kinder’s duties, Enron made a new announcement: Jeff Skilling would become the company’s new president and chief operating officer instead.

 • • • 

In his physical appearance, Skilling was a dramatically different man. He’d always been disheveled in a nerdlike way, and over the years, his poor eating habits and lack of exercise had taken their toll; at the time his marriage was bottoming out, he’d ballooned to nearly 200 pounds. After a scare from chest pain, he resolved to get in fighting trim. Skilling began lifting weights and dropped 65 pounds in a couple of months. He later started using a hair-growth drug to recarpet his balding scalp. At the age of 43, he’d never looked better.

But as a business executive, Skilling really hadn’t changed at all. Even though he’d been running ECT for six years, he still thought like a consultant, enamored, always, of the Big Idea, with surprisingly little appreciation for how one got things done in the real world. He had zero interest in the nuts and bolts of operations. He was as incapable of getting tough with his core group as Ken Lay was with Enron’s top executives. He had a narrow, even selfish, view of what constituted success that revolved solely around ECT; he was largely indifferent to the rest of Enron.

Yet suddenly he was in charge, running a company that was generating $13 billion in annual revenues, employed 11,700 people, operated in 22 countries, and had an array of problems that needed to be fixed. “It was a recipe for disaster,” says an early ECT executive. “You had Lay, who was disengaged, and you had Skilling, who was a big-picture guy and a terrible manager.” And this isn’t just hindsight speaking. There were many Enron executives, even at the time, who felt that Skilling was miscast in Kinder’s old job. One of them, Forrest Hoglund, who ran Enron Oil and Gas, even told him so directly. “You’re a very bright guy,” Hoglund said to Skilling shortly after the appointment had been announced. “But when you become president, you’re going to have nine different masters. I’m sorry, but based on your temperament, you’re not going to be very good at that.”

For his part, Ken Lay never appreciated what big shoes he was asking Skilling to fill. “Lay had a lack of understanding of just how much Kinder did,” says a longtime corporate officer. “He felt anybody he selected could run that company the same way Rich did.” When he maneuvered to prevent Kinder from becoming Enron’s CEO, Lay made a big mistake. Now he had compounded his mistake by naming Jeff Skilling as the company’s new president.

 • • • 

Between 1989 and 1994, Enron’s stock consistently outperformed the Standard & Poor’s 500. In each of those years, the company had met or exceeded its earnings targets, and Wall Street had responded by pushing up the stock; during that time span, the stock rose 233 percent, compared to the S&P 500’s 65 percent. Enron’s record of regularly beating the market’s most important barometer was a point of enormous pride for the company; Lay and Kinder never tired of boasting about the accomplishment.

In 1995, the streak was broken. Though the stock rose a healthy 25 percent, the S&P 500 did better, rising some 34 percent. But it was 1996 when it became clear that Wall Street was having second thoughts about Enron. That was the year that Enron missed its earnings target, as profits rose only 12 percent instead of the expected 15 percent, and for the second year in a row, Enron lagged the market index. In fact, the earnings miss was only part of the problem. The huge Dabhol contract had fallen apart, and it was only at year-end that Rebecca Mark had miraculously managed to get the project back on track.

Wall Street was even raising questions about Enron’s quality of earnings, meaning that stock analysts were beginning to look askance at some of the steps that Enron had employed to hit its earnings targets. “One of the biggest concerns consistently voiced about Enron is the complexity of its operations and how those interrelationships affect the quality of its earnings,” wrote a Morgan Stanley analyst in the spring of 1997.

When investors are in love with a stock, they’ll forgive a lot. The analysts will ignore potential problems, and they’ll accept management’s word that, say, a nonrecurring charge really is nonrecurring and not part of the ordinary course of business. They’ll work hard to put a positive gloss on even the most ho-hum corporate announcements. But when Wall Street goes negative on a stock, the opposite phenomenon takes place: a remorseless skepticism takes hold, as investors search for clues that more bad news is on the way.

Such was the case with Enron as Skilling took over as president. Analysts who’d had strong buys on the stock during most of the Kinder era were downgrading Enron to a hold—which is Wall Street’s code for sell. Carol Coale at Prudential Securities—one of the leading analysts of Enron—downgraded in October 1996, pointedly noting that in the third quarter, four cents a share of the company’s profits had come from selling a stake in Teesside. An analyst at Dean Witter Reynolds, who had downgraded Enron a few months earlier, cited “Dabhol uncertainty.”

One of Enron’s looming problems, which the analysts had belatedly begun picking up on, was the old J-Block contract. Remember J-Block? That was the terrible deal Enron signed in March 1993 in the wake of its Teesside triumph. With the approval of Lay and Kinder, the company had agreed to a long-term contract committing it to purchase a huge amount of gas, as much as it had bought for Teesside. The gas would flow from a part of the North Sea called J-Block, which would be ready to come on line in 1996.

What made the deal so foolish was that it was a classic take-or-pay deal. Back then, during the early giddiness over Teesside, Enron officials had assumed that it would be easy to find customers for the additional gas. Bob Kelly, Wing’s old deputy, who was then running Enron Europe and had negotiated the J-Block deal, even thought he might be able to use the gas to fuel a second Teesside-type plant he hoped to build.

But all of the assumptions the international team made turned out to be horribly wrong. The problem was that Enron had committed to a price near the top of the market. By 1995, the spot-market price had dropped far below what Enron had agreed to pay. That meant it was no longer possible to sell the gas at a profit, and it simply didn’t make economic sense to use it for another plant.

Which is not to say that the company hadn’t had its chances to unload the gas. In the months after the deal was signed, Enron had numerous chances to sell the J-Block gas at about the price it had committed to pay. But Kelly had been transferred back to Houston in 1993, and his successors in Enron’s London office turned down the suitors, holding out the hope that the market would soon resume its climb, allowing them to book a profit. Executives who had not been involved in the original J-Block deal later stumbled across an inch-thick file of letters from companies inquiring about the gas with the standard Enron reply saying that the gas was not for sale.

By 1995, Enron’s exposure was approaching $2 billion at a time when Enron’s total market value wasn’t much more than $5 billion. J-Block was posing a serious threat to Enron’s survival. Kinder had grown increasingly frustrated, at one point pounding his fist on a conference table: “You mean with all this goddamn high-priced talent in this room nobody can tell me what is going on with this fucking J-Block contract?”

Kinder had dispatched a series of teams from Skilling’s ECT to grapple with the problem. One executive was so shocked after reviewing the drafts of the contract—every negotiating point seemed to have been resolved against Enron—that he hired a private investigator to explore whether someone on the company’s negotiating team had taken a payoff. (Ultimately they found no evidence of impropriety.)

Kinder even flew to England to try to negotiate a settlement himself. But after a stormy meeting with the producers, led by Phillips Petroleum, the talks collapsed and everyone headed for the courthouse. Enron sued to void the deal, using a number of technical excuses. But the most it could get from the courts was a temporary reprieve: Enron, the courts ruled, wouldn’t have to take the gas until late 1997. By then, the atmosphere between the two sides had become so ugly that Enron executives regularly had their London offices swept for bugs. As the date to start delivery loomed, J-Block was still some $1.5 billion in the hole.

Though the company was eventually forced to discuss J-Block in its public SEC filings, Enron minimized the problem, insisting that it did not expect the contract to have a “materially adverse effect on its financial position.” London-based insiders shook their heads at this assertion; one later called it “mind-boggling.”

And in their newly skeptical mode, the securities analysts who followed Enron weren’t buying it either. Several began to make inquiries in England and raised tough questions in their reports to clients. Although they never discovered the full magnitude of Enron’s J-Block exposure, they certainly sensed that it was much bigger than Enron was letting on. As the Dean Witter analyst succinctly put it, “J Block contracts add additional measure of risk . . . with the price of gas under the contracts now well above the market price.”

With Kinder gone, J-Block was now Jeff Skilling’s problem, and he wasn’t a bit happy about it. It wasn’t so much the size of the problem that bothered him or even that Wall Street was breathing down his neck to take care of it. It was that he just hated having to fix a mess that someone else had made. Never mind that he was now the president of the entire company and that solving other people’s problems was a big part of his job.

But Skilling knew it was critical to get rid of the problem, so he moved quickly. Though the spot price of natural gas had begun to rise in 1997, Skilling decided that it was too risky to hope that price alone would bail Enron out of J-Block. Instead, Skilling decided to negotiate his way out of trouble. Virtually the first thing Skilling did upon becoming president of Enron was fly to Bartlesville, Oklahoma, where Phillips was headquartered, and meet with his Phillips counterpart, James Mulva.

Skilling told Mulva he wanted to negotiate a settlement—and the Phillips president agreed to talks, grueling ones, which dragged on for months. Because Skilling was willing to pay a big price to make the problem go away, he was able to do what Kinder hadn’t: come up with a new J-Block agreement. It was announced in June. Enron would make a $440 million up-front cash payment to Phillips and the other producers of the J-Block. In return, the pricing was restructured to float with the market (though Enron still had to take the J-Block gas and find buyers for it). Enron booked a $675 million pretax charge as the total cost of cleaning up J-Block.

At the end of the quarter, hoping to get all the bad news out at once, Enron also took a $100 million charge against another problem Skilling had inherited—a bad investment the company had made in a Houston ship channel plant producing something called MTBE, a chemical additive that made gasoline burn more cleanly. The two charges wrecked Enron’s annual profits. For 1997, Skilling’s first year as COO, Enron made only $105 million. That was a staggering 82 percent drop from the year before. Not since 1988 had Enron made so little money.