EXHIBIT 99.2
ENRON
WILLIAM POWERS, Jr.
Member of the Enron Board of
Directors and
Chairman of the Special
Investigation Committee
3600 Murillo Circle
Austin, TX 78703
512-232-1120
February 1, 2002
To the Members of the Board of Directors
Enron Corporation
Enclosed is a copy of the Report of the Special Investigation
Committee.
Sincerely,
/s/ William Powers, Jr.
William Powers, Jr.
Enclosure
REPORT OF INVESTIGATION
BY THE
SPECIAL INVESTIGATIVE COMMITTEE
OF THE
BOARD OF DIRECTORS OF ENRON CORP.
William C. Powers, Jr., Chair
Raymond S. Troubh
Herbert S. Winokur, Jr.
Counsel
Wilmer, Cutler & Pickering
February 1, 2002
TABLE OF CONTENTS
EXECUTIVE SUMMARY AND CONCLUSIONS..................................................................1
- ---------------------------------
INTRODUCTION.......................................................................................29
- ------------
I. BACKGROUND: ENRON AND SPECIAL PURPOSE ENTITIES.........................................36
- -- -----------------------------------------------
II. CHEWCO..................................................................................41
- --- ------
A. Formation of Chewco...........................................................43
-- -------------------
B. Limited Board Approval........................................................46
-- ----------------------
C. SPE Non-Consolidation "Control" Requirement...................................47
-- -------------------------------------------
D. SPE Non-Consolidation "Equity" Requirement....................................49
-- ------------------------------------------
E. Fees Paid to Chewco/Kopper....................................................54
-- --------------------------
F. Enron Revenue Recognition Issues..............................................56
-- --------------------------------
1. Enron Guaranty Fee..................................................56
-- ------------------
2. "Required Payments" to Enron........................................57
-- ----------------------------
3. Recognition of Revenue from Enron Stock.............................58
-- ---------------------------------------
G. Enron's Repurchase of Chewco's Limited Partnership Interest...................60
-- -----------------------------------------------------------
1. Negotiations........................................................60
-- ------------
2. Buyout Transaction..................................................62
-- ------------------
3. Returns to Kopper/Dodson............................................64
-- ------------------------
4. Tax Indemnity Payment...............................................64
-- ---------------------
H. Decision to Restate...........................................................66
-- -------------------
i
III. LJM HISTORY AND GOVERNANCE..............................................................68
- ---- --------------------------
A. Formation and Authorization of LJM Cayman, L.P. and
LJM2 Co-Investment, L.P.......................................................68
- ---------------------------------------------
B. LJM Governance Issues.........................................................75
-- ---------------------
IV. RHYTHMS NETCONNECTIONS..................................................................77
- --- ----------------------
A. Origin of the Transaction.....................................................77
-- -------------------------
B. Structure of the Transaction..................................................79
-- ----------------------------
C. Structure and Pricing Issues..................................................82
-- ----------------------------
1. Nature of the Rhythms "Hedge".......................................82
-- -----------------------------
2. SPE Equity Requirement..............................................83
-- ----------------------
3. Pricing and Credit Capacity.........................................84
-- ---------------------------
D. Adjustment of the "Hedge" and Repayment of the Note...........................85
-- ---------------------------------------------------
E. Unwinding the Transaction.....................................................87
-- -------------------------
1. Negotiations........................................................87
-- ------------
2. Terms...............................................................89
-- -----
3. Financial Results...................................................89
-- -----------------
F. Financial Participation of Enron Employees in the Unwind......................92
-- --------------------------------------------------------
V. THE RAPTORS.............................................................................97
- -- -----------
A. Raptor I......................................................................99
-- --------
1. Formation and Structure.............................................99
-- -----------------------
2. Enron's Approval of Raptor I........................................105
-- ----------------------------
3. Early Activity in Raptor I..........................................107
-- --------------------------
4. Credit Capacity Concerns in the Fall of 2000........................110
-- --------------------------------------------
B. Raptors II and IV.............................................................111
-- -----------------
ii
C. Raptor III....................................................................114
-- ----------
1. The New Power Company...............................................115
-- ---------------------
2. The Creation of Raptor III..........................................115
-- --------------------------
3. Decline in Raptor III's Credit Capacity.............................118
-- ---------------------------------------
D. Raptor Restructuring..........................................................119
-- --------------------
1. Fourth Quarter 2000 Temporary Fix...................................119
-- ---------------------------------
2. First Quarter 2001 Restructuring....................................121
-- --------------------------------
a. The Search for a Solution................................121
-- -------------------------
b. The Restructuring Transaction............................122
-- -----------------------------
E. Unwind of the Raptors.........................................................125
-- ---------------------
F. Conclusions on the Raptors....................................................128
-- --------------------------
VI. OTHER TRANSACTIONS WITH LJM.............................................................134
- --- ---------------------------
A. Illustrative Transactions with LJM............................................135
-- ----------------------------------
1. Cuiaba..............................................................135
-- ------
2. ENA CLO.............................................................138
-- -------
3. Nowa Sarzyna (Poland Power Plant)...................................140
-- ---------------------------------
4. MEGS................................................................141
-- ----
5. Yosemite............................................................142
-- --------
6. Backbone............................................................143
-- --------
B. Other Transactions with LJM...................................................145
-- ---------------------------
iii
VII. OVERSIGHT BY THE BOARD OF DIRECTORS AND MANAGEMENT......................................148
- ---- --------------------------------------------------
A. Oversight by the Board of Directors...........................................148
-- -----------------------------------
1. The Chewco Transaction..............................................149
-- ----------------------
2. Creation of LJM1 and LJM2...........................................150
-- -------------------------
3. Creation of the Raptor Vehicles.....................................156
-- -------------------------------
4. Board Oversight of the Ongoing Relationship with LJM................158
-- ----------------------------------------------------
B. Oversight by Management.......................................................165
-- -----------------------
C. The Watkins Letter............................................................172
-- ------------------
VIII. RELATED-PARTY DISCLOSURE ISSUES.........................................................178
- ----- -------------------------------
A. Standards for Disclosure of Related-Party Transactions........................178
-- ------------------------------------------------------
B. Enron's Disclosure Process....................................................181
-- --------------------------
C. Proxy Statement Disclosures...................................................184
-- ---------------------------
1. Enron's Disclosures.................................................184
-- -------------------
2. Adequacy of Disclosures.............................................187
-- -----------------------
D. Financial Statement Footnote Disclosures......................................192
-- ----------------------------------------
1. Enron's Disclosures.................................................192
-- -------------------
2. Adequacy of Disclosures.............................................197
-- -----------------------
E. Conclusions on Disclosure.....................................................200
-- -------------------------
iv
EXECUTIVE SUMMARY AND CONCLUSIONS
The Special Investigative Committee of the Board of Directors of
Enron Corp. submits this Report of Investigation to the Board of Directors. In
accordance with our mandate, the Report addresses transactions between Enron and
investment partnerships created and managed by Andrew S. Fastow, Enron's former
Executive Vice President and Chief Financial Officer, and by other Enron
employees who worked with Fastow.
The Committee has done its best, given the available time and
resources, to conduct a careful and impartial investigation. We have prepared a
Report that explains the substance of the most significant transactions and
highlights their most important accounting, corporate governance, management
oversight, and public disclosure issues. An exhaustive investigation of these
related-party transactions would require time and resources beyond those
available to the Committee. We were not asked, and we have not attempted, to
investigate the causes of Enron's bankruptcy or the numerous business judgments
and external factors that contributed it. Many questions currently part of
public discussion--such as questions relating to Enron's international business
and commercial electricity ventures, broadband communications activities,
transactions in Enron securities by insiders, or management of employee 401(k)
plans--are beyond the scope of the authority we were given by the Board.
There were some practical limitations on the information available to
the Committee in preparing this Report. We had no power to compel third parties
to submit to interviews, produce documents, or otherwise provide information.
Certain former Enron employees who (we were told) played substantial roles in
1
one or more of the transactions under investigation--including Fastow, Michael
J. Kopper, and Ben F. Glisan, Jr.--declined to be interviewed either entirely or
with respect to most issues. We have had only limited access to certain
workpapers of Arthur Andersen LLP ("Andersen"), Enron's outside auditors, and no
access to materials in the possession of the Fastow partnerships or their
limited partners. Information from these sources could affect our conclusions.
This Executive Summary and Conclusions highlights important parts of
the Report and summarizes our conclusions. It is based on the complete set of
facts, explanations and limitations described in the Report, and should be read
with the Report itself. Standing alone, it does not, and cannot, provide a full
understanding of the facts and analysis underlying our conclusions.
BACKGROUND
On October 16, 2001, Enron announced that it was taking a $544
million after-tax charge against earnings related to transactions with LJM2
Co-Investment, L.P. ("LJM2"), a partnership created and managed by Fastow. It
also announced a reduction of shareholders' equity of $1.2 billion related to
transactions with that same entity.
Less than one month later, Enron announced that it was restating its
financial statements for the period from 1997 through 2001 because of accounting
errors relating to transactions with a different Fastow partnership, LJM Cayman,
L.P. ("LJM1"), and an additional related-party entity, Chewco Investments, L.P.
("Chewco"). Chewco was managed by an Enron Global Finance employee, Kopper, who
reported to Fastow.
2
The LJM1- and Chewco-related restatement, like the earlier charge
against earnings and reduction of shareholders' equity, was very large. It
reduced Enron's reported net income by $28 million in 1997 (of $105 million
total), by $133 million in 1998 (of $703 million total), by $248 million in 1999
(of $893 million total), and by $99 million in 2000 (of $979 million total). The
restatement reduced reported shareholders' equity by $258 million in 1997, by
$391 million in 1998, by $710 million in 1999, and by $754 million in 2000. It
increased reported debt by $711 million in 1997, by $561 million in 1998, by
$685 million in 1999, and by $628 million in 2000. Enron also revealed, for the
first time, that it had learned that Fastow received more than $30 million from
LJM1 and LJM2. These announcements destroyed market confidence and investor
trust in Enron. Less than one month later, Enron filed for bankruptcy.
SUMMARY OF FINDINGS
This Committee was established on October 28, 2001, to conduct an
investigation of the related-party transactions. We have examined the specific
transactions that led to the third-quarter 2001 earnings charge and the
restatement. We also have attempted to examine all of the approximately two
dozen other transactions between Enron and these related-party entities: what
these transactions were, why they took place, what went wrong, and who was
responsible.
Our investigation identified significant problems beyond those Enron
has already disclosed. Enron employees involved in the partnerships were
enriched, in the aggregate, by tens of millions of dollars they should never
have received--Fastow by at least $30 million, Kopper by at least $10 million,
two others by $1 million each, and still two more by amounts we believe were at
least in the hundreds of thousands of dollars. We have seen no evidence that any
3
of these employees, except Fastow, obtained the permission required by Enron's
Code of Conduct of Business Affairs to own interests in the partnerships.
Moreover, the extent of Fastow's ownership and financial windfall was
inconsistent with his representations to Enron's Board of Directors.
This personal enrichment of Enron employees, however, was merely one
aspect of a deeper and more serious problem. These partnerships--Chewco, LJM1,
and LJM2--were used by Enron Management to enter into transactions that it could
not, or would not, do with unrelated commercial entities. Many of the most
significant transactions apparently were designed to accomplish favorable
financial statement results, not to achieve bona fide economic objectives or to
transfer risk. Some transactions were designed so that, had they followed
applicable accounting rules, Enron could have kept assets and liabilities
(especially debt) off of its balance sheet; but the transactions did not follow
those rules.
Other transactions were implemented--improperly, we are informed by
our accounting advisors--to offset losses. They allowed Enron to conceal from
the market very large losses resulting from Enron's merchant investments by
creating an appearance that those investments were hedged--that is, that a third
party was obligated to pay Enron the amount of those losses--when in fact that
third party was simply an entity in which only Enron had a substantial economic
stake. We believe these transactions resulted in Enron reporting earnings from
the third quarter of 2000 through the third quarter of 2001 that were almost $1
billion higher than should have been reported.
4
Enron's original accounting treatment of the Chewco and LJM1
transactions that led to Enron's November 2001 restatement was clearly wrong,
apparently the result of mistakes either in structuring the transactions or in
basic accounting. In other cases, the accounting treatment was likely wrong,
notwithstanding creative efforts to circumvent accounting principles through the
complex structuring of transactions that lacked fundamental economic substance.
In virtually all of the transactions, Enron's accounting treatment was
determined with extensive participation and structuring advice from Andersen,
which Management reported to the Board. Enron's records show that Andersen
billed Enron $5.7 million for advice in connection with the LJM and Chewco
transactions alone, above and beyond its regular audit fees.
Many of the transactions involve an accounting structure known as a
"special purpose entity" or "special purpose vehicle" (referred to as an "SPE"
in this Summary and in the Report). A company that does business with an SPE may
treat that SPE as if it were an independent, outside entity for accounting
purposes if two conditions are met: (1) an owner independent of the company must
make a substantive equity investment of at least 3% of the SPE's assets, and
that 3% must remain at risk throughout the transaction; and (2) the independent
owner must exercise control of the SPE. In those circumstances, the company may
record gains and losses on transactions with the SPE, and the assets and
liabilities of the SPE are not included in the company's balance sheet, even
though the company and the SPE are closely related. It was the technical failure
of some of the structures with which Enron did business to satisfy these
requirements that led to Enron's restatement.
5
SUMMARY OF TRANSACTIONS AND MATTERS REVIEWED
The following are brief summaries of the principal transactions and
matters in which we have identified substantial problems:
THE CHEWCO TRANSACTION
The first of the related-party transactions we examined involved
Chewco Investments L.P., a limited partnership managed by Kopper. Because of
this transaction, Enron filed inaccurate financial statements from 1997 through
2001, and provided an unauthorized and unjustifiable financial windfall to
Kopper.
From 1993 through 1996, Enron and the California Public Employees'
Retirement System ("CalPERS") were partners in a $500 million joint venture
investment partnership called Joint Energy Development Investment Limited
Partnership ("JEDI"). Because Enron and CalPERS had joint control of the
partnership, Enron did not consolidate JEDI into its consolidated financial
statements. The financial statement impact of non-consolidation was significant:
Enron would record its contractual share of gains and losses from JEDI on its
income statement and would disclose the gain or loss separately in its financial
statement footnotes, but would not show JEDI's debt on its balance sheet.
In November 1997, Enron wanted to redeem CalPERS' interest in JEDI so
that CalPERS would invest in another, larger partnership. Enron needed to find a
new partner, or else it would have to consolidate JEDI into its financial
statements, which it did not want to do. Enron assisted Kopper (whom Fastow
identified for the role) in forming Chewco to purchase CalPERS' interest. Kopper
6
was the manager and owner of Chewco's general partner. Under the SPE rules
summarized above, Enron could only avoid consolidating JEDI onto Enron's
financial statements if Chewco had some independent ownership with a minimum of
3% of equity capital at risk. Enron and Kopper, however, were unable to locate
any such outside investor, and instead financed Chewco's purchase of the JEDI
interest almost entirely with debt, not equity. This was done hurriedly and in
apparent disregard of the accounting requirements for non-consolidation.
Notwithstanding the shortfall in required equity capital, Enron did not
consolidate Chewco (or JEDI) into its consolidated financial statements.
Kopper and others (including Andersen) declined to speak with us
about why this transaction was structured in a way that did not comply with the
non-consolidation rules. Enron, and any Enron employee acting in Enron's
interest, had every incentive to ensure that Chewco complied with these rules.
We do not know whether this mistake resulted from bad judgment or carelessness
on the part of Enron employees or Andersen, or whether it was caused by Kopper
or others putting their own interests ahead of their obligations to Enron.
The consequences, however, were enormous. When Enron and Andersen
reviewed the transaction closely in 2001, they concluded that Chewco did not
satisfy the SPE accounting rules and--because JEDI's non-consolidation depended
on Chewco's status--neither did JEDI. In November 2001, Enron announced that it
would consolidate Chewco and JEDI retroactive to 1997. As detailed in the
Background section above, this retroactive consolidation resulted in a massive
reduction in Enron's reported net income and a massive increase in its reported
debt.
7
Beyond the financial statement consequences, the Chewco transaction
raises substantial corporate governance and management oversight issues. Under
Enron's Code of Conduct of Business Affairs, Kopper was prohibited from having a
financial or managerial role in Chewco unless the Chairman and CEO determined
that his participation "does not adversely affect the best interests of the
Company." Notwithstanding this requirement, we have seen no evidence that his
participation was ever disclosed to, or approved by, either Kenneth Lay (who was
Chairman and CEO) or the Board of Directors.
While the consequences of the transaction were devastating to Enron,
Kopper reaped a financial windfall from his role in Chewco. This was largely a
result of arrangements that he appears to have negotiated with Fastow. From
December 1997 through December 2000, Kopper received $2 million in "management"
and other fees relating to Chewco. Our review failed to identify how these
payments were determined, or what, if anything, Kopper did to justify the
payments. More importantly, in March 2001 Enron repurchased Chewco's interest in
JEDI on terms Kopper apparently negotiated with Fastow (during a time period in
which Kopper had undisclosed interests with Fastow in both LJM1 and LJM2).
Kopper had invested $125,000 in Chewco in 1997. The repurchase resulted in
Kopper's (and a friend to whom he had transferred part of his interest)
receiving more than $10 million from Enron.
THE LJM TRANSACTIONS
In 1999, with Board approval, Enron entered into business
relationships with two partnerships in which Fastow was the manager and an
investor. The transactions between Enron and the LJM partnerships resulted in
8
Enron increasing its reported financial results by more than a billion dollars,
and enriching Fastow and his co-investors by tens of millions of dollars at
Enron's expense.
The two members of the Special Investigative Committee who have
reviewed the Board's decision to permit Fastow to participate in LJM
notwithstanding the conflict of interest have concluded that this arrangement
was fundamentally flawed.1/ A relationship with the most senior financial
officer of a public company--particularly one requiring as many controls and as
much oversight by others as this one did--should not have been undertaken in the
first place.
The Board approved Fastow's participation in the LJM partnerships
with full knowledge and discussion of the obvious conflict of interest that
would result. The Board apparently believed that the conflict, and the
substantial risks associated with it, could be mitigated through certain
controls (involving oversight by both the Board and Senior Management) to ensure
that transactions were done on terms fair to Enron. In taking this step, the
Board thought that the LJM partnerships would offer business benefits to Enron
that would outweigh the potential costs. The principal reason advanced by
Management in favor of the relationship, in the case of LJM1, was that it would
permit Enron to accomplish a particular transaction it could not otherwise
- ----------------------------
1/ One member of the Special Investigative Committee, Herbert S. Winokur, Jr.,
was a member of the Board of Directors and the Finance Committee during the
relevant period. The portions of the Report describing and evaluating actions of
the Board and its Committees are solely the views of the other two members of
the Committee, Dean William C. Powers, Jr. of the University of Texas School of
Law and Raymond S. Troubh.
9
accomplish. In the case of LJM2, Management advocated that it would provide
Enron with an additional potential buyer of assets that Enron wanted to sell,
and that Fastow's familiarity with the Company and the assets to be sold would
permit Enron to move more quickly and incur fewer transaction costs.
Over time, the Board required, and Management told the Board it was
implementing, an ever-increasing set of procedures and controls over the
related-party transactions. These included, most importantly, review and
approval of all LJM transactions by Richard Causey, the Chief Accounting
Officer; and Richard Buy, the Chief Risk Officer; and, later during the period,
Jeffrey Skilling, the President and COO (and later CEO). The Board also directed
its Audit and Compliance Committee to conduct annual reviews of all LJM
transactions.
These controls as designed were not rigorous enough, and their
implementation and oversight was inadequate at both the Management and Board
levels. No one in Management accepted primary responsibility for oversight; the
controls were not executed properly; and there were structural defects in those
controls that became apparent over time. For instance, while neither the Chief
Accounting Officer, Causey, nor the Chief Risk Officer, Buy, ignored his
responsibilities, they interpreted their roles very narrowly and did not give
the transactions the degree of review the Board believed was occurring. Skilling
appears to have been almost entirely uninvolved in the process, notwithstanding
representations made to the Board that he had undertaken a significant role. No
one in Management stepped forward to address the issues as they arose, or to
bring the apparent problems to the Board's attention.
10
As we discuss further below, the Board, having determined to allow
the related-party transactions to proceed, did not give sufficient scrutiny to
the information that was provided to it thereafter. While there was important
information that appears to have been withheld from the Board, the annual
reviews of LJM transactions by the Audit and Compliance Committee (and later
also the Finance Committee) appear to have involved only brief presentations by
Management (with Andersen present at the Audit Committee) and did not involve
any meaningful examination of the nature or terms of the transactions. Moreover,
even though Board Committee-mandated procedures required a review by the
Compensation Committee of Fastow's compensation from the partnerships, neither
the Board nor Senior Management asked Fastow for the amount of his LJM-related
compensation until October 2001, after media reports focused on Fastow's role in
LJM.
From June 1999 through June 2001, Enron entered into more than 20
distinct transactions with the LJM partnerships. These were of two general
types: asset sales and purported "hedging" transactions. Each of these types of
transactions was flawed, although the latter ultimately caused much more harm to
Enron.
ASSET SALES. Enron sold assets to LJM that it wanted to remove from
its books. These transactions often occurred close to the end of financial
reporting periods. While there is nothing improper about such transactions if
they actually transfer the risks and rewards of ownership to the other party,
there are substantial questions whether any such transfer occurred in some of
the sales to LJM.
11
Near the end of the third and fourth quarters of 1999, Enron sold
interests in seven assets to LJM1 and LJM2. These transactions appeared
consistent with the stated purpose of allowing Fastow to participate in the
partnerships--the transactions were done quickly, and permitted Enron to remove
the assets from its balance sheet and record a gain in some cases. However,
events that occurred after the sales call into question the legitimacy of the
sales. In particular: (1) Enron bought back five of the seven assets after the
close of the financial reporting period, in some cases within a matter of
months; (2) the LJM partnerships made a profit on every transaction, even when
the asset it had purchased appears to have declined in market value; and (3)
according to a presentation Fastow made to the Board's Finance Committee, those
transactions generated, directly or indirectly, "earnings" to Enron of $229
million in the second half of 1999 (apparently including one hedging
transaction). (The details of the transactions are discussed in Section VI of
the Report.) Although we have not been able to confirm Fastow's calculation,
Enron's reported earnings for that period were $570 million (pre-tax) and $549
million (after-tax).
We have identified some evidence that, in three of these transactions
where Enron ultimately bought back LJM's interest, Enron had agreed in advance
to protect the LJM partnerships against loss. If this was in fact the case, it
was likely inappropriate to treat the transactions as sales. There also are
plausible, more innocent explanations for some of the repurchases, but a
sufficient basis remains for further examination. With respect to those
transactions in which risk apparently did not pass from Enron, the LJM
partnerships functioned as a vehicle to accommodate Enron in the management of
its reported financial results.
12
HEDGING TRANSACTIONS. The first "hedging" transaction between Enron
and LJM occurred in June 1999, and was approved by the Board in conjunction with
its approval of Fastow's participation in LJM1. The normal idea of a hedge is to
contract with a creditworthy outside party that is prepared--for a price--to
take on the economic risk of an investment. If the value of the investment goes
down, that outside party will bear the loss. That is not what happened here.
Instead, Enron transferred its own stock to an SPE in exchange for a note. The
Fastow partnership, LJM1, was to provide the outside equity necessary for the
SPE to qualify for non-consolidation. Through the use of options, the SPE
purported to take on the risk that the price of the stock of Rhythms
NetConnections Inc. ("Rhythms"), an internet service provider, would decline.
The idea was to "hedge" Enron's profitable merchant investment in Rhythms stock,
allowing Enron to offset losses on Rhythms if the price of Rhythms stock
declined. If the SPE were required to pay Enron on the Rhythms options, the
transferred Enron stock would be the principal source of payment.
The other "hedging" transactions occurred in 2000 and 2001 and
involved SPEs known as the "Raptor" vehicles. Expanding on the idea of the
Rhythms transaction, these were extraordinarily complex structures. They were
funded principally with Enron's own stock (or contracts for the delivery of
Enron stock) that was intended to "hedge" against declines in the value of a
large group of Enron's merchant investments. LJM2 provided the outside equity
designed to avoid consolidation of the Raptor SPEs.
The asset sales and hedging transactions raised a variety of issues,
including the following:
13
ACCOUNTING AND FINANCIAL REPORTING ISSUES. Although Andersen approved
the transactions, in fact the "hedging" transactions did not involve substantive
transfers of economic risk. The transactions may have looked superficially like
economic hedges, but they actually functioned only as "accounting" hedges. They
appear to have been designed to circumvent accounting rules by recording hedging
gains to offset losses in the value of merchant investments on Enron's quarterly
and annual income statements. The economic reality of these transactions was
that Enron never escaped the risk of loss, because it had provided the bulk of
the capital with which the SPEs would pay Enron.
Enron used this strategy to avoid recognizing losses for a time. In
1999, Enron recognized after-tax income of $95 million from the Rhythms
transaction, which offset losses on the Rhythms investment. In the last two
quarters of 2000, Enron recognized revenues of $500 million on derivative
transactions with the Raptor entities, which offset losses in Enron's merchant
investments, and recognized pre-tax earnings of $532 million (including net
interest income). Enron's reported pre-tax earnings for the last two quarters of
2000 totaled $650 million. "Earnings" from the Raptors accounted for more than
80% of that total.
The idea of hedging Enron's investments with the value of Enron's
capital stock had a serious drawback as an economic matter. If the value of the
investments fell at the same time as the value of Enron stock fell, the SPEs
would be unable to meet their obligations and the "hedges" would fail. This is
precisely what happened in late 2000 and early 2001. Two of the Raptor SPEs
lacked sufficient credit capacity to pay Enron on the "hedges." As a result, in
late March 2001, it appeared that Enron would be required to take a pre-tax
charge against earnings of more than $500 million to reflect the shortfall in
14
credit capacity. Rather than take that loss, Enron "restructured" the Raptor
vehicles by, among other things, transferring more than $800 million of
contracts to receive its own stock to them just before quarter-end. This
transaction apparently was not disclosed to or authorized by the Board, involved
a transfer of very substantial value for insufficient consideration, and appears
inconsistent with governing accounting rules. It continued the concealment of
the substantial losses in Enron's merchant investments.
However, even these efforts could not avoid the inevitable results of
hedges that were supported only by Enron stock in a declining market. As the
value of Enron's merchant investments continued to fall in 2001, the credit
problems in the Raptor entities became insoluble. Ultimately, the SPEs were
terminated in September 2001. This resulted in the unexpected announcement on
October 16, 2001, of a $544 million after-tax charge against earnings. In
addition, Enron was required to reduce shareholders' equity by $1.2 billion.
While the equity reduction was primarily the result of accounting errors made in
2000 and early 2001, the charge against earnings was the result of Enron's
"hedging" its investments--not with a creditworthy counter-party, but with
itself.
CONSOLIDATION ISSUES. In addition to the accounting abuses involving
use of Enron stock to avoid recognizing losses on merchant investments, the
Rhythms transaction involved the same SPE equity problem that undermined Chewco
and JEDI. As we stated above, in 2001, Enron and Andersen concluded that Chewco
lacked sufficient outside equity at risk to qualify for non-consolidation. At
the same time, Enron and Andersen also concluded that the LJM1 SPE in the
Rhythms transaction failed the same threshold accounting requirement. In recent
Congressional testimony, Andersen's CEO explained that the firm had simply been
wrong in 1999 when it concluded (and presumably advised Enron) that the LJM1 SPE
15
satisfied the non-consolidation requirements. As a result, in November 2001,
Enron announced that it would restate prior period financials to consolidate the
LJM1 SPE retroactively to 1999. This retroactive consolidation decreased Enron's
reported net income by $95 million (of $893 million total) in 1999 and by $8
million (of $979 million total) in 2000.
SELF-DEALING ISSUES. While these related-party transactions
facilitated a variety of accounting and financial reporting abuses by Enron,
they were extraordinarily lucrative for Fastow and others. In exchange for their
passive and largely risk-free roles in these transactions, the LJM partnerships
and their investors were richly rewarded. Fastow and other Enron employees
received tens of millions of dollars they should not have received. These
benefits came at Enron's expense.
When Enron and LJM1 (through Fastow) negotiated a termination of the
Rhythms "hedge" in 2000, the terms of the transaction were extraordinarily
generous to LJM1 and its investors. These investors walked away with tens of
millions of dollars in value that, in an arm's-length context, Enron would never
have given away. Moreover, based on the information available to us, it appears
that Fastow had offered interests in the Rhythms termination to Kopper and four
other Enron employees. These investments, in a partnership called "Southampton
Place," provided spectacular returns. In exchange for a $25,000 investment,
Fastow received (through a family foundation) $4.5 million in approximately two
months. Two other employees, who each invested $5,800, each received $1 million
in the same time period. We have seen no evidence that Fastow or any of these
employees obtained clearance for those investments, as required by Enron's Code
of Conduct. Kopper and the other Enron employees who received these vast returns
16
were all involved in transactions between Enron and the LJM partnerships in
2000--some representing Enron.
PUBLIC DISCLOSURE
Enron's publicly-filed reports disclosed the existence of the LJM
partnerships. Indeed, there was substantial factual information about Enron's
transactions with these partnerships in Enron's quarterly and annual reports and
in its proxy statements. Various disclosures were approved by one or more of
Enron's outside auditors and its inside and outside counsel. However, these
disclosures were obtuse, did not communicate the essence of the transactions
completely or clearly, and failed to convey the substance of what was going on
between Enron and the partnerships. The disclosures also did not communicate the
nature or extent of Fastow's financial interest in the LJM partnerships. This
was the result of an effort to avoid disclosing Fastow's financial interest and
to downplay the significance of the related-party transactions and, in some
respects, to disguise their substance and import. The disclosures also asserted
that the related-party transactions were reasonable compared to transactions
with third parties, apparently without any factual basis. The process by which
the relevant disclosures were crafted was influenced substantially by Enron
Global Finance (Fastow's group). There was an absence of forceful and effective
oversight by Senior Enron Management and in-house counsel, and objective and
critical professional advice by outside counsel at Vinson & Elkins, or auditors
at Andersen.
17
THE PARTICIPANTS
The actions and inactions of many participants led to the
related-party abuses, and the financial reporting and disclosure failures, that
we identify in our Report. These participants include not only the employees who
enriched themselves at Enron's expense, but also Enron's Management, Board of
Directors and outside advisors. The factual basis and analysis for these
conclusions are set out in the Report. In summary, based on the evidence
available to us, the Committee notes the following:
ANDREW FASTOW. Fastow was Enron's Chief Financial Officer and was
involved on both sides of the related-party transactions. What he presented as
an arrangement intended to benefit Enron became, over time, a means of both
enriching himself personally and facilitating manipulation of Enron's financial
statements. Both of these objectives were inconsistent with Fastow's fiduciary
duties to Enron and anything the Board authorized. The evidence suggests that he
(1) placed his own personal interests and those of the LJM partnerships ahead of
Enron's interests; (2) used his position in Enron to influence (or attempt to
influence) Enron employees who were engaging in transactions on Enron's behalf
with the LJM partnerships; and (3) failed to disclose to Enron's Board of
Directors important information it was entitled to receive. In particular, we
have seen no evidence that he disclosed Kopper's role in Chewco or LJM2, or the
level of profitability of the LJM partnerships (and his personal and family
interests in those profits), which far exceeded what he had led the Board to
expect. He apparently also violated and caused violations of Enron's Code of
Conduct by purchasing, and offering to Enron employees, extraordinarily
18
lucrative interests in the Southampton Place partnership. He did so at a time
when at least one of those employees was actively working on Enron's behalf in
transactions with LJM2.
ENRON'S MANAGEMENT. Individually, and collectively, Enron's
Management failed to carry out its substantive responsibility for ensuring that
the transactions were fair to Enron--which in many cases they were not--and its
responsibility for implementing a system of oversight and controls over the
transactions with the LJM partnerships. There were several direct consequences
of this failure: transactions were executed on terms that were not fair to Enron
and that enriched Fastow and others; Enron engaged in transactions that had
little economic substance and misstated Enron's financial results; and the
disclosures Enron made to its shareholders and the public did not fully or
accurately communicate relevant information. We discuss here the involvement of
Kenneth Lay, Jeffrey Skilling, Richard Causey, and Richard Buy.
For much of the period in question, Lay was the Chief Executive
Officer of Enron and, in effect, the captain of the ship. As CEO, he had the
ultimate responsibility for taking reasonable steps to ensure that the officers
reporting to him performed their oversight duties properly. He does not appear
to have directed their attention, or his own, to the oversight of the LJM
partnerships. Ultimately, a large measure of the responsibility rests with the
CEO.
Lay approved the arrangements under which Enron permitted Fastow to
engage in related-party transactions with Enron and authorized the Rhythms
transaction and three of the Raptor vehicles. He bears significant
responsibility for those flawed decisions, as well as for Enron's failure to
implement sufficiently rigorous procedural controls to prevent the abuses that
19
flowed from this inherent conflict of interest. In connection with the LJM
transactions, the evidence we have examined suggests that Lay functioned almost
entirely as a Director, and less as a member of Management. It appears that both
he and Skilling agreed, and the Board understood, that Skilling was the senior
member of Management responsible for the LJM relationship.
Skilling was Enron's President and Chief Operating Officer, and later
its Chief Executive Officer, until his resignation in August 2001. The Board
assumed, and properly so, that during the entire period of time covered by the
events discussed in this Report, Skilling was sufficiently knowledgeable of and
involved in the overall operations of Enron that he would see to it that matters
of significance would be brought to the Board's attention. With respect to the
LJM partnerships, Skilling personally supported the Board's decision to permit
Fastow to proceed with LJM, notwithstanding Fastow's conflict of interest.
Skilling had direct responsibility for ensuring that those reporting to him
performed their oversight duties properly. He likewise had substantial
responsibility to make sure that the internal controls that the Board put in
place--particularly those involving related-party transactions with the
Company's CFO--functioned properly. He has described the detail of his
expressly-assigned oversight role as minimal. That answer, however, misses the
point. As the magnitude and significance of the related-party transactions to
Enron increased over time, it is difficult to understand why Skilling did not
ensure that those controls were rigorously adhered to and enforced. Based upon
his own description of events, Skilling does not appear to have given much
attention to these duties. Skilling certainly knew or should have known of the
magnitude and the risks associated with these transactions. Skilling, who prides
20
himself on the controls he put in place in many areas at Enron, bears
substantial responsibility for the failure of the system of internal controls to
mitigate the risk inherent in the relationship between Enron and the LJM
partnerships.
Skilling met in March 2000 with Jeffrey McMahon, Enron's Treasurer
(who reported to Fastow). McMahon told us that he approached Skilling with
serious concerns about Enron's dealings with the LJM partnerships. McMahon and
Skilling disagree on some important elements of what was said. However, if
McMahon's account (which is reflected in what he describes as contemporaneous
talking points for the discussion) is correct, it appears that Skilling did not
take action (nor did McMahon approach Lay or the Board) after being put on
notice that Fastow was pressuring Enron employees who were negotiating with
LJM--clear evidence that the controls were not effective. There also is
conflicting evidence regarding Skilling's knowledge of the March 2001 Raptor
restructuring transaction. Although Skilling denies it, if the account of other
Enron employees is accurate, Skilling both approved a transaction that was
designed to conceal substantial losses in Enron's merchant investments and
withheld from the Board important information about that transaction.
Causey was and is Enron's Chief Accounting Officer. He presided over
and participated in a series of accounting judgments that, based on the
accounting advice we have received, went well beyond the aggressive. The fact
that these judgments were, in most if not all cases, made with the concurrence
of Andersen is a significant, though not entirely exonerating, fact.
21
Causey was also charged by the Board of Directors with a substantial
role in the oversight of Enron's relationship with the LJM partnerships. He was
to review and approve all transactions between Enron and the LJM partnerships,
and he was to review those transactions with the Audit and Compliance Committee
annually. The evidence we have examined suggests that he did not implement a
procedure for identifying all LJM1 or LJM2 transactions and did not give those
transactions the level of scrutiny the Board had reason to believe he would. He
did not provide the Audit and Compliance Committee with the full and complete
information about the transactions, in particular the Raptor III and Raptor
restructuring transactions, that it needed to fulfill its duties.
Buy was and is Enron's Senior Risk Officer. The Board of Directors
also charged him with a substantial role in the oversight of Enron's
relationship with the LJM partnerships. He was to review and approve all
transactions between them. The evidence we have examined suggests that he did
not implement a procedure for identifying all LJM1 or LJM2 transactions. Perhaps
more importantly, he apparently saw his role as more narrow than the Board had
reason to believe, and did not act affirmatively to carry out (or ensure that
others carried out) a careful review of the economic terms of all transactions
between Enron and LJM.
THE BOARD OF DIRECTORS. With respect to the issues that are the
subject of this investigation, the Board of Directors failed, in our judgment,
in its oversight duties. This had serious consequences for Enron, its employees,
and its shareholders.
The Board of Directors approved the arrangements that allowed the
Company's CFO to serve as general partner in partnerships that participated in
significant financial transactions with Enron. As noted earlier, the two members
22
of the Special Investigative Committee who have participated in this review of
the Board's actions believe this decision was fundamentally flawed. The Board
substantially underestimated the severity of the conflict and overestimated the
degree to which management controls and procedures could contain the problem.
After having authorized a conflict of interest creating as much risk
as this one, the Board had an obligation to give careful attention to the
transactions that followed. It failed to do this. It cannot be faulted for the
various instances in which it was apparently denied important information
concerning certain of the transactions in question. However, it can and should
be faulted for failing to demand more information, and for failing to probe and
understand the information that did come to it. The Board authorized the Rhythms
transaction and three of the Raptor transactions. It appears that many of its
members did not understand those transactions--the economic rationale, the
consequences, and the risks. Nor does it appear that they reacted to warning
signs in those transactions as they were presented, including the statement to
the Finance Committee in May 2000 that the proposed Raptor transaction raised a
risk of "accounting scrutiny." We do note, however, that the Committee was told
that Andersen was "comfortable" with the transaction. As complex as the
transactions were, the existence of Fastow's conflict of interest demanded that
the Board gain a better understanding of the LJM transactions that came before
it, and ensure (whether through one of its Committees or through use of outside
consultants) that they were fair to Enron.
The Audit and Compliance Committee, and later the Finance Committee,
took on a specific role in the control structure by carrying out periodic
reviews of the LJM transactions. This was an opportunity to probe the
23
transactions thoroughly, and to seek outside advice as to any issues outside the
Board members' expertise. Instead, these reviews appear to have been too brief,
too limited in scope, and too superficial to serve their intended function. The
Compensation Committee was given the role of reviewing Fastow's compensation
from the LJM entities, and did not carry out this review. This remained the case
even after the Committees were on notice that the LJM transactions were
contributing very large percentages of Enron's earnings. In sum, the Board did
not effectively meet its obligation with respect to the LJM transactions.
The Board, and in particular the Audit and Compliance Committee, has
the duty of ultimate oversight over the Company's financial reporting. While the
primary responsibility for the financial reporting abuses discussed in the
Report lies with Management, the participating members of this Committee believe
those abuses could and should have been prevented or detected at an earlier time
had the Board been more aggressive and vigilant.
OUTSIDE PROFESSIONAL ADVISORS. The evidence available to us suggests
that Andersen did not fulfill its professional responsibilities in connection
with its audits of Enron's financial statements, or its obligation to bring to
the attention of Enron's Board (or the Audit and Compliance Committee) concerns
about Enron's internal controls over the related-party transactions. Andersen
has admitted that it erred in concluding that the Rhythms transaction was
structured properly under the SPE non-consolidation rules. Enron was required to
restate its financial results for 1999 and 2000 as a result. Andersen
participated in the structuring and accounting treatment of the Raptor
transactions, and charged over $1 million for its services, yet it apparently
failed to provide the objective accounting judgment that should have prevented
24
these transactions from going forward. According to Enron's internal accountants
(though this apparently has been disputed by Andersen), Andersen also reviewed
and approved the recording of additional equity in March 2001 in connection with
this restructuring. In September 2001, Andersen required Enron to reverse this
accounting treatment, leading to the $1.2 billion reduction of equity. Andersen
apparently failed to note or take action with respect to the deficiencies in
Enron's public disclosure documents.
According to recent public disclosures, Andersen also failed to bring
to the attention of Enron's Audit and Compliance Committee serious reservations
Andersen partners voiced internally about the related-party transactions. An
internal Andersen e-mail from February 2001 released in connection with recent
Congressional hearings suggests that Andersen had concerns about Enron's
disclosures of the related-party transactions. A week after that e-mail,
however, Andersen's engagement partner told the Audit and Compliance Committee
that, with respect to related-party transactions, "[r]equired disclosure [had
been] reviewed for adequacy," and that Andersen would issue an unqualified audit
opinion. From 1997 to 2001, Enron paid Andersen $5.7 million in connection with
work performed specifically on the LJM and Chewco transactions. The Board
appears to have reasonably relied upon the professional judgment of Andersen
concerning Enron's financial statements and the adequacy of controls for the
related-party transactions. Our review indicates that Andersen failed to meet
its responsibilities in both respects.
Vinson & Elkins, as Enron's longstanding outside counsel, provided
advice and prepared documentation in connection with many of the transactions
discussed in the Report. It also assisted Enron with the preparation of its
25
disclosures of related-party transactions in the proxy statements and the
footnotes to the financial statements in Enron's periodic SEC filings.2/
Management and the Board relied heavily on the perceived approval by Vinson &
Elkins of the structure and disclosure of the transactions. Enron's Audit and
Compliance Committee, as well as in-house counsel, looked to it for assurance
that Enron's public disclosures were legally sufficient. It would be
inappropriate to fault Vinson & Elkins for accounting matters, which are not
within its expertise. However, Vinson & Elkins should have brought a stronger,
more objective and more critical voice to the disclosure process.
ENRON EMPLOYEES WHO INVESTED IN THE LJM PARTNERSHIPS. Michael Kopper,
who worked for Fastow in the Finance area, enriched himself substantially at
Enron's expense by virtue of his roles in Chewco, Southampton Place, and
possibly LJM2. In a transaction he negotiated with Fastow, Kopper, and his
co-investor in Chewco received more than $10 million from Enron for a $125,000
investment. This was inconsistent with his fiduciary duties to Enron and, as
best we can determine, with anything the Board--which apparently was unaware of
his Chewco activities--authorized. We do not know what financial returns he
received from his undisclosed investments in LJM2 or Southampton Place. Kopper
violated Enron's Code of Conduct not only by purchasing his personal interests
in Chewco, LJM2, and Southampton, but also by secretly offering an interest in
Southampton to another Enron employee.
- ---------------------------
2/ Because of the relationship between Vinson & Elkins and the University of
Texas School of Law, the portions of the Report describing and evaluating
actions of Vinson & Elkins are solely the views of Troubh and Winokur.
26
Ben Glisan, an accountant and later McMahon's successor as Enron's
Treasurer, was a principal hands-on Enron participant in two transactions that
ultimately required restatements of earnings and equity: Chewco and the Raptor
structures. Because Glisan declined to be interviewed by us on Chewco, we cannot
speak with certainty about Glisan's knowledge of the facts that should have led
to the conclusion that Chewco failed to comply with the non-consolidation
requirement. There is, however, substantial evidence that he was aware of such
facts. In the case of Raptor, Glisan shares responsibility for accounting
judgments that, as we understand based on the accounting advice we have
received, went well beyond the aggressive. As with Causey, the fact that these
judgments were, in most if not all cases, made with the concurrence of Andersen
is a significant, though not entirely exonerating, fact. Moreover, Glisan
violated Enron's Code of Conduct by accepting an interest in Southampton Place
without prior disclosure to or consent from Enron's Chairman and Chief Executive
Officer--and doing so at a time when he was working on Enron's behalf on
transactions with LJM2, including Raptor.
Kristina Mordaunt (an in-house lawyer at Enron), Kathy Lynn (an
employee in the Finance area), and Anne Yaeger Patel (also an employee in
Finance) appear to have violated Enron's Code of Conduct by accepting interests
in Southampton Place without obtaining the consent of Enron's Chairman and Chief
Executive Officer.
* * *
The tragic consequences of the related-party transactions and
accounting errors were the result of failures at many levels and by many people:
a flawed idea, self-enrichment by employees, inadequately-designed controls,
27
poor implementation, inattentive oversight, simple (and not-so-simple)
accounting mistakes, and overreaching in a culture that appears to have
encouraged pushing the limits. Our review indicates that many of those
consequences could and should have been avoided.
28
The Special Investigative Committee of the Board of Directors of
Enron Corp. submits this Report of Investigation to the Board of Directors.
INTRODUCTION
As directed by the Board, this Report addresses transactions between
Enron and investment partnerships created and managed by Andrew S. Fastow,
Enron's former Executive Vice President and Chief Financial Officer ("CFO"), and
other Enron employees who worked for Fastow.
Many of the transactions we reviewed are extraordinarily complex. The
Committee has done its best, given the available time and resources, to conduct
a careful and impartial investigation. We have prepared a Report that explains
the substance of the transactions and highlights their most important
accounting, corporate governance, management oversight, and public disclosure
issues. An exhaustive investigation of these related-party transactions would
require time and resources beyond those available to the Committee. In light of
the Board's expressed desire for a prompt explanation of these transactions, and
pressing requests from governmental authorities to both the Committee and the
Company, we provide this Report without further delay. We believe that the
information and analysis it provides is a substantial first step in reviewing
and understanding these transactions, and serves as an important starting point
for further governmental or other investigations.
The Committee's mandate was specific and focused, so we need to
explain what we did not do. We were not asked, and we have not attempted, to
investigate the causes of Enron's bankruptcy or the numerous business judgments
29
and external factors that contributed it. Many questions currently part of
public discussion--such as questions relating to Enron's international business
and commercial electricity ventures, broadband communications, transactions in
Enron securities by insiders, or management of employee 401(k) plans--are beyond
the scope of the authority we were given by the Board.
FORMATION OF THE COMMITTEE. On October 16, 2001, Enron announced its
earnings for the third quarter of 2001. The announcement included an unexpected
after-tax charge against earnings of $544 million "related to losses associated
with certain investments, principally Enron's interest in The New Power Company,
broadband and technology investments, and early termination during the third
quarter of certain structured finance arrangements with a previously disclosed
entity." In a conference call with securities analysts that day, Enron Chairman
Kenneth Lay said that Enron's shareholders' equity was being reduced by $1.2
billion in connection with "the early termination" of "certain structured
finance arrangements with a previously disclosed- entity." Both the $544 million
charge and the reduction of shareholders' equity related to transactions between
Enron and LJM2 Co-Investment, L.P. ("LJM2"), a partnership created and managed
by Fastow. The immediate response from the investment community and the media
was intense and negative.
On October 22, Enron announced that the Securities and Exchange
Commission ("SEC") had requested that Enron voluntarily provide information
about the related-party transactions with LJM2 that had been addressed in
30
Enron's earnings announcement. Two days later, on October 24, Enron announced
that Fastow would be on a leave of absence and would be replaced as CFO.
The Board of Directors established a Special Committee on October 28,
consisting of three directors who were not employees of Enron. The Board
authorized the Committee to conduct an investigation of the related-party
transactions that were the subject of the SEC inquiry. In the weeks that
followed, two new members were added to the Board: Dean William C. Powers, Jr.
of the University of Texas School of Law and Raymond S. Troubh. Powers and
Troubh, neither of whom had been a member of the Board at the time of the
transactions under investigation, were appointed to the Committee (later renamed
the Special Investigative Committee) and Powers was named Chairman. Two of the
previously-appointed Directors stepped down so that the new Directors would
constitute a majority. As constituted after these changes, the Committee's
members are Powers, Troubh, and Herbert S. Winokur, Jr.3/
- -------------------------
3/ Powers became Dean of the University of Texas Law School on September 1,
2000. He has been on the faculty since 1977. James Derrick, Enron's General
Counsel, served on the Law School Foundation Board of Directors and the
Executive Committee of the Law Alumni Association. He resigned from both
positions when Powers was appointed to the Enron Board. He had previously been
President of the Law Alumni Association. In 1998, Enron pledged a $250,000 gift
to the Law School; the final payment was made in January 2001. Enron has also
provided $2,250 in matching money for gifts made to the Law School by Enron
employees. Vinson & Elkins has been a major financial supporter of the Law
School. The portions of the Report describing and evaluating actions of Vinson &
Elkins are solely the views of Troubh and Winokur.
Winokur has been a member of the Board of Directors of Enron since 1985. He was
Chairman of the Finance Committee during the time period relevant to this Report
and participated in the decisions of the Board and the Finance Committee that
are addressed in the Report. The portions of the Report describing and
evaluating actions of the Board and its Committees are solely the views of
Powers and Troubh.
31
The Committee engaged Wilmer, Cutler & Pickering as its legal
counsel. Wilmer, Cutler engaged Deloitte & Touche LLP to provide accounting
assistance.4/ The Committee has relied on Wilmer, Cutler for legal advice and
Deloitte & Touche for advice on accounting issues.
On November 8, 2001, Enron filed a Current Report on Form 8-K
providing additional information about the previously announced charges, and
about its business transactions with LJM2 and another limited partnership in
which Fastow had been the general partner (LJM Cayman, L.P., known as "LJM1").
Enron also announced its intention to restate its prior period financial
statements for the years ending December 31, 1997 through 2000, and the quarters
ending March 31 and June 30, 2001. On November 19, 2001, Enron filed its
quarterly report on Form 10-Q, which provided additional information about the
restatement. On December 2, 2001, Enron and certain of its subsidiaries filed
voluntary petitions for relief under Chapter 11 of the United States Bankruptcy
Code.
- ---------------------------
4/ Wilmer, Cutler has performed certain legal services distinct from this Report
and unrelated to any issues addressed in this Report for Enron or its
subsidiaries in the last five years. These consist of the representation of an
Enron subsidiary before the United States Supreme Court in Enron Power
Marketing, Inc. v. Federal Energy Regulatory Commission, ___ U.S. ___, 121 S.
Ct. 2587 (2001), and the representation of Enron in connection with
consideration by the European Commission of a merger of two outside entities.
Deloitte & Touche has previously performed certain accounting and tax services
for Enron, and certain limited tax-related services for Chewco Investments, not
relating to the issues discussed in this Report. It also conducted a peer review
of Arthur Andersen LLP in late 2001, including an expanded scope review of
Andersen's Houston office, although this peer review did not cover Andersen's
work for Enron.
32
THE COMMITTEE'S INVESTIGATION. Our investigation was a private
internal inquiry. We requested and received voluntary production of documents
from many people inside and outside of Enron. Many people also cooperated by
providing information through interviews and otherwise. The Committee's counsel
reviewed more than 430,000 pages of documents and interviewed more than 65
people, several more than once. Counsel interviewed nine current Enron
Directors, more than 50 current and former Enron employees, and some of Enron's
outside professional advisors.
There were some practical limitations on the information available to
the Committee in preparing this Report. Although the Board directed that Enron
employees cooperate with us, we had no power to compel third parties to submit
to interviews, produce documents, or otherwise provide information. Certain
former Enron employees who (we were told) played substantial roles in one or
more of the transactions under investigation--including Fastow, Michael J.
Kopper, and Ben F. Glisan, Jr.--declined to be interviewed either entirely or
with respect to most issues. Fastow provided a limited number of documents and
submitted to a brief interview, during which he declined to respond to most
questions.5/
- -----------------------
5/ In addition, largely because of time constraints and resource limitations
resulting from the Company's bankruptcy, there are certain Enron-related
materials the Committee has not been able to review (or review fully). At
present, it is impossible to determine whether those materials contain important
information. For example, the Committee has had little or no access to e-mails
that are still being retrieved from archive tapes. Our counsel has informed us
that, based on experience in other investigations, review of e-mails of this
type may provide information that could be relevant to our analysis and
conclusions.
33
Moreover, we have not had access to information and materials in the
possession of many of the relevant third parties. Arthur Andersen LLP
("Andersen") permitted the Committee to review some, but not all, of its
workpapers relating to Enron. It did not provide copies of those workpapers or
allow the Committee to interview knowledgeable Andersen personnel.
Representatives of LJM1 and LJM2 (collectively, "the LJM partnerships") declined
to provide documents to the Committee and, in light of a confidentiality
agreement between those entities and their limited partners, the Committee has
not had access to materials in the possession of the limited partners.
There also may be differences between information obtained through
voluntary interviews and document requests and information obtained through
testimony under oath and by compulsory legal process. In particular, there can
be differences between the quality of evidence obtained in informal interviews
(such as the ones we conducted) and information obtained in questioning and
cross-examination under oath. Moreover, given the circumstances surrounding
Enron's demise and the many pending governmental investigations, some of the
people we interviewed may have been motivated to describe events in a manner
colored by self-interest or hindsight. We made every effort to maintain
objectivity. When appropriate, our counsel used cross-examination techniques to
test the credibility of witnesses. Within these inherent limitations, we believe
that our
34
investigation was both careful and impartial, and that the evidence developed is
a reasonable foundation on which to base at least preliminary judgments.6/
- --------------------------
6/ Many of the transactions discussed in this Report are extraordinarily
complex. In order to enhance the reader's understanding, we have taken several
steps:
First, the Report uses certain conventions. The term "Enron" refers
either to Enron Corp. or any of its subsidiaries or affiliates, unless the
context requires greater precision. Dollar amounts or share amounts are
approximate unless the precise figure is important. Each person is identified by
his or her full name (and title, where relevant) the first time he or she is
mentioned, and thereafter by last name only. No disrespect is intended. There
were literally hundreds of people who were involved, in one way or another, in
the transactions we reviewed. To avoid confusion, we refer to all but a few of
the most substantial participants by title, position, or function rather than by
name. The Report also omits certain details of transactions where we considered
it appropriate in order to make the substance of the transaction more
understandable to the non-expert reader.
Second, where we believed it would be helpful, we have included in
the text of the report diagrams of the transactions being discussed. The
diagrams omit certain details in order to make the structure and transaction
more understandable.
Third, we have included in the Appendix both a glossary of certain
terms and a timeline showing relevant events. Those are not intended to be
exhaustive or all-inclusive, but rather as summaries of relevant information.
Fourth, the historical financial data presented in this Report do not
reflect the effects, if any, of the announced restatement of prior period
financial statements, unless otherwise indicated.
35
I. BACKGROUND: ENRON AND SPECIAL PURPOSE ENTITIES
During the late 1990s, Enron grew rapidly and moved into areas it
believed fit its basic business plan: buy or develop an asset, such as a
pipeline or power plant, and then expand it by building a wholesale or retail
business around the asset. During the period from 1996 to 1998, we are told,
approximately 60% of Enron's earnings were generated from businesses in which
Enron was not engaged ten years earlier, and some 30% to 40% were generated from
businesses in which Enron was not engaged five years earlier.
Much of this growth involved large initial capital investments that
were not expected to generate significant earnings or cash flow in the short
term. While Enron believed these investments would be beneficial over a period
of time, they placed immediate pressure on Enron's balance sheet. Enron already
had a substantial debt load. Funding the new investments by issuing additional
debt was unattractive because cash flow in the early years would be insufficient
to service that debt and would place pressure on Enron's credit ratings.
Maintaining Enron's credit ratings at investment grade was vital to the conduct
of its energy trading business. Alternatively, funding the investments by
issuing additional equity was also unattractive because the earnings in the
early years would be insufficient to avoid "dilution"--that is, reducing
earnings per share.
One perceived solution to this finance problem was to find outside
investors willing to enter into arrangements that would enable Enron to retain
those risks it believed it could manage effectively, and the related rewards.
These joint investments typically were structured as separate entities to which
Enron and other investors contributed assets or other consideration. These
36
entities could borrow directly from outside lenders, although in many cases a
guaranty or other form of credit support was required from Enron.
Enron's treatment of the entities for financial statement purposes
was subject to accounting rules that determine whether the entity should be
consolidated in its entirety (including all of its assets and liabilities) into
Enron's balance sheet, or should instead be treated as an investment by Enron.
Enron management preferred the latter treatment--known as
"off-balance-sheet"--because it would enable Enron to present itself more
attractively as measured by the ratios favored by Wall Street analysts and
rating agencies. Enron engaged in numerous transactions structured in ways that
resulted in off-balance-sheet treatment. Some were joint ventures. Others were
structured as a vehicle known as a "special purpose entity" or "special purpose
vehicle" (referred to as an "SPE" in this Report). Some involved both.
From the early 1990s through 2001, we understand that Enron used SPEs
in many aspects of its business. We have been told that these included:
synthetic lease transactions, which involved the sale to an SPE of an asset and
lease back of that asset (such as Enron's headquarters building in Houston);
sales to SPEs of "financial assets" (a debt or equity interest owned by Enron);
sales to merchant "hedging" SPEs of Enron stock and contracts to receive Enron
stock; and transfers of other assets to entities that have limited outside
equity.
There is no generally accepted definition of SPEs to distinguish them
from other legal entities, although the staff of the Financial Accounting
Standards Board ("FASB") has used the concept of entities whose activities and
powers are significantly limited by their charter or other contractual
37
arrangement. An SPE may take any legal form, including a corporation,
partnership, or trust. At the margin, it may be difficult to determine whether
an entity is or is not an SPE; key considerations in the accounting literature
include how long the entity is intended to be in existence, and the restrictions
placed on its activities.
The accounting literature provides only limited guidance concerning
when an SPE should be consolidated with its sponsor for financial statement
purposes. Much of the literature developed in the context of synthetic lease
transactions, in which an SPE acquires property or equipment and leases it to a
single lessee. The accounting objective of these lease transactions was to
finance the acquisition of an asset while keeping the corresponding debt off of
the acquiring company's balance sheet. SPEs later came to be used in other
non-leasing transactions, largely to obtain similar accounting results. Over
time, in part because of SEC staff concerns that there was no standard practice
in dealing with the consolidation of SPEs, the FASB Emerging Issues Task Force
released several statements attempting to clarify the relevant principles. By
the late 1990s, several generally recognized consolidation principles had been
established.
To begin, "[t]here is a presumption that consolidated statements are
more meaningful than separate statements and that they are usually necessary for
a fair presentation when one of the companies in the group directly or
indirectly has a controlling financial interest in the other companies . . . ."
FASB, Accounting Research Bulletin No. 51, Consolidated Financial Statements
(1959). Ordinarily, the majority holder of a class of equity funded by
independent third parties should consolidate (assuming the equity meets certain
38
criteria dealing with size, ability to exercise control, and exposure to risk
and rewards). If there is no independent equity, or if the independent equity
fails to meet the criteria, then the presumption is that the transferor of
assets to the SPE or its sponsor should consolidate the SPE.
This presumption in favor of consolidation can be overcome only if
two conditions are met:
First, an independent owner or owners of the SPE must make a
substantive capital investment in the SPE, and that investment must have
substantive risks and rewards of ownership during the entire term of the
transaction. Where there is only a nominal outside capital investment, or where
the initial investment is withdrawn early, then the SPE should be consolidated.
The SEC staff has taken the position that 3% of total capital is the minimum
acceptable investment for the substantive residual capital, but that the
appropriate level for any particular SPE depends on various facts and
circumstances. Distributions reducing the equity below the minimum require the
independent owner to make an additional investment. Investments are not at risk
if supported by a letter of credit or other form of guaranty on the initial
investment or a guaranteed return.
Second, the independent owner must exercise control over the SPE to
avoid consolidation. This is a subjective standard. Control is not determined
solely by reference to majority ownership or day-to-day operation of the
venture, but instead depends on the relative rights of investors. Accountants
often look to accounting literature on partnership control rights for guidance
in making this evaluation.
Of the many SPEs utilized by Enron over the past several years, some
were involved in the transactions between Enron and related parties that are the
subject of this Report. We have only looked at these SPEs. The unconsolidated
39
SPEs involved in Enron's related-party transactions present issues on both
aspects of the non-consolidation test: whether any outside investor had more
than 3% residual capital at risk in the entities, and whether any investor other
than Enron exercised sufficient control over the entities to justify
non-consolidation. We discuss these issues below in connection with specific
entities and transactions.
40
II. CHEWCO
Chewco Investments L.P. is a limited partnership formed in 1997.
Transactions between Enron and Chewco are a prologue for Enron's later dealings
with the LJM partnerships. Chewco is, to our knowledge, the first time Enron's
Finance group (under Fastow) used an SPE run by an Enron employee to keep a
significant investment partnership outside of Enron's consolidated financial
statements.
Enron's dealings with Chewco raise many of the same accounting and
corporate governance issues posed by the LJM transactions we discuss below. Like
the LJM partnerships, Chewco's ownership structure was a mystery to most Enron
employees, including many who dealt with Chewco on behalf of Enron. Like LJM,
the transactions between Enron and Chewco resulted in a financial windfall to an
Enron employee. Some of this financial benefit resulted from transactions that
make little apparent economic or business sense from Enron's perspective. But
there is also an important distinction: The participation of an Enron employee
as a principal of Chewco appears to have been accomplished without any
presentation to, or approval by, Enron's Board of Directors.
Chewco played a central role in Enron's November 2001 decision to
restate its prior period financial statements. In order to achieve the
off-balance sheet treatment that Enron desired for an investment partnership,
Chewco (which was a limited partner in the partnership) was required to satisfy
the accounting requirements for a non-consolidated SPE, including having a
minimum of 3% equity at risk provided by outside investors. But Enron Management
and Chewco's general partner could not locate third parties willing to invest in
the entity. Instead, they created a financing structure for Chewco that--on its
41
face--fell at least $6.6 million (or more than 50%) short of the required
third-party equity. Despite this shortfall, Enron accounted for Chewco as if it
were an unconsolidated SPE from 1997 through March 2001.
We do not know why this happened. Enron had every incentive to ensure
that Chewco met the requirements for non-consolidation. It is reasonable to
assume that Enron employees, if motivated solely to protect Enron's interests,
would have taken the necessary steps to ensure that Chewco had adequate outside
equity. Unfortunately, several of the principal participants in the transaction
declined to be interviewed or otherwise to provide information to us. For this
reason, we have been unable to determine whether Chewco's failure to qualify for
non-consolidation resulted from bad judgment or negligence, or whether it was
caused by Enron employees putting their own economic or personal interests ahead
of their obligations to Enron.
When the Chewco transaction was reviewed closely in late October and
early November 2001, both Enron and Andersen concluded that Chewco was an SPE
without sufficient outside equity, and that it should have been consolidated
into Enron's financial statements. As a result, Enron announced in November that
it would restate its prior period financial statements from 1997 through 2001.
The retroactive consolidation of Chewco--and the investment partnership in which
Chewco was a limited partner--had a huge impact. It decreased Enron's reported
net income by $28 million (out of $105 million total) in 1997, by $133 million
(out of $703 million total) in 1998, by $153 million (out of $893 million total)
in 1999, and by $91 million (out of $979 million total) in 2000. It also
increased Enron's reported debt by $711 million in 1997, by $561 million in
1998, by $685 million in 1999, and by $628 million in 2000.
42
A. FORMATION OF CHEWCO
In 1993, Enron and the California Public Employees' Retirement System
("CalPERS") entered into a joint venture investment partnership called Joint
Energy Development Investment Limited Partnership ("JEDI"). Enron was the
general partner and contributed $250 million in Enron stock. CalPERS was the
limited partner and contributed $250 million in cash. Because Enron and CalPERS
had joint control, Enron did not consolidate JEDI into its consolidated
financial statements.
In 1997, Enron considered forming a $1 billion partnership with
CalPERS called "JEDI II." Enron believed that CalPERS would not invest
simultaneously in both JEDI and JEDI II, so Enron suggested it buy out CalPERS'
interest in JEDI. Enron and CalPERS attempted to value CalPERS' interest
(CalPERS retained an investment bank) and discussed an appropriate buyout price.
In order to maintain JEDI as an unconsolidated entity, Enron needed
to identify a new limited partner. Fastow initially proposed that he act as the
manager of, and an investor in, a new entity called "Chewco Investments"--named
after the Star Wars character "Chewbacca." Although other Enron employees would
be permitted to participate in Chewco, Fastow proposed to solicit the bulk of
Chewco's equity capital from third-party investors. He suggested that Chewco
investors would want a manager who, like him, knew the underlying assets in JEDI
and could help manage them effectively. Fastow told Enron employees that Jeffrey
Skilling, then Enron's President and Chief Operating Officer ("COO") had
43
approved his participation in Chewco as long as it would not have to be
disclosed in Enron's proxy statement.7/
Both Enron's in-house counsel and its longstanding outside counsel,
Vinson & Elkins, subsequently advised Fastow that his participation in Chewco
would require (1) disclosure in Enron's proxy statement, and (2) approval from
the Chairman and CEO under Enron's Code of Conduct of Business Affairs ("Code of
Conduct").8/ As a result, Kopper, an Enron employee who reported to Fastow, was
substituted as the proposed manager of Chewco. Unlike Fastow, Kopper was not a
senior officer of Enron, so his role in Chewco would not require proxy statement
disclosure (but would require approval under Enron's Code of Conduct).
Enron ultimately reached agreement with CalPERS to redeem its JEDI
limited partnership interest for $383 million. In order to close that
transaction promptly, Chewco was formed as a Delaware limited liability company
on very short notice in early November 1997. As initially formed, Kopper
(through intermediary entities) was the sole member of both the managing member
and regular member of Chewco. Enron's counsel, Vinson & Elkins, prepared the
legal documentation for these entities in a period of approximately 48 hours.
- -------------------------
7/ Skilling told us that he recalled Fastow's proposing that the Chewco outside
investors be members of Fastow's wife's family, and that Skilling told Fastow he
did not think that was a good idea.
8/ Enron's Code of Conduct provided that no full-time officer or employee should
"[o]wn an interest in or participate, directly or indirectly, in the profits of
any other entity which does business with or is a competitor of the Company,
unless such ownership or participation has been previously disclosed in writing
to the Chairman of the Board and Chief Executive Officer of Enron Corp. and such
officer has determined that such interest or participation does not adversely
affect the best interests of the Company."
44
Enron also put together a bridge financing arrangement, under which Chewco and
its members would borrow $383 million from two banks on an unsecured basis to
buy CalPERS' interest from JEDI. The loans were to be guaranteed by Enron.
Enron employees involved in the transaction understood that the
Chewco structure did not comply with SPE consolidation rules. Kopper, an Enron
employee, controlled Chewco, and there was no third-party equity in Chewco.
There was only debt. The intention was, by year end, to replace the bridge
financing with another structure that would qualify Chewco as an SPE with
sufficient outside equity. Ben F. Glisan, Jr., the Enron "transaction support"
employee with principal responsibility for accounting matters in the Chewco
transaction, believed that such a transaction would preserve JEDI's
unconsolidated status if closed by year end.
While Chewco was being formed, Enron and Chewco were negotiating the
economic terms (primarily the profit distribution "waterfall") of their JEDI
partnership. Kopper was the business negotiator for Chewco. During the
negotiations, Fastow contacted Enron's business negotiator (who reported to him)
and suggested that he was pushing too hard for Enron and that the deal needed to
be closed. Enron's negotiator explained to Fastow the status of the discussions
with Kopper, that he believed it was his job to obtain the best economic terms
for Enron, and that accepting Kopper's current position would (based on Enron's
economic modeling) result in greater benefits to Chewco than would be required
if the negotiations continued. We were told that Fastow indicated he was
comfortable closing the transaction on the terms then proposed by Kopper.
Enron's negotiator told us he was uncomfortable with this discussion and
45
Fastow's intervention, and believes that Enron could have improved its position
if he had been permitted to continue the negotiations.
B. LIMITED BOARD APPROVAL
The Chewco transaction was presented to the Board's Executive
Committee on November 5, 1997, at a meeting held by telephone conference call.
The minutes of the meeting reflect that Skilling presented the background of
JEDI, and that Fastow explained that Chewco would purchase CalPERS' interest in
JEDI. Fastow described Chewco as an SPE not affiliated with either Enron or
CalPERS. According to the minutes, he "reviewed the economics of the project,
the financing arrangements, and the corporate structure of the acquiring
company." He also presented a diagram of the proposed permanent financing
arrangement, which involved (1) a $250 million subordinated loan to Chewco from
a bank (Enron would guarantee the loan); (2) a $132 million advance to Chewco
from JEDI under a revolving credit agreement; and (3) $11 million in "equity"
contributed by Chewco. Neither the diagram nor the minutes contains any
indication of the source of this equity contribution. The Committee voted to
approve Enron's guaranty of the bridge loan and the subsequent subordinated
loan. The minutes of the meeting of the full Board on December 9 show that these
approvals were briefly reported by the Committee to the Board at that meeting.
Enron's Code of Conduct required Kopper to obtain approval for his
participation in Chewco from the Chairman and CEO. Lay, who held both positions
at this time, said he does not know Kopper and is confident that he was neither
informed of Kopper's participation nor asked to approve it under the Code.9/
46
Skilling, who was President and COO, said that Fastow made him aware that Kopper
would manage Chewco. Skilling told us that, based on Fastow's recommendation, he
approved Kopper's role in Chewco. Skilling's approval, however, did not satisfy
the requirements of the Code of Conduct. Skilling also said he believes he
discussed Kopper's role in Chewco with the Board at some point.
We have located no written record of the approval Skilling described
or any disclosure to the Board concerning Kopper's role. Although the minutes
show that Kopper was on the Executive Committee's November 5 conference call
when the Chewco loan guaranty was discussed and approved, the minutes do not
reflect any mention of Kopper's personal participation in the Chewco
transaction. Other than Skilling, none of the Directors we interviewed
(including Lay and John Duncan, Chairman of the Executive Committee) recalls
being informed of, or approving, Kopper's role in Chewco.
C. SPE NON-CONSOLIDATION "CONTROL" REQUIREMENT
If Enron controlled Chewco, the accounting rules for SPEs required
that Chewco be consolidated into Enron's consolidated financial statements. This
principle raised two relevant issues: (1) did Kopper control Chewco, and (2) did
Kopper, by virtue of his position at Enron, provide Enron with control over
Chewco? With respect to the first question, as formed in November, Kopper
- -----------------------
9/ The minutes of the November 5 Executive Committee meeting reflect that Lay
joined the meeting "during" Fastow's presentation concerning Chewco.
47
controlled Chewco. Kopper was the sole member of Chewco's managing member, and
had complete authority over Chewco's actions.
In December 1997, Enron and Kopper made two changes to the Chewco
structure that were apparently designed to address the control element. First,
Chewco was converted to a limited partnership, with Kopper as the manager of
Chewco's general partner. The new Chewco partnership agreement provided some
modest limits on the general partner's ability to manage the partnership's
affairs. Second, an entity called "Big River Funding LLC" became the limited
partner of Chewco. The sole member of Big River was an entity called "Little
River Funding LLC." Those entities had been part of the bridge financing
structure and, at the time, Kopper had controlled them both. But by an
assignment dated December 18, Kopper transferred his ownership interest in Big
River and Little River to William D. Dodson.10/ This transfer left Kopper with
no formal interest in Chewco's limited partner.
The assessment of control under applicable accounting literature was,
and continues to be, subjective. In general, there is a rebuttable presumption
that a general partner exercises control over a partnership. The presumption can
be overcome if the substance of the partnership arrangement provides that the
general partner is not in control of major operating and financial policies. The
changes to the Chewco structure and limitations on the general partner's ability
to manage the partnership's affairs may have been sufficient to overcome that
- ---------------------
10/ It is presently common knowledge among Enron Finance employees that Kopper
and Dodson are domestic partners. We do not have information concerning their
relationship in December 1997 or what, if anything, Enron Finance employees knew
about it at that time.
48
presumption, but the issue is not free from doubt. In addition, even if Kopper
did control Chewco, it is not clear whether Enron would be deemed to control
Chewco. Although Kopper may have been able to influence Enron's actions
concerning Chewco, he was not a senior officer of Enron and may not have had
sufficient authority within the company for his actions to be considered those
of Enron for these purposes.
D. SPE NON-CONSOLIDATION "EQUITY" REQUIREMENT
In order to qualify for non-consolidation, Chewco also had to have a
minimum of 3% outside equity at risk. As formed in early November, however,
Chewco had no equity. There had been efforts to obtain outside equity--including
preparing a private placement memorandum and making contact with potential
investors--but those efforts were unsuccessful.
In November and December of 1997, Enron and Kopper created a new
capital structure for Chewco, which had three elements:
o $240 million unsecured subordinated loan to Chewco from Barclays
Bank PLC, which Enron would guarantee;
o $132 million advance from JEDI to Chewco under a revolving credit
agreement; and
o $11.5 million in equity (representing approximately 3% of total
capital) from Chewco's general and limited partners.
Kopper invested approximately $115,000 in Chewco's general partner, and
approximately $10,000 in its limited partner before transferring his limited
partnership interest to Dodson. But no third-party investors were identified to
provide outside equity. Instead, to obtain the remaining $11.4 million, Enron
49
and Kopper reached agreement with Barclays Bank to obtain what were described as
"equity loans" to Big River (Chewco's limited partner) and Little River (Big
River's sole member).
The Barclays loans to Big River and Little River were reflected in
documents that resembled promissory notes and loan agreements, but were labeled
"certificates" and "funding agreements." Instead of requiring Big River and
Little River to pay interest to Barclays, the documents required them to pay
"yield" at a specified percentage rate. The documentation was intended to allow
Barclays to characterize the advances as loans (for business and regulatory
reasons), while allowing Enron and Chewco simultaneously to characterize them as
equity contributions (for accounting reasons). During this time period, that was
not an unusual practice for SPE financing.
In order to secure its right to repayment, Barclays required Big
River and Little River to establish cash "reserve accounts." The parties
initially made an effort to maintain the "equity" appearance of the
transaction--by providing that the reserve accounts would be funded only with
the last 3% of any cash distributions from JEDI to Chewco, and that Barclays
could not utilize those funds if it would bring Chewco's "equity" below 3%. But
Barclays ultimately required that the reserve accounts be funded with $6.6
million in cash at closing, and that the reserve accounts be fully pledged to
secure repayment of the $11.4 million.
In order to fund the reserve accounts, JEDI made a special $16.6
million distribution to Chewco. In late November, JEDI had sold one of its
assets--an interest in Coda Energy, Inc., and its subsidiary Taurus Energy
50
Corp.11/ Chewco's share of the proceeds of that sale was $16.6 million. In a
letter agreement dated December 30, 1997, Enron and Chewco agreed that Chewco
could utilize part of the $16.6 million to "fund . . . reserve accounts in an
aggregate amount equal to $6,580,000: (a) the Little River Base Reserve Account
. . . in an amount equal to $197,400 and (b) the Big River Base Reserve Account
. . . in an amount equal to $6,382,600." The letter agreement was prepared by
Vinson & Elkins and was signed by an officer of Enron and by Kopper. Pursuant to
the agreement, at closing on December 30, JEDI wired $6.6 million to Barclays to
fund the reserve accounts.
A diagram of the Chewco transaction is set forth below:
[DESCRIPTION OF DIAGRAM: Enron guarantees Chewco debt to Barclays; Barclays
loans $240 million to Chewco; Chewco issues notes to Barclays; Chewco pays
guarantee fee to Enron; Enron is a general partner in the JEDI Limited
Partnership ("JEDI"); Chewco is a limited partner in JEDI; Chewco invests $383
million in JEDI; JEDI gives Chewco a $132 million advance under a revolving
credit agreement; Chewco issues notes to JEDI; SONR #1 L.P. is the general
partner in Chewco and Big River Funding LLC is the limited partner in Chewco;
the sole member of Big River Funding LLC is Little River Funding LLC; SONR #1
invests $115,000 in Chewco; Big River Funding LLC invests $11.4 million in
Chewco; SONR #1 L.P. is the general partner in SONR #1 LLC; SONR #1 LLC invests
$1,000 in SONR #1 L.P.; Michael Kopper is the sole member of SONR #1 LLC;
William Dodson and Michael Kopper invest $114,000 in SONR #1 L.P. and are its
Limited Partners; William Dodson has 2.5% interest in SONR #1 L.P. and Michael
Kopper has a 96.5% interest in SONR #1 L.P.; Little River Funding LLC invests
$341,000 in Big River Funding LLC; Barclays lends $331,000 to Little River
Funding LLC in exchange for a note issued to Barclays; Barclays lends $11.1
million to Big River Funding LLC in exchange for a note issued to Barclays; SONR
#2 LLC is the sole member of Little River Funding LLC; SONR #2 LLC invests
$10,000 in Little River Funding LLC; William Dodson, who replaced Michael
Kopper, is the sole member of SONR#2 LLC; Chewco invests $6.6 million in the Big
River and Little River Reserve Accounts.]
- -----------------------
11/ Enron employees told us that JEDI's decision to sell Coda was not related to
Chewco's purchase of CalPERS' interest in JEDI.
51
The existence of this cash collateral for the Barclays funding was
fatal to Chewco's compliance with the 3% equity requirement. Even assuming that
the Barclays funding could properly have been considered "equity" for purposes
of the 3% requirement, the equity was not at risk for the portion that was
secured by $6.6 million in cash collateral. At a minimum, Chewco fell short of
the required equity at risk by that amount and did not qualify as an adequately
capitalized SPE.12/ As a result, Chewco should have been consolidated into
Enron's consolidated financial statements from the outset and, because JEDI's
non-consolidation depended upon Chewco's non-consolidation status, JEDI also
should have been consolidated beginning in November 1997.
Many of the people involved in this transaction for Enron profess no
recollection of the Barclays funding, the reserve accounts, or the $6.6 million
in cash collateral. This group includes the Enron officer who signed the
December 30 letter agreement and the authorization for the $6.6 million wire
transfer to Barclays at closing. By contrast, others told us that those matters
were known and openly discussed. Their recollection is supported by a
substantial amount of contemporaneous evidence.
There is little doubt that Kopper (who signed all of the agreements
with Barclays and the December 30 letter) was aware of the relevant facts. The
evidence also indicates that Glisan, who had principal responsibility for
Enron's accounting for the transaction, attended meetings at which the details
- -----------------------
12/ Even if the Barclays loans did qualify as outside equity at risk, there is a
question whether Chewco met the 3% requirement because a small portion of the
required 3%--Kopper's $125,000--came from a person affiliated with Enron. If
Kopper's contribution is not counted, even with the Barclays funding Chewco had
slightly less than 3% outside equity.
52
of the reserve accounts and the cash collateral were discussed. If Glisan knew
about the cash collateral in the reserve accounts at closing, it is implausible
that he (or any other knowledgeable accountant) would have concluded that Chewco
met the 3% standard.13/
Although Andersen reviewed the transaction at the time it occurred,
we do not know what information the firm received or what advice it provided.
Enron's records show that Andersen billed Enron $80,000 in connection with its
1997 review of the Chewco transaction. The CEO of Andersen testified in a
Congressional hearing on December 12, 2001 that the firm had performed
unspecified "audit procedures" on the transaction in 1997, was aware at the time
that $11.4 million had come from "a large international financial institution"
(presumably Barclays), and concluded that it met the test for 3% residual
equity. He also testified, however, that Andersen was unaware that cash
collateral had been placed in the reserve accounts at closing.
The Andersen workpapers we were permitted to review indicate that
Andersen was aware of the $16.6 million distribution to Chewco in 1997, and that
it had traced the cash disbursements to JEDI's records. We do not know what
Andersen did to trace those disbursements, or whether its review did or should
have identified facts relating to funding the reserve accounts. We have been
- -----------------------
13/ Documents from 1997 indicate that Glisan was actively monitoring the
accounting literature and guidance on the substantive outside equity
requirements for non-consolidated SPEs. We located a handwritten note apparently
made by Glisan that identifies one of the "unique characteristics" of the Chewco
transaction as "minimization of 3rd party capital." We do not know what Glisan
meant by this reference because he declined to be interviewed by us (other than
a brief interview on another subject).
53
otherwise unable to confirm or disprove Andersen's public statements about the
transaction.
Largely because Kopper, Glisan, and Andersen declined to speak with
us on this subject, we have been unable to determine why the parties utilized a
financing structure for Chewco that plainly did not satisfy the SPE
non-consolidation requirements. Enron had every incentive to ensure that Chewco
was properly capitalized. It is reasonable to assume that Enron employees, if
motivated to protect only Enron's interests, would have taken the necessary
steps to ensure that Chewco had sufficient outside equity. We do not know
whether Chewco's failure to qualify resulted from bad judgment or carelessness
on the part of Enron employees or Andersen, or whether it was caused by Kopper
or other Enron employees putting their own interests ahead of their obligations
to Enron.
E. FEES PAID TO CHEWCO/KOPPER
From December 1997 through December 2000, Kopper (through the Chewco
general partner) was paid approximately $2 million in "fees" relating to Chewco.
It is unclear what legitimate purposes justified these fees, how the amounts of
the payments were determined, or what, if anything, was done by Kopper or Chewco
to earn the payments. These fee payments raise substantial management oversight
issues.
During this period, the Chewco partnership agreement provided that
Chewco would pay an annual "management fee" of $500,000 to its general partner,
an entity called SONR #1 L.P. Kopper was the sole manager of the general partner
of SONR #1, and owned more than 95% of the limited partnership interest in SONR
#1. (Dodson owned the remainder of the interest.) None of the persons we
interviewed could identify how this fee was determined or what "management" work
54
was expected of the Chewco general partner. Through December 2000, SONR #1
received a total of $1.6 million in Chewco management fees. With minor
exceptions, these fees were not paid out of income distributed to Chewco from
JEDI. Instead, they were drawn down by Chewco from the revolving credit
agreement with JEDI.14/
Chewco apparently required little management. The principal
activities were back-office matters such as requesting draws under the JEDI
revolving credit agreement, paying interest on the Barclays subordinated loan to
Chewco (until December 1998 when it was repaid) and on the Barclays "equity"
loans to Big River and Little River, and preparing unaudited financial
statements for internal use. For most of the relevant period, these tasks were
performed by an Enron employee on Enron time. In addition, during certain
periods, these tasks appear to have been performed by Fastow's wife, who had
previously worked in Enron's Finance group. We do not know if she received
compensation for performing these services.
In December 1998, Chewco received a payment of $400,000 from Enron.
This payment is variously described as a "restructuring" fee, an "amendment"
fee, and a "nuisance" fee. None of the people we interviewed could identify a
basis for this payment. Although both the JEDI partnership agreement and
revolving credit agreement were amended in November and December 1998, those
amendments appear generally to be beneficial to Chewco and, therefore, should
- ----------------------
14/ As discussed below, upon Enron's repurchasing Chewco's interest in JEDI in
March 2001, Enron permitted Chewco to extend repayment on $15 million of the
then-outstanding balance on the revolving credit agreement. That $15 million
obligation is unsecured and non-recourse.
55
not have required compensation to induce Chewco's consent.15/ Glisan signed the
approval form for the wire transfer of the $400,000 fee to Chewco.
F. ENRON REVENUE RECOGNITION ISSUES
Beginning in December 1997, Enron took steps to recognize revenues
arising from the JEDI partnership (in which Chewco was Enron's limited partner)
that we believe are unusual and, in some cases, likely would not have been
undertaken if Chewco had been an unrelated third party. These include fees paid
to Enron by JEDI and Chewco that appear to have had as their principal purpose
accelerating Enron's ability to recognize revenue. These fees do not implicate
the serious management oversight issues that are raised by the fee payments to
Kopper, but they present significant questions about the accounting treatment
that permitted Enron to recognize certain of these revenues. Moreover, although
the revenues at issue on some of these payments are relatively small compared to
Enron's overall financial statements, they raise larger questions about Enron's
approach to revenue recognition issues in JEDI.
1. ENRON GUARANTY FEE
As described above, Enron provided a guaranty of the $240 million
unsecured subordinated loan by Barclays to Chewco in December 1997. Pursuant to
a letter agreement, Chewco agreed to pay Enron a guaranty fee of $10 million
(cash at closing) plus 315 basis points annually on the average outstanding
- -----------------------
15/ Although such compensation may not be unusual in the arm's-length,
commercial context, it is hard to understand the justification for payment of a
substantial fee to Chewco in these circumstances.
56
balance of the loan. This fee was not calculated based on any analysis of the
risks involved in providing the guaranty, or on typical commercial terms.
Instead, the fee took into account the overall economics of the transaction to
Enron and the accelerated revenue recognition that would result from
characterizing the payment as a fee.
During the 12 months that the subordinated loan was outstanding,
Chewco paid Enron $17.4 million under this fee agreement. JEDI was the source of
these payments to Enron. The first $7 million was taken from the $16.6 million
distribution to Chewco at closing, and the remainder was drawn down by Chewco
from its revolving credit agreement with JEDI. For accounting purposes, Enron
characterized these payments as "structuring fees" and recognized income from
the $10 million up-front fee in December 1997 (and for the annual fees when paid
during 1998). These were not in fact "structuring fees," however, and accounting
rules generally require guaranty fee income to be recognized over the guaranty
period. Enron's accounting treatment for the $10 million payment was not
consistent with those rules.
2. "REQUIRED PAYMENTS" TO ENRON
The December 1997 JEDI partnership agreement required JEDI to pay
Enron (the general partner) an annual management fee.16/ Under applicable
accounting principles, Enron could recognize income from this fee only when
services were rendered. In March 1998, however, Enron and Chewco amended the
partnership agreement to convert 80% of the annual management fee to a "required
- ---------------------
16/ The annual fee was the greater of (a) 2.5% of $383 million less any
distributions received by Chewco, or (b) $2 million.
57
payment" to Enron. Although this had no effect on the amount payable to Enron,
it had a substantial effect on Enron's recognition of revenue. As of March 31,
1998, Enron recorded a $28 million asset, which represented the discounted net
present value of the "required payment" through June 2003, and immediately
recognized $25.7 million in income ($28 million net of a reserve). Glisan was
principally responsible for Enron's accounting for this transaction. We were
told that he suggested the change to the partnership agreement so that Enron
could recognize additional earnings during the first quarter of 1998.
Enron's accounting raises questions concerning whether the "required
payment" should have been recognized over the period from 1998 to 2003. If the
payment was contingent on Enron's providing ongoing management to JEDI, Enron
may have been required to recognize the income over the covered period.
Accounting standards for revenue recognition generally require that the services
be provided before recording revenue. It seems doubtful that the management
services related to the "required payment" (covering 1998 to 2003) had all been
provided at the time Enron recognized the $25.7 million in income. If those
services had not been provided by March 1998, Enron's accounting appears to have
been incorrect.
3. RECOGNITION OF REVENUE FROM ENRON STOCK
From the inception of JEDI in 1993 through the first quarter of 2000,
Enron picked up its contractual share of income or losses from JEDI using the
equity method of accounting. JEDI was a merchant investment fund that carried
its assets at fair value. Changes in fair value of the assets were recorded in
JEDI's income statement. JEDI held 12 million shares of Enron stock, which were
58
carried at fair value. During this period, Enron recorded an undetermined amount
of income resulting from appreciation in the value of its own stock. Under
generally accepted accounting principles, however, a company is generally
precluded from recognizing an increase in the value of its own stock as income.
Enron had a formula for computing how much income it could record
from appreciation of its own stock held by JEDI. Enron and Andersen apparently
developed the formula in 1996, and modified it over time. While Enron could not
quantify for us how much income it recorded from the appreciation of Enron stock
held by JEDI, Andersen's workpapers for the first quarter of 2000 indicate that
Enron recorded $126 million in Enron stock appreciation during that quarter.
Anderson's workpapers for the third quarter of 2000 reflect a decision
(described as having been made in the first quarter) that income from Enron
stock held by JEDI could no longer be recorded on Enron's income statement. The
workpapers do not say whether this decision was made by Andersen, Enron, or
jointly.
In the first quarter of 2001, Enron stock held by JEDI declined in
value by approximately $94 million. Enron did not record its share of this
loss--approximately $90 million. Enron's internal accountants decided not to
record this loss based on discussions with Andersen. According to the Enron
accountants, they were told by Andersen that Enron was not recording increases
in value of Enron stock held by JEDI and therefore should not record decreases.
We do not understand the basis on which Enron recorded increases in value of
Enron stock held by JEDI in 2000 and prior years, and are unable to reconcile
59
that recognition of income with the advice apparently provided by Andersen in
2001 concerning not recording decreases in Enron stock value.
G. ENRON'S REPURCHASE OF CHEWCO'S LIMITED PARTNERSHIP INTEREST
In March 2001, Enron repurchased Chewco's limited partnership
interest in JEDI and consolidated JEDI into its consolidated financial
statements. Fastow was personally involved in the negotiations and
decision-making on this repurchase. As described below, the repurchase resulted
in an enormous financial windfall to Kopper and Dodson (who collectively had
invested only $125,000). Much of the payout to these individuals is difficult to
justify or understand from Enron's perspective, and at least $2.6 million of the
payout appears inappropriate on its face. Moreover, Kopper received most of
these benefits--by coincidence or design--shortly before he purchased Fastow's
interests in the LJM partnerships (described below in Section III). Because
Fastow and Kopper declined to be interviewed by us concerning the Chewco
repurchase, we do not have the benefit of their responses to the serious issues
addressed in this section.
1. NEGOTIATIONS
During the first quarter of 2000, senior personnel in Enron's Finance
area came to the conclusion that JEDI was essentially in a liquidation mode, and
had become an expensive off-balance sheet financing vehicle. They approached
Fastow, who agreed with their conclusion. The next step was to determine an
appropriate buyout price for Chewco's interest in JEDI.
60
The discussions concerning the buyout terms involved, among others,
Fastow, Kopper, and Jeffrey McMahon (then Senior Vice President, Finance and
Treasurer of Enron).17/ Because JEDI's assets had increased in value since 1997,
on paper Chewco's limited partnership interest had become valuable. On the other
hand, Kopper and Dodson had invested only $125,000 in Chewco.
McMahon told us that, in light of the circumstances, he proposed to
Fastow that the buyout be structured to provide a $1 million return to the
Chewco investors.18/ According to a document McMahon identified as the written
buyout analysis he provided to Fastow, this would give the investors a 152%
internal rate of return on their investment and a return on capital multiple of
7.99. McMahon said that Fastow received the proposal, said he would discuss it
with Kopper, and later reported back to McMahon that he had negotiated a payment
of $10 million. McMahon also said that Fastow told him that Skilling had
approved the $10 million payment. McMahon's recollection of events is consistent
with a handwritten memorandum addressed to "Andy" (in what we are told is
Kopper's handwriting) that analyzes McMahon's written proposal and refers to
Enron's purchasing Chewco's interest for $10.5 million. McMahon said he told
- ------------------------
17/ During a brief interview, Fastow told us that he had not participated in
these negotiations because, in light of Kopper's having become his partner in
the general partner of LJM2, he believed it would have been inappropriate.
Fastow's statement is contrary to information we obtained from interviews of
several people familiar with the negotiations, all of whom said he was
personally involved. Moreover, Fastow's statement is inconsistent with the
handwritten memorandum, addressed to "Andy," that is discussed in the text
below. We showed a copy of the memorandum to Fastow during the brief interview,
but he declined to respond to any questions about it.
18/ McMahon also said he believed at the time that Dodson was the outside equity
investor in Chewco, and that Kopper was representing Dodson in the buyout
discussions.
61
Fastow that $10 million would be inappropriate and, if that was the agreement,
it would be better for Enron to continue with the current JEDI structure and not
buy out Chewco's interest.
By mid-2000, Enron had decided to purchase Chewco's interest on terms
that would provide a $10.5 million return to the Chewco investors. Chewco had
already received $7.5 million in cash (net) from JEDI, so Chewco would receive
an additional cash payment at closing of $3 million.19/ By this point, McMahon
had left the Treasurer's position and the Finance group. We were unable to
locate any direct evidence about who made the ultimate decision on the buyout
amount. Skilling told us that he had no involvement in the buyout transaction,
including being advised of or approving the payment amount.
2. BUYOUT TRANSACTION
The buyout was completed in March 2001, when Enron and Chewco entered
into a Purchase Agreement (dated March 26, 2001) for repurchasing Chewco's
interest. (It is not clear why the transaction did not close until the first
quarter of 2001.) The contract price for the purchase was $35 million, which was
determined by taking:
o The $3 million cash payment that had been agreed to in 2000; plus
- -------------------------
19/ The $7.5 million consisted of several elements: (1) distributions from JEDI
that funded the Big River and Little River reserve accounts and interest on
those amounts; (2) distributions from JEDI and advances under the revolving
credit agreement that funded Chewco's working capital reserve and interest on
those amounts; (3) the $400,000 fee paid in December 1998; and (4) other net
cash distributions from JEDI, some of which had been used to repay the
subordinated loan and equity loans from Barclays and part of the outstanding
balance on the revolving credit agreement.
62
o $5.7 million to cover the remaining "required payments" due to
Enron under the JEDI partnership agreement (as discussed above in
Section II(F)(2));20/ plus --
o $26.3 million to cover all but $15 million of Chewco's
outstanding $41.3 million obligation under the revolving credit
agreement with JEDI.
At closing, pursuant to a letter agreement with Chewco, Enron kept the $5.7
million and wired $29.3 million to Chewco; Chewco then paid down $26.3 million
on the revolving credit agreement and retained the remaining $3 million.
Chewco was not required to pay off the entire $41.3 million balance
on the revolving credit agreement. Instead, it paid only $26.3 million, and the
remaining $15 million was converted to a term loan due in January 2003. The $15
million was left outstanding because, in December 1999, Chewco had paid $15
million to LJM1 to purchase certificates in Osprey Trust.21/ Although not
disclosed in either the Purchase Agreement or the term loan agreement, Enron and
Chewco agreed (1) to make the terms of the loan agreement (maturity date,
interest rates) match those of the Osprey Trust certificates, and (2) that
Chewco would be required to use the principal paid from the Osprey Trust
certificates to repay the $15 million term loan, and would retain any yield paid
on the certificates (which it could use to pay interest on the term loan). Enron
did not, however, require that the Osprey Trust certificates serve as collateral
- --------------------------
20/ The $5.7 million payment is referred to in the Purchase Agreement as being
for unspecified "breakage costs." There is some evidence that this generic
description was used because it was less likely to draw attention from Andersen
during their review of the transaction. Because Andersen did not permit us to
review workpapers from 2001 or interview their personnel on this matter, we do
not know what review Andersen conducted. Enron's records show that it paid
$25,000 in fees to Andersen in connection with the Chewco buyout.
21/ Osprey Trust is a limited partner, along with Enron, in Whitewing
Associates.
63
for the $15 million loan. The loan is unsecured and non-recourse to Kopper and
Dodson.22/
3. RETURNS TO KOPPER/DODSON
As a result of the buyout, Kopper and Dodson received an enormous
return on their $125,000 investment in Chewco. In total, they received
approximately $7.5 million (net) cash during the term of the investment, plus an
additional $3 million cash payment at closing. Even assuming Chewco incurred
some modest expenses that were not reimbursed at the time by Enron or drawn down
on the revolving credit line, this represents an internal rate of return of more
than 360%.
This rate of return does not take into account the $1.6 million in
management fees received by Kopper. It also does not reflect the fact that the
buyout was tax-free to Chewco, as described below.
4. TAX INDEMNITY PAYMENT
One of the most serious issues that we identified in connection with
the Chewco buyout is a $2.6 million payment made by Enron to Chewco in
mid-September 2001. Chewco first requested the payment after the buyout was
consummated--under a Tax Indemnity Agreement between Enron and Chewco that was
part of the original 1997 transaction. There is credible evidence that Fastow
authorized the payment to Chewco even though Enron's in-house counsel advised
- ------------------------
22/ In effect, if Chewco does not repay the unsecured loan when it comes due in
2003, it will amount to a forgiveness by Enron of $15 million in advances under
the revolving credit agreement (which funded, among other things, the payment of
management fees to Kopper). We understand that Chewco made the first semi-annual
interest payment under the term loan in a timely manner in August 2001.
64
him unequivocally that there was no basis in the Agreement for the payment, and
that Enron had no legal obligation to make it.
When Chewco purchased the JEDI limited partnership interest in 1997,
Enron and Chewco executed a Tax Indemnity Agreement. Agreements of this sort are
not unusual in transactions where anticipated cash flows to the limited partner
may be insufficient to satisfy the partner's current tax obligations. On its
face, the Agreement compensates Chewco for the difference between Chewco's
current tax obligations and its cash receipts during the partnership. Chewco
subsequently requested payments, and Enron made payments, for that purpose prior
to 2001.
After the closing of Enron's buyout of Chewco in March 2001, Kopper
requested an additional payment under the Tax Indemnity Agreement. Kopper
claimed that Chewco was due a payment to cover any tax liabilities resulting
from the negotiated buyout of Chewco's partnership interest. Enron's in-house
legal counsel (who had been involved in the 1997 negotiations) consulted with
Vinson & Elkins (who also had been involved in the negotiations) concerning
Chewco's claim. Both concluded that the Agreement was not intended to cover, and
did not cover, a purchase of Chewco's partnership interest. In-house counsel
communicated this conclusion to Kopper.
The amount of the indemnity payment in dispute was $2.6 million.
After further inconclusive discussions, Kopper told Enron's in-house counsel
that he would consult with Fastow. Fastow then called the counsel, who says he
told Fastow unequivocally that the Agreement did not require Enron to make any
payment to Chewco. In a subsequent conversation, Fastow told Enron's counsel
that he had spoken with Skilling and that Skilling (who Fastow said was familiar
65
with the Agreement and the buyout transaction) had decided that the payment
should be made. As a result, in September 2001, Enron paid Chewco an additional
$2.6 million to cover its tax liabilities in connection with the buyout.
Skilling told us he does not recall any communications with Fastow concerning
the payment. Fastow declined to respond to questions on this subject.
H. DECISION TO RESTATE
In late October 2001, the Enron Board (responding to media reports)
requested a briefing by Management on Chewco. Glisan was responsible for
presenting the briefing at a Board meeting on short notice. Following the
briefing, Enron accounting and legal personnel (as well as Vinson & Elkins)
undertook to review documents relating to Chewco. This review identified the
documents relating to the funding of the Big River and Little River reserve
accounts in December 1997 through the $16.6 million distribution from JEDI.
Enron brought those documents to the attention of Andersen, and
consulted with Andersen concerning the accounting implications of the funded
reserve accounts. After being shown the documents by Enron and discussing the
accounting issues with Enron personnel, Andersen provided the notice of
"possible illegal acts" that Andersen's CEO highlighted in his Congressional
testimony on December 12, 2001.
Enron's accounting personnel and Andersen both concluded that, in
light of the funded reserve accounts, Chewco lacked sufficient outside equity at
risk and should have been consolidated in November 1997.23/ In addition, because
66
JEDI's non-consolidation depended on Chewco's status, Enron and Andersen
concluded that JEDI also should have been consolidated in November 1997. In a
Current Report on Form 8-K filed on November 8, 2001, Enron announced that it
would restate its prior period financials to reflect the consolidation of those
entities as of November 1997.
- ------------------------
23/ When presented in late October 2001 with evidence of the $6.6 million cash
collateral in the reserve accounts, Glisan apparently agreed that the collateral
precluded any reasonable argument that Chewco satisfied the 3% requirement, but
claimed that he had been unaware of it at the time of the transaction.
67
III. LJM HISTORY AND GOVERNANCE
A. FORMATION AND AUTHORIZATION OF LJM CAYMAN, L.P. AND LJM2
CO-INVESTMENT, L.P.
Enron entered into more than 20 distinct transactions with the two
LJM partnerships. Each transaction theoretically involved a transfer of risk.
The LJM partnerships rarely lost money on a transaction with Enron that has been
closed, so far as we are aware, even when they purchased assets that apparently
declined in value after the sale. These transactions had a significant effect on
Enron's financial statements. Taken together, they resulted in substantial
recognition of income, and the avoidance of substantial recognition of loss.
This section discusses the formation and authorization of these partnerships. It
also addresses their governance insofar as it is relevant to Enron's ability to
avoid consolidating them for financial statement purposes. The Board decisions
described in this section are addressed in greater detail in Section VII, below.
LJM1. On June 18, 1999, Fastow discussed with Lay and Skilling a
proposal to establish a partnership, subsequently named LJM Cayman, L.P.
("LJM1"). This partnership would enter into a specific transaction with Enron.
Fastow would serve as the general partner and would seek investments by outside
investors. Fastow presented his participation as something he did not desire
personally, but was necessary to attract investors to permit Enron to hedge its
substantial investment in Rhythms NetConnections, Inc. ("Rhythms"), and possibly
to purchase other assets in Enron's merchant portfolio. Lay and Skilling agreed
to present the proposal to the Board.
68
At a Board meeting on June 28, 1999, Lay called on Skilling, who in
turn called on Fastow, to present the proposal. Fastow described the structure
of LJM1 and the hedging transaction (which is described in Section IV below).
Fastow disclosed that he would serve as the general partner of LJM1 and
represented that he would invest $1 million. He described the distribution
formula for earnings of LJM1, and said he would receive certain management fees
from the partnership.24/ He told the Board that this proposal would require
action pursuant to Enron's Code of Conduct (an action within Lay's authority)
based on a determination that Fastow's participation as the managing partner of
LJM1 "will not adversely affect the interests" of Enron.
After a discussion, the Board adopted a resolution approving the
proposed transaction with LJM1. The resolution ratified a determination by the
Office of the Chairman that Fastow's participation in LJM1 would not adversely
affect the interests of Enron.
LJM1 was formed in June 1999. Fastow became the sole and managing
member of LJM Partners, LLC, which was the general partner of LJM Partners, L.P.
This, in turn, was the general partner of LJM1. Fastow raised $15 million from
two limited partners, ERNB Ltd. (which we understand was affiliated with CSFB),
- -----------------------
24/ The hedging transaction Fastow proposed included the transfer of restricted
Enron stock to LJM1. The Board was told that all proceeds from appreciation in
the value of Enron stock would go to the limited partners in LJM1, and not to
Fastow; that 100% of the proceeds from all other assets would go to Fastow until
he had received a rate of return of 25% on his invested capital; and that of any
remaining income, half would go to Fastow and half would be divided among the
partners (including Fastow) in proportion to their capital commitments.
69
and Campsie Ltd. (which we understand was affiliated with NatWest). The
following is a diagram of the LJM1 structure:
[DESCRIPTION OF DIAGRAM: Andrew Fastow is the sole and managing member of LJM
Partners, LLC; LJM Partners, LLC is the general partner in LJM Partners, L.P.;
Andrew Fastow is the limited partner in LJM Partners, L.P.; LJM Partners, L.P.
is the general partner in LJM Caymen, L.P. ("LJM1"); ERNB Ltd. and Campsie Ltd.
are the limited partners in LJM1; LJM1 is the limited partner in LJM Swap Sub,
L.P.; LJM SwapCo is the general partner in LJM Swap Sub, L.P.; Andrew Fastow is
the sole director of LJM SwapCo.]
LJM1 entered into three transactions with Enron: (1) the effort to
hedge Enron's position in Rhythms NetConnections stock, (2) the purchase of a
portion of Enron's interest in a Brazilian power project (Cuiaba), and (3) a
purchase of certificates of an SPE called "Osprey Trust." The first two of these
transactions raise issues of significant concern to this investigation, and are
described further below in Sections IV and VI.
LJM2. In October 1999, Fastow proposed to the Finance Committee of
the Board the creation of a second partnership, LJM2 Co-Investment, L.P.
("LJM2"). Again, he would serve as general partner through intermediaries. LJM2
70
was intended to be a much larger private equity fund than LJM1. Fastow said he
would raise $200 million or more of institutional private equity to create an
investment partnership that could readily purchase assets Enron wanted to
syndicate.
This proposal was taken up at a Finance Committee meeting on October
11, 1999. The meeting was attended by other Directors and officers, including
Lay and Skilling. According to the minutes, Fastow reported on various benefits
Enron received from transactions with LJM1. He described the need for Enron to
syndicate its capital investments in order to grow. He said that investments
could be syndicated more quickly and at less cost through a private equity fund
that he would establish. This fund would provide Enron's business units an
additional potential buyer of any assets they wanted to sell.
The minutes and our interviews reflect that the Finance Committee
discussed this proposal, including the conflict of interest presented by
Fastow's dual roles as CFO of Enron and general partner of LJM2. Fastow proposed
as a control that all transactions between Enron and LJM2 be subject to the
approval of both Causey, Enron's Chief Accounting Officer, and Buy, Enron's
Chief Risk Officer. In addition, the Audit and Compliance Committee would
annually review all transactions completed in the prior year. Based on this
discussion, the Committee voted to recommend to the Board that the Board find
that Fastow's participation in LJM2 would not adversely affect the best
interests of Enron.
71
Later that day the Chairman of the Finance Committee, Herbert S.
Winokur, Jr., presented the Committee's recommendation to the full Board.
According to the minutes, he described the controls that had been discussed in
the Finance Committee and noted that Enron and LJM2 would not be obligated to
engage in transactions with each other. The Board unanimously adopted a
resolution "adopt[ing] and ratify[ing]" the determination of the Office of the
Chairman necessary to permit Fastow to form LJM2 under Enron's Code of Conduct.
LJM2 was formed in October 1999. Its general partner was LJM2 Capital
Management, L.P. With the assistance of a placement agent, LJM2 solicited
prospective investors as limited partners using a confidential Private Placement
Memorandum ("PPM") detailing, among other things, the "unusually attractive
investment opportunity" resulting from the partnership's connection to Enron.
The PPM emphasized Fastow's position as Enron's CFO, and that LJM2's day-to-day
activities would be managed by Fastow, Kopper, and Glisan. (We did not see any
evidence that the Board was informed of the participation of Kopper or Glisan;
Glisan later claimed his inclusion in the PPM was a mistake.) It explained that
"[t]he Partnership expects that Enron will be the Partnership's primary source
of investment opportunities" and that it "expects to benefit from having the
opportunity to invest in Enron-generated investment opportunities that would not
be available otherwise to outside investors." The PPM specifically noted that
Fastow's "access to Enron's information pertaining to potential investments will
contribute to superior returns." The drafts of the PPM were reviewed by Enron
in-house lawyers and Vinson & Elkins. Both groups focused on ensuring that the
solicitation did not appear to come from Enron or any of its subsidiaries.
72
We understand that LJM2 ultimately had approximately 50 limited
partners, including American Home Assurance Co., Arkansas Teachers Retirement
System, the MacArthur Foundation, and entities affiliated with Merrill Lynch,
J.P Morgan, Citicorp, First Union, Deutsche Bank, G.E. Capital, and Dresdner
Kleinwort Benson. We are not certain of this because LJM2 declined to provide
any information to us. We further understand that the investors, including the
general partner, made aggregate capital commitments of $394 million. The general
partner, LJM2 Capital Management, L.P., itself had a general partner and two
limited partners. The general partner was LJM2 Capital Management, LLC, of which
Fastow was the managing member. The limited partners were Fastow and, at some
point after the creation of LJM2, an entity named Big Doe LLC. Kopper was the
managing member of Big Doe.25/ (In July 2001, Kopper resigned from Enron and
purchased Fastow's interest in LJM2.) The following is a diagram of the LJM2
structure:
- ---------------------
25/ In his capacity as an Enron employee, Kopper reported to Fastow throughout
the existence of LJM2 until his resignation in July 2001. We have seen no
evidence that Kopper obtained the required consent to his participation in LJM2
under Enron's Code of Conduct. Kopper certified his compliance with the Code in
writing, most recently in September 2000.
73
[DESCRIPTION OF DIAGRAM: LJM Co-Investment, L.P. ("LJM2") has certain individual
investors as its limited partners and has LJM2 Capital Management, L.P. as its
general partner. LJM2 Capital Management, L.P.'s class A limited partner is
Andrew Fastow and its class B limited partner is Big Doe, LLC; Michael Kopper is
the managing member of Big Doe, LLC; LJM2 Capital Management, L.P.'s general
partners is LJM2 Capital Management, LLC and Andrew Fastow is the managing
member of LJM2 Capital Management, LLC.]
In April 2000, Enron and LJM Management L.P. entered into a "Services
Agreement" under which Enron agreed to have its staff perform certain tasks (for
a fee), including opening and closing accounts, executing wire transfers, and
"Investment Execution & Administration." The Services Agreement described these
activities as "purely ministerial," and contemplated that LJM would pay market
rates. That same month, Causey and Fastow signed an agreement regarding the use
of Enron employees by LJM1 and LJM2. The employees would continue to be
"regular, full-time" Enron employees for benefits purposes, but the LJM
partnerships would pay the bonuses, and in some cases the base salary. LJM would
also pay the costs. The memorandum describing this agreement says that "[i]t is
74
understood that some activities conducted by LJM2 employees will also be for the
benefit of Enron," and that in such cases Causey and Fastow would "reasonably
agree upon allocation of costs to Enron and LJM2." This understanding was
memorialized in a second Services Agreement dated July 17, 2000. We were unable
to determine what LJM2 actually paid for any services under these agreements.
The LJM partnerships entered into more than 20 distinct transactions
with Enron. A substantial number of these transactions raise issues of
significant concern, and are described further in Sections IV, V, and VI of this
Report.
B. LJM GOVERNANCE ISSUES
The structures of LJM1 and LJM2--in which Fastow controlled the
general partner of each partnership--raise questions about non-consolidation by
Enron of the LJM partnerships and certain entities (described in more detail
below) in which one of the LJM partnerships was an investor. In each case, Enron
could avoid consolidation under relevant accounting rules only if the entity was
controlled by an independent third party with substantive equity and risks and
rewards of ownership. The first question, then, is whether Fastow controlled
LJM1 and LJM2. If so, Enron arguably would control LJM1 and LJM2, and Enron
would be required to consolidate them on its financial statements.
As described above, the criteria for determining control with respect
to general partners are subjective. Nevertheless, the accounting rules indicate
that a sole general partner should not be viewed as controlling a limited
75
partnership if the partnership agreement provides for the removal of the general
partner by a reasonable vote of the limited partners, without cause, and without
a significant penalty. Similarly, other limits on the authority of the general
partner, such as requiring approval for the acquisition or sale of principal
assets, could be viewed as giving the limited partners sufficient control for
non-consolidation.
Both LJM1 and LJM2 present substantial questions about whether Fastow
was in effective control. Fastow was the effective general partner of both
partnerships, and had management authority over them. On the other hand, both
partnership agreements limited the general partner's investment authority, and
required approval of certain investment decisions by the limited partners.
Moreover, the LJM2 partnership agreement provided for removal of the general
partner, without cause, by a recommendation of an Advisory Committee and a vote
of the limited partners (initially limited partners with 75% in interest, later
reduced to two-thirds). Given the role of the limited partners (which were
somewhat different for LJM1 and LJM2, and in the case of LJM2 changed over
time), arguments could be made both for and against consolidation based on
Fastow's control of the partnerships. Andersen's workpapers include a discussion
of the limited partner oversight in LJM2 and changes in June 2000 to strengthen
the rights of limited partners to remove the general partner and members of the
Advisory Committee.
We have reviewed these issues in detail, and have concluded that
there are no clear answers under relevant accounting standards. Fastow declined
to speak with us about these issues. As we have noted, the limited partners of
both LJM1 and LJM2, citing confidentiality provisions in the partnership
agreements, declined to cooperate with our investigation by providing documents
or interviews.
76
IV. RHYTHMS NETCONNECTIONS
The Rhythms transaction was Enron's first business dealing with the
LJM partnerships. The transaction is significant for several reasons. It was the
first time that Enron transferred its own stock to an SPE and used the SPE to
"hedge" an Enron merchant investment. In this respect, Rhythms was the precursor
to the Raptor vehicles discussed below in Section V. Rhythms also provided the
first--and perhaps most dramatic--example of how the purportedly "arm's-length"
negotiations between Enron and the LJM partnerships resulted in economic terms
that were skewed toward LJM and enriched Fastow and other investors. In the case
of Rhythms, those investors included several Enron employees who were secretly
offered financial interests by Fastow and who accepted them in apparent
violation of Enron's Code of Conduct.
A. ORIGIN OF THE TRANSACTION
In March 1998, Enron invested $10 million in the stock of Rhythms
NetConnections, Inc. ("Rhythms"), a privately-held internet service provider for
businesses using digital subscriber line technology, by purchasing 5.4 million
shares of stock at $1.85 per share. On April 7, 1999, Rhythms went public at $21
per share. By the close of the trading day, the stock price reached $69.
By May 1999, Enron's investment in Rhythms was worth approximately
$300 million, but Enron was prohibited (by a lock-up agreement) from selling its
shares before the end of 1999. Because Enron accounted for the investment as
part of its merchant portfolio, it marked the Rhythms position to market,
meaning that increases and decreases in the value of Rhythms stock were
reflected on Enron's income statement. Skilling was concerned about the
77
volatility of Rhythms stock and wanted to hedge the position to capture the
value already achieved and protect against future volatility in income. Given
the size of Enron's position, the relative illiquidity of Rhythms stock, and the
lack of comparable securities in the market, it would have been virtually
impossible (or prohibitively expensive) to hedge Rhythms commercially.
Enron also was looking for a way to take advantage of an increase in
value of Enron stock reflected in forward contracts (to purchase a specified
number of Enron shares at a fixed price) that Enron had with an investment
bank.26/ Under generally accepted accounting principles, a company is generally
precluded from recognizing an increase in value of its own stock (including
forward contracts) as income. Enron sought to use what it viewed as this
"trapped" or "embedded" value.
Fastow and Glisan developed a plan to hedge the Rhythms investment by
taking advantage of the value in the Enron shares covered by the forward
contracts. They proposed to create a limited partnership SPE, capitalized
primarily with the appreciated Enron stock from the forward contracts. This SPE
would then engage in a "hedging" transaction with Enron involving the Rhythms
stock, allowing Enron to offset losses on Rhythms if the price of Rhythms
declined. Fastow would form the partnership and serve as the general partner.
- -----------------------
26/ Enron originally entered into these contracts to hedge economically the
dilution resulting from its employee stock option programs. The contracts had
become significantly more valuable due to an increase in the price of Enron
stock.
78
On June 18, 1999, Fastow presented the proposal to Lay and Skilling,
and received approval to bring it to the Board. Ten days later, on June 28,
Fastow presented the proposal to the Board at a special meeting (described above
in Section III.A.). The minutes indicate that Fastow identified the
"appreciated" value in the Enron shares subject to the forward contracts, and
explained that the value would be transferred to LJM1 in exchange for a note
receivable. This would permit LJM1 to enter into a swap with Enron to hedge
Enron's position in Rhythms. Fastow's presentation materials described the
anticipated value to Enron and the extent of Fastow's economic interest in LJM1,
and stated (on two different slides) that Fastow would not receive "any current
or future (appreciated) value of ENE stock."27/ The minutes indicate that Fastow
also told the Board that an outside accounting firm would render a fairness
opinion stating that the value Enron would receive in the transaction exceeded
the value of the forward contracts Enron was transferring to LJM1. The Board
voted to approve the transaction at the same time it approved Fastow's role in
LJM1.
B. STRUCTURE OF THE TRANSACTION
The Rhythms transaction closed on June 30, 1999. The parties to the
transaction were Enron, LJM1, and LJM Swap Sub L.P. ("Swap Sub"). Swap Sub was a
limited partnership created for purposes of the transaction and was intended to
be a non-consolidated SPE. An entity controlled by Fastow, LJM SwapCo., was the
general partner of Swap Sub. LJM1 was the limited partner of Swap Sub and was
- -------------------------
27/ Fastow's presentation said that he would be the general partner of LJM1. To
implement the restriction against his benefiting from Enron stock, the LJM1
partnership agreement provided that all distributions of the proceeds from Enron
stock would be to the limited partners of LJM1.
79
meant to provide the required 3% outside equity at risk. We do not know why Swap
Sub was used, although a reasonable inference is that it was used to shield LJM1
from legal liability on any derivative transactions with Enron.
As finally structured, the transaction had three principal elements:
First, Enron restructured the forward contracts, releasing 3.4
million shares of Enron stock that it then transferred to LJM1. At the closing
price on June 30, these shares had a value of approximately $276 million. Enron,
however, placed a contractual restriction on most of the shares that precluded
their sale or transfer for four years. The restriction also precluded LJM1 and
Swap Sub from hedging the Enron stock for one year. The restriction did not,
however, preclude LJM1 from pledging the shares as security for a loan. The
value of the shares was discounted by approximately $108 million (or 39%) to
account for the restriction. In exchange for these Enron shares, LJM1 gave Enron
a note (due on March 31, 2000) for $64 million.
Second, LJM1 capitalized Swap Sub by transferring 1.6 million of the
Enron shares to Swap Sub, along with $3.75 million in cash.28/
Third, Enron received from Swap Sub a put option on 5.4 million
shares of Rhythms stock. Under the option, Enron could require Swap Sub to
- -------------------------
28/ LJM1 obtained the cash by selling an unrestricted portion of the 3.4 million
Enron shares transferred by Enron to LJM1.
80
purchase the Rhythms shares at $56 per share in June 2004. The put option was
valued at approximately $104 million.
A diagram of the Rhythms transaction is set forth below:
[DESCRIPTION OF DIAGRAM: LJM Swap Sub, L.P. ("Swap Sub") is the general partner
of LJM SwapCo; Andrew Fastow is the sole director of LJM SwapCo; LJM Cayman,
L.P. ("LJM1") is the limited partner in Swap Sub; LJM1's general partner is LJM
Partners, L.P., which transferred $1 million to LJM1; LJM1's limited partners
are ERNB Ltd. (CSFB), which transferred $7.5 million to LJM1 and Campsie Ltd.
(NatWest), which transferred $7.5 million to LJM1; Enron transferred 3.4 million
shares of its stock to LJM1; LJM1 issued a $64 million note to Enron; LJM1
transferred $1.6 million of the Enron shares and $3.75 million in cash to Swap
Sub; Swap Sub gave Enron a put option on 5.4 million shares of Rhythms stock.]
Enron obtained a fairness opinion from PricewaterhouseCoopers ("PwC")
on the exchange of the 3.4 million restricted Enron shares for the Rhythms put
and the $64 million note. PwC opined that the range of value for the Enron
shares was $170-$223 million, that the range of value for the Rhythms put and
81
note was $164-$204 million, and that the consideration received by Enron
therefore was fair from a financial point of view.29/
C. STRUCTURE AND PRICING ISSUES
1. NATURE OF THE RHYTHMS "HEDGE"
The "hedge" that Enron obtained on its Rhythms position affected the
gains and losses Enron reported on its income statement but was not, and could
not have been, a true economic hedge. Attempting to use the "trapped" value in
the forward contracts, Enron transferred to LJM1, and LJM1 transferred to Swap
Sub, 1.6 million shares of the restricted Enron stock. Swap Sub's ability to
make good on the Rhythms put rested largely on the value of the Enron stock. If
Enron stock performed well, Swap Sub could perform on the put even if Rhythms
stock declined--although the losses would be absorbed by the value in the Enron
stock. But if Enron stock and Rhythms stock both declined, Swap Sub would be
unable to perform on the put and Enron's hedge on Rhythms would have failed. In
either case, this structure is in sharp contrast to a typical economic hedge,
- ------------------------
29/ The transaction as initially closed on June 30 was somewhat different. In
late July or early August, the parties adjusted the terms by reducing the term
of the Rhythms put option and increasing the note payable to Enron. None of the
people we interviewed were able to explain why these changes were made, although
some assumed that PwC may have required the changes in order to issue its
fairness opinion. When the Board approved the transaction, it included in its
resolution the statement: "Kenneth Lay and Jeffrey Skilling are hereby appointed
as a Committee of the Board . . . to determine if the consideration received by
the Company is sufficient in the event of a change in the terms of such
transaction from those presented to the Board." We found no evidence that any of
the changes implemented in July or August were presented to Lay or Skilling for
approval.
82
which is obtained by paying a market price to a creditworthy counter-party who
will take on the economic risk of a loss.
There are substantial accounting questions raised by using an SPE as
a counter-party to hedge price risk when the primary source of payment by the
SPE is an entity's own stock--although Andersen apparently approved it in this
case. Those accounting issues are of central concern to the Raptor transactions.
A detailed discussion of those issues is set out in Section V below relating to
the Raptors.
2. SPE EQUITY REQUIREMENT
In order to satisfy the SPE requirement for non-consolidation, Swap
Sub needed to have a minimum of 3% outside equity at risk. At its formation on
June 30, 1999, Swap Sub had negative equity because its liability (the Rhythms
put, valued at $104 million) greatly exceeded its assets ($3.75 million in cash
plus $80 million in restricted Enron stock). On this basis alone, there is a
substantial question whether Swap Sub had sufficient equity to satisfy the
requirement for non-consolidation.
Our review of whether Swap Sub met the 3% requirement was limited by
the absence of information. We were unable to interview either Glisan (who was
primarily responsible for Enron's accounting of the transaction) or Andersen. We
do not know what analysis they relied on to conclude that Swap Sub was properly
capitalized.
Andersen indicated recently that it made an error in 1999 in
analyzing whether Swap Sub qualified for non-consolidation. In his December 12,
2001, Congressional testimony, Andersen's CEO said:
83
In evaluating the 3 percent residual equity level required to qualify
for non-consolidation, there were some complex issues concerning the
valuation of various assets and liabilities. When we reviewed this
transaction again in October 2001, we determined that our team's
initial judgment that the 3 percent test was met was in error. We
promptly told Enron to correct it.
Andersen did not explain further the nature of the error. Our review of the
workpapers that Andersen made available indicates that at least some of the
analyses were performed using the unrestricted value, rather than the discounted
value, of the Enron stock in Swap Sub. This may be the error to which Andersen
refers.
On November 8, 2001, Enron announced that Swap Sub was not properly
capitalized with outside equity and should have been consolidated. As a result,
Enron said it would restate prior period financial statements to reflect the
consolidation retroactive to 1999, which would have the effect of decreasing
Enron's net income by $95 million in 1999 and $8 million in 2000.
3. PRICING AND CREDIT CAPACITY
We encountered sharply divergent recollections about how Enron priced
the Rhythms put option and analyzed the credit capacity of Swap Sub. Vincent
Kaminski, head of Enron's Research Group--which handled sophisticated option
pricing and modeling issues--told us that he was very uncomfortable with the
transaction and brought his concerns to Richard Buy (head of Enron's Risk
Assessment and Control ("RAC") Group), his supervisor. Kaminski says that, based
on the quantitative analysis performed by his group, he strongly recommended to
Buy that Enron not proceed with the transaction. Kaminski recalls that he gave
Buy three reasons: (1) the transaction involved an obvious conflict of interest
because of Fastow's personal involvement in LJM1; (2) the payout was skewed
84
against Enron because LJM1 would receive its benefit much earlier in the
transaction; and (3) the structure was unstable from a credit capacity
standpoint because the SPE was capitalized largely with Enron stock. Buy told us
that he does not recall any discussions with Kaminski (or Kaminski's group being
involved in the transaction). Buy says that at some point his group evaluated
the credit capacity, found that it was too low, and recommended changes in the
structure that improved it.
D. ADJUSTMENT OF THE "HEDGE" AND REPAYMENT OF THE NOTE
After the transaction closed on June 30, Enron accounting personnel
realized that the put option from Swap Sub on Rhythms stock was not reducing
Rhythms-related volatility in Enron's income statement to the degree desired.30/
In an effort to improve the hedge, Enron entered into four more derivative
transactions on Rhythms stock (put and call options) with Swap Sub at no cost to
either party. The options were put in place on July 13, less than two weeks
after the closing. They were designed to get the economics of the hedge closer
to a swap. Analysts in Kaminski's group modeled the hedge to help Glisan
determine how the options should be structured and priced.
On December 17, 1999, three months before it was due, LJM1 paid the
$64 million note plus accrued interest. The source of this payment is unclear.
LJM1 had only $16 million in initial equity. In September 1999 (as described
below in SectionVI.A.1.), LJM1 purchased an interest in the Cuiaba project from
Enron for $11.3 million. There is some evidence that LJM1 may have obtained
- ------------------------
30/ Because the put provided one-sided protection, Enron was exposed to income
statement volatility when Rhythms' price increased and subsequently decreased.
In addition, Enron was subject to income statement volatility from the time
value component of the put option.
85
additional capital to make the December payment.31/ There also is evidence that
LJM1 may have sold some of the restricted Enron stock to finance the $64 million
repayment.32/ Unless the restriction was released, such sales would have been in
violation of LJM1's agreement with Enron. The restriction agreement did permit
LJM1 to use the shares as collateral for a loan, and it is possible that LJM1
repaid the $64 million note by borrowing against the shares.
Regardless of how LJM1 obtained the funds to repay the $64 million
note, LJM1 retained significant value in the 3.6 million Enron shares
(post-split) it was holding.33/ Even assuming LJM1 liquidated shares to pay the
note (which at the closing price on December 17 would have required selling 1.6
million shares), LJM1 would have retained 2 million (post-split) Enron shares
having an unrestricted value of $82 million on December 17.
- ------------------------
31/ In a document titled "Ben Glisan, Jr. FY 99 - Accomplishments," Glisan
identified: "LJM1 Liquidity--Transaction resulted in additional partnership
capital being invested into LJM so that an [sic] $64 MM loan from ENE could be
repaid." Because Glisan declined to be interviewed on this subject, we do not
know the meaning of this reference.
32/ In addition, on December 17, the reported trading volume in Enron stock was
5.1 million shares, approximately twice the normal volume. To our knowledge, the
only evidence of the restriction on LJM1's Enron stock is the letter agreement
between the parties.
33/ LJM1 had received 3.4 million (pre-split) shares and had transferred 1.6
million to Swap Sub. There was a 2-for-1 split in August 1999. That left 1.8
million (pre-split), or 3.6 million (post-split), shares in LJM1.
86
E. UNWINDING THE TRANSACTION
In the first quarter of 2000, Enron decided to liquidate its Rhythms
position. This decision was based on several factors: (1) the expiration of the
lock-up on Rhythms stock; (2) the intervening decline in the value of Rhythms
stock; and (3) the continuing volatility of the Rhythms position and the hedge.
Skilling made this decision. Even after the additional options had been put in
place in July 1999, Enron's earnings continued to fluctuate as the position and
options were marked to market.
During this period, Enron's accounting staff focused on the credit
capacity of Swap Sub. Kaminski told us that, in February or March of 2000, the
accounting group asked him to analyze the credit capacity of the Rhythms
structure. Kaminski and his analysts reviewed the structure and determined there
was a 68% probability that the structure would default and would not be able to
meet its obligations to Enron on the Rhythms put. Kaminski says that, when he
relayed this conclusion to the accounting group, they said they had suspected
that would be the result. Causey told us that he did not recall this
quantification of the likelihood of credit failure, but he did remember
discussions about credit risk. He also told us he recalled considering the
possibility that Enron might need to establish a credit reserve, but was not
sure whether a reserve had been created. Our review did not identify any
evidence that such a reserve was established.
1. NEGOTIATIONS
Once Enron decided to liquidate the Rhythms position, it had to
terminate the derivatives with Swap Sub. Causey had principal responsibility for
87
implementing the termination. In late February or early March 2000, Causey
approached Fastow about unwinding the transaction.
On March 8, 2000, as the negotiations were underway, Enron gave Swap
Sub a put on 3.1 million shares (post-split) of Enron stock at $71.31 per share.
Swap Sub did not pay any option premium or provide any other consideration in
exchange for the put. On March 8, the closing price of Enron stock was $67.19
per share; the put was therefore "in the money" to Swap Sub by $4.12 per share
(or approximately $12.8 million intrinsic value) on the day it was executed.34/
Causey told us he believes the put was given to Swap Sub to stabilize the
structure and freeze the economics so that the negotiations could be completed.
Causey said that, at the outset, Fastow emphasized that he had no
interest in the Enron stock owned by LJM1 and Swap Sub. Causey took this to mean
that Fastow had no residual interest in the unwind of the transaction. Causey
says Fastow told him that he was negotiating with his limited partners on the
appropriate terms to unwind the transaction. Fastow subsequently came back to
Causey with a proposal that Swap Sub receive $30 million from Enron in
connection with the unwind. Causey and others saw their responsibility as
determining whether that price would be fair to Enron. After analysis, they
concluded that it was fair and Enron agreed to the proposal.
- -------------------------
34/ We were told that the put was agreed to by Enron when the current market
price was $71.31, but the price went down before the put documentation was
executed.
88
2. TERMS
Enron and Swap Sub entered into a letter agreement dated March 22,
2000, setting out the terms of the unwind. At the same time, Enron agreed to
loan $10 million to Swap Sub. We were told that Fastow informed Causey that he
was going to buy out one of his LJM1 limited partners for that amount, and Swap
Sub agreed that it would repay the loan with the proceeds of the unwind. The
unwind terms were: (1) termination of the options on Rhythms; (2) Swap Sub's
returning to Enron the 3.1 million (post-split) Enron shares that it had
received from LJM1 but keeping the $3.75 million cash that it had received from
LJM1; and (3) Enron's paying $16.7 million to Swap Sub.35/ The letter agreement
was executed by Causey for Enron and by Fastow for Swap Sub and for
"Southampton, L.P.," which was described in the letter as the owner of Swap Sub.
The final agreement (which made no material change in the terms) was effective
as of April 28, 2000.
3. FINANCIAL RESULTS
The unwind transaction resulted in a huge windfall to Swap Sub and
LJM1. Enron did not seek or obtain a fairness opinion on the unwind. We have not
identified any evidence that the Board or any Board Committee was informed of
the transaction. Lay told us he was unaware of the transaction. Skilling told us
he was aware that Enron had sold its Rhythms position, but was not aware of the
terms on which the hedge was unwound. We have not located any Enron Deal
- -------------------------
35/ The $16.7 million payment was calculated as follows: $30 million per the
agreement between Fastow and Causey, plus $500,000 for accrued dividends on the
Enron stock, less $3.75 million cash in Swap Sub, less $10.1 million principal
and interest on the loan.
89
Approval Sheet ("DASH"), an internal document summarizing the transaction and
showing required approvals, concerning the unwind.36/
SWAP SUB. Because of the decline in price of Rhythms stock, the
Rhythms options were substantially in the money to Enron when the structure was
unwound. Enron calculated the options as having a value of $207 million. In
exchange for terminating these options (and receiving approximately $27 million
cash), Swap Sub returned Enron shares having an unrestricted market value of
$234 million. Enron's accounting personnel determined that this exchange was
fair, using the unrestricted value of the shares.
The Enron shares, however, were not unrestricted. They carried a
four-year contractual restriction. Because of the restriction, at closing on
June 30, 1999, those shares were given a valuation discount of 38%.37/ Although
some of the discount would have amortized from June 1999 through March 2000, a
substantial amount should have remained. For example, assuming straight-line
amortization of the restricted discount over four years, at the closing price on
March 22, 2000, there would have been approximately $72 million of the discount
left at the time of the unwind. If an appropriate valuation discount had been
applied to the shares at that time, the value Enron gave up (the $207 million in
- -------------------------
36/ Enron policy required the RAC Group to prepare a DASH for every business
transaction that involved an expenditure of capital by Enron. The DASH had to be
approved by the relevant business unit, the Legal Department, RAC, and Senior
Management before funds could be distributed.
37/ The PwC fairness opinion given in connection with the initial transaction
concluded that a restriction discount of 20% to 40% was reasonable.
90
Rhythms options plus $27 million in cash) exceeded the value Enron received
($161 million in restricted Enron shares) by more than $70 million. It is
difficult to understand why Enron's accounting personnel did not use the
discounted value of the restricted shares to assess the fairness of the
exchange.38/
When Enron unwound the Raptor vehicles (discussed below in Section
V.E.), as part of the accounting for the transaction, Andersen required Enron to
use the discounted value of Enron shares it received. Andersen reviewed the
Rhythms unwind in 2000, but apparently raised no questions about Enron bringing
the stock back at its unrestricted value.
LJM1. After LJM1 transferred Enron shares to Swap Sub in June 1999,
LJM1 retained 3.6 million (post-split) Enron shares that it had received as part
of the initial transaction. Those shares were not addressed in the April 2000
unwind; LJM1 was simply permitted to retain them. We have not been able to
determine what happened to those shares between June 1999 and April 2000
(although, as noted above, it is possible that LJM1 sold some or all of the
shares in December 1999 to generate funds to pay the $64 million note). At the
- -------------------------
38/ Causey told us he did not recall whether Enron had used the unrestricted
value of the shares in connection with the unwind. He and others in the
Accounting Group told us they were focused primarily on the value of what Enron
was receiving, not the value of what Swap Sub was getting or giving up, and from
Enron's perspective the restriction (if the shares were in Enron's hands) was
not important.
91
closing of the initial transaction in June 1999, those shares had a discounted
value of $89 million. If LJM1 still held the shares on April 28, 2000, they had
an undiscounted value (at closing price) of $251 million, and a smaller
discounted value. Even assuming LJM1 used some of the shares to repay the $64
million note in December 1999, being permitted to retain the balance after the
unwind provided LJM1 with an enormous economic benefit if those shares were sold
or hedged.
F. FINANCIAL PARTICIPATION OF ENRON EMPLOYEES IN THE UNWIND
Unbeknownst to virtually everyone at Enron, several Enron employees
had obtained, in March 2000, financial interests in the unwind transaction.
These include Fastow, Kopper, Glisan, Kristina Mordaunt, Kathy Lynn, and Anne
Yaeger Patel. Fastow's participation was inconsistent with his representation to
the Board that he would not receive any "current or future (appreciated) value"
of Enron stock in the Rhythms transaction. We have not seen evidence that any of
the employees, including Fastow, obtained approval from the Chairman and CEO
under the Code of Conduct to participate financially in the profits of an entity
doing business with Enron. Each of the employees certified in writing their
compliance with the Code. While every Code violation is a matter to be taken
seriously, these violations are particularly troubling. At or around the time
they were benefiting from LJM1, these employees were all involved in one or more
transactions between Enron and LJM2. Glisan and Mordaunt were involved on
Enron's side.
Contemporaneously with the March 22, 2000 letter agreement between
Enron and Swap Sub (setting out the terms of the unwind), the Enron employees
signed an agreement for a limited partnership called "Southampton Place, L.P."
As described in the March 20, 2000 partnership agreement, Southampton's purpose
was to acquire a portion of the interest held by an existing limited partner of
LJM1. The general partner of Southampton was an entity named "Big Doe, LLC."
92
Kopper signed the agreement as a member of Big Doe.39/ The limited partners were
"The Fastow Family Foundation" (signed by Fastow as "Director"), Glisan,
Mordaunt, Lynn, Yaeger Patel, and Michael Hinds (an LJM2 employee). The
agreement shows that the capital contributions of the partners were $25,000 each
for Big Doe and the Fastow Foundation, $5,800 each for Glisan and Mordaunt, and
smaller amounts for the others--a total of $70,000.
Our understanding of Southampton is limited because, other than
Mordaunt, none of the employees would agree to be interviewed in detail on the
subject. Mordaunt said that she was approached by Kopper in late February or
early March 2000. Kopper told her that management personnel of one of LJM1's
limited partners had expressed an interest in buying out part of their
employer's interest, and that Fastow and Kopper were forming a limited
partnership to purchase part of the interest. Mordaunt says that Kopper assured
her that LJM1 was not doing any new business with Enron. In a brief interview
conducted at the outset of our investigation, Glisan told us that he was
approached by Fastow with a proposal similar to what Mordaunt described as
advanced by Kopper.40/
We have not seen evidence that any of the employees sought a
determination from the Chairman and CEO that their investment in Southampton
would not adversely affect Enron's best interests. Mordaunt told us that she did
not consider seeking consent because she believed LJM1 was not currently doing
business with Enron, and that the partnership was simply buying into a cash flow
- -------------------------
39/ As described above in Section III, Big Doe also was a limited partner of
LJM2's general partner.
40/ Yaeger Patel's legal counsel informed us that she had been told by her
"superiors" that she would receive a "bonus" for her work at LJM, and that the
bonus was paid to her and other LJM employees by allowing them to purchase a
small interest in Southampton.
93
from a transaction that had been negotiated previously. (She also suggested,
with the benefit of hindsight, that this judgment was wrong and that she did not
consider the issue carefully enough at the time.)41/ Glisan told us that he
asked LJM1's outside counsel, Kirkland & Ellis, whether the investment would be
viewed as a related-party transaction with Enron, and was told that it would
not. Neither Glisan nor Kirkland & Ellis consulted with Enron's counsel.42/
We do not know whether Southampton actually purchased part of the
LJM1 limited partner's interest.43/ It does appear from other documents,
including the March 22 letter agreement between Enron and Swap Sub, that
Southampton became the indirect owner of Swap Sub.44/ We do not know how this
ownership interest was acquired or what consideration, if any, was paid.
- -------------------------
41/ In late October 2001, after there was considerable media attention devoted
to the LJM partnerships, Mordaunt voluntarily disclosed the fact of her
investment to Enron.
42/ Yaeger Patel's legal counsel informed us that she was told by her
"superiors" and "internal company counsel advising LJM" that all necessary
approvals or waivers for her LJM activities had been obtained.
43/ Our inquiry did identify some evidence that Chewco (described above in
Section II) may have transferred $1 million to the account of Campsie, Ltd., an
LJM1 limited partner, in March 2000 at or around the time of the unwinding of
the Rhythms transaction.
44/ The letter agreement indicates that Southampton, L.P., of which Southampton
Place is the general partner, owns 100% of the limited partner interests in Swap
Sub and 100% of Swap Sub's general partner. At the time of the initial Rhythms
transaction, the closing documents indicated that LJM1 was the limited partner
of Swap Sub. Based on our interviews, none of the Enron employees involved in
the Rhythms unwind noticed that Southampton appeared to have replaced (or
supplemented) LJM1 as a limited partner.
94
Even based on the limited information we have, the Enron employees
received massive returns on their modest investments. We have seen documents
indicating that, in return for its $25,000 investment, the Fastow Family
Foundation received $4.5 million on May 1, 2000. Glisan and Mordaunt separately
told us that, in return for their small investments, they each received
approximately $1 million within a matter of one or two months, an extraordinary
return. Mordaunt told us that she got no explanation from Kopper for the size of
this return. He said only that Enron had wanted to terminate the Rhythms options
early. We do not know what Big Doe (Kopper), Lynn, or Yaeger Patel received. The
magnitude of these returns raises serious questions as to why Fastow and Kopper
offered these investments to the other employees.
In 2000, Glisan was involved on behalf of Enron in several
significant transactions with LJM2. Most notably, he was a major participant in
the Raptor transactions. He presented the Raptor I transaction to the Board, and
was intimately involved in designing its structure. Enron approval documents
show Glisan as the "business unit originator" and "person negotiating for Enron"
in the Raptor I, II, and IV transactions. Glisan signed each of those approval
documents. In May 2000, Glisan succeeded McMahon as Treasurer of Enron. Glisan
told us that Fastow never asked him for any favors or other consideration in
return for the Southampton investment.
Mordaunt is a lawyer. She was involved in the initial Rhythms
transaction as General Counsel, Structured Finance. Later in 1999, she became
General Counsel of Enron Communications (which later became Enron Broadband
Services). To our knowledge, Mordaunt was involved in one transaction with LJM2
in mid-2000. She acted as Enron's business unit legal counsel in connection with
the Backbone transaction (which involved LJM2's purchase of dark fiber-optic
95
cable from Enron and is discussed below in Section VI.B.1.). She signed the
internal approval sheet. She told us she was never asked for, and never
provided, anything in return for the Southampton investment.
Kopper, Lynn, and Yaeger Patel all were Enron employees in the
Finance area. All three are specifically identified in the Services Agreement
between Enron and LJM2 as employees who will do work for LJM2 during 2000 and
receive compensation from both Enron and LJM2. At the time of their departures
from Enron, Kopper was a Managing Director, Lynn was a Vice President, and
Yaeger Patel was a non-officer employee.
96
V. THE RAPTORS
The transactions between Enron and LJM2 that had the greatest impact
on Enron's financial statements involved four SPEs known as the "Raptors."
Expanding on the concepts underlying the Rhythms transaction (described in the
preceding Section of this Report), Enron sought to use the "embedded" value of
its own equity to counteract declines in the value of certain of its merchant
investments. Enron used the extremely complex Raptor structured finance vehicles
to avoid reflecting losses in the value of some merchant investments in its
income statement. Enron did this by entering into derivative transactions with
the Raptors that functioned as "accounting" hedges. If the value of the merchant
investment declined, the value of the corresponding hedge would increase by an
equal amount. Consequently, the decline--which was recorded each quarter on
Enron's income statement--would be offset by an increase of income from the
hedge.
As with the Rhythms hedge, these transactions were not true economic
hedges. Had Enron hedged its merchant investments with a creditworthy,
independent outside party, it may have been able successfully to transfer the
economic risk of a decline in the investments. But it did not do this. Instead,
Enron and LJM2 created counter-parties for these accounting hedges--the
Raptors--but Enron still bore virtually all of the economic risk. In effect,
Enron was hedging risk with itself.
In three of the four Raptors, the vehicle's financial ability to
hedge was created by Enron's transferring its own stock (or contracts to receive
Enron stock) to the entity, at a discount to the market price. This "accounting"
hedge would work, and the Raptors would be able to "pay" Enron on the hedge, as
97
long as Enron's stock price remained strong, and especially if it increased.
Thus, the Raptors were designed to make use of forecasted future growth of
Enron's stock price to shield Enron's income statement from reflecting future
losses incurred on merchant investments. This strategy of using Enron's own
stock to offset losses runs counter to a basic principle of accounting and
financial reporting: except under limited circumstances, a business may not
recognize gains due to the increase in the value of its capital stock on its
income statement.
When the value of many of Enron's merchant investments fell in late
2000 and early 2001, the Raptors' hedging obligations to Enron grew. At the same
time, however, the value of Enron's stock declined, decreasing the ability of
the Raptors to meet those obligations. These two factors combined to create the
very real possibility that Enron would have to record at the end of first
quarter 2001 a $500 million impairment of the Raptors' obligations to it.
Without bringing this issue to the attention of the Board, and with the design
and effect of avoiding a massive credit reserve, Enron Management restructured
the vehicles in the first quarter of 2001. In the third quarter of 2001,
however, as the merchant investments and Enron's stock price continued to
decline, Enron finally terminated the vehicles. In doing so, it incurred the
after-tax charge of $544 million ($710 million pre-tax) that Enron disclosed on
October 16, 2001 in its initial third quarter earnings release.
Enron also reported that same day that it would reduce shareholder
equity by $1.2 billion. One billion of that $1.2 billion involved the correction
of accounting errors relating to Enron's prior issuance of Enron common stock
(and stock contracts) to the Raptors in the second quarter of 2000 and the first
quarter of 2001; the other $200 million related to termination of the Raptors.
98
The Raptors made an extremely significant contribution to Enron's
reported financial results over the last five quarters before Enron sought
bankruptcy protection--i.e., from the third quarter of 2000 through the third
quarter of 2001. Transactions with the Raptors during that period allowed Enron
to avoid reflecting on its income statement almost $1 billion in losses on its
merchant investments. Not including the $710 million pre-tax charge Enron
recorded in the third quarter of 2001 related to the termination of the Raptors,
Enron's reported pre-tax earnings during that five-quarter period were $1.5
billion. We cannot be certain what Enron might have done to mitigate losses in
its merchant investment portfolio had it not constructed the Raptors to hedge
certain of the investments. Nonetheless, if one were to subtract from Enron's
earnings the $1.1 billion in income (including interest income) recognized from
its transactions with the Raptors, Enron's pre-tax earnings for that period
would have been $429 million, a decline of 72%.
The following description of the Raptors simplifies an extremely
complicated set of transactions involving a complex structured finance vehicle
through which Enron entered into sophisticated hedges and derivatives
transactions. Although we describe these transactions in some depth, even the
detail here is only a summary.
A. RAPTOR I
1. FORMATION AND STRUCTURE
In late 1999, at Skilling's urging, a group of Enron commercial and
accounting professionals began to devise a mechanism that would allow Enron to
hedge a portion of its merchant investment portfolio. These investments were
"marked to market," with changes recorded in income every quarter for financial
statement purposes. They had increased in value dramatically. Skilling said he
99
wanted to protect the value of these investments and avoid excessive
quarter-to-quarter volatility. Due to the size and illiquidity of many of these
investments, they could not practicably be hedged through traditional
transactions with third parties.
With the logic and seeming success (at that time) of the Rhythms
hedge fresh in mind, Ben Glisan, who became Enron's Treasurer in May 2000, led
the effort. Accountants from Andersen were closely involved in structuring the
Raptors.45/ Attorneys from Vinson & Elkins also were consulted frequently,
particularly on securities law issues, and also prepared the transaction
documents.
The first Raptor (Raptor I), created effective April 18, 2000, was an
SPE called Talon LLC ("Talon"). Talon was created solely to engage in hedging
transactions with Enron. LJM2 invested $30 million in cash and received a
membership interest. Through a wholly-owned subsidiary named Harrier, Enron
contributed $1,000 cash, a $50 million promissory note, and Enron stock and
Enron stock contracts with a fair market value of approximately $537 million.46/
Because Talon was restricted from selling, pledging or hedging the Enron shares
for three years, the shares were valued at about a 35% discount to their market
- -------------------------
45/ Enron's records show that Andersen billed Enron approximately $335,000 in
connection with its work on the creation of the Raptors in the first several
months of 2000.
46/ The stock in Raptor I came from shares of Enron stock received from
restructuring forward contracts Enron had with an investment bank, which
released shares of Enron stock. (This was the same source as the Enron stock
used in the Rhythms transaction.) The Enron "stock contract" in Raptor I
consisted of a contingent forward contract held by a wholly-owned Enron
subsidiary, Peregrine, under which it had a contingent right to receive Enron
stock on March 1, 2003 from another entity, Whitewing, if the price of Enron
stock exceeded a certain level.
100
value. This valuation was supported by a fairness opinion provided by PwC. In
return for its contribution, Enron received a membership interest in Talon and a
revolving promissory note from Talon, with an initial principal amount of $400
million. Through a series of agreements, LJM2 was the effective manager of
Talon.
A very simplified diagram of Raptor I appears below:
[DESCRIPTION OF DIAGRAM: Enron owns 100% of Harrier; Harrier contributes Enron
Stock, Stock Contracts, a promissory note for $50 million and $1,000 cash to
Talon (SPE) in exchange for an LLC Interest in, and a $400 million note from,
Talon (SPE); Talon (SPE) and Harrier engage in derivative transactions; LJM2
invests $30 million in cash in exchange for an LLC interest in Talon (SPE);
Enron purchased a put option for $41 million from Talon (SPE) for the right to
require Talon (SPE) to purchase 7.2 million shares of Enron stock at a strike
price of $57.50; and LJM2 delivers a fair market value put of its LLC interest
to Harrier.]
Once Talon received the contributions from Enron and LJM2, it had $30
million of "outside" equity to meet the 3% outside equity requirement for SPE
treatment as an unconsolidated entity. Enron calculated that Talon theoretically
could enter into derivatives with Enron up to approximately $500 million in
notional value. By Enron's calculation, it also had what appeared to be a
capacity to absorb losses on derivative contracts up to almost $217 million.
101
This credit capacity consisted of LJM2's $30 million investment plus the $187
million value of the 35% discount on the Enron stock and stock contracts. Enron
concluded that Talon could sell the Enron stock at its unrestricted value to
meet Talon's obligations.
There was an additional important requirement before Talon could
enter into hedging transactions with Enron. It was understood by those who
structured Talon--although it is not reflected in the Talon documents or Board
presentations--that Talon would not write any derivatives until LJM2 received an
initial return of $41 million or a 30% annualized rate of return, whichever was
greater, from income earned by Talon. Put another way, before hedging could
begin, LJM2 had to have received back the entire amount of its investment plus a
substantial return. This allowed LJM2 effectively to receive a return of its
capital but, from an accounting perspective, leave $30 million of capital "at
risk" to meet the 3% outside equity requirement for non-consolidation. If LJM2
did not receive its specified return in six months, it could require Enron to
purchase its interest in Talon at a value based on the unrestricted price of
Talon's Enron stock and stock contracts. These terms were remarkably favorable
to LJM2, and served no apparent business purpose for Enron. Moreover, because
Talon's Enron stock and stock contracts would have to decline in value by $187
million before Talon incurred any loss, LJM2 did not bear first-dollar risk of
loss, as typically required for SPE non-consolidation. After LJM2 received its
specified return, Enron then was entitled to 100% of any further distributions
of Talon's earnings.47/ Thus, by the time any hedging began, LJM2 would have
- -------------------------
47/ During Talon's existence, this changed slightly. After LJM2 received its
initial $41 million return, it made an additional equity investment of $6
million and was entitled to receive a 12.5% return on that additional
contribution, to the extent Talon had sufficient earnings.
102
received a return that substantially exceeded its initial investment while
retaining only a limited economic stake in the ongoing venture--principally the
return of its original investment upon Talon's liquidation. In fact, Fastow told
his limited partners in LJM2 that the Raptors were "divested investments" after
LJM2 received its specified $41 million return.
To create the required $41 million of income for distribution to
LJM2, Enron purchased from Talon a put option on Enron stock for a premium of
$41 million. The put option gave Enron the right to require Talon to purchase
approximately 7.2 million shares of Enron common stock on October 18, 2000, six
months after the effective date of the transaction, at a strike price of $57.50
per share. The closing price of Enron stock was $68 per share when Enron
purchased the put. As long as Enron's share price remained above $57.50, the put
option would expire worthless to Enron, and Talon would be entitled to record
the $41 million premium as income. It could then distribute $41 million to LJM2,
but continue to treat Talon as an adequately capitalized, unconsolidated SPE.48/
Enron's purchase of the put option for $41 million was unusual for
two reasons. First, from an economic perspective--rather than merely a means to
pay LJM2--the put option was a bet by Enron that its own stock price would
decline substantially. Second, the price of the put was calculated by a method
appropriate only if the transaction were between two fully creditworthy parties.
- -------------------------
48/ Economically, this $41 million distribution reflected a return of and on
LJM2's initial investment, but for accounting purposes the distribution was a
return on the original investment. Thus, LJM2 technically still had $30 million
equity in Talon. Nevertheless, Fastow told his LJM2 investors in April 2001 that
after settlement of the Enron puts, "LJM2 had already received its return of and
on capital."
103
In fact, Talon was not sufficiently creditworthy. Other than the Enron stock and
stock contracts, it had only $71 million of assets --the $30 million LJM2
investment and the $41 million premium-- to meet its obligations on the put, but
it had written a put on more than 7 million shares of Enron stock. If the Enron
stock price declined below approximately $47 per share (about $10 per share
below the strike price), Talon would owe Enron the entire $71 million, and Talon
would be unable to meet its remaining obligations. Thus, the put provided only
about $10 per share of price protection to Enron, and for that reason was worth
substantially less than $41 million. The transaction makes little apparent
commercial sense, other than to enable Enron to transfer money to LJM2 in
exchange for its participation in vehicles that would allow Enron to engage in
hedging transactions.
As it turned out, Enron did not have to wait six months for the put
to expire and for hedging transactions to begin. At Fastow's suggestion, Causey,
on behalf of Enron, and Fastow, on behalf of Talon and LJM2, settled the option
early, as of August 3, 2000. Since Enron stock had increased in value and the
period remaining on the put option had dwindled, the option was worth much less.
Talon returned $4 million of the $41 million option premium to Enron, but
nevertheless paid LJM2 $41 million. That left LJM2 with little further financial
interest in what happened to Talon. This distribution resulted in an annualized
rate of return that LJM2 calculated in a report to its investors at 193%. Enron
also paid LJM2's legal and accounting fees, and a management fee of $250,000 per
year. With LJM2 having received a $41 million payment, Talon was now available
to begin entering into hedging transactions with Enron.
104
2. Enron's Approval of Raptor I
Although the deal-closing documents were dated April 18, 2000, the
transaction did not receive formal approval from Enron's Management or Board
until several weeks later.
The approval of Raptor I by Enron's Management is reflected in two
documents, an "LJM2 Approval Sheet" and an Enron Deal Summary. Both were
executed between May 22 and June 12, 2000, long after the transaction closed.
The LJM2 Approval Sheet very briefly describes the transaction and the
distribution "waterfall" of Talon's earnings (including the initial $41 million
payment to LJM2), and reports that Kopper--a Managing Director of
Enron--negotiated on behalf of LJM2. The Approval Sheet was signed by Glisan,
Causey and Buy, but the signature line for Skilling was blank.49/ The LJM2
Approval Sheet refers to an "attached" DASH. A Deal Summary is attached, which
is largely identical to the Approval Sheet, but added: "It is expected that
Talon will have earnings and cash sufficient to distribute $41 million to LJM2
within six months, yielding an annualized return on investment to LJM2 of 76.8%"
This document was signed only by Glisan and Scott Sefton, the General Counsel of
Enron Global Finance, Fastow's group.
Glisan and Causey presented Raptor I to the Finance Committee of the
Board on May 1, 2000, with Lay, Skilling, and Fastow in attendance. According to
the minutes, Glisan described Raptor as "a risk management program to enable the
Company to hedge the profit and loss volatility of the Company's investments."
- ----------
49/ We discuss Skilling's role in the management and oversight of transactions
with the LJM partnerships in Section VII, below.
105
He explained that Enron and LJM2 would establish "a non-affiliated vehicle ...
as a hedge counter-party to selected investments," explained how Talon would be
funded, and explained "the level of hedging protection Talon could initially
provide."
Although the minutes do not contain any detail regarding what Glisan
told the Committee, it appears that his remarks were guided by a three-page
written presentation provided to the Committee entitled "Project Raptor: Hedging
Program for Enron Assets." The materials stated that Talon would be capitalized
with $400 million in "excess [Enron] stock." It also stated that, "[i]nitially,
[the] vehicle can provide approximately $200 million of P&L [profit and loss]
protection to ENE. As ENE stock price increases, the vehicle's P&L protection
capacity increases as well." The materials also disclosed LJM2's investment and
expected return: "LJM2 will provide non-ENE equity and will be entitled to 30%
annualized return plus fees," with Enron entitled to all upside after LJM2
received its return. The materials did not disclose that LJM2's contractually
specified return was the greater of a 30% annualized return or $41 million.
The Finance Committee was also given information strongly suggesting,
if not making perfectly clear, that the Raptor vehicle was not a true economic
hedge. Notes on the presentation materials, apparently taken at the meeting by
Enron's Corporate Secretary to assist her in preparing the minutes, state: "Does
not transfer economic risk but transfers P&L volatility."50/
- ----------
50/ This thought was repeated in a May 2000 presentation describing the Raptor
hedging program prepared by Enron Global Finance for Enron Broadband Services.
106
According to the minutes, Causey informed the Finance Committee that
Andersen "had spent considerable time analyzing the Talon structure and the
governance structure of LJM2 and was comfortable with the proposed transaction."
Glisan apparently presented a chart identifying three principal "risks" of
Raptor: (1) "accounting scrutiny"; (2) a substantial decline in Enron stock
price; and (3) counter-party credit. For each of them, the chart also identified
corresponding "[m]itigants:" (1) the transaction had been reviewed by Causey and
Andersen; (2) Enron could negotiate an early termination of Talon with LJM2; and
(3) the assets of Talon were subject to a "master netting agreement."
The Finance Committee voted to recommend Project Raptor to the full
Board. The Board approved the transaction the following day, May 2, 2000.
3 Early Activity in Raptor I
The unwritten understanding was that Talon could not engage in hedging
transactions with Enron until LJM2 received its initial $41 million return.
After LJM2 received its $41 million, Talon then began to execute derivative
transactions with Enron. With one exception, these transactions took the form of
"total return swaps" on interests in Enron merchant investments--that is,
derivatives under which Talon would receive the amount of any future gains in
the value of those investments, but also would have to pay Enron the amount of
- ----------
It stated that a "substantial decline in the price of [Enron] stock will cause
the program to terminate early and may return credit risk to Enron," and thus
the Raptor program was "[n]ot an economic hedge; ... credit risk retained with
Enron Corp."
107
any future losses. The total notional value of the derivatives was approximately
$734 million.
All of the documentation for the derivative transactions between Enron
and Talon was signed by Causey for Enron and by Fastow for Talon. They all were
dated "as of" August 3, 2000. Contemporaneous documents, however, demonstrate
that many, if not all, of the transactions were not finally agreed upon until
sometime in mid-September, and were back-dated to be effective "as of" August 3,
2000. The purpose of dating the derivative transactions on the same day appears
to have been administrative: Andersen required Enron to recalculate whether
LJM2's equity investment constituted at least 3% of the Raptor's total assets
each time the Raptor entered into a transaction with Enron. Treating each of the
Raptor I transactions as if they all occurred on one day allowed Enron to make
this calculation only once.
We have found no direct evidence explaining why August 3 was selected
as the single date. We note, however, that August 3 was the date on which the
stock of Avici Systems, a public company in which Enron held a very large stake,
traded at its all-time high ($162.50 per share). By entering into a total return
swap with Talon on Avici stock on that date, Enron was able to lock in the
maximum possible gains. By September 30, 2000, the quarter end, the stock had
declined to $95 per share. By dating the swap "as of" August 3, Enron was able
to offset losses of nearly $75 million on its quarterly financial statements. If
Enron had treated the swap on Avici as effective on September 15,
2000--approximately when the agreement between Enron and LJM2 actually occurred
and when Avici was trading at $95.50 per share--Enron would not have been able
to offset any significant losses on Avici in Enron's third quarter financial
108
statements. Because LJM2 had already received back from Talon its $30 million
investment along with another $11 million, it had little economic incentive to
resist dating or structuring transactions that would benefit Enron for income
statement purposes at Talon's expense.
There is some evidence of a concern within Enron North America ("ENA"),
which held almost all of the assets that were subject to Raptor derivative
transactions, that ENA selected only assets that were expected to decline
substantially in value. On September 1, 2000, an ENA attorney, Stuart Zisman,
wrote (emphasis added):
Our original understanding of this transaction was that all types of
assets/securities would be introduced into this structure (including
both those that are viewed favorably and those that are viewed as being
poor investments). As it turns out, we have discovered that a majority
of the investments being introduced into the Raptor Structure are bad
ones. This is disconcerting [because] ... it might lead one to believe
that the financial books at Enron are being "cooked" in order to
eliminate a drag on earnings that would otherwise occur under fair
value accounting . . . .
ENA's two most senior attorneys received this memorandum, as did several senior
ENA business people. Zisman met with the senior ENA attorneys. He told them
that, contrary to what the memorandum implied, he did not know whether only
"bad" assets had in fact been selected for Raptor, but that he was concerned
Raptor could be misused in that way. The senior ENA attorneys and the senior ENA
business people who received Zisman's memorandum--for varying reasons and with
varying levels of direct knowledge--believed the assertion in Zisman's memo to
be untrue, so they did not take any further action.
109
4. Credit Capacity Concerns in the Fall of 2000
As the value of Enron's merchant investments declined in the fall of
2000, the amounts Talon owed Enron increased. This became a matter of
significant concern at Enron. If Talon's total liabilities (including the amount
owed to Enron) exceeded its total assets (which consisted almost entirely of the
unrestricted value of Enron stock and stock contracts), Enron would have to
record a charge to income based on Talon's credit deficiency. Consequently,
Enron's accounting department kept track of Talon's credit capacity on a daily
basis.
To protect Talon against a possible decline in Enron stock price--which
would decrease the value of Talon's principal asset, and thereby decrease its
credit capacity--on October 30, 2000, Enron entered into a "costless collar" on
the approximately 7.6 million Enron shares and stock contracts in Talon.51/ The
"collar" provided that, if Enron stock fell below $81, Enron would pay Talon the
amount of any loss. If Enron stock increased above $116 per share, Talon would
pay Enron the amount of any gain. If the stock price was between the floor and
ceiling, neither party was obligated to the other. This protected Talon's credit
capacity against possible future declines in Enron stock.
This collar was inconsistent with certain fundamental elements of the
original transaction. Enron had originally transferred $537 million of its own
stock and stock contracts to Talon. It discounted the value of that stock by
approximately 35% because it was restricted from being sold, pledged or hedged
- ----------
51/ The collar was "costless" because Enron and LJM2 owed each other equal
premiums for the transaction. Because the collar was indexed to Enron's own
stock and met certain accounting criteria, Enron was not required to mark it to
market. Instead, it was considered an equity transaction.
110
for a three-year period. These restrictions reduced the value of the stock, and
were a key basis for PwC's fairness opinion. By agreeing to the collar, Enron
had to lift, in part, the restriction that had justified the 35% discount on the
stock ($187 million). Causey signed the document waiving the restriction.
Thus, on October 30, 2000, the value of Talon's principal asset, the
Enron stock and stock contracts, was protected from future declines. Even so,
the value of Enron's merchant investments was rapidly declining, so Talon's
credit capacity was still in jeopardy.
B. Raptors II and IV
Enron and LJM2 established two more Raptors--known as Raptor II and
Raptor IV--that were not materially different from Raptor I. (A fourth vehicle,
Raptor III, is discussed in the next section.) Both Raptors II and IV received
only contingent contracts to obtain a specified number of Enron shares.52/
Raptor II was authorized by the Executive Committee of the Board at its meeting
on June 22, 2000. The minutes state that Fastow told the Committee that a second
- ----------
52/ As noted above in Section V.A.1., Enron contributed to Raptor I a contingent
forward contract held by a wholly-owned Enron subsidiary, Peregrine, under which
Peregrine had a right to receive Enron stock on March 1, 2003 from Whitewing.
Enron contributed similar contingent stock-delivery contracts to Raptors II and
IV. In all, Enron sold the rights to 18 million contingent Enron shares, to be
delivered in 2003, to Raptor I (3.9 million shares), Raptor II (7.8 million
shares) and Raptor IV (6.3 million shares). The contingency was based on Enron
stock price on March 1, 2003. If on that date the price of Enron stock was above
$53 per share, Raptor I would receive all of its shares; if it was above $63 per
share, Raptor II would receive all of its shares; and if it was above $76 per
share, Raptor IV would receive all of its shares. If, on the other hand, the
price of Enron stock on that date was below $63 per share, Raptor IV would
receive no shares; if it was below $53 per share, Raptor II would receive no
shares; and if it was below $50 per share, Raptor I would receive no shares.
111
Raptor was needed because "there had been tremendous utilization by the business
units of Raptor I." In fact, at that point there had been no derivative
transactions between Talon and Enron. A presentation distributed to the
Executive Committee stated: "Initially, the vehicle can provide approximately
$200 million of P&L protection to ENE [Enron]. As ENE stock price increases, the
vehicle's P&L protection capacity increases as well." The closing documents for
Raptor II were dated June 29, 2000.
Raptor IV was presented to the Finance Committee at its meeting on
August 7, 2000.53/ With Skilling, Fastow, Buy and Causey in attendance, Glisan
first discussed Raptors I and II. He "noted that Raptor I was almost completely
utilized and that Raptor II would not be available for utilization until later
in the year." (There is no indication that Glisan explained why Raptor II would
not be available--under the unwritten agreement, Raptor II would not write
derivatives with Enron until LJM2 received its specified $41 million or 30%
return.) Glisan then informed the Committee that "the Company was proposing an
additional Raptor structure . . . to increase available capacity." After a
discussion that is not described in the minutes, the Finance Committee voted to
recommend Raptor IV to the Board. Later that day, Skilling informed the Board
that the Executive Committee had approved Raptor II at its June meeting, and
- ----------
53/ The Finance Committee and Board minutes refer to this vehicle as "Raptor
III," not "Raptor IV." However, as we explain below, another Raptor vehicle was
activated after Raptor II and before what the Board referred to as "Raptor III."
This Raptor vehicle, which is widely referred to as Raptor III by Enron
employees involved in the transactions, was not brought to the Board for
approval. In order to be consistent with the terms used by the parties at the
time (and reflected in contemporaneous documents), we refer to what the Board
called Raptor III as Raptor IV.
112
that Raptor IV would "provide additional mechanisms to hedge the profit and loss
volatility of the Company's investments." The Board then approved Raptor IV. The
closing documents for Raptor IV were dated September 11, 2000.54/
Just as it had done with Talon in Raptor I, Enron paid Raptor II's SPE,
"Timberwolf," and Raptor IV's SPE, "Bobcat," $41 million each for share-settled
put options. As in Raptor I, the put options were settled early, and each of the
entities then distributed approximately $41 million to LJM2.55/ Although these
distributions meant that both Timberwolf and Bobcat were available to engage in
derivative transactions with Enron, Enron engaged in derivative transactions
only with Timberwolf. These transactions, entered into as of September 22, 2000
and December 28, 2000, had a total notional value of $513 million. Enron did not
make use of Bobcat because, as we explain below, concerns regarding the
declining credit capacity of Raptors I and III led Enron to use Bobcat's
available credit capacity to prop them up.
As in Raptor I, Enron entered into costless collars on the Enron stock
contracts in Timberwolf and Bobcat to provide credit capacity support to the
Raptors. Causey approved the collars. The Timberwolf shares were collared on
November 27, 2000, at a floor of $79 and a ceiling of $112. The Bobcat shares
were collared on January 24, 2001, at a floor of $83 and a ceiling of $112. As
- ----------
54/ Skilling signed the LJM2 Approval Sheet for Raptor IV--the only such sheet
he signed for the Raptors, and one of the few sheets he signed at all. Notably,
the Approval Sheet was not signed by Skilling, Buy and Causey until March 2001,
some six months after the deal had closed and the Board had approved the
transaction.
55/ LJM2 made an additional equity investment of $1.1 million in Raptor II at
the time the initial put terminated. LJM2 had a potential 15% return on that
additional investment.
113
in the case of Raptor I, this collaring was inconsistent with the premise on
which the stock contracts had been discounted when they were originally
transferred to Timberwolf and Bobcat. The shares were restricted for three
years, and their value was thus discounted from market value. The collars,
however, effectively lifted the restriction.
C. Raptor III
Raptor III was a variation of the other Raptor transactions, but with
an important difference. It was intended to hedge a single, large Enron
investment in The New Power Company ("TNPC").56/ Instead of holding Enron stock,
Raptor III held the stock of the very company whose stock it was intended to
hedge--TNPC. (Technically, Raptor III held warrants to purchase approximately 24
million shares of TNPC stock for a nominal price. These warrants were thus the
economic equivalent of stock.) If the value of TNPC stock decreased, the
vehicle's obligation to Enron on the hedge would increase in direct proportion.
At the same time, its ability to pay Enron would decrease. Raptor III was thus
the derivatives equivalent of doubling-down on a bet on TNPC. This
extraordinarily fragile structure came under pressure almost immediately, as the
stock of TNPC decreased sharply after its public offering.
- ----------
56/ When TNPC went public, its name changed to New Power Holdings, Inc., but
Enron personnel continued to refer to the company as TNPC. In order to be
consistent with the terms used by the parties at the time and contemporaneous
documents, we refer to New Power Holdings as TNPC.
114
1. The New Power Company
TNPC was a residential and commercial power delivery company Enron
created as a separate entity. Enron owned a 75% interest. It was not publicly
traded in early 2000. Enron sold a portion of its holdings to an SPE, known as
Hawaii 125-0 ("Hawaii"), that Enron formed with an outside institutional
investor. Enron's basis in the warrants was zero. Enron recorded large gains in
connection with the sales, and then entered into total return swaps under which
Enron retained most of the economic risks and rewards of the holdings it had
sold. As a result, Enron bore the economic risks and rewards of TNPC, and would
have to reflect any gains or losses on its income statement on a mark-to-market
basis. In July 2000, Enron also sold warrants for TNPC to other investors
(including LJM2) for the equivalent of $10.75 per share.
Enron contemplated an initial public offering of TNPC stock occurring
in the Fall of 2000. Anticipating that the stock price would fluctuate--causing
volatility in Enron's income statement--Enron wanted to hedge the risk it had
taken on through its total return swaps with Hawaii. To "hedge" its accounting
exposure, Enron once again used the Raptor structure.
2. The Creation of Raptor III
As in the creation of the other Raptors, internal Enron accountants
worked closely with Andersen in designing Raptor III. Andersen's billings for
work on Raptor III were approximately $55,000. Attorneys from Vinson & Elkins
were also consulted and prepared the transaction documents. The structure of
Raptor III, however, was different from the other Raptors because Enron did not
have ready access to shares of its stock to contribute to the vehicle. Rather
115
than seeking Board authorization for new Enron shares, which would have resulted
in dilution of earnings per share, Enron Management chose to contribute some of
Enron's TNPC holdings to Raptor III's SPE, "Porcupine."
A very simplified diagram of Raptor III appears below:
[DESCRIPTION OF DIAGRAM: Enron owns 100% of Pronghorn; Pringhorn contributes
TNPC stock and $1,000 cash to Porcupine (SPE) in exchange for an LLC interest
in, and a promissory note for $259 million from, Porcupine (SPE); Pronghorn and
Porcupine (SPE) engage in derivative transactions; LJM2 contributes $30 million
to Porcupine (SPE) in exchange for an LLC interest in Porcupine (SPE).]
Enron and LJM2 created Raptor III effective September 27, 2000. Unlike
the other Raptor transactions, Raptor III was not presented to the Board or to
any of its Committees, possibly because no Enron stock was involved. We have
seen no evidence that the members of the Board, other than Skilling, were aware
of the transaction. Nor have we seen any evidence that an LJM2 Approval Sheet,
Enron Investment Summary, or DASH was prepared for this transaction.
116
As with the other Raptors, LJM2 contributed $30 million to Porcupine.
It was understood that LJM2 would receive its substantial return before
Porcupine would enter into derivative transactions with Enron. In Raptor III,
LJM2's specified return was set at $39.5 million or a 30% annualized rate of
return, whichever was greater. It received a return of $39.5 million in only one
week.
On September 27 Enron delivered approximately 24 million shares of TNPC
stock to Porcupine at $10.75 per share. Enron received a note from Porcupine for
$259 million, which Enron recorded at zero because it had essentially no basis
in the TNPC stock sold to Porcupine. Enron did not obtain a fairness opinion
with respect to the transaction. We are told that Enron, after consulting with
Andersen, reasoned that its private sale of TNPC interests several months
earlier at $10.75 per share was adequate support for the price of its transfer
to Porcupine. The "road show" for the TNPC initial public offering was already
underway, and there is evidence that Enron personnel were aware that the
offering was likely to be completed at a much higher price. Indeed, on September
22, 2000--five days before the transaction with Porcupine at $10.75 per
share--Enron distributed a letter to certain of its employees offering them an
opportunity to purchase shares of TNPC in the offering and noting that "the
current estimated price range [for the shares] is $18.00 to $20.00 per share."
Nonetheless, Enron, with Andersen's knowledge and agreement, concluded that the
last actual transaction was the best indicator of the appropriate price in
valuing the warrants sold by Enron to Porcupine. On October 5, one week after
Enron contributed the warrants to Porcupine at a price equivalent to $10.75 per
share, TNPC's initial public offering went forward at $21 per share.
117
On the day of the initial public offering, the TNPC shares (for which
Porcupine had paid $10.75 five days earlier) closed at $27 per share. That same
day, Porcupine declared a distribution to LJM2 of $39.5 million, giving LJM2 its
specified return and permitting Porcupine to enter into a hedging transaction
with Enron. LJM2 calculated its internal rate of return on this distribution as
2500%.
Enron and Porcupine immediately executed a total return swap on 18
million shares of TNPC at $21 per share. As a result, Enron locked in an
accounting gain related to the Hawaii transactions of approximately $370
million. This gain, however, depended on Porcupine remaining a creditworthy
counter-party, which in turn depended on the price of TNPC stock holding steady
or increasing in value.
3. Decline in Raptor III's Credit Capacity
Although the initial public offering of TNPC was a success, the stock's
value immediately began to deteriorate. After a week of trading, the share price
had dropped below the offering price. By mid-November, TNPC stock was trading
below $10 per share. This had a double-whammy effect on Porcupine: Its
obligation to Enron on its hedge grew, but at the same time its TNPC stock--the
principal, and essentially only, asset with which it could pay Enron--fell in
value. In essence, Porcupine had two long positions on TNPC stock. Consequently,
Enron's transaction with Porcupine was not a true economic hedge.
118
D. Raptor Restructuring
By November 2000, Enron had entered into derivative transactions with
Raptors I, II and III with a notional value of over $1.5 billion. Enron's
accounting department prepared a daily tracking report on the performance of the
Raptors. In its December 29, 2000 report, Enron calculated its net gain (and the
Raptors' corresponding net loss) on these transactions to be slightly over $500
million. Enron could recognize these gains--offsetting corresponding losses on
the investments in its merchant portfolio--only if the Raptors had the capacity
to make good on their debt to Enron. If they did not, Enron would be required to
record a "credit reserve," reflecting a charge on its income statement. Such a
loss would defeat the very purpose of the Raptors, which was to shield Enron's
financial statements from reflecting the change in value of its merchant
investments.
1. Fourth Quarter 2000 Temporary Fix
Raptor I and Raptor III developed significant credit capacity problems
near the end of 2000. For Raptor I, the problem was that many of the derivative
transactions with Enron resulted in losses to Talon, but the price of Enron
stock had not appreciated significantly. The collar that Enron applied to the
shares in Raptor I in October provided some credit support to Talon as Enron's
share price dipped below $81 per share, but by mid-December the derivative
losses surpassed the value of Talon's assets, creating a negative credit
capacity.
119
Raptor III was faring no better. The price of TNPC stock had fallen
dramatically from its initial public offering price, and was trading below $10 a
share. Raptor III's assets had therefore declined substantially in value, and
its obligation to Enron had increased. As a result, Raptor III also had negative
credit capacity.
In an effort to avoid having to record a loss for Raptors I and III on
its 2000 financial statements, Enron's accountants, working with Andersen,
decided to use the "excess" credit capacity in Raptors II and IV to shore up the
credit capacity in Raptors I and III. A 45-day cross-guarantee agreement, dated
December 22, 2000, essentially merged the credit capacity of all four Raptors.
The effect was that Enron would not, for year end, record a credit reserve loss
unless there was negative credit capacity on a combined basis. Enron paid LJM2
$50,000 to enter into this agreement, even though the cross-guarantee had no
effect on LJM2's economic interests. We have seen no evidence that Enron's Board
was informed of either the credit capacity problem or the solution selected to
resolve that problem. Enron did not record a reserve for the year ending
December 31, 2000.57/
- ----------
57/ At the time, Andersen agreed with Enron's view that the 45-day
cross-guarantee among the Raptors to avoid a credit reserve loss was permissible
from an accounting perspective. The workpapers that Andersen made available
included a memorandum dated December 28, 2000, by Andersen's local audit team,
which states that it consulted two partners in Andersen's Chicago office on the
45-day cross-guarantee. The workpapers also include an amended version of the
December 28, 2000 memorandum, dated October 12, 2001, stating that the partners
in the Chicago office advised that the 45-day cross-guarantee was not a
permissible means to avoid a credit reserve loss.
120
2. First Quarter 2001 Restructuring
In the first quarter of 2001, the credit capacity of the Raptors
continued to decline. By late March, it appeared that Enron would have to take a
pre-tax charge against earnings of more than $500 million to reflect the
shortfall in credit capacity of Raptors I and III. Enron did not take this
charge, and the Board was not informed of the situation. Instead, Enron
Management restructured the Raptors. The Board was not informed about that,
either.
a. The Search for a Solution
The December cross-guarantee agreement was intended as a temporary
remedy. In early January, a team of Enron accountants worked to find a more
permanent solution. The need for a solution increased during the first quarter
of 2001 because the values of both Enron and TNPC stock fell, and the Raptors'
losses on their derivative transactions with Enron increased. The daily tracking
reports that were circulated within the Global Finance, RAC, and Accounting
Departments showed that the Raptors' credit shortfall grew to $504 million by
the end of the quarter.
Senior Enron employees told us that Skilling, who became Enron's CEO
during the first quarter of 2001, was aware of this problem and was intensely
interested in its resolution. We were told that, during the first quarter of
2001, Skilling said that fixing the Raptors' credit capacity problem was one of
the Company's highest priorities. When the Raptors' restructuring was
accomplished, Skilling called one of the accountants who worked on the project
to thank him personally. Skilling disputes these accounts. He told us that he
recalls being informed in only general terms that there was a credit capacity
121
issue with the hedges in the Raptors due to the falling price of Enron stock and
the assets being hedged, and that the problem could be solved. He told us he
understood the matter to be an accounting issue, and that he recalls having no
significant involvement in, or understanding of, the problem. Skilling also told
us that, in his view, if it had been necessary to take a loss in the first
quarter, Enron could have done so without undue harm to its stock price because
many other companies at that time were reporting losses in high-tech
investments.
We found no evidence that Lay, who stepped aside as CEO midway through
the first quarter, was aware of these events. It is significant, however, that
Skilling claims to have had only a passing involvement in the restructuring. The
potential impact of the problem, and the chosen solution, were of considerable
consequence to the Company in Skilling's first quarter as CEO. Either Skilling
was not nearly as involved in Enron's business as his reputation--and his own
description of his approach to his job--would suggest, or he was deliberately
kept in the dark by those involved in the restructuring. Whichever is the case,
Skilling now says that he has no recollection of the details of the
restructuring transaction.
b. The Restructuring Transaction
The restructuring transaction, which was made effective as of March 26,
2001, consisted of two principal parts: a cross-collateralization of the Raptors
and an additional infusion of Enron stock contracts.58/ By Enron's calculations,
the restructuring allowed Enron to record only a $36.6 million credit reserve
- ----------
58/ Each of the transaction documents is dated April 13, 2001--after the close
of the first quarter--but say they are "effective as of March 26, 2001." A
letter
122
loss for the first quarter of 2001, rather than the $504 million loss Enron
would have recorded if the Raptors had not been restructured.
In the first part of the restructuring, Enron assigned its right to
receive any distribution upon the termination of any Raptor to any other Raptor
that lacked sufficient assets to pay its obligation to Enron. Thus, Enron agreed
that if, for example, it were to receive a distribution from Timberwolf upon the
termination of Raptor II, but Talon (Raptor I) lacked sufficient assets to back
its obligation to Enron, Enron would allow Talon to use the distribution that
otherwise would have gone from Timberwolf to Enron to satisfy Talon's
obligations. This had the effect of shoring up the credit capacity of the
vehicles with credit deficits, but only to the extent of the excess capacity in
other Raptors.
But the credit deficiencies in Raptors I and III were too great for the
other two Raptors to absorb. This problem was magnified by a risk that most of
the Enron stock from the stock contracts included in the Raptors' capital could
become unavailable. The source of shares for the stock contracts that Enron had
originally transferred to Raptors I, II and IV was a contract that conditioned
the availability of the shares on their stock trading at or above $50 per share
on March 1, 2003. By March 22, 2001, however, Enron stock was trading at $55, so
there was a concern that the shares would not be available to the Raptors. This
would further erode their credit capacity.
- ----------
agreement was executed on March 30, 2001, which stated an intention to enter
into an agreement, and set forth the agreement's material terms and conditions.
123
To make up for this potential shortfall, Enron entered into an
extremely complex transaction with Raptors II and IV. The essence of the
transaction was that Enron agreed to deliver up to 18 million additional Enron
shares, if necessary, to Raptors II and IV to make up any Enron stock shortfall
from the original stock contracts. In return, Raptors II and IV increased their
notes payable to Enron by a total of approximately $260 million.
In addition, to add credit capacity to Raptors II and IV (which in turn
supported Raptors I and III), Enron sold them 12 million shares of Enron stock,
to be delivered on March 1, 2005, at $47 per share. In exchange, Raptors II and
IV increased their notes payable to Enron by a total of $568 million. The $47
per share price for the Enron stock contracts represented a 23% discount to the
current market price of $61 per share. The basis for this discount was that the
shares could not be sold, pledged or hedged for a four-year period. This had the
effect of increasing the credit capacity of the Raptors by approximately $170
million.
At the same time, however, Enron entered into an agreement with the
Raptors to hedge those shares that the restriction agreement had prevented the
Raptors from hedging. It did so through additional costless collar derivative
transactions. This was inconsistent with having discounted the price of the
shares by 23%. Enron did not obtain a fairness opinion on this transaction.59/
Enron based the 23% discount on an analysis done by its internal Research Group.
However, the Research Group was not made aware of the collaring arrangement when
it performed its analysis. When the group's head, Kaminski, learned several
- ----------
59/ There is evidence that Enron accountants contacted outside investment banks
seeking a fairness opinion and were unable to obtain what they regarded to be a
suitable opinion.
124
months later that the discounted shares had been simultaneously collared, he
informed Andersen and the Enron accountants who had worked on the restructuring
that this could not be reconciled with the discount.
Restructuring the Raptors allowed Enron to avoid reflecting the $504
million credit reserve loss in its first quarter financial statements. Instead,
it recorded only a $36.6 million credit reserve loss.
E. Unwind of the Raptors
The complicated restructuring of the Raptors "solved" the problem only
temporarily. By late summer of 2001, the continuing decline in Enron and TNPC
stock caused a new credit deficiency of hundreds of millions of dollars. The
collaring arrangements Enron had with the Raptors aggravated the situation,
because Enron now faced the prospect of having to deliver so many shares of its
stock to the Raptors that its reported earnings per share would be diluted
significantly.
At the same time, an unrelated, but extraordinarily serious, Raptor
accounting problem emerged. In August 2001, Andersen and Enron accountants
realized that the accounting treatment for the Enron stock and stock contracts
contributed to Raptors I, II and IV was wrong. Enron had accounted for the Enron
shares sold in April 2000 to Talon (Raptor I), in exchange for a $172 million
promissory note, as an increase to "notes receivable" and to "shareholders'
equity." This increased shareholders' equity by $172 million in Enron's second,
third and fourth quarter 2000 financial reports. Enron made similar entries when
it sold Enron stock contracts in March 2001 to Timberwolf and Bobcat (Raptors II
and IV) for notes totaling $828 million. This accounting treatment increased
125
shareholders' equity by a total of $1 billion in Enron's first and second
quarter 2001 financial reports. Enron accountants told us that Andersen was
aware of, and approved, the accounting treatment for the Enron stock contracts
sold to the Raptors in the first quarter of 2001. Andersen did not permit us to
interview any of the Andersen personnel involved.
In September 2001, Andersen and Enron concluded that the prior
accounting entries were wrong, and the proper accounting for these transactions
would have been to show the notes receivable as a reduction to shareholders'
equity. This would have had no net effect on Enron's equity balance. Enron
decided to correct these mistaken entries in its third quarter 2001 financial
statements. At the time, Enron accounting personnel and Andersen concluded
(using a qualitative analysis) that the error was not material and a restatement
was not necessary. But when Enron announced on November 8, 2001 that it would
restate its prior financials (for other reasons), it included the reduction of
shareholders' equity. The correction of the error in Enron's third quarter
financial statements resulted in a reduction of $1 billion ($172 million plus
$828 million) to its previously overstated equity balance.60/
- ----------
60/ Enron recorded a $1.2 billion reduction to shareholders' equity in its third
quarter 2001 financial statement. One billion dollars of this reduction was due
to correcting the overstatement of shareholders' equity that had been discovered
in August. The additional approximately $200 million resulted from the fact that
the notes receivable that Enron held for the stock and stock contracts sold to
the Raptors were valued at a total of $1.9 billion, while the Enron stock and
stock contracts held by the Raptors, which Enron took back when the Raptors were
terminated, was valued at $2.1 billion. The $200 million difference was recorded
as a reduction to shareholders' equity, and added to the $1 billion reduction
that was recorded to correct the accounting error. Together, these two items
accounted for the $1.2 billion reduction in shareholders' equity.
126
In mid-September, with the quarter-end approaching, Causey met with Lay
(who had just recently reassumed the position of CEO because of Skilling's
resignation) and Greg Whalley (Enron's COO) to discuss problems with the
Raptors. Causey presented a series of options, including leaving the vehicles in
place as they were, transactions to ameliorate the situation, and terminating
the Raptors. Lay and Whalley directed Causey to terminate the Raptors.
Enron did so on September 28, 2001, paying LJM2 approximately $35
million. This purchase price apparently was the result of a private negotiation
between Fastow (who had sold his interest in LJM2 to Kopper in July), on behalf
of Enron, and Kopper, on behalf of LJM2. This figure apparently reflected a
calculation that LJM2's residual interest in the Raptors was $61 million.
Enron accounted for the buy-out of the Raptors under typical business
combination accounting, in which the assets and liabilities of the acquired
entity are recorded at their fair value, and any excess cost typically is
recorded as goodwill. However, Andersen told Enron to record the excess as a
charge to income. As of September 28, 2001, Enron calculated that the Raptors'
combined assets were approximately $2.5 billion,61/ and their combined
liabilities were approximately $3.2 billion. The difference between the Raptors'
assets and liabilities, plus the $35 million payment to LJM2, resulted in a
- ----------
61/ This valued the Enron stock and stock contracts, including the collars, in
the Raptors at a restricted value of $2.1 billion. Unrestricted, the Enron stock
would have been worth approximately $350 million more, but Andersen insisted
that Enron calculate the value of the stock at its restricted value. While
Enron's stock price at the termination had decreased significantly to $27 per
share, the collars provided a floor on all of the stock and stock contracts at
prices ranging from $61 to $83 per share.
127
charge of approximately $710 million ($544 million after taxes) reflected in
Enron's third quarter 2001 financial statements.
It is unclear whether the accounting treatment of the termination was
correct. Enron's transactions with the Raptors had resulted in the recognition
of earnings of $532 million during 2000, and $545 million during the first nine
months of 2001, for a total of almost $1.1 billion. After taking the unwind
charge of $710 million, Enron had still recognized pre-tax earnings from its
transactions with the Raptors of $367 million. Thus, it may have been more
appropriate for Enron to have reversed the full $1.1 billion of previously
recorded pre-tax earnings when it bought back the Raptors.
F. Conclusions on the Raptors
The Raptors were an effort to use gains in Enron's stock price and
restriction discounts to avoid reflecting losses on Enron's income statement.
Were this permissible, a company with access to its outstanding stock could
place itself on an ascending spiral: an increasing stock price would enable it
to keep losses in its investments from public view; which, in turn, would spur
further increases in its stock price; which, in turn, would increase its
capacity to keep losses in its investments from public view.
Moreover, LJM2 invested $30 million in each of the Raptors, but
promptly received back the amount of its original investment and much more.
Fastow, a fiduciary to Enron and its shareholders, reported to the LJM2
investors in October 2000 that their internal rates of return on the four
Raptors were 193%, 278%, 2500%, and a projected 125%, respectively. These
extremely large returns were far in excess of the 30% annualized rate of return
described in the May 1, 2000 presentation to the Finance Committee. They were
128
the result of very substantial and very rapid transfers of cash--about $41
million per Raptor, in less than six months each time--from the Raptors to LJM2.
LJM2 was largely assured of a windfall from the inception of the transaction.
Although LJM2 technically still had a $30 million investment in each of the
Raptors, its original investment effectively had been returned.
The returns to LJM2 appear not to have been for a risk taken, but
rather for a service provided: LJM2 lent its name to a vehicle by which Enron
could circumvent accounting convention. The losses Enron incurred on its
merchant investments were not hedged in any accepted sense of that term. The
losses were merely moved from Enron's income statement to the equity section of
its balance sheet. As a practical matter, Enron was hedging with itself. There
was no interested counter-party in these transactions once LJM2 had been paid
its initial return.
Proper financial accounting does not permit this result. To reach it,
the accountants at Enron and Andersen--including the local engagement team and,
apparently, Andersen's national office experts in Chicago--had to surmount
numerous obstacles presented by pertinent accounting rules. Although they
apparently believed that they had succeeded, a careful review of the
transactions shows that they appear to violate or raise serious issues under
several accounting rules:
1. Accounting principles generally forbid a company from recognizing an
increase in the value of its capital stock in its income statement except under
limited circumstances not present here. The substance of the Raptors effectively
allowed Enron to report gains on its income statement that were backed almost
129
entirely by Enron stock, and contracts to receive Enron stock, held by the
Raptors.
2. After the distribution of LJM2's specified initial return, LJM2
appears not to have had sufficient equity at risk in the Raptor transactions to
satisfy the 3% requirement for unconsolidated SPEs. Fastow himself made this
point in a private communication with LJM2 investors in April 2001 (emphasis
added):
After the settlement of the [Enron] puts, Enron and the Raptor
vehicles began entering into derivative transactions designed to hedge
the volatility of a number of equity investments held by Enron. LJM2's
return on these investments was not at risk to the performance of
derivatives in the vehicles, given that LJM2 had already received its
return of and on capital.
This is particularly true for Raptor III, where the impending initial public
offering makes any argument that the vehicle was at risk especially difficult to
sustain. Indeed, for high-risk derivative transactions, such as the hedges
involved here, it is not clear that 3%, which is the minimum acceptable
third-party investment, would suffice even if it were at risk.
3. In light of Enron's influence over the Raptors, it is not clear that
it was entitled to use the cost method of accounting, instead of the equity
method. Had Enron used the equity method, any gains in the Raptor hedges would
have been required to be eliminated and thus would not have provided Enron with
the desired offset to its merchant investment losses.
4. It is not clear that the discount on the value of Enron stock and
stock contracts created by the restriction on sale, assignment, transfer, or
hedging should have been taken into account in calculating the credit capacity
of the Raptors. This is especially true after Enron subsequently collared the
130
shares, effectively removing the justification for at least a portion of the
original discount.
5. In the case of Raptor III, Enron did not record a note receivable on
its balance sheet reflecting the amount owed it by the Raptor (Porcupine), and
did not reduce Porcupine's net assets by the amount of that note ($259 million)
in calculating Porcupine's credit capacity. By ignoring Porcupine's legal
obligation to repay this note for purposes of calculating its credit capacity,
Enron effectively overstated Porcupine's credit capacity by $259 million.
6. By issuing collars simultaneously with providing the Enron stock
contracts in the Raptor restructuring, Enron effectively provided the vehicles a
fixed return representing the difference between the sales price and the collar
floor. It appears that this could have been treated for accounting purposes as a
dividend paid to a stockholder, by reducing income available to shareholders in
calculating earnings per share.
7. Even if the Raptor restructuring had been valid in other respects,
it may not have permitted Enron to avoid reporting the $504 million impairment
of the Raptor notes receivable in the first quarter of 2001. Proper accounting
for this transaction should have given only prospective effect to the
restructuring.
The creation, and especially the subsequent restructuring, of the
Raptors was perceived by many within Enron as a triumph of accounting ingenuity
by a group of innovative accountants. We believe that perception was mistaken.
Especially after the restructuring, the Raptors were little more than a highly
complex accounting construct that was destined to collapse.
131
It is particularly surprising that the accountants at Andersen, who
should have brought a measure of objectivity and perspective to these
transactions, did not do so. Based on the recollections of those involved in the
transactions and a large collection of documentary evidence, there is no
question that Andersen accountants were in a position to understand all the
critical features of the Raptors and offer advice on the appropriate accounting
treatment. Andersen's total bill for Raptor-related work came to approximately
$1.3 million. Indeed, there is abundant evidence that Andersen in fact offered
Enron advice at every step, from inception through restructuring and ultimately
to terminating the Raptors. Enron followed that advice. The Andersen workpapers
we were permitted to review do not reflect consideration of a number of the
important accounting issues that we believe exist.
As we note above, Enron's use of the Raptors allowed Enron to avoid
reflecting almost $1 billion in losses on its merchant investments over a period
spanning just a little more than one year. Without the Raptors, and excluding
the $710 million pre-tax charge Enron took in the third quarter of 2001, Enron's
pre-tax earnings from the third quarter of 2000 through the third quarter of
2001 would have been $429 million, rather than the $1.5 billion that Enron
reported. Quarter by quarter, the Raptors' contribution to Enron's pre-tax
earnings (in millions) is shown below:
132
Quarter Reported Earnings Earnings Without Raptors Raptors' Contribution to Earnings
- ------- ----------------- ------------------------ ---------------------------------
3Q 2000 $364 $295 $69
4Q 2000 $286 ($176) $462
1Q 2001 $536 $281 $255
2Q 2001 $530 $490 $40
3Q 2001* ($210) ($461) $251
====== ====== ====
TOTAL $1506 $429 $1,077
* Third quarter 2001 figures exclude the $710 million pre-tax charge to earnings
related to the termination of the Raptors.
133
VI. OTHER TRANSACTIONS WITH LJM
In addition to Rhythms and the Raptors, Enron and the LJM partnerships
engaged in almost twenty transactions from September 1999 through July 2001,
when Fastow sold his interest in LJM2 to Kopper.62/ Many of these transactions
illustrate well the difficulty Enron encountered, and failed to resolve, when it
engaged in related-party transactions with the LJM partnerships.
On the surface, these transactions appear to be consistent with Enron's
purpose in permitting Fastow to manage the partnerships: Enron sold assets to a
purported third party without much difficulty, which permitted Enron to avoid
consolidating the assets and record a gain in some cases. But events after many
of these sales--particularly those that occurred near the end of the third and
fourth quarters of 1999--call into question the legitimacy of the sales
themselves and the manner in which Enron accounted for the transactions. In
particular: (1) After the close of the relevant financial reporting period,
Enron bought back five of the seven assets sold during the last two quarters of
1999, in some cases within three months; (2) the LJM partnerships made a profit
on every transaction, even when the asset it had purchased appears to have
declined in market value; and (3) according to a presentation Fastow made to the
Board's Finance Committee, those transactions generated, directly or indirectly,
"earnings" to Enron of $229 million in the second half of 1999. (This figure
apparently includes the Rhythms transaction, but we have not been able to
- ----------
62/ A timeline of Enron's transactions with the LJM partnerships appears at
Appendix B.
134
confirm Fastow's calculation.) Enron recorded $570 million total in pre-tax
earnings ($549 million after tax) for that period.
There is some evidence that Enron employees agreed, in undocumented
side deals, to insure the LJM partnerships against loss in three of these
transactions. There are also plausible, more innocent explanations for Enron's
repurchases. What seems clear is that the LJM partnerships were not simply
potential buyers of Enron assets on par with other third parties. Rather, Enron
sold assets to the LJM partnerships that it could not, or did not wish to, sell
to other buyers. The details of six transactions follow.
A. Illustrative Transactions with LJM
1. Cuiaba
In September 1999, Enron sold LJM1 a 13% stake in a company building a
power plant in Cuiaba, Brazil. This was the first transaction between Enron and
LJM1 after the Rhythms hedge. This sale, for approximately $11.3 million,
altered Enron's accounting treatment of a related gas supply contract and
enabled Enron to realize $34 million of mark-to-market income in the third
quarter of 1999, and another $31 million of mark-to-market income in the fourth
quarter of 1999. In August 2001, Enron repurchased LJM1's interest in Cuiaba for
$14.4 million.
As of mid-1999, Enron owned a 65% stake in a Brazilian company, Empresa
Productora de Energia Ltda ("EPE"), with a right to appoint three directors. A
third party owned the remainder, with a right to appoint one director. Enron's
Brazilian business unit wanted to reduce its ownership interest, but had
difficulty finding a buyer, in part because the plant was experiencing
135
significant construction problems. In June 1999, Glisan, who reported to Fastow,
advised the employee handling the sale effort that LJM1 would purchase an
interest in EPE.
This employee negotiated the transaction with LJM1 on behalf of Enron.
It is indicative of the confusion over roles that a second employee, whom the
first employee believed was negotiating on behalf of LJM1, says she too was
functioning as an Enron employee. The second employee, who worked in Enron
Global Finance and reported to Fastow, said she believed she was an intermediary
between the other Enron employee and Fastow, and that Fastow negotiated for
LJM1.
The transaction was effective September 30, 1999. The terms were that
LJM1 would pay Enron $11.3 million for a 13% interest in EPE and certain
redeemable preference shares in an Enron subsidiary. LJM1 also would have the
right to appoint one member of EPE's Board of Directors. LJM1 granted Enron the
exclusive right to market LJM1's interest to other buyers. If the sale occurred
before May 9, 2000, LJM1's return would be capped at 13%, and Enron would keep
any excess amount. If the sale occurred after May 9, 2000, LJM1's return would
be capped at 25%.63/
Enron took the position that, as a result of the decrease in its
ownership interest, it no longer controlled EPE and was not required to
consolidate EPE in its balance sheet. This permitted Enron to mark-to-market a
portion of a gas supply contract one of its subsidiaries had with the project,
- ----------
63/ The date at which the cap increased was later extended to August 9, 2000,
for a $240,000 fee paid to LJM1.
136
enabling Enron to realize a total of $65 million of mark-to-market income in the
second half of 1999.
After the sale to LJM1, the Cuiaba project encountered serious
technical and environmental problems. Despite the fact that the value of the
interest purchased by LJM1 likely declined sharply due to these problems, Enron
bought back LJM1's interest on August 15, 2001, for $14.4 million. The price was
calculated to provide LJM1 its maximum possible rate of return. This was not
required by the terms of Enron's agreement with LJM1, which had set a maximum,
not a minimum, amount that LJM1 could earn on its investment.
We were told two reasons why Enron paid this amount. The Enron employee
who negotiated the buy-back said that it had become critical to Enron to gain
back the board seat controlled by LJM1. He said that LJM1 had not appointed a
director due to liability concerns, which left only three board members.
Disputes had arisen between Enron and the third party because of cost overruns,
and the third party's director could stymie action merely by leaving Board
meetings and denying the Board a quorum. Skilling told us that he was not
surprised that Enron bought the interest back because personnel in Enron's
Brazilian subsidiary had made misrepresentations to LJM1 in connection with the
original sale, and that he would have authorized a buyback with any outside
party under these circumstances.
On the other hand, the Enron employee reporting to Fastow who
participated in the negotiation of the original transaction told us that Fastow
had told her there was a clear understanding that Enron would buy back LJM1's
investment if Enron were not able to find another buyer for the interest. We are
137
not able to resolve the differences in recollections. LJM1's equity investment
could not have been "at risk" within the meaning of the relevant accounting rule
if Enron had agreed to make LJM1 whole for its investment. In that case, Enron
would have been required to consolidate EPE, and could not have recognized the
mark-to-market gains from the gas supply contract.
2. ENA CLO
On December 22, 1999, Enron North America ("ENA") pooled a group of
loans receivable into a Trust. It sold approximately $324 million of Notes and
equity, providing the purchasers certain rights to the cash flow from repayment
of the loans. The securities representing these rights are known as
collateralized loan obligations ("CLO's"). There were different classes, or
"tranches," of these securities, representing an order of preference in which
the tranches were entitled to repayment. The tranches were rated by Fitch, Inc.,
and marketed to institutional investors by Bear Stearns.
The lowest-rated tranches--those with last claim on the repayments of
the loans in the pool--were extremely difficult to sell. It is our understanding
that no outside buyer could be found. Eventually, the lowest tranche of Notes
was sold to an affiliate of Whitewing (an investment partnership in which Enron
is a limited partner) and LJM2. The equity tranche, which was last in line on
claims to the funds flow, was bought by LJM2 for $12.9 million. LJM2 paid a
total of $32.5 million for its investment. The investors in Whitewing (in which
LJM2 also held an interest) were required to approve its purchase of the Notes.
An Enron employee who worked on the transaction told us that the head of the ENA
138
finance group told one of the Whitewing investors that if the Notes defaulted,
Enron would find a way to make the investor whole.
Two days before LJM2 paid $32.5 million for its interests in the CLO's
Notes and equity, another Whitewing affiliate loaned LJM2 $38.5 million. This
loan agreement was signed on behalf of the Whitewing affiliate by an Enron
employee who had assisted in the effort to sell the CLO tranches. The employee
told us she does not recall the loan transaction. We are unable to determine
whether the loan was intended to fund LJM2's acquisition of the CLO securities,
although the amount and timing is suggestive. This may cast doubt on the
economic substance of LJM2's investment.
This CLO sale did not result in recognition of income by Enron because
Enron carried the loans at fair value. However, because the loans were sold
without recourse to Enron, Enron was no longer subject to the credit exposure.
The loans in the CLO Trust performed very poorly; shortly after being
transferred into the CLO Trust, several loans defaulted. On September 1, 2000,
Enron provided credit support to the CLO Trust by giving it a put option with a
notional value of $113 million. Enron did not charge the CLO Trust a premium for
this option. A substantial portion of the risk related to this put option--which
did not exist until September 1, 2000--was "hedged" in Raptor I, effective
August 3, 2000.
The put option proved insufficient to support the CLO because the loan
portfolio continued to deteriorate. In order to protect its reputation in the
capital markets, in May and July 2001 Enron repurchased all of the outstanding
Notes at par plus accrued interest. Enron also repurchased LJM2's equity stake
at cost.
139
This transaction provides additional evidence (1) of a general
understanding that LJM2 was available to purchase assets that Enron wished to
sell but that no outside buyer wished to purchase; (2) that Enron would offer
the financial assistance necessary to enable LJM2 to do this; and (3) that Enron
protected LJM2 against suffering any loss in its transactions with Enron.
3. Nowa Sarzyna (Poland Power Plant)
On December 21, 1999, Enron sold to LJM2 a 75% interest in a company
that owned the Nowa Sarzyna power plant under construction in Poland. Enron did
not want to consolidate the asset in its balance sheet. While Enron had intended
to sell the asset to a third party or transfer it to an investment partnership
it was attempting to form, Enron was unable to find a buyer before year-end.
Enron settled on LJM2 as a temporary holder of the asset. LJM2 paid a total of
$30 million, part of it in the form of a loan and part an equity investment.
Enron recorded a gain of approximately $16 million on the sale.
When this transaction closed, it was clear this would be only a
temporary solution. The credit agreement governing the debt financing of the
plant required Enron to hold at least 47.5% of the equity in the project until
completion. Enron was able to obtain a waiver of that requirement, but only
through March 31, 2000. It was unable to obtain a further waiver and, after the
plant malfunctioned during a test, Enron was unable to find a buyer for LJM2's
interest. On March 29, 2000, Enron and Whitewing bought out LJM2's equity
interest and repaid the loan for a total of $31.9 million. This provided LJM2
approximately a 25% rate of return.
140
4. MEGS
On December 29, 1999, Enron sold to LJM2 a 90% equity interest in a
company, MEGS LLC, that owned a natural gas gathering system in the Gulf of
Mexico. Enron had attempted to sell this interest to another party, but was
unable to close that transaction by year-end. Closing the transaction by the end
of the year would enable Enron to avoid consolidating the asset for year-end
financial reporting purposes. LJM2 purchased a $23.2 million note of MEGS for
$25.6 million and an equity interest in MEGS for $743,000.
The parties apparently expected to find a permanent buyer within 90
days. The terms of the sale gave Enron an exclusive right to market the LJM2
interest for that period of time, and capped LJM2's return on any such sale at a
25% rate of return.
We were told that early reports indicated that the gas wells feeding
the gathering system were performing above expectations. On March 6, 2000, Enron
(though a different subsidiary) repurchased LJM2's interests. It paid LJM2 an
amount necessary to give it the maximum allowed return. Subsequently, Enron
recorded an impairment on the gas wells in 2001 due to diminished performance.
The decision to buy back LJM2's interests in MEGS was reflected on a
DASH. Jeff McMahon, then Enron's Treasurer, at first declined to sign. Under the
signature block he wrote: "There were no economics run to demonstrate this
investment makes sense. Therefore, we cannot opine on its marketability or
ability to syndicate." McMahon told us he did not see any sense in Enron
purchasing this asset, which would simply add to Enron's balance sheet and
provide only a very modest return.
141
5. Yosemite
In November 1999, Enron and an institutional investor paid $37.5
million each to purchase all the certificates issued by a trust called
"Yosemite." In late December, Enron determined that it needed to reduce its
holdings of the Yosemite certificates from 50% to 10% before the end of the
year. This was so that it could avoid disclosing its ownership of the
certificates in its "unconsolidated affiliates" footnote to its 1999 financial
statements on Form 10-K. The plan, apparently, was for an affiliate of
Whitewing, called "Condor," ultimately to acquire the Yosemite certificates
Enron was selling. But for reasons that are unclear--and that none of the Enron
employees who we interviewed could explain--Enron did not feel it could sell the
certificates directly to Condor. Enron needed to find an intermediate owner of
the certificates.
With only a short time before year-end, the Enron employees responsible
for selling the Yosemite certificates believed they had no real option other
than to offer the certificates to LJM2. They approached LJM2, which apparently
insisted on a very large fee--$1 million or more--for LJM2 to purchase the
certificates before reselling them to Condor. The Enron employees, believing
that some fee was appropriate for LJM2's services, offered $100,000. Fastow then
called one of the employees to complain that he was negotiating too hard about
the fee, and that he was holding up a transaction that was important for Enron
to complete before year-end. The employee went to McMahon, his supervisor.
McMahon says he confronted Fastow about pressuring the employee. Following this
discussion, LJM2 retreated and the deal closed with Enron paying the fee it
originally offered.
142
Even apart from Fastow's intervention, the transaction itself is
unusual in several respects. First, it was widely understood that LJM2 was
involved simply to hold the Yosemite certificates briefly before selling them to
another entity. The LJM2 Approval Sheet (which was not prepared until February
2000) clearly states, with emphasis in the original, that "LJM2 intends to sell
this investment to Condor within one week of purchase." Second, the legal
documents show Enron selling the certificates to LJM2 on December 29, 1999, and
then LJM2 selling the certificates to Condor the next day, December 30,
1999--thus disposing of the certificates before year-end. It is not clear how
this would achieve Enron's financial disclosure goals. Finally, the actual
transaction does not appear to have occurred in late December 1999 but, instead,
on February 28, 2000. The transaction involved Condor loaning $35 million to
LJM2, which then immediately used the proceeds to purchase the Yosemite
certificates from Enron, which LJM2 immediately passed on to Condor, which
resulted in the original loan to LJM2 being repaid. In other words, Condor
bought the certificates from Yosemite, with the money and certificates
passing--ever so briefly--through LJM2. For that, LJM2 earned $100,000 plus
expenses.
6. Backbone
In the late 1990s, Enron Broadband Services ("EBS") embarked on an
effort to build a nationwide fiber optic cable network. It laid thousands of
miles of fiber optic cable and purchased the rights to thousands of additional
miles of fiber. In mid-May 2000, EBS decided to sell by the end of the second
quarter a portion of its unactivated "dark" fiber. There was substantial
pressure to close the transaction so that EBS could meet its second quarter
143
numbers. With the quarter-end approaching, the EBS business people felt they had
no choice other than to approach LJM2.
The proposed terms called for EBS to remarket the fiber after LJM2
purchased it, and capped LJM2's return on the resale at 18%. Initially, Kopper
negotiated on behalf of LJM2. But as the negotiations were nearing a conclusion
in late June, Fastow inserted himself in the process. He was angry that EBS
proposed to sell LJM2 dark fiber that was not certified as usable, and that it
might take as long as a year for it to be certified. He first confronted EBS'
general counsel, Kristina Mordaunt, the former general counsel to Fastow's group
and his recent partner in the Southampton Place partnership. Fastow complained
to her that EBS was the most difficult business unit with which to negotiate.
Fastow then complained directly to two of the lead negotiators for EBS, telling
them that EBS was putting LJM2 in a difficult position by selling it uncertified
fiber.
Fastow's involvement caused great distress for the EBS team. They
understood that their job was to get the best deal possible for Enron, but
driving a hard bargain for Enron drew the ire of Enron's CFO. The EBS team went
to Causey and Ken Rice, the CEO of EBS, for assistance. Together, they decided
to accommodate Fastow's concern by sweetening EBS' original offer by providing
LJM2 with a 25% capped return if EBS did not resell the fiber within two years.
Ultimately, the transaction closed on those terms, with LJM2 promised an 18%
capped return if Enron resold the fiber within two years, and a 25% capped
return if Enron sold the fiber after two years. The additional term did not come
into play because the fiber was sold within two years.
144
The EBS business people involved in the transaction believe they
obtained a good result for EBS notwithstanding Fastow's intercession. Enron
recorded a $54 million gain as a result of the transaction with LJM2. Moreover,
we are told that all the fiber ultimately was sold later for cash (or letters of
credit) to substantial industry participants. Nonetheless, the episode
illustrates well the fundamental dilemma of the Company's CFO serving
concurrently as the managing partner of a business transacting with the Company.
Finally, this transaction is notable for one other reason. It is the
only LJM transaction in which Lay signed the DASH and LJM2 Approval Sheet.
B. Other Transactions with LJM
Enron engaged in several other transactions in 1999 and 2000 with the
LJM partnerships. A majority of these transactions involved debt or equity
investments by LJM in Enron-sponsored SPEs. These SPEs owned, directly or
indirectly, a variety of operating and financial assets. These transactions also
included direct or indirect investments by LJM in Enron affiliates. The effect
on Enron's financial statements from these transactions varied. The dates,
amount of LJM's investments, and summary descriptions of these transactions are
provided in the following table:
145
- ----------------- -------------- --------------------------------- ----------------------------------------
Date Amount Transaction Description
- ---- ------ ----------- -----------
(in millions)
- ----------------- -------------- --------------------------------- ----------------------------------------
September 1999 $15 Purchase of Osprey Trust Purchase of equity in limited partner
certificates of Whitewing
- ----------------- -------------- --------------------------------- ----------------------------------------
December 1999 $3 Investment in Bob West Treasure Purchase of a portion of Enron's
equity in an entity that provided
financing for the acquisition of
natural gas reserves
- ----------------- -------------- --------------------------------- ----------------------------------------
January 2000 $0.7 Investment in Cortez Purchase of equity in an SPE that held
the voting rights to 25% of TNPC
common stock
- ----------------- -------------- --------------------------------- ----------------------------------------
March 2000 $12.5 Investment in Rawhide Purchase of equity in an SPE, which
was a monetization of a pool of Enron
North America and Enron International
assets
- ----------------- -------------- --------------------------------- ----------------------------------------
May 2000 $11.3 (1) Blue Dog Sale of call option to Enron on
contracts to purchase two gas turbines
- ----------------- -------------- --------------------------------- ----------------------------------------
June 2000 $10 Investment in Margaux Purchase of equity in an SPE,
which was a monetization of European
power plant investments
- ----------------- -------------- --------------------------------- ----------------------------------------
Sale of put option agreement with a
utility that had previously purchased
July 2000 $42.9 (2) Coyote Springs Enron's right to acquire a gas turbine
- ----------------- -------------- --------------------------------- ----------------------------------------
July 2000 $50 Investment in TNPC Purchase of warrants exercisable for
stock of TNPC in a private placement
offering
- ----------------- -------------- --------------------------------- ----------------------------------------
July 2000 $26 Purchase of Osprey Trust Purchase of equity in an affiliate of
certificates Whitewing
- ----------------- -------------- --------------------------------- ----------------------------------------
October 2000 $6.5 Purchase of Osprey Associates Purchase of equity in an affiliate of
certificates Whitewing
- ----------------- -------------- --------------------------------- ----------------------------------------
146
- ----------------- -------------- --------------------------------- ----------------------------------------
December 2000 $8 (3) Investment in Fishtail Purchase of equity in an SPE that
would receive preferred economics of
Enron's pulp and paper trading business
- ----------------- -------------- --------------------------------- ----------------------------------------
December 2000 $1 Investment in JGB Trust (Avici) Provide equity in an SPE, which was
used to monetize Enron's equity
investment in Avici, which was being
hedged in Raptor I
- ----------------- -------------- --------------------------------- ----------------------------------------
December 2000 $1.8 Investment in LAB Trust Provide equity in an SPE, which was
(Catalytica) used to monetize Enron's equity
investment in Catalytica, which was
being hedged in Raptor I
- -----------------------------------------------------------------------------------------------------------
(1) Amount represents the notional amount under the option agreement. Enron paid
$1.2 million for this option. The option was subsequently exercised by Enron.
- -----------------------------------------------------------------------------------------------------------
(2) Amount represents the notional amount under the option agreement. The
utility paid a premium of $3.5 million to LJM2 for this option. Subsequently,
the utility assigned its rights to acquire the turbine to an Enron subsidiary.
(3) Amount represents the equity in an SPE that held the rights to paper and
pulp trading operations for 5 years. Enron monetized its retained interest and
recorded a $115 million gain.
- -----------------------------------------------------------------------------------------------------------
147
VII. OVERSIGHT BY THE BOARD OF DIRECTORS AND MANAGEMENT 64/
Oversight of the related-party transactions by Enron's Board of
Directors and Management failed for many reasons. As a threshold matter, in our
opinion the very concept of related-party transactions of this magnitude with
the CFO was flawed. The Board put many controls in place, but the controls were
not adequate, and they were not adequately implemented. Some senior members of
Management did not exercise sufficient oversight, and did not respond adequately
when issues arose that required a vigorous response. The Board assigned the
Audit and Compliance Committee an expanded duty to review the transactions, but
the Committee carried out the reviews only in a cursory way. The Board of
Directors was denied important information that might have led it to take
action, but the Board also did not fully appreciate the significance of some of
the specific information that came before it. Enron's outside auditors
supposedly examined Enron's internal controls, but did not identify or bring to
the Audit Committee's attention the inadequacies in their implementation.
A. Oversight by the Board of Directors
-----------------------------------
Enron's Board of Directors played a role in approving and overseeing
the related-party transactions. This section examines the involvement of the
Board and its Committees, where they were involved, in (1) the Chewco
transaction, (2) permitting Fastow to proceed with LJM1 and LJM2 despite his
- ----------
64/ The portions of this Section describing and evaluating actions of the Board
and its Committees are solely the views of Powers and Troubh.
148
conflict of interest, (3) creating the Raptor vehicles, and (4) overseeing the
ongoing relationship between Enron and LJM.65/
1. The Chewco Transaction
We found no evidence that the Board of Directors (other than Skilling)
was aware that an Enron employee, Kopper, was an investor in or manager of
Chewco.66/ Because substantial Enron loan guarantees were required to permit
Chewco to acquire CalPERS' interest in JEDI, the Chewco transaction was brought
before the Executive Committee of the Board (by conference call) on November 5,
1997. Fastow made the presentation. According to the minutes of the meeting,
Fastow reviewed "the corporate structure of the acquiring company." The minutes
and the interviews we conducted do not reveal any disclosure to the Executive
Committee of Kopper's role, and they do not indicate that the Executive
Committee (or Lay) was asked for or made the finding necessary under Enron's
Code of Conduct to permit Kopper to have a financial interest in Chewco. Both
Fastow and Kopper participated in the telephonic meeting. Each had an obligation
to bring Kopper's role to the Committee's attention. Fastow and Kopper have
declined to be interviewed on this subject.
- ----------
65/ We have not seen any evidence that any member of the Board of Directors had
a financial interest in any of the partnerships that are discussed here.
66/ Skilling said he was aware that Kopper had a managerial role in Chewco, but
not that Kopper had a financial interest. He said he believes he disclosed this
to the Board at some point, but we found no other evidence that he did. We also
saw no evidence that the Board, other than possibly Skilling, was aware of
Enron's repurchasing Chewco's interest in JEDI or of the associated tax
indemnity payment.
149
2. Creation of LJM1 and LJM2
The Board understood that LJM1 and LJM2, both recommended by
Management, presented substantially different issues. The Board discussed the
advantages and disadvantages of permitting Fastow to manage each of these
partnerships. The Board also recognized the need to ensure that Fastow did not
profit unfairly at Enron's expense, and adopted substantial controls.
Nevertheless, these controls did not accomplish their intended purpose.
LJM1. LJM1 came before the Board on June 28, 1999. The Board believed
it was addressing a specific, already-negotiated transaction, rather than a
series of future transactions. This was the Rhythms "hedge." It was presented as
a transaction that would benefit Enron by reducing income statement volatility
resulting from a large investment that could not be sold. The Board understood
that (1) the terms were already fixed, (2) Enron would receive an opinion by
PricewaterhouseCoopers as to the fairness of the consideration received by
Enron, and (3) Fastow would not benefit from changes in the value of Enron stock
that Enron contributed to the transaction. The Board saw little need to address
controls over already-completed negotiations. Indeed, the Board's resolution
specified that Lay and Skilling--neither of whom had a conflict of
interest--would represent Enron "in the event of a change in the terms of [the
Rhythms] transaction from those presented to the Board for its
consideration."67/
- ----------
67/ In fact, there were subsequent changes in the Rhythms transaction, including
the additional put and call options in July 1999 and the change in the LJM1
payment from $50 million to $64 million. We found no evidence that either Lay or
150
When it approved LJM1, the Board does not appear to have considered the
need to set up a procedure to obtain detailed information about Fastow's
compensation from or financial interest in the transactions. This information
should have been necessary to ensure that Fastow would not benefit from changes
in the value of Enron stock, as Fastow had promised. Even though the Board was
informed that "LJM may negotiate with the Company regarding the purchase of
additional assets in the Merchant Portfolio," it did not consider the need for
safeguards that would protect Enron in transactions between Enron and LJM1. In
fact, LJM1 did purchase an interest in Cuiaba from Enron in September 1999.
LJM2. In the case of LJM2, the proposal presented to the Board
contemplated creation of an entity with which Enron would conduct a number of
transactions. The principal stated advantage of Fastow's involvement in LJM2 was
that it could then purchase assets that Enron wanted to sell more quickly and
with lower transaction costs. This was a legitimate potential advantage of LJM2,
and it was proper for the Board to consider it.68/
Nevertheless, there were very substantial risks arising from Fastow's
acknowledged conflict of interest. First, given Fastow's position as Enron's
CFO, LJM2 would create a poor public appearance, even if the transactions had
been immaculate and there had been sound controls. The minutes do not reflect
- ----------
Skilling was advised of or approved these changes, despite the Board's
resolution requiring their approval of any changes.
68/ The Board was apparently not informed of the involvement of other Enron
employees in LJM2, including Kopper's financial stake and the extent of the role
played by other Enron employees under the Services Agreement between Enron and
LJM2.
151
discussion of this issue, but our interviews indicate that it was raised. During
the rising stock market, analysts and investors generally ignored Fastow's dual
roles and his conflict of interest, but when doubts were cast on Enron's
transactions with LJM1 and LJM2 in connection with Enron's earnings announcement
on October 16, 2001, this appearance became a serious problem.
Second, Fastow's position at Enron and his financial incentives and
duties arising out of LJM1 and LJM2 could cause transactions to occur on terms
unfair to Enron or overly generous to LJM1 and LJM2.69/ The Board discussed this
issue at length and concluded that the risk could be adequately mitigated. The
Directors viewed the prospective LJM2 relationship as providing an additional
potential buyer for assets in Enron business units. If LJM2 offered a better
price than other buyers on asset purchases or other transactions, Enron would
sell to LJM2. This could occur because Fastow's familiarity with the assets
might improve his assessment of the risk, or might lower his transaction costs
for due diligence. In our interviews, several Directors cited these benefits of
permitting Fastow to manage LJM2. If a better price was available elsewhere,
Enron could sell to the higher bidder. Based on Fastow's presentation, the
Directors envisioned a model in which Enron business units controlled the assets
- ----------
69/ The presentation to the Board on LJM1 discussed the structure by which
Fastow would be compensated, and therefore provided the Board with a basis for
forming an expectation about the level of his compensation. The presentation to
the Board on LJM2 did not. It provided only that "LJM2 has typical private
equity fund fees and promote [sic]," targeted at "$200 + million institutional
private equity." When LJM2 was initially approved, it does not appear that there
was discussion at the Board level about a much larger fund and the levels of
compensation Fastow would receive, although it was discussed later.
152
to be sold to LJM2 (or alternative potential buyers) and would be negotiating on
behalf of Enron. Because each business unit's financial results were at stake,
the Board assumed they had an incentive to insist that the transactions were on
the most favorable terms available in the market. This was a plausible
assumption, but in practice this incentive proved ineffective in ensuring
arm's-length dealings.
Moreover, several Directors stated that they believed Andersen would
review the transactions to provide a safeguard. The minutes of the Finance
Committee meeting on October 11, 1999 (apparently not attended by
representatives of Andersen) identify "the review by Arthur Andersen LLP" as a
factor in the Committee's consideration of LJM2. Andersen did in fact (1)
provide substantial services with respect to structuring and accounting for many
of the transactions, (2) review Enron's financial statement disclosures with
respect to the related-party transactions (including representations that "the
terms of the transactions were reasonable and no less favorable than the terms
of similar arrangements with unrelated third parties"), and (3) confirm
Andersen's involvement in representations to the Audit and Compliance Committee
at its annual reviews of the LJM transactions. The Board was entitled to rely on
Andersen's involvement in these respects. In addition, one would reasonably
expect auditors to raise questions to their client--the Audit and Compliance
Committee--if confronted with transactions whose economic substance was in
doubt, or if controls required by the Board of Directors were not followed, as
was the case here.70/
- ----------
70/ We are unable to determine why Andersen did not detect the various control
failures described below. At its meeting with the Audit and Compliance Committee
on May 1, 2000, an Andersen representative identified related-party transactions
as an area to be given "high priorit[y] due to the inherent risks that were
153
Further, the Board adopted, or was informed that Management had
adopted, a number of controls to protect Enron's interests. When the LJM2
proposal was brought to the Finance Committee and the Board in October 1999, two
specific controls were recommended and adopted:
o Enron's Chief Accounting Officer, Rick Causey, and Chief Risk Officer,
Rick Buy, would review and approve all transactions between Enron and
LJM2.
o The Audit and Compliance Committee of the Board would annually review
all transactions from the last year "and make any recommendations they
deemed appropriate."
In addition, the Board noted that Enron had no "obligation" to engage in
transactions with LJM. The Board also was told that disclosures of individual
related-party asset sales was "probably" required in periodic SEC filings and
proxy solicitation materials, which would mean involving Enron's internal
lawyers, outside counsel at Vinson & Elkins, and Andersen to review the
disclosures.
Additional controls were added, or described as having been added, at
later meetings. A year later, on October 6 and 7, 2000, respectively, the
Finance Committee and the full Board considered a proposal with respect to a new
entity, LJM3.71/ Fastow informed the Directors, in a meeting at which Skilling,
Causey and Buy were present, that additional controls over transactions between
- ----------
present." Moreover, in the engagement letter between Andersen and Enron dated
May 2, 2000, the engagement partner wrote that Andersen's work would "consist of
an examination of management's assertion that the system of internal control of
Enron as of December 31, 2000, was adequate to provide reasonable assurance as
to the reliability of financial statements. . . ." Because Andersen declined to
permit its representatives to be interviewed, we do not know what, if any, steps
Andersen took in light of these observations.
71/ LJM3 was never created.
154
Enron and LJM1 and LJM2 had been put in place. These included: o Fastow
expressly agreed that he still owed his fiduciary responsibility to Enron.
o The Board or the Office of the Chairman could ask Fastow to
resign from LJM at any time.
o Skilling, in addition to Buy and Causey, approved all
transactions between Enron and the LJM partnerships.
o The Legal Department was responsible for maintaining audit
trails and files on all transactions.
o A review of Fastow's economic interest in Enron and LJM was
presented to Skilling.
One Director also proposed that the Finance Committee review the LJM
transactions on a quarterly basis. Another Director proposed that the
Compensation and Management Development Committee review the compensation
received by Fastow from the LJM partnerships and Enron. Both proposals were
adopted by the Finance Committee.
Finally, the Finance Committee (in addition to the Audit and Compliance
Committee) was informed on February 12, 2001, of still more procedures and
controls:
o The use within Enron of an "LJM Deal Approval Sheet"--in
addition to the normal DASH--for every transaction with LJM,
describing the transaction and its economics, and requiring
approval by senior level commercial, technical, and commercial
support professionals. (This procedure had, in fact, been
adopted by early 2000.)
o The use of an "LJM Approval Process Checklist" that included
matters such as alternative sales options and counter-parties;
a determination that the transaction was conducted at arm's
length, and any evidence to the contrary; disclosure
obligations; and review not only by Causey and Buy but also by
Skilling.
o LJM senior professionals do not ever negotiate on behalf of
Enron.
o People negotiating on behalf of Enron "report to senior Enron
professionals apart from Andrew Fastow."
155
o Global Finance Commercial, Legal and Accounting Departments
monitor compliance with procedures and controls, and regularly
update Causey and Buy.
o Internal and outside counsel are regularly consulted regarding
disclosure obligations and review any such disclosures.
These controls were a genuine effort by the Board to satisfy itself
that Enron's interests would be protected.
At bottom, however, the need for such an extensive set of controls said
something fundamental about the wisdom of permitting the CFO to take on this
conflict of interest. The two members of the Special Committee participating in
this review of the Board's actions believe that a conflict of this significance
that could be managed only through so many controls and procedures should not
have been approved in the first place.
3. Creation of the Raptor Vehicles
The Board authorized Raptor I in May of 2000. The Board was entitled to
rely on assurances it received that Enron's internal accountants and Andersen
had fully evaluated and approved the accounting treatment of the transaction,
but there was nevertheless an opportunity for the members of the Board to
identify flaws and pursue open questions.72/
- ----------
72/ The Board cannot be faulted for lack of oversight over the most troubling
Raptor transactions: Raptor III and the Raptor restructuring. With the possible
exception of Skilling, who says he recalls being vaguely aware of these
particular events, the members of the Board do not appear to have been informed
about these transactions. Neither the minutes nor the witnesses we interviewed
indicate that Raptor III was ever brought to the Board or its Committees. This
may have been because no Enron stock was issued. Raptor III also does not appear
to have been disclosed at the February 2001 meetings of the Audit and Compliance
Committee or the Finance Committee. The list presented at the February 2001
meetings refers generally to "Raptors I, II, III, IV," but the Finance Committee
had reason to believe the transactions referred to as Raptors III and IV were
156
Raptor I was presented to the Finance Committee on May 1, 2000. It was
presented to the Board the following day. The Committee and Board were not given
all of the details, but they were given a substantial amount of information.
They understood this transaction to be another version of the Rhythms
transaction, which they had approved the previous year and believed to have
performed successfully. They were informed that the hedging capacity of Raptor I
came from the value of Enron's own stock, with which Enron would "seed" the
vehicle. They were informed that Enron would purchase a share-settled put on
approximately seven million shares of its own stock. Handwritten notes
apparently taken by the corporate secretary suggest that the Committee was
informed that the structure "[d]oes not transfer economic risk but transfers P&L
volatility." At least some members of the Committee understood that this was an
accounting-related transaction, not an economic hedge. On a list the Committee
(and, it appears, the Board) was shown about the risks posed by the Raptor
vehicle, the first risk was of "[a]ccounting scrutiny." The list said that this
risk was mitigated by the fact that the "[t]ransaction [was] reviewed by CAO
[Causey] and Arthur Anderson [sic]."
We believe that each of these elements should have been the subject of
detailed questioning that might have led the Finance Committee or the Board to
discover the fundamental flaws in the design and purpose of the transaction. The
discussion, if accurately described by the handwritten notes, suggested an
absence of economic substance: a hedge that does not transfer economic risk is
not a real hedge. While it is often the case that sales to SPEs transfer only
limited economic risk, a hedge that does not transfer economic risk is not a
- ----------
substantially identical to Raptor I. Raptor III, as described earlier in this
Report, was not presented to or authorized by the Board.
157
meaningful concept. Enron's purchasing a "put" on its own stock from Talon
(Raptor I)--a bet against the value of that stock--had no apparent business
purpose. The statement that the first risk to be considered was that of
"[a]ccounting scrutiny" was a red flag that should have led to the Board's
referring the proposal to the Audit and Compliance Committee for careful
assessment of any controversial accounting issues, and should have led that
Committee to conduct a probing discussion with Andersen.
The involvement of Enron's internal accountants, and the reported (and
actual) involvement of Andersen, gave the Finance Committee and the Board reason
to presume that the transaction was proper. Raptor was an extremely complex
transaction, presented to the Committee by advocates who conveyed confidence and
assurance that the proposal was in Enron's best interests, and that it was in
compliance with legal and accounting rules. Nevertheless, this was a proposal
that deserved closer and more critical examination.
4. Board Oversight of the Ongoing Relationship with LJM
Two control procedures adopted by the Board (and indeed sound corporate
governance) called for specific oversight by Committees of the Board. These were
periodic reviews of the transactions and of Fastow's compensation from LJM.73/
- ----------
73/ Enron's Board of Directors met five times each year in regular meetings, and
from time to time in special meetings. The regular meetings typically involved
committee meetings as well. The Finance Committee and the Audit and Compliance
Committee each generally met for one to two hours the afternoon before the Board
meeting.
158
Committee Review. In addition to the meetings at which LJM1 and LJM2
were approved, the Audit and Compliance Committee and the Finance Committee
reviewed certain aspects of the LJM transactions. The Audit and Compliance
Committee did so by means of annual reviews in February 2000 and February 2001.
The Finance Committee did so by means of a report from Fastow on May 1, 2000 and
an annual review in February 2001.
The Committee reviews did not effectively supplement Management's
oversight (such as it was). Though part of this may be attributed to the
Committees, part may not. The Committees were severely hampered by the fact that
significant information about the LJM relationship was withheld from them, in at
least five respects:
First, in each of the two years in which the February annual review
occurred, Causey presented to the Committees a list of transactions with LJM1
and LJM2 in the preceding year. The lists were incomplete (though Causey says he
did not know this, and in any event a more complete presentation may not have
affected the Committee's review): the 1999 list identified eight transactions,
when in fact there were ten, and the 2000 list of transactions omitted the
"buyback" transactions described earlier. Knowledge of these "buyback"
transactions would have raised substantial questions about the nature and
purpose of the earlier sales.
Second, Fastow represented to the Finance Committee on May 1, 2000,
that LJM2 had a projected internal rate of return on its investments of 17.95%,
which was consistent with the returns the Committee members said they
anticipated for a "bridge" investor such as LJM2. In contrast, at the annual
meeting of LJM2 limited partners on October 26, 2000, Fastow presented written
159
materials showing that their projected internal rate of return on these
investments was 51%. While some of this dramatic increase may have been
attributable to transactions after May 1--in particular the Raptor
transactions--there is no indication that Fastow ever corrected the
misimpression he gave the Finance Committee about the anticipated profitability
of LJM2.
Third, it appears that, at the meeting for the February 2001 review,
the Committees were not provided with important information. The presentation
included a discussion of the Raptor vehicles that had been created the preceding
year. Apparently, however, the Committees were not told that two of the vehicles
then owed Enron approximately $175 million more than they had the capacity to
pay. This information was contained in a report that was provided daily to
Causey and Buy, but it appears that neither of them brought it to either
Committee's attention.
Fourth, it does not appear that the Board was informed either that, by
March of 2001, this deficit had grown to about $500 million, or that this would
have led to a charge against Enron's earnings in that quarter if not addressed
prior to March 31. Nor does it appear that the Board was informed about
restructuring the Raptor vehicles on March 26, 2001, or the transfer of
approximately $800 million of Enron stock contracts that was part of that
transaction. The restructuring was directed at avoiding a charge to earnings.
While these transactions may or may not have required Board action as a
technical matter, it is difficult to understand why matters of such significance
and sensitivity at Enron would not have been brought to the attention of the
Board. Causey and Buy, among others, were aware of the deficit and
restructuring. Skilling recalls being only vaguely aware of these events, but
160
other witnesses have told us that Skilling, then in his first quarter as CEO,
was aware of and intensely interested in the restructuring.
Fifth, recent public disclosures show that Andersen held an internal
meeting on February 5, 2001, to address serious concerns about Enron's
accounting for and oversight of the LJM relationship. The people attending that
meeting reportedly decided to suggest that Enron establish a special committee
of the Board of Directors to review the fairness of LJM transactions or to
provide for other procedures or controls, such as competitive bidding. Enron's
Audit and Compliance Committee held a meeting one week later, on February 12,
2001, which was attended by David B. Duncan and Thomas H. Bauer, two of the
Andersen partners who (according to the public disclosures) had also been in
attendance at the Andersen meeting on February 5. We are told (although the
minutes do not reflect) that the Committee also conducted an executive session
with the Andersen representatives, in the absence of Enron's management, to
inquire if Andersen had any concerns it wished to express. There is no evidence
that Andersen raised concerns about LJM.
There is no evidence of any discussion by either Andersen
representative about the problems or concerns they apparently had discussed
internally just one week earlier. None of the Committee members we interviewed
recalls that such concerns were raised, and the minutes make no mention of any
discussion of the subject. Rather, according to the minutes and to written
presentation materials, Duncan reported that "no material weaknesses had been
identified" in Andersen's audit and that Andersen's "[o]pinion regarding
161
internal control ... [w]ill be unqualified."74/ While we have not had access to
either Duncan or Bauer, the minutes do not indicate that the Andersen
representatives made any comments to the Committee about controls while Causey
was reviewing them, or recommended forming a special committee to review the
fairness of the LJM transactions, or recommended any other procedures or review.
The Board cannot be faulted for failing to act on information that was
withheld, but it can be faulted for the limited scrutiny it gave to the
transactions between Enron and the LJM partnerships. The Board had agreed to
permit Enron to take on the risks of doing business with its CFO, but had done
so on the condition that the Audit and Compliance Committee (and later also the
Finance Committee) review Enron's transactions with the LJM partnerships. These
reviews were a significant part of the control structure, and should have been
more than just another brief item on the agenda.
In fact, the reviews were brief, reportedly lasting ten to fifteen
minutes. More to the point, the specific economic terms, and the benefits to
LJM1 or LJM2 (or to Fastow), were not discussed. There does not appear to have
been much, if any, probing with respect to the underlying basis for Causey's
representation that the transactions were at arm's-length and that "the process
was working effectively." The reviews did provide the Committees with what they
believed was an assurance that Causey had in fact looked at the transactions--an
entirely appropriate objective for a Board Committee-level review of ordinary
- ----------
74/ The written materials included "Selected Observations" on financial
reporting. "Related party transactions" were one of five areas singled out in
this section. Andersen's comments were that "Relationship issues add scrutiny
risk to: [j]udgmental structuring and valuation issues [and] [u]nderstanding of
transaction completeness" and "Required disclosures reviewed for adequacy."
162
transactions with outside parties.75/ But these were not normal transactions.
There was little point in relying on Audit and Compliance Committee review as a
control over these transactions if that review did not have more depth or
substance.76/
Review of Fastow's Compensation. Committee-mandated procedures required
reviewing Fastow's compensation from LJM1 and LJM2. This should have been an
important control. As much as any other procedure, it might have provided a
warning if the transactions were on terms too generous to LJM1 or LJM2. It might
have indicated whether the representation that Fastow would not profit from
increases in the price of Enron stock was accurate. It might have revealed
whether Fastow's gains were inconsistent with the understanding reported by a
number of Board members that he would be receiving only modest compensation from
LJM, commensurate with the approximately three hours per week he told the
Finance Committee in May 2000 he was spending on LJM matters.
- ----------
75/ Or. St. ss. 60.357(2) (1999) ("a director is entitled to rely on
information, opinions, reports or statements including financial statements and
other financial data, if prepared or presented by: . . . [o]ne or more officers
or employees of the corporation whom the director reasonably believes to be
reliable and competent in the matters presented [and] legal counsel, public
accountants or other persons as to matters the director reasonably believes are
within the person's professional or expert competence . . . .").
76/ The need for careful scrutiny became even greater in May 2000, when Fastow
asserted to the Finance Committee that transactions between Enron and the two
LJM entities had provided earnings to Enron during 1999 of $229.5 million.
Enron's total net income for the two quarters of 1999 in which the LJM
partnerships had been existence was $549 million. The following year, Enron's
2000 Form 10-K disclosed that it had generated some $500 million of revenues in
2000 (virtually all of it going directly to the bottom line) from the Raptor
transactions alone, thereby offsetting losses on Enron merchant investments that
would otherwise have reduced earnings. These were very substantial contributors
to Enron's earnings for each of those periods.
163
We have seen only very limited information concerning Fastow's
compensation from the LJM partnerships. As discussed above in Section IV, we
have seen documents indicating that Fastow's family foundation received $4.5
million in May 2000 from the Southampton investment. We also have reviewed some
1999 and 2000 Schedules K-1 for the partnerships that Fastow provided. At a
minimum, the K-1s indicate that Fastow's partnership capital increased by $15
million in 1999 and $16 million in 2000, for a total of over $31 million, and
that he received distributions of $18.7 million in 2000.
The Board's review apparently never occurred until October 2001, after
newspaper reports focused attention on Fastow's involvement in LJM1 and LJM2.
(The information Fastow provided orally to members of the Board in October 2001
is generally consistent with the figures discussed above.) The only references
we have found to procedures for checking whether Fastow's compensation was
modest, as the Board had expected, are in the minutes of the October 6, 2000
meeting of the Finance Committee. There, Fastow told the Committee (in
Skilling's presence) that Skilling received "a review of [Fastow's] economic
interest in [Enron] and the LJM funds," and the Committee then unanimously
agreed that the Compensation Committee should review Fastow's compensation from
LJM1 and LJM2. Although a number of members of the Compensation Committee were
present at this Finance Committee meeting, it does not appear that the
Compensation Committee thereafter performed a review. Moreover, Skilling said he
did not review the actual amount of Fastow's LJM1 or LJM2 compensation. He said
that, instead, he received a handwritten document (from Fastow) showing only
164
that Fastow's economic stake in Enron was substantially larger than his economic
stake in LJM1 and LJM2.77/
Some witnesses expressed the view that direct inquiry into Fastow's
compensation would have been inappropriate or intrusive, or might have
compromised the independence of LJM. We do not understand this reticence, and we
disagree. First, the Board apparently did require inquiry into Fastow's
compensation, but it either was not done or was done ineffectively. Second, we
do not believe that requiring Fastow to provide a copy of his tax return from
the partnerships, or similar information, would have been inappropriate. The
independence of LJM was not predicated on Fastow's independence from Enron;
rather, it was predicated on the existence of a structure within LJM that
created limited partner control because Fastow was technically viewed as being
controlled by Enron. Thus Enron's scrutinizing Fastow's compensation was not
inconsistent with the independence of LJM.
B. Oversight by Management
Management had the primary responsibility for implementing the Board's
resolutions and controls. Management failed to do this in several respects. No
one accepted primary responsibility for oversight, the controls were not
- ----------
77/ Skilling reasoned that Fastow's comparatively larger economic stake in Enron
relative to his interest in the LJM partnerships would create an incentive for
Fastow to place Enron's interests ahead of those of LJM1 and LJM2. This was the
objective of the exercise, as Skilling saw it. While we understand this
explanation, we do not believe that the reasoning is valid. Even if Fastow's
economic interest in Enron were far greater than his interest in LJM1 and LJM2,
his potential benefits from even one transaction that favored LJM1 or LJM2--in
which he had a direct and substantial stake--might far outweigh any detriment to
him as a holder of stock or options in Enron, on which the transaction could be
expected to have minimal financial impact.
165
executed properly, and there were apparent structural defects in the controls
that no one undertook to remedy or to bring to the Board's attention. In short,
no one was minding the store.
The most fundamental management control flaw was the lack of separation
between LJM and Enron personnel, and the failure to recognize that the inherent
conflict was persistent and unmanageable. Fastow, as CFO, knew what assets
Enron's business units wanted to sell, how badly and how soon they wanted to
sell them, and whether they had alternative buyers. He was in a position to
exert great pressure and influence, directly or indirectly, on Enron personnel
who were negotiating with LJM. We have been told of instances in which he used
that pressure to try to obtain better terms for LJM, and where people reporting
to him instructed business units that LJM would be the buyer of the asset they
wished to sell. Pursuant to the Services Agreement between Enron and LJM, Enron
employees worked for LJM while still sitting in their Enron offices, side by
side with people who were acting on behalf of Enron. Simply put, there was
little of the separation and independence required to enable Enron employees to
negotiate effectively against LJM2.
In many cases, the safeguard requiring that a transaction could be
negotiated on behalf of Enron only by employees who did not report to Fastow was
ignored. We have identified at least 13 transactions between Enron and LJM2 in
which the individuals negotiating on behalf of Enron reported directly or
indirectly to Fastow.
This situation led one Fastow subordinate, then-Treasurer Jeff McMahon,
to complain to Skilling in March 2000. While McMahon's and Skilling's
recollections of their conversation differ, McMahon's contemporaneous
166
handwritten discussion points, which he says he followed in the meeting, include
these notations:
o "LJM situation where AF [Andy Fastow] wears 2 hats and upside
comp is so great creates a conflict I am right in the middle
of."
o "I find myself negotiating with Andy [to whom he then
reported] on Enron matters and am pressured to do a deal that
I do not believe is in the best interests of the
shareholders."
o "Bonuses do get affected -- MK [Michael Kopper], JM [Jeff
McMahon]"78/
McMahon's notes also indicate he raised the concern that Fastow was pressuring
investment banks that did business with Enron to invest in LJM2.
Skilling has said he recalls the conversation focusing only on
McMahon's compensation. Even if that is true, it still may have suggested that
Fastow's conflict was placing pressure on an Enron employee. The conversation
presented an issue that required remedial action: a solution by Management, a
report to the Board that its controls were not working properly, or both.
Skilling took no action of which we are aware, and shortly thereafter McMahon
accepted a transfer within Enron that removed him from contact with LJM. Neither
Skilling nor McMahon raised the issue with Lay or the Board.
Conflicts continued. Indeed, the Raptor transactions, which provided
the most lucrative returns to LJM2 of any of its transactions with Enron,
followed soon after McMahon's meeting with Skilling. The Raptor I transaction
was designed by Ben Glisan--McMahon's successor as Treasurer--who reported to
- ----------
78/ McMahon says this was a reference to his perception that Kopper, who had
worked closely with Fastow, had received a very large bonus, while McMahon felt
he had been penalized for his resistance with respect to LJM.
167
Fastow, and by others in Fastow's Global Finance Group. Another Enron employee
responsible for later Raptors was Trushar Patel. He was in the Global Finance
Group and married to Anne Yaeger Patel, an Enron employee who assisted Fastow at
LJM2. Both Yaeger Patel and Glisan also shared in the Southampton Place
partnership windfall, during the same period the Raptor transactions were in
progress.
The Board's first and most-relied-on control was review of transactions
by the Chief Accounting Officer, Causey, and the Chief Risk Officer, Buy.
Neither ignored his responsibility completely, but neither appears to have given
the transactions anywhere near the level of scrutiny the Board understood they
were giving. Neither imposed a procedure for identifying all LJM1 or LJM2
transactions and for assuring that they went through the required procedures. It
appears that some of the transactions, including the "buybacks" of assets
previously sold to LJM1 or LJM2, did not even come to Causey or Buy for review.
Although Buy has said he was aware that changes were made to the Raptors during
the first quarter of 2001, he also said he was not involved in reviewing those
changes. He should have reviewed this transaction, like all other transactions
with LJM2.
Even with respect to the transactions that he did review, Causey said
he viewed his role as being primarily determining that the appropriate business
unit personnel had signed off. Buy said he viewed his role as being primarily to
evaluate Enron's risk.79/ It does not appear that Causey or Buy had the
- ----------
79/ Buy and a subordinate who assisted him on certain of the transactions have
said that in cases where Enron was selling to LJM2 an interest in an asset that
Enron had acquired, they checked to see that the sale price was consistent with
the acquisition price. This appears to be the one point in the review process at
168
necessary time, or spent the necessary time, to provide an effective check, even
though the Board was led to believe they had done so.
Skilling appears to have been almost entirely uninvolved in overseeing
the LJM transactions, even though in October 2000 the Finance Committee was told
by Fastow--apparently in Skilling's presence--that Skilling had undertaken
substantial duties.80/ Fastow told the Committee that there could be no
transactions with the LJM entities without Skilling's approval, and that
Skilling was reviewing Fastow's compensation. Skilling described himself to us
as having little or no role with respect to the individual LJM transactions, and
said he had no detailed understanding of the Raptor transactions (apart from
their general purpose). His signature is absent from many LJM Deal Approval
Sheets, even though the Finance Committee was told that his approval was
required. Skilling said he would sign off on transactions if Causey and Buy had
signed off, suggesting he made no independent assessment of the transactions'
fairness. This was not sufficient in light of the representations to the Board.
It does not appear that Lay had, or was intended to have, any
managerial role in connection with LJM once the entities became operational. His
involvement was principally on the same basis as other Directors. By the
accounts of both Lay and Skilling, the division of labor between them was that
- ----------
which there was an appropriate examination of the substance of the transactions;
in fact, the price of the assets sold by Enron to LJM2 does not appear to have
been where the problems arose.
80/ The minutes of the October 6, 2000 meeting of the Finance Committee report
Fastow saying that "Buy, Causey and Skilling review all transactions between the
Company and the LJM funds." The minutes state that Skilling, along with Buy and
Causey, "attended the meeting." Skilling told us that he may not have been
present for Fastow's remarks.
169
Skilling, as President and COO (later CEO) had full responsibility for domestic
operational activities such as these. Skilling said he would keep Lay apprised
of major issues, but does not recall discussing LJM matters with him. Likewise,
the Enron employees we interviewed did not recall discussing LJM matters with
Lay after the entities were created other than at Board and Board Committee
meetings, except in two instances after he resumed the position of CEO in August
and September of 2001 (the Watkins letter, discussed in Section VII.C, and the
termination of the Raptors, discussed in Section V.E.). Still, during the period
while Lay was CEO, he bore ultimate management responsibility.
Still other controls were not properly implemented. The LJM Deal
Approval Sheet process was not well-designed, and it was not consistently
followed. We have been unable to locate Approval Sheets for some transactions.
Other Approval Sheets do not have all the required signatures. The Approval
Sheet form contained pre-printed check marks in boxes signifying compliance with
a number of controls and disclosure concerns, with the intention that a
signature would be added to certify the accuracy of the pre-printed check-marks.
Some transactions closed before the Approval Sheets were completed. The Approval
Sheets did not require any documentation of efforts to find third party,
unrelated buyers for Enron assets other than LJM1 or LJM2, and it does not
appear that such efforts were systematically pursued. Some of the questions on
the Approval Sheets were framed with boilerplate conclusions ("Was this
transaction done strictly on an arm's-length basis?"), and others were worded in
a fashion that set unreasonably low standards or were worded in the negative
("Was Enron advised by any third party that this transaction was not fair, from
170
a financial perspective, to Enron?"). In practice, it appears the LJM Deal
Approval Sheets were a formality that provided little control.
Apart from these failures of execution, perhaps the most basic reason
the controls failed was structural. Most of the controls were based on a model
in which Enron's business units were in full command of transactions and had the
time and motivation to find the highest price for assets they were selling. In
some cases, transactions were consistent with this model, but in many of the
transactions the assumptions underlying this model did not apply. The Raptor
transactions had little economic substance. In effect, they were transfers of
economic risk from one Enron pocket to another, apparently to create income that
would offset mark-to-market losses on merchant investments on Enron's income
statement. The Chief Accounting Officer was not the most effective guardian
against transactions of this sort, because the Accounting Department was at or
near the root of the transactions. Other transactions were temporary transfers
of assets Enron wanted off its balance sheet. It is unclear in some of the cases
whether economic risk ever passed from Enron to LJM1 or LJM2. The fundamental
flaw in these transactions was not that the price was too low. Instead, as a
matter of economic substance, it is not clear that anything was really being
bought or sold. Controls that were directed at assuring a fair price to Enron
were ineffective to address this problem.
In sum, the controls that were in place were not effectively
implemented by Management, and the conflict was so fundamental and pervasive
that it overwhelmed the controls as the relationship progressed. The failure of
any of Enron's Senior Management to oversee the process, and the failure of
Skilling to address the problem of Fastow's influence over the Enron side of
171
transactions on the one occasion when, by McMahon's account, it did come to his
attention, permitted the problem to continue unabated until late 2001.
C. The Watkins Letter
In light of considerable public attention to what has been described as
a "whistleblower" letter to Lay by an Enron employee, Sherron Watkins, we set
out the facts as we know them here. However, we were not asked to, and we have
not, conducted an inquiry into the resulting investigation.
Shortly after Enron announced Skilling's unexpected resignation on
August 14, 2001, Watkins sent a one-page anonymous letter to Lay.81/ The letter
stated that "Enron has been very aggressive in its accounting--most notably the
Raptor transactions." The letter raised serious questions concerning the
accounting treatment and economic substance of the Raptor transactions (and
transactions between Enron and Condor Trust, a subsidiary of Whitewing
Associates), identifying several of the matters discussed in this Report. It
concluded that "I am incredibly nervous that we will implode in a wave of
accounting scandals." Lay told us that he viewed the letter as thoughtfully
written and alarming.
- ----------
81/ Watkins, through her counsel, declined to be interviewed by us. From other
sources, we understand that she is an accountant who spent eight years at
Andersen, both in Houston and New York. She joined Enron in October 1993,
working for Fastow in the corporate finance area. Over the next eight years, she
worked in several different positions, including jobs in Enron's materials and
metals operations, Enron International, and broadband. She left Enron as part of
a downsizing in the spring of 2001, but returned in June 2001 to work for Fastow
on a project of listing and gathering information about assets that Enron may
want to consider selling.
172
Lay gave a copy of the letter to James V. Derrick, Jr., Enron's General
Counsel. Lay and Derrick agreed that Enron should retain an outside law firm to
conduct an investigation. Derrick told us he believed that Vinson & Elkins
("V&E") was the logical choice because, among other things, it was familiar with
Enron and LJM matters. Both Lay and Derrick believed that V&E would be able to
conduct an investigation more quickly than another firm, and would be able to
follow the road map Watkins had provided. Derrick says that he and Lay both
recognized there was a downside to retaining V&E because it had been involved in
the Raptor and other LJM transactions. (Watkins subsequently made this point to
Lay during the meeting described below and in a supplemental letter she gave to
him.) But they concluded that the investigation should be a preliminary one,
designed to determine whether there were new facts indicating that a full
investigation--involving independent lawyers and accountants--should be
performed.
Derrick contacted V&E to determine whether it could, under the legal
ethics rules, handle the investigation. He says that V&E considered the issue,
and told him that it could take on the matter. Two V&E partners, including the
Enron relationship partner and a litigation partner who had not done any prior
work for Enron, were assigned to handle the investigation. Derrick and V&E
agreed that V&E's review would not include questioning the accounting treatment
and advice from Andersen, or a detailed review of individual LJM transactions.
Instead, V&E would conduct a "preliminary investigation," which was defined as
determining whether the facts raised by Watkins warranted further independent
legal or accounting review.
173
Watkins subsequently identified herself as the author of the letter. On
August 22, one week after she sent her letter, she met with Lay in his office
for approximately one hour. She brought with her an expanded version of the
letter and some supporting documents. Lay recalls that her major focus was
Raptor, and she explained her concerns about the transaction to him. Lay
believed that she was serious about her views and did not have any ulterior
motives. He told her that Enron would investigate the issues she raised.82/
V&E began its investigation on August 23 or 24. Over the next two
weeks, V&E reviewed documents and conducted interviews. V&E obtained the
documents primarily from the General Counsel of Enron Global Finance. We were
told that V&E, not Enron, selected the documents that were reviewed. V&E
interviewed eight Enron officers, six of whom were at the Executive Vice
President level or higher, and two Andersen partners. V&E also had informal
discussions with lawyers in the firm who had worked on some of the LJM
transactions, as well as in-house counsel at Enron. No former Enron officers or
employees were interviewed. We were told that V&E selected the interviewees.
After completing this initial review, on September 10, V&E interviewed
Watkins. In addition, V&E provided copies of Watkins' letters (both the original
one-page letter and the supplemental letter that she gave to Lay at the meeting)
to Andersen, and had a follow-up meeting with the Andersen partners to discuss
their reactions. V&E also conducted follow-up interviews with Fastow and Causey.
- ----------
82/ Andersen documents recently released by a Congressional committee indicate
that, on August 20, Watkins contacted a friend in Andersen's Houston office and
orally communicated her concerns.
174
On September 21, the V&E partners met with Lay and Derrick and made an
oral presentation of their findings. That presentation closely tracked the
substance of what V&E later reported in its October 15, 2001 letter to Derrick.
At Lay's and Derrick's request, the V&E lawyers also briefed Robert Jaedicke,
the Chairman of the Audit and Compliance Committee, on their findings. The
lawyers made a similar presentation to the full Audit and Compliance Committee
in early October 2001.
V&E reported in writing on its investigation in a letter to Derrick
dated October 15, 2001. The letter described the scope of the undertaking and
identified the documents reviewed and the witnesses interviewed. It then
identified four primary areas of concern raised by Watkins: (1) the "apparent"
conflict of interest due to Fastow's role in LJM; (2) the accounting treatment
for the Raptor transactions; (3) the adequacy of the public disclosures of the
transactions; and (4) the potential impact on Enron's financial statements. On
these issues, V&E observed that Enron's procedures for monitoring LJM
transactions "were generally adhered to," and the transactions "were uniformly
approved by legal, technical and commercial professionals as well as the Chief
Accounting and Risk Officers." V&E also noted the workplace "awkwardness" of
having Enron employees working for LJM sitting next to Enron employees.
On the conflict issues, V&E described McMahon's concerns and his
discussions with Fastow and Skilling (described above), but noted that McMahon
was unable to identify a specific transaction where Enron suffered economic
harm. V&E concluded that "none of the individuals interviewed could identify any
transaction between Enron and LJM that was not reasonable from Enron's
standpoint or that was contrary to Enron's best interests." On the accounting
issues, V&E said that both Enron and Andersen acknowledge "that the accounting
175
treatment on the Condor/Whitewing and Raptor transactions is creative and
aggressive, but no one has reason to believe that it is inappropriate from a
technical standpoint." V&E concluded that the facts revealed in its preliminary
investigation did not warrant a "further widespread investigation by independent
counsel or auditors," although they did note that the "bad cosmetics" of the
Raptor related-party transactions, coupled with the poor performance of the
assets placed in the Raptor vehicles, created "a serious risk of adverse
publicity and litigation."
V&E provided a copy of its report to Andersen. V&E also met with
Watkins to describe the investigation and go over the report. The lawyers asked
Watkins whether she had any additional factual information to pass along, and
were told that she did not.
With the benefit of hindsight, and the information set out in this
Report, Watkins was right about several of the important concerns she raised. On
certain points, she was right about the problem, but had the underlying facts
wrong. In other areas, particularly her views about the public perception of the
transactions, her predictions were strikingly accurate. Overall, her letter
provided a road map to a number of the troubling issues presented by the
Raptors.
The result of the V&E review was largely predetermined by the scope and
nature of the investigation and the process employed. We identified the most
serious problems in the Raptor transactions only after a detailed examination of
the relevant transactions and, most importantly, discussions with our accounting
advisors--both steps that Enron determined (and V&E accepted) would not be part
of V&E's investigation. With the exception of Watkins, V&E spoke only with very
senior people at Enron and Andersen. Those people, with few exceptions, had
176
substantial professional and personal stakes in the matters under review. The
scope and process of the investigation appear to have been structured with less
skepticism than was needed to see through these particularly complex
transactions.83/
- ----------
83/ We note that by the time of Watkins' letter--August 2001--all of the Raptor
transactions were complete with the exception of their termination, which
occurred in September 2001.
177
VIII. RELATED-PARTY DISCLOSURE ISSUES
Enron, like all public companies, was required by the federal
securities laws to describe its related-party transactions to shareholders and
to members of the investing public in several different disclosure documents:
the periodic reports filed with the SEC on a quarterly and annual basis, and the
annual proxy solicitation materials sent to shareholders. We found significant
issues concerning Enron's public disclosures of related-party transactions.
Overall, Enron failed to disclose facts that were important for an
understanding of the substance of the transactions. The Company did disclose
that there were large transactions with entities in which the CFO had an
interest. Enron did not, however, set forth the CFO's actual or likely economic
benefits from these transactions and, most importantly, never clearly disclosed
the purposes behind these transactions or the complete financial statement
effects of these complex arrangements. The disclosures also asserted without
adequate foundation, in effect, that the arrangements were comparable to
arm's-length transactions. We believe that the responsibility for these
inadequate disclosures is shared by Enron Management, the Audit and Compliance
Committee of the Board, Enron's in-house counsel, Vinson & Elkins, and Andersen.
A. Standards for Disclosure of Related-Party Transactions
The most basic standards governing Enron's disclosure to investors and
to the market are familiar: companies must not make untrue statements of
material fact, or omit material facts necessary to make the statements made, in
light of the circumstances in which they were made, not misleading. Specific
178
guidelines also govern disclosure of transactions with related parties in proxy
statements and periodic SEC filings, and in financial statement footnotes.
Item 404 of SEC Regulation S-K sets out the requirements for disclosing
related-party transactions in the non-financial statement portions of SEC
filings, including proxy statements and the annual reports on Form 10-K. (As
many public companies do, Enron addressed the disclosure requirements of Item
404 in its 10-Ks by incorporating the discussion from the proxy statement by
reference.) Item 404(a) requires disclosure of, among other things, transactions
exceeding $60,000 in which an executive officer of the company has a material
interest, "naming such person and indicating the person's relationship to the
registrant, the nature of such person's interest in the transaction(s), the
amount of such transaction(s) and, where practicable, the amount of such
person's interest in the transaction(s)." The instructions to this section
provide: "The materiality of any interest is to be determined on the basis of
the significance of the information to investors in light of all the
circumstances of the particular case. The importance of the interest to the
person having the interest, the relationship of the parties to the transaction
with each other and the amount involved in the transactions are among the
factors to be considered in determining the significance of the information to
investors."
Public companies must also provide financial statements in periodic
quarterly and annual SEC filings. Statement of Financial Accounting Standards
No. 57 sets forth the requirements under generally accepted accounting
principles ("GAAP") concerning disclosures of related-party transactions in
financial statements. Simply put, the financial statements must disclose
material related-party transactions, and must include certain specific
information: "(a) The nature of the relationship(s) involved; (b) A description
179
of the transactions, . . . and such other information deemed necessary to an
understanding of the effects of the transactions on the financial statements;
(c) The dollar amounts of transactions . . . [and] (d) Amounts due from or to
related parties . . . ." The standard provides that, "[i]n some cases,
aggregation of similar transactions by type of related party may be
appropriate," and that, "[i]f necessary to the understanding of the
relationship, the name of the related party should be disclosed." SEC Regulation
S-X, ss. 4-08(k), provides that "[r]elated party transactions should be
identified and the amounts stated on the face of the balance sheet, income
statement, or statement of cash flows." These disclosures are typically provided
in a footnote to the consolidated financial statements.
Following the original release of FAS 57, public companies and their
professional advisors and auditors have received little guidance from the
accounting profession or the SEC concerning how these standards should be
applied to disclosures of particular types of transactions. Enron Management and
its auditors and outside counsel were required to make many judgment calls in
deciding what entities qualified as a "related party," and when and how to
report transactions with them. Indeed, in light of the Enron experience, the
"Big-5" accounting firms petitioned the SEC on December 31, 2001, for guidance
in preparing disclosures in annual reports in several areas, including
"relationships and transactions on terms that would not be available from
clearly independent third parties." On January 22, 2002, the SEC issued a
statement urging companies, among other things, to "consider describing the
elements of the transactions that are necessary for an understanding of the
transactions' business purpose and economic substance, their effects on the
financial statements, and the special risks or contingencies arising from these
180
transactions." The SEC emphasized, however, that its guidance was meant "to
suggest statements that issuers should consider in meeting their current
disclosure obligations" and "does not create new legal requirements, nor does it
modify existing legal requirements" (emphasis added).
B. Enron's Disclosure Process
Enron's related-party disclosures in its proxy statements, as well as
in the financial statement footnotes in its periodic reports, resulted from
collaborative efforts among Enron's Senior Management, employees in the legal,
accounting, investor relations, and business units, and outside advisors at
Andersen and Vinson & Elkins. Nevertheless, it appears that no one outside of
Enron Global Finance, the entity principally responsible for the related-party
transactions, exercised significant supervision or control over the disclosure
process concerning these transactions.
The initial drafts of the footnotes to the financial statements in the
periodic reports on Forms 10-Q and 10-K were prepared by Enron corporate
accountants in the Financial Reporting Group. The Director of Financial
Reporting circulated drafts to a large group of people, including Rex Rogers, an
Enron Associate General Counsel responsible for securities law matters, in-house
counsel at Enron Global Finance, the transaction support groups who worked on
the transactions at issue, the Investor Relations Department, and Vinson &
Elkins and Andersen. Vinson & Elkins informed us that they may not have seen all
of the filings in advance. The Financial Reporting Group collected comments from
the various reviewers, made changes, and distributed revised versions. This
process was repeated until all outstanding issues had been resolved. We were
told that Causey, Enron's Chief Accounting Officer, was the final arbiter of
181
unresolved differences among the various contributors to the financial reporting
process. Causey told us that, while he signed the public filings and met with
Andersen engagement partner Duncan to resolve certain issues, he relied on the
Financial Reporting Group, lawyers, and transaction support staff for the
disclosures. The Audit and Compliance Committee reviewed drafts of the financial
statement footnotes and discussed them with Causey. During the relevant period,
Skilling reviewed the periodic filings after the accountants and lawyers had
agreed on the proposed disclosures. Causey signed the Forms 10-Q and 10-K as the
Chief Accounting Officer. All of the Directors and Fastow signed the 10-Ks as
well.
Preparation of the related-party transaction disclosures followed this
general pattern, with one major exception: we were told that, because the
related-party transactions were often extremely complex, the Enron Corp.
accountants and lawyers responsible for financial reporting relied heavily
on--and generally deferred to--the officers and employees in Enron Global
Finance who were closer to the transactions and actually knew the details. The
Financial Reporting Group circulated drafts of the related-party footnotes
internally, and both Andersen and Vinson & Elkins commented on these
disclosures. Causey, who was charged by the Board with approving the
transactions with the LJM partnerships, paid attention to the related-party
transaction footnotes, and we were told that he made the final decisions on
their contents. Skilling said that he consistently looked at the discussions of
related-party transactions.
While accountants took the lead in preparing the financial statement
footnote disclosures, lawyers played a more central role in preparing the proxy
statements, including the disclosures of the related-party transactions. This
process was organized by Associate General Counsel Rogers and lawyers working
182
for him, with substantial advice from Vinson & Elkins. James Derrick, Enron's
General Counsel, reviewed the final drafts to look for obvious errors, but
otherwise had little involvement with the related-party proxy statement
disclosures. He said that he relied on his staff, Vinson & Elkins, and Andersen
to make sure the disclosures were correct and complied with the rules. Enron's
in-house counsel say they relied on advice from Vinson & Elkins in deciding
whether the proposed disclosures were adequate, particularly with respect to
related-party transactions.
As with the financial statement footnotes, drafts of the proxy
statements were circulated repeatedly to a wide group. The Financial Reporting
Group checked the draft proxy statements to make sure that the amounts reported
in the proxies were supported by the information in the financial statements,
but generally was not otherwise involved in the drafting. Senior Management and
the Board of Directors were given an opportunity to comment on proxy statement
drafts, and they appear to have paid comparatively more attention to the proxy
statements than to the financial statements in the periodic reports. We were
told that members of the Board focused particular attention to the disclosures
about themselves, and were not directed specifically to the related-party
disclosures by Management. Lay was generally involved in the disclosure process
only to the same extent as the outside directors.
There was no systematic procedure in place for ensuring identification
of all transactions with related parties that needed to be disclosed in
financial statement footnotes or proxy statements. In the case of the financial
statement footnotes, the Financial Reporting Group included transactions of
which it was aware in the first draft, and relied on the comment process to
183
identify any transactions that had not been included. For the proxy statements,
the lawyers and accountants with Enron Global Finance generally provided the
lists of relevant transactions. It does not appear that the LJM Approval Sheets
or files in the legal department were consulted to ensure that all of the
transactions in the period were covered by the related-party disclosures
(although, as noted above, it also does not appear that the Approval Sheets were
complete).
C. Proxy Statement Disclosures
1. Enron's Disclosures
The "Certain Transactions" sections of Enron's proxy statements in 2000
and 2001 included disclosures of transactions with the LJM partnerships.
Enron described the establishment of LJM1 and LJM2 in its May 2000
proxy statement. Each was described as "a private investment company that
primarily engages in acquiring or investing in energy and communications related
investments." Concerning LJM1, Enron disclosed that "Andrew S. Fastow, Executive
Vice President and Chief Financial Officer of Enron, is the managing member of
LJM1's general partner. The general partner of LJM1 is entitled to receive a
percentage of the profits of LJM1 in excess of the general partner's proportion
of the total capital contributed to LJM1, depending upon the performance of the
investments made by LJM1." Essentially the same disclosure was repeated with
respect to LJM2. The proxy statement did not give the amount of compensation
Fastow had received, or specify the compensation formula in any more detail.
184
The 2000 proxy statement discussed the Rhythms transaction with LJM1 by
describing the details of the "effect" of "a series of transactions involving a
third party and LJM Cayman, L.P." The disclosures identified the number of
shares of Enron stock and other instruments that changed hands, but did not
describe any purpose behind the transactions. The disclosures said that, "[i]n
connection with the transactions, LJM1 agreed that Mr. Fastow would have no
pecuniary interest in such Enron Common Stock and would be restricted from
voting on matters related to such shares."
The proxy statement next disclosed that, "[i]n the second half of 1999,
Enron entered into eight transactions with LJM1 and LJM2," and then described
them in general terms:
In six of these transactions, LJM1 and/or LJM2 acquired various debt
and equity securities of certain Enron subsidiaries and affiliates that
were directly or indirectly engaged in the domestic and/or
international energy business. The aggregate consideration agreed to be
paid to Enron pursuant to these six transactions was approximately
$119.3 million. In the seventh transaction, LJM2 paid $12.9 million for
an equity interest in an Enron securitization vehicle (that owned
approximately $300 million of merchant assets) and loaned $19.6 million
to such vehicle. In the eighth transaction, LJM2 borrowed $38.5 million
from an Enron affiliate, which loan was outstanding at year end.
The 2000 proxy statement also included representations concerning the
arm's-length nature of the transactions with LJM. Concerning LJM1, Enron stated
that "[m]anagement believes that the terms of the transactions were reasonable
and no less favorable than the terms of similar arrangements with unrelated
third parties." With respect to LJM2, Enron included the same representation and
added that "[t]hese transactions occurred in the ordinary course of Enron's
business and were negotiated on an arm's-length basis with senior officers of
Enron other than Mr.
Fastow."
185
Enron's 2001 proxy statement again identified Fastow as the managing
member of LJM2's general partner and repeated the assertion that the
transactions with LJM2 "occurred in the ordinary course of Enron's business and
were negotiated on an arm's length basis with senior officers of Enron other
than Mr. Fastow." The transactions themselves were discussed in two groups, and
for each Enron combined a general description of the purpose of the transactions
with an aggregated summary of the terms. Concerning the acquisition by LJM2 of
Enron assets, the proxy statement said:
During 2000, [Enron] entered into a number of transactions with [LJM2]
. . . primarily involving either assets Enron had decided to sell or
risk management activities intended to limit Enron's exposure to price
and value fluctuations with respect to various assets . . . . In ten of
these transactions LJM2 acquired various debt and equity securities, or
other ownership interests, from Enron that were directly or indirectly
engaged in the domestic and/or international energy or communication
business, while in one transaction LJM2 acquired dark fiber from an
Enron subsidiary. The aggregate consideration to be paid to Enron
pursuant to these eleven transactions was approximately $213 million.
Also during 2000, LJM2 sold to Enron certain merchant investment
interests for a total consideration of approximately $76 million.
Concerning the derivative transactions with LJM2, the proxy statement said:
Also, during 2000, Enron engaged in other transactions with LJM2
intended to manage price and value risk with regard to certain merchant
and similar assets by entering into derivatives, including swaps, puts,
and collars. As part of such risk management transactions, LJM2
purchased equity interests in four structured finance vehicles for a
total of approximately $127 million. Enron, in turn, contributed a
combination of assets, Enron notes payable, restricted shares of
outstanding Enron stock (and the restricted right to receive additional
Enron shares) in exchange for interests in the vehicles. Enron and LJM2
subsequently entered into derivative transactions through these four
vehicles with a combined notional amount of approximately $2.1 billion.
186
2. Adequacy of Disclosures
Given the circumstances in which Enron now finds itself, it is
difficult to avoid coloring a review of prior disclosure documents with the
benefit of 20/20 hindsight. We have tried to avoid that impulse. Indeed, there
were substantial disclosures regarding most of the related-party transactions at
issue here, including their magnitude and even some of the "mechanics" of the
transactions. Any reader of those disclosures should have recognized that these
arrangements were complex, the dollar amounts involved were substantial, and the
transactions were significant for evaluating the Company's financial
performance. Nevertheless, the disclosures were fundamentally inadequate.
Fastow's Compensation. The failure to set forth Fastow's compensation
from the LJM transactions and the process leading to that decision raise
substantial issues. Item 404 of Regulation S-K required the disclosure "where
practicable" of "the amount of [Fastow's] interest in the transactions." We have
been told that there was significant discussion, both within Enron Management
and with outside advisors, about whether Enron could avoid disclosing Fastow's
compensation from the related parties in the face of that fairly clear language.
The consensus of people involved in drafting the proxy disclosures was to
accommodate the strong desire of Fastow (and others) to avoid disclosure if
there was a legitimate basis to do so.
For the 2000 proxy statement, the issue was discussed among members of
Enron's Senior Management, its in-house counsel, its lawyers at Vinson & Elkins,
and Andersen. In the end, the proxy statement simply noted that the general
partner of LJM1 and LJM2, of which Fastow was the managing member, was entitled
to a share of the profits in excess of its proportional capital investment in
187
the partnership. The rationale, as memorialized in a memorandum written by
Jordan Mintz, the General Counsel of Enron Global Finance, was that the "where
practicable" language of Item 404 (referred to above) provided the basis for not
setting forth the amount of Fastow's compensation from LJM. Because the majority
of transactions between Enron and LJM1 or LJM2 were "open" during the proxy
reporting period--that is, the ultimate and final determination of obligations
and payments remained uncertain--the in-house and outside counsel concluded it
was not "practicable" to determine what Fastow had earned as the managing member
of the general partner.
The same rationale applied to the multiple "open" transactions in place
at the time the 2001 proxy statement was prepared, although it was acknowledged
that some of the transactions had closed in 2000 or early 2001 and the rationale
would have little force once most of the transactions closed. The lawyers
apparently did little if any investigation into what proportion of the
transactions remained open at the time of the 2001 proxy statement filing.
The Rhythms transaction had terminated in early 2000, however, and the
lawyers understood that Fastow had received compensation from LJM1 for that
transaction. Enron therefore needed a different basis or theory to support the
decision not to disclose. The Enron lawyers and Vinson & Elkins began with the
assumption that the 2000 proxy statement had already met all disclosure
requirements related to the Rhythms transaction, even without reference to the
economic interest of Fastow. The 2001 proxy would have covered the compensation
Fastow received from the unwind in 2000 of the Rhythms position. The lawyers
reasoned that the Rhythms transaction had terminated in 2000 "pursuant to terms
188
allowed for under the original agreement" entered into in 1999. Because the
prior proxy statement had addressed the disclosure requirements relating to the
Rhythms transaction, they decided that no financial information regarding what
Fastow earned in the transaction had to be disclosed in 2001--notwithstanding
that it was now more "practicable" to do so.
It turns out that the factual premise on which the lawyers based this
analysis in the Memorandum--that "there was no new transaction involving LJM1
and Enron in the year 2000"--was wrong. In fact, Enron gave an in-the-money put
option to LJM Swap Sub in 2000 in connection with the unwinding of the Rhythms
transaction. Even without this new put option, however, it was questionable to
say that the termination simply "occurred under conditions permitted in the
original agreement." That statement was true to the extent that nothing in the
original agreement prohibited an early termination, but the agreement did not
prescribe a termination process or terms. At least some lawyers involved in the
disclosure process knew that the unwind of the Rhythms transaction had been
carefully negotiated in 2000.
Beyond this factual problem, the non-disclosure rationale seems to have
missed the point. Although the precise amount of compensation to which Fastow
ultimately was entitled may still have been subject to adjustment, the magnitude
of the amount was knowable and should have been disclosed. Furthermore, the
instructions to Item 404 provide that "[t]he amount of the interest of any
person [subject to disclosure] . . . shall be computed without regard to the
amount of the profit or loss involved in the transaction(s)." This instruction,
in addition to the basic purpose of the proxy disclosure rules on the interests
of Management in transactions with the Company, seems to have been lost. Enron
189
had an obligation to disclose the "amount of [Fastow's] interest in the
transaction(s)" (emphasis added), not just his income. The lawyers apparently
searched for and embraced a technical rationale to avoid that disclosure.
It appears that the in-house Enron lawyers and Vinson & Elkins agreed
with these disclosure decisions, although Mintz wrote that "[t]he decision not
to disclose in this instance was a close call; arguably, the more conservative
approach would have been to disclose." The memorandum he wrote suggests that
"other pertinent (and competing) issues" that Fastow had raised led or
contributed to the non-disclosure decision, which was only possible because of a
quirk of timing. As the memorandum said, "[i]t was, perhaps, fortuitous that the
RhythmsNet transaction extended over two proxy filing years and our knowledge of
certain facts was delinked by two separate filings; thus, we have relied on two
different arguments for avoiding financial disclosure for you as the LJM1
general partner in 1999 and 2000." We have been told that a number of people
expressed varying degrees of skepticism about the rationales for not disclosing
the amount of Fastow's compensation, but that none objected strongly.84/
- ----------
84/ Mintz did warn Fastow that it was highly likely that his compensation from
the LJM transactions would have to be disclosed in Enron's 2002 proxy statement.
It is unclear to what extent this warning contributed to Fastow's decision to
sell his interest in LJM2 in the third quarter of 2001. In May 2001, Mintz also
retained an outside law firm (Fried, Frank, Harris, Shriver & Jacobson from
Washington, D.C.) to examine Enron's relationship with the LJM partnerships,
Enron's prior disclosures, and the disclosures that might be required even after
Fastow sold his interest in LJM2. In June 2001, Fried, Frank provided a summary
of the relevant standards, raised some questions concerning prior disclosures,
and made some preliminary recommendations for future filings in light of
Fastow's decision to sell his interest in LJM2. From what we have seen, Fried,
Frank did not take particular issue with the prior disclosure decisions
concerning Fastow's compensation.
190
The disclosure decisions concerning Fastow's interest in the LJM
transactions were also made without the key participants knowing the amount--or
even the magnitude--of the interest in question. This is because no one--not
members of Senior Management (such as Lay, Skilling or Causey), not the Board,
and not Vinson & Elkins--ever pressed for the information, and Fastow did not
volunteer it.85/ The amount of the interest should have weighed in the
disclosure decision. Senior Management apparently permitted Fastow to avoid
answering the relevant portion of the questionnaires designed to collect
information from all executives and directors for the proxy statement
disclosures. In 2000, Fastow responded to the questionnaire by attaching an
addendum at the suggestion of the lawyers referring the reader to the
then-General Counsel of Enron Global Finance for information on Fastow's
interests in LJM1 and LJM2. In 2001, Fastow attached an addendum approved by
in-house and outside counsel saying only that "the nature of my relationship
between LJM1 and LJM2 (including payments made, or proposed to be made, between
such entities and Enron) are [sic] described in the Company's 1999 and 2000
Proxy Disclosure under `Certain Transactions.'"
Descriptions of the Transactions. Item 404(a) of Regulation S-K also
requires a description of the related-party transactions in which the amount of
the transaction exceeds $60,000 and an executive has a material interest. All of
- ----------
85/ As we have explained (see Section VII.A.), the Finance Committee of the
Board in October 2000 asked the Compensation Committee to review the
compensation received by Fastow from the LJM partnerships. This request
reflected a recognition that the compensation information was important for the
Board and management to know, but the review apparently was not conducted.
191
Enron's transactions with the LJM partnerships discussed in this Report met this
threshold and had to be disclosed.
For the most part, the Company's proxy statement descriptions of the
related-party transactions with LJM1 and LJM2 were factually correct, as far as
they went. Nevertheless, it is difficult for a reader of the proxy statements to
understand the nature of the transactions or their significance. The disclosures
omit several important facts. The 2001 proxy, for example, refers to the sale by
LJM2 of certain merchant investments to Enron in 2000 for $76 million. This
disclosure, however, omits the fact that these transactions were buybacks of
assets that Enron had sold to LJM2 the year before in what were described (in
the prior year's proxy statement) as arm's-length transactions. And, while Enron
contributions to the Raptor entities are mentioned, the document does not
disclose that, by the terms of the deal, $82 million was distributed to LJM2
(and therefore to its partners) from Raptors I and II in 2000, even before those
entities began derivative transactions with Enron. This last fact is of critical
importance to any fair assessment of the transaction.
D. Financial Statement Footnote Disclosures
1. Enron's Disclosures
Enron included a footnote concerning "Related Party Transactions" to
the financial statements in its reports on Forms 10-Q and 10-K beginning with
the second quarter of 1999, when the transactions with the LJM partnerships
began, through the second quarter of 2001. The disclosures in those footnotes
fall into several categories.
192
Structure of LJM1 and LJM2. The description of LJM1 in the 10-Q for the
second quarter of 1999 was similar to the one the Company used in the 2000 proxy
statement, described above. The footnote said that "[a] senior officer of Enron
is managing member of LJM's general partner." This footnote did not identify
Fastow as the "senior officer of Enron," nor did the financial statement
disclosure in any subsequent period. The disclosure also did not detail how LJM
or Fastow would be compensated in the transactions, although it did say that
"LJM agreed that the Enron officer would have no pecuniary interest in . . .
Enron common shares and would be restricted from voting on matters related to
such shares or to any future transactions with Enron." Substantially the same
disclosures were made in the third quarter 10-Q and in the 1999 10-K.
The Company first described LJM2 in the 1999 10-K. Enron stated that
"LJM2 Co-Investment, L.P. (LJM2) was formed in December 1999 as a private
investment company which engages in acquiring or investing in primarily
energy-related or communications-related businesses" and that LJM2 "has the same
general partner as LJM[1]."
In the 10-Q for the second quarter of 2000, Enron described the LJM
partnerships as follows: "In the first half of 2000, Enron entered into
transactions with limited partnerships (the Related Party), whose general
partner's managing member is a senior officer of Enron. The limited partners of
the Related Party are unrelated to Enron." From the second quarter of 2000
forward, Enron did not identify LJM1 or LJM2 by name in the financial statement
disclosures, using the generic term "Related Party" instead. This description
was substantially unchanged until the second quarter of 2001, when the 10-Q
reflected the sale of Fastow's interest in LJM by stating that "the senior
193
officer, who previously was the general partner of these partnerships, sold all
of his financial interests as of July 31, 2001, and no longer has any management
responsibilities for these entities" and that, "[a]ccordingly, such partnerships
are no longer related parties to Enron."
In the 10-Qs for the first and second quarters of 2001, Enron
represented that "[a]ll transactions with the Related Party are approved by
Enron's senior risk officers as well as reviewed annually by the Board of
Directors."
Descriptions of Transactions. Significant portions of the financial
statement footnotes on related-party transactions were devoted to descriptions
of transactions between Enron and the LJM partnerships.
Beginning with the 10-Q filed for the second quarter of 1999, Enron
discussed the Rhythms transaction with LJM1 much as it did in the 2000 proxy
statement. The disclosures identified the number of shares of stock and other
instruments that changed hands; the description in the 1999 10-K removed the
numbers of shares. In the 10-Q for the first quarter of 2000, the footnote
described the April 2000 termination of the Rhythms transaction with a number of
the transaction particulars.
Beginning with the 1999 10-K, Enron disclosed in each periodic filing
that LJM1 and/or LJM2 acquired, directly or indirectly, merchant assets and
other investments from Enron. These assets were not specifically identified in
the disclosures; instead, Enron gave only the approximate dollar value of the
assets, either individually or by groupings of similar transactions. We were
told that Enron had a general corporate policy, not limited to related-party
transactions, against identifying counter-parties in financial statement
194
footnotes. The Financial Reporting Group maintained backup materials to support
the figures in the financial statement footnotes, and to identify the specific
transactions that were covered by the related-party disclosures.
Enron introduced the first Raptor transactions in the 10-Q for the
second quarter of 2000, and provided more detailed disclosures for all four
Raptor vehicles in the 10-Q for the third quarter and in the 2000 10-K. These
disclosures had two main parts: a fairly detailed description of the
contributions Enron made to the Raptor Vehicles (referred to as the "Entities")
at their creation, and a discussion of the derivative transactions between Enron
and the Raptor Vehicles through which Enron sought to hedge certain merchant
investments and other assets. In the third quarter 10-Q and the 10-K, Enron
disclosed that it had recognized revenues of approximately $60 million and $500
million, respectively, related to the derivative transactions, which offset
market value changes of certain merchant investments. (The 10-Qs for the first,
second, and third quarters of 2001 included corresponding sets of disclosures.)
The 10-Qs for the first and second quarters of 2001 identified instruments that
the various parties to the Raptor restructuring transactions received.
Assertions That Transactions Were Arm's-Length. In each of the
financial statement footnote disclosures concerning the transactions with LJM,
Enron made a representation apparently designed to reassure investors that the
transactions were fair to the Company. The language of this disclosure changed a
number of times during the period at issue.
195
Enron stated in the 10-Q for the second and third quarters of 1999 that
"[m]anagement believes that the terms of the transactions were reasonable and no
less favorable than the terms of similar arrangements with unrelated third
parties." The 10-K for 1999, however, removed the assertion that the
transactions were "reasonable" and represented instead only that "the terms of
the transactions with related parties are representative of terms that would be
negotiated with unrelated third parties" (emphasis added). The reasonableness
assertion reappeared in the disclosures for the first quarter of 2000, modifying
the 1999 10-K version to read: "the terms of the transactions with related
parties were reasonable and are representative of terms that would be negotiated
with unrelated third parties." Enron used this formulation until the 10-K for
2000, which conditioned the assertion of reasonableness to claim only that "the
transactions with the Related Party were reasonable compared to those which
could have been negotiated with unrelated third parties" (emphasis added).
Although the paper trail details the iterations through which these
management assertions passed during the drafting process, it is unclear who was
responsible for the changes, or to what extent these changes were intended to
reflect substantive differences in the characterizations of the transactions. We
also do not know what steps Management or Andersen took to verify that the
assertions were true before they were made. Handwritten notes next to the
management assertion on drafts of the 1999 10-K read "need positive evidence"
and "needs research."
We learned that some consideration was given to expanding the
discussion of the fairness of the related-party transactions to Enron by
describing certain advantages that had been identified at the time that Board
approval was sought. Handwritten notes on drafts of the 10-K for 2000 suggest
196
adding that "transacting with the Related Party provides Enron with additional
benefits related to the speed of execution and a counterparty who has a better
understand[ing] of complex transactions." In the end, however, the drafters of
the disclosures decided against including these or other similar reasons for the
related-party transactions.
2. Adequacy of Disclosures
The financial statement footnote disclosures in the periodic reports
were comparatively more detailed (except with respect to Fastow's interest in
the transactions) than the proxy statement disclosures. Nevertheless, the
footnote disclosures failed to achieve a fundamental objective: they did not
communicate the essence of the transactions in a sufficiently clear fashion to
enable a reader of the financial statements to understand what was going on.
Even after months of investigation, and with access to Enron's information, we
remain uncertain as to what transactions some of the disclosures refer. The
footnotes also glossed over issues concerning the potential risks and returns of
the transactions, their business purpose, accounting policies they implicated,
and contingencies involved. In short, the volume of details that Enron provided
in the financial statement footnotes did not compensate for the obtuseness of
the overall disclosure. FAS Statement No. 57 required Enron to provide "[a]
description of the transactions, . . . and such other information deemed
necessary to an understanding of the effects of the transactions on the
197
financial statements" (emphasis added). We think that Enron's related-party
transaction disclosures fell short of this goal.86/
Beyond this general point, our investigation found two particular
problems with the related-party disclosures in the financial statement
footnotes:
First, Enron lacked the factual basis required by the accounting
literature to make the assertions in each SEC filing concerning how the LJM
transactions compared to transactions with unrelated third parties. We were told
by Enron officers and employees that they believed this management assertion to
be required under the accounting literature. In fact, the accounting literature
provides: "Transactions involving related parties cannot be presumed to be
carried out on an arm's-length basis, as the requisite conditions of
competitive, free-market dealings may not exist. Representations about
transactions with related parties, if made, shall not imply that the
related-party transactions were consummated on terms equivalent to those that
prevail in arm's-length transactions unless such representations can be
substantiated." Statement of Financial Accounting Standards No. 57, P. 3
- ----------
86/ In June 2001, outside lawyers from the Fried, Frank firm, who had been asked
by Mintz to look over the related-party transaction disclosures around the time
of Fastow's sale of his interest in LJM2, reported the following concerning
disclosure of LJM transactions: "Prior 10-Q disclosure appeared to leave some
informational gaps, which were noted by those who commented on the Company's
filings. We want to emphasize that we are not in a position to evaluate whether
material information was omitted from the prior statements, and have not done
so. However, from the standpoint of closing the discussion of these matters once
and for all, we would consider supplementing the prior disclosures, where it is
possible to do so, especially on such points as the purpose of the specific
transactions entered into and the `bottom-line' financial impact on the Company
and the LJM partners."
198
(emphasis added).87/ We have not been able to identify any steps taken by Enron
Management, Andersen, or Vinson & Elkins to substantiate the assertions that the
LJM transactions were "representative of" or "reasonable compared to" similar
transactions with unrelated third parties--even though notes on some drafts
refer to questions being raised about factual support for these
representations.88/ Indeed, based on the terms of the deals, it seems likely
that many of them could only have been entered into with related parties.
Second, the publicly filed financial statement disclosures omitted a
number of key details about the transactions. For example, the Company disclosed
in the 2000 10-K that "Enron paid $123 million to purchase share-settled options
from the [Raptor] Entities on 21.7 million shares of Enron common stock." What
it did not disclose, however, was that Enron purchased puts on Enron stock. It
likely would have been relevant to investors that Enron had entered into a
- ----------
87/ Auditors are under an obligation not to agree to such disclosures without
substantiation: "Except for routine transactions, it will generally not be
possible to determine whether a particular transaction would have taken place if
the parties had not been related, or, assuming it would have taken place, what
the terms and manner of settlement would have been. Accordingly, it is difficult
to substantiate representations that a transaction was consummated on terms
equivalent to those that prevail in arm's-length transactions. If such a
representation is included in the financial statements and the auditor believes
that the representation is unsubstantiated by management, he or she should
express a qualified or adverse opinion because of a departure from generally
accepted accounting principles, depending on materiality . . . ." AICPA,
Codification of Statements on Auditing Standards, ss. 334.12, Related Parties.
88/ The Fried, Frank review in June 2001 identified this issue as well, urging
the company to identify what members of "management" had reviewed the
transactions and what they had done. The firm also suggested to Mintz that the
Audit and Compliance Committee, or a special committee of the Board appointed
for this purpose, conduct "a review of the fairness of the terms of the
transactions to the Company" to bolster the documentation for these
representations. It does not appear that such a review was undertaken.
199
derivative transaction that was, on its face, predicated on the assumption that
its stock price would decline substantially. Another example: Enron explained
that the LJM partnerships bought merchant assets from Enron, but the footnote
disclosures failed to mention that Enron repurchased some of these
assets--sometimes within a matter of months, and sometimes before the periodic
filing was made. No one interviewed in our inquiry could provide a plausible
explanation why the repurchases from the related parties should not have been
disclosed in the same manner as the original sales. It is fair to conclude that
disclosure of the repurchases so close in time to the original transactions
could have called the economic substance of the reported transactions with LJM
into question.89/
E. Conclusions on Disclosure
Based on the foregoing information, the Committee has reached several
general conclusions concerning the disclosures of related-party transactions in
Enron's proxy statements and in the financial statement footnotes in the
Company's periodic filings.
First, while it has been widely reported that the related-party
transactions connected to Fastow involved "secret" partnerships and other SPEs,
we believe that is not generally the case. Although Enron could have, and we
- ----------
89 Enron explained in the 10-Q for the second quarter of 2001 that "the senior
officer, who previously was the general partner of these [LJM] partnerships,
sold all of his financial interests . . . and no longer has any management
responsibilities for these entities." It did not disclose, however, that the
interest was sold to Kopper, then a former employee of Enron, and therefore gave
an impression that the interest would be held more independently from Enron than
it was. We were told that Vinson & Elkins recommended disclosure of this fact,
but that Enron's Investor Relations Department objected, and the Vinson & Elkins
lawyers felt that they could not say it was legally required.
200
believe in some respects should have, been more expansive under the governing
standards in its descriptions of these entities and Enron's transactions with
them, the fact remains that the LJM partnerships, the Raptor entities, and
transactions between Enron and those entities all were disclosed to some extent
in Enron's public filings.
Second, Enron's disclosures and the information we have about how they
were drafted reflect a strong predisposition on the part of at least some in the
Company to minimize the disclosures about the related-party transactions. Fastow
made clear that he did not want his compensation from the LJM partnerships to be
disclosed, and the process reflected a general effort to say as little as
possible about these transactions. While we recognize that Enron was not alone
in seeking to say as little as the law allowed, particularly on sensitive
subjects, we were told by more than one person that the Company spent
considerable time and effort working to say as little as possible about the LJM
transactions in the disclosure documents. It also appears that Enron Management
structured some transactions to avoid disclosure (such as the Chewco and
Yosemite transactions described above). That impulse to avoid public exposure,
coupled with the significance of the transactions for Enron's income statements
and balance sheets, should have raised red flags for Senior Management, as well
as for Enron's outside auditors and lawyers. Unfortunately, it apparently did
not.
Third, the inadequate disclosures concerning the related-party
transactions resulted, at least in part, from the fact that the process leading
to those disclosures appears to have been driven by the officers and employees
in Enron Global Finance, rather than by Senior Management with ultimate
responsibility, in-house or outside counsel, or the Audit and Compliance
201
Committee. In fairness, the complexity of the transactions in question made it
difficult for those not involved in their actual negotiation or structuring to
have been sufficiently steeped in the details to allow for a complete
understanding of the essence of what was involved. Nevertheless, the in-house
and outside lawyers should have been familiar with the securities law disclosure
requirements and should have exercised independent judgment about the
appropriateness of the Company's statements. Causey was the Chief Accounting
Officer and was specifically charged by the Board with reviewing Enron's
transactions with the LJM partnerships. Causey should have been in a unique
position to bring relative familiarity with the transactions to bear on the
disclosures. The evidence we have seen suggests he did not. Similarly, the Audit
and Compliance Committee reviewed the draft disclosures and had been charged by
the Board with reviewing the related-party transactions. It appears, however,
that none of these people independent of the Enron officers and employees
responsible for the transactions provided forceful or effective oversight of the
disclosure process.
Fourth, while we have not had the benefit of Andersen's position on a
number of these issues, the evidence we have seen suggests Andersen accountants
did not function as an effective check on the disclosure approach taken by the
Company. Andersen was copied on drafts of the financial statement footnotes and
the proxy statements, and we were told that it routinely provided comments on
the related-party transaction disclosures in response. We also understand that
the Andersen auditors closest to Enron Global Finance were involved in the
drafting of at least some of the disclosures. An internal Andersen e-mail from
February 2001 released in connection with recent Congressional hearings suggests
202
that Andersen may have had concerns about the disclosures of the related-party
transactions in the financial statement footnotes. Andersen did not express such
concerns to the Board. On the contrary, Andersen's engagement partner told the
Audit and Compliance Committee just a week after the internal e-mail that, with
respect to related-party transactions, "[r]equired disclosure [had been]
reviewed for adequacy," and that Andersen would issue an unqualified audit
opinion on the financial statements.
203
APPENDIX A
GLOSSARY
--------
BALANCE SHEET
a financial report that shows the company's assets, liabilities, and
shareholders' equity as of the close of a reporting period
CALL
an option that entitles the option holder to buy from the counter-party
a commodity, financial instrument, or other asset at an exercise or
strike price throughout the option term or at a fixed date in the
future (the expiration date)
COLLAR
a derivative transaction combining a put and a call (one written and
one purchased) that effectively sets a limit on the gain and the loss
that the holder of the contract will realize
CONSOLIDATED FINANCIAL STATEMENT
a financial statement that brings together all the assets, liabilities,
and operating results of a parent company and its subsidiaries, as if
the group were a single enterprise
COST METHOD OF ACCOUNTING
an accounting method whereby an investor records an investment at the
cost it paid, and does not record any gains or losses until receiving a
distribution or disposing of that investment
COSTLESS COLLAR
a collar in which the premiums payable on the put and the call equal
one another, so neither party pays the other at the inception of the
transaction
CREDIT CAPACITY
a counter-party's ability to meet its financial obligations
DERIVATIVE
a contract whose value is based on the performance of an underlying
financial asset, index, or other investment
EQUITY METHOD OF ACCOUNTING
an accounting method whereby an investor initially records an
investment in an entity at cost and then, in contrast to the cost
method of accounting, adjusts that amount to recognize its share of the
entity's earnings or losses The investor does not recognize any gains
or losses resulting from its transactions with the entity
FAIR VALUE
the amount at which an asset (liability) could be bought (incurred) or
sold (settled) in a current transaction between willing parties
FAIRNESS OPINION
professional judgment on the fairness of the price being offered in a
transaction
FORM 10-K
annual report filed with the Securities and Exchange Commission
providing a comprehensive overview of the registrant's business and
filed within 90 days after the end of the company's fiscal year
FORM 10-Q
quarterly report filed with the Securities and Exchange Commission for
each of the first three fiscal quarters of the company's fiscal year
and due within 45 days of the close of the quarter
FORWARD CONTRACT
a contract to purchase or sell a specific quantity of a commodity,
currency, or financial instrument at a specified price with delivery
and settlement at a specified future date
HEDGE
a strategy used to minimize price risk
INCOME STATEMENT
a summary of the revenues, costs, and expenses of a company during an
accounting period
IN THE MONEY
a call option is in-the-money if the price of the underlying commodity,
financial instrument, or other asset exceeds the strike or exercise
price; a put option is in-the-money if the strike or exercise price
exceeds the price of the underlying commodity, financial instrument, or
other asset
JOINT VENTURE
an enterprise owned and operated by a limited number of parties (the
joint venturers) as a separate and specific business or project for
their mutual benefit
MERCHANT INVESTMENT
an investment in a public or private equity, debt security, loan, or an
interest in a limited partnership that is carried at fair value
NOTIONAL VALUE OR NOTIONAL AMOUNT
the face value of the underlying instrument on which a derivative is
contracted
OPTION PREMIUM
amount paid for the right to either buy or sell the underlying
commodity, financial instrument, or other asset at a particular price
within a certain time period
PROMISSORY NOTE
written promise committing the party writing the note to pay the holder
of the note a specified sum of money, either on demand or at a certain
date, with or without interest
PROXY STATEMENT
information that the Securities and Exchange Commission requires
companies to provide to shareholders before they vote by proxy on
company matters
PUT
an option that entitles the option holder to sell to the counter-party
a commodity, financial instrument, or other asset at an exercise or
strike price throughout the option term or at a fixed date in the
future (the expiration date)
SHARE-SETTLED DERIVATIVE
a derivative contract in which the party with a loss delivers to the
party with a gain shares or units of the underlying commodity,
financial instrument, or other asset
SPECIAL PURPOSE ENTITY (OR SPECIAL PURPOSE VEHICLE)
typically an entity created for a limited purpose, with a limited life
and limited activities, and designed to benefit a single company
TOTAL RETURN SWAP
an arrangement whereby one party agrees to pay the other party the
appreciation from an asset and receive payments from the other party
for the depreciation of an asset
WARRANT
option to purchase a specified number of shares of stock at a stated
price for a specific time period
APPENDIX B
TIMELINE
JUNE - DECEMBER 1999
DESCRIPTION OF TIMELINE:
Timeline - June-December 1999
- -----------------------------
6/30/1999 LJM1 formed; RhythmsNet closes
9/23/1999 Invest in Osprey Trust Certificates
9/30/1999 Invest in Cuiaba
10/20/1999 LJM2 formed
12/14/1999 Sell Osprey Trust Certificates to Chewco
12/20/1999 $38.5 million loan from Whitewing
12/21/1999 Invest in Nowa Sarzyna (Poland)
12/22/1999 Invest in ENA CLO Trust
12/28/1999 Invest in Bob West Treasure
12/29/1999 Invest in Yosemite Certificates
12/29/1999 Invest in MEGS
12/30/1999 Sell Yosemite Certificates
1
Timeline - January-June 2000
- ----------------------------
1/6/2000 Invest in Cortez
3/6/2000 Sell MEGS
3/23/2000 RhythmsNet Loan
3/28/2000 Invest in Rawhide
3/29/2000 Sell - Nowa Sarzyna
4/18/2000 Invest in Raptor I
4/28/2000 RhythmsNet Unwind
5/9/2000 Extension Fee - Cuiaba
5/11/2000 Option Premium - Blue Dog
6/2/2000 Distribution - Bob West Treasure
6/26/2000 Invest in Margaux
6/29/2000 Invest in Raptor II
6/30/2000 Purchase - Backbone
2
Timeline - July-December 2000
- -----------------------------
7/7/2000 Option Fee - Coyote Springs
7/10/2000 Invest in TNPC
7/12/2000 Invest in Osprey Trust Certificates
8/3/2000 $41 million Distribution - Raptor I (effective date); Additional
Investment in Raptor I (effective date)
9/11/2000 Invest in Raptor IV
9/22/2000 $41 million Distribution Raptor II; Additional Investment in
Raptor II; Invest in Raptor III
10/5/2000 $39.5 million Distribution - Raptor III
10/10/2000 Invest in Osprey Assoc. Certificates
11/11/2000 Option Extension Fee - Blue Dog
11/17/2000 Final Payment - Loan from Whitewing
12/11/2000 Invest in Lab Trust (Catalytica); Invest in JGB Trust (Avici)
12/15/2000 Option Exercised - Blue Dog
12/22/2000 Invest in Fishtail
12/28/2000 Sell - Backbone
3
Timeline - January-December 2001
- --------------------------------
1/23/2001 $40.5 million Distribution - Raptor IV
2/12/2001 Jeff Skilling named CEO
3/12/2001 Sell Lab Trust (Catalytica)
3/26/2001 Sell - Chewco Interest in JEDI; Raptor Restructure
5/17/2001 Sell - ENA CLO
July 2001 Michael Kopper Buys Andrew Fastow's Interest in LJM2
8/14/2001 Jeff Skilling Resigns
8/15/2001 Sell - Cuiaba
August 2001 Sherron Watkins Letter sent to Ken Lay
9/18/2001 Tax Indemnity Payment to Chewco
9/28/2001 Raptor Unwind
10/16/2001 3rd Quarter 2001 Earnings Release
10/24/2001 Andrew Fastow Placed on Leave; Jeff McMahon Named CFO
11/8/2001 Restatement Announced
4