Dream Job Turns Into a Nightmare

Accounting That Mystified

Skilling's most important innovation may have been in spearheading a fundamental change in the way Enron did business. In 1992, he persuaded federal regulators to permit the company to use an accounting method known as mark to market. It was an accepted technique for brokerages and trading companies, who used it to record the value of their securities at the close of the market each day. Until Skilling, it had not been permitted for energy companies.

He won approval over the objections of some Securities and Exchange Commission staffers. That day, he gave an elated shout and a cheer went up in the office. The coup allowed the company to count projected earnings from long-term energy contracts -- money it might not collect for 20 years, if ever -- as current income.

Skilling personally benefited: His employment contract guaranteed him as much as 3 percent of the value of his division's business, and that value would soar with mark-to-market accounting.

Beginning in the mid-1990s, Enron's trading operations grew geometrically. By 2000, company revenue had increased to $100 billion from $13 billion in 1996, the year before Skilling became president. Former Enron employees would later assert the mark-to-market accounting technique was widely misused to inflate those numbers through manipulation of projected future revenue flows.

"When we marked to market, we were truly controlling our revenue. That was how your business model was set up," said Rudy Sutherland Jr., 35, a former Enron trading software manager. "You could always meet [Wall Street's] expectations."

Enron's accounting mystified almost everyone. Analysts, investors, even some top executives say they were baffled by it.

In a small meeting with Skilling in 2000, Robert J. Hermann, the company's former general tax counsel, asked, "Are we really making any money?"

Skilling acted surprised.

"He said, 'Yeah, why? What are you concerned with?' " Hermann later recalled.

Hermann told Skilling he was worried that the company was paying so little in taxes.

"I've always believed if you are making real money you pay taxes," Hermann said.

Skilling, Hermann said, explained that mark-to-market accounting allowed Enron to make money and grow without bringing in a lot of cash and paying a lot of taxes.

Hermann was in his office the next day when the phone rang. It was Skilling. He pleasantly inquired, "Are you comfortable with that explanation? Did that answer make sense? Are you comfortable?"

"Not entirely," Hermann said.

But he was not shocked either. He knew that Enron's numbers depended on a lot of arcane deals, and managers faced intense pressure to meet earnings targets. His tax division was a major profit center for the company, providing tax benefits that boosted the company's earnings by $1 billion over five years.

"We believed we could just about do anything because we always did," Hermann said later.

"We would sit there and talk to each other in my department and say, 'I can't believe we are going to be able to make the earnings.' We'd say, 'But we always have.' And then we would."

The Raptors' Risks

By August 2001, however, the Enron alchemy was no longer working. Long-hidden problems were becoming unmanageable.

The gravest of these was the impending failure of the vastly complex Raptor transactions.

Skilling had ordered his experts to construct the deals and put his chief financial officer, Andrew S. Fastow, in charge. The four Raptor ventures were owned by Enron and a private investment partnership called LJM2, which was run by Fastow. His dual roles at the company and the partnership were an obvious conflict of interest, but Enron's board had approved it at the urging of Lay and Skilling.

The Raptors protected Enron's investments in risky start-up companies through a financial transaction called a hedge, which would cover Enron's losses if the stocks of New Power and the other start-ups fell.

Under accounting rules, Enron needed an independent investor to make such a hedge work. But no true outside investors would give Enron such a guarantee on reasonable terms because the risk was too great.

So Enron turned to LJM2. Under its agreement with the partnership, Enron contributed about $2 billion in stock to the Raptors and LJM2 contributed $120 million in cash.

But in a twist that would look highly suspicious to investigators later, Enron repaid LJM2's initial investment within six months, plus another $40 million in profit. That left only Enron stock or stock pledges at risk in the deal.

In effect, Enron was hedging with itself and bearing all the risk.

The hedge worked as long as Enron's stock price stayed high, giving the Raptors the ability to cover any Enron investment losses.

If Enron's stock dropped in value, however, the Raptors would be unable to pay and the company would be exposed to large losses.

Enron's top officials were well aware of the Raptors' risks, documents and interviews show.

The previous summer a relatively new Enron lawyer named Stuart Zisman reviewed the Raptors in order to write a legal risk memo. He concluded that the transactions posed grave risks and "might lead one to believe that the financial books at Enron are being manipulated."

Zisman's boss, Mark Haedicke, responded by reprimanding him for using critical and inflammatory language, such as "cleverly designed" to describe the transactions.

After meeting with senior attorneys in his department, Zisman shifted his position, saying he did not know whether the transactions were being manipulated, but feared they might be.

A few months after Zisman's memo, the Raptors first got into trouble when two of the four partnership deals began to fail -- their obligations to Enron began to exceed their ability to pay.

Enron executives fixed the problem temporarily by having the two solvent Raptors cover the debt of the two failing ones.

The problems persisted and the Raptors had to be rescued again three months later in March 2001, just after Skilling took over as CEO. The solution: Fastow and Richard Causey, the chief accounting officer, arranged to transfer 12 million Enron shares, worth more than $700 million at the time, into the Raptors from another partnership.

Causey later told investigators Skilling approved the solution.

This "solution" appalled some of the most senior accountants at Arthur Andersen LLP, Enron's outside auditor. Those accountants specialized in reviewing tricky accounting maneuvers. But Andersen approved the deals anyway, under strong pressure from its client. The only alternative for Enron was to face up to a $500 million loss in the first quarter.

Skilling would later testify before Congress that he did not know the details of the Raptors' problems, would not have understood them if he had and left them to his top aides to solve. But Causey and other Enron executives said Skilling was "intensely interested" in efforts to solve the Raptors' problems, an assertion that Skilling denied.

Ryan Siurek, a senior director on Causey's team, told investigators that he believed Skilling was the "ultimate decision-maker" on the Raptors' rescue.

In fact, Siurek said that he helped Causey prepare a presentation laying out alternatives so Skilling could "make decisions" on the rescue.

Several senior Enron executives said the cautious Causey, one of Skilling's hand-picked lieutenants, would not have kept his boss in the dark on such a critical transaction.

On March 26, 2001, the day the Raptors' second rescue was executed, Siurek received a phone call. It was Skilling, offering thanks and congratulations.

Tragedy at Teesside

An Aug. 8 blast at Enron's Teesside Power Plant in England killed three workers.

The next day, Skilling flew there on a trip arranged by a public relations firm called Gentle Persuasion. He perched on the settee in the modest parlor of Philomena Higgins, whose son Darren, 28, was among the dead.

Higgins, 68, was so numb she would not have cared if the queen of England had stopped by offering condolences. "Where he came from I'm probably just a peasant," Higgins said. "Afterward, when I thought about it, it was very kind of him to fly over to visit the family. He seemed very genuinely concerned."

Days later, colleagues concluded that the Teesside tragedy compelled Skilling to rethink his life.

If his visit sparked an epiphany, Higgins did not notice.

"He didn't go into deep conversation," she said. "To be quite honest, if he said two dozen words that was about the whole of it. He stayed a half-hour, he passed on the condolences of the whole company, worldwide. He did shake my hand and give me a kiss on the cheek when he was going."

In the middle of August, Ken Lay returned from an overseas trip and met with Skilling, who went over a list of company business. At the end, Skilling added a shocker: He wanted to resign.

He said he wanted to spend more time with his family, mentioning teenagers and a "family issue," Lay would later recall. Skilling said the pressure had gotten to him. He could not do anything about Enron's dropping stock price. He could not sleep.

Lay asked Skilling to take the weekend to reconsider. In fact, Lay had been privately planning his own departure from Enron, he said later. Now, his handpicked successor was beating him to the door.

On Monday, Lay again implored Skilling to stay. But he was adamant. That night, an emotional Skilling informed the board of directors at a working dinner. Lay later said Skilling teared up. At the meeting, Causey and another Enron executive ticked off a litany of serious problems facing the company, from negative cash flow in the first half of the year to price-gouging investigations in California.

On Aug. 14, Skilling announced his resignation publicly. His last official performance was that day at Lay's side, as both men assured investors that there was no bad news lurking behind the departure. Enron had never been in better shape, they said.

The next day, Carol Coale, the Prudential Securities analyst who had been skeptical of Enron's claims of success, asked to meet with Skilling. She saw him in his office, next to the boardroom at the top of the Enron tower.

To Coale, he looked not just beaten, but broken. He talked about feeling exhausted and needing to attend to family problems. She asked why he had not allowed himself to get fired, so that he could collect a $20 million severance package.

"I can't go around Houston and hold my head up if I've been fired by Enron," she recalled him saying. "Houston is a pretty small town."

Crownover, Skilling's former boss at McKinsey, called him after the resignation to offer condolences. "He had been going 100 miles an hour for a dozen years. I think he just got frazzled," Crownover said later. Skilling had finally failed at something.

"Somebody who's been that high up, has been lauded and has a high regard for his own ability, to go from the tip of the top to the bottom, I just think it got to be too much," Crownover said.

What Skilling knew about Enron's growing predicament remains the subject of much debate and speculation.

Skilling later testified before Congress that when he left, the company was "in strong financial condition" and "highly profitable." He depended on Enron's experts and outside lawyers and accountants, he said.

"I was not aware of any financing arrangements designed to conceal liabilities or inflate profitability," he said. "The financial statements issued by Enron, as far as I knew, accurately reflected the financial condition of the company."

A chief executive is entitled to rely on expert subordinates, but is responsible for overseeing them, said William McLucas, the Washington lawyer who headed the investigation of Enron launched by its outside directors. "There cannot be willful blindness," said McLucas, a former SEC enforcement chief.

The financial problems that Skilling said he was unaware of included the Raptors. But they were proposed and approved by Skilling and were responsible for most of Enron's reported profit in 2000 and 2001. Skilling also attended at least one board meeting where Andersen warned that Enron was using untested "high-risk" accounting maneuvers that might not withstand regulatory scrutiny, company records show.

In addition, Skilling personally approved Enron's confidential tax transactions that had created more than $1 billion in one-time paper profits since 1997, according to Hermann, the former chief tax executive. Investors had no way of knowing that these profits were not coming from the company's ongoing businesses.

One former colleague said Skilling's position was unambiguous: He knew whatever he chose to know.

"He knew what he needed to know to win," said John Ballentine, former president of an Enron pipeline subsidiary. "That doesn't equate to knowing what the company needed."

When the Whistle Blew

On Aug. 15, the day after Skilling quit, a 41-year-old Enron vice president named Sherron Watkins wrote a now-famous anonymous letter to Lay suggesting that Skilling was running from an approaching storm.

"I am incredibly nervous that we will implode in a wave of accounting scandals," the letter said. "Skilling's abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting." She specifically cited the Raptor transactions.

Watkins was not Enron's Mother Teresa. Ambitious like her peers, she worried about her future at Enron after an unsuccessful stint at the company's failing broadband Internet venture. She had gotten a temporary assignment to evaluate Fastow's LJM transactions, including the Raptors, as Enron pondered what to do with them. And that had led her to Enron's hollow center.

She did something unheard of inside the company: she blew the whistle so loudly it sounded all the way to the top of the headquarters tower.

In her memo, Watkins asked Lay to respond to her concerns during an all-employee meeting scheduled for that week. Reacting to a potential whistle-blower in their midst, Lay's top advisers drafted talking points for Lay to use at the meeting, in case the letter writer surfaced.

But nobody at the meeting asked the tough questions.

On Aug. 17, shrugging off the Skilling resignation, Lehman Brothers rated the company a "strong buy" and said: "The Enron machine is in top shape and continues to roll along. We don't see any reason to change our estimates or outlook."

Enron shares were trading at slightly more than $36 a share.

In the third week of August, Chung Wu, a UBS PaineWebber broker in Houston, e-mailed 73 investment clients saying Enron was in trouble and advising them to consider selling their shares. Some of his clients were Enron executives, and the managers of the company's stock option plan soon heard about Wu's action. They demanded that he be disciplined.

PaineWebber handled personal investing for many Enron top executives, and the firm itself was recommending Enron to investors as "a strong buy." PaineWebber later said it fired Wu because he gave clients advice contrary to the company's without authorization.

On Aug. 20, Watkins, who had once worked at Arthur Andersen, made an ostensibly social phone call to a former colleague there, James A. Hecker.

After chatting about the job market and Skilling's resignation, Watkins raised some of the same concerns about LJM and the Raptors she had put in her letter to Lay. She told Hecker she thought Enron's financial disclosures were incomplete and misleading.

Hecker told her it sounded as if she had some good questions.

He hung up the phone concerned enough to write a three-page memo to alert Andersen about her concerns. He took care to vet his memo with David Duncan, the senior Andersen partner heading the Enron audit team.

Hecker e-mailed his colleague asking him to look for any " 'smoking guns' that you can't extinguish."

Andersen had okayed the Raptors deals for Enron. Trouble for Enron was trouble for Andersen.

'Train Wreck' Scenario

Shortly after writing her anonymous letter, Watkins identified herself. She met with Lay on Aug. 22. She brought with her a follow-up memo with more details. Watkins complained that Fastow and his LJM partners already had their investment repaid -- with a profit -- in the Raptor deals and thus had "no skin in the game." Enron bore all the risk. Now that risk was becoming a reality.

"All has gone against us," she concluded in the memo.

After assuring her he would look into the matter, Lay turned her letter over to Enron's general counsel, James Derrick. With Lay's approval, Derrick hired the company's main outside law firm, Vinson & Elkins, to conduct a preliminary inquiry to determine whether a fuller investigation was necessary.

One of the first people the law firm interviewed, on Aug. 27, was Fastow. He made it plain he was annoyed at being questioned.

Sure, some of his LJM deals were conducted in a "gray area" and would cause some "bad cosmetics" if news of them landed in the business press. But they had been approved by the board, by Andersen and by Enron's Office of the Chairman, which meant Lay and Skilling.

These were great deals for Enron, Fastow said. In the very first one, involving a hedge of an Enron investment in a tech stock called Rhythms NetConnections, Fastow noted that Enron had booked hundreds of millions in profit.

Fastow dismissed the "train wreck" scenario laid out in Watkins's letter. The letter writer was simply wrong, he said. The thrust of his interview was that the Raptors posed no serious threat to Enron.

But he glossed over the gravest risk. Written into the Raptors deal was Enron's promise to add as many shares of its own stock as needed to keep the Raptors structures solvent, up to a point. If Enron's stock fell below $20 a share, the company could not make good on the promise. And the Raptors would go broke.

Four days later, on Aug. 31, the Vinson & Elkins lawyers interviewed Causey. It was true, he said, if Enron stock dropped to $20 a share or below, the Raptors losses would begin appearing on the company's financial statements. In other words, at that point the train would go off the rails.

"All these consequences were known to Jeff Skilling and Ken Lay through discussion of this structure," Causey told the V&E lawyers.

That day, Enron stock closed at $34.99 a share. It had lost more than $10 a share that month. The $20 precipice was drawing closer.

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