The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (72 page)

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On Tuesday, November 13, more than $2 billion arrived on Enron’s doorstep—$1.5 billion from Dynegy and $550 million from the first installment of its bank pipeline loans, which had taken a long time to finalize. The bank loans and Dynegy’s money “should easily provide Enron with adequate liquidity to conduct business,” Dynegy CFO Rob Doty noted a day earlier. “This should put any fears surrounding Enron’s liquidity immediately to rest.”

Enron executives agreed. Greg Whalley said the Dynegy deal provided the company with “ample liquidity.” On a November 14 conference call with analysts, CFO McMahon pointedly denied Enron was experiencing a “cash drain.” That very day, John Arnold instructed a trading subordinate to take a harder line with a counterparty asking for cash collateral. “Since ENE is flush with liquidity,” Arnold wrote in an e-mail, “he should be very comfortable that we can pay our bills.”

But just four days later, McMahon reported a very different situation to the Enron board. “Mr. McMahon reported liquidity was very tight,” noted the minutes from the Sunday, November 18, meeting. Management was still chasing after more capital; McMahon “noted the need to extend the debt maturities of the Company.” Treasurer Ray Bowen added that if Enron couldn’t postpone $1 billion in debt coming due, “the Company could end the year with inadequate liquidity for its operations.”

Even after the Dynegy deal was announced, cash continued to rush out the door. Trading partners refused to take Enron’s credit, insisting on more collateral. The number of transactions on Enron Online plummeted—50 percent below normal levels—as counterparties struggled to cut their Enron exposure. Many companies stopped trading with Enron altogether. The company’s European operation was deteriorating too. And EES reported trouble closing new contracts. Enron’s earthward spiral was accelerating.

Desperate for a way to shift the momentum, Enron executives pressed the special investigative committee of the board—the one that had started work just three weeks earlier, with the help of special counsel Bill McLucas and his forensic accountants—to complete its work and issue its report. “These guys actually thought that the big-picture problems were not going to yield anything fundamentally wrong,” recalls one of the investigators in amazement. “Everyone wanted us to come out and say to the masses outside of the operating room, ‘We’ve opened the patient up, and everything’s fine.’ ”

On Monday, November 19, McMahon and Whalley led a two-hour presentation to more than 200 bankers from 75 lenders at the Waldorf-Astoria Hotel in New York. Security guards checked identification at the doors. Once inside, the bankers received copies of a 65-page presentation, marked privileged and confidential.

The meeting was billed as a detailed review of Enron’s problems and how management was tackling them. The idea was to air everything out, then enlist the banks’ help in restructuring the company’s crushing debt so that Enron would survive long enough to complete the Dynegy merger. By Enron’s calculation, the company would need to repay more than $9.1 billion in debt by the end of 2002.

Much of the meeting served as a remarkably blunt repudiation of the Skilling era. Lay, whose credibility was shot, was absent; Whalley and McMahon wanted to present themselves as the company’s new guard that could lead Enron out of this mess.

This accounting was far more candid than any that had come before. Enron, the presentation noted, was suffering from “a complete loss of investor and creditor confidence,” “no access to capital,” maturing debt that exceeded its cash flow, and “too much leverage tied to stock price.” Enron had borrowed too much and issued too little equity, blown the money on bad investments, and suffered from “possible control failure.” The off-balance-sheet debt, structured-finance deals, and prepays were all detailed.

Part of the problem, the bankers were told, was that large strategic transactions—Azurix, broadband, Dabhol, and New Power—had been exempt from RAC scrutiny. Buy’s role had merely been to “highlight the risk” for senior management. Now—belatedly—that would change. Beginning in December, all Enron deals would require RAC approval. Only the board would be able to override a RAC veto.

Whalley and McMahon summed it all up by contrasting the “Old Enron” and “New Enron.” The old Enron was characterized by a “deal shop mentality,” a “black box” approach, “constant development of new businesses,” and related-party deals; and it was “earnings-driven.” The new Enron would offer “open communication,” “financial transparency,” an emphasis on cash, and a focus on the core business and completing the Dynegy merger.

But as Chuck Watson saw it, when Enron filed its third-quarter report with the SEC that day, it was strictly the old Enron. The 10-Q filing, which the company delayed five days to better sort out its various problems, contained three pieces of terrible news.

First, Enron’s earnings for the third quarter were actually worse than previously reported—a loss of $664 million—and things also looked bleaker than expected for the fourth quarter. Enron attributed its latest problems to “a reduced level of transaction activity by trading counterparties.” In other words, the trading business was drying up.

Then there were fresh surprises on the SPE front. The assets inside Whitewing had dropped far below the amount of its obligations; this meant Enron might have to take a new $700 million charge to earnings. Enron also revealed that a ratings downgrade one week earlier had triggered an obligation to repay $690 million in debt in an off-balance-sheet vehicle called Rawhide. For some reasons, this SPE—the creation of Michael Kopper and Ben Glisan—had been rigged to explode if S&P cut Enron to one step
above
junk grade. No one appeared to have even known about the problem until the default notice arrived. Now Enron had eight days to come up with the money.

And cash, the company also revealed, was in desperately short supply. Despite the $2 billion that had arrived on November 13, Enron had only $1.2 billion left. Counting the money it had in hand before getting the $2 billion, that meant Enron had burned through at least a billion dollars
in six days
and $2 billion in less than a month. Clearly Enron no longer had ample liquidity.

Watson went ballistic. He fired off a letter to Lay: “We have not been consulted in a timely manner regarding developments since November 9. We were not briefed in advance on the issues in your 10-Q. Our team had to make repeated phone calls to your finance and accounting officials in an attempt to obtain information. Some of the most significant information in the Q was never shown to us at all.” Watson added: “We believe that Enron is going to have to do a far better job of communicating with us and with the marketplace for this transaction to reach a successful conclusion.”

Watson also gave Lay a call, telling him: “You and I need to go to lunch, buddy.” The Dynegy CEO was now harboring serious doubts about the deal. With this latest revelation, Enron was back on the ropes. Where had the $2 billion gone? Incredibly, Enron didn’t seem to know. Enron quickly negotiated some extra time on the $690 million Rawhide debt, but the company would now need billions more. Where would it come from?

Watson was also embarrassed by the Enron disclosure. To the reporters who called Dynegy for comment, it was obvious that his team hadn’t known this news was coming—and that’s how they would cast it in their stories. It wasn’t just bad faith; the news made Dynegy look foolish. Watson’s company was using its credibility to prop up Enron’s; now Enron’s behavior was damaging Dynegy.

“I’m not used to people lying to me,” Watson told Lay during a two-hour lunch in a private room at the downtown Coronado Club. “You guys need to get your act together, or this deal’s not going to close.” Suddenly all of Dynegy’s “conservative” assumptions didn’t look so conservative after all. By week’s end, Enron’s shares had fallen to $4.71. Goldman Sachs had downgraded both merger partners, but Dynegy’s stock was down only 7 percent; apparently Wall Street now assumed that Watson would find a way out of the deal.

In addition, Watson was discovering that the Enron culture wasn’t such a good fit after all. After getting a peek at Lay’s new G-5 jet, he told a colleague, “I nearly had a heart attack.” He kept learning about Enron executives who made twice what their Dynegy counterparts made. And as Enron started planning for layoffs, he heard about the company’s extravagant severance plan: two weeks’ pay for each year of service—plus
another
two weeks for each $10,000 of base pay. It wasn’t hard to see where
some
of Enron’s money went.

In the week after the merger was announced, Watson went on an East Coast swing to pitch the deal to analysts and investors. He took Whalley and Horton along with him. Everywhere they went, the Enron executives came under attack. They finally left the road show early and went home. “These people are hated worse than I thought,” Watson later said.

The list of those suing the company grew to include Enron’s own employees, who had seen much of their retirement-plan savings disappear. They claimed Enron’s top executives had misled them about the riskiness of Enron shares and locked them into their plummeting holdings for a month while the com-
pany changed plan administrators. Between the company’s savings and stock-ownership plans—60 percent of the total assets in both consisted of Enron stock— 20,000 Enron employees lost about $2 billion in 2001.

Some, however, did manage to get some of their savings out. During November, as Enron was spiraling downward, scores of current and retired executives who had participated in the company’s deferred-compensation program—which set aside earnings in exchange for tax breaks—clamored for their money. Formal requests for such accelerated distributions were submitted by 211 plan participants. Some 126—personally approved by Whalley—received $53 million in cash. The rest are likely to get virtually nothing.

In the chaos of late November, everyone was maneuvering for position, elbowing for money that Enron didn’t have. Jordan Mintz, for instance, was working on Thanksgiving Day when a call came in from a Lehman Brothers lawyer who’d been threatening to go to court to force immediate repayment on a $120 million Enron debt. “I just faxed you a draft complaint,” he said. “You might want to take a look at it.” Back off, Mintz finally told him. “You want to be the one to throw Enron into bankruptcy?” He didn’t—Lehman was also serving as Dynegy’s financial adviser.

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Dynegy’s deal team had responded to the startling Enron 10-Q by intensify-
ing its diligence, fueled by rage. “We were ripshit,” recalls one Dynegy adviser. Watson’s side began to suspect that this was yet another Enron scam. Says an
executive involved in the deal: “They thought they could just get our money and keep their game going.”

Given all the anger, it was hard to see how the deal could still work. But Watson agreed to try, on one condition: Ken Lay had to go—immediately. Watson had concluded he needed his own team running Enron, right away. This was an audacious proposal; an acquirer usually keeps its hands off the target until the acquisition closes. Any change would require the agreement of the Enron board, which had long been in Lay’s pocket. But Watson felt he had no choice. Without a different team in place, he figured, Enron would be dead and buried long before the deal could close.

Watson wasn’t just after Lay’s head; he wanted to replace Jim Derrick, the general counsel, and appoint a new CFO, too. He planned to bring in a cash-management team to get a handle on the finances and a divestiture team to start selling assets.

To replace Lay, Watson tapped a respected Houston executive named Joe Foster. Foster was a true heavyweight; he had served as chairman of Tenneco, then started his own oil and gas company, called Newfield Exploration, where he remained board chairman. The two men knew each other partly from working together on the board at Baker Hughes, where Foster had served as interim chairman and CEO. As Watson envisioned it, Foster would hold the same posts at Enron until the sale closed.

With a new executive team as a starting demand, Watson dispatched his CFO and investment bankers over the Thanksgiving weekend to a resort in Westchester County, New York, where everyone met to see if the deal—and Enron—could be saved. Enron sent its top executives: Lay, Whalley, and McMahon. Watson remained at his new vacation home in Cabo San Lucas, Mexico, monitoring events by phone. His number two, Bergstrom, stayed away, too.

By Sunday, it looked as if the pieces might come together. A little after 10
P
.
M
.
, Lay convened a conference-call meeting to update his board. Because of the severe drop in the price of Enron shares, it had been clear that the deal would need to be recut just two weeks after it was struck. This also was extraordinary. The new exchange ratio—0.12 Dynegy share for each Enron share—valued Lay’s company at about $4 billion, less than half the previous price. The board unanimously approved the new terms.

But the deal wasn’t yet done, not by a long shot. To maintain an investment-rade rating, Enron needed new capital. The idea was that J. P. Mor-
gan Chase, Citi, and Dynegy would each put up a third of the money. And that would be enough only if the company could reschedule all of the debt that was supposed to be paid off by the end of 2002. The banks would also need to convert much of their debt to equity. But after initially talking about big dollars—“We’re in for a billion,” Chase’s Jimmy Lee proclaimed at one point—the banks danced away from making giant commitments even though closing the deal was supposed to bring them a giant payday. In addition to the $15 million advisory fee each had already received, J. P. Morgan Chase and Citi were due to get an additional $45 million apiece from Enron.

Finally, there was the issue of replacing Lay. The Enron CEO had dutifully explained the demand to his board. It made no decision that Sunday night.

On Monday, talks continued in Houston. Lay told his board that he thought the deal could still be saved. Now the rating agencies started expressing doubts. They noticed that the banks, for all their talk, weren’t putting up the big money. They were worried about the deterioration of the trading business, which had generated almost all of Enron’s reported profits. With Enron’s crushing debt load, they didn’t see how the company could borrow any more on its own. And without a big infusion of extra cash, they didn’t see how Enron could pay off the $9 billion in debt coming due. Still, reluctant to provide the death blow, the rating agencies agreed to hold off on an immediate downgrade.