Cheating Saved Him $300 Million

Hello! This is Deep Pockets #20.

I have a simple 4-step plan for anyone who plans to make a huge fortune AND keep it for as long as possible. This 4-step plan works 99.9999999%* of the time. Here it is. Write this down somewhere:

• Step 1: Make a huge fortune.

• Step 2: Get married, have kids, enjoy life, etc.

• Step 3: Hire an excellent financial advisor.

• Step 4: DO NOT FALL IN LOVE WITH A STRIPPER.

As you hopefully recall, last week’s Deep Pockets story was about Houston oil tycoon J. Howard Marshall. J. Howard is the perfect example of someone who did not follow step #4. As a result, his 14-month marriage to stripper-turned-actress Anna Nicole Smith came extremely close to costing his estate $475 million. And that would have been on top of the millions of dollars worth of gifts and benefits Anna had already received during their “relationship” and the millions his estate spent on legal fees fighting her for two decades. Call it, conservatively, a $500 million potential loss for falling in love with a stripper.

There are countless other examples, BUT, as I said a moment ago, my 4-step plan is not 100% perfect. It only works 99.9999999% of the time. Today, you’re going to hear what happened in the .0000001% example.

By pure coincidence, today’s story also involves a rich Houston businessman who fell in love with a stripper in the 1990s. And while the affair did destroy his marriage, it also turned out to be the luckiest financial break of a lifetime…

*not based on actual studies of any kind. Pulled out of my brain for dramatic effect… but probably not far off from reality

DEEP DIVE: Cheating on his wife saved him $280 million…

Lou Pai was born in Nanjing, China, in 1947. A decade before he was born, Lou’s father earned a Master’s degree from the Massachusetts Institute of Technology and a Ph.D. from the California Institute of Technology. His focus was aeronautics and applied mathematics.

When Lou was a baby, the family moved from China to the United States after his father landed a teaching job at Cornell University. The family settled in Maryland in 1953 when his father moved to the University of Maryland, College Park. He would remain there for the rest of his career.

According to his 1996 NYTimes obituary, Lou’s father, Dr. Shih-I Pai, “conducted pioneering studies focusing on the drag and lift of ever-faster airplanes, space engines and missiles… [and] published 14 textbooks and 130 scientific papers about fluid and plasma dynamics.”

Lou’s dad was smart. So was Lou. For college, Lou followed his father to the University of Maryland, where he earned B.S. and M.S. degrees in economics.

After college, Lou worked for various federal government agencies, including the Securities and Exchange Commission. As you probably could have guessed, bureaucratic federal jobs were not a path to riches.

Where would a young math genius go in the 1980s to seek their fortune? Silicon Valley was a sleepy cow town. Hollywood was in a rut. Seattle was a fishing and timber hub. Wall Street was still a dull banking and legal town.

If you wanted to make a huge fortune in the early 1980s, you moved to…

Texas.

Specifically, Houston.

The election of business-friendly Republican Ronald Reagan in 1980, combined with technological advances like fracking, dramatically increased both the demand and production of natural gas and oil in the United States. The epicenter of this new oil and gas boom was Houston.

In 1985, two huge natural gas and oil players merged: Houston Natural Gas and InterNorth. Consultants were hired to come up with a name for the new company. The consultants landed on “Enteron” as a play on the positive connotations of the words “energy,” “enter,” and “on.”

Enteron was already printed on letterhead and business cards when someone pointed out that “enteron” is also the word for the digestive tract/intestinal system. So the name was shortened to…

Enron

Houston Natural Gas’ founder/CEO was tapped to be the CEO of the new entity. His name was Ken Lay.

In 1987, Lou Pai went to work at Enron. At the time, Enron was a fairly boring regional energy supplier, selling oil and natural gas to utilities at a set market rate.

Ken Lay did not want to be CEO of a boring regional energy supplier. The same year Lou Pai was hired, Enron brought consultants from McKinsey & Company to help it find a sexier new business model.

One of the McKinsey consultants was a brash 33-year-old named Jeff Skilling.

Skilling had an idea.

Taking advantage of deregulation made possible by Reagan and his business-friendly Republican administration, Skilling thought Enron should build the country’s first “forward market” for natural gas. A “forward market” is a financial market where contracts are traded for the future delivery of a commodity (natural gas, rice, orange juice concentrate, etc). For example, let’s say a bakery needs to purchase 1,000 pounds of flour in three months to meet its production demands. But the bakery is worried the price is going to go up. To hedge against the potential price increase, the bakery would enter into a forward contract found on a forward market to lock in their prices today.

Skilling wanted Enron to create the country’s first forward market for natural gas.

If successful, Enron would transform from a boring regional energy supplier into a financial trading firm. Wall Street… in Houston. Enron could theoretically make unlimited money by merely providing and maintaining the marketplace.

Ken Lay was so excited and impressed that he actually hired Skilling away from McKensey to put the plan into action. In 1990, 35-year-old Jeff Skilling was named chairman and CEO of the newly created division, Enron Finance Corp. The following year, he became chairman of Enron Gas Services. He was then named CEO of Enron Capital and Trade Resources. In 1997, Skilling became Enron’s overall Chief Operating Officer, the second-most powerful person in the company behind only Ken Lay.

As he rose up the ranks at Enron, Skilling was impressed by an introverted math genius who managed one of the company’s many random business units. The introverted math genius was Lou Pai. They worked hand-in-hand, putting Skilling’s plan into action. In March 1997, Jeff and Lou created a new subdivision called Enron Energy Services. Lou was named CEO.

Enron Energy Services

The goal of Enron Energy Services (EES) was to create an alternative financial market where consumers and businesses could buy gas and electricity directly from dozens of utility companies. Think of it like this - If you live in Los Angeles, Southern California Edison is your ONLY option for electricity, and SoCal Gas is your ONLY option for gas. So whatever they set the prices at is what you pay. It would be nice if consumers could choose from an alternate market that had dozens of hundreds of utilities competing.

That’s what EES wanted to create for consumer and small business energy needs. And they spent a small fortune on advertisements around the country, attempting to sell people on the idea of buying all their energy directly in one place. A noble concept if it worked!

Unfortunately, the implementation of EES' ambitious goals turned out to be a huge disaster. Between 1997 and 2001, EES blew through $500 million in operating expenses without ever generating any significant revenues. Between all of the various Enron subsidiaries that Lou Pai ran during his tenure, he set roughly $1 billion on fire.

But through it all, Lou Pai was one of Skilling’s guys. Perhaps his most important right-hand man. So even though his efforts LOST the company around $1 billion, he was still one of Enron’s most important and highest-paid employees. During his tenure just as CEO of EES, Lou earned approximately $100 million in salary. That does not include stock.

Lou Pai also received enormous grants of Enron stock. And this will be important in a moment.

Outside of being known as an introverted math genius. Lou Pai earned a reputation for taking part in the lavish excesses of Enron’s corporate culture. He frequently charged very expensive lunches and dinners on his company credit card. According to legend, he used Enron’s corporate jets like a personal shuttle. It has been estimated that every time Lou flew between his various homes, it cost Enron $45,000.

But private jets and lunches were not Lou Pai’s most famous vice.

According to the amazing book "The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron":

"Only two things seemed to motivate Lou Pai. Money, and a peculiar fascination with strippers."

Lou would reportedly visit a particular Houston strip club (located not far from Enron's world headquarters) every night after work. He would conduct meetings at the strip club and treat the top-performing salesman to wild backroom parties 100% funded by his Enron corporate credit card.

As legend has it, the strippers didn't believe such a mild-mannered, almost meek person was actually a powerful energy company CEO. How did Lou prove his identity? He would bring the strippers up to Enron offices, where they would continue the party late into the night.

By the way, Lou was married and had two kids at home while all this was going on. He and his wife, Lanna, had been married for over twenty years.

To avoid getting caught by Lanna, on his way home from the strip club, Lou would stop by a gas station and splash a little bit of gasoline on himself to get rid of the stripper scent.

As you might imagine, coming home every night smelling like gasoline probably isn't a sustainable lifestyle. Worse yet, at some point, going to strip clubs turned into a full-on affair with a stripper named Melanie Fewell. Just like Lou, when the affair started, Melanie also happened to be married with two kids.

It was a mess that got even messier when Melanie became pregnant. Lou and Melanie welcomed a daughter on April 16, 1997.

Lou’s wife, Lanna, found out about the affair and the love child in January 1998. A few months later, he moved out of the family home. To make matters worse, around this time, Enron had grown tired of Lou's strip club expenses and the secret disaster that EES had become. Lou wasn't exactly fired from Enron, but he also wasn't exactly encouraged to stay on as CEO of EES, either.

We’ll come back to Lou Pai in a minute…

Enron Fucks Around

As a reminder, in early 1997, Jeff Skilling became COO of Enron. At that point, Enron’s market cap was around $12 billion. Over the next two years, Enron’s market cap increased, but not all that much. Below is a chart of Enron’s market cap between January 1997 and December 1999:

As you can see, Enron’s market cap was mostly flat but then indeed grew to around $27 billion by late 1999.

What started happening at Enron in the late 1990s?

Unsatisfied that his master plan led to a flat stock price, Jeff Skilling pushed Enron to adopt a “mark-to-market” accounting method.

What does that mean?

Let’s let’s say you buy a house for $100,000. You hope to sell this house in two years for $120,000. Under traditional accounting methods (and rational sanity), you wouldn’t count that $20,000 gain until you actually sell the house for $120k. Using mark-to-market, if you believe the home’s market value has increased to $120,000 at some point, you immediately record a $20,000 profit… without actually selling the home.

And at Enron, it was even weirder. Sticking with the house analogy. Enron buys a house for $100,000. At the time of purchase it predicts the house will be worth $120,000 in two years. So, at the point of purchase, Enron records a $20,000 profit. What happens if the house doesn’t increase in value? What happens if it burns down? Enron kept the $20,000 profit on its books.

Here’s a real example:

Beginning in the late 1990s, Enron spent over $1 billion laying thousands of miles of broadband cable around the country. In July 2000, Enron and Blockbuster Video signed a 20-year agreement to create a streaming network that would deliver on-demand movies through these cables to customers in cities around the US. With separate partners, Enron wanted to eventually add sports and games to “Enron Broadband.”

From just the Blockbuster partnership alone, Enron estimated it would eventually earn $110 million in profits. So, using mark-to-market, it booked $110 million as a profit on its P&L immediately in late 2000.

Enron was the first non-financial company in the world to adopt mark-to-market for its long-term contracts.

These deals were buzzy and expensive, but they weren’t necessarily illegal or against accounting standards at the time. Enron was ALSO doing some very illegal things.

Enron created a bunch of phony shell companies called “Special Purpose Entities.” Enron then signed deals with these phony shell companies that created totally imagined and inflated profits while also hiding very real actual debt. These Special Purpose entities are a complicated detour, so I’m just going to leave it at that. You get the picture.

Enron Finds Out

So, how did that Blockbuster partnership work out? If it was a twenty-year partnership announced in July 2000, it should have run through July 2020, right?

It died nine months later when Blockbuster withdrew from the partnership in March 2001. And yet, Enron kept the $110 million in future profits recorded as booked earnings for late 2000!

In February 2001, Jeff Skilling replaced Ken Lay as CEO.

On April 17, 2001, Enron held a quarterly earnings call with investment managers and analysts who were already questioning the legitimacy of these buzzy deals and the accounting methods. On this call, a fund manager asked Skilling what should have been a simple question but turned out to be the first sign something was really wrong at Enron. Here’s the question the analyst posed to Skilling:

“You know, you are the only financial institution that can’t produce a balance sheet or cash flow statement with their earnings.”

And here’s Skilling’s reply:

“You, you, you... Well, uh… thank you very much. We appreciate it.”

An empty but harmless statement, right? Well, Skilling thought the phone was muted at the end of that sentence. It wasn’t. So his full reply went out to the world:

“You, you, you... Well, uh… thank you very much. We appreciate it…. Asshole.”

Here’s a recording of the actual interaction:

On the day of that earnings call, Enron’s market cap was $46.35 billion. I’ve circled that point on the chart below. Take a look at what happened over the next eight months:

As you can see, that infamous investor call began a slow downward march for Enron’s stock price (and therefore market cap).

On August 14, 2001, Jeff Skilling abruptly resigned from Enron, citing vague personal reasons. Over the next few weeks, Skilling sold $60 million worth of his Enron shares.

Ken Lay came back as CEO after Skilling’s resignation, but by now, Wall Street could smell something rotten at Enron.

At its all-time high, August 2000, Enron’s stock price was $90 and Enron’s market cap was $67 billion.

On September 26, 2001, with the stock at $25 and the market cap around $18 billion, Ken Lay addressed nervous employees in an all-hands meeting. At this point, employees were free to sell their shares as they pleased because the company was in an open sales window. That window would close on October 26, when the company went into a lockdown ahead of its quarterly earnings report release.

During that company meeting, Ken told his nervous employees that Enron’s third-quarter earnings report was “looking great… We hit our numbers. We are continuing to have strong growth in our businesses… The balance sheet is strong…. The company is fundamentally sound [and] at current prices… this seems to be an incredibly cheap stock.”

He encouraged employees to “talk up the stock and talk positively about Enron to your family and friends.”

Ken even told his employees that he was so confident in the stock that he had purchased additional shares for himself. That was partially true. He did exercise some options to buy shares, but he also sold shares leading up to this employee conference. When you added up all the purchases and sales, the net result was that Ken Lay SOLD $20 million worth of shares in the previous two months.

Less than two months later, on November 29, 2001, Enron stock was trading for $1. The company’s market cap had fallen to $190 million.

On December 2, 2001, Enron filed for bankruptcy. The following day, the stock price shrunk to $0.40, bringing the market cap down to $90 million.

With $65 billion in assets at its peak, it was the largest bankruptcy in corporate history up to that point. At its peak, Enron was the fifth largest company in America.

Thousands of employees lost their jobs, and many of them also lost their life savings, which was mostly made up of Enron stock.

The Reckoning

In the aftermath of Enron’s shocking bankruptcy, Jeff Skilling and Ken Lay were both indicted. In May 2006, they were both found guilty. Despite spending $70 million on his defense and appeals, Skilling was sentenced to 24 years in prison. He served 12 years.

Ken Lay was scheduled to be sentenced in October 2006. In the meantime, he was allowed to remain free on bail. On July 5, 2006, he died of a heart attack at his vacation home in Colorado.

Ken Lay’s all-time peak net worth was $400 million. When he died, he was worth negative $250,000.

Enron’s CFO Andrew Fastow, the guy who managed the illegal Special Purpose Entities, was sentenced to six years in prison. He served five. His wife, Lea Fastow, Enron’s former assistant treasurer, was also indicted and ended up going to jail for a year.

Richard Causey, the former Chief Accounting Officer, served five years in prison.

Enron’s 111-year-old accounting firm, Arthur Anderson, lost its license and was effectively dissolved in August 2002.

What About Lou Pai?

Ken Lay and Jeff Skilling weren’t the only Enron executives who sold shares leading up to the fall. Between early 1999 and August 2001, 29 top company executives sold $1.1 billion worth of shares. Ken Lay sold $101 million worth of his shares. Jeff Skilling sold $67 million. Andrew Fastow, the CFO, sold $30 million. The biggest seller of all sold $353 million worth of shares. Care to guess who that seller was?

When we left off, it was early 1999, and Lou Pai had just moved out of the family home after his wife of 20 years discovered he had a child with a stripper. Divorce papers were filed, and the couple agreed to mediation. Mediation took place between April and May 2000.

Following the terms of their mediation, Lou agreed to sell 100% of his Enron holdings.

He sold the majority of his shares during a three-week period between May 18 and June 7, 2000. I’ve highlighted that period when the sales took place with a red circle in the market cap chart below:

He sold another chunk in mid-2001 at about half the price of his previous sales.

In total, Lou Pai sold $353 million worth of Enron shares, more than any other executive by a factor of three. Those shares would have been totally worthless by the end of 2001. That is why falling in love with and impregnating a stripper was the best financial move of Lou Pai’s life.

Keep in mind that $353 million number is just stock sales. It doesn’t include the roughly $100 million Lou earned in salary.

Lou’s ex-wife, Lanna, was paid an undisclosed lump sum. She was also given the couple’s former mansion in Houston, a multi-million-dollar condo in Houston, and their $3 million house in Hawaii.

After the divorce and his firing from Enron, Lou and Melanie retreated to his 77,000-acre ranch in Colorado, which he bought in 1999 for $23 million. That ranch actually made him the second-largest landowner in the state. He sold this ranch in 2004 for $60 million. He and Melanie also bought a horse-breeding facility in Texas and a new home in the Houston suburbs.

In 2005, he founded an asset management firm called Element Markets, which specialized in selling renewable energy credits to institutional clients. Element Markets was acquired in 2022.

In July 2008, Lou agreed to pay $31.5 million to settle charges with the SEC, the same agency where he started his career decades ago. He has always denied having any knowledge of Enron’s troubles and only sold because of the terms of his mediation agreement.

Finally, if you assumed Lou’s affair with a stripper ended up being just a fling, you are wrong! Lou and Melanie are still married! They operated horse farms in Texas and Virginia, and in May 2022, Lou and Melanie paid $8.2 million for an equestrian estate in Wellington, Florida. Their daughter is a champion dressage… player? Rider? Dressager? She’s very good at dressage.

And while this story has a happy ending for Lou and Melaine, let me remind you that they are the .0000001% example. If you make a fortune someday and want to keep it, don’t forget my 4-step plan. Write it down and frame it:

• Step 1: Make a huge fortune.

• Step 2: Get married, have kids, enjoy life, etc.

• Step 3: Hire an excellent financial advisor.

• Step 4: DO NOT FALL IN LOVE WITH A STRIPPER.

FINAL WORD

On the next edition of “Deep Pockets,” we’ll reveal a critical wealth-building strategy that is the reason Oprah is a multi-billionaire instead of a “mere” multi-millionaire.

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