System Failure
Deregulation, Political Corruption,
Corporate Fraud and the Enron Debacle

By Andrew Wheat

Smitten by the genius with which it manipulated successive U.S. presidencies, the late great Enron Corporation tried to manipulate its own investors. Shareholders — who had not balked at Enron’s political machinations — forced it into the largest bankruptcy in U.S. history by dumping its stock when they learned that Enron had played them for chumps.

From humble origins in the 1985 merger of two gas companies, Houston-based Enron transformed itself into the nation’s seventh-largest reporter of corporate revenues. It did so by pioneering energy trading and flimflam accounting. At its peak, Enron controlled a fourth of all U.S. gas and electricity trades, profiting from the spread between a buyer’s biding price and a seller’s asking price.

In recent years, however, other energy companies launched competing trading operations, squeezing Enron’s profits. At the same time, Enron launched disastrous financial trading ventures that took it away from its core energy business, trading such disparate commodities as water, paper, steel, computer bandwidth and weather derivatives.

Rather than admitting to a lull in its breakneck growth, the company took ever-bolder steps to cook its books. Enron pumped up reported earnings and hid mountains of debt to preserve the illusion of its once-stellar performance. Enron’s colossal failure required a string of failures by Enron management, its “independent” board of directors, the legal and accounting professions, investors, stock analysts, credit rating agencies and numerous government officials and regulators.

Energy revolution
Enron doggedly pursued a vision in which natural gas would supplant other electric-generating fuels and consumers would buy kilowatts from competing suppliers rather than from a monopoly. It is no coincidence that a one-time gas company spearheaded this deregulation, since the United States effectively deregulated gas a decade before electricity.

Responding to supply shortages in 1978, Congress deregulated gas producer prices. From 1985 (when Enron formed) through 1992, the Federal Energy Regulatory Commission (FERC) issued rulings that eventually permitted open access to private gas pipelines, thereby relieving gas distribution bottlenecks. Subsequent steps by FERC and the Commodities Futures Trading Commission created huge gas futures markets that allowed industrial consumers to hedge the prices that they pay for energy commodities.

Congress took the first step toward electricity deregulation in 1978, when it authorized FERC to let private power producers compete in wholesale markets. This allowed industrial power users to bypass the utility monopolies, which still controlled the residential power market. FERC started approving such licenses in the late 1980s. Congress gave deregulation another nudge in 1992, when it deregulated wholesale markets further and required utilities to share transmission lines, thereby allowing utilities in high-rate states to buy power from cheaper, out-of-state suppliers.

California drove the electric deregulation experiment home in 1996, when its legislature unanimously passed a sweeping bill to deregulate the state’s residential electricity markets. A slew of other states followed suit, including such major markets as Pennsylvania, Illinois, New York and Texas.

Acute labor pains accompanied the birth of deregulated electricity markets. The scorching summer of 1998 brought severe power shortages and price spikes of up to 20,000 percent to Midwestern and Eastern wholesale markets. Since California’s residential electricity market opened in 1998, few households have switched electricity providers, yet consumers periodically have been hit by rolling blackouts and skyrocketing power bills. As deregulation’s leading proponent and beneficiary, Enron became a deregulation poster boy widely accused of profiteering from a complex system that few people understand [See “Power Struggle: California’s Engineered Energy Crisis and the Potential of Public Power,” Multinational Monitor, June 2001].

Political power trader
To become the energy power broker that revolutionized how electricity flows into sockets, Enron had to master political power first, turning power trading into a double entendre. Residential electric deregulation would likely not be any more than a distant notion in the United States without Enron’s aggressive political machinations. Enron’s deregulatory vision encompassed staggering expenditures to restructure the nation’s electricity infrastructure. Yet the greatest obstacles were political, since Enron targeted a monopoly system that fed vast fortunes and bureaucracies. To clear these hurdles, Enron bred and fed armies of politicians in Houston, many state capitals, Washington and even abroad. Enron inundated these politicos with lobbyists and contributions, and ushered a steady stream of once and future public officials though its revolving doors.

Legendary examples of Enron’s aggressive use of such political carrots and sticks include:

• When ex-President Bush took a Gulf War victory tour in 1993, Enron paid members of his entourage — including former Secretary of State James Baker and Gulf War Lieutenant General Thomas Kelly — to lobby Kuwait for contracts to replace its destroyed power plants;
• Clinton cabinet members — including National Security Advisor Anthony Lake — threatened to cut off U.S. aid to the world’s poorest country in 1995 if Mozambique failed to give Enron a pipeline contract [See “1995’s Ten Worst Corporations,” Multinational Monitor, December 1995];
• Ken Lay told the Financial Times in August that if Maharashtra state does not start paying Enron for power from Enron-built generators, the U.S. government could stop “providing any aid or assistance” to India [See “Enron Deal Blows a Fuse,” Multinational Monitor, July/August 1995].
• Enron has paid Texas Senator Phil Gramm’s wife, Wendy, $50,000 a year to sit on its board since 1993, just after she began deregulating energy futures markets as chair of the Commodities Futures Trading Commission;
• Fellow board member John Wakeham, who deregulated UK energy markets as Margaret Thatcher’s energy secretary, joined Gramm on the board’s audit committee (which was supposed to independently review Enron’s cooked books);
• Senator Phil Gramm championed the 2000 Futures Modernization Act that further slashed commodity futures regulation and granted special exemptions to Enron;
• In 1996, Texas Supreme Court justices — who received more money from Enron than any other corporate donor —slashed $224,989 off the taxes that a lower court said Enron owed to a school district; and,
• Then-Argentine Public Works Minister Rodolfo Terragno has said, over Bush’s denial, that the current U.S. president lobbied him to give Enron a $300 million pipeline in 1988, when the elder Bush was vice president.

Enron’s PAC, executives and treasury spent $10.2 million to influence the U.S. government in the 1998 and 2000 election cycles, according to the Center for Responsive Politics. This includes $6.7 million spent on federal lobbyists and $3.5 million that Enron showered on federal PACs and candidates. Republicans got most of Enron’s money, reflecting the preference of Enron Chair Ken Lay. Yet many Democrats also ate at Enron’s trough. The center reports that 71 percent of U.S. senators and 43 percent of House members took Enron money.

Enron’s political influence went far beyond Washington, as the company led the charge to deregulate state electricity markets nationwide. Enron spent $726,643 to influence California politicians in 2000 and the first nine months of 2001. In its home state of Texas, Enron spent $5.8 million to lobby and fund state politicians in the 1998 and 2000 election cycles, according to Texans for Public Justice.

Fueling Bush
No other politician approaches the benefits that George W. Bush has reaped from Enron. During the 2000 presidential campaign, the Center for Public Integrity named Enron as the single largest patron of Bush’s entire political career. Over the years, Bush received $774,100 from Enron (excluding Enron’s $2 million in soft money donations to the GOP since Bush’s presidential bid) and achieved “frequent-flier” status aboard Enron corporate jets. For his part, Bush has championed Enron causes from Austin to Washington. Bush’s greatest gifts to Enron as governor were:

• Deregulating the state’s electricity markets in 1999;
• Passing tort laws that make it harder for people to recover damages from businesses in court (Ken Lay is a major underwriter of the powerful Texans for Lawsuit Reform PAC); and
• Coddling Enron and other polluters that own filthy “grandfathered” plants with exemptions from Texas’ 30-year-old clean-air laws [See “Dirty Old Grandfathered Plants,” Multinational Monitor, June 1998].

Enron’s influence trailed Bush to Washington. The retired general that Bush tapped as Army secretary headed an Enron subsidiary that won contracts to privatize Army-owned utilities. “I see no reason whatsoever why the Army is in the energy business,” Secretary Thomas White said last year. U.S. Trade Representative Robert Zoellick and White House economist Lawrence Lindsey were paid Enron advisers before Bush appointed them to his administration. Bush tapped Enron lobbyist and former Montana Governor Marc Racicot to head the national Republican Party in late 2000.

Bush named Ken Lay to his Energy Department transition team and resisted calls for price controls when Enron and other power companies were accused of price gouging to exploit the West Coast power crisis. Lay reportedly was the only energy executive who had a private audience with Vice President Dick Cheney when he huddled with industry representatives to draft the administration’s energy policy.

Then-FERC Chair Curt Hebert said that Lay warned him in 2000 that he would lose Enron’s support at the White House if he continued to oppose open access to privately owned power lines. While Lay said Hebert misconstrued their conversation, Hebert resigned last August, three weeks after denouncing this pressure. Bush replaced him with Enron-backed Texas Public Utility Commission Chair Pat Wood. Texas Governor Rick Perry (who took $237,000 from Enron since 1997) then replaced Wood with Enron de Mexico President Max Yzaguirre. In the midst of the Enron scandal in January 2002, Yzaguirre succumbed to widespread calls for his resignation.

Power outage
Although some institutional investors already had grilled Enron to try to make sense of its impenetrable financial statements, the first public sign that Wall Street’s darling might be troubled came in August 2001. That is when Ken Lay’s handpicked successor resigned just six months after taking the helm. Investors simply did not believe that CEO Jeff Skilling—the hard-driving force behind Enron’s decision to shed hard assets like pipelines and power plants for energy trading—really resigned for “personal reasons.” To reassure investors, Lay resumed CEO duties, promising to improve financial disclosures at a time when “the company is in the strongest shape it’s ever been in.”

As the Wall Street Journal, which broke the Enron story, later revealed, the quarterly report that Enron filed on the day that Skilling resigned contained a time bomb. The report alluded to hundreds of millions of dollars worth of deals with investment “partnerships” that had been run and partly owned by Enron Chief Financial Officer Andrew Fastow. Though virtually unknown to outsiders, some Enron employees complained about Fastow’s partnerships, which Enron ostensibly used to raise hundreds of millions of dollars and to hedge trading risks. The partnerships split Fastow between his fiduciary allegiance to Enron investors and his personal interest in partnerships, which earned him an estimated $30 million. Over the next few months, Enron would disclose the existence of many more partnerships that the company secretly used to inflate its earnings and to hide mountains of debt.

Enron’s quarterly report issued in October 2001 stressed that its core energy trading business fueled an impressive 26 percent increase in recurring earnings. But disturbing revelations dampened this good news. First, Enron said it was taking a whopping $1 billion write-off to cover losses in such non-core ventures as computer bandwidth trades. The report also alluded to “early termination” of “finance arrangements with a previously disclosed entity.” This turned out to be Enron’s way of not disclosing that Fastow’s partnerships were forcing the company to sustain a $462 million charge.

The same report announced an astonishing $1.2 billion reduction in shareholder equity (the difference between Enron’s assets and liabilities). Enron blamed this hit on an undisclosed “accounting error.” In fact, Enron had issued 62 million shares of its own stock to the partnerships, which promised to repay the stock’s value to Enron. Enron improperly treated these repayment pledges as if they were cash. When the partnerships failed to repay the value of the stock, Enron retired it, forcing its investors to eat a $1.2 billion loss in value.

With relatively few hard assets, an astonishing amount of Enron’s value was built on market trust. When that trust disappeared, so did Enron. People did business with Enron’s coveted trading operations because they were confident that the company could stand behind commitments to buy so much gas, electricity or bandwidth. Many of these financial transactions required Enron to expedite payment in the event that its credit rating took a hit. Now the credit agencies were at the door asking about Enron’s stealth partnerships and its trading partners were turning to competitors. In a market sell-off, Enron stock that sold for $80 a share at the beginning of the year now sold for under a $1.

Teetering on the brink of ruin, Enron agreed to be taken over by Dynegy, a smaller competitor that promised massive infusions of cash. The day before the slated November 9 merger announcement, however, Enron disclosed two new partnerships: Chewco and JEDI. Enron set up these entities after it began falling short of earnings targets in 1997. Befitting their “Star Wars” names, Enron used JEDI and Chewco for special effects, artificially boosting its profits and making hundreds of millions of dollars in Enron debt vanish. Enron now said it had overstated its earning for the past four years by $586 million, or 20 percent. During this same period, Enron executives and directors raided the piggy bank by selling more than $1 billion in company stock.

Soon after this disclosure, the SEC launched a formal investigation of the company. Enron disclosed on November 19 that its earnings might take another $700 million haircut as a result of asset devaluations at another investment partnership. Falling credit ratings were triggering expedited payments of $690 million, the company added. On November 28, Standard & Poors dropped Enron’s credit rating to “junk” status and Dynegy called off the merger. Enron announced on December 2 that it would file for bankruptcy.

When investors sent Enron’s ship crashing back to earth, its storied political and mental prowess failed, leaving its arrogant executives to bang their fists on their suddenly unresponsive controls. Chair Ken Lay chided investors for overreacting to a bit of bad news. In a conference call, CEO Jeff Skilling called an analyst an “asshole” for daring to challenge Enron’s financial numbers. When credit agencies prepared to downgrade Enron’s rating to near-junk status, CFO Fastow futilely lobbied them to raise Enron’s rating, which he said would improve its performance and thereby justify the inflated rating. But everyone else finally realized that it was time to pull the plug on Enron.

Enron’s impact
Enron made a strategic decision in 1989 to phase out ownership of hard energy assets such as power plants and pipelines in order to pin its fortunes on energy trading. This proved so successful that a decade later Enron leapt into trading a slew of commodities and financial derivatives, becoming both an energy company and an unregulated financial institution. By 2000, Enron lobbyists were demanding — and receiving — greater deregulation of both industries.

Enron’s colossal failure is a cautionary tale of a corporate giant that operated without meaningful checks and balances. Enron’s failure followed a stunning string of failures. These included Enron’s managers, who grossly misled investors; its “independent” board and the legal and accounting professions, which signed off on bogus transactions; investors, stock analysts and credit rating agencies, which bought or promoted what they did not understand; and government officials and regulators, who were too busy deregulating to check this corporate abuse.

After Enron’s fall, the Securities and Exchange Commission, the Justice Department, the Labor Department and many congressional committees launched hearings, probes and investigations. This scrutiny is unlikely to reverse the wave of electricity deregulation that Enron pioneered. Many companies have followed Enron’s lead into the energy trading business (with some, such as Dynegy, Calpine and El Paso Corp., rushing to reduce debt and improve disclosures to limit the Enron contagion). Indeed, even bankrupt Enron has cut a deal with the Swiss bank UBS to revive its Enron Online trading operations under a new name.

“The industry is doing an amazing job of spin,” says Janee Briesemeister, a Consumers Union utility analyst in Austin. “Everyone is saying Enron has no bearing on deregulation. I don’t think Enron will mean a devastating [deregulation] collapse like in California. But when you have the largest energy trading company collapse, along with all the associated banks and everything, I think there is no question that there will be closer scrutiny by investors and lenders. The cost of money will be greater, slowing down electric generation and transmission projects, and these costs will filter down to consumers.”

“Put Enron together with California’s [deregulation] experience and you’ve got a failed experiment,” says deregulation critic Doug Heller of California’s Foundation for Taxpayer and Consumer Rights. But Heller concedes that, “The fear, however, is that people will write this off as corporate malfeasance and leave it at that alone.” Before Bush (who himself was once the target of an inconclusive SEC probe) appointed him as SEC Chair, Harvey Pitt defended such securities malfeasors as inside trader king Ivan Boesky from the SEC. Representing the accounting industry in 2000, Pitt helped defeat a reform that his predecessor proposed to bar auditors from receiving additional consulting fees from clients (critics suggest that Arthur Andersen’s independence was compromised by the $27 million in non-auditing fees that it billed to Enron). Pitt’s SEC has instituted an amnesty program that minimizes or eliminates punishment for wayward firms that turn themselves in. In a telling line in a Wall Street Journal op-ed in December, Pitt wrote that future Enrons can be prevented “if we focus attention on finding solutions instead of scapegoats.” Pitt’s SEC is unlikely to prevent future Enrons by slamming Enron malfeasors with the maximum legal penalties.

The most likely legacy of the Enron debacle is that the accounting police will mandate limited improvements in corporate disclosures. Congress also will debate—and may even pass—reforms to prevent employees from sinking most of their pension funds into their employer’s stock—as Enron employees did to ruinous effect. But it is unlikely that the same government officials who spent the span of Enron’s lifetime deregulating U.S. energy markets will muster the energy required to turn that battleship around. The climate of inadequate regulatory controls that fostered the Enron debacle in the first place is likely to weather this storm, as other wealthy corporate interests step into Enron’s void to finance the next election season.