Infectious Greed (63 page)

And then there were the insider sales: in all, Gary Winnick cashed in $735 million of stock, and other insiders sold $4.5 billion, four times more than similarly situated people at Enron.
¹⁶
Early investors in Global Crossing who later sold at a huge profit included former president George H. W. Bush, who took stock in lieu of a speaking fee, and Terry McAuliffe, the former chairman of the Democratic National Committee, who invested $100,000 in 1997 and cashed out for $18 million after the IPO. Many of these shares were sold when Global Crossing was near its peak in February 2000, when the market value of the firm's shares was $47 billion, almost as much as Enron's value.

In 1999, as Enron was exploring the idea of expanding into telecommunications, Global Crossing and Enron began discussing deals they might do together. In December 1999, Enron did its first trade of broadband fiber-optic capacity—a monthly contract between New York and Los Angeles on one of Global Crossing's new networks.
¹⁷
The relationship would last until just before Enron's collapse; Gary Winnick and Jeff Skilling spoke about one end-of-quarter deal just before Skilling resigned in August 2001.
¹⁸

Global Crossing and Enron were a natural fit. Fiber-optic networks
were laid along the path of natural-gas pipelines, so there were reasons for Enron and Global Crossing to do legitimate business together. Enron was more interested in financial techniques than bricks-and-mortar projects, and Global Crossing's executives quickly learned that financial engineering could be more profitable than any other form of engineering the firm had used. The dealings between the two firms quickly became focused more on accounting numbers than economic reality, just as Enron's risk-management manual had instructed: accounting numbers were the important measure of performance.

As Global Crossing and Enron developed a relationship, Enron also was advising other companies about how to create phantom revenue and earnings. For example, in July 2000, Enron visited AT&T to pitch its expertise in various complex structured transactions. Enron's pitch book was audacious: Enron claimed to have replicated its capabilities in natural gas and energy in the telecommunications sector, and said it would be “the world's largest buyer and seller of bandwidth,” “the world's largest provider of premium broadband delivery services,” and would “deploy the most open, efficient network with broad connectivity.” These were bold claims to be making to AT&T, which had long been the leading telecommunications company. But AT&T was dying, and although Michael Armstrong, the firm's leader, had tried numerous financial tricks—from spinning off various divisions to issuing
tracking stock,
whose value was based on the performance of particular business lines—AT&T's stock price was at a low. Enron officials thumbed their noses at AT&T's hard assets, arguing that they could simply “swap” into fiber-optic networks, buying the rights to use other firms' capacity, and thereby become a leading telecommunications firm overnight, without wasting the time and resources necessary to build its own network.

Enron offered AT&T a variety of complicated transactions designed to improve AT&T's financial numbers. These were essentially turbocharged versions of the simple schemes Cendant and others had used to “borrow” profits from future years.

One idea related to AT&T's practice of selling rights to its bandwidth in exchange for a prepaid amount from a customer. Customers did long-term deals with AT&T, and instead of agreeing to pay a fixed rate over time, they agreed to prepay a discounted amount up front. For example, if a customer bought 20-year rights to AT&T's bandwidth, the cost might be $5 million per year, or $100 million in all spread over 20 years.
Instead of agreeing to pay over time, the customer would agree to prepay some discounted amount up front—say, $40 million.

The problem with such a deal, according to Enron, was that accounting rules required AT&T to spread out the income from the $40 million up-front payment over the 20-year period, so that it reported earnings of just $2 million per year. That made economic sense, given that AT&T would incur costs from its obligation to provide broadband services during the 20-year period. But Enron claimed it could arrange a deal so that AT&T reported the full $5 million per year instead.

Here is how it would work. Enron created a Special Purpose Entity, and the customer prepaid $40 million to the SPE instead of to AT&T. AT&T then entered into an over-the-counter derivative with the SPE in which AT&T received a “loan” of $40 million and agreed to pay interest during the 20-year period. Enron then entered into derivatives with both the SPE and AT&T, in which Enron received the full $5 million per year from the SPE and passed that amount on to AT&T. It was a complex daisy chain; but, essentially, AT&T borrowed money from itself, and recognized the additional borrowed amount—an extra $3 million per year—as income. According to Enron, AT&T arguably received $5 million in “income” per year from the SPE, and the “loan” with the SPE was an over-the-counter derivative that did not need to be reported (remember, such derivatives transactions were unregulated and fell outside the scope of traditional accounting rules).

AT&T had frittered away tens of billions of dollars of shareholder value through failed investments in telecommunications, and financial gimmickry, but this scheme was too much—even for AT&T. The company rejected Enron's proposal, even though it seemed unlikely that regulators would detect these deals. Even if they did, they likely would not understand them. Still, the pitch book for the AT&T deal gave a picture of Enron's overall dealings, and Enron sold similar products to other companies, reportedly including Lucent, Owens Corning, and even a handful of utility companies.

Then there was Global Crossing.

In March 2001, a little over a year after Enron's first deal with Global Crossing, the two firms entered into a long-term swap. On the surface, the swap appeared to be a fiber-optic deal, in which Enron paid for eight years of access to Global Crossing's fiber-optic network and Global Crossing purchased something called “network services” from Enron.
¹⁹
Enron paid
$17 million up front, whereas Global Crossing agreed to make monthly payments for eight years.

In reality, the fiber-optic and network-services rights roughly cancelled each other, leaving only a $17 million “loan” from Enron with monthly “interest” payments to be made by Global Crossing. Global Crossing reported earnings from selling rights to its fiber-optic network, but did not report the “loan” as a liability. Enron reported $5 million of gains from the sale of network services, but did not record the fact that Global Crossing owed it $17 million. Both companies benefited from the appearance of high volumes of transactions in network rights.
²⁰
It was exactly the same as the $8 billion of prepaid swap deals Citigroup and J. P. Morgan Chase had sold to Enron, except that now Enron was playing the role of a bank, arranging the deal on its own with Global Crossing.

This swap, and others like it, were designed to help Global Crossing “manufacture” earnings, especially at the end of a financial quarter. Like the Wall Street banks, Enron disclaimed any responsibility for how Global Crossing accounted for the swap on its financial statements. One Enron executive reportedly said, “We were selling them bullets; they could use them any way they wanted.” Enron executives argued that there was nothing wrong with manufacturing earnings, and defended the swap with Global Crossing, because “[e]veryone was over-reporting their numbers back then.”
²¹

During the time of these trades with Enron, Global Crossing also began entering into swap transactions with other firms, to trade rights known in the telecommunications industry as Indefeasible Rights of Use. IRUs were created at AT&T, which had trained many of the executives running various telecommunications companies. Now, many of these executives' companies were inflating their revenue and earnings with IRU swaps—telecommunications executives from AT&T included Joseph Nacchio, CEO of Qwest; and Robert Annunziata and Leo Hindery Jr., who had been CEOs of Global Crossing. Even Jack Grubman, the analyst from Salomon, had come from AT&T.

In an IRU swap, two telecommunications companies agreed to exchange the rights to use bandwidth on different parts of their fiber-optic networks. One company might exchange the rights to use lines in New York for rights of roughly the same value in Kansas.

The beauty of IRUs, from the perspective of a telecommunications company, was that accounting rules arguably permitted companies to treat the two legs of the swap differently, recording the revenue leg up front,
while deferring the expense leg over time. In 1999, the SEC had published “Staff Accounting Bulletin No. 101” in an attempt to standardize the way companies recognized their revenues, and to ban revenue recognition practices that had deceived investors during the late 1990s (recall Al Dunlap's “channel stuffing” of barbecue grills at Sunbeam). This bulletin set forth the requirements for when certain revenues should be recognized and for when certain costs should be spread over time. The bulletin was lengthy and complex; but, essentially, Global Crossing and other companies were using one portion of the bulletin to justify up-front recognition of revenues, while using another portion of the bulletin to justify spreading expenses over time. Global Crossing could argue that the incoming payments from the IRU were revenues, to be recognized right away, while the outgoing payments were a capital expense, to be spread over a period of several years.

Not everyone in Global Crossing's accounting department agreed with this interpretation. Roy Olofson, a vice president of finance at Global Crossing, believed the legs of the swap should be treated equivalently. But any support he had—within Global Crossing or among the firm's auditors at Arthur Andersen—evaporated in May 2000, when Global Crossing hired Joseph P. Perrone as a senior vice president of finance. Perrone had been at Arthur Andersen for thirty-one years, where he audited Global Crossing, was involved in discussions about how to account for IRUs, and even suggested some restrictions on Global Crossing's accounting practices.
²²
Winnick lured Perrone with a huge guaranteed bonus and 500,000 stock options, worth millions of dollars.
²³
(In addition, it was Perrone's son who ran
Withit.com
, the Internet company that did its first major deal with Global Crossing.) With Perrone at Global Crossing in 2000, Arthur Andersen received $2.3 million in audit fees and $12 million for non-audit work. Not surprisingly, Global Crossing's executives listened to Perrone more than Olofson.

Olofson began reporting directly to Perrone during mid-2000, and the two men immediately clashed over accounting policies. However, the disputes lasted only a few months, because Olofson was diagnosed with lung cancer and took a leave from the firm beginning in January 2001.

While the cat was away, the mice began to play. Global Crossing's executives proposed to use IRU swaps in March 2001—the end of the firm's first financial quarter—to generate revenues and earnings that the company needed to meet analysts' expectations. Global Crossing's accountants wanted employees entering into these swaps to be sure the swaps
contained the correct language, so that they would receive appropriate accounting treatment. On March 8, 2001, they circulated a memorandum stressing, “It is important for GX [Global Crossing] to classify these purchases as a capital lease versus a pre-paid service, because the classification affects how the expense impacts our EBITDA [earnings] calculation. A capital lease expense is excluded from our EBITDA calculation, while a service expense is included as a deduction in our EBITDA.” In other words, the accountants wanted to ensure that the cost of deals was spread over time, not included as an immediate expense. (EBITDA is an acronym for one important measure of accounting earnings: Earnings Before Interest, Tax, Depreciation, and Amortization.)

One $100 million IRU swap was with Qwest, a telecommunications company that had outbid Global Crossing for U.S. West, one of the regional Bell companies created by the breakup of AT&T. Qwest then used the IRU swap technique on its own. During the first three quarters of 2001, Qwest sold $870 million of capacity and bought $868 million of capacity—to and from the same parties.
²⁴
These swaps appeared to be round-trip transactions, which served no purpose other than to inflate Qwest's revenues. A year later, on July 28, 2002, Qwest would file a billion-dollar-plus restatement, admitting that it had improperly recorded revenues from these trades.

Meanwhile, Global Crossing did IRU swaps with other companies. When Olofson returned to work in May 2001, he expressed concern about the financial statements Global Crossing had filed for the first quarter of 2001. Olofson told Perrone he believed Global Crossing had done illegitimate end-of-quarter swaps to achieve revenue and earnings targets. Global Crossing conducted a study to assess the value of the firm's swaps, and concluded that less than 20 percent of the swaps actually could be added to Global Crossing's network.
²⁵
In other words, Global Crossing found it was doing swaps that had no real business use.

Nevertheless, the firm continued doing IRU swaps, and continued booking revenue up front and spreading expenses over time. According to Olofson, $720 million of Global Crossing's $3.2 billion in revenue during the first half of 2001 was from illegitimate swaps.
²⁶
Olofson also claimed that thirteen of eighteen of these swaps occurred during the last two days of the quarter,
²⁷
making it appear that Global Crossing was using the IRU swaps as a last-minute way to create fictional earnings it needed to meet quarterly expectations.