The Fall of Enron

How ex-CEO Jeff Skilling's strategy grew so complex that even his boss couldn't get a handle on it

To former Enron (ENE ) CEO Jeffrey K. Skilling, there were two kinds of people in the world: those who got it and those who didn't. "It" was Enron's complex strategy for minting rich profits and returns from a trading and risk-management business built essentially on assets owned by others. Vertically integrated behemoths like ExxonMobil Corp. (XOM ), whose balance sheet was rich with oil reserves, gas stations, and other assets, were dinosaurs to a contemptuous Skilling. "In the old days, people worked for the assets," Skilling mused in an interview last January. "We've turned it around--what we've said is the assets work for the people."

But who looks like Tyrannosaurus Rex now? As Enron Corp. struggles to salvage something from the nation's largest bankruptcy case, filed on Dec. 2, it's clear that the real Enron was a far cry from the nimble "asset light" market maker that Skilling proclaimed. And the financial maneuvering and off-balance-sheet partnerships that he and ex-Chief Financial Officer Andrew S. Fastow perfected to remove everything from telecom fiber to water companies from Enron's debt-heavy balance sheet helped spark the company's implosion. "Jeff's theory was assets were bad, intellectual capital was good," says one former senior executive. Employees readily embraced the rhetoric, the executive says, but they "didn't understand how it was funded."

Neither did many others. Bankers, stock analysts, auditors, and Enron's own board failed to comprehend the risks in this heavily leveraged trading giant. Enron's bankruptcy filings show $13.1 billion in debt for the parent company and an additional $18.1 billion for affiliates. But that doesn't include at least $20 billion more estimated to exist off the balance sheet. Kenneth L. Lay, 59, who had nurtured Skilling, 48, as his successor, sparked the first wave of panic when he revealed in an Oct. 16 conference call with analysts that deals involving partnerships run by his CFO would knock $1.2 billion off shareholder equity. Lay, who had been out of day-to-day management for years, was never able to clearly explain how the partnerships worked or why anyone shouldn't assume the worst--that they were set up to hide Enron's problems, inflate earnings, and personally benefit the executives who managed some of them.

That uncertainty ultimately scuttled Enron's best hope for a rescue: its deal to be acquired by its smaller but healthier rival, Dynegy Inc. (DYN ) Now Enron is frantically seeking a rock-solid banking partner to help maintain some shred of its once-mighty trading empire. Already, 4,000 Enron workers in Houston have lost their jobs. And hundreds of creditors, from banks to telecoms to construction companies, are trying to recover part of the billions they're owed.

From the beginning, Lay had a vision for Enron that went far beyond that of a traditional energy company. When Lay formed Enron from the merger of two pipeline companies in 1985, he understood that deregulation of the business would offer vast new opportunities. To exploit them, he turned to Skilling, then a McKinsey & Co. consultant. Skilling was the chief nuts-and-bolts-operator from 1997 until his departure last summer, and the architect of an increasingly byzantine financial structure. After he abruptly quit in August, citing personal reasons, and his right-hand financier Fastow was ousted Oct. 24, there was no one left to explain it.

Much of the blame for Enron's collapse has focused on the partnerships, but the seeds of its destruction were planted well before the October surprises. According to former insiders and other sources close to Enron, it was already on shaky financial ground from a slew of bad investments, including overseas projects ranging from a water business in England to a power distributor in Brazil. "You make enough billion-dollar mistakes, and they add up," says one source close to Enron's top executives. In June, Standard & Poor's analysts put the company on notice that its underperforming international assets were of growing concern. But S&P, which like BusinessWeek is a unit of The McGraw-Hill companies, ultimately reaffirmed the credit ratings, based on Enron's apparent willingness to sell assets and take other steps.

Behind all the analyses of Enron was the assumption that the core energy business was thriving. It was still growing rapidly, but margins were inevitably coming down as the market matured. "Once that growth slowed, any weakness would start becoming more apparent," says Standard & Poor's Corp. director Todd A. Shipman. "They were not the best at watching their cost." Indeed, the tight risk controls that seemed to work well in the trading business apparently didn't apply to other parts of the company.

Skilling's answer to growing competition in energy trading was to push Enron's innovative techniques into new arenas, everything from broadband to metals, steel, and even advertising time and space. Skilling knew he had to find a way to finance his big growth plans and manage the international problems without killing the company's critical investment-grade credit rating. Without a clever solution, trading partners would flee, or the cost of doing deals would become insurmountable.

"HE'S HEARTBROKEN." No one ever disputed that Skilling was clever. The Pittsburgh-born son of a sales manager for an Illinois valve company, he took over as production director at a startup Aurora (Ill.) TV station at age 13 when an older staffer quit and he was the only one who knew how to operate the equipment. Skilling landed a full-tuition scholarship to Southern Methodist University in Dallas to study engineering, but quickly changed to business. After graduation, he went to work for a Houston bank. The bank later went bust while Skilling was at Harvard Business School. Skilling said that fiasco made him determined to keep strict risk controls on Enron's trading business. He once told BusinessWeek that "I've never not been successful in business or work, ever." Skilling now declines to comment, but his brother Tom, a Chicago TV weatherman, says of him: "He's heartbroken over what's going on there.... We were not raised to look on these kinds of things absent emotion."

Enron's "intellectual capital" was Skilling's pride and joy. He recruited more than 250 newly minted MBAs each year from the nation's top business schools. Meteorologists and PhDs in math and economics helped analyze and model the vast amounts of data that Enron used in its trading operations. A forced ranking system weeded out the poor performers. "It was as competitive internally as it was externally," says one former executive.

It was no surprise then that Skilling would turn to a bright young finance wizard, Fastow, to help him find capital for his rapidly expanding empire. Boasting an MBA from Northwestern University, Fastow was recruited to Enron in 1990 from Continental Bank, where he worked on leveraged buyouts. Articulate, handsome, and mature beyond his years, he became Enron's CFO at age 36. In October, 1999, he earned CFO Magazine's CFO Excellence Award for Capital Structure Management. An effusive Skilling crowed to the magazine: "We didn't want someone stuck in the past, since the industry of yesterday is no longer. Andy has the intelligence and the youthful exuberance to think in new ways."

But Skilling's fondness for the buttoned-down Fastow was not widely shared. Many colleagues considered him a prickly, even vindictive man, prone to attacking those he didn't like in Enron's group performance reviews. Fastow, through his attorney, declined to comment for this story. When he formed and took a personal stake in the LJM partnerships that blew up in October, the conflict of interest inherent in those deals only added to his colleagues' distaste for him. Enron admits Fastow earned more than $30 million from the partnerships. The Enron CFO wasn't any more popular on Wall Street, where investment bankers bristled at the finance group's "we're smarter than you guys" attitude. Indeed, that came back to haunt Enron when it needed capital commitments to stem the liquidity crisis. "It's the sort of organization about which people said, `Screw them. We don't really owe them anything,"' says one investment banker.

While LJM--and Fastow's direct personal involvement and enrichment--shocked many, the deal was just the latest version of a financing strategy that Skilling and Fastow had used to good effect many times since the mid-'90s to fund investments with private equity while keeping assets and debt off the balance sheet. Keeping the debt off Enron's books depended on a steady or rising stock price and an investment- grade credit rating. "They were put together with good intentions to offset some risk," says S&P analyst Ron M. Barone. "It's conceivable that it got away from them."

Did it ever. The off-balance-sheet structures grew increasingly complex and risky, according to insiders and others who have studied the deals. Some, with names like Osprey, Whitewing, and Marlin, were revealed in Enron's financial filings and even rated by the big credit-rating agencies. But almost no one seemed to have a clear picture of Enron's total debt, what triggers might hasten repayment, or how some of the deals could dilute shareholder equity. "No one ever sat down and added up how many liabilities would come due if this company got downgraded," says one lender involved with Enron. Many investors were unaware of provisions in some deals that could essentially dump the debts back on Enron. In some cases, if Enron's stock fell below a certain price and the credit rating dropped below investment grade--once unimaginable--nearly $4 billion in partnership debt would have to be covered by Enron. At the same time, the value of the assets in many of these partnerships was dropping, making it even harder for Enron to cover the debt.

HIGH HOPES. Skilling tried to accelerate the sale of international assets after becoming chief operating officer in 1997, but the efforts were arduous and time-consuming. Even as tech stocks melted down, Skilling was determined not to scale back his grandiose broadband trading dreams or the resulting price-to-earnings multiple of almost 60 that they helped create for Enron's stock. At its peak in August, 2000, about a third of the stock's $90 price was attributable to expectations for growth of broadband trading, executives estimate.

That rapidly rising stock price--up 55% in '99 and 87% in 2000--gave Skilling and Fastow a hot currency for luring investors into their off-balance-sheet deals. They quickly became dependent on such deals to finance their expansion efforts. "It was like crack," says a company insider. Trouble is, Enron's stock came tumbling back to earth when market valuations fell this year. By April, its price had fallen to about 55. And its far-flung operational troubles were taking their own toll. In its much-hyped broadband business, for instance, a capacity glut and financial meltdown made it hard to find creditworthy counterparties for trading. And after spending some $1.2 billion to build and operate a fiber-optic network, Enron found itself with an asset whose value was rapidly deteriorating. Even last year, company executives could see the need to cut back an operation that had 1,700 employees and a cash burn rate of $700 million a year.

"SOMETHING TO PROVE." And the international problems weren't going away. Enron's 65% stake in the $3 billion Dabhol power plant in India was mired in a dispute with its largest customer, which refused to pay for electricity. Some Indian politicians have despised the deal for years, claiming that cunning and even corrupt Enron executives cut a deal that charged India too much for its power.

Enron's ill-fated 1998 investment in the water-services business was another drag on earnings. Many saw the purchase of Wessex Water in England as a "consolation prize" for Rebecca P. Mark, the hard-charging Enron executive who had negotiated the Dabhol deal and other investments around the world. With Skilling having won out as Lay's clear heir apparent, top executives wanted to move her out of the way, say former insiders. A narrowly split board approved the Wessex deal, which formed the core of Azurix Corp., to be run by Mark. But Enron was blindsided by British regulators who slashed the rates the utility could charge. Meanwhile, Mark piled on more high-priced water assets. "Once [Skilling] put her there, he let her go wild," says a former executive. "And she's going to go wild because she has something to prove." Mark spent too much on a water concession in Brazil and ran into political obstacles. She declined to comment for this story.

But if Azurix was a prime example of Enron's sketchy investment strategy, it also demonstrated how the company tried to disguise its problems with financial alchemy. To set up the company, Enron formed a partnership called the Atlantic Water Trust, in which it held a 50% stake. That kept Wessex off Enron's balance sheet. Enron's partner in the joint venture was Marlin Water Trust, which consisted of institutional investors. To help attract them, Enron promised to back up the debt with its own stock if necessary. But if Enron's credit rating fell below investment grade and the stock fell below a certain point, Enron could be on the hook for the partnership's $915 million in debt.

The end for Enron came when its murky finances and less-than-forthright disclosures spooked investors and Dynegy. The clincher came when Dynegy's bankers spent hours sifting through a supposedly final draft of Enron's about-to-be-released 10Q--only to discover two pages of damning new numbers when the quarterly statement was made publicly available. Debt coming due in the fourth quarter had leapt from under $1 billion to $2.8 billion. Even worse, cash on hand--to which Dynegy had recently contributed $1.5 billion--shrunk from $3 billion to $1.2 billion. Dynegy "had a two-hour meeting with the new treasurer of Enron, who had been in that seat for two weeks," said a source close to the deal. "He had no clue where the numbers came from."

RESPECT FOR ASSETS. Skilling and Fastow face most of the wrath of reeling employees. "Someone told me yesterday if they see Jeff Skilling on the street, they would scratch out his eyes," says a former executive. One of Fastow's lawyers, David B. Gerger, says his client has been the subject of death threats and anti-Semitic tirades in Internet chat rooms. "Naturally people look for scapegoats, but it would be wrong to scapegoat Mr. Fastow," says Gerger.

He confirms that Fastow has hired a big gun to handle his civil litigation: David Boies's firm, which represented the Justice Dept. in its suit against Microsoft Corp. On Dec. 5, Milberg Weiss Bershad Hynes & Lerach filed a suit against Fastow, Skilling, and 27 other Enron executives, saying they illegally made more than $1 billion off stock sales before Enron tanked. And a source at the Securities & Exchange Commission says four U.S. Attorney Offices are considering whether to pursue criminal charges against Enron and its officers.

Would the cash squeeze have caught up to Enron, even without Skilling's and Fastow's fancy financing? Credit analysts still argue that the debt would have been manageable, absent the crisis of confidence that dried up Enron's trading business and access to the capital markets. But even they have a new respect for old-fashioned, high-quality assets. "When things get really tough, hard assets are the kind you can depend upon," says S&P's Shipman. That's something Enron's whiz-kid financiers failed to appreciate.

By Wendy Zellner and Stephanie Anderson Forest in Dallas with Emily Thornton, Peter Coy, Heather Timmons, Louis Lavelle, and David Henry in New York, and bureau reports