Judgment Day for Enron
"Ultimately, this is a story about people." So begins Bethany McLean and Peter Elkind's account of the remarkable collapse of Enron. While their book and film "The Smartest Guys in the Room" is chock full of incriminating documents, tales of accounting fraud and complex business rules bent, it is primarily the story of a handful of characters whose personalities and unethical actions led to the biggest business scandal of our time. When Enron collapsed, 4,500 jobs were eradicated along with $70 billion in investors' money, while top executives lined their pockets with millions.
Ken Lay and Jeff Skilling, chairman and CEO behind the company, led Enron to become one of the largest companies in the United States. Founded in 1985, the company generated billions of dollars in profits. But in December 2001, Enron was forced to declare bankruptcy, revealing that Enron's profits were artificially inflated. Lay and Skilling, whose company was once trumped as "the company of the future," now face a future in prison.
The government prosecution will seek to show that Lay and Skilling were well aware of, and had in fact encouraged and endorsed Enron's sleazy deals -- most notably manipulating the market and contributing to the California energy crisis. While the widely acclaimed book and film "The Smartest Guys in the Room" provide a prolific amount of evidence implicating Lay and Skilling in misleading the public, this is far from an "open and shut" case. Lay and Skilling have repeatedly pointed to CFO Andrew Fastow as the true culprit behind any corruption. Furthermore, both Lay and Skilling are expected to insist that they were "true believers" in the company, and that they had no idea that the company was collapsing.
The trial will therefore rely on key witnesses such as head of accounting Richard Causey, who recently negotiated a deal with the prosecution, to prove that Lay and Skilling were in the know. The importance of this trial hinges on the fact that Enron, and the many financial institutions implicated in their scandals, were once held as the paragon of innovative business strategy in the United States. The business world will be watching this case closely because it will set the standard for what will and will not be tolerated in corporate America.
Peter Elkind, co-author of "The Smartest Guys in the Room" and senior writer for Fortune spoke with AlterNet about the rise and fall of Enron, as well as what we can expect to see from the coming trial.
Why is this trial something the public should pay attention to?
Peter Elkind:This is the trial of the two top guys at Enron -- Ken Lay, chairman and CEO and Jeff Skilling, CEO. And Enron was a big deal because it was the consummate corporate scandal. It has powerful implications for how business is done in America. It also is a morality tale about people who were corrupted by greedy culture. These were not people who walked into Enron looking to commit fraud. They were people who were seduced by the millions they could make and the corruption of the culture itself. Throughout the past four years there has been a huge federal investigation to get to the bottom of what happened at Enron.
Briefly, what was the Enron scandal about?
This company, viewed as a model for how to do business in America and in the world, suddenly evaporated. What's dramatic about it is the transformation from what it appeared to be to the reality Ã¢â‚¬Â¦ was so stunning. It was a house of cards. It was an illusion. And now, finally, after three previous trials and a very long period of investigation, the government is trying to hold those top guys accountable for what happened. Ken Lay and Jeff Skilling are poster children for corporate misbehavior.
What kind of transactions was Enron involved in?
Enron was a number of businesses. It was most famously an energy trader and played a part in the California energy crisis in terms of multiplying prices for Californians. This caused blackouts in the California energy crisis that subsequently led to Arnold Schwarzenegger's ascendance to governor. Enron manipulated the semi-deregulated California energy, moving energy out of the state to create artificial shortages so that prices would spike, and then selling the power back into the state at higher prices.
Why were they able to this?
It was made possible because it was a newly deregulated market, but deregulated in a very complex way. There were lots of rules that Enron, which is a master of manipulating rules, could exploit. Enron had very smart energy traders, and if you gave them an opening, they would drive right through it. They were completely mercenary, and they did not stop to think that in creating a crisis in the state, and giving deregulation a horrible name, they would undo their long-term goal, which was to allow deregulation throughout the country. Because it was such a disaster in California, it brought the state-by-state process of deregulation to a grinding halt. These guys didn't stop to think if it was appropriate to destroy and ravage this economy and create a situation in which people couldn't cool their homes and power their businesses. All they thought was, "We can exploit these rules; there's clever ways to do it, so let's do it." But in contrast to their broadband business, energy trading was in fact a real business, and Enron actually made a lot of money.
The broadband business was cut from whole cloth. Enron was presenting itself as doing two things: It was going to make a ton of money trading unused broadband capacity on the internet, and to do this it was going to use its own proprietary network. It was also going to have to be able to move bandwidth capacity around from user to user. So, if I had more bandwidth than I had needed, I could sell my excess to someone else who didn't have enough. But the technical ability to do that didn't exist. It's impossible to do, and so that never made a penny.
Similarly, Enron was selling itself as being able to provide video on demand so that it could stream movies into people's homes. Now there's a variation of this being done. But, at the time, Enron was really unable to do it. They didn't have movies to stream, and the hardware wasn't developed. In short, it couldn't do what it claimed it could do. It announced this capacity and this network, and oversold it. It actually booked more than $100 million in profits on a deal with Blockbuster. It never made a penny on this deal because it fell apart before it was ever really put in place. Enron booked profits on the business in order to make its quarterly earnings. It was boasting about this to Wall Street and increased its share price by billions of dollars as a result. It actually had an analysts meeting in January 2000 where it hyped its broadband business, and its stock price went up 25 percent in a day. Literally, analysts were running out of the room saying, "Buy Enron shares. This is the greatest thing."
Where did this kind of "creative" thinking come from?
There was a survey conducted by Fortune magazine where Enron was repeatedly voted the most innovative company in America. Of course, it was the most innovative company in America, we just didn't know how innovative. This "innovative" thinking came in good part from mind of Jeff Skilling. Enron did invent some things, but it more often took existing things to the extreme. Skilling had the notion that what's valuable in business is an idea. He believed that a company should be able to book the profits from an idea at the moment the idea is conceived. So, if you have an idea for a new kind of car, you should be able to book the profits before you have built a factory, or a single car. Of course, in the real world, ideas are great, but they often don't work out as conceived at the time. At Enron, they would book the profits from a power plant deal before the power plant was ever built. It's called mark-to-market accounting. It is a very extreme approach.
How common is this type of accounting?
Mark-to-market accounting is appropriate in some places. For instance, if you're Goldman Sachs and you want to value your portfolio on the basis of the price of all your stock from a given day. But there's a market in these stocks. The problem at Enron was that they were trying to put prices on long-term energy-supply deals. So, they were basically making a guess on the price of energy 10 or 15 years down the road, when there was no real market or pricing mechanism for it. So, instead of being mark-to-market, where you're just looking at the prices of the market ten years ahead, they were doing what they called mark-to-model -- which is essentially guessing.
So, they were valuing what the market would make of their own ideas?
Yes. It's enormously subject to manipulation and deceit. Your profits are basically whatever you say they're going to be. So if you need to book additional profits for a period, you could just say that the price of energy will go up. This accounting was pretty much unique to Enron. Enron was on the leading evil edge of this behavior and this approach. There were some companies that were imitating Enron -- starting to creep out in that direction -- but nobody was doing it like Enron was.
How was Enron keeping itself afloat towards the end, as it became bankrupt?
There was the Nigerian barge deal. Enron owned three Nigerian power barges, basically floating power plants. They were desperate to make their profit numbers -- the profits that Wall Street expected for a particular quarter. So, they got Merrill-Lynch to agree to take the barges off their hands right at the end of a quarter so that it could then book a profit from the sale of the barges. But Enron also made a deal with Merrill Lynch where it agreed to take the barges off Merrill Lynch's hands six months down the road. This meant that this was not a true sale; Merrill Lynch did not have anything at risk. Enron was engaged in a fraudulent deal, and the booking of these profits was illegal. As a result of this, a handful of Merrill Lynch bankers are now in prison, including the head of investment of Merrill at the time.
Were there many other banks that were implicated in Enron's fraudulent deals?
Yes. In the November 2003 issue of Fortune, we ran a cover story headlined "Partners in Crime." This was the story of how banks -- Citi, JP Morgan, Chase and Merrill Lynch -- helped Enron pull off the scam. The banks were among Enron's greatest enablers. Enron could not have committed the fraud it pulled off without enormous help from the blue-chip investment banks, from top law firms and accountants.
Are they sharing the blame?
Well, not fully. The banks are sharing the blame financially because they have all been sued and pay financial penalties with the FCC. In some cases -- for instance the Nigerian barge deal -- some of their executives have gone to prison.
What kind of evidence implicated these banks?
What's stunning is the number of emails and memos from bankers saying, "We know Enron is doing this deal to hide its debt, to chin up its profits and to inflate its cash flow, but it'll be okay because we're going to get a big fee on this." That's literally what they were saying. It was shameless. It was astounding to read email after email where the bankers know what's going on. They were just addicted to the profits from doing business with Enron. The banks are going to pay big settlements in a number of cases in civil lawsuits. But again, it's probably dwarfed by how much money they made by doing business with Enron.
Do you think there is a need for laws that would more concretely make this kind of behavior illegal, or do you think it's well reigned in by these fines and civil procedures that are brought by shareholders?
I think it's a real problem. For instance, there was the Arthur Andersen case, which was the first Enron trial. Andersen was Enron's accountant. This was a case where an institution was not charged with accounting fraud, but obstruction of justice because they destroyed documents related to Enron. Andersen played a big part in allowing Enron to do what it did. It was getting $1 million a week -- money that it was highly addicted to. The charge against Arthur Andersen, though it wasn't accounting fraud, basically destroyed the firm.
The conviction of obstruction of justice was then reversed by the Supreme Court because it destroyed thousands of jobs, while it was only the highest level of Arthur Anderson guilty of the actions. Now, given the history of what happened at Anderson, law enforcement authorities are very reluctant to charge these big investment banks and institutions with criminal wrongdoing. They're much more likely to target some individuals in the institutions. But, what if the fraud is endemic, and encouraged up and down the line, and people are aware of it? It's a good debate as to whether the institutions themselves should be charged. If the company is big, obviously it would have a devastating effect on the U.S. and global economic system. So, it's a "too big to fail" to fail syndrome.
Skilling is facing roughly 35 indictments, while Lay is facing seven. Does this stand to reason?
Well, there's a distinction between criminal responsibility and moral responsibility in this story. Ken Lay, in my view, is broadly responsible for what happened to Enron -- for the fraud, greed and the collapse of the company. He has as much responsibility for that as Jeff Skilling. He was the chairman and CEO of the company for almost his entire life, took out 200 million in stock and tens of millions of dollars in bonuses. He was in a position to shape, more than anyone else, the culture of the business. But, this is different from criminal liability. There's no question that he was less connected to the day-to-day events at Enron than Jeff Skilling.
Chief Financial Officer Andrew Fastow seems to have become the black sheep of the trials. Why has this happened, and is it legitimate?
For Lay and Skilling, he's an easy target. Their position, incredibly, is not just that they didn't know about the fraud at Enron, but that there was no fraud at Enron except for Andy Fastow. But, Enron wasn't making money and Andy Fastow's manipulations hid that fact. When Enron collapsed, it wasn't what Ken Lay didn't know that caused Enron to collapse -- that Andy Fastow was lining his pockets -- it was what Ken Lay did know. This was the knowledge that Andy Fastow, the chief financial officer (CFO) of Enron, had private partnerships that were doing business deals with the company. What panicked everyone and caused the death spiral of Enron was the fear that Fastow's games might be hiding the true financial situation -- the debt and inflated company profits -- of Enron. And they were. Lay had authorized Fastow to play this unholy role of doing business with the company where he was the CFO.
They're trying to make him a scapegoat. But, that's much harder to do now because there's going to be a parade of witnesses, in addition to Fastow, saying there was bad stuff going on at Enron and these guys, Skilling in particular, knew about it. But also, there will be a parade of people saying that Lay was briefed about Enron's treacherous financial straits and was still telling the world that there was nothing wrong with the company, that it was in great shape.
Richard Causey, Enron's chief accounting officer, recently struck a deal with the prosecution. How will the trial be different because of this?
It's a big help for the prosecution. First, it simplifies the trial. In a criminal case like this, the shorter and simpler the better. Complication and longer trials lead to confusion in the minds of jurors, and that creates doubt, which leads to a not guilty verdict. Causey is the guy about whom there would have been the most complicated testimony because he's an accountant. There will still be a good bit of that, but this reduces it somewhat. It also makes it cleaner because it's two CEOs that the government is going after as opposed to the two CEOs and this third guy whose case is much more difficult. It's a much easier story to tell jurors.
Does pushing a more simplified case prevent the establishment of needed precedents on the more complex issues in the business world?
I don't think so. If these guys are convicted on the notion that you cannot fundamentally mislead the world about the company's financial condition, that's the big picture issue. That's a message that will go out from this trial and resonate in the business world broadly. I think that this is a much more important message -- an affirmation of fidelity to the truth -- than a verdict that they broke accounting rule "16C, subsection A." The problem at Enron was that they always found loopholes and ways to manipulate the rules. In many ways, then, they were technically operating legally?
Obviously, what they were claiming was preposterous. The notion that they were booking profits of $150 million on the broadband deal when it hadn't made a single penny of profits is absurd. They can say, "We followed these very complex pages of accounting guidelines, and our accountant signed off on it, and the lawyers signed off on it, so we're innocent of committing a crime."
In the "Smartest Guys in the Room" book, there's this great image of "dog vs. duck." The story is this: You've got a dog, and for accounting purposes, you need it to be duck. So, you slap a yellow beak on its nose, put some feathers on it and webbed feet on its paws. Then you say, "Look, it's a duck, because it meets all the accounting standards for what a duck is." But you know it's still a dog. This is the difference between the way things really are in the world versus simply following proper procedures. Obviously Enron, in common-sense terms, was a huge fraud. But when you get to the nitty-gritty details of any individual deal, there's a complicated argument about whether or not they followed the rules. They certainly tried to follow the letter of the law, while completely ignoring the substance of the law.
"The Smartest Guys in the Room" focuses on Skilling and Lay's personalities and their need to believe Enron was successful. The argument they make is that they didn't intend to mislead the public. How much of a role does "intent" play in this trial?
There is certainly a part of Jeff Skilling and Ken Lay that showed that they were true believers. It's an argument that their lawyers are certainly going to make, and that they will make if they take the stand. Lay makes a point that he didn't unload some Enron stock that he could have if he really thought the company was going down. His lawyers can essentially argue that he was delusional to believe that the company was in good shape. Intent is a big issue in a criminal case. If you're making a claim that someone deceived people, you have to argue that they intended to deceive them. There's a part of both Ken Lay and Jeff Skilling that was self-delusional. Skilling's notions of how to book profits is so fervent, and he's so contemptuous of anything that gets in the way of his notion of reality that the question of what he really believed is a complex issue. Did he really believe that Enron was in great shape when he left? He's going to make that argument, but there's an awful lot of evidence that he had every reason to believe that it wasn't.
Are practices like Enron's going on in other businesses? Is Enron being made a scapegoat?
Ken Lay claims, in a speech he made in Houston last month that these practices are going on in every business in America. I think that's nonsense. A lot of business executives would disagree adamantly with that point of view. I think Enron is being made an example of, and it should be. What happened at Enron was especially egregious. There should be a sense that, if you mislead the public, and engage in deceit, there are terrific consequences because a lot of people get hurt. Enron wan an enormous shock to our entire financial system, and it did a huge amount of damage.
What can we expect to see in this trial?
I think there will be a lot of boring testimony as well as a lot of very dramatic moments. I think Lay's testimony will be fascinating. He poses as this grandfatherly figure when in fact there is a huge amount of arrogance behind his behavior. He went though huge sums of money. Here's a guy who had three houses in Aspen and who thought nothing of sending the corporate jet to pick up his daughter's house guests, even if the company was spiraling into disaster. It will be fascinating to see him questioned intensely because that has yet to happen. His view of the world, as he stated in his speech, seems so delusional that it make you wonder whether he could really be that detached from reality, or whether it is just an astounding pose. Fastow should be interesting as well. He has never told his story in public.
What should we keep an eye out for in the days to come? What are the key issues?
One key issue will be whether Causey testifies and, if he does, what he says Lay and Skilling were aware of. Causey was intimately involved with lots of sleazy deals at Enron. He was the point guy in the accounting of all this stuff, and if he testifies that he knew this was questionable, and raised this with Skilling, and discussed it with Lay, or that they gave him the go-ahead, that's very bad news for both of them.
There is a particular issue involving Fastow called the "global galactic deal." There were rumors that Skilling had guaranteed Fastow that he wouldn't lose money in his partnerships. His partnerships were a tool for Enron to manipulate its books, but Fastow also made money on these deals. If Enron guaranteed that Fastow wouldn't lose money on any of these deals, it would render all of the accounting for them fraudulent. Like the Nigerian barge deal, if he was guaranteed a profit, it wasn't a true sale. So, that's potentially a real smoking gun for Skilling.
To read more on the background of Enron and the trial, visit the Houston Chronicle's special coverage, and stay tuned to AlterNet for future coverage of the trial.