When Enron needed cash, the company’s chief financial officer had just the answer: a web of companies that would keep the firm’s liabilities off its books – and make him rich. In the second extract from his new book, Robert Bryce describes the rise of ‘a master of creative financing’
Tuesday November 5, 2002 The Guardian
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By mid-1999 Enron had a sticky finance problem. A year earlier, the company had invested $10m (Â£6.4m) in a fledgling internet service provider called Rhythms NetConnections. In early 1999, Rhythms had gone public and the internet bubble had sent its stock into the stratosphere. On the first day of trading, the company’s stock closed at $69. Suddenly, Enron’s share in the company was worth about $300m. But Enron couldn’t sell it. Under the terms of its original investment, Enron had agreed to hold the shares until the end of 1999.
After thinking about the matter for some time, Andy Fastow, Enron’s cocky young chief financial officer, came up with a convoluted plan to help Enron preserve the value of its Rhythms NetConnections investment. The plan would be executed by a new limited partnership called LJM Cayman, LP, which would be controlled by Fastow. The name had Fastow’s personal stamp on it, created from the initials of Fastow’s wife, Lea, and the couple’s two children.
LJM1 would function as a parking lot for Enron, a place where the company could stow and retrieve assets. Those assets would be hidden from Wall Street and small investors because LJM would not be owned by Enron. Therefore, all of LJM1’s functions and assets would be separate from Enron’s balance sheet. Unlike an earlier off-balance-sheet deal, Whitewing, LJM1 would be controlled by an Enron insider, Fastow. On June 18, 1999, Fastow met with chairman Ken Lay and CEO Jeff Skilling. He proposed to create LJM1 with an investment of $1m of his own money and $15m from two limited partners. Additional capital for the new entity would come from Enron, which would invest 3.4m shares of restricted stock in LJM1. Lay and Skilling apparently thought Fastow’s idea was a good one, even though on the surface it appeared that LJM1 failed to meet the test for off-the-balance-sheet deals. LJM1 was going to be used to move debts and risky investments (including Rhythms) off Enron’s balance sheet. But to do that, LJM1 had to satisfy three requirements:
Â· At least 3% of the equity had to come from outside (that is, non-Enron) investors.
Â· The entity could not be controlled by Enron.
Â· Enron was not liable for any loans or other liabilities.
LJM1 might have qualified under two of the three. But how was Enron going to be able to prove that LJM1 wasn’t controlled by Enron when the company’s CFO was managing all of the investments? It appears that neither Lay nor Skilling thought about it. Nor did Lay consider how much money Fastow might make on the assets he was buying from Enron. After a bit more discussion, Lay agreed to bring Fastow’s proposal to the Enron board of directors at the board meeting on June 28, 1999.
At that board meeting, after a short debate, the company’s board of directors agreed to waive Enron’s ethics policy, which prohibited the company’s officers from doing deals directly with the company, and approved the LJM1 deal. The approval opened the floodgates. And LJM1 became the cornerstone of Fastow’s financial house of cards.
No one at Enron – or anyone else, for that matter – ever accused Fastow of excessive humility. And throughout 2000 and early 2001, the company’s chief financial officer was at the apogee of his self-diagnosed genius. Fastow was fully convinced that his skein of partnerships and off-the-balance-sheet entities, with its mind-numbingly complicated spider’s web of interconnections and interdependent relationships, was the ultimate advance in financial engineering. “I can strip out any risk,” Fastow once bragged to a co-worker.
It is not just his colleagues who were convinced. At the end of 1999, CFO magazine had named him one of their CFOs of the year, giving him its “CFO excellence award for capital structure”, an award given to him for helping make Enron into “a master of creative financing”. The magazine praised Fastow’s work on the financing structure, which he created so that Enron could buy water company Azurix, as well as several power plants, while keeping the debts off its balance sheet. When the award was announced, Skilling praised Fastow to CFO magazine, saying that Enron needed “someone to rethink the entire financing structure at Enron from soup to nuts. Andy has the intelligence and the youthful exuberance to think in new ways. [He] deserves every accolade tossed his way.”
Fastow enjoyed the rewards of his special position too. On top of his salary and earnings from the sale of Enron stock ($33,675,000 between 1998 and 2001), his investments in LJM1 and LJM2 earned him no less than $45m. He was partial to fancy watches: he often wore a Franck Muller model known as a “Master Banker” (no snickering, please), a spiffy analogue watch that showed the time in three different time zones. It cost about $9,000. In late February 2000, he bought a house in the exclusive Houston suburb of River Oaks.
Other Enron big shots already lived in the same 77019 postcode. Ken Lay had been in River Oaks for years. Jeff Skilling also lived there. So it made sense that when Fastow started pulling the big money, he bought a house on Del Monte Drive in the heart of River Oaks.
“Andy wanted to keep up with the things that Skilling was doing. Skilling had a house in River Oaks. For Andy to be at that level, he needed the big house, too,” said one finance executive who worked closely with Fastow.
Fastow’s special-purpose entities became a fast and dirty way for Enron to manufacture additional revenues in a big hurry. In the last 11 days of 1999, Fastow’s companies did seven separate deals with Enron. In addition to a power plant in Poland, Fastow’s LJM2 entities bought a stake in some of Enron’s loans, bought part of Enron’s stake in a natural-gas gathering system in the Gulf of Mexico, bought a stake in a trust Enron had invested in called Yosemite, and bought part of Enron’s stake in a company that provided financing for natural-gas producers.
The advantage Fastow brought to Enron with the off-the-balance-sheet entities was the ability to do deals quickly. Enron was “looking for a quick way to sell assets to generate income,” said one long-time Enron finance person. “If you control both sides of the deal, you can do it very quickly at any price you want. That’s an advantage versus a situation where you’re trying to sell it to a third party, where it might take a year or more. It was a way for them to control the entire process.”
Fastow helped Enron control the process through a flock of entities with names such as Osprey, Osprey Trust, Timberwolf, Bobcat, Egret, Condor, Rawhide, Sundance, Ponderosa, Harrier, Porcupine and Mojave. He also created a quartet of misbegotten entities known as the Raptors.
The sham deals quickly became one of Enron’s main business units. In 1999 alone, Fastow’s deals inflated Enron’s profits by $248m – that’s more than one-fourth of the $893m in profits Enron reported that year. In between September 1999 and July 2001, Fastow’s LJM1 and LJM2 did about 20 different deals with Enron. And Fastow’s flimflam partnerships made a profit on every transaction they did with Enron. It looked as if Fastow could not lose. Using Enron’s stock instead of cash to prop up his financial house of cards seemed like a great idea. Enron’s stock had begun 2000 stuck at about $43. However, thanks to the hype surrounding Enron Broadband Services, it quickly began to climb into the ionosphere. By the middle of the year, it was trading in the $70s. On August 23, 2000, it hit its all-time high – $90 a share. Enron’s stock – it seemed – was better than cash.
Given that rising stock price, Fastow apparently convinced Enron to pledge a total of $1bn worth of its stock to the Raptors. The Enron stock would provide the “capital” that the Raptors needed to do transactions. In return, the Raptors would help Enron lock in tens of millions of dollars in gains on stock it held in newly public companies, like hardware maker Avici Systems and The New Power Company, an energy company that planned to sell electric power to individual homeowners.
While the accountants slept, Enron’s attorneys were starting to worry about the Raptor deals. On September 1, 2000, Stuart Zisman, an attorney who had been looking at the Raptors, sent an email to his superiors in Enron’s legal department that said: “We have discovered that a majority of the investments being introduced into the Raptor Structure are bad ones. This is disconcerting – it might lead one to believe that the financial books at Enron are being ‘cooked’ in order to eliminate a drag on earnings.”
Enron was cooking the books and Fastow was the chef de cuisine. So where was Andersen this whole time? It was, as usual, cashing Enron’s cheques. In exchange for its work on the Raptor deals, Andersen charged Enron a total of $1.3m.