Conspiracy of Fools (53 page)

But the forty-one million dollars couldn’t be deemed as a return of the original investment; otherwise, there would be no independent cash in the deal. So Glisan had to find a way to argue that LJM2 still had thirty million dollars at risk in Talon. Semantics provided the answer. The forty-one million would be deemed a distribution of pure profit to LJM2. That would arguably still leave the fund with thirty million in Talon.

It was all smoke and mirrors. The requirement for an independent three percent investment was designed to make sure
somebody
cared about the financial performance of an entity like Talon. Otherwise, the company that set it up could just dump all its low-quality assets into a special-purpose entity, making its own performance look superb. But once Fastow had locked in his profit, he couldn’t care less what deals Talon did. LJM2’s investors would still see a stellar performance, guaranteed by the forty-one-million-dollar payout.

But the Enron shares couldn’t be sold to make the payment; Talon needed cash from someplace else. So the team went to the only source available: Enron itself. Under this last leg of the plan, Enron would pay Talon forty-one million dollars. In exchange, Talon would commit to pay Enron a sum of cash if the company’s own stock dropped in price.

Even for a transaction that had already soared past the outer reaches of common sense, this final step was a mass of contradictions. Talon was dependent on the value of Enron stock to make good on the hedge. In other words, by setting up Talon, Enron was betting its stock price would hold steady or go
up
. But now it was paying Talon millions of dollars in a bet that the price would go
down
. And of course, Talon would be hard-pressed to honor its commitment; if Enron’s stock went down, the entity would lose its primary source of capital to compensate the company for the decline.

Talon was nothing more than Enron itself. Enron had handed it some assets; in the event that the merchant investment lost value, Talon would hand the assets back. Enron would be better off economically by doing nothing at all—at least then it would save forty-one million dollars.

———

As Glisan’s explanations about Raptor droned on, Ron Astin and Mark Spradling, lawyers from Vinson & Elkins advising on the deal, grew uncomfortable. In particular, it seemed this forty-one-million-dollar distribution to LJM2 would eliminate all of the independent equity in the deal.

“Ben, wait,” Astin said. “Doesn’t that leave Talon with insufficient outside equity?”

“Not at all,” Glisan responded. “It’s a return
on
capital, not a return
of
capital. LJM2 keeps its interest in Talon. The three percent is still satisfied.”

Astin wasn’t convinced. Glisan’s word game just sounded too cute. Still, the lawyers had time to mull it over, maybe talk it through with Andersen. After all, they were the accountants. Not Vinson & Elkins.

Chewco had become nothing but a headache. The entity formed years before—and now secretly owned by Michael Kopper and his domestic partner—for the purpose of buying half of the JEDI partnership had emerged as a source of endless trouble at Enron.

Both Enron and Chewco had to prepare valuations of JEDI’s assets for establishing Enron’s profits and figuring out if Chewco was owed any money. But their conclusions were sharply at odds; Kopper argued that the Chewco assets were worth double what Enron’s analysts calculated. The disagreement broke down into bickering.

McMahon was sick of it. Why did Chewco even exist? He still didn’t know. Maybe it would be better, he thought, to buy out Chewco and make JEDI wholly owned by Enron. He asked Bill Brown what he thought of that idea.

“Well,” Brown replied, “buying out Chewco would mean negotiating a deal with Kopper.”

That wasn’t a fun prospect. “Does that mean Fastow will be involved?” McMahon asked.

Brown said yes. So McMahon cut out the middleman and went straight to Fastow with the proposal.

A million-dollar profit seemed fair. From what McMahon could figure, the Chewco investors put up $125,000 for an investment just over a year old. They couldn’t possibly object to an annual return approaching 800 percent.

But Fastow didn’t like the number. “I’ll take it to Michael, but he’s never going to accept that.”

Soon after, Fastow called McMahon and Brown in for a discussion. He had been right; Kopper had refused. He proposed another deal, one that would give Chewco a ten-million-dollar profit.

McMahon gaped at him. An
8,000 percent return
. “You’ve gotta be kidding,” he said. “Ten million?” Fastow nodded.

“Ten million
dollars?
Why don’t you just tell Michael to check what company is on his paychecks. He works for Enron. Ten million is unconscionable.”

“I think it sounds fair,” Fastow said with a shrug.

No way, McMahon said. This money would go to Kopper’s domestic partner or Kopper himself. It was extortion.

“I will not allow this company to pay ten million dollars for this,” McMahon said. “Tell Michael there’s no deal.”

At his home on the evening of Friday, January 28, David Bermingham of Greenwich NatWest sat in front of his computer, crunching some LJM1 numbers. He hit the “return” button and up popped a figure he was happy to see.

Bermingham was analyzing the value of Swap Sub, set up by LJM1. That entity held a huge slug of the Enron shares gifted to LJM1 and was legally responsible for making good on the Rhythms hedge. In essence, for the Rhythms hedge, LJM1 collected cash from investors, Swap Sub did the business. For a long time Swap Sub wasn’t exciting. Weeks before, on January 5, Bermingham had reviewed an analysis showing Swap Sub had a value of
negative
twenty-five million dollars.

Then, it happened. Scott McNealy walked into a room. Analysts went nuts, and so did Enron’s stock price. Now it wasn’t just the usual lot of shareholders who had a paper fortune—so did Swap Sub. Bermingham’s calculations showed that if the Rhythms hedge was shut down and the value of Swap Sub distributed, the LJM1 investors would make millions.

That got Bermingham thinking. His office was in turmoil. National Westminster, the parent of Greenwich NatWest, looked like it would soon be acquired by Royal Bank of Scotland. Greenwich was sure to be sold. Bermingham and his pals—who had brought LJM1 to the bank—could be out on the street. Then this windfall of profits would go to—whom? RBS? That, Bermingham decided, just wasn’t right.

Not when there was another choice: the guys who worked on the deal. Bermingham, Giles Darby, Gary Mulgrew.
They
should make the profits. They might be able to pull it off, with help—from Fastow, probably Kopper, too. Then it could work. The next day, Bermingham typed an e-mail to Darby, explaining his analysis of LJM1 and Swap Sub.

“There is quite some value there now,” Bermingham typed. “The trick
will be in capturing it. I have a couple of ideas but it may be good if I don’t share them with anyone until we know our fate!!!” The next conspiracy had begun.

The conference call between Houston and Chicago had been dragging on for more than thirty minutes. The Andersen accountants had been intensely reviewing Project Raptor for days; now, on February 3, they were trying to decide whether the deal could be done under the accounting rules.

Calling from Houston with the Enron engagement team were David Duncan and Deb Cash, along with Carl Bass, now with the Professional Standards Group. On the line in Chicago were John Stewart and Jim Green, both from the PSG.

The whole idea, as described by Duncan and Cash, struck Bass as ludicrous. Enron was just shifting around assets and pretending to set up a hedge—with itself.

“This whole deal has no substance,” Bass said. “All the money at risk comes from Enron. How is this a hedge?”

Duncan countered with a monologue on the three percent rule. But the accountants in Chicago were unconvinced.

“Why not bring in a real third party, like Goldman Sachs, to do a straight hedge?” Bass asked.

“They don’t want to do that,” Duncan said. “It would be too expensive.”

That spoke volumes. If the market won’t provide the hedge at a low price, there was probably a good reason.

“Look, David, the way it is put together is just not going to work,” Green said.

“Well, wait a minute,” Duncan responded. “Listen to this. What if we make these changes?”

A nip here, a tuck there, and everybody started signing on. It made Bass’s head ache. Whether Raptor could be twisted to meet some tortured interpretation of the rules wasn’t the point.
The deal did nothing
. It didn’t protect against losses. Apparently, the client didn’t
care
. Enron just wanted protection from having to
report
losses.

The next morning, Bass arrived early in the office. He had been thinking a lot about Raptor since the previous day, and his doubts had hardened into conviction. Nobody should be doing this deal. He logged on to the Andersen system and addressed an e-mail to Stewart and Green.

“I am still bothered by the transaction we discussed yesterday,” Bass typed.

Essentially, he wrote, Enron was jury-rigging a contraption to hedge with
itself. “I have to ask myself, why not do a straight deal with Goldman?” Bass typed. “They said so themselves. It will be too expensive.”

And why was Enron providing the capital Talon would use for hedging? “Because,” Bass wrote, “no bank is dumb enough to loan money whose payment is dependent on changes in the value of an Internet stock”

At 6:38
A.M.
, Bass hit the “send” button.

The response came back in just over an hour. Stewart wrote that it sounded like Bass was arguing Talon would have to be consolidated into Enron. “We should discuss it some more,” he wrote. “You have some good points.”

Three days later, Azurix was ready with its latest plan to save the company. At a board meeting, Rebecca Mark explained that the company was on the verge of a big announcement: it was about to plunge into the dot-com mania, a surefire way to drive up the stock price.

The idea was to create a sort of Enron Lite, a trading business designed not for gas and electricity, but for water. Not long ago, Enron had introduced an operation called Enron Online that allowed it to serve as a principal for energy trades over the Internet, and it had grown like gangbusters. Well, this new idea—
water2water.com
—would do the same thing, Mark said. It would be a huge business.

The directors listened, skeptical. Online trading for electricity and gas made sense, since those commodities were pretty much the same all over. But
water?
Upstate New York wouldn’t trade with downstate. Different localities had different qualities; it simply wasn’t standardized. Of course, there were industrial uses for water, like applications for farms. But why would potential customers turn to the Internet when they could just turn on the spigot?

As Mark rambled on about the latest brainstorm, the directors grew restless. They had made it clear to her repeatedly that they wanted to see belt-tightening in the company. Yet here she was, proposing more spending. All told, she still planned to burn through in excess of $100 million a year.

And Mark thought even that was tight. “Again,” she said, “I would advise that the best option is to pursue an aggressive growth strategy rather than cutting back.”

The directors jumped on her. “Rebecca, that is not going to happen,” Pug Winokur said. “We have turned aside that idea, and we are not going back to it.”

Skilling picked it up from there. “Rebecca, this is just not enough. I mean, look at this. You’ve got something like thirty million dollars here for computer-system development.”

“That’s for the Internet water exchange,” she said. “That will give us a significant growth in market cap.”

Skilling sucked in a breath. Spending millions just so Azurix could bandy about the word “Internet”? Did she really think that would make investors clamor for Azurix stock? Was there
any
real business plan here?

“Rebecca, you need to cut the burn rate way back,” one of the directors said. “Down to forty million”

Mark’s face fell. “Wait a minute—”

“Forty million, Rebecca,” Skilling interrupted. “That’s all you’ve got. Figure out how to make it work.”

Mark was stunned. There was no way she could pursue her vision with just forty million dollars. She wouldn’t be able to make acquisitions. No bidding, no public relations. Forget the corporate jets. Azurix would be reduced to managing the water assets it already owned. It was a dreadful prospect.

“I can’t in good conscience do this,” she said. “We would have to cut the water2water site, which is going to be gigantic. It would mean abandoning it.”

Lay spoke up. “Rebecca, we need to see this alternative. Run the scenario, and show us what it means.”

After the meeting broke up, Mark, Lay, and Skilling stayed behind. It was time for another talk.

Lay was the first to speak. “Rebecca, I want to stress that this is very serious. And to tell you the truth, I don’t think the board has confidence in the case you’re making.”

He eyed her, seeing if this was getting through.

“I think we need to see something that is a much more significant effort to ratchet this back,” he said. “I want you to know that’s what the board wants.”

Mark nodded. “I got that loud and clear,” she said.

All right, Lay replied. He and Skilling left the room and climbed onto the elevator.

“She hasn’t thought this through,” Lay said suddenly. “She doesn’t understand the severity of it.”

Skilling felt a wave of relief.
Lay got it
.

That same afternoon, directors from Enron’s audit committee clustered around the circular table in the boardroom to hear the final wrap-up for 1999, checking for accounting problems that might need attention. Robert Jaedicke, the Stanford Business School dean who chaired the committee, recognized David Duncan for Andersen’s annual audit review. As usual, everything sounded great.

“Arthur Andersen’s financial statement opinion for 1999 will be unqualified,” Duncan said. “There were no significant audit adjustments, or disagreements with management, or other significant difficulties.”