Hidden Debts, Deals Scuttle Last Chance

'A $690 Million Bullet'

On Nov. 19, the big public news of the day was the filing of the company's quarterly financial report. Enron revealed that it had run through more than $1.5 billion in cash since announcing the Dynegy deal, just 10 days before. Much of the cash was apparently extracted by companies now demanding more collateral from Enron on existing long-term energy transactions.

That was just part of the bad news.

Enron had told Dynegy before their merger that its European trading operations had a $53 million operating profit in the July-September quarter. But in its disclosure, Enron reported that its European operations had actually taken a $21 million loss.

Most devastating was Enron's disclosure that a $690 million loan, due to be settled in two years, might have to be repaid within weeks because of the latest drop in Enron's credit rating, to one level above junk-bond status.

If Enron's credit rating was reduced to junk status, confidential clauses in its financing contracts required it to accelerate payments on an additional $3.9 billion in debt from two off-the-book partnerships. Analysts immediately concluded that Enron couldn't pay.

The appearance of these obligations was the last crack in Enron's carefully crafted facade.

The magnitude of Enron's debt had been one of its most carefully guarded secrets, a fundamental reason for the web of private and off-balance-sheet financial deals Fastow's team had spun.

In September, Enron had said its debts totaled $12.5 billion. But it had billions more in off-balance-sheet obligations.

Enron's two lead bankers had become important enablers in the company's efforts to disguise its debt, a Senate subcommittee would later conclude. The banks deny that assertion.

Officials at J.P. Morgan and Citigroup worked with Enron finance executives to develop a series of transactions called prepays that on the surface looked like sales of commodities -- in most cases, natural gas. But they worked like hidden loans, Senate investigators said.

Instead of being disclosed as debt, the funds that Enron received from the banks were commingled with trading revenue on the company's financial statements. The transactions were a crucial source of cash, but investors could not tell that the funds would have to be repaid -- just like loans. Bank officials said the deals were legal and Enron reported them as trading transactions.

The company had raised $8 billion in this way since the mid-1990s. As its problems mounted in 2001, Enron drew on prepays even more heavily, raising $5 billion in the first half of the year alone.

Watson was surprised by the debt disclosure, which he would later call a "$690 million bullet in the head."

Watson demanded to meet with Lay the next day. He wanted answers.

"I said that I had to know exactly where the $1.5 billion went," Watson said later. Lay's answers didn't satisfy Watson.

A spokeswoman for Lay said he disputed Watson's account. Had the Dynegy chief executive asked about Enron's cash position, Lay would have turned the question over to his chief financial officer, she said.

Watson had cast himself as Enron's savior. But he made some Enron executives uneasy -- they wondered whether his real goal was to scuttle the merger and run off with Enron's pipeline.

The revelations about the $690 million obligation and the vanishing cash gave Watson an opening to back out of the deal.

Negotiations Seesaw

In the days after Thanksgiving, Lay tried to salvage the Dynegy deal. He was now willing to accept less than half of the original purchase price. Enron's major lenders, who could not free themselves from the company without accepting huge losses, agreed to put more money into the deal.

Gathered at a Westchester, N.Y., conference center on Nov. 23, Lay and his team met hour after hour with Dynegy representatives. Watson, in touch by phone, stayed in Mexico for a family vacation. Negotiations seesawed for several days.

On Nov. 26, Lay boarded an Enron corporate jet for home, believing, aides said, that negotiators had made progress and that an agreement was within reach.

As his plane sat ready for takeoff, Lay got a phone call. Watson would not go along after all, aides told him.

Enron had produced too many surprises.

Watson complained that no one could tell him what Enron was really worth. The deal was dead.

Lay had failed, and the company he had built over the past 15 years was failing with him. From the summit of success just two years earlier, Lay could not unload his company even at a bargain price to a smaller rival. His house of cards had tumbled.

'A Pretty Good Meltdown'

Enron's bankers, meanwhile, were scrambling. On Nov. 26, a J.P. Morgan banker exchanged e-mails with a business associate quoting a colleague as saying Enron was close to defaulting on its prepay contracts and "in the grip of 'a pretty good meltdown.' "

The same day another J.P. Morgan banker sent an e-mail recounting a "Large Exposures Meeting" where bankers calculated that Enron owed the bank $353 million just on mark-to-market energy trades. The next day, a puzzled J.P. Morgan vice chairman responded: "still hard for me to get a fix on this . . . What is our loss potential?"

On Nov. 28, the credit-rating agencies downgraded Enron to junk-bond status, after concluding the Dynegy takeover would not succeed. Enron's stock price dropped from $4.11 to 61 cents. That day, Enron shut down its online trading business, just shy of its two-year anniversary.

Only bankruptcy was left.

A Surprise Bonus

That same day, Enron's chief tax counsel, Robert J. Hermann, returned from vacation to find panicked colleagues scrambling to salvage what they could of their life savings.

Word was spreading that the company might file for bankruptcy protection that weekend.

The company was letting some executives get money out of one of its deferred-compensation plans, where employees had banked salaries and bonuses in flush times. By 9:30 a.m. Hermann had submitted a form asking to withdraw $60,000 from the only plan he participated in that was permitting withdrawals.

Anxious to help a friend, Hermann quickly e-mailed the form to retired Enron vice president Alberto Gude. By about 10 a.m., Gude had filled out the form and shot it back. Hermann's secretary rushed to turn it in.

Hermann, still an important Enron insider, received his money the next day. Enron wired it into his bank account, he said. But with money running out, Enron favored current employees over retirees. Gude never received a penny.

Throughout the week, there had been rumors that some people were getting generous bonuses to entice them to remain through the difficult months ahead.

At about 5 p.m. on Friday, Nov. 30, Hermann was sitting in his office when the phone rang. It was his boss, telling him somewhat mysteriously to leave headquarters and meet him across the street in Enron's new building, where builders were still applying the final touches.

Hermann did. His boss presented him with two envelopes, telling him one contained a bonus check for Hermann, and the other held checks for more than a dozen key employees in the tax department.

Hermann's heart sank. The banks were closed. By Monday morning there wouldn't be a bank in Houston that would cash a check from Enron.

"What good is it?" Hermann thought, walking back to his office.

He lifted the flap on one of the envelopes. It was filled with cashier's checks. This was Enron after all, and the company still knew how to pay a bonus.

"I thought 'how are they going to make this work?' " Hermann recalled. "But dammit, somebody had figured it out."

Alone at the End

Ken Lay was alone. He drew back a privacy curtain in the emergency room of St. Luke's Episcopal Hospital and padded into view bare-legged, wearing a half-tied hospital gown, slippers and a confused expression.

It was Saturday, Dec. 1, less than 24 hours before the fast-ebbing braggadocio of Enron, the self-proclaimed World's Leading Energy Company, finally dissolved into bankruptcy.

Lay wanted out of the hospital. He was needed at an important meeting downtown. The besieged executive locked eyes with the first person he encountered and mistook him for a emergency-room worker.

"Do you know when I'm going to be able to get out of here?" Lay asked a shocked Jeff S. Blumenthal, 38, an Enron tax attorney. Blumenthal happened to be at St. Luke's waiting for his wife, who had fallen off a horse, to be X-rayed.

"Well, I sure don't; I don't work here," Blumenthal recalled saying, embarrassed, as he tugged his scruffy weekend sweater to indicate it wasn't medical garb. He directed Lay to a nearby nurse.

"I thought, 'surely, the guy's not in here with chest pains' because nobody was paying much attention to him," Blumenthal recalled in an interview. In fact, Lay told him he was there with an earache.

"There were six rooms in the emergency room," Blumenthal said. "All six were filled with patients. Everybody had somebody with them, a wife, a husband, a couple of kids. He was the only one who was all alone."

Looking back on the fall of Enron, one former executive of the company thinks about a 15th century allegorical poem and the painting it inspired: "Ship of Fools."

The painting by Hieronymus Bosch depicts all humankind- the saints and the sinners- aimlessly voyaging through the ages toward unreachable harbors. Every passenger is a fool. The Ship of Fools is not about other people, one commentator observed, it is about us.

"The world wants to be deceived," the poem says.

The flaws of Enron began at the center and radiated outward in ever-larger circles. Former chief executive Jeffrey K. Skilling was determined to create a company like none other, and he did. Enron was unique: a true innovator in energy marketing.

But the company also was a master illusionist, taking advantage of the most arcane accounting and legal technicalities to turn debt into equity, loans into cash flow and tax-deductions into earnings. A multitude of technical truths added up to a false portrait of success.

Kenneth L. Lay was the paterfamilias, an inspiring and comforting figurehead until he failed. Skilling was the strategist, whose hubris drove Enron beyond the rules. Andrew S. Fastow was his indispensable tactician.

They did not act alone. Inside Enron, a wider circle of executives saw what was wrong and didn't stop it. Most never thought to try. It wasn't only the bonuses, the $750 million paid in 2000 alone. Enron's tale of success was so compelling that people who had ethical doubts just doubted themselves.

"Bells and whistles go off, but then you say it's Jeff and Ken and Andy and everybody is supporting it . . . so maybe if I don't get it, maybe I'm wrong," one high-ranking executive said. "You got lulled. You got seduced. If you didn't jump on the bandwagon, maybe you just weren't smart."

One former Enron executive struggling to understand what went wrong noted that a frog dropped in a pot of boiling water will quickly jump out and save itself. But put a frog in cool water and turn up the heat gradually, and it will stay until it dies.

"That's us," Robert J. Hermann, the company's former general tax counsel, agreed.

Beyond Enron, the cream of an entire generation- the brightest minds at the best legal, accounting, investment and consulting firms- helped the company present its charade of profitability and success. Of Enron's $1.5 billion in earnings in the 15 months leading up to September 2001, more than $1 billion came from financial and accounting gimmicks that became the real business of Enron, investigators for Enron's board concluded.

Accountants and lawyers would attest to the legality and correctness of the particulars of Enron's dealmaking without challenging the misleading impact of the whole.

A Merrill Lynch & Co. senior finance executive wrote a note to himself in 1999 about the hazards of helping Enron write its financial fiction: "Reputational risks i.e. aid/abet income stmt [statement] manipulation."

Enron's chief accounting officer, Richard A. Causey, followed accounting rules and had gotten Andersen's approval on major accounting actions at the company, his lawyer said this week. Enron's outside directors relied on Andersen's judgment, an attorney for the directors said.

Enron was a product of its times. It became addicted to growth, and when real growth stopped took greater and greater risks to create the appearance of growth, said Robert F. Bruner, a University of Virginia business professor who studied the company.

The death spiral of Enron's stock price, from a pinnacle of $90 a share late in 2000 down to pennies, wiped out more than $60 billion of stock market investment, much of it in the mutual funds and retirement accounts of typical Americans.

Enron mirrored the cycle of speculation and market mania in the 1990s stock market that brought woe to millions of investors- all passengers on the ship of fools.

"Nobody wanted to hear bad news," said Tom Peters, the famous management consultant who once was Skilling's colleague at McKinsey & Co. "Did Miss Smith or Mr. Jones whose entire pension fund was wiped out get what they deserve? Of course not. But did we collectively get what we deserved? Absolutely."

In the eight months since Enron's bankruptcy, a growing list of companies have followed it on scandal's path, led by WorldCom, Global Crossing, Tyco International, Adelphia Communications and Qwest Communications.

Corporate wrongdoing has catapulted to the top of Washington's agenda. A month ago, the accounting industry and Republican allies had bottled up a major accounting reform bill in Congress. Then WorldCom, the nation's second-largest telecommunications company, followed Enron into bankruptcy court, and reform suddenly became bipartisan.

On Tuesday, President Bush signed accounting-reform legislation that supporters call the most important crackdown on corporate crime since the New Deal.

It creates an oversight board to investigate and punish accounting violations. Chief executives and financial officers must certify the accuracy of financial statements. White-collar criminals will face fines as high as $5 million and prison terms of up to 20 years.

"This law says to every dishonest corporate leader: You'll be exposed and punished. The era of low standards and false profits is over," Bush said.

Congress is working on legislation to protect workers' pensions, an effort inspired by Enron's mishandling of its employees' savings plans.

Corporate lobbyists have stalled proposals to require companies to count stock options as business expenses. In the wake of Enron and WorldCom, however, some companies have made the change voluntarily, among them General Electric Co., Coca-Cola, Wachovia, Bank One and the Washington Post Co.

The excesses of Enron have turned government regulators into reformers, too.

Enron was a prime beneficiary of the relaxed regulatory climate of the 1990s.

Lay, an energy regulator in the 1970s, built the company to take advantage of the deregulation of natural gas prices and sales that began in the Reagan administration. Regulators once were overwhelmed by Enron. "I don't think FERC [the Federal Energy Regulatory Commission] could have penetrated the operations of Enron in such a way to prevent what has happened," said James A. Hoecker, who chaired the commission during Enron's rise.

Energy and securities regulators, facing intense political and public pressure, have vowed to learn from the lessons of Enron. But important accounting rules exploited by Enron haven't been touched by reforms, and the task of preventing future scandals rests largely on the agencies that couldn't stop Enron.

Enron's secrecy and complexity, which once bewildered regulators and investors, now bedevils law enforcement.

The government has arrested some executives recently accused of simple accounting, tax or stock fraud at other companies. But prosecutors are moving slowly to document their theory that fraud broadly permeated Enron.

Enron executives who are the central focus of that investigation now live strange new lives, consulting with criminal attorneys in between taking their kids to ball games.

No Enron executives have been charged.

In a criminal fraud complaint against three British bankers, federal authorities said Fastow helped them organize a scheme to cheat the bankers' employer, an investor in one of Fastow's former partnerships. The former Enron CFO is coaching a son's youth baseball team, fishing, jogging and preparing to move into a 12,000-square-foot home in Houston's elegant River Oaks neighborhood, according to news reports.

Lay has begun showing up at charity events and board meetings around Houston, but people don't defer to him as they once did. "He is calm, poised and very thoughtful. But anyone who thinks he hasn't been massively impacted and deeply hurt by this is dead wrong," said James D. Calaway, president of the Center for Houston's Future.

Sherron Watkins, 42, whose memo to Lay triggered the series of events that ultimately exposed the folly that was Enron, still works there. She's busy assessing the value of Enron's assets for the creditors' committee in bankruptcy court. Her oil executive husband remains enormously proud of what she dared to do.

"She's the only one who felt compelled to come forward to say, 'wait a minute, what are we doing here? Is what we're doing allowed?'" Richard Watkins, 52, said this week. "She doesn't need anyone else to tell her what's right. She knows what's right."

The human toll of Enron's fall is still being tallied. Thousands of employees from Enron and its accounting firm, Arthur Andersen, lost their jobs as the companies fell together.

Alberto Gude, an Enron retiree, lost his life savings and was forced to go back to work in a consulting job that keeps him on the road, away from his family, five nights a week.

"Sometimes I wake up in the middle of the night and say: 'This is not happening,'" Gude, 62, said last week.

In January, J. Clifford Baxter, 43, a former Enron executive who had idolized his close friend Skilling, left his beautiful suburban home in the middle of the night, parked his Mercedes-Benz and shot and killed himself.

"He was heartbroken," said Bob Gray, a friend and Houston attorney who eulogized Baxter at his funeral. "He felt all the good things they had hoped to build were sullied."

Skilling proved a compelling and charismatic mourner.

"Did you ever see the movie the Big Chill?" Gray asked, recalling the scene as he, Skilling and other Baxter friends held vigil. "It was 10 days of intense crying together, laughing together, working on trying to understand and get things settled."

Skilling may have unwittingly written as good an epitaph as Enron will ever get.

After taking over as Enron's chief executive in February 2001, he gave an interview with the company's in-house magazine.

Asked about the best advice he had ever received, Skilling replied: "If it doesn't make any sense, don't believe it."

Staff researchers Margot Williams and Lucy Shackelford contributed to this report.