Kochland Read online

  Koch’s development group would become one of the largest, most effective deal-making machines in the United States. The group would come to embody modern American capitalism in the early twenty-first century, an era when private equity and hedge funds scoured the landscape in search of acquisitions. Charles Koch quietly built a private equity firm inside his offices in Wichita that would rival anything created on Wall Street. In the earliest days, in the 1980s, virtually nobody outside Koch Industries headquarters knew that the development group existed.

  The development group made its first major deal in 1981. It came along thanks to Bernard Paulson, the head of oil refining. He had spotted an opportunity in part because of the computer models that he had perfected to help him run the Pine Bend refinery. The data helped Paulson determine exactly which units he should run, what products he should produce, and which markets he should sell into. The computer models gave Paulson a kind of X-ray vision into oil markets. Now, Paulson turned that vision outward, toward his competitors.

  * * *

  Koch Industries sold a lot of crude oil to a refinery owned by Sun Oil in Corpus Christi. But Koch didn’t just collect money when it sold crude to Sun Oil. It also collected intelligence.

  Bernard Paulson’s team knew how much oil Sun was purchasing, and what kind of oil. Then he learned who Sun’s customers were, and what those customers paid for Sun’s product. Paulson began using his computer models to study the market that surrounded Sun Oil’s refinery. He studied what equipment was inside the refinery and at what volume that equipment could process oil. He learned what products Sun was making and at what volumes. He learned where Sun was selling its products and at what price.

  The Sun Oil refinery in Corpus Christi processed the same kind of “light crude” that most other refineries used.I Sun Oil did not have the type of coker towers that processed the heavy, sulfur-rich crudes refined at Pine Bend. This made the Corpus Christi refinery somewhat ordinary—it was doing the same thing that many refineries were doing along the Gulf Coast. It didn’t have the same kind of competitive niche that Koch enjoyed in Pine Bend.

  But Paulson saw something in Corpus Christi that even the refinery’s owner did not seem to appreciate: he saw that a market opportunity was being wasted. The Sun Oil refinery had equipment that could process oil and turn it into a petrochemical called paraxylene (pronounced pair-uh-ZIE-lene). Paraxylene was one of those products that Koch Industries excelled at making and selling: it was obscure, difficult to produce, and used in one form or another by virtually everyone. Paraxylene was the raw material for synthetic fibers and materials like dimethyl-terephthalate acid and purified terephthalic acid. These chemicals, in turn, were used to make things like polyethylene terephthalate and saturated polyester polymers. Most people have never heard of these chemicals, but they are the building blocks for plastic containers, bottles, drapes, upholstery, clothing like polyester suits, electrical insulation, and photographic film. Paraxylene was something that everybody bought without knowing it. And demand for paraxylene was growing. There were ever-more types of synthetic clothing and an ever-increasing demand for plastic containers to hold drinks or household chemicals.

  If Koch bought the Corpus Christi plant, Paulson realized, the acquisition would open up an entirely new market for the company: the market for paraxylene and other petrochemicals. And, true to Koch’s philosophy, the market would be new but not entirely foreign. Koch knew the petrochemical business already. It could apply the expertise developed at Pine Bend to manufacturing paraxylene in Texas. On top of all of this, it appeared to Paulson and others that Sun Oil wasn’t aware of the opportunity it was missing in Corpus Christi. Sun was making and selling paraxylene but not at nearly the levels that it could.

  In September of 1981 Koch Industries paid $265 million in cash for the refinery, and Paulson immediately started expanding it. He more than doubled its paraxylene output. He bought a used hydrocracking tower from a refinery in Europe and had it shipped to Texas, bragging to Charles Koch that he bought the tower for 40 percent of what it would cost “off the shelf.” Koch Industries became one of the largest paraxylene producers in the United States.

  * * *

  In 1987, Phil Dubose got the promotion of a lifetime. He went from running Koch’s marine division and barges to overseeing a vast piece of Koch’s pipeline and trucking infrastructure. Dubose’s job title was transportation manager for the southeast division (division 5). He was responsible for all of Koch’s transportation infrastructure in the southeast quadrant of the nation, a territory that stretched from Louisiana in the west to the Florida coast in the east, and all the way up to New York in the north. Inside this region, Dubose was responsible for the trucking operations, pipelines, and the marine tankers in the Gulf of Mexico. Several branch offices reported directly to him, each with its own superintendent. He spent a lot of time traveling to each office and consulting with the local teams.

  “I lived in airports—God almighty! To this day, I still get an uncomfortable feeling about airports. I just lived in those things,” Dubose said. “The thing I could never get over was eating by yourself. That was tough.”

  The machinery and supply chains that Dubose oversaw were exceedingly complicated. But the economic rules that he lived by remained relatively simple. The rules had not changed for him since he had been an oil gauger roving the backwaters of the bayou on a skiff back in the early 1970s. Dubose knew that his career still hinged on whether he was over or short. When he was an oil gauger, Dubose made sure he was over when he drained small oil tanks. Now he had to make sure he was over on a shipping network that covered many states.

  The reasons for this had to do with the nature of the pipeline business. Koch made its money in the transportation business by moving oil, not just by selling it. The actual value of the oil in its pipeline was of secondary importance to Koch Industries. What really mattered was ensuring that the oil was moving. When the oil was moving, Koch was paid to collect it and to deliver it. This means that Koch was som what protected from the volatility in prices that continued to roil markets during the 1980s. During the mideighties, for example, a market crash sent many oil drillers out of business and depressed the economy of oil-rich places like Houston. But this volatility did not matter so much to Dubose. What mattered far more to him was being over. He wanted to make sure that his region was selling more oil than it collected, keeping a “comfortable margin” of overages across operations. Of course, it was impossible for Koch to consistently sell more oil than it collected, which is why oil gaugers used the Koch method to underreport how much oil they took.

  Every month, Dubose received a packet of information mailed from Wichita. It was the statistical report compiled by the computer whizzes at headquarters. This was Dubose’s report card, in effect. And the most important number on the report card, the number that he focused on more than any other, was the overage that he reported. Dubose knew that if his region came in over, he would be praised, promoted, and well paid. If his region came up short, then he would be questioned, sidelined, and ultimately fired. “I lived and died by that” monthly report, he said. “They put it on your desk, and you just stared at it for a couple of hours before you even opened the sucker. . . . That’s how you kept your job with Koch. By coming out over. You could not come out short at all.”

  Some producers complained to Dubose about the company’s measurement practices—they thought Koch was cheating them by taking more of their oil than it paid for. But the measurement margins in dispute were small, and it was still profitable for oil producers to sell through Koch. Most of the producers were more interested in getting the oil moved quickly and on time, and they didn’t want to quibble over Koch’s gauging techniques. Dubose ensured that his region was over month after month, and, in doing so, he was favored by the managers in Wichita.

  Dubose was not some sort of anomaly. Koch’s pipeline and trucking managers across the country, from Florida to Oklahoma to California, took
great pains to make certain they were over. Some of these managers, like Dubose, might have thought that they were stealing. Others simply considered the measurement practices to be “aggressive” but fair overall. After all, measuring oil was an imprecise art. Koch executives simply saw themselves as ensuring that the imprecision did not hurt Koch’s bottom line. Dubose had learned this himself as early as 1968: They saw where they could manipulate this because it’s such a gray area. And they took advantage of it. From this point of view, Koch was just playing hardball.

  From an outsider’s point of view, things looked quite different. For someone who was new to the oil business, Koch’s conduct might have looked an awful lot like stealing. This point of view was about to come spilling out into the public realm. And it would do so in ways that endangered everything that Charles Koch had built.

  * * *

  I. Light crude oil has a low viscosity and flows easily at room temperature. Heavy crude is more dense and doesn’t flow as easily.

  CHAPTER 7

  * * *

  The Enemies Circle

  (1985–1992)

  During the late 1980s, Koch Industries faced two external threats that changed the company’s future. The threats were separate—one came from the US government; the other came from Bill Koch—but Charles Koch and his leadership team saw the threats as intertwined. It seemed to them that Bill Koch was still bitter at being forced out of the company and was using the government as his proxy to attack Charles. In fact, the government was pursuing its own criminal investigation into Charles Koch and Koch Industries, an investigation that arose from the years of aggressive mismeasurement inside Koch’s oil gathering divisions.

  The government threat intensified in May of 1989, when the Senate Select Committee on Indian Affairs held a series of daylong public hearings in Washington, DC. The hearings presented the evidence of oil theft collected by the Senate investigator Ken Ballen and FBI special agent James Elroy, who had surveilled Koch employees.

  The issue of oil theft was the subject of one hearing, and that hearing focused exclusively on Koch Industries. The reasons for this were simple. Evidence in the case pointed to Koch Industries as the primary culprit in the oil theft. No other company had such dramatically high overage levels, according to data obtained by the committee. Senate investigators believed that Koch had been caught red-handed, and the other companies had not.I The committee asked Charles Koch to testify at the hearing, but he refused. When the Senate released its final report, it stated declaratively: “Koch Oil (‘Koch’), a subsidiary of Koch Industries and the largest purchaser of Indian oil in the country, is the most dramatic example of an oil company stealing by deliberate mismeasurement and fraudulent reporting.”

  When the Senate hearings were complete, Ken Ballen and his team boxed up their evidence and sent it to federal prosecutors with the US Attorney’s office in Oklahoma City. The US Attorney launched a criminal investigation that was aimed squarely at Charles Koch. Agent Jim Elroy stayed on the case and intensified his surveillance.

  This legal threat coincided with another attack from Bill Koch. Bill had become suspicious of Charles Koch in 1985, when he learned that Koch Industries had repaid almost all of the $1.1 billion in debt that was taken on to buy out Bill and his brother Fred. Koch Industries paid the debt about three times faster than it had expected to. “I was stunned,” Bill Koch later told a journalist with Fortune magazine. “How could they have so much cash?”

  Bill became convinced that his brother Charles had lied to him back in 1983 by dramatically understating the company’s value. To Bill, there was simply no other way to explain Koch’s meteoric profitability since his departure. On June 7, 1985, Bill filed a federal lawsuit against Charles Koch, Sterling Varner, and Koch Industries, alleging that they defrauded him.

  The suit was the first volley in a sprawling battle that would last more than twenty years. The conflict spilled outside of the courtroom and spread to every corner of Koch Industries’ business, and into David and Charles Koch’s personal lives. Bill sent spies into the company as fake employees. He used wiretaps and hired private detectives to pose as journalists. His public relations team tried to plant damaging stories about Charles Koch in the media.

  When Bill Koch heard the allegations of oil mismeasurement and theft, he incorporated them into his strategy. He tried, on his own, to collect damning evidence about the Koch method.

  Inside Koch Industries, Bill’s attack and the government’s investigation were mistakenly seen as one and the same. This created a paranoid mind-set that seeped through the ranks of Koch’s leadership. The federal government was seen as illegitimate, as a pawn that could be manipulated by billionaires. A universe of varied institutions—from newspapers, magazines, and government agencies, to law firms and competing companies—was divided into two opposing camps: there were those who worked for Charles Koch, and those who worked for Bill. No institution was seen as being neutral.

  For Charles Koch, the twin attacks would sharpen and deepen his feelings toward government. He had always been a staunch foe of regulation, but the events of the 1980s would harden his opposition into a kind of loathing. Before this time, Koch Industries had been pestered and harassed by inspectors from the EPA, and by cumbersome rules imposed by the Department of Energy. But now his company was under surveillance from the FBI, whose agents were interrogating Koch employees in their homes. The threat was immediate, and it was personal. The threat would change the course of Koch Industries—and American politics along with it.

  * * *

  In 1989, the federal investigation into oil theft was transferred to a federal prosecutor named Nancy S. Jones. She was a tough-minded woman from Independence, Missouri, with many years of experience investigating fraud: first for the New York State Attorney General’s Office and then for the US Attorney’s Office in the Northern District of New York.

  Jones took over the case after getting a call from Jim Elroy. She didn’t know the FBI agent very well but was receptive when he told her that he had one hell of a case involving theft and corporate fraud.

  Jones was skeptical, at first, when Elroy walked her through the evidence he had amassed against Koch Industries. Elroy had obtained compelling material, to be sure, but Jones didn’t think it was strong enough to file criminal charges. She had a high bar for filing charges, and didn’t like to lose in front of a jury. Perhaps more importantly, Jones didn’t like charging low-level employees. To her mind, Elroy’s photos and statements from oil gaugers, which proved theft, were not enough. She wanted to know just how high up the chain of command at Koch Industries the culpability went.

  Jones empaneled a federal grand jury, which operated in secret to obtain evidence of any high-level conspiracy at Koch to steal oil. The grand jury investigated Koch Industries for many months.

  By 1990, Jones was convinced that criminal wrongdoing was underway at Koch. And she believed the theft might have been ordered from high levels in the company. Even at this early stage, Jones felt she had enough evidence to safely charge multiple Koch Oil gaugers with theft. She believed there was also enough evidence to charge a group of higher-level managers with directing the criminal behavior. Jones and Elroy continued their investigation, however, because they wanted to push even higher up the chain of command at Koch, maybe all the way to the executive suite. Their evidence suggested that they hadn’t yet reached the primary actors. “There was too much at stake in the case, to settle for the underlings,” Jones recalled.

  As Jones pressed her case from the US Attorney’s office, executives at Koch Industries saw the hand of Bill Koch at play. In September or October of 1988, Koch’s top attorney, Don Cordes, heard a “cocktail rumor” that Bill Koch was “trying to get the Senate interested in investigating Koch’s measurement practices,” according to court testimony later given by Cordes. That same month, Koch Industries received its first subpoena from the Select Committee on Indian Affairs, asking for a huge cache of documents relat
ed to its oil gathering practices in Oklahoma. It must have seemed to Cordes that the two efforts were combined, even though that was not true. The Senate investigation was prompted by the investigative reporting series in the Arizona Republic. According to Mike Masterson, a lead reporter who cowrote the series and was involved in it from the beginning, Bill Koch did not tip off reporters to the story. They came upon it while reporting on persistent problems on Indian reservations and heard claims about rampant oil theft. Bill Koch had heard about the inquiry and adopted it as a weapon to use against his brother.

  Koch Industries responded by circling the wagons against investigators and closing down access to vital records at the heart of its oil gathering operation. Almost immediately when the US Senate began its investigation, Koch Industries issued a new set of “Standards of Corporate Conduct” to employees throughout the company. The standards also included a provision that would likely conceal evidence of oil theft that would have occurred through mismeasurement.

  The standards of conduct said that no Koch employee should defraud anyone by making false entries into Koch’s books. This would effectively ban the Koch Method of oil measurement, which required oil gaugers to record fraudulent numbers on run tickets and receipts they left behind at oil wells.