Prophets of loss

The Enron failure happened so quickly and with such devastating impact that no-one could have predicted it. Sure, some analysts and pundits in Houston had said that Enron would fall on hard times or that its stock price would get walloped - but bankruptcy? Not a chance.

And yet, Mighty Enron had gone Chapter 11. And it had done it Texas-style, in the biggest and gaudiest way possible - with superlatives aplenty. It was - for the span of seven months - the biggest bankruptcy in American history (WorldCom’s bankruptcy, in July this year, eclipsed Enron). With $63.4 billion in assets, Enron was nearly two times larger than Texaco when that energy firm went under in 1987.

The Enron failure is the biggest political scandal in American history. By the time of its bankruptcy, Enron owned - or perhaps was just renting - politicians in the White House, Congress, state courts, state legislatures, and bureaucrats at every level.

It’s the biggest scandal ever to hit Wall Street. The Enron debacle has ensnared every major investment bank in New York, including Merrill Lynch, Citigroup, JP Morgan Chase, UBS, and dozens of others. Those banks not only lent Enron huge sums of money and did investment banking for the company, but their executives invested in Enron’s off-the-balance-sheet partnerships. And the same bankers employed a gaggle of analysts who, given enough investment banking work by Enron, were happy to put out "strong buys" on the company’s stock.

It’s the biggest scandal ever to hit accounting, the world’s second oldest profession. The once-great accounting firm Arthur Andersen wasn’t just in bed with Enron, the venerable firm was providing the company with auditing and consulting services, while sharing office space, all in exchange for $52 million per year in fees. Today, Andersen, which was found guilty on 15 June, 2002, of obstructing justice in the Enron investigation, has all but disappeared in a cloud of ignominy.

The Enron collapse is the most egregious example of executive piracy in American corporate history. A handful of executives made unbelievable fortunes - tens, even hundreds of millions of dollars - at the same time that Enron was being driven into the ground. Between 1998 and 2001, two dozen Enron executives and board members sold company stock worth more than $1.1 billion - and that’s only what’s been discovered so far. And that total doesn’t include the huge salaries, bonuses, and other cash payments made to Enron executives during their reign of plunder.

Lou Pai had two passions in life: money and watching young women take off their clothes; at Enron, he was able to gorge on both. By spring 2000, though, it appears that Pai’s predilection for strippers had him on a one-way trip to the divorce court. His wife of 24 years, Lanna Pai, had tolerated his infidelities long enough. She and their two children (and lots of Enron employees) had been hearing the rumours about Lou and the strippers for years, and now she wanted out - for good.

Pai, the small (about 5’5" tall), spookily quiet maths brain, was not worth the trouble. They’d been quarrelling for months. Court records show their marriage was troubled. On 15 June, 1999, Lanna Pai filed a document in Harris County District Court in her divorce action against her husband. The court granted Lanna Pai a temporary restraining order that prohibited Lou Pai from "causing bodily injury" to her or to their children, "threatening" her or their children, and "destroying, removing, concealing, encumbering, transferring or otherwise harming or reducing the value of the property of one or both of the parties."

It appeared that if they were going to split the sheets for good, Lanna wanted her share of the fortune that Lou had been accumulating at Enron. So Lou Pai began doing what lots of other Enron insiders were doing. He began selling his Enron stock. Pai didn’t mind. He already had more money, stock and land than he’d ever dreamed possible. He was going to stay quiet and out of sight, just like he always had, but now he could do it in style with his babe-a-licious girlfriend, a former topless dancer named Melanie Fewell.

Pai had been sleeping with Fewell since the early 1990s even though both of them were married. And in 1996, according to the New York Times, Fewell’s then-husband named Lou Pai as a problem in their marriage, describing Pai in court documents as her "paramour" and employer. But soon, both Pai and Fewell would be free, and they were going to have plenty of space to keep their privacy.

For instance, they could go to Pai’s own 14,000ft-tall mountain. Reportedly the only person in Colorado to own his own "fourteener", Pai has title to a huge ranch that contains Culebra Peak, which at 14,047ft is the 51st highest point in the lower 48 states.

Lou Pai, one of four children, got his undergraduate degree from the University of Maryland. He served two years in the US Army before returning to Maryland to get his master’s degree in economics. He worked in Washington, DC, for a few years, then moved to Houston in the 1980s to take a job with Conoco. In 1987 he was hired at Enron by Bruce Stram, a friend from graduate school, to work in the company’s strategic planning department. Pai’s work in planning went well, but he had a gift for trading, a gift that was discovered shortly after Jeff Skilling [Enron’s CEO] began setting up the company’s Gas Bank.

Pai proved himself so quickly that Skilling feared Pai would defect and go to another Houston company, Natural Gas Clearinghouse. Pai was quickly promoted to vice-president. But his supervisor at the time regretted the move almost immediately. By promoting Pai, said the executive, "I violated two principles of mine. First, the person should take a leadership role. Second, the person going into the job needs to take on more responsibility and carry the corporate flag. Turns out I violated both of them. Pai didn’t have leadership capability and he didn’t have management capabilities."

But management capability was never a prerequisite for advancement at Enron under Skilling. Pai was proof of that. He was the most asocial of those in Skilling’s inner circle. Pai was happiest when he was left alone, and by being one of Skilling’s chosen few, he was able to achieve that goal throughout his Enron tenure. "I’d get on the elevator with him and he wouldn’t make eye contact. He was so strange," one woman who worked with Pai remembered.

Stories of Pai’s fascination with strippers were legion at Enron. One executive recalled getting an expense report from Pai in 1990, shortly after Pai began working for him. "It was $757 for one lunch. He and two or three co-workers had gone to Rick’s [a Houston strip club]. I said, ‘I’m not approving this. You are going to have to take care of this yourself.’ I couldn’t understand why he would do that kind of thing. You just don’t do that in business." But that executive didn’t stay at Enron long. And Pai reverted to his old ways, ways that Skilling tolerated.

Without Pai, some Enron insiders thought Skilling would never have been able to establish Enron’s burgeoning trading business. Pai had the intellectual firepower and focus needed to create the computer programs and systems that allowed Skilling to fulfil his vision of changing Enron into a quasi-investment bank. Pai was "the one person smart enough" to handle the job, as one banker who worked closely with him put it.

Skilling liked Pai because "Pai was willing to go to any length" to get a deal done, recalled one Enron veteran. And by 1997, after a stint as president and chief operating officer of the Enron trading arm, Pai was made chairman and CEO of Enron Energy Services, another business unit that Jeff Skilling hyped, and then hyped some more.

The idea behind the business was simple: Sell long-term energy supply contracts to big industrial users. Enron succeeded quite well in signing up customers who were attracted to Enron’s promise of fixed-price contracts for electricity and natural gas. But Enron Energy Services apparently failed to make any money.

By 2000, Pai and his second in command at Enron Energy Services, Thomas White (whom "the senator from Enron", Phil Gramm, would later introduce to a Senate committee as "one of the most outstanding managers in corporate America"), were overseeing a division with more than 1,000 employees. And like the rest of Enron, the focus was on mark-to-market revenue, not cash.

In fact, Enron Energy Services appeared to be nothing more than a gigantic cash drain on Enron. That was true despite financial reports that showed huge growth. In 1999, the division reported losing $68 million on sales of $1.8 billion. In 2000, it reported a $165 million operating profit on revenues of $4.6 billion.

But like everything else associated with Pai’s company, those numbers appeared to be a mirage. To entice new industrial customers to sign long-term contracts, Enron Energy Services often paid them huge amounts of money to sign the contract. In one case - a 15-year energy supply deal with pharmaceutical giant Eli Lilly - Enron Energy Services paid the firm $50 million up front.

In other cases, the company used mark-to-market accounting to create the illusion of profits. In one deal, signed in February 2001 with Quaker Oats, Enron Energy Services agreed to supply 15 different Quaker plants with natural gas, electricity, and trained personnel to maintain the company’s boilers. Under the terms of the deal, which was later reported by the Financial Times, the company guaranteed Quaker would save about $4.4 million per year in energy costs. Then, before turning on a single light, Enron projected it would make $36.8 million profit over the life of the 10-year deal and immediately booked [said it had received] $23.4 million of that amount.

"Everybody I talked to always thought the mark-to-market thing would come back and bite us," said one veteran of Enron Energy Services. "You always had to find new deals to cover the previous deals." And just as the traders on Enron’s trading floor got paid to do big trades, the deal makers at Enron Energy Services got paid to book big deals, regardless of whether they were profitable or not. "The deal makers got paid all their bonuses up-front" when their deals closed, said one of Pai’s co-workers. "We didn’t know if a deal would be good or bad or ugly. I kept arguing that we needed to stretch out these bonuses and pay them out based on their success. But Lou always wanted to have them paid right away."

According to his co-workers at Enron Energy Services, Pai never appeared overly concerned about his company’s profitability. Those same co-workers admired his intellect, if not his work ethic. "Pai had a brilliant mind. He could think of several complicated things at one time," one source remarked. "While everyone was struggling to understand one part of the problem, he had everything figured out. Everyone who met him was impressed with him."

However, few people thought he applied himself once he got to the energy services business. He rarely took phone calls. He often sat in his office alone, reading the paper. Another source said Pai would often come in at 9am and leave by mid-afternoon. "And he never took any work home."

What Pai lacked in Protestant work ethic, he made up for in his compensation negotiation skills. In the early days of the trading business, "Pai would be in here every few weeks trying to renegotiate his contract," said one Enron veteran. "I’d throw him out of my office. But Skilling would always agree to sweeten his deal." Another long-time Enron employee who worked with Pai in the trading business said, "Everything Lou wanted was stock options. It was stock, stock, stock. Then when he went to Enron Energy Services, he got a whole other bunch of stock in that deal."

Enron was more aggressive in awarding options than almost any other company in the Fortune 500. By the end of 2000, over 13 per cent of all of Enron’s outstanding stock was held in options, and a big hunk of them were held by executives like Pai. Skilling and Enron chairman Ken Lay could dump Enron stock options on Pai and the rest of the favoured few because the accounting treatment for stock options was so favourable.

For companies, giving stock options was better than a free lunch: It was a lunch the company got paid to eat. Under the accounting rules in place in 2000, if Enron paid Pai a bonus of, say, $1 million in cash, the company would have had to report that expense on its profit-and-loss statement. But with options, even though Enron incurred real costs in granting them to Pai, the company didn’t have to record the expense on its profit-and-loss statement. Furthermore, Enron (and every other company that used options) could deduct the cost of the options as an expense from its tax liability.

All of that means that corporate honchos can reward themselves with a boatload (or two) of stock options without hurting the company’s profit reports. Then, when the options are exercised, the company could treat the appreciation in the value of the shares - the option holder’s profit - as an expense for tax purposes. By the end of 2000, Enron’s incredibly generous stock option ploy turned what would have been a federal income tax bill of $112 million into a $278 million refund. That’s better than any free lunch.

Of course, Enron wasn’t the only company using options to its advantage. Between 1994 and 1998, the number of options granted by companies in the Standard & Poor’s 500 jumped from 1.6 billion options to over 4.4 billion. And all of those options had a big effect on those companies’ profits. Between 1995 and 2000, the average earnings growth rate of America’s biggest companies would have been reduced by nearly 25 per cent if those companies had been required to report their stock option grants as expenses on their financial statements.

Stock options may be better than free for corporate fat cats, but they can cost shareholders real money. The most commonly recognised problem is shareholder dilution. When an executive exercises an option on, say, one million shares of stock, the company must add those shares to the existing number of outstanding shares. Thus, a company that had 100 million shares outstanding before the executive exercised the option would have 101 million shares available on the open market after the transaction.

That hurts the existing shareholders because their shares have been diluted (albeit fractionally) by the addition of the new shares. To combat the problem of dilution, many companies buy back their shares on the open market after executives exercise their options. The buyback reduces dilution, but it reduces the amount of cash available to the company for other expenses like equipment and inventory. If the option grants are really large, the company may even borrow money to buy back its shares, a move that weakens its balance sheet.

About the same time Lou Pai began selling huge blocks of his Enron stock, Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc - and the unofficial conscience of corporate America - protested the widespread use of stock options by American companies. In his company’s annual report Buffett wrote, "Whatever the merits of options may be, their accounting treatment is outrageous."

In August 1999, Federal Reserve chairman Alan Greenspan estimated that excessive use of options had caused American companies to overstate their profits by one to two percentage points over the previous five years. But those factors paled in comparison to the real danger of the massive stock option grants that had been passed out by Enron: they created a huge incentive for the company’s top management to cut corners, to keep important information hidden.

Enron’s annual reports show just how effectively Skilling was using those options. Before him, the number of stock options available to be granted to employees stayed relatively constant - Enron had about 25.4 million shares of its stock tied up in outstanding options. However, at the end of 1997, Skilling’s first year as president and CEO, the number of outstanding options that Enron employees could exercise had ballooned to 39.4 million shares.

By 1999, Skilling was handing out Enron stock options like they were nothing more than cheap candy. By the end of that year, Enron had granted more than 93.5 million shares of stock to its employees in the form of options. Skilling had turned Enron into a stock option colossus. And with their future potential wealth closely tied to the appreciation of the company’s stock, Enron’s top executives like Fastow, Pai and Skilling had millions of reasons to keep bad deals and bad debts from surfacing in the company’s financial reports.

By late spring 2000, Lou Pai was in his early fifties - older than any of the other members of Skilling’s mafia. And he had more responsibility than almost any of the other members of the Enron Executive Committee. He was the chairman of the New Power Company, a company that Enron was betting would be able to gain market share in retail energy markets by offering homeowners and others electricity and gas at prices lower than they were paying their local utilities companies.

Enron had placed a huge wager on New Power, which was nearly ready for its initial public offering. In addition, Pai had already been the chairman and CEO of the energy services business for three years. He was ready to slow down. He’d prowled Houston’s strip bars for more than a decade, and he’d found the one woman who really lit his fire. And besides, he was already Big Rich.

He’d spent about $23 million buying Culebra Peak and the ranch in Colorado. And he still owned about a zillion Enron stock options. It was time to sell and move on with his life. So he did just that. On May 31, 2000, Lou Pai became one of the first Enron Big Shots to take a huge payout under the company’s supergenerous stock option scheme. When the markets closed that day, Pai had sold $79.9 million worth of his Enron stock.

Lou Pai was cashing out. And there was more insider selling to come. Lots more.

Pipe Dreams: Greed, Ego and the Death of Enron by Robert Bryce is published by Public Affairs Ltd, priced 9.99.