The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (37 page)

The memo explicitly boasted that Fastow’s insider status “will contribute to superior returns.” The partnership’s goal, it added, was to generate an annual internal rate of return for investors “in excess of 30%” after payment of all fees. On the issue of compensation too, the offering memo was instructive: Fastow and company would receive an annual fee of 2 percent of investors’ capital—at the fund’s projected $200 million minimum, that amounted to $4 million a year just for starters—plus 20 percent or more of the partnership’s total return.

Although this offering document had been completed well before the board meeting at which LJM2 was approved, it was never shown to the board, not then or at any other time. The directors and top Enron executives who presumably were supposed to be overseeing Fastow’s conflict—Lay, Skilling, Buy, and Causey—all say they never asked to see any LJM2 partnership documents. One Enron director, Robert Belfer, later said he received the LJM2 placement memo in the mail, offering him the opportunity to invest, but that he threw it away without reading it. Finance committee chairman Herbert (Pug) Winokur later explained that he didn’t need to see the memo because it had been reviewed by Enron’s lawyers at Vinson & Elkins.

A month before the board vote, Fastow had been even more explicit about how he planned to run LJM2. With Kopper in tow, Fastow addressed salesmen from Merrill’s private-equity team in a remarkable September 16 meeting at the firm’s offices near the World Trade Center in lower Manhattan. He spoke to them for almost an hour. His remarks were preserved on videotape. There was no talk during this meeting about limiting his efforts to three hours a week. On the contrary, Fastow openly described LJM as his ticket out of Enron. “This is what I’d like to do,” he declared. “Being CFO of Enron is as good a CFO position as anyone could have in America, I think. This is what I want to be my next step. I want to run an investment business. This is a unique opportunity to set it up, with unique access to deals.”

The Merrill group seemed taken aback at the sheer audacity of it all. Just how would all this work? Would Fastow get to see competing bids for Enron deals? Standing in front of the room, Fastow shuffled his feet and offered a cat-that-ate-the-canary grin. “It’s very hard for me
not
to see competing bids.” As CFO of Enron, didn’t he have an obligation to represent the company in negotiations? “I will always be on the
LJM
side of the transaction,” he replied. Fastow continued: “Do I know everything that’s going on? Do I have to sign off on every deal that goes in there?
Yes.
” He would be in the “unique position” of being able to “know everything” about all of Enron’s assets.

The sheer volume of Enron deal flow would allow him to cherry-pick great opportunities, Fastow added. (“You’ve got $7 billion in assets coming in every year; that roughly means I’ve got $7 billion in assets coming out the other side.”) And so would Enron’s eagerness to unload assets (“If we want to sell an investment, we want it done by the end of the quarter.”) The deal selection would be “truly staggering,” Fastow promised. “The prime hunting ground is going to be highly complex structured deals that have to be moved in a short time frame”—something that was never in short supply at Enron. As for how Fastow planned to recruit fund investors, a Merrill executive stated the obvious: “Andy, as chief financial officer of Enron, is heavily banked.” This was an amazing opportunity, Fastow declared. “We have a real opportunity here to bust it wide open.”

In the midst of this explanation of how he would play his hand in a game where he got to see all the cards, Fastow allowed himself a special moment of giddy, smug delight. “The only thing that’s amazing to me,” he said with a sly grin, “is that our really smart investment bankers didn’t figure this out first.”

After Fastow’s appearance, even his friends at Merrill wanted a word of additional assurance that Fastow wasn’t straying too far from the Enron reservation. On October 7, Tilney and Rob Furst, a second Texas-based Merrill banker, presented Fastow with a short list of questions for Skilling.

Had he considered how much time “Andy and his team” would be spend-
ing on LJM2? If they raised even more than the anticipated $200 million, was Skilling still comfortable with the situation? And finally, was he comfort-
able with “the internal mechanics put in place to resolve the conflict of interest issue?”

Four days later, the Merrill bankers got the reply they wanted to hear. “It was apparent that Jeff Skilling has spent a great deal of time with LJM matters,” Tilney and Furst reported, in a brief memo to the “LJM due diligence File.” They added:

Jeff is comfortable with the conflict of interest issue for the following reasons:

1. Andy has no control of asset sale decision.

2. Rick Causey, EVP and Chief Accounting Officer, will review all transactions.

3. Audit Committee of the Board will receive LJM2 financial statements.

The memo offered one final observation: “Jeff stressed how important transparency and disclosure will be to the success of the arrangement.”

In fact, LJM2 hadn’t yet even gone to the Enron board for approval; over the duration of the fund’s life, the audit committee received none of the fund’s financial statements.

 • • • 

As CFO of Enron, Andy Fastow was indeed “heavily banked”—and he didn’t hesitate to use this leverage as he set about raising money for LJM2. For the banks, the calculation was simple: Fastow maintained a stranglehold on doling out Enron’s extraordinarily lucrative banking and financing work—and he kept score. Ponying up for LJM2 was a price the banks needed to pay to retain his favor. Fastow made the connection overt: his annual appraisal of individual bank performance explicitly noted their level of participation in LJM.

Fastow had begun hitting on banks to commit to LJM2 months before the fund had even won board approval. One of his prime targets was Chase Manhattan Bank, which was hungering for more Enron business. The maneuvering that preceded the bank’s inevitable decision to pony up illustrates just how openly Chase viewed LJM2 as a ticket to more Enron business.

Chase Manhattan’s Houston relationship manager, Rick Walker, was almost as close to Fastow as Merrill’s Schuyler Tilney. Fastow wanted the bank to commit to a $20 million investment in LJM2. In August 1999, Walker sent a long memo to his two bosses, Jimmy Lee, head of global investment banking, and Todd Maclin, head of the global oil and gas business, supporting Fastow’s request that Chase serve as an “anchor investor” for his fund.

The request should be viewed as “a relationship-driven exercise,” Walker wrote. While Fastow was anticipating 30 percent returns, Walker was eyeing other benefits, such as “substantial financing and M&A opportunities” from LJM2 and “continued deal flow from Enron Corp.” Noted Walker: “Andy has always performed on his promises to help Chase with its investment banking strategies. . . .” Though Walker knew Fastow was likely to hand the job of marketing LJM2 to Merrill, the CFO had hinted that Merrill’s role might be “limited” and Chase might get future LJM business. “This is a carrot from Andy to Chase,” reported Walker, “and one I think we should consider taking.”

Walker advised his bosses that money invested in LJM2 was practically a sure bet. “Andy’s position with Enron affords him superior insight into Enron’s merchant portfolio,” he noted, and the fund’s ability to move quickly “will command a premium from Enron.” Unlike the Enron board, Walker also harbored no illusions about Fastow’s motivation. The CFO’s involvement, he noted, would have “significant impact on [Fastow’s] wealth.”

Walker didn’t just send the memo to his bosses. He also quietly faxed it to Fastow, with a personal message on the cover sheet: “Andy—Following is my draft memo—most of which I wrote last week. I’m looking forward to your comments and also discussing your schedule—do you still want to meet with Jimmy Lee next Wednesday morning? I’m currently holding my schedule open so that I could be there with you . . . Rick.”

Maclin, who had recently joined Walker on a weekend fishing trip with Fastow, strongly backed the investment. Their time with Fastow, he wrote Lee in a follow-up memo, had made it clear that a $20 million commitment to LJM would produce “deal flow out of the fund” for Chase and “a closer relationship with Enron leading to more M&A and corporate finance opportunities with the company.” When Lee scheduled a meeting with Fastow, Maclin noted: “. . . he is very important to the business flow out of Enron. . . . The $20 million investment in his LJM2 fund is important to him, and I believe it will buy us a lot from Enron in return, especially since it’s Andy’s baby.”

But after meeting with Fastow, Lee had some doubts. He forwarded the LJM materials to another bank executive with the hand-scrawled message across the cover sheet: “Will you please look into this with Rick Walker. It is a ‘captive’
fund to Enron. I am skeptical because this guy running it is inexperienced & sounds very naïve. However, this relationship is very big and important. We ‘may’ have to do a little. J.”

Ultimately, Lee agreed to put $10 million in the fund. After getting the news, Maclin jotted a note to Walker reminding him that the bank was expecting a quick payoff: “Rick—Now that you got your $10 mil, we need an M&A mandate—something big & high profile. When do we go ask Fastow for this order??” It didn’t take long for the returns to start flowing. Within months, Chase had received $650,000 in LJM underwriting fees.

In the midst of these internal deliberations, an Enron executive named Gene Humphrey—coincidentally, the man who hired Andy Fastow—approached Chase with a request for an equity investment in another fund. This one was sponsored directly by Enron and was aimed at providing venture capital to inner-city businesses owned by women or minorities. The Enron Economic Development Corporation, as it was called, was close to Ken Lay’s heart. But Fastow quickly advised Walker that the bank could feel free to ignore it; LJM was the real priority. Andy made it “crystal clear” that “there is absolutely no pressure on Chase to invest in this fund concept,” Walker e-mailed his bosses. “Andy was also very emphatic that he did not want anything to detract from our efforts to work with him on his LJM2 investment fund.”

Fastow was putting the hard sell on all the financial institutions that did business with Enron. “All of our significant relationships are coming,” he advised one Houston banker while soliciting a big investment. The message was clear: if the bank didn’t kick in, it might not remain “significant.” So the commitments poured in: First Union, $25 million; CIBC and J. P. Morgan, $15 million; Chase and Credit Suisse First Boston, $10 million apiece; Donaldson, Lufkin & Jenrette, $5 million. Merrill signed on for $5 million, and the hallway buzz about the fund was so strong that 97 individual Merrill employees agreed to invest another $17.6 million. (Merrill received a $3 million placement fee.) Citigroup, whose annual fees from Enron exceeded $40 million, committed $10 million. An internal e-mail later noted: “The initial investment in the fund was based solely on Enron’s relationship with Citigroup, not potential investment returns.” Lehman Brothers was so shocked that the Enron board would approve such an arrangement that it insisted on receiving a certified copy of the board resolution approving Fastow’s conflict. Then it signed on for $10 million.

For the most part, financial institutions and insurance companies provided the early money, but there were plenty of other blue-chip institutional investors: Weyerhaeuser, the MacArthur Foundation, the Arkansas Teacher Retirement System, and the Institute for Advanced Study in Princeton. By the time he was done, Fastow had roped in 51 investor groups and raised capital commitments of $392 million—almost twice his original goal.

 • • • 

With the board’s blessing and its coffers brimming, LJM2 leaped into action, instantly becoming the single most powerful tool for managing Enron’s earnings. Fastow proudly informed the board that in less than six months his two LJMs had contributed $229.5 million to Enron’s earnings, generated more than $2 billion in cash flow, and, he insisted, saved Enron $2.3 million in fees. In 1999, LJM had also participated in Enron’s usual end-of-year frenzied deal making, which Fastow reported this way: “Q4 1999: 8 days/6 deals/$125 million.”

What’s remarkable about all this is that Fastow wasn’t using his inside information to cherry-pick Enron’s best deals, as he’d promised his investors. The projects he was steering LJM into were among Enron’s
worst,
the dogs the company couldn’t unload on anyone else. Yet even when these investments further deteriorated in LJM’s portfolio, Fastow’s fund almost always somehow managed to make a profit.

The reason was simple: the game was rigged. LJM was really just doing Enron’s dirty work: warehousing troubled assets, allowing Enron to get them off its balance sheet and book the profits and cash flow it desperately needed to please Wall Street. LJM’s real business was making Enron look good. And in return, LJM was getting paid handsomely for its troubles through secret special arrangements with Enron.

Consider, for example, Cuiabá, a deeply troubled power project Enron was building in Brazil. The plant, which was being built in phases, was supposed to hook up to a natural-gas pipeline that Enron was laying from Bolivia to Brazil, through an endangered tropical forest. By the fall of 1999, Cuiabá was experiencing major problems, and Enron wanted to sell down its stake in the project. Not surprisingly, there were no interested buyers.

Enter LJM1. In September, Fastow’s first partnership bought a 13 percent stake for $11.3 million in the joint venture that owned Cuiabá. By cutting Enron’s stake, LJM allowed Enron to keep $200 million in debt from the project off its books and record $65 million in mark-to-market profits on a gas-supply contract with the plant. After the sale to LJM1 was completed, the plant’s situation—and, presumably, its market value—continued to worsen. Rick Buy, Enron’s chief risk officer, later recalled being delighted that Enron had reduced its stake in the plant. Cuiabá was in a group of troubled assets that Fastow’s finance team referred to as “Enron’s nuclear waste.”