Enron's implosion was anything but sudden

By TOM FOWLER Copyright 2004 Houston Chronicle

Dec. 20, 2005, 10:50AM

Enron's tumble from Wall Street darling to corporate deadbeat seemed precipitous. Now,
however, it's clear the fall was a long time coming.

While the company grew rapidly through the 1990s, some of the worst manifestations of its
culture -- obsessions with bonuses, the stock price and exotic accounting -- were also growing,
and out of control.

Though the corporation's character flaws can be traced to its earliest days, they flourished
under top executive Jeff Skilling.

He didn't act in a vacuum. Enron had a distracted, hands-off chairman, a compliant board of
directors and an impotent staff of accountants, auditors and lawyers.

But it was Skilling's relentless push for creativity and competitiveness that fostered a growth-at-
any-cost culture, drowning out voices of caution and overriding all checks and balances.

Skilling's attorney derides as "ridiculous" any suggestion his client allowed internal controls to be
overriden. But interviews with dozens of current and former employees over the past year reveal
that the creative aggressiveness Skilling deemed essential to dominating new markets went
untempered by good business sense or fiscal discipline. The same decisions lauded as key to
the company's future were also key to its demise.

"It was all about taking profits now and worrying about the details later," said one former Enron
deal maker. "The Enron system was just ripe for corruption."

Enron's culture wasn't spawned overnight. Its roots go back to the earliest days of the company,
before Skilling came aboard.

In 1987, company auditors learned of a billion-dollar oil-trading scandal at the company's

Valhalla, N.Y., offices. For years, traders there had falsified transactions to boost volume -- and
fatten their bonuses.

Instead of firing the traders and contacting authorities, Chairman Ken Lay and his management
team kept them on the payroll and tried to cover up the problems. Lay said the company needed
the revenue.

Six months later, however, the traders had dug the hole even deeper and competitors were
growing suspicious. If word got out, Enron's trading partners could have demanded the
company cover its positions with cash, which it didn't have.
Only then were the traders fired and charged with crimes. Enron narrowly skirted insolvency by
bluffing the markets, then slowly unwinding the trades. The company later reported an $85
million loss, but sources say it was probably at least $136 million.

Not long after, in the early 1990s, Enron made one of its earliest uses of creative financing,
through a massive English power plant project known as Teesside. Enron owned about half of
the project but was able to book as much as $100 million in revenue while the plant was still
being built by acting as its own general contractor. That was years before the project earned a
dime.

Teesside was also one of the earliest deals where managers reaped the benefits of an
aggressive bonus program. Those who closed major deals were paid up to 3 percent of the
value of the entire deal, payable when it was struck, not when the project actually began earning
money. Many former employees say this upfront bonus encouraged deal makers to inflate their
projected returns.

Deal inflation eventually became so widespread that one division, Enron Energy Services, had
to eliminate its bonus program.

"They realized they couldn't pay us real bonuses based on alleged profits," said a former deal
maker with EES.

Such practices were a byproduct of the company's obsession with its stock price, which was
driven in the earlier years by Rich Kinder, chief operating officer from 1990 to 1996.

Changing of the guard

Kinder, a lawyer, began as chief counsel but gradually became more like a president and chief
financial officer, demanding his managers meet lofty earnings targets, said former executives.

"He was very bottom-line oriented and would terrify people if they didn't meet their goals," said
former chief tax counsel Robert Hermann, who left Enron earlier this year. "If he could have
opened his office windows I'm sure he would have made people walk the plank."

Kinder left Enron in 1996 when it became clear Lay would not be stepping aside soon. That
opened the door for Skilling, who had joined Enron in 1990 after working with the company as a
consultant with McKinsey & Co. Except for their desire to grow the company, the two could
hardly have been more dissimilar.

Kinder focused on operations and cash flow, the best single indicator of a company's real
earnings. He met weekly with all division heads and grilled them on details, especially
expenses.

"Kinder would approve an expense as if it were from his own checkbook," said Alberto Gude, a
former vice president of information services. "He made you work through the details of your
spending before he'd say OK."

Skilling did not care about expenses or seemingly much about day-to-day operations. Former
colleagues say he disliked meetings, delegated responsibility and relied heavily on Chief
Accounting Officer Rick Causey for details of what the many divisions of the company were
doing.

Instead of cash flow, Skilling was concerned about revenue increases and widening profit
margins.

"It was a well-known fact that Skilling didn't care what the expenses were so long as the
margins looked good," said George Strong, a longtime lobbyist for Enron.

That became a problem beginning in the mid-1990s, when the company began buying,
expanding and launching businesses left and right.

"There were a lot of start-up businesses, so I guess he was content to let them have expenses
since that's what it took to build new business," Hermann said. "But there came a point in time
where he needed to call them in and say `OK, enough's enough.' "

"When Kinder left and Skilling took over the presidency," Strong said, "I started feeling that
people were not looking at the longer-term perspective."

No hiring of `softies'

A classic example of the short-term thinking came when Strong recommended the company try
to win a lucrative energy management contract for a major public school district.

"I told a manager that replacing the school district's current company wouldn't happen overnight,
that it could take as long as a year to convince them. But I hit a brick wall," Strong said. "He
said, `I haven't got a year. If I can't do it in three months I won't do it because my bonus
depends on it.' "

That attitude was a product of the atmosphere Skilling nurtured, his former colleagues say. A
key component of that atmosphere was hiring a certain kind of person. In the late 1990s, the
human resources department began giving recruiters a new set of "cheat sheets" on what to
look for in job candidates.

"It was not your typical, hard-working, extracurricular-activities type of student," said one
manager who helped with recruiting. "It was a sharp-dressing extrovert, someone who would fit
in as a ruthless trader. We weren't looking for softies."

Drawn from Harvard, Yale, Princeton, Rice, Northwestern and other leading universities, the
new hires were smart, even brilliant, but did not prove to be good managers.

"If you keep telling people how smart they are, after awhile they start to think they have nothing
else they need to learn," said one former manager, now in his mid-30s. "It was such a go-go,
high-achievement environment that there wasn't close monitoring to make sure people learned
the basics of good management."

The atmosphere became something like a college fraternity, where traders and deal makers
were treated as brothers and the rest of the staff as pledges, said a former recruiter.
"Working in any of the support positions was like going through rush," the former recruiter said.
"You'd have to become aggressive and ruthless before they would say, `Good boy, you're one
of us now.' "

To enforce his particular vision, Skilling encouraged all units to use an employee-evaluation
process he first implemented in Enron Capital & Trade, the division he first led.

That process -- "rank and yank," as it came to be called -- came to epitomize the company
culture. Employees spent about two weeks annually ranking fellow employees' value to the
company, from 1 down to 5. The process could be brutal, and often led to employees
downgrading their peers to make themselves look better. And each division was forced to rank a
fifth of the employees as 5s.

"We hired the best and brightest people, but now they were telling us we had to arbitrarily fire 20
percent of them. Why would we want to do that?" Hermann said. "Every company in America
uses some sort of rating system, but the way it was used at Enron was just too divisive."

Skilling's attorney, Bruce Hiler, said the idea that Skilling created a culture that damaged the
company is "ridiculous."

"There was an extensive internal control environment, which my client was instrumental in
putting in place," Hiler said. "There were about 15 people that reviewed people for performance
ratings, which would mitigate any possibility of anybody holding things over the heads of others.
It just doesn't make sense."

Sensible or not, many others say, it happened regularly.

People had to get it

The cultural changes in the company even threatened the very language that defined the
company's values: respect, integrity, communication and excellence. In the late 1990s, the
company's Visions and Values Task Force considered expressing the principles with words
such as "smart," "bold" and "aggressive." The effort failed, but it spoke volumes about what was
afoot at Enron.

Smart, bold and aggressive people tend to get impatient with rules. The relentless demand to
create new ways to make money -- or appear to make money -- spawned an environment
where raising questions about a deal was considered disloyal or, worse, an indication someone
"didn't get it."

In theory, Enron had mechanisms in place to raise such questions, to assess risk and
accurately report financial numbers.

Enron's external auditor was the once-venerable Arthur Andersen, dubbed the "Marine Corps of
accounting" for the hard-nosed attention to accounting standards it once exemplified.

Enron required that deals be rigorously analyzed, a process that often included review by the
legal department of the originating unit, the corporate legal department, the chief risk officer and
chief accounting officer.
But the system was easily overridden. Deal originators could determine the total value of their
proposals by manipulating such factors as the long-term price for whatever was being bought or
sold. Their bonuses were based on the total value of the deal, not the cash it brought in.

All this was designed to pump up the quarterly reports, made possible by "mark-to-market"
accounting, a system Skilling pushed Enron to adopt in 1991 that allows a company to report as
current revenue the total value of a deal over its projected lifetime.

Mark-to-market as it was used at Enron made earnings look good, pumping up the stock price
and increasing the value of the thousands of stock options executives received as
compensation.

"It was a moral hazard being able to record your profits immediately," one former executive said.
"It created many temptations."

Squelching dissent

Resisting that temptation was difficult. Testimony from the Arthur Andersen criminal trial in 2002
detailed how external auditors were often bullied to sign off on complex and controversial
accounting maneuvers.

Andersen partner Carl Bass said he was demoted from his role on the firm's prestigious internal
review group when Enron officials complained about his objections to certain deals.

Former Enron executive Jeff McMahon testified to Congress early this year that Skilling
essentially demoted him after he complained about Andrew Fastow's dual role as CFO and
manager of two outside partnerships that invested in Enron deals.

McMahon said Fastow had told him afterward, "You should assume everything you say to Mr.
Skilling gets to me."

And former Merrill Lynch analyst John Olson has said he was forced out of his job with the
company in Houston after his persistent criticisms of Enron.

Members of Enron's own internal watchdog group, Risk Assessment and Control, found it
particularly difficult to say no. Those who tried to stop deals regularly were given negative
performance reviews under "rank and yank," said former employees.

"The RAC would say the assumptions made in a deal weren't realistic, but they were never able
to kill a deal," said a former worker who tried to push deals through the group. "They could be
pushed around because they knew we could screw them over through the performance review
committee."

Another former trader said his boss's attitude toward accountants and risk managers was typical
of many in the company: " `If they're not here helping us close deals, there's no need for them,' "
he said.

Deal makers regularly invoked Skilling's name when trying to get their proposals approved, a
tactic that carried much weight because the head of RAC, Rick Buy, answered to Skilling.
Top dog's fear factor

The influence of Skilling went beyond his official title. In a company stuffed with brilliant people,
he was arguably the smartest.

One of the top students in his class at the Harvard School of Business and a former partner at
consulting powerhouse McKinsey, his intelligence was often intimidating, even to customers and
business partners, Hermann said.

"In a business situation you begin to wonder if you're going to be taken advantage of when
you're facing someone so smart," Hermann said. "We'd have to send marketing people out after
they met Jeff to calm them down and reassure them we were good people."

A senior engineer involved in international projects described one rank-and-yank session when
Skilling cut off some positive comments about a company veteran: "This guy has spent 30 years
in the same job in oil and gas. If he's that good he'd be a trader by now."

The Skilling fear factor rubbed off on a handful of other top executives whose close ties to him
made them known as "Friends of Jeff." They included Ken Rice and Kevin Hannon, the two top
executives with Enron Broadband; Greg Whalley, the president and chief operating officer of
Enron Wholesale Services who became president and chief operating officer of the company
after Skilling left; Dave Delainey, the CEO of Enron Energy Services; and John Lavorato, a top
energy trading executive.

Some observers believe Skilling's style was a product of his background with McKinsey.

"Rank and yank" was a variation on a system developed by McKinsey. The "asset light" mantra
that Skilling preached -- of a company that owned few hard assets and made all its money off
trading and services -- was also a McKinsey-endorsed concept.

But like many consulting firms, McKinsey has gained a reputation as a flock of thinkers, not
doers. Great at devising grand strategies, but not at making them work over the long term.

Skilling's background was reflected in his hands-off approach to details. Soon after taking over
as chief operating officer, he revived the long-dormant post of chief financial officer and
delegated many of the management responsibilities that Kinder had overseen to other
executives.

The McKinsey influence can also be seen in his vocal belief that Enron could adapt the skills it
developed in creating energy trading markets to such disparate products as Internet bandwidth,
paper products and even weather.

The belief was so strong that it wasn't felt necessary to hire executives with telecommunications
experience to build its broadband business. Instead, it simply gave the job to successful gas
traders such as Rice and Hannon.

"These were people that didn't know how to spell `broadband,' nevermind run that business,"
said a former senior vice president. "But if you questioned them and the wisdom of the
business, you would be ridiculed because you `didn't get it.' "
And when a business did fail or a deal fell apart, more effort was put into hiding the
consequences than owning up to the problem. Debt and losses were anathema to Enron's
financial statements.

In late 2000, for example, officials with EES, the division formed to sell power at the retail level,
decided to remove the hedges it had put on several big energy trades so it could lock in the
higher prices they were fetching during California's energy crisis. The maneuver allowed EES to
report a big profit one quarter, but when the markets broke the other way, it was hit with a loss
of as much as $800 million.

Rather than report it, former employees say, EES' trading activity was shifted under Enron's
main trading business, where the huge revenues easily concealed the big loss. The reason for
the shift was never publicly disclosed.

Similarly, four particularly notorious Enron partnerships, known as the Raptors, were created
solely to hide losses.

The Raptors were set up in late 2000 as hedges against the declining value of investments in
other companies. For example, in 1998 Enron invested $28 million in Rhythms NetConnections.
When the Internet service provider's stock went up, it was worth more than $500 million to
Enron. The company then recorded the increase as revenue even though it didn't sell the stock.

Since mark-to-market accounting would require Enron to report a decrease in Rhythms' share
price as a loss, Enron put the stock into one of the Raptors as a hedge against such a drop. But
Enron used its own stock as its contribution to the partnership, assuming that its own share
price would not fall. When both stocks fell at the same time, the Raptor went bankrupt.

How did it get this way?

In retrospect, Enron's problems may seem obvious. But the view from inside the company was
rarely clear.

"Every division and business unit was like its own silo, separate from all the other businesses,"
said the former CEO of one of the divisions. "It was decentralized and not heavy on teamwork,
with all of the divisions in competition with each other for resources."

Many employees say they saw things that were a concern, such as over-the-top bonuses and
rampant expense-account abuse.

"I used to feel bad about the cost of my hotels overseas, so I'd eat at Taco Bell," said a former
division president. "But then I'd hear about these young managers dropping hundreds of dollars
every night on meals, and I wondered what had happened to allow that."

But since most only saw their part of the business, they assumed the problems were isolated.

"You understood your piece of the business and maybe what the guy next to you did, but very
few understood the big picture," a former broadband worker said. "That segmentation allowed
us to get work done very quickly, but it isolated that institutional knowledge into the hands of
very few people."
Despite the company's downfall, many former employees say they still do not regret their time
there.

"I lived the culture at Enron for 10 years and I really think it was the individual executives who
did this to us," said a former trading executive. "Most everybody I knew at the company was
honest and charitable."

"I don't think anyone started out with a plan to defraud the company," Hermann said.
"Everything at Enron seemed to start out right, but somewhere something slipped. People's
mentality switched from focusing on the future good of the company to `let's just do it today.'

"But once you start doing deals like that, maybe your mindset changes. Maybe you start to do
deals just to do them."

Over the years, Strong said he saw many opportunities for key Enron employees to speak up.

"But they chose to look the other way," he said. "The culture wasn't one that wanted to hear
about such concerns."

"In principle the system would work," said a former executive. "But it broke down because those
expected to hold others accountable either didn't have the power to do their job or they lacked
the will.

"In a business as risky as ours you can't afford to take off the safeties."