Wednesday, August 15, 2018

Life in The Fastow Lane

By on August 3, 2018

Editor’s note: This story first appeared in the Aug. 2-8 issue of Caribbean Business.

“Do you consider yourself a misleading person?”—So begins a Q & A session with former Enron CFO Andrew Fastow immediately after his presentation to a room full of presidents and CEOs held in Puerto Rico several months ago. Fastow pled guilty to conspiracy to commit securities and wire fraud in 2004 and was sentenced to 10 years in prison for helping to orchestrate a corporate strategy to defraud Enron’s shareholders and causing more than $40 billion in market losses in the process. When he responded affirmatively—“well, what I will say is I was guilty of those crimes”—in a confessional before those 100 people, Fastow’s body language was downright contrite, tears often welling up as he recalled those days of judgment.

“Look, this is important—Today I absolutely, unequivocally believe I was guilty. I didn’t at the time. It took me a long time, as I explained yesterday, to understand really what I had done wrong,” he reaffirmed in an exclusive interview with Caribbean Business that took place the day after his public allocution. “I believe that what I did was wrong, I believe that it was unethical, and I believe that it was illegal. And I am very sorry for what I did, and I wish that I could undo it. I am embarrassed every day of my life, for what I did. I did it not with malice, but with a serious character flaw because I never asked myself if I was doing the right thing. I never asked myself the ethical question, I only asked myself whether or not I was allowed to do it. And that allowed me to rationalize, to justify what was fraudulent behavior.”

Truth be told, malfeasance underpinned Enron’s corporate culture in those days of fraud; it started at the top with Enron President and Chief Executive Officer Jeff Skilling, who encouraged creative accounting schemes, and eventual Chief Executive Officer Ken Lay, who was complicit in hiding Enron’s plummeting stock value. Fastow, who had been recruited by a headhunting firm because of his unique skillset packaging commercial loan obligations (CLO) at Continental Bank, became a rising star at Enron. The company wanted to find a way to securitize oil and gas reserves, which at the time had not been done before. Fastow was up to the task.

Caribbean Business Executive Editor Philipe Schoene and former Enron CFO Andrew Fastow

“We basically packaged up what were called volumetric production payments, which are the interest in hydrocarbon flows from wells, and we were able to create securities and sell those securities to banks and investors,” Fastow told Caribbean Business during the interview that took place inside the business center of a Condado hotel. “But it was an open-ended pool where we were able to continue to add new assets as Enron originated them. So, we did the first asset-backed securitization of oil and gas, but the form of oil and gas was volumetric production payments.”

Seven years later, Skilling, a huge proponent of “creative” accounting, was promoted president and chief operating officer of Enron; Skilling brought Fastow up to the corporate offices where he was named senior V.P. of Finance prior to becoming the chief financial officer a year later.

Bridge over troubled waters

Skilling encouraged accounting practices that helped pad Enron’s stock value. A year into Fastow’s tenure at Enron, Fastow learned of a new technique called mark-to-market to pad stock value using projected earnings.

How did that come about? “I didn’t even know what mark-to-market was. About a year into my time into Enron—late in the afternoon one day, I see a bunch of people in the conference room popping the corks out of champagne bottles. So, I walk in and I ask: ‘Hey, what is going on?’ They explained that the SEC [Securities & Exchange Commission] had just approved mark-to-market accounting for Enron for its gas contracts. In fact, I was told the SEC had insisted Enron had to use mark-to-market accounting for the gas contracts. And, in fact, it was very analogous to interest-rate contracts and foreign-exchange contracts, and oil contracts.”

Fastow claims he was not quite sure of the significance of the accounting method until he ran into Skilling later that evening. “I remember asking him: ‘Why is mark-to-market accounting such a big deal to you?’ And, he looked at me and said: ‘Andy, yesterday I was worth $5 million, today I am worth $50 million—the reason being that a huge component of Jeff Skilling and some other executive’s compensation in this particular division of Enron was based on performance units—essentially the reported earnings generated by the subsidiary. So, it is like a tracking stock if you will.’”

With mark-to-market accounting versus accrual accounting, the future earnings are brought forward to the present. So, reported earnings in the subsidiary jumped 10-fold overnight—just because of the change that the SEC approved overnight. It was, in Fastow’s view, the beginning of the problem—not mark-to-market alone, “but that there was a disconnect between reported earnings and cash—a huge problem. When Jeff Skilling took over for Ken Lay, he did not have the same focus on cash and that gap, which had been growing over the years, accelerated greatly.”

“So, we had all these reported earnings, which had been driving the stock prices up. But, you know what? The cash that was supposed to come in over time—it wasn’t coming in,” Fastow recalled with a furrowed brow, as if to revisit his dismay. And, for a while, it did not seem like a problem, because we had been growing so quickly; we had been booking more contracts than we were rolling off, so we should always be in a negative cash position, and then we expected a flood of cash to come in. What we found by about 2001 was that a lot of those contracts were mispriced because, in mark-to-market accounting, especially when you are dealing with long-dated contracts, companies have the flexibility to make assumptions about future prices. And it turns out many of our people were making very aggressive assumptions, and so the cash did not show up. That led to having to do more and more financial engineering by me to cover up that gap.”

“And then the second half of the story, if you want to use this phrase, was the cover-up—financial engineering to keep us at investment grade, to keep our stock price up,” Fastow told Caribbean Business point blank.

As long as Fastow kept Enron’s stock bubble inflated, his star shone brightly; ironically, the fledgling CFO received a trophy as CFO of the year in 2000, for the very same accounting practices that landed him in jail four years later. In fact, one of the more questionable deals Fastow engineered—the creation of a corporation named LJM to hide debt—employed the same off-balance sheet accounting encouraged by Enron and its accountants Arthur Andersen.

But the LJM deal had an additional layer because it involved the creation of a company owned in part by Fastow where Enron’s losses could be hidden. Enron held a board meeting that lasted more than two hours, an eternity compared to what normally are 15- to 30-minute affairs.

“And so, for this particular transaction, which I would argue was perhaps the craziest or most egregious transaction because it created this terrible, irreconcilable conflict of interest—they called a special board meeting to discuss it,” Fastow explained. Arthur Andersen was present to explain how they had structured the off-balance sheet transaction, so it would work from an accounting standpoint; the attorneys were there to vouchsafe that it was legal, and they even brought sample disclosures—what the footnote would look like, for example.

“And at the end of the day, if you were to boil the whole discussion down to one sentence: ‘Well this is completely legal, but it looks really bad.’ And it did look bad; it was a terrible conflict of interest,” Fastow recalled.

During that meeting, the chairman of the board’s executive committee turned to Jeff Skilling and Ken Lay and asked them what they thought the greatest risk to Enron was. “And Jeff Skilling’s reply was: ‘Wall Street Journal risk.’—Those were his exact words. There is no getting around that this deal stinks when you look at it. So, the board talked about it a little while longer and the conclusion was that, yeah, it looked really bad—you could say it stunk. If a reporter from the Wall Street Journal [WSJ] decides to focus on it or if an equity analyst decides to focus on it, they would simply bring them in and sit them down with the attorneys, and with the auditors and they would get comfortable because they would see it is legal.”

Fastow tells that story to highlight what he sees as Enron’s fatal culture flaw, which is to focus on rules but not principles. “We only asked the question: ‘Are we allowed to do this’; we didn’t ask the question: ‘Is it the right thing to do?’” Fastow explained. The board got the closest that I had ever witnessed anyone getting when it asked those questions, but ultimately, they said if the rules say we can do it, that is what we are going to do. And, ultimately, that was the deal that the WSJ focused on in October of 2001, which was when the real panic began.”

Perhaps sensing the end of the charade, Skilling pre-emptively resigned, leaving the House of Cards in the hands of Lay. The WSJ risk that Skilling foretold, came true in October 2001; Fastow became the fall guy and was fired in mid-October 2001. The once-star CFO was about to become the Defrauder of the Year in the eyes of Main Justice; still he did not intend to plead guilty.

Fastow and furious

When the smoke subsided, and the mirrors shattered at Enron, main justice sought to make this a criminal investigation. “From October—I was fired in mid-October—until late December, I don’t recall anyone ever discussing any criminal liability. It was perceived to be a civil matter…the SEC had issued a Wells notice in September that they were going to begin an investigation. And, of course, when stock drops like that and there are questions about accounting, you should assume there is going to be a derivative shareholder lawsuit. But no one was talking criminal and, as far as I knew, no one at the Justice Department was involved because that is for criminal matters; the SEC is involved for civil—until late in December when my attorney told me that someone in Washington had decided to make this criminal.

The Enron Task Force had more than 100 people working on the case at one time. There were always leaders at the Task Force and the leaders changed over time. In the beginning, the person heading the Task Force was a woman by the name of Leslie Caldwell. She ultimately became the deputy attorney general and now is out of the Justice Department.

“Main Justice also created an elite operation to go after Enron specifically,” according to Jesse Eisenberg in his book, “The Chickenshit Club,” in which he reports on those golden days of prosecution at Main Justice before it fell into disrepute for pusillanimous culture underpinned by politics. “Though the trials were long, arduous, but full of good breaks, prosecutors won guilty verdicts against key architects of the Enron fraud through working three main witnesses: Delainey, Fastow and company treasurer Ben Glisan Jr.… The government needed Glisan, Delainey and Fastow. Without all three, the Enron Task Force would have failed.

Interestingly, Fastow reached a nontraditional agreement in which he cooperated without receiving a reduced sentence.

The Task Force targeted Arthur Andersen, Enron’s accounting firm, Eisenberg reports, and they went after “a British investment bank, NatWest [National Westminster], which had helped orchestrate a shady Enron transaction. [The prosecutors outlined NatWest’s effort to help Fastow and Michael Kopper, his young right-hand man, create an off-balance sheet entity to hide Enron debt.]

Kopper explained how Fastow was the “mastermind behind the most troubling aspect of the Enron frauds: Its off-balance sheet vehicles.” In October 2002, the task force indicted Fastow. He pleaded not guilty.

Larry Thomson, the deputy attorney general, and Robert Mueller, the FBI director, vowed to put the bad guys in jail; ultimately, they were after Skilling and Lay. They would have to turn to Fastow to achieve their objective, so in May 2003, they indicted Fastow’s wife on charges of tax evasion. With the prospect that they would both be in jail at the same time, while their small children remained in the care of others at home, Fastow made a deal.

According to the Eisenberg account: On Jan. 14, 2004, more than two years after Enron declared bankruptcy, both Fastows pleaded guilty, Andrew accepted one count of conspiracy to commit wire fraud and one count of conspiracy to commit wire and securities fraud. His sentence of 10 years was later reduced to six years and he testified that other Enron executives—namely Skilling and Lay—were complicit in Enron’s fraudulent scheme. For his cooperation, the prosecution agreed to allow his wife to serve one year, while Andrew remained at home. He then served his time when Lea finished doing time—the children would not be without both parents.

“I can tell you I know for a fact that subsequent prosecutors in the Enron Task Force told me that is the only reason they charged my wife,” Fastow recalls. “And one of the former prosecutors on the Enron Task Force wrote a book and even says in the book that is the only reason that they did it.”

“In essence, to paraphrase the quote—the ends justified the means, because it forced me to plead guilty. But look, this is important, and I ask your indulgence on this—regardless of how I ended up pleading guilty, today I absolutely, unequivocally believe I was guilty.”

Fastow now spends his time traveling the United States, sharing his story, hoping people will focus on principle, rather than skirting the law with nitpicky, hair-splitting arguments exonerating criminal actions.

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