April 26, 2002

Anatomy of a Fall: Keys to Success Left Kenneth Lay Open to Disaster

To the many people who know and admire Kenneth Lay, the former chairman and chief executive of Enron Corp., he's a brilliant, hard-working, decent, God-fearing man who couldn't possibly have been responsible for one of the biggest corporate collapses in history.

To some of the same people, he's also an ambitious man who grew so enamored of the trappings of his extraordinary success that he neglected their source, Enron, and blithely allowed his trusted lieutenants to plunge the company into a mire of deception and possible fraud.

It's the enigma central to the collapse of Enron. The same attributes that underpinned Mr. Lay's success -- tireless ambition, stubborn optimism and sometimes easy trust -- helped bring about his downfall.

His ambition carried him from rural Missouri to the pinnacle of worldly success. He earned a Ph.D. in economics in night school. He went to Washington and helped lay the groundwork for deregulation of the nation's natural-gas industry. He built one of the largest companies in the world, Enron. And he made enough money to buy million-dollar homes and give millions of dollars to the needy.

But that isn't how Mr. Lay is likely to be remembered in history. Enron's demise last year wiped out billions of investor dollars and cost the jobs of thousands of employees. The financial dealings that triggered the debacle have become the focus of shareholder lawsuits alleging fraud and federal investigations into possible wrongdoing. In January, Mr. Lay resigned as chairman and chief executive officer.

Investigators are still trying to determine what Mr. Lay knew and when. Mr. Lay himself has said he knew little of what was going on and believed the dealings were legal because they had the approval of Enron's accountants and attorneys.

But early on, Mr. Lay blessed the relaxation of conflict-of-interest rules designed to protect Enron from the very kinds of transactions that brought the company down, and he participated in board meetings allowing the creation of the off-balance-sheet partnerships that were part of those transactions. By late summer 2001, when he was reassuring investors and employees that all was well, he had already been informed that the company had problems with some investment vehicles that could cost it hundreds of millions of dollars.

In an 80-minute interview last week in his 12th-floor office a few miles from the twin Enron towers in downtown Houston, Mr. Lay, 60 years old, declined to comment on any aspect of Enron's collapse. He sounded detached from the debacle and upbeat about his career at Enron: "One of our great successes at Enron was creating a culture, an environment, where people could try to achieve their God-given potential. But certainly I wanted it to be a highly moral and highly ethical environment. I have done the best job I can of following that everywhere I have been."

He was six years old in 1948 when disaster struck his father's business. Omer Lay owned a feed store in Raymondville, Mo., population 175. He also bought chickens from local farmers and resold them to stores in nearby towns.

One day, a delivery man crashed a truck carrying a load of Omer Lay's chickens. Most of the chickens died. Wiped out financially, Omer Lay closed his store and took a job as a traveling salesman for the Home Comfort Stove Co.

For the next many months, the Lays -- Omer and Ruth, and Kenny and his sisters, the elder Bonnie and the younger Sharon -- bounced around Missouri and Mississippi. Thanksgiving dinner that year was lunch meat with bread.

The Lays then moved in with Ruth's sister and her husband and their four children in Rush Hill in central Missouri. Omer worked at a farm-equipment store and preached at the town's church. Kenny and his sisters played on dirt streets marked by knee-high concrete posts. "My sisters and I still talk about it. We don't recall any despair or any woe-is-us or any really negative thoughts or feelings," Mr. Lay says. His parents "felt like there was really no problem too great. As long as you continued to work hard and had a lot of faith, you'd work your way through it."

Ambitions From the Start

Kenny's ambition was evident from the start. He earned good grades at Rush Hill's three-room schoolhouse. He delivered three different newspapers. He mowed the local cemetery. He plowed fields, chopped thistle and cleaned chicken coops. He gave some of his earnings to his parents.

At Community R-VI High School, he sang in the choir, was elected president of the freshman class, and worked on the school paper. Richard Webber, who played with him in the high-school trombone quartet, recalls Mr. Lay's preparation for the state band competition. "He didn't want to make any mistakes, so he practiced until he didn't make any," says Mr. Webber, now presiding commissioner of Audrain County.

In 1958, the Lays moved to Columbia, Mo., where two years later, Ken Lay enrolled at the University of Missouri. While a pledge at the Beta Theta Pi fraternity, he helped fellow pledge Philip Prather with his statistics class. "He'd get so upset because I didn't get it, but he hung in there with me," says Mr. Prather, who owns a company that manages apartments in Columbia. "He wanted that top rung, and it was pretty obvious to see."

His sophomore year, he took economics with Prof. Pinkney Walker, a campus legend for his humor-laced lectures. Mr. Lay found himself captivated by theories of how markets and companies work. Dr. Walker encouraged Mr. Lay to pursue a master's degree. "A brilliant kid," says Dr. Walker, now retired and living in Fort Myers, Fla.

After leaving MU in 1965, Mr. Lay took a job as an economist with Humble Oil, a Houston predecessor of Exxon Corp. Chairman Mike Wright tapped the younger man to write his speeches during Mr. Wright's one-year stint as president of the U.S. Chamber of Commerce. After Mr. Lay finished training at the Naval Officer Candidate School in Newport, R.I., Pentagon brass -- having seen speeches he had penned -- gave him a plum assignment studying military procurement. All along, he was pursuing his Ph.D. in economics from the University of Houston.

Buoyed by Optimism

It was 1971. Mr. Lay had married his college sweetheart, Judith Ayers, and they had two young children. At 29, Mr. Lay still wasn't sure what he wanted to make of his life. His optimism buoyed him. "It just seemed, for whatever reasons, at the right points in my life, there would always be doors open and doors shut," he says now.

One opened when Dr. Walker, his former teacher, was appointed to the Federal Power Commission, precursor to today's Federal Energy Regulatory Commission. As a boy perched on a tractor, Kenny Lay had wondered why the government paid farmers to leave certain fields fallow. Now, as an economist who believed free markets worked best, he wondered why Washington still regulated natural gas when supplies were drying up. He wrote speeches for Dr. Walker that shook up Washington with their fervor for deregulation.

After a year, Dr. Walker went back to Missouri, but Mr. Lay continued the crusade as a deputy undersecretary of energy at the Interior Department. "Federal regulations are a failure," he told a banquet at MU.

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With his wife and two children, Mr. Lay left Washington in 1974 to become vice president of corporate development for Florida Gas Transmission Co. in Winter Park, Fla. He impressed Chairman and CEO W. J. "Jack" Bowen. "You never had to worry about him doing the wrong thing," Mr. Bowen says. "He could see the big picture."

In two years, Mr. Lay became president of the company's gas subsidiary, and then took on greater responsibilities when Continental Group acquired Florida Gas in 1979. Work demands took a toll on his marriage. He and Judie separated in January 1981 and divorced in mid-1982. Mr. Lay soon after married Linda Phillips, who had been his assistant at Florida Gas.

By mid-1982, Mr. Lay was living in Houston and working as president and chief operating officer of Transco Energy Corp., now headed by Mr. Bowen, his old boss at Florida Gas. A wave of hostile takeovers was rocking the energy industry because pipeline assets, which often generated huge sums of cash, looked undervalued on company books.

In 1984, Coastal Corp. made a $1.3 billion hostile bid for Houston Natural Gas Co. Mr. Lay's Transco offered to be HNG's "white knight" buyer. HNG escaped on its own, but its directors liked Mr. Lay so much that they asked him to replace HNG Chairman and CEO M.D. "Bill" Matthews.

Doubling the Size of HNG

Mr. Lay took over in June 1984. In the next six months, he doubled the size of HNG by acquiring Florida Gas and Transwestern Pipeline Co. With Florida Gas came Mr. Lay's fellow MU grad, Richard Kinder, the company's general counsel. Mr. Kinder quickly rose to vice chairman. While Mr. Lay mapped broad company strategy, Mr. Kinder called managers to account and focused on how money actually was being made.

Mr. Lay wanted to build the biggest pipeline system in the country. He figured it would give him leverage as Washington continued to disassemble a regulatory structure in place since 1938.

Pipeline operator Samuel Segnar, chief executive of InterNorth Inc., gave Mr. Lay his chance in the spring of 1985, when he called about a merger. In May, InterNorth agreed to acquire Mr. Lay's company for $2.3 billion, creating a 37,000-mile pipeline network, the nation's biggest coast-to-coast system.

Within six months of the deal, the board announced that Mr. Segnar was out and Mr. Lay was taking over. People familiar with the situation say directors felt that Mr. Segnar was too aloof. Mr. Lay became chairman and chief executive in February 1986. On April 10, five days before his 44th birthday, the company changed its name to Enron.

Ten years later, Mr. Lay was patriarch of the biggest integrated gas and electricity company in the U.S., with annual revenue of $13 billion and assets valued at $16 billion. Fortune magazine named it the nation's "most innovative company." Mr. Lay bragged that 40% of Enron's profit came from businesses that hadn't existed a decade before.

Enron was cutting contracts worth billions of dollars for gas, electricity and oil. It was building a $3 billion power plant in India, though problems with the government there got construction suspended barely a month into the project. In the U.S., it was planning to sidestep utilities and sell electricity directly to consumers.

People rallied to the mission. They were making a lot of money, and they liked Ken Lay. He remembered first names. He jotted personal notes on memos. He liked jawing with pipeline operators and fellow Ph.D.s alike.

Seeking Talent

Mr. Lay sought to hire the smartest, most talented people, give them room and trust them to do the right thing. One was Jeffrey Skilling, a former McKinsey & Co. consultant and Harvard M.B.A. He built the Enron Capital & Trade energy-trading unit, which fueled the company's growth in the 1990s.

As Enron grew, so did Mr. Lay's involvement in politics, civic projects and charity work. At the request of President George H.W. Bush, Mr. Lay served as co-chairman of the 1990 economic summit in Houston. Two years later, he was chairman of the host committee for the GOP convention. Under Mr. Lay, Enron became a big contributor to the GOP, including nearly $2 million given to President George W. Bush during his political career, as well as to the Democratic Party. There was talk that Mr. Lay would return to Washington one day as a cabinet member.

He embraced his role as Enron's "Mr. Outside," the company's statesman and chief lobbyist. As the FERC was preparing to issue a key order deregulating electricity in 1996, Mr. Lay dropped in on Commissioner William Massey. Enron wanted FERC to assert itself, because a state-by-state approach to deregulation would be "too lumpy," Mr. Massey says. "I remember him saying, 'I cut my teeth here. FERC was moving in the right direction, and we're counting on you to make it work.' "

By now, the boy from Missouri was a full-fledged corporate mogul. He and wife Linda contributed to and raised tens of millions of dollars for the Houston United Way, the local Holocaust Museum, the University of Houston, the United Negro College Fund, the YMCA and many other causes. When the Houston Astros threatened to leave the city in 1996, Mr. Lay led the successful campaign to get a new stadium built.

In 1996, Mr. Lay made $3.17 million in salary and other compensation. He owned homes worth millions in Houston, nearby Galveston and Aspen, Colo. To friends and associates, the man who had bounced from home to home as a youth loved the perks of his position.

He still might wear brown shoes with a black suit, but members of Congress sought his advice. He flew around the world to speak at economic conferences. He was invited to join company boards. He exchanged personal notes with Henry Kissinger and played golf with President Clinton and Jack Nicklaus.

Columbia, Mo., attorney Dan Simon chatted with Mr. Lay at their 35th high-school reunion picnic in 1995. Mr. Simon says Mr. Lay talked about the house he had bought in Houston's exclusive River Oaks neighborhood.

"He made the remark that he'd given his wife a decorating budget of $2 million, and she had exceeded it in the first month or two," Mr. Simon says. "It seemed out of character. He was brought up the same way I was and that would be, you don't talk about your money." A spokeswoman for Mr. Lay says he doesn't recall making the remark.

Likewise, Mr. Prather says, "Kenny had a real desire to meet important people and be acquainted with important people. ... The thing that didn't fit was, that wasn't where he came from."

Mr. Lay says he's glad some prominent people are friends, "but it's not something that I've necessarily sought out."

'Discretionary Night'

One evening, Mr. Lay was lounging around his pool in Houston with Mr. Prather when the Enron chief lamented that he had only one or two "discretionary nights" a month.

"What the hell's a discretionary night?" Mr. Prather asked.

A night without anything scheduled, Mr. Lay said.

He wanted more time for charity, politics and, perhaps, teaching, several people who know him say. In 1994 and again in 1996, he says he approached board members about relinquishing his title to Mr. Kinder, now Enron's president and chief operating officer. As Enron's "Mr. Inside," Mr. Kinder ran the company day-to-day, many former Enron employees say.

Managers dreaded his Monday morning meetings, where he demanded up-to-the-minute reports from the heads of Enron's businesses. "Kinder would sit in that room with his yellow pad and he knew every goddam thing happening in that company," says Terry Thorn, a former Enron executive who worked at the company for 20 years.

But both times Mr. Lay approached them, Enron directors declined to promote Mr. Kinder. The reasons are unclear. At the end of 1996, Mr. Kinder resigned. He is now chairman and CEO of Kinder Morgan Inc., a Houston operator of pipelines and other energy-related assets. Through a spokesman, Mr. Kinder says he wasn't aware that the board had rejected promoting him.

Soon after Mr. Kinder left, Mr. Lay elevated Mr. Skilling to president and chief operating officer. Former executives say Mr. Skilling could bore in on financial performance when he desired, as Mr. Kinder had, but was more enamored of the big picture, like Mr. Lay. Mr. Skilling also was less inclined than Mr. Kinder to invest in hard assets, like pipelines, and pushed Enron toward an "asset-lite" strategy that relied more on trading prowess. There were exceptions. Mr. Skilling let Enron invest more than $2 billion in a fiber-optic network that now is worth nearly nothing.

One April evening in 1998, the Horatio Alger Association of Distinguished Americans, named for the 19th-century author of fictional rags-to-riches tales, honored Mr. Lay and nine others for having "triumphed over adversity to achieve access."

"Yes, the American dream is alive and well," he told the audience. Applauding were dozens of friends, family and Enron colleagues, a few flown in by Mr. Lay. There was also a reception at the Supreme Court and dinner at the Library of Congress. "It was a celebration of joy that Ken wanted to share with every friend he ever had," says Vivian Purdy, wife of an MU administrator who decades before had helped Mr. Lay find money for college. "It was a fairy tale."

Enron had its highest annual profit ever in 1998, and earnings kept rising in 1999. Mr. Lay's letter to shareholders in the annual report for 1999 said: "Enron is moving so fast that sometimes others have trouble defining us. But we know who we are."

In mid-1999, Enron executives began the maneuvers that doomed the company. According to interviews and minutes of board meetings, Mr. Lay supported the creation of the first of two unusual partnerships to be headed and run by Mr. Fastow, then Enron's chief financial officer. LJM Cayman L.P., the first, was followed by an even larger partnership, LJM2 Co-Investment L.P., four months later.

These partnerships were designed to move debt off Enron's balance sheet and provide an influx of cash from outside investors such as banks and wealthy individuals. The ensuing flood of outside capital helped Enron temporarily pump up stated earnings by hundreds of millions of dollars.

Mr. Fastow used his intimate knowledge of Enron's finances and assets to produce for investors annualized returns, on some transactions, as high as 2,400%. To allow Mr. Fastow to work both sides of the street, Enron's board -- with Mr. Lay present -- eased the company's conflict-of-interest rules that would have prohibited such self-dealing.

In addition to the LJM partnerships, Mr. Fastow helped Enron create and manage many other partnerships and investment vehicles in which he held no equity interest. As these deals proliferated, many failed to actually shift risk away from the company. In many cases, Enron pledged assets -- such as foreign power plants or its common stock -- without always clearly disclosing to its shareholders and bondholders that they might be on the hook if the assets in the partnerships lost value.

In June 1999 and again in May 2000, Mr. Lay participated in board discussions of Mr. Fastow's role in LJM partnerships, according to board records. Mr. Lay signed an approval sheet permitting Enron to sell to one of the LJMs a piece of its fiber-optic network for nearly $91 million.

Mr. Lay stepped down as CEO in February 2001 as part of an expected succession. The board was comfortable with Mr. Skilling, who became CEO while Mr. Lay remained chairman.

Less Engaged

Many people close to Enron say Mr. Lay had become even less engaged in running Enron during Mr. Skilling's tenure as president and COO. He was content to trust Mr. Skilling so long as earnings and the stock price were climbing, these people say.

But even inside the company, "we knew that we pushed the limit in our accounting practices, and that people would come in with their [earnings] numbers whether we really did [achieve them] or not," says Gary Foster, a former Enron communications specialist who says he admires Mr. Lay. "Ken really believed these numbers that we were giving him, because of this blind optimism."

By the time Mr. Skilling took over as CEO, Enron was having trouble with some of its partnerships because the company's stock price was declining, thus reducing the value of the collateral used in many deals. When the price dropped to a certain "trigger" level -- combined with a reduction in Enron's credit rating -- investors in the partnerships could demand payment of billions of dollars from Enron.

On Aug. 14, Mr. Skilling resigned, saying he wanted more time with his family. He also acknowledged losing sleep over Enron's stock price, which was falling with the entire stock market.

A few days later, Mr. Lay descended from Enron's 50-story headquarters and crossed the street to the Hyatt Regency Hotel. When he stepped onto the dais in the Imperial Ballroom, hundreds of Enron employees jumped to their feet, clapping. Mr. Lay had agreed to return as CEO. He told the workers that he knew they were concerned about Mr. Skilling's resignation, but that Enron was going to be all right. "I stepped down once. I can step down again -- but I'm not in a big hurry," he said.

Patrick Wood III, chairman of the FERC, saw Mr. Lay on Oct. 3 at a Washington energy summit sponsored by Enron. The FERC official was amazed at Mr. Lay's demeanor: "He was like a professor, very engaged in the substance of the discussions. He didn't appear to have a care in the world."

On Oct. 16, Enron disclosed that it was taking a $1.01 billion charge, creating a $618 million loss. The charge related to huge, previously undisclosed losses in Enron's water, broadband and retail electricity businesses, as well as fallout from some investment vehicles.

The Wall Street Journal and then others began reporting Enron's use of off-balance-sheet entities. In an Oct. 23 conference call with analysts, Mr. Lay defended the company, saying he had "the highest faith and confidence" in Mr. Fastow.

"It was clear that Lay had no idea what these guys were talking about," says an Enron executive who was on the call. "It was weird."

The next day, Enron put Mr. Fastow on leave of absence.

The morning before Thanksgiving, he huddled in a conference room off his 50th floor office with a team of corporate turnaround experts. The Securities and Exchange Commission was investigating. Enron's stock had fallen to $6.98 from an all-time high of $90.75 in August 2000. But Mr. Lay told the advisers he didn't believe the banks to which Enron owed billions would let it file for Chapter 11 bankruptcy protection, a person who was in the room says.

The advisers didn't share his optimism. After vetting Enron, they had found almost nothing of value -- just debts. Hearing this, Mr. Lay glanced away, his face ashen. Even then, he wouldn't give up. He told the advisers Enron would work things out over the holiday weekend, the same person says.

Enron filed for Chapter 11 on Dec. 2. The next day, more than 4,000 employees were laid off. Thousands more lost huge chunks of their retirement savings that had been invested in Enron stock.

By the time Mr. Lay resigned as chairman and CEO on Jan. 23, the Justice Department was investigating, and he had been named as a defendant in numerous shareholder lawsuits alleging fraud. He was questioned by a special board committee investigating Enron's collapse, and a memo summarizing the interview repeatedly uses phrases such as "does not recall" and "did not know" to describe his answers.

Pleading the Fifth

On Feb. 12, Mr. Lay told the Senate Commerce Committee that, on the advice of counsel, he was invoking his Fifth Amendment right not to answer questions that could be self-incriminating.

Two months after that, Mr. Lay sat down for an interview in his Houston office. On his desk rested an Enron paperweight bearing the slogan, "Vision and Values." Talking about his life, he was able to recall the months in which events occurred more than 15 years ago.

On the advice of his lawyers, he wouldn't answer questions on Enron's collapse. Kelly Kimberly, a spokeswoman for Mr. Lay, says he is "profoundly saddened" by Enron's collapse and its effect on employees, retirees and others. "It's not possible for Ken Lay or any CEO of a company this size to be involved in every day-to-day detail of the company. A great deal has to be delegated to other senior officers."

In the interview, Mr. Lay did take credit for trying to imbue the Enron of the 1990s with his personal values. "I was always on the forefront of trying to make sure that our people did in fact live and honor those values -- respect, integrity, excellence," he said. "And the culture -- again, it's kind of hard to know how far we can go on this. ... Integrity and character are incredibly important to me."

He said he has enjoyed spending more time with his family. Despite what has happened, he said, "I'm absolutely confident that we'll get through this, and there will be something else that's going to be exciting and fun on the other side."

-- Kelly Spors contributed to this article.

Write to Bryan Gruley at bryan.gruley@wsj.com³ and Rebecca Smith at rebecca.smith@wsj.com⁴

Updated April 26, 2002 9:45 p.m. EDT