Losses, Conflicts Threaten Survival

That was the toughest question Lay fielded. The analysts seemed satisfied.

Asked last week to comment on Lay's statements, a Lay spokeswoman responded: "Based on the information available to him from whatever source, Mr. Lay firmly believed his statements to be true."

Word Leaks Out

Watkins had warned Lay of a growing risk that the company's "funny accounting" would wind up in the newspapers.

On the morning of Oct. 17, it did. A Wall Street Journal article spotlighted Fastow's conflicting roles as both Enron's CFO and the head of LJM. The article pointed out that Enron's recent losses occurred in deals with Fastow's partnerships. But the newspaper quoted Lay as saying all was well -- no conflicts had been permitted.

The following day, another Journal story zeroed in on the $1.2 billion reduction in shareholder equity. The reduction troubled people on Wall Street because Enron had done a poor job of explaining it. Moody's had put Enron's long-term debt on review for a possible downgrade.

In cryptic bits and pieces, the story of LJM finally was coming out.

Lay traveled to Boston that day to try to mollify about 40 investment-fund managers and securities analysts. Enron treated them to an elegant lunch at the Four Seasons Hotel. Cued by a PowerPoint presentation, Lay led the analysts through predictions of ever-rising revenue.

What the analysts wanted to know about was the $1.2 billion error highlighted in that morning's paper. Instead, the Enron chairman attacked the critical press coverage, calling it an irresponsible wild goose chase. Lay vigorously defended Fastow and assured the audience there were no more losses coming from other private partnerships.

Gregory Phelps, who manages $1 billion in energy and utility stocks at John Hancock Advisers Inc., noticed that Lay was looking right at him.

"This is a one-time thing," Lay said, according to Phelps. "There is nothing else out there."

Lay took one or two more questions, then suddenly looked at his watch and stopped. Lay's aides said, " 'We have to go' and just hustled out of there," Phelps said later.

'A Big Disconnect'

As dawn broke over Houston four days later, Oct. 22, news traveled over the financial wires: the SEC had launched a preliminary inquiry into Fastow and his partnerships.

At 8:30 a.m., Lay presided over a long-planned meeting with Enron's top-tier managers in the Dogwood room on the third floor of the Hyatt in downtown Houston. The meeting had been scheduled to review the company's third-quarter financial results. About 200 executives, the burnished elite of Enron's brain trust, attended.

Most hadn't yet heard about the SEC investigation, and Lay didn't mention it. Instead, he told those assembled that Enron's board and senior management were united behind Fastow. Lay wanted his executives to unite behind Fastow, too.

As Lay talked, some in the audience checked handheld BlackBerry messaging devices. News of the SEC investigation flashed. Enron's stock price flashed, too. The shares were plunging. Before the day was over, the stock would drop 20 percent, to $20.65.

Sharp, testy questions errupted about the company's vulnerable position and Fastow and his private partnerships.

Lay tried to reassure the managers.

"Well, we don't think we did anything wrong, but knowing what we do now, we would never do it again," Lay said, according to Robert J. Hermann, then Enron's general tax counsel.

Hermann had everything invested in Enron: his professional pride, his network of golfing buddies and his retirement savings, worth more than $10 million before Enron stock began to tumble.

Hermann raised his hand and said: "Ken, there is a big disconnect. How can you say we didn't do anything wrong, but would never do it again? Is 'what we know now' is that we got caught?"

Lay glared at Hermann. "It was like I'd put my head on the tracks," Hermann later recalled.

Vince Kaminski, the respected and normally reserved head of research, raised his hand and told Lay, "I'm in the terrible position of having to disagree with you."

"It's okay, anybody can," Lay said, according to one account. He invited Kaminski, a Polish-born mathematics whiz and expert in risk management, to speak.

Kaminski strode to the podium and accepted the microphone.

Enron should never have gotten involved in secret, high-risk deals with Fastow's private partnerships, he said. He had warned against that course back in June 1999.

"What Andy Fastow did was not only improper, it was terminally stupid," Kaminski said. "The only fighting chance we have is to come clean."

Lay looked "sort of blank," Hermann recalled. "It was like somebody getting pummeled, and he just stood there and took it."

Finally, Enron's new president, Greg Whalley, who had taken over when Jeffrey K. Skilling resigned in August, stepped in. "That's enough, Vince," he said.

Fastow's Role

Early the next morning, Oct. 23, Lay and a small group of advisers huddled in the conference room adjoining his 50th-floor office suite. The mood was tense.

In just a few minutes, Lay was scheduled to preside over a live webcast chat with securities analysts. Enron had to address the growing firestorm about Fastow's role in the LJM partnerships.

Enron's publicists and executives had drafted a carefully worded script. It suggested that no one at Enron was responsible for the LJM partnerships. Failure, it would seem, was an orphan.

With minutes to spare before the conference, Ronald T. Astin, a lawyer with Enron's outside law firm, Vinson & Elkins LLP, was asked to help fix the script. He rewrote it to say that it was Fastow who presented the LJM proposal to the board.

Fastow read Astin's changes and exploded, Astin later told investigators. Fastow yelled that Astin was wrong about who was responsible for LJM. "It was Skilling!" he shouted.

At 8:30 a.m. Houston time, financial analysts from Boston to San Francisco joined the conference by phone and Internet.

"There has been a lot of recent attention to transactions Enron previously entered into with LJM, a private equity partnership," Lay said, addressing LJM and Fastow head on. "Let me reiterate a couple of things. We clearly heard investor concerns earlier this year, and Andy Fastow, Enron's chief financial officer, ceased all affiliations with LJM."

Lay added that Fastow was doing "an outstanding job."

"We're very concerned the way Andy's character has been kind of loosely thrown about over the last few days in certain articles," Lay said. Fastow's role at LJM had been monitored rigorously so that Enron's interests would never be compromised, he said.

This conference call was much tougher than the one a week earlier. One questioner after another pressed Lay and his aides for more information about Fastow and Enron's hidden debt obligations.

"There is an appearance that you are hiding something," said Fleischer, the Goldman Sachs securities analyst who once had been such a strong Enron booster that he compared the company's magical earnings growth to Michael Jordan's scoring.

"We're not trying to conceal anything," Lay responded. "We're not hiding anything."

After the analysts call, Lay went almost immediately to another arena, a Hyatt ballroom packed with several thousand Enron employees.

"Let me say right up front, I am absolutely heartbroken about what's happened," Lay said.

"Many of you were a lot wealthier six to nine months ago, are now concerned about the college education for your kids, maybe the mortgage on your house, maybe your retirement, and for that I am incredibly sorry. But we are going to get it back."

Lay read a series of questions from the audience. Nerves were frayed. Decorum had vanished. One employee had written: "I would like to know if you are on crack? If so, that would explain a lot. If not, you may want to start because it's going to be a long time before we trust you again."

That very day Lay took a $4 million cash advance from the company. Over the next three days, he would draw an additional $19 million. He immediately repaid $6 million of the amount by transferring his Enron stock to the company. That allowed him to unload stock but avoid an immediate reporting requirement. A board member later called this Lay's "ATM approach."

Lay's spokeswoman said recently: "He could not have done these transactions without Enron's knowledge. These transactions were in accordance with his employment contract."

Shredding Intensifies

The accountants at Andersen listened to Lay's conference call and were troubled. "The call did not go particularly well," Duncan would later say. "There were many pointed questions asked that the company appeared to struggle to fully answer."

Immediately afterward, Duncan held a meeting with his audit team and told them to get serious about complying with the company's document-retention policy.

Andersen had known for days that Enron could expect a SEC subpoena for its records, Duncan later testified. But none had arrived by that afternoon.

Andersen's Enron audit team asked Sharon Thibaut, the woman overseeing document shredding at Andersen's main Houston office, to send empty trunks for them to pack with documents they wanted destroyed. The auditors filled more than 18 trunks and more than 30 boxes.

E-mails flew back and forth between Andersen offices around the world as accountants discussed what to destroy.

Over the next few days, shredding at Andersen reached a crescendo and e-mail deletions nearly tripled.

Overwhelmed by the volume, Thibaut asked for extra help from the firm's outside disposal service, Shred-it. The company motto: "Your secrets are safe with us."

Andersen said later that the Enron documents were destroyed under its routine document-retention procedures and not in an effort to cover up anything.

A Simple Question

Enron's board of directors was just beginning to grasp the predicament.

For years board members had gone along compliantly with Enron's management. One former executive described board questions as "Tee-ball stuff: Are you happy with everything?"

Board member Charles A. LeMaistre, president emeritus of the M.D. Anderson Cancer Center at the University of Texas, told the Wall Street Journal that Fastow's LJM compensation was a way to keep him at Enron.

"We try to make sure that all executives at Enron are sufficiently well paid to meet what the market would offer," he said.

But neither LeMaistre nor the other directors knew just how lucrative a deal LJM had been for Fastow. Everybody had always tiptoed around the subject.

In the first year of LJM's existence, the board didn't ask for details on Fastow's income. Skilling asked a few questions but didn't obtain the right answers. In October 2000, the board asked its compensation committee to get the answer.

LeMaistre, head of the committee, chose a roundabout route, asking Enron's compensation director to provide the outside income of all top executives. He said he hadn't singled out Fastow because he didn't want to start office gossip.

He didn't get the information, so he asked again. When that attempt failed, LeMaistre gave up, he told Senate investigators.

Even as October wore on and the furor over Fastow's partnership deals grew, LeMaistre remained timid about confronting the young executive about how much money he'd made from LJM. He sought out Enron's general counsel, James V. Derrick, for advice in adopting just the right tone. Derrick prepared a polite script for LeMaistre: "We very much appreciate your willingness to visit with us."

Armed with the script, LeMaistre telephoned Fastow and posed the question: How much?

It was $45 million, Fastow said.

LeMaistre wrote in the margin of his script: "incredible."

Fastow Departs

Fastow's answer stunned Lay, too, he said later. A day after publicly praising Fastow, Lay concluded he had to go.

Lay replaced him with former treasurer Jeffrey McMahon, who had questioned Fastow's conflicts in the spring of 2000 and soon found himself in another job with the company. Now, with those conflicts exposed to the light of day, McMahon took Fastow's job.

Lay announced Oct. 24 that Fastow had taken "a leave of absence."

"In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as CFO."

That day, Carol Coale of Prudential Securities Inc., an early Enron skeptic, became the first analyst to break from the pack and issue a sell recommendation for Enron stock.

Chewco Emerges

Two days later, another problem emerged.

On Oct. 26, a subdued Ben Glisan faced his team of accountants and lawyers inside in-house attorney Kristina Mordaunt's office at the 1400 Smith St. headquarters tower.

Somebody tell me we didn't do this, he pleaded.

Glisan was Enron's treasurer, Fastow's clever and trusted aide. He had helped design the Raptor deals and dreamed up many of the colorful names for the company's confidential investment deals.

Soon after Fastow's abrupt departure, the media began getting tips about another Fastow deal named Chewco. The Wall Street Journal had just published a story raising questions about the deal.

So Glisan gathered his troops and dispatched a manager to retrieve the Chewco file. The file revealed a series of accounting errors.

In the waning days of 1997, Fastow's team had created Chewco Investments L.P., a confidential partnership that Enron needed in order to keep more than $600 million in debt off the company's books, hiding it from analysts and ordinary investors. It was the first time the company had set up an off-the-books partnership run by one of its own employees, making it a precursor for the LJM1 and LJM2 private partnerships later run by Fastow.

Enron could have sought truly independent investors. But Fastow saw a different opportunity: Enron would create a private investment group and Fastow would assign his top deputy, Michael J. Kopper, to manage it.

Using code names to conceal their identities in the documents, Kopper and his domestic partner, a Continental Airlines employee named William Dodson, became Chewco's "owners." The pair put in $125,000 of their own and borrowed $11 million more from Barclays Bank. Enron guaranteed those loans, further undermining Chewco's independence from the company.

The deal had worked out splendidly for Kopper and Dodson. When Enron closed down the partnership early in 2001, it paid them $10.5 million -- nearly 100 times their investment. Earlier, McMahon, then Enron's treasurer, had clashed with Fastow over the size of Kopper and Dodson's windfall, arguing that it should be no more than $1 million. Fastow prevailed.

Kopper and Dodson have declined requests for interviews.

Chewco would prove disastrous for Enron. Accounting rules required that at least 3 percent of Chewco's funding come in the form of equity from outside investors in order for the partnership to be considered independent for bookkeeping purposes.

Through an apparent oversight back in 1997, Kopper and Dodson's stake in Chewco had fallen just short of the 3 percent outside equity stake required to make the deal conform to accounting rules.

In October 2001, leafing through the Chewco file, Glisan looked dejected. The error was plain to see.

"We're toast," Glisan said, according to one colleague's account.

Now Glisan would have to tell the beleagured Lay about another mistake. Because Chewco was no longer considered independent of Enron, the company would have to restate its earnings downward, taking a $405 million loss.

Technical Truth

Lay also had to deal with the SEC inquiry. Needing outside expertise, Lay hired former SEC enforcement chief William R. McLucas and his partners at the law firm of Wilmer, Cutler & Pickering. McLucas and his colleagues urged Lay to make an independent investigation of Fastow's conduct. Lay immediately agreed.

Williams Powers, dean of the University of Texas School of Law, was added to Enron's board to head the inquiry, aided by Wilmer, Cutler lawyers. Enron announced the appointment of the special investigative committee on Oct. 28. Soon, a squad of outside lawyers and accountants were fanning out through the company headquarters asking tough questions.

In this atmosphere a nervous Mordaunt told Enron general counsel Derrick that she'd invested with Fastow in an LJM deal. She didn't want Lay to be blindsided, she said.

Mordaunt was advised to talk to the outside attorneys, who had taken over most of the fourth floor of Enron's headquarters.

She told them her story: Nineteen months earlier, in March 2000, Kopper had invited her to join in a confidential investment deal that would take place when the LJM1 partnership was terminated. Fastow had organized it. Ben Glisan and other Fastow confidantes also got a piece of the deal.

They called the partnership Southampton Place, after a swank Houston neighborhood favored by many young Enron executives. Southampton bought out the interests of one of LJM1's principal investors, a British bank, and then Enron brought out Southampton, adding another step to the process -- and another round of profit-taking.

When the deal was concluded in May 2000, the partners' secret profits were astounding.

Glisan and Mordaunt had invested $5,800 apiece. Each got back a cool million. The Southampton investors had worked on both sides of the deals Fastow structured between LJM and Enron. Glisan and Mordaunt were responsible for protecting Enron's interests as the deals were struck, negotiating for Enron against LJM. Yet they had allowed themselves to be made rich by LJM's conflicted general partner -- Andy Fastow.

Once the outside attorneys began hearing about Southampton, the Enron executives who'd invested in it were finished.

Glisan and Mordaunt were confronted, fired and escorted from the building.

Glisan declined a request for an interview through his lawyer. Mordaunt's attorney, Hayden Burns, said she did not know the deal was improper when she invested. Mordaunt, in a second interview with Wilmer, Cutler attorneys, broke down. She felt distress because "there was so much about these transactions that she did not know," Burns said.

When McMahon had succeeded Fastow he asked Glisan whether he was involved in any outside partnerships. No, Glisan said, McMahon later told investigators.

So after Glisan was sent home in disgrace, McMahon called him.

Why had Glisan lied? McMahon asked him.

He had only invested in a subsidiary of a partnership that did business with Enron, Glisan replied.

So it wasn't a lie, technically, he said.

Calling on Friends

Enron's bankers were starting to get worried, and the company executives feared they would desert them. That would be the death blow. The company had borrowed billions of dollars from the leading banks of New York, Switzerland, Canada and Germany, backing the debt with promises of Enron shares. If Enron's stock price fell below specified trigger points and its credit was downgraded in tandem, the lenders could demand immediate payment, bankrupting the company.

The stock price had already fallen below the triggers. Only the company's investment-grade credit rating remained as a buffer against approaching disaster.

The three major private credit-rating firms had given Enron slack in the past. Now a decision by any one to severly downgrade Enron's credit would cut the company's lifeline of cash from banks, triggering a relentless sequence of loan defaults.

Lay still had friends in Washington, cultivated through six presidencies by his extensive political fundraising for both parties. His calls were taken by the top people.

On Oct. 28 and 29, Lay told two members of President Bush's cabinet about Enron's growing financial crisis. He said to Commerce Secretary Donald L. Evans that Enron would "welcome any kind of support" in heading off a threatened credit downgrade by one of the credit agencies, Moody's Investors Service.

Bush administration officials looked at Enron's plight, then backed away from any intervention.

On Oct. 29, Enron locked down its company 401(k) savings plan for two weeks, barring employees from selling Enron stock they had purchased for their retirement. More than $1 billion of the plan's funds had been invested in the company's stock at the beginning of the year, when the stock was selling for nearly $80 a share. Those savings were vaporizing as the price plunged.

Enron said the action had been planned for a long time to make administration changes to the savings plan. Enron employees later filed a lawsuit alleging that the company blocked them from selling in an effort to prevent the stock's collapse from accelerating.

During the lockdown, Enron's stock price dropped 28 percent, from $13.81 to $9.98.

Another Memo

On Oct. 29, Moody's cut Enron's credit rating to just above junk-bond level, noting that the disclosures about Fastow's partnerships had severely damaged market confidence in the company.

Sherron Watkins, the woman whose memo on Aug. 14 had unleashed the maelstorm, sat down to write another one.

In her Oct. 30 memo she coolly calculated all the angles.

For herself, she made a bid for a big new job. She was available "ASAP" to become Lay's personal "devil's advocate," unraveling knotty accounting and unmasking employees who were lying out of self-preservation.

For Lay and Enron, she plotted a course of damage-control to "rebuild investor confidence."

Step 1: Blame subordinates. The "culprits are Skilling, Fastow, Glisan and Causey."

"Lay to be open about his involvement or more importantly, his lack thereof," her memo said. "Lay to admit that he trusted the wrong people."

Step 2: Blame the lawyers and accountants. "Mistake #2: he relied on V&E and Arthur Andersen to opine on their own work." Lay should now fire both firms.

Step 3: Lay should be a statesman and work the system.

"This is a problem we must all address and fix for corporate America as a whole. Ken Lay and his board were duped by a COO who wanted (earnings) targets met no matter what the consequences, a CFO motivated by personal greed and 2 of the most respected firms, AA&Co and V&E, who had both grown too wealthy off Enron's yearly business and no longer performed their roles."

The bad news, Watkins concluded, was that Enron's sins had been "horrific."

The good news, she wrote, was that "Nobody wants Ken Lay's head. He's very well respected in the community."

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