[Senate Prints 107-70]
[From the U.S. Government Publishing Office]
107th Congress
2d Session COMMITTEE PRINT S. Prt.
107-70
_______________________________________________________________________
THE ROLE OF THE BOARD OF DIRECTORS IN ENRON'S COLLAPSE
__________
R E P O R T
prepared by the
PERMANENT SUBCOMMITTEE ON
INVESTIGATIONS
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
[GRAPHIC] [TIFF OMITTED] CONGRESS.#13
July 8, 2002
U. S. GOVERNMENT PRINTING OFFICE
80-393 WASHINGTON : 2002
___________________________________________________________________________
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COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky
MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois
Joyce A. Rechtschaffen, Staff Director and Counsel
Richard A. Hertling, Minority Staff Director
Darla D. Cassell, Chief Clerk
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PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan, Chairman
DANIEL K. AKAKA, Hawaii SUSAN M. COLLINS, Maine
RICHARD J. DURBIN, Illinois TED STEVENS, Alaska
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky
MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois
Elise J. Bean, Acting Staff Director and Chief Counsel
Kim Corthell, Minority Staff Director
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Page
SUBCOMMITTEE INVESTIGATION....................................... 1
SUBCOMMITTEE FINDINGS............................................ 2
(1) Fiduciary Failure........................................ 3
(2) High Risk Accounting..................................... 3
(3) Inappropriate Conflicts of Interest...................... 3
(4) Extensive Undisclosed Off-The-Books Activity............. 3
(5) Excessive Compensation................................... 3
(6) Lack of Independence..................................... 3
SUBCOMMITTEE RECOMMENDATIONS..................................... 4
(1) Strengthening Oversight.................................. 4
(2) Strengthening Independence............................... 4
BACKGROUND....................................................... 5
Fiduciary Obligations of Boards of Directors................. 5
Enron Corporation............................................ 6
Enron Board.................................................. 8
FACTUAL BASIS FOR FINDINGS....................................... 11
Finding (1) Fiduciary Failure................................ 11
Finding (2) High Risk Accounting............................. 14
Andersen Briefings on High Risk Areas..................... 15
Other Evidence of Board Awareness of Enron's High Risk
Accounting................................................. 20
Finding (3) Inappropriate Conflicts of Interest.............. 23
Board Approval of LJM With Few Questions Asked............ 24
Flawed Controls to Mitigate LJM Conflicts................. 27
Inadequate Board Oversight of LJM Transactions With Enron. 29
Inadequate Board Oversight of Fastow's LJM Compensation... 32
LJM Profits at the Expense of Enron....................... 34
Finding (4) Extensive Undisclosed Off-The-Books Activity..... 36
Whitewing................................................. 36
LJM Partnerships.......................................... 39
The Raptors............................................... 40
Inadequate Public Disclosure.............................. 47
Finding (5) Excessive Compensation........................... 48
Finding (6) Lack of Independence............................. 51
Board Independence........................................ 51
Auditor Independence...................................... 53
CONCLUSION....................................................... 55
Appendix 1: Red Flags Know to Enron's Board...................... 56
Appendix 2: Sherron Watkins' Letter to Board Chairman Kenneth Lay
(8/15/01)...................................................... 57
THE ROLE OF THE BOARD OF
DIRECTORS IN ENRON'S COLLAPSE
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SUBCOMMITTEE INVESTIGATION
On December 2, 2001, Enron Corporation, then the seventh
largest publicly traded corporation in the United States,
declared bankruptcy. That bankruptcy sent shock waves
throughout the country, on both Wall Street and Main Street
where over half of American families now invest directly or
indirectly in the stock market. Thousands of Enron employees
lost not only their jobs but a significant part of their
retirement savings; Enron shareholders saw the value of their
investments plummet; and hundreds, if not thousands of
businesses around the world, were turned into Enron creditors
in bankruptcy court likely to receive only pennies on the
dollars owed to them.
On January 2, 2002, Senator Carl Levin, Chairman of the
Permanent Subcommittee on Investigations, and Senator Susan M.
Collins, the Ranking Minority Member, announced that the
Subcommittee would conduct an in-depth investigation into the
collapse of the Enron Corporation. The following month the
Subcommittee issued over 50 subpoenas to Enron Board members,
Enron officers, the Enron Corporation, and the Andersen
accounting firm. Over the next few months, additional subpoenas
and document requests were directed to other accounting firms
and financial institutions. By May 2002, the Subcommittee staff
had reviewed over 350 boxes of documents, including the
available meeting minutes, presentations, and attachments for
the full Board and its Finance and Audit Committees. The
Subcommittee staff also spoke with representatives of Enron
Corporation and Andersen, as well as numerous financial
institutions and experts in corporate governance and
accounting.
During April 2002, the Subcommittee staff interviewed 13
past and present Enron Board members, none of whom had
previously been interviewed by the U.S. Department of Justice,
Federal Bureau of Investigation, or the Securities and Exchange
Commission. These lengthy interviews, lasting between 3 and 8
hours, were conducted with the following Enron Board members:
Robert A. Belfer, Norman P. Blake, Jr., Ronnie C. Chan, John H.
Duncan, Dr. Wendy L. Gramm, Dr. Robert K. Jaedicke, Dr. Charles
A. LeMaistre, Dr. John Mendelsohn, Paulo Ferraz Pereira, Frank
Savage, Lord John Wakeham, Charls Walker, and Herbert S.
Winokur, Jr. All Board members appeared voluntarily, and all
were represented by the same legal counsel.
On May 7, 2002, the Subcommittee held a hearing on the role
and responsibility of the Enron Board of Directors to safeguard
shareholder interests and on its role in Enron's collapse and
bankruptcy. Two panels of witnesses testified under oath. The
first panel consisted of five past and present Enron Board
members, including the current Board Chairman and the past
Chairmen of the key Board Committees. The witnesses were as
follows:
Norman P. Blake, Jr. (1994-2002), Interim Chairman of
the Enron Board and former member of the Enron Finance
and Compensation Committees, has extensive corporate,
Board, and investment experience, including past
service on the Board of General Electric, and current
service as Audit Committee Chairman of the Board of
Owens Corning;
John H. Duncan (1985-2001), former Chairman of the
Enron Executive Committee, has extensive corporate and
Board experience, including helping to found and manage
Gulf and Western Industries;
Herbert S. Winokur, Jr. (1985-2002), current Board
member, former Chairman of the Finance Committee, and
former member of the Powers Special Committee, holds
two advanced degrees from Harvard University and has
extensive corporate, Board, and investment experience;
Dr. Robert K. Jaedicke (1985-2001), former Chairman of
the Enron Audit and Compliance Committee, is Dean
Emeritus of the Stanford Business School, and a former
accounting professor; and
Dr. Charles A. LeMaistre (1985-2001), former Chairman
of the Enron Compensation Committee, is former
President of the M.D. Anderson Cancer Center, a large,
well-respected, and complex medical facility in
Texas.\1\
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\1\ Two Enron Directors, Mr. Blake and Mr. Winokur, who were
members of the Board at the time of the May 7 hearing, resigned from
the Enron Board on June 6, 2002.
The second panel consisted of three experts in corporate
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governance and accounting:
Robert H. Campbell is former Chairman of the Board and
Chief Executive Officer of Sunoco, Inc., and current
Board member at Hershey Foods, CIGNA, and the Pew
Charitable Trusts;
Charles M. Elson is Director of the Center for
Corporate Governance, University of Delaware, and a
former member of the Board of Sunbeam Corporation; and
Michael H. Sutton is the former Chief Accountant of the
Securities and Exchange Commission from 1995 to 1998.
SUBCOMMITTEE FINDINGS
Based upon the evidence before it, including over one
million pages of subpoenaed documents, interviews of 13 Enron
Board members, and the Subcommittee hearing on May 7, 2002, the
U.S. Senate Permanent Subcommittee on Investigations makes the
following findings with respect to the role of the Enron Board
of Directors in Enron's collapse and bankruptcy.
(1) Fiduciary Failure. The Enron Board of Directors
failed to safeguard Enron shareholders and contributed
to the collapse of the seventh largest public company
in the United States, by allowing Enron to engage in
high risk accounting, inappropriate conflict of
interest transactions, extensive undisclosed off-the-
books activities, and excessive executive compensation.
The Board witnessed numerous indications of
questionable practices by Enron management over several
years, but chose to ignore them to the detriment of
Enron shareholders, employees and business associates.
(2) High Risk Accounting. The Enron Board of
Directors knowingly allowed Enron to engage in high
risk accounting practices.
(3) Inappropriate Conflicts of Interest. Despite
clear conflicts of interest, the Enron Board of
Directors approved an unprecedented arrangement
allowing Enron's Chief Financial Officer to establish
and operate the LJM private equity funds which
transacted business with Enron and profited at Enron's
expense. The Board exercised inadequate oversight of
LJM transaction and compensation controls and failed to
protect Enron shareholders from unfair dealing.
(4) Extensive Undisclosed Off-The-Books Activity. The
Enron Board of Directors knowingly allowed Enron to
conduct billions of dollars in off-the-books activity
to make its financial condition appear better than it
was and failed to ensure adequate public disclosure of
material off-the-books liabilities that contributed to
Enron's collapse.
(5) Excessive Compensation. The Enron Board of
Directors approved excessive compensation for company
executives, failed to monitor the cumulative cash drain
caused by Enron's 2000 annual bonus and performance
unit plans, and failed to monitor or halt abuse by
Board Chairman and Chief Executive Officer Kenneth Lay
of a company-financed, multi-million dollar, personal
credit line.
(6) Lack of Independence. The independence of the
Enron Board of Directors was compromised by financial
ties between the company and certain Board members. The
Board also failed to ensure the independence of the
company's auditor, allowing Andersen to provide
internal audit and consulting services while serving as
Enron's outside auditor.
SUBCOMMITTEE RECOMMENDATIONS
Based upon the evidence before it and the findings made in
this report, the U.S. Senate Permanent Subcommittee on
Investigations makes the following recommendations:
(1) Strengthening Oversight. Directors of publicly
traded companies should take steps to:
L (a) prohibit accounting practices and transactions
that put the company at high risk of non-compliance
with generally accepted accounting principles and
result in misleading and inaccurate financial
statements;
L (b) prohibit conflict of interest arrangements
that allow company transactions with a business owned
or operated by senior company personnel;
L (c) prohibit off-the-books activity used to make
the company's financial condition appear better than it
is, and require full public disclosure of all assets,
liabilities and activities that materially affect the
company's financial condition;
L (d) prevent excessive executive compensation,
including by ----
L (i) exercising ongoing oversight of compensation
plans and payments;
L (ii) barring the issuance of company-financed
loans to directors and senior officers of the company;
and
L (iii) preventing stock-based compensation plans
that encourage company personnel to use improper
accounting or other improper measures to increase the
company stock price for personal gain; and
L (e) prohibit the company's outside auditor from
also providing internal auditing or consulting services
to the company and from auditing its own work for the
company.
(2) Strengthening Independence. The Securities and
Exchange Commission and the self-regulatory
organizations, including the national stock exchanges,
should:
L (a) strengthen requirements for director
independence at publicly traded companies, including by
requiring a majority of the outside directors to be
free of material financial ties to the company other
than through director compensation;
L (b) strengthen requirements for Audit Committees
at publicly traded companies, including by requiring
the Audit Committee Chair to possess financial
management or accounting expertise, and by requiring a
written Audit Committee charter that obligates the
Committee to oversee the company's financial statements
and accounting practices and to hire and fire the
outside auditor; and
L (c) strengthen requirements for auditor
independence, including by prohibiting the company's
outside auditor from simultaneously providing the
company with internal auditing or consulting services
and from auditing its own work for the company.
BACKGROUND
Fiduciary Obligations of Boards of Directors. In the United
States, the Board of Directors sits at the apex of a company's
governing structure. A typical Board's duties include reviewing
the company's overall business strategy; selecting and
compensating the company's senior executives; evaluating the
company's outside auditor; overseeing the company's financial
statements; and monitoring overall company performance.
According to the Business Roundtable, the Board's ``paramount
duty'' is to safeguard the interests of the company's
shareholders.\2\
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\2\ ``Statement on Corporate Governance,'' The Business Roundtable
(9/97) at 3.
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Directors operate under state laws which impose fiduciary
duties on them to act in good faith, with reasonable care, and
in the best interest of the corporation and its shareholders.
Courts generally discuss three types of fiduciary obligations.
As one court put it:
``Three broad duties stem from the fiduciary status of
corporate directors: namely, the duties of obedience,
loyalty, and due care. The duty of obedience requires a
director to avoid committing . . . acts beyond the
scope of the powers of a corporation as defined by its
charter or the laws of the state of incorporation. . .
. The duty of loyalty dictates that a director must act
in good faith and must not allow his personal interest
to prevail over the interests of the corporation. . . .
[T]he duty of care requires a director to be diligent
and prudent in managing the corporation's affairs.''
\3\
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\3\ Gearheart Industries v. Smith International, 741 F.2d 707, 719
(5th Cir. 1984).
In most States, directors also operate under a legal
doctrine called the ``business judgment rule,'' which generally
provides directors with broad discretion, absent evidence of
fraud, gross negligence or other misconduct, to make good faith
business decisions. Most States permit corporations to
indemnify their directors from liabilities associated with
civil, criminal or administrative proceedings against the
company, and most U.S. publicly traded corporations, including
Enron, purchase directors' liability insurance that pays for a
director's legal expenses and other costs in the event of such
proceedings.
Among the most important of Board duties is the
responsibility the Board shares with the company's management
and auditors to ensure that the financial statements provided
by the company to its shareholders and the investing public
fairly present the financial condition of the company. This
responsibility requires more than ensuring the company's
technical compliance with generally accepted accounting
principles. According to the Second Circuit Court of Appeals,
this technical compliance may be evidence that a company is
acting in good faith, but it is not necessarily conclusive. The
``critical test,'' the Court said, is ``whether the financial
statements as a whole fairly present the financial position''
of the company.\4\
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\4\ U.S. v. Simon, 425 F.2d 796, 805-6 (2nd Cir. 1969), cert.
denied, 397 U.S. 1006 (1970) (quoting, in part, the trial judge). See
also 15 U.S.C. 77s and 78m (``Every issuer . . . shall . . . keep
books, records, and accounts, which, in reasonable detail, accurately
and fairly reflect the transactions and disposition of the assets of
the issuer.'')
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Over the years, blue ribbon commissions, corporate
organizations, and academic scholars have addressed the
fiduciary obligations of Boards of Directors of publicly traded
companies, including their role in ensuring accurate financial
statements. In 1999, the Committee of Sponsoring Organizations
of the Treadway Commission issued a report on ``Fraudulent
Financial Reporting 1987-1997; An Analysis of U.S. Public
Companies,'' evaluating 200 cases of publicly traded companies
involved in financial statement fraud. Among other findings,
the report stated that companies with fraudulent financial
statements appeared to have boards ``dominated by insiders''
and ``weak'' audit committees that rarely met. The report
stated that its results ``highlight the need for an effective
control environment, or `tone at the top' '' and urged
improvements in companies' internal controls, governance and
ethics.
In 2000, the Blue Ribbon Commission on Improving the
Effectiveness of Corporate Audit Committees issued 10
recommendations identifying best Committee practices at
publicly traded companies. The Commission recommended that all
publicly traded companies establish an audit committee with a
formal charter and members who are independent and
``financially literate,'' at least one of whom has accounting
or financial management expertise. The Commission recommended
that audit committees: (1) evaluate the objectivity and
independence of the company auditor; (2) discuss the
``auditor's judgements about the quality, not just the
acceptability, of the company's accounting principles as
applied in its financial reporting,'' including the ``clarity
of the company's financial disclosures and degree of
aggressiveness or conservatism of the company's accounting
principles''; (3) determine that the company's financial
statements are ``fairly presented in conformity with generally
accepted accounting principles in all material respects''; and
(4) discuss with the auditor ``significant [accounting]
adjustments, management judgement and accounting estimates,
significant new accounting policies, and disagreements with
management.''
The Commission report states: ``Board membership is no
longer just a reward for `making it' in corporate America;
being a director today requires the appropriate attitude and
capabilities, and it demands time and attention.'' The report
urges boards of directors to ``understand and adopt the
attitude of the modern board which recognizes that the board
must perform active and independent oversight to be, as the law
requires, a fiduciary for those who invest in the
corporation.''
Enron Corporation. At the time of Enron's collapse in
December 2001, Enron Corporation was listed as the seventh
largest company in the United States, with over $100 billion in
gross revenues and more than 20,000 employees worldwide. It had
received widespread recognition for its transition from an old-
line energy company with pipelines and power plants, to a high
tech global enterprise that traded energy contracts like
commodities, launched into new industries like broadband
communications, and oversaw a multi-billion-dollar
international investment portfolio.
One of Enron's key corporate achievements during the 1990's
was creation of an on-line energy trading business that bought
and sold contracts to deliver energy products like natural gas,
oil, or electricity. Enron treated these contracts as
marketable commodities comparable to securities or commodity
futures, but was able to develop and run the business outside
of existing controls on investment companies and commodity
brokers. The nature of the new business required Enron's access
to significant lines of credit to ensure that the company had
the funds at the end of each business day to settle the energy
contracts traded on its on-line system. This new business also
caused Enron to experience large earnings fluctuations from
quarter to quarter. Those large fluctuations potentially
affected the credit rating Enron received, and its credit
rating affected Enron's ability to obtain low-cost financing
and attract investment. In order to ensure an investment-grade
credit rating, Enron began to emphasize increasing its cash
flow, lowering its debt, and smoothing its earnings on its
financial statements to meet the criteria set by credit rating
agencies like Moody's and Standard & Poor's.
Enron developed a number of new strategies to accomplish
its financial statement objectives. They included developing
energy contracts Enron called ``prepays'' in which Enron was
paid a large sum in advance to deliver natural gas or other
energy products over a period of years; designing hedges to
reduce the risk of long-term energy delivery contracts; and
pooling energy contracts and securitizing them through bonds or
other financial instruments sold to investors. Another high
profile strategy, referred to as making the company ``asset
light,'' was aimed at shedding, or increasing immediate returns
on, the company's capital-intensive energy projects like power
plants that had traditionally been associated with low returns
and persistent debt on the company's books. The goal was either
to sell these assets outright or to sell interests in them to
investors, and record the income as earnings which top Enron
officials called ``monetizing'' or ``syndicating'' the assets.
A presentation made to the Finance Committee in October 2000,
summarized this strategy as follows.\5\ It stated that Enron's
``[e]nergy and communications investments typically do not
generate significant cashflow and earnings for 1 to 3 years.''
It stated that Enron had ``[l]imited cash flow to service
additional debt'' and ``[l]imited earnings to cover dilution of
additional equity.'' It concluded that ``Enron must syndicate''
or share its investment costs ``in order to grow.''
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\5\ Hearing Exhibit 39, ``Private Equity Strategy'' (Finance
Committee presentation, 10/00), included in the hearing before the
Permanent Subcommittee on Investigations on The Role of the Board of
Directors in Enron's Collapse, May 7, 2002, S. Hrg. 107-511.
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One of the problems with Enron's new strategies, however,
was finding counterparties willing to invest in Enron assets or
share the significant risks associated with long-term energy
production facilities and delivery contracts.\6\ The October
2000 presentation to the Finance Committee showed that one
solution Enron had devised was to sell or syndicate its assets,
not to independent third parties, but to ``unconsolidated
affiliates''--businesses like Whitewing, LJM, JEDI, the Hawaii
125-0 Trust and others that were not included in Enron's
financial statements but were so closely associated with the
company that Enron considered their assets to be part of
Enron's own holdings. The October 2000 presentation, for
example, informed the Finance Committee that Enron had a total
of $60 billion in assets, of which about $27 billion, or nearly
50 percent, were lodged with Enron's ``unconsolidated
affiliates.''
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\6\ As part of its asset light strategy, during the summer of 2000,
Enron worked on a transaction called ``Project Summer'' to sell $6
billion of its international assets to a single purchaser in the Middle
East. Enron's Directors indicated during their interviews that this
deal fell through when the purchaser's key decisionmaker became ill.
Enron then pursued the asset sales on a piecemeal basis, using
Whitewing, LJM, and others.
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All of the Board members interviewed by the Subcommittee
were well aware of and supported Enron's intense focus on its
credit rating, cash flow, and debt burden. All were familiar
with the company's ``asset light'' strategy and actions taken
by Enron to move billions of dollars in assets off its balance
sheet to separate but affiliated companies. All knew that, to
accomplish its objectives, Enron had been relying increasingly
on complicated transactions with convoluted financing and
accounting structures, including transactions with multiple
special purpose entities, hedges, derivatives, swaps, forward
contracts, prepaid contracts, and other forms of structured
finance. While there is no empirical data on the extent to
which U.S. public companies use these devices, it appears that
few companies outside of investment banks use them as
extensively as Enron. At Enron, they became dominant; at its
peak, the company apparently had between $15 and $20 billion
involved in hundreds of structured finance transactions.
Enron Board. In 2001, Enron's Board of Directors had 15
members, several of whom had 20 years or more experience on the
Board of Enron or its predecessor companies. Many of Enron's
Directors served on the boards of other companies as well. At
the hearing, John Duncan, former Chairman of the Executive
Committee, described his fellow Board members as well educated,
``experienced, successful businessmen and women,'' and
``experts in areas of finance and accounting.'' \7\ The
Subcommittee interviews found the Directors to have a wealth of
sophisticated business and investment experience and
considerable expertise in accounting, derivatives, and
structured finance.
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\7\ Hearing Record at 14.
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Enron Board members uniformly described internal Board
relations as harmonious. They said that Board votes were
generally unanimous and could recall only two instances over
the course of many years involving dissenting votes. The
Directors also described a good working relationship with Enron
management. Several had close personal relationships with Board
Chairman and Chief Executive Officer (CEO) Kenneth L. Lay. All
indicated they had possessed great respect for senior Enron
officers, trusting the integrity and competence of Mr. Lay;
President and Chief Operating Officer (and later CEO) Jeffrey
K. Skilling; Chief Financial Officer Andrew S. Fastow; Chief
Accounting Officer Richard A. Causey; Chief Risk Officer
Richard Buy; and the Treasurer Jeffrey McMahon and later Ben
Glisan. Mr. Lay served as Chairman of the Board from 1986 until
he resigned in 2002. Mr. Skilling was a Board member from 1997
until August 2001, when he resigned from Enron.
The Enron Board was organized into five committees:
(1) The Executive Committee met on an as needed basis
to handle urgent business matters between scheduled
Board meetings. Its members in 2001 were Mr. Duncan,
the Chairman; Mr. Lay, Mr. Skilling, Mr. Belfer, Dr.
LeMaistre, and Mr. Winokur.
(2) The Finance Committee was responsible for
approving major transactions which, in 2001, met or
exceeded $75 million in value. It also reviewed
transactions valued between $25 million and $75
million; oversaw Enron's risk management efforts; and
provided guidance on the company's financial decisions
and policies. Its members in 2001 were Mr. Winokur, the
Chairman; Mr. Belfer, Mr. Blake, Mr. Chan, Mr. Pereira,
and Mr. Savage.
(3) The Audit and Compliance Committee reviewed
Enron's accounting and compliance programs, approved
Enron's financial statements and reports, and was the
primary liaison with Andersen. Its members in 2001 were
Dr. Jaedicke, the Chairman; Mr. Chan, Dr. Gramm, Dr.
Mendelsohn, Mr. Pereira, and Lord Wakeham. Dr. Jaedicke
and Lord Wakeham had formal accounting training and
professional experience. Dr. Mendelsohn was the only
Committee member who appeared to have limited
familiarity with complex accounting principles.
(4) The Compensation Committee established and
monitored Enron's compensation policies and plans for
directors, officers and employees. Its members in 2001
were Dr. LeMaistre, the Chairman; Mr. Blake, Mr.
Duncan, Dr. Jaedicke, and Mr. Savage.
(5) The Nominating Committee nominated individuals to
serve as directors. Its members in 2001 were Lord
Wakeham, the Chairman; Dr. Gramm, Dr. Mendelsohn, and
Mr. Meyer.
The Board normally met five times during the year, with
additional special meetings as needed. Board meetings usually
lasted 2 days, with the first day devoted to Committee meetings
and a Board dinner, and the second day devoted to a meeting of
the full Board. Committee meetings generally lasted between 1
and 2 hours and were arranged to allow Board members, who
typically sat on three Committees, to attend all assigned
Committee meetings. Full Board meetings also generally lasted
between 1 and 2 hours. Special Board meetings, as well as
meetings of the Executive Committee, were typically conducted
by telephone conference.
Committee chairmen typically spoke with Enron management by
telephone prior to Committee meetings to develop the proposed
Committee meeting agenda. Board members said that Enron
management provided them with these agendas as well as
extensive background and briefing materials prior to Board
meetings including, in the case of Finance Committee members,
numerous Deal Approval Sheets (DASHs) for approval of major
transactions. Board members varied in how much time they spent
reading the materials and preparing for Board meetings, with
the reported preparation time for each meeting varying between
2 hours and 2 days. On some occasions, Enron provided a private
plane to transport Board members from various locations to a
Board meeting, and Board members discussed company issues
during the flight. Enron also organized occasional trips abroad
which some Board members attended to view company assets and
operations.
During the Committee meetings, Enron management generally
provided presentations on company performance, internal
controls, new business ventures, specific transactions, or
other topics of interest. The Finance Committee generally heard
from Mr. Fastow, Mr. Causey, Mr. Buy, Mr. McMahon, and,
occasionally, Mr. Glisan. The Audit Committee generally heard
from Mr. Causey, Mr. Buy, and Andersen personnel. The
Compensation Committee generally heard from the company's top
compensation official, Mary Joyce, and from the company's
compensation consultant, Towers Perrin. On occasion, the
Committees heard from other senior Enron officers as well. At
the full Board meetings, Board members typically received
presentations from each Committee Chairman summarizing the
Committee's work and recommendations, as well as from Enron
management, and, occasionally, Andersen or the company's chief
outside legal counsel, Vinson & Elkins. Mr. Lay and Mr.
Skilling usually attended Executive, Finance, and Audit
Committee meetings, as well as the full Board meetings. Mr. Lay
attended many Compensation Committee meetings as well. The
Subcommittee interviews indicated that, altogether, Board
members appeared to have routine contact with less than a dozen
senior officers at Enron. The Board did not have a practice of
meeting without Enron management present.
Regular presentations on Enron's financial statements,
accounting practices, and audit results were provided by
Andersen to the Audit Committee. The Audit Committee Chairman
would then report on the presentation to the full Board. On
most occasions, three Andersen senior partners from Andersen's
Houston office attended Audit Committee meetings. They were D.
Stephen Goddard, head of the Houston office; David Duncan, head
of the Andersen ``engagement team'' that provided auditing,
consulting, and other services to Enron; and Thomas H. Bauer,
another senior member of the Enron engagement team. Before
becoming head of the Houston office, Mr. Goddard had led the
Enron engagement team for Andersen. Mr. Duncan became the
``worldwide engagement partner'' for Enron in 1997, and from
that point on typically made the Andersen presentations to the
Audit Committee. The Audit Committee offered Andersen personnel
an opportunity to present information to them without
management present.
Minutes summarizing Committee and Board meetings were kept
by the Corporate Secretary, who often took handwritten notes on
Committee and Board presentations during the Board's
deliberations and afterward developed and circulated draft
minutes to Enron management, Board members, and legal counsel.
The draft minutes were formally presented to and approved by
Committee and Board members at subsequent meetings.
Outside of the formal Committee and Board meetings, the
Enron Directors described very little interaction or
communication either among Board members or between Board
members and Enron or Andersen personnel, until the company
began experiencing severe problems in October 2001. From
October until the company's bankruptcy on December 2, 2001, the
Board held numerous special meetings, at times on almost a
daily basis.
Enron Board members were compensated with cash, restricted
stock, phantom stock units, and stock options.\8\ The total
cash and equity compensation of Enron Board members in 2000 was
valued by Enron at about $350,000 or more than twice the
national average for Board compensation at a U.S. publicly
traded corporation.\9\
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\8\ See Hearing Exhibits 35a and 35b on Enron Board Member
compensation, prepared by the Subcommittee based upon information in
Enron filings with the Security and Exchange Commission (SEC). Phantom
stock units at Enron were deferred cash payments whose amounts were
linked to the value of Enron stock.
\9\ See ``Director Compensation; Purposes, Principles, and Best
Practices,'' Report of the Blue Ribbon Commission of the National
Association of Corporate Directors (2001) at page V (average total
Board compensation at top 200 U.S. public corporations in 2000, was
$138,747).
FACTUAL BASIS FOR FINDINGS
Finding (1): The Enron Board of Directors failed to
safeguard Enron shareholders and contributed to the
collapse of the seventh largest public company in the
United States, by allowing Enron to engage in high risk
accounting, inappropriate conflict of interest
transactions, extensive undisclosed off-the-books
activities, and excessive executive compensation. The
Board witnessed numerous indications of questionable
practices by Enron management over several years, but
chose to ignore them to the detriment of Enron
shareholders, employees and business associates.
One of the striking features of the Enron collapse is the
company's abrupt and dramatic transformation from a well-
respected and award-winning company to a disgraced and bankrupt
enterprise in less than 3 months. Steady revelations since
October 2001 have raised questions about numerous aspects of
the company's operations, from its extensive undisclosed off-
the-books dealings, often with companies run by Enron
personnel,\10\ to an April 2002 SEC filing announcing that the
company's financial statements were unreliable and the book
value of its assets would have to be written down as much as
$24 billion,\11\ to its apparent manipulations of the
California energy market,\12\ to tax strategies which
apparently included Enron's ordering its tax department to
produce billions of dollars in company earnings through the use
of complex tax shelters.\13\
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\10\ See, for example, Hearing Exhibit 44, ``Partnership Spurs
Enron Equity Cut, Wall Street Journal (10/18/01).
\11\ Form 8-K filed by Enron Corporation with SEC (4/22/02).
\12\ See, for example, Hearing Exhibit 75, memorandum by Christian
Yoder and Stephen Hall of Steol Rives L.L.P. to Richard Sanders (12/8/
00) regarding ``Traders'' Strategies in the California Wholesale Power
Markets/ISO Sanctions,'' analyzing strategies used by Enron energy
traders in the California wholesale energy markets during 2000.
\13\ See ``Enron's Other Strategy: Taxes; Internal Papers Reveal
How Complex Deals Boosted Profits by $1 Billion,'' Washington Post (5/
22/02).
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During their Subcommittee interviews, the Enron Directors
seemed to indicate that they were as surprised as anyone by the
company's collapse. But a chart produced at the Subcommittee
hearing marks more than a dozen incidents over 3 years that
should have raised Board concerns about the activities of the
company.\14\ The first listed incident, in February 1999, is an
Audit Committee meeting in which Board members were told that
Enron was using accounting practices that ``push limits'' and
were ``at the edge'' of acceptable practice. Three times in
1999 and 2000, the Board was asked to and approved an
unprecedented arrangement allowing Enron's CFO to set up
private equity funds, the LJM partnerships, to do business with
Enron for the purpose of improving Enron's financial
statements. The Board also approved moving an affiliated
company, Whitewing, off the company books, while guaranteeing
its debt with $1.4 billion in Enron stock and helping it obtain
funding for the purchase of Enron assets. Committee and Board
presentations throughout 1999, 2000, and 2001 chronicled the
company's foray into more and more off-the-books activity.
Three times in 2000, the Board was asked to and approved
complex transactions called the Raptors, despite questionable
accounting and ongoing risk to the company. The Board was also
informed that, in 6 short months, LJM had produced over $2
billion in funds flow for Enron, and Enron's gross revenues had
jumped from $40 billion in 1999 to $100 billion in 2000. These
figures are striking, yet apparently no Board member questioned
them.
---------------------------------------------------------------------------
\14\ Hearing Exhibit 1, ``Red Flags Known to Enron's Board,''
prepared by the Subcommittee and attached to this report as Appendix 1
on page 56.
---------------------------------------------------------------------------
In 2001, evidence began to mount that not all was well at
Enron. The company's stock price began declining. In March
2001, a prominent Fortune article questioned the company's
opaque financial statements.\15\ In April, Board members were
told that 64 percent of Enron's assets were ``troubled'' or
performing ``below expectations.'' \16\ They were also told of
international assets that were overvalued on Enron's books by
$2.3 billion.\17\ In mid-2001, the company's high profile,
extensive broadband investments began to lose value. During the
summer, the Board watched Mr. Fastow sell his LJM stake and Mr.
Skilling suddenly resign from the company. In her letter to Mr.
Lay on the day after Mr. Skilling's resignation, Sherron
Watkins wrote, ``Skilling's abrupt departure will raise
suspicions of accounting improprieties and valuation issues. .
. . The spotlight will be on us, the market just can't accept
that Skilling is leaving his dream job.'' \18\ But neither
Board Chairman Lay nor any other Board member used the Skilling
departure as a red flag warranting a hard look at Enron's
operations. Even in early October 2001, when told of an
anonymous employee letter warning of company problems and an
$800 million earnings charge from the Raptors termination, the
interviewed Board members told the Subcommittee staff they had
left the October Board meeting feeling the company was still on
track.
---------------------------------------------------------------------------
\15\ ``Is Enron Overpriced?'' by Bethany McLean, Fortune (3/5/01).
\16\ See Hearing Exhibit 40, ``Summary of Investment Portfolio''
(Finance Committee presentation, 4/01), indicating that 10 percent of
Enron's global investment portfolio was ``troubled'' and 54 percent was
performing ``below expectations.'' See also Hearing Exhibit 41b,
``Portfolio Summary'' (Finance Committee presentation, 8/13/01),
showing that, although the overall percentage of underperforming assets
were nearly the same at 67%, the percentage of assets in the
``troubled'' category had quadrupled, from 10% to 45%.
\17\ Hearing Exhibit 71, ``Enron Global Assets and Services; Equity
Value Schedule'' (6/01), Bates E103411.
\18\ Sherron Watkins' letter to Board Chairman Kenneth Lay (8/15/
01) at 1, attached to this report as Appendix 2 on page 57.
---------------------------------------------------------------------------
But the company was not on track. In mid-October 2001,
press reports began leaking Enron's extensive undisclosed off-
the-books dealings with LJM and the millions of dollars Mr.
Fastow had made at Enron's expense. Reports also emerged about
Enron's dealings with JEDI and a previously undisclosed related
company called Chewco which was owned and operated by another
Enron employee Michael Kopper and which, due to improper
accounting years earlier, Enron had to consolidate on its books
in 2001, with a $500 million loss. Also disclosed in October
2001 was a $1.2 billion reduction in shareholder equity, which
arose from an incorrect accounting methodology Enron used for
the Raptors, which Andersen had advocated but later decided was
in violation of generally accepted accounting principles and
had to be changed. Investors reacted to these disclosures by
selling Enron stock, causing a further decline in Enron's stock
price. In November, a proposed merger with Dynegy failed.
Credit rating agencies then dropped Enron's rating to below
investment grade, and its collapse into bankruptcy followed.
While the evidence indicates that, in some instances, Enron
Board members were misinformed or misled, the Subcommittee
investigation found that overall the Board received substantial
information about Enron's plans and activities and explicitly
authorized or allowed many of the questionable Enron
strategies, policies, and transactions now subject to
criticism. Enron's high-risk accounting practices, for example,
were not hidden from the Board. The Board knew of them and took
no action to prevent Enron from using them. The Board was
briefed on the purpose and nature of the Whitewing, LJM, and
Raptor transactions, explicitly approved them, and received
updates on their operations. Enron's extensive off-the-books
activity was not only well known to the Board, but was made
possible by Board resolutions authorizing new unconsolidated
entities, Enron preferred shares, and Enron stock collateral
that was featured in many of the off-the-books deals.
The Subcommittee's findings related to the Enron Board
build upon the findings made by the Special Investigation
Committee set up by the Board itself under the chairmanship of
William Powers, Jr. On February 1, 2002, the Powers Committee
issued a report concluding that the Enron ``Board of Directors
failed . . . in its oversight duties'' with ``serious
consequences for Enron, its employees, and its shareholders.''
\19\ With respect to Enron's questionable accounting practices,
the Powers Report concluded that ``[w]hile the primary
responsibility for the financial reporting abuses . . . lies
with Management, . . . those abuses could and should have been
prevented or detected at an earlier time had the Board been
more aggressive and vigilant.'' \20\
---------------------------------------------------------------------------
\19\ Hearing Exhibit 84, ``Report on Investigation by the Special
Investigative Committee of the Board of Directors of Enron
Corporation'' (2/1/02), which is retained in the files of the
Subcommittee, (hereinafter ``Powers Report'') at 22.
\20\ See Powers Report at 24.
---------------------------------------------------------------------------
During their interviews, all 13 Enron Board members
strongly disagreed with the Powers Report conclusions that the
Board had failed in its oversight duties. They contended that
they had reasonably relied on assurances provided by Enron
management, Andersen, and Vinson & Elkins, and had met their
obligation to provide reasonable oversight of company
operations. During the hearing, all five Board witnesses
explicitly rejected any share of responsibility for Enron's
collapse. John Duncan, former Executive Committee Chairman,
testified that the Board ``worked hard'' and ``asked probing
questions.'' He said the problem at Enron was that Enron
management did not ``tell the truth,'' and both management and
Andersen personnel ``were well aware of the problems facing the
company and they did not tell us.'' \21\ Mr. Winokur, former
head of the Finance Committee, testified that Enron was ``a
cautionary reminder of the limits of a director's role'' which
is by nature a ``part-time job.'' \22\ He stated, ``We cannot,
I submit, be criticized for failing to address or remedy
problems that have been concealed from us.'' \23\
---------------------------------------------------------------------------
\21\ Hearing Record at 14-15.
\22\ Id. at 18.
\23\ Id. at 19.
---------------------------------------------------------------------------
But much of what was wrong at Enron was not concealed from
its Board of Directors. High risk accounting practices,
extensive undisclosed off-the-books transactions, inappropriate
conflict of interest transactions, and excessive compensation
plans were known to and authorized by the Board. The
Subcommittee investigation did not substantiate the claims that
the Enron Board members challenged management and asked tough
questions. Instead, the investigation found a Board that
routinely relied on Enron management and Andersen
representations with little or no effort to verify the
information provided, that readily approved new business
ventures and complex transactions, and that exercised weak
oversight of company operations. The investigation also
identified a number of financial ties between Board members and
Enron which, collectively, raise questions about Board member
independence and willingness to challenge management.
The failure of any Enron Board member to accept any degree
of personal responsibility for Enron's collapse is a telling
indicator of the Board's failure to recognize its fiduciary
obligations to set the company's overall strategic direction,
oversee management, and ensure responsible financial reporting.
Finding (2): The Enron Board of Directors knowingly
allowed Enron to engage in high risk accounting
practices.
One of the most disturbing developments in the
Subcommittee's investigation was the accumulation of evidence
that the Enron Board knowingly allowed Enron's use of high risk
accounting practices. All three of the expert witnesses at the
May 7 hearing expressed surprise and concern at the role of the
Audit Committee in countenancing these practices. Mr. Campbell,
who has extensive corporate management and Board experience,
testified that he could not ``imagine . . . sitting down with
the auditors and being told that we are using high-risk
auditing practices and just agreeing with that.'' \24\ He
called ``[g]oing forward with that kind of an environment''
equivalent to ``going down a slippery slope,'' and said Board
approval of high risk practices ``is unlike any board that I
have ever seen or heard of.'' Mr. Elson, a corporate governance
expert, testified that being told of high risk activities by
the company's outside auditor ``is a giant red flag'' that
should have caused Board members to ask ``an awful lot of
questions'' and might have necessitated bringing in a third
party to evaluate the company's accounting practices.\25\
---------------------------------------------------------------------------
\24\ Hearing Record at 109.
\25\ Id. at 109.
---------------------------------------------------------------------------
Andersen Briefings on High Risk Areas. The charter of the
Enron Audit Committee explicitly requires the Committee to
ensure the independence of the company's auditors, assess
Enron's internal controls and the quality of its financial
reporting, and review Enron's financial statements.\26\
According to the charter, the Audit Committee's ``principal
functions'' also include:
---------------------------------------------------------------------------
\26\ Hearing Exhibit 47b, ``Enron Corp. Audit and Compliance
Committee Charter'' (2/12/01), Bates CL382-84.
--``[d]iscuss[ing] with the independent auditor
information relating to the auditor's judgments about
the quality of the Company's accounting principles,
including . . . the clarity and completeness of the
Company's accounting information contained in the
---------------------------------------------------------------------------
financial statements'';
--determin[ing] whether Enron's ``internal financial
controls . . . provide reasonable assurance that the
Company's publicly reported financial statements are
presented fairly in conformity with generally accepted
accounting principles''; and
--``[a]pprov[ing] major changes and other major
questions of choice regarding the appropriate
accounting principles and practices to be followed when
preparing the Company's financial statement for the
purpose of making recommendations to the Board of
Directors as necessary.''
Materials produced by the Enron Audit Committee and
Andersen indicate that Andersen personnel regularly briefed the
Enron Audit Committee about Enron's accounting practices, and
that Andersen regularly informed the Audit Committee that Enron
was using accounting practices that, due to their novel design,
application in areas without established precedent, or
significant reliance on subjective judgments by management
personnel, invited scrutiny and presented a high degree of risk
of non-compliance with generally accepted accounting
principles.\27\
---------------------------------------------------------------------------
\27\ See Hearing Exhibits 2 through 9, Andersen presentations to
Enron Audit Committee.
---------------------------------------------------------------------------
For example, one such briefing took place on February 7,
1999, during an Enron Audit Committee meeting attended by all
of the Audit Committee members, four Andersen representatives,
and several senior Enron officers, including Mr. Lay and Mr.
Skilling.\28\ This Committee meeting took place in London,
during the first leg of a company-sponsored trip for Board
members to inspect Enron operations in England and India. It
was followed by a full Board meeting the next day. Audit
Committee Chairman Dr. Jaedicke presided over the meeting which
lasted about 90 minutes. The four Andersen representatives
present were Stephen Goddard, head of the Andersen office in
Houston; Douglas King, head of the Andersen office in London;
David Duncan, head of the Enron engagement team, and Thomas
Bauer, a senior member of the Enron engagement team.
---------------------------------------------------------------------------
\28\ Hearing Exhibit 2b (Audit Committee minutes from 2/7/99).
---------------------------------------------------------------------------
The Committee minutes report that, at the February 1999
meeting, Mr. Duncan reviewed Enron's 1998 financial statements,
audit and internal controls. The minutes state that Mr. Duncan
then ``reviewed selected observations by Arthur Andersen
including a risk profile analysis of accounting judgements,
disclosure judgements, and rule changes. He was joined in the
discussion by Mr. Bauer.'' \29\ In connection with its risk
profile of Enron, Andersen provided Audit Committee members
with a one-page document entitled, ``Selected Observations 1998
Financial Reporting.'' \30\ This document identified four
accounting issues at Enron: ``Highly Structured Transactions,''
``Commodity and Equity Portfolio,'' ``Purchase Accounting,''
and ``Balance Sheet Issues,'' three of which also had sub-
issues. Each issue was followed by a ``Risk Profile'' table
with three headings: ``Accounting Judgements,'' ``Disclosure
Judgements,'' and ``Rule Changes.'' The table then assigned an
``H,'' ``M,'' or ``L'' rating to each element of the Risk
Profile. The ``H'' stood for ``High,'' the ``M'' for
``Medium,'' and the ``L'' for ``Low.'' Each of the listed
accounting issues was followed by one, two, or three ``H's,''
meaning it was rated as high risk.
---------------------------------------------------------------------------
\29\ Hearing Exhibit 2b (Audit Committee minutes from 2/7/99) at 2.
\30\ Hearing Exhibit 2a, ``Selected Observations 1998 Financial
Reporting'' (Audit Committee presentation, 2/7/99).
---------------------------------------------------------------------------
Andersen's legal counsel told the Subcommittee staff that
this document was intended to inform the Audit Committee that
Enron was using a number of high risk accounting practices.
Andersen's legal counsel explained that this document was
intended to advise the Audit Committee that, even with
Andersen's backing, Enron's use of the identified accounting
practices invited accounting scrutiny and ran the risk that the
company could later be found to be in noncompliance with
generally accepted accounting principles. In addition,
Andersen's legal counsel indicated that the firm intended to
convey to the Audit Committee that Enron's use of highly
structured transactions, with multiple special purpose entities
and complex overlapping transactions, ran the risk that, if one
element failed, the entire structure might fail and cause the
company to fall into noncompliance.
Another document with the same heading, ``Selected
Observations 1998 Financial Reporting,'' was used by Mr. Duncan
as his personal talking points for the February 1999
briefing.\31\ This document lists nine accounting practices,
followed by a Risk Profile table using the same H, M, and L
system. Each of the identified accounting practices is followed
by one, two, or three ``H's,'' meaning each had been rated as a
high risk. A handwritten note by Mr. Duncan in the lower right-
hand corner of the document states:
---------------------------------------------------------------------------
\31\ Hearing Exhibit 3, ``Selected Observations 1998 Financial
Reporting'' (David Duncan talking points for Audit Committee
presentation, 2/7/99), a copy of which was not provided to the Audit
Committee during the meeting.
``Obviously, we are on board with all of these, but
many push limits and have a high `others could have a
different view' risk profile.'' \32\
---------------------------------------------------------------------------
\32\ Hearing Exhibit 3, ``Selected Observations 1998 Financial
Reporting'' (David Duncan talking points for Audit Committee
presentation, 2/7/99), a copy of which was not provided to the Audit
Committee during the meeting. See also Hearing Exhibit 4, prepared by
the Subcommittee, transcribing the handwritten note by David Duncan and
other information contained in Hearing Exhibit 3.
While Mr. Duncan did not make himself available in response to
a Subcommittee request to elaborate on this note, his colleague
Mr. Bauer confirmed through legal counsel that Mr. Duncan had
conveyed this information to the Audit Committee. In a letter
dated May 2, 2002, Mr. Bauer's legal counsel wrote the
---------------------------------------------------------------------------
following:
``As you requested, on behalf of Tom Bauer, a partner
in Arthur Andersen, I am responding to your inquiries.
. . . To the best of Mr. Bauer's knowledge, the
handwriting on the document . . . is the handwriting of
David Duncan. It reflects what Mr. Duncan and others
discussed at an Enron Audit Committee meeting held on
February 7, 1999. . . . The risk profile of Enron as
reflected in the document was discussed at that meeting
with and among the members of the Audit Committee and
the representatives of the Company who attended. . . .
Certain risk areas were described as `pushing the
limits', as reflected in Mr. Duncan's notes, or as
being `at the edge.' '' \33\
---------------------------------------------------------------------------
\33\ Hearing Exhibit 5, letter dated 5/2/02 from Bauer's legal
counsel to the Subcommittee.
In short, on February 7, 1999, Andersen informed the Audit
Committee members that Enron was engaged in accounting
practices that ``push limits'' or were ``at the edge'' of
acceptable practice. In the discussion that followed, Andersen
did not advocate any change in company practice, and no Board
member objected to Enron's actions, requested a second opinion
of Enron's accounting practices, or demanded a more prudent
approach.
The February 1999 meeting was not the only briefing in
which Andersen notified the Audit Committee that Enron was
engaged in high risk accounting practices. In fact, similar
briefings took place once or twice each year from 1999 through
2001, with similar presentations prepared by Andersen.\34\ The
presentations regularly identified high risk areas such as
Enron's use of highly structured transactions and related party
transactions. Minutes from an Audit Committee meeting in May
2000, for example, state: ``Mr. Duncan discussed the financial
reporting areas that [Andersen] had determined to be high
priorities due to inherent risks that were present. He stated
that the ongoing high priority areas included structured
transactions, the merchant portfolio, commodity trading
activities, project development activities and intercompany and
related party transactions.'' \35\ Handwritten notes on the
bottom of a 2001 presentation to the Audit Committee, added by
the Enron Corporate Secretary during the course of Andersen's
oral presentation, state: ``There are a number of areas where
accounting rules have not kept up w/ the Company's practices
and some interpretation is necessary.'' \36\ Andersen's legal
counsel representatives told the Subcommittee staff that each
presentation was intended to convey the same message to the
Audit Committee, that Enron was using high risk accounting
practices.
---------------------------------------------------------------------------
\34\ See Hearing Exhibit 6 (Audit Committee presentation, 5/3/99);
Hearing Exhibit 7a (Audit Committee presentation, 5/1/00); Hearing
Exhibit 8a (Audit Committee presentation, 2/12/01); and Hearing Exhibit
9 (Audit Committee presentation, 4/20/01).
\35\ Hearing Exhibit 7c (Audit Committee minutes from 5/1/00) at 2.
\36\ Hearing Exhibit 8a (Audit Committee presentation, 2/12/01).
---------------------------------------------------------------------------
Other internal Andersen documents offer additional proof
that Andersen viewed Enron as engaged in high risk accounting.
For example, most large auditing firms, including Andersen,
perform an annual client risk analysis to ensure the firm
understands each client and how much effort will be required in
an audit to ensure that the client complies with generally
accepted accounting principles. Andersen's 1999 and 2000 client
risk analyses placed Enron in its category for ``Maximum''
risk.\37\ The 2000 analysis, which was signed by David Duncan
and four other Andersen partners, identified several ``Risk
Drivers'' for Enron, including stating that Enron ``Management
Pressures'' were ``Very Significant'' and that the ``Accounting
and Financial Reporting Risk'' associated with Enron was also
``Very Significant.'' The analyses offered some specific
comments explaining the maximum risk rating, including the
following:
---------------------------------------------------------------------------
\37\ Hearing Exhibits 10a and 10b, excerpts from Andersen's 1999
and 2000 annual client risk analysis of Enron Corporation.
``Enron has aggressive earnings targets and enters into
numerous complex transactions to achieve those
---------------------------------------------------------------------------
targets.''
``The Company's personnel are very sophisticated and
enter into numerous complex transactions and are often
aggressive in structuring transactions to achieve
derived financial reporting objectives.''
``Form over substance transactions.''
An email dated February 6, 2001, sent to David Duncan and
Thomas Bauer by another Andersen partner, Michael D. Jones,
offers further proof that Andersen viewed Enron as engaged in
risky accounting. This email summarizes a meeting held the
previous day by 14 senior Andersen partners to decide whether
the firm should retain Enron as a client. The email indicates
that the group was aware of and uneasy about a number of
accounting practices and transactions at Enron. The email,
included in Hearing Exhibit 73, states:
``Significant discussion was held regarding the related
party transactions with LJM including the materiality
of such amounts to Enron's income statement and the
amount retained `off balance sheet'. The discussion
focused on Fastow's conflicts of interest in his
capacity as CFO and the LJM fund manager, the amount of
earnings that Fastow receives for his services and
participation in LJM, the disclosures of the
transactions in the financial footnotes, Enron's [Board
of Directors'] views regarding the transactions and our
and management's communication of such transactions to
the [Board of Directors] and our testing of such
transactions to ensure that we fully understand the
economics and substance of the transactions. . . . A
significant discussion was also held regarding Enron's
[mark-to-market] earnings and the fact that it was
`intelligent gambling'. . . . We discussed Enron's
dependence on transaction execution to meet financial
objectives, the fact that Enron often is creating
industries and markets and transactions for which there
are no specific rules which requires significant
judgement and that Enron is aggressive in its
transaction structuring. . . .
``Ultimately, the conclusion was reached to retain
Enron as a client citing that it appeared that we had
the appropriate people and processes in place to serve
Enron and manage our engagement risks.''
In a meeting prior to the May 7 hearing, Andersen's legal
counsel told Subcommittee staff that Andersen clearly
considered Enron to be engaged in high risk accounting. In
response to a question, one of Andersen's attorneys said that
it would be ``ridiculous'' to characterize Enron as engaged in
mainstream accounting.
During the hearing, Dr. Jaedicke, the former Audit
Committee Chairman, said that ``[w]e knew that the company was
engaged in high-risk and innovative transactions,'' but did not
recall being told that the company's accounting practices
``push limits.'' \38\ He testified:
---------------------------------------------------------------------------
\38\ Hearing Record at 30-31.
``David Duncan did tell us on several occasions that
these were complex transactions, that they were complex
structures, that Enron was a complex company. They were
moving very fast, and very careful accounting judgments
were required. . . . I do not recall him saying, well,
`others could have a different view.' But I think all
of us understood that these were highly structured, new
kinds of transactions, but . . . Enron paid Arthur
Andersen some pretty hefty fees, to try to be in on the
beginning of these transactions so that those
accounting judgments . . . would be properly made. . .
. Now, when we would ask them [Andersen], even in
executive session, about, OK, how do you feel about
these, the usual expression was one of comfort. It was
not, these are the highest risk transactions on our
scale of one to 10. . . .'' \39\
---------------------------------------------------------------------------
\39\ Id. at 29 and 32.
During their interviews, a number of Enron Board members
stated that Enron was engaged in complex accounting and was
operating in areas with few established accounting guidelines,
but most declined to characterize Enron's accounting as high
risk or aggressive. Mr. Blake characterized Enron as engaged in
``leading edge,'' not ``aggressive'' accounting. Lord Wakeham,
a chartered accountant and chairman of an audit committee at
another company, said that Enron was engaged in business
transactions that had ``not been done by many companies in the
world'' and were ``relatively new.'' He indicated that he
believed Enron's practices were within the bounds of generally
accepted accounting principles since they had been approved by
Andersen. He told the Subcommittee staff that he had believed
Andersen would stand by their accounting advice and was shocked
when, in 2001, Andersen began to reverse course and repudiate
the accounting methodologies and judgments it had earlier
provided.
Other Evidence of Board Awareness of Enron's High Risk
Accounting. In addition to the Audit Committee's receipt of
explicit briefings on Enron's high risk accounting practices,
many other documents demonstrate that the Board knowingly
allowed Enron to use high risk accounting techniques,
questionable valuation methodologies, and highly structured
transactions to achieve favorable financial statement results.
In April 2002, for example, Enron filed with the Securities
and Exchange Commission (SEC) an 8-K filing indicating that the
company had on its books assets that were overvalued by
billions of dollars, apparently due to questionable valuation
methodologies.\40\ In this filing, Enron announced its intent
to write-down $14 billion in the book value of its assets due
to ``historical carrying value[s]'' which ``may have been
overstated due to possible accounting errors or
irregularities'' and another $10 billion in ``downward
adjustments on certain price risk management assets and
collateral'' involving unspecified ``forwards, swaps, options,
energy transportation contracts utilized for trading activities
and other instruments with third parties.'' \41\
---------------------------------------------------------------------------
\40\ Form 8-K filed by Enron Corporation with SEC (4/22/02).
\41\ Id. at 2-3.
---------------------------------------------------------------------------
The evidence indicates that at least some of these
valuation issues were brought to the attention of Enron Board
members. For example, in 1999, Audit Committee members were
given a nine-page presentation on mark-to-market and fair value
accounting issues, and told how Enron divisions were expanding
their use of fair value accounting which ``require[d]
continuous revaluation of asset[s] and liabilities'' on Enron's
books.\42\ In May 2000, Board members were told about a dispute
between Enron divisions on how energy derivatives and contracts
should be valued on Enron's books and did not object when the
company decided to go with the more aggressive valuation
model.\43\ From 1999 through 2001, Board members were regularly
briefed about Enron's ``merchant assets,'' an accounting
classification that Enron used to justify recording on its
books a higher market value for certain assets, rather than a
lower, historical cost.\44\ Once Enron recorded the higher
market value, however, if that market value later fell, it is
unclear whether Enron would record the lower value. One
document provided to the Finance Committee in the summer of
2001, for example, lists Enron's international merchant assets
and indicates that they were overvalued on Enron's books by
$2.3 billion, compared to their market value as then determined
by Enron's own staff.\45\
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\42\ Hearing Exhibit 51 (Audit Committee presentation, 10/11/99),
Bates JW779-87, at 2.
\43\ Hearing Exhibit 28a (Finance Committee minutes, 5/1/00) at 4-
5.
\44\ See, for example, references to Enron's merchant assets or
merchant portfolio in Audit Committee presentations, Hearing Exhibit 2
(Audit Committee presentation, 2/7/99); Hearing Exhibit 6 (Audit
Committee presentation, 5/3/99); Hearing Exhibit 7a (Audit Committee
presentation, 5/1/00); Hearing Exhibit 7c (Audit Committee minutes, 5/
1/00) at 2; Hearing Exhibit 9 (Audit Committee presentation, 4/20/01);
as well as in Finance Committee presentations, Hearing Exhibit 56d
(Finance Committee minutes 12/13/99) at 2; Hearing Exhibit 56e (Board
minutes 12/14/99) at 4; Hearing Exhibit 28a (Finance Committee minutes,
5/1/00) at 4; and Hearing Exhibit 56k (Finance Committee minutes 2/12/
01) at 2.
\45\ Hearing Exhibit 71, ``Enron Global Assets and Services; Equity
Value Schedule'' (6/01), Bates E103411. Despite the huge valuation gap,
none of the interviewed Board members could recall either inquiring
into this difference or determining whether Enron's assets were
correctly valued in its financial statements. See also Watkins' letter
to Board Chairman Lay (8/15/01) at 1, attached to this report as
Appendix 2 on page 57. (``We do have valuation issues with our
international assets and possibly some of our EES [mark-to-market]
positions.'')
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Other documents, such as Board and Committee presentations
and Deal Approval Sheets (DASHs), routinely presented complex
structured transactions for Board approval, at times with
schematic charts mapping out multiple special purpose entities
and complex financing arrangements.\46\ When Enron presented
for Board approval the Rhythms and Raptors transactions, for
example, explained more fully below, Enron and Andersen
personnel explicitly told Board members that the proposed
transactions involved innovative uses of derivatives, Enron
stock, forward contracts, and off-the-books special purpose
entities.\47\ Finance Committee presentations also alerted
Board members to Enron's increasing use of ``Prepays'' and
``FASB 125 Sales,'' complex transactions that used
sophisticated accounting rules to add billions of dollars to
Enron's reported earnings and cash flow.\48\
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\46\ See, for example, Hearing Exhibit 15 (Whitewing), Hearing
Exhibit 19 (LJM1) and Hearing Exhibit 28b (Raptor I). See also, for
example, Hearing Exhibits 56d and 56e (Finance Committee minutes from
12/13/99 at 3; and Board minutes from 12/14/99 at 5).
\47\ During his Subcommittee interview, Mr. Blake stated that he
was told and had understood that the Raptor transactions involved
``very creative'' accounting. The Subcommittee staff was told by an
Enron employee who overheard it that Mr. Blake also commented to Mr.
Fastow that Enron ought to get ``a patent'' on the Raptor structures to
sell them to other companies.
\48\ See, for example, Hearing Exhibit 42, ``Finance Related Asset
Sales; Prepays and 125 Sales'' (Finance Committee presentation, 8/01),
showing dramatic increases in the dollar value of ``Prepays'' and
``FASB 125 Sales'' at Enron over a 3-year period. Total dollar value of
these transactions climbed from $6.7 billion in 1999, to $9.2 billion
in 2000, to $6.5 billion in the first 6 months of 2001. The
Subcommittee's analysis indicates that ``Prepays'' refers to prepaid
forward contracts under which, in essence, Enron received an advance
payment for a commitment to deliver a commodity, such as natural gas,
in the future. The evidence also indicates, however, that the forward
payments actually operated as loans that were disguised as trading
activity, in order to be booked as cash flow from operations rather
than debt on Enron's financial statements. FASB 125 is an accounting
rule intended to allow investment companies such as stock brokerages to
recognize earnings and cash flow from the sale of ``financial assets''
such as stock or mortgage backed securities. The Subcommittee analysis
indicates that ``FASB 125 Sales'' refers to Enron's practice of selling
a portion of its interest in a hard, physical asset like a power plant
to a third party; classifying the instrument used to convey that
interest as a ``financial asset'' under FASB 125; and then recognizing
immediate earnings and cash flow from the sale. Both types of
transactions raise numerous accounting issues.
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The Powers Report criticized Enron for engaging in
``significant transactions'' that were ``apparently designed to
accomplish favorable financial statement results, not to
achieve bona fide economic objectives or to transfer risk.''
\49\ The Powers Report also criticized Enron actions to
``conceal from the market very large losses resulting from
Enron's merchant investments'' and to ``circumvent accounting
principles'' through the use of complex transactions ``that
lacked fundamental economic substance.'' \50\ All of the Board
members interviewed by the Subcommittee staff denied approving
particular transactions or accounting practices for the reasons
described in the Powers Report. Yet numerous presentations
described or urged Board approval of transactions in light of
their favorable impact on Enron's financial statements. For
example:
---------------------------------------------------------------------------
\49\ Powers Report at 4.
\50\ Id. at 4-5.
---------------------------------------------------------------------------
--LLJM1 and LJM2, Mr. Fastow's private equity funds,
were lauded for producing over $2 billion in ``Funds
flow'' for Enron and over $200 million in Enron
``Earnings.'' \51\
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\51\ Hearing Exhibit 23, ``LJM2 Update'' (Finance Committee
presentation, 5/1/00).
--LA presentation identifying $2 billion in past and
planned Enron asset sales during 2000, primarily to
LJM2 and two other unconsolidated affiliates, Whitewing
and the Hawaii 125-0 Trust, is characterized as a
``2000 Balance Sheet Management'' effort.\52\
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\52\ Hearing Exhibit 17, ``EGF Execution Schedule; 2000 Balance
Sheet Management'' (Finance Committee presentation, 8/00). The document
indicated that about $1.5 billion of the $2 billion total involved
LJM2, Whitewing or Hawaii 125-0 Trust.
--LThe Board itself apparently set ``funds flow and
balance sheet ratio targets'' for Enron to achieve, as
shown by an Enron Global Markets presentation reporting
on the company's actual versus targeted
performance.\53\
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\53\ Hearing Exhibit 70, ``Enron's Funds Flow Targets'' (Enron
Global Markets presentation 3/01), Bates EC27671 (reporting on ``Enron
Corp. funds flow and balance sheet ratio targets set by the Board of
Directors versus actual results'').
--LEnron's 10 largest transactions in the second half
of 2000 are described to the Finance Committee in terms
of their balance sheet impact, producing ``Positive
Funds Flow,'' ``Debt reduction,'' or ``Balance Sheet
protection'' for the company.\54\
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\54\ Hearing Exhibit 60, ``Major Transactions; Largest 10
Transactions (June 30-December 31)'' (Finance Committee presentation,
12/11/00), Bates EC24832.
--LEven a tax matter, identified as the ``Tammy Tax
Advantaged Transaction,'' is explained to the Finance
Committee in terms of producing $500 million in ``Debt
reduction'' for the company.\55\
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\55\ Id. See also ``Enron's Other Strategy: Taxes; Internal Papers
Reveal How Complex Deals Boosted Profits by $1 Billion,'' Washington
Post (5/22/02), alleging 11 tax transactions at Enron were undertaken
to produce earnings or cash flow on Enron's financial statements.
Still another indicator of Enron's high risk accounting is
the long list of related entities disclosed in Enron's 10-K
filings for 1999 and 2000, which were approved and signed by
Enron Board members. These filings list almost 3,000 separate
entities, with over 800 organized in well-known offshore
jurisdictions, including about 120 in the Turks and Caicos, and
about 600 using the same post office box in the Cayman Islands.
No Board member who signed the 10-K filings expressed an
objection to or concern about Enron's thousands of related
entities or the complex transactions in which they were
involved.
When confronted by evidence of Enron's high risk
accounting, all of the Board members interviewed by the
Subcommittee pointed out that Enron's auditor, Andersen, had
given the company a clean audit opinion each year. None
recalled any occasion on which Andersen had expressed any
objection to a particular transaction or accounting practice at
Enron, despite evidence indicating that, internally at
Andersen, concerns about Enron's accounting were commonplace.
But a failure by Andersen to object does not preclude a finding
that the Enron Board, with Andersen's concurrence, knowingly
allowed Enron to use high risk accounting and failed in its
fiduciary duty to ensure the company engaged in responsible
financial reporting.
Finding (3): Despite clear conflicts of interest, the
Enron Board of Directors approved an unprecedented
arrangement allowing Enron's Chief Financial Officer to
establish and operate the LJM private equity funds
which transacted business with Enron and profited at
Enron's expense. The Board exercised inadequate
oversight of LJM transaction and compensation controls
and failed to protect Enron shareholders from unfair
dealing.
The Enron Board's decision to waive the company's code of
conduct and allow its Chief Financial Officer (CFO) Andrew
Fastow to establish and operate off-the-books entities designed
to transact business with Enron was also highly unusual and
disturbing. This arrangement allowed inappropriate conflict of
interest transactions as well as accounting and related party
disclosure problems, due to the dual role of Mr. Fastow as a
senior officer at Enron and an equity holder and general
manager of the new entities. Nevertheless, with little debate
or independent inquiry, the Enron Board approved three code of
conduct waivers enabling Mr. Fastow to establish three private
equity funds in 1999 and 2000, known as LJM1, LJM2 and
LJM3.\56\
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\56\ The initials ``LJM'' apparently refer to Mr. Fastow's wife and
children. Of the three LJM entities approved by the Enron Board, only
LJM1 and LJM2 became active. LJM1 was organized as a limited
partnership in the Cayman Islands and refers to a company named LJM
Cayman, L.P. LJM2 was organized as a Delaware limited partnership and
refers to a company named LJM2 Co-Investment, L.P. In each instance,
the entity that served as the general partner of LJM1 or LJM2 and was
responsible for running the equity fund on a day-to-day basis was
wholly owned by Mr. Fastow through a complex set of intermediaries.
LJM1 and LJM2 also each had a variety of limited partners, most of whom
were third party investors such as banks, pension funds, or insurance
companies who contributed capital to the fund. See Powers Report at 68-
74. In the case of LJM1, Mr. Fastow and five other Enron employees
later formed a partnership known as Southampton, L.P. and took
ownership of a key LJM1 subsidiary. Id. at 92-93.
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The Enron Board approved code of conduct waivers for Mr.
Fastow knowing that the LJM partnerships were designed to
transact business primarily with Enron, and controls would be
needed to ensure the LJM transactions and Mr. Fastow's
compensation were fair to Enron. The Board failed, however, to
make sure the controls were effective, to monitor the fairness
of the transactions, or to monitor Mr. Fastow's LJM-related
compensation. The result was that the LJM partnerships realized
hundreds of millions of dollars in profits at Enron's expense.
Enron's code of conduct for its employees expressly
prohibited Enron employees from obtaining personal financial
gain from a company doing business with Enron.\57\ This
prohibition could be waived, however, by the CEO upon a finding
that a proposed arrangement would ``not adversely affect the
best interests of the Company.'' \58\ In the case of the LJM
partnerships, Mr. Lay approved waiving the code of conduct
prohibition for Mr. Fastow, but also asked the Enron Board to
ratify his decision, even though Board concurrence was not
explicitly required by company rules.\59\ Evidence introduced
in the Andersen criminal trial indicates that the idea for
Board ratification may have originated with Andersen.
Apparently, a number of senior Andersen personnel, including
David Duncan, had serious concerns about the LJM proposal and
were reluctant to support it. Benjamin Neuhausen, a member of
Andersen's Professional Standard Group, wrote in a 5/28/99
email to David Duncan:
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\57\ See Hearing Exhibit 26, ``Enron Code of Ethics'' (7/00)
(``Business Ethics'') at 12:
``LEmployees of Enron Corp. . . . are charged with conducting
their business affairs in accordance with the highest ethical
standards. An employee shall not conduct himself or herself in a manner
which directly or indirectly would be detrimental to the best interests
of the Company or in a manner which would bring to the employee
financial gain separately derived as a direct consequence of his or her
employment with the Company.''
\58\ Hearing Exhibit 26 (``Conflicts of Interest, Investments, and
Outside Business Interests of Officers and Employees'') at 57:
``L[N]o 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.''
\59\ At the hearing, Mr. Winokur and Dr. Jaedicke contended that
the Board did not actually ``waive'' the company's code of conduct, but
``applied'' it in the LJM matters. Hearing Record at 17, 59-60.
However, all three LJM presentations explicitly request Board approval
of a code of conduct waiver. Hearing Exhibit 19, ``Project LJM Board
Presentation'' (``Waiver of Code of Conduct'') at 8; Hearing Exhibit
20, ``LJM 2 Summary'' (``Ratify decision of Office of the Chairman to
waive Code of Conduct in order to allow A. Fastow participation in LJM2
as General Partner''); Hearing Exhibit 56h, ``LJM3 presentation to the
Finance Committee,'' page entitled ``LJM3'' (``Ratify decision of
Office of Chairman to waive Code of Conduct in order to allow A. Fastow
involvement as General Partner of LJM''), Bates EC 25373-80 and RJ903.
``Setting aside the accounting, idea of a venture
entity managed by CFO is terrible from a business point
of view. Conflicts galore. Why would any director in
his or her right mind ever approve such a scheme?''
\60\
---------------------------------------------------------------------------
\60\ Hearing Exhibit 55, ``Defendant Andersen Exhibit 763,'' U.S.
v. Arthur Andersen (USDC SD Texas, Criminal Action No. H-02-0121).
---------------------------------------------------------------------------
Mr. Duncan responded in a 6/1/99 email as follows:
``[O]n your point 1 (i.e., the whole thing is a bad
idea), I really couldn't agree more. Rest assured that
I have already communicated and it has been agreed to
by Andy that CEO, General [Counsel], and Board
discussion and approval will be a requirement, on our
part, for acceptance of a venture similar to what we
have been discussing.'' \61\
---------------------------------------------------------------------------
\61\ Id. ``Defendant Andersen Exhibit 764.'' Andersen personnel
also had significant accounting-related concerns with LJM, in a number
of areas discussed in this email and other documents. One major concern
was that LJM was being established as a special purpose entity outside
of Enron's control, yet was to be managed by a senior Enron officer.
Mr. Fastow contended that LJM would not be under his or Enron's
control, because LJM's limited partners could remove him at will.
Andersen noted in an internal memorandum, however, that the limited
partners could remove him only if they obtained supermajorities in two
separate votes, which Andersen said ``was at the very upper limit of
what may be acceptable.'' Hearing Exhibit 59, ``Memorandum to the Files
by David Duncan and others'' (12/31/99, as amended 10/12/01), Bates
AASCGA(TX)1375-78, at 2. Andersen nonetheless eventually gave its
approval to the LJM partnerships.
Board Approval of LJM With Few Questions Asked. Board
approval proved easy to obtain. The first LJM presentation made
to the Board took place on June 28, 1999, at a special Board
meeting held by teleconference.\62\ The Board was told that
LJM1 would be set up as a special purpose entity that would not
be on Enron's balance sheet, and it would be owned in part and
managed by Mr. Fastow. Its first transaction, which was
presented to the Board for approval, involved a high tech stock
called Rhythms NetConnections, which Enron had purchased at the
company's initial public offering for $10 million and whose
value had skyrocketed to about $300 million. Enron had already
recognized the appreciation in the stock price as earnings on
its financial statements, and wanted to protect its income
statements from any loss if the stock price fell. The Board was
told that, through a novel and complicated transaction, LJM1
could provide a ``hedge'' on the Rhythms stock ``at no cost to
Enron.'' Better yet, LJM1 could pay Enron $50 million in cash
to do so, which the Board was reminded ``counts as funds
flow.'' The Board was also told that LJM1 would not be limited
to that single transaction, but could ``negotiat[e] with Enron
for purchase of additional merchant assets.'' \63\
---------------------------------------------------------------------------
\62\ Hearing Exhibit 19, ``Project LJM Board Presentation'' (6/28/
99).
\63\ Although some Board members described LJM1 as an entity that
engaged in a single transaction, LJM1 was designed to engage in
multiple transactions and did so. LJM1's ability to engage in multiple
transactions was made clear not only in the Board presentation, but
also in the Board minutes which state: ``In addition, LJM may negotiate
with the Company regarding the purchase of additional assets in the
Merchant Portfolio.'' The Board presentation also characterized LJM1 as
a possible ``Future Investment Management Company,'' and suggested that
LJM1 might be used to ``[c]apture Cuiaba/Electro value,'' referring to
investments Enron held in two other energy projects. LJM1, in fact,
entered into two additional multi-million dollar transactions involving
purchasing an interest in a Brazilian power plant owned and run by
Enron, and purchasing Osprey debt certificates from Whitewing which
LJM1 held for 3 months before selling them to Chewco. See also Powers
Report at 70.
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The Board members interviewed about this matter generally
acknowledged that the LJM1 transaction was unprecedented, both
because of the CFO's code of conduct waiver and the nature of
the Rhythms transaction which supposedly allowed LJM1 to hedge
a highly volatile stock at no cost to Enron and to pay Enron
$50 million as part of the hedging structure. Despite these
highly unusual features, the Board ratified the code of conduct
waiver and approved the LJM1 proposal with little study or
debate. For example, contrary to the Board's usual practice,
the LJM1 proposal was never reviewed by the Finance Committee
before it was submitted to the full Board for consideration. It
was presented to the Board itself for the first time in written
materials faxed to Board members 3 days before the special
meeting. During the meeting itself, Board discussion of the
proposal appears to have been minimal. The Board minutes show
that the special meeting considered a number of matters in
addition to the LJM1 proposal, including resolutions
authorizing a major stock split, an increase in the shares in
the company's stock compensation plan, the purchase of a new
corporate jet, and an investment in a Middle Eastern power
plant.\64\ Mr. Lay also discussed a reorganization underway at
Enron. Yet the entire meeting lasted 1 hour.\65\
---------------------------------------------------------------------------
\64\ Hearing Exhibit 56a (Board minutes 6/28/99).
\65\ Id.
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When asked why the Board moved so quickly on such an
unusual proposal, the Board members suggested during their
interviews that they had seen LJM1 as involving a single
transaction, the Rhythms stock ``hedge,'' for which the company
had obtained a fairness opinion from an outside accounting firm
and which involved little risk to Enron.\66\ At the hearing,
Dr. Jaedicke, former head of the Audit Committee, explained
that the Board meeting took place shortly before the close of
the second quarter reporting period in 1999, and the company
``did not want to be in the position of having a fair value
investment, a stock on their books, a mark-to-market [asset],
without a hedge.'' \67\ Enron obtained Board approval of LJM1's
formation and the Rhythms transaction on June 28, 2 days prior
to the end of the reporting period on June 30.
---------------------------------------------------------------------------
\66\ The evidence indicates, however, that the Board could not have
relied on the fairness opinion in deciding to move quickly in June
1999, because that opinion was not mentioned in the Board presentation
and was not provided by PriceWaterhouseCoopers until 2 months later--
after the transaction itself was completed. See draft fairness opinion
(8/13/99), Bates EC2 13298; and Hearing Exhibit 57 (final fairness
opinion 8/17/99), Bates AASCGA1949.2-49.6 (the final fairness opinion,
conveyed by letter from PriceWaterhouseCoopers, explicitly notes that
it is evaluating a completed transaction which became ``effective as of
June 30, 1999'').
\67\ Hearing Record at 61.
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About 3 months later, in October 1999, the Board was asked
to approve a second LJM partnership, LJM2, described as a
``[f]ollow-on private equity fund to LJM1.'' \68\ The
``purpose'' of creating LJM2 was described as providing a
``source of private equity for Enron to manage its investment
portfolio risk, funds flow, and financial flexibility.'' \69\
In his Subcommittee interview, Mr. Blake described LJM2 as an
``extension of Enron'' intended to serve as an ``empty bucket''
for Enron assets. He said that LJM2 was supposed to create ``an
internal Enron marketplace'' in which Enron business units
could sell Enron assets to Mr. Fastow's fund allegedly in
``arm's length'' negotiations at less cost and at a quicker
pace than would be possible in transactions with a completely
independent party. Due to Mr. Fastow's participation, the Board
was asked to ratify a second code of conduct waiver that would
allow him to set up and manage LJM2, hold an ownership interest
in the fund, locate additional investors and financing, and
receive compensation for his efforts.
---------------------------------------------------------------------------
\68\ Hearing Exhibit 20, ``LJM 2 Summary'' (10/11/99).
\69\ Id.
---------------------------------------------------------------------------
This time the LJM2 proposal went first to the Finance
Committee, which approved it in a 90-minute meeting on October
11, 1999, after what Mr. Winokur, the Committee Chairman,
described as ``a vigorous discussion.'' \70\ The following day,
Mr. Winokur recommended LJM2's approval to the full Board. The
Board approved it on October 12, 1999. Although Enron Board
members contend they routinely challenged Enron management
proposals, Mr. Fastow had apparently been so confident of Board
approval that he had already completed negotiations with
Merrill Lynch to develop an LJM2 marketing strategy and had
approved an LJM2 private placement memorandum which Merrill
Lynch released on October 13, 1999, 1 day after the Board
meeting scheduled to approve LJM2's formation.\71\
---------------------------------------------------------------------------
\70\ Hearing Record at 63.
\71\ Hearing Exhibit 21, ``LJM2 Co-Investment, L.P. Private
Placement Memorandum'' (10/13/99). See also Hearing Exhibit 58,
``Supplement Number One to Private Placement Memorandum'' (12/15/99),
Bates LJM58123, at 1.
---------------------------------------------------------------------------
No Board member recalled asking to see or actually
reviewing the private placement memorandum or other LJM2
marketing materials, either then or later. One Board member,
Robert Belfer, told the Subcommittee staff that he actually
received the memorandum in the mail, offering him the
opportunity to invest in LJM2, but threw it away without
reading it. At the hearing, Mr. Winokur testified that the
Finance Committee had been told that Enron's legal counsel,
Vinson & Elkins, had reviewed the memorandum and relied on the
law firm to alert the Board to any problems.\72\ He indicated
that Vinson & Elkins never told the Board anything was amiss,
which is why the Board never requested or reviewed the
material. Had the Board reviewed the memorandum, the Directors
would have learned that it named not only Mr. Fastow, but also
two other senior Enron financial officers as LJM2 principals,
Michael Kopper and Ben Glisan, both of whom worked for Mr.
Fastow and neither of whom had obtained a code of conduct
waiver to participate in LJM2. The memorandum also explicitly
touted the officers' inside access to Enron information and
``deal flow'' as selling points for the LJM2 fund.
---------------------------------------------------------------------------
\72\ Hearing Record at 64.
---------------------------------------------------------------------------
In October 2000, the Finance Committee and the full Board
approved the establishment of LJM3, with a third code of
conduct waiver and even less debate.\73\ That same month, LJM
issued its first annual report to its investors laying out its
activities and returns, but, again, no Enron Board member
requested or reviewed this report.\74\ Had they reviewed it,
the Board members would have learned that LJM claimed to be
making substantial profits from its deals with Enron and might
have reconsidered the conflicts of interest inherent in the
transactions.
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\73\ Hearing Exhibit 56h, ``LJM3 presentation to the Finance
Committee'' (10/6/00), Bates EC 25373-80.
\74\ Hearing Exhibit 25, ``LJM Investments Annual Partnership
Meeting'' (10/26/00).
---------------------------------------------------------------------------
At the Subcommittee hearing on May 7, all three of the
expert witnesses expressed surprise and dismay that the Enron
Board had approved the LJM arrangement in light of the clear
conflicts of interest. The arrangement essentially permitted
Enron's top financial control officer--an individual with
personal knowledge of Enron's assets, liabilities and profit
margins--to set up his own company and sit on both sides of the
table in negotiations between his business and his employer.
The expert witnesses could not recall a similar situation at
any other publicly traded company; nor could any Board member
identify a precedent for the Board's decision. The Powers
Report called the LJM arrangement ``fundamentally flawed.''
\75\ Mr. Campbell, former Chairman of the Board of a major
publicly traded company, told the Subcommittee staff that had
he been confronted with a similar proposal by a CFO, he would
have told the CFO ``no''; if the CFO managed to bring up the
proposal at a Board meeting he would have voted ``no''; and if
the Board had adopted the proposal over his objection, he would
have resigned from the Board the next day. But the interviewed
Enron Board members refused to acknowledge any lapse in
judgment. Most, in fact, defended the decision to authorize the
LJM partnerships and declared that they would support a similar
arrangement at another company if appropriate approvals and
controls were provided.\76\
---------------------------------------------------------------------------
\75\ Powers Report at 9.
\76\ See, for example, Hearing Record at 62, in which Dr. Jaedicke
testified that another board on which he serves considered authorizing
a similar outside equity fund to be run by a senior company officer.
Dr. Jaedicke testified that he was prepared to support this
arrangement, but did not actually have the chance to do so, because it
ultimately did not go forward.
---------------------------------------------------------------------------
Flawed Controls to Mitigate LJM Conflicts. Most of the
interviewed Board members said they had not been troubled by
the conflicts of interest posed by the LJM partnerships due to
the controls adopted to mitigate the conflicts. These controls
were intended to ensure the fairness of both the LJM
transactions with Enron and the amount of LJM-related
compensation paid to Mr. Fastow. But the evidence indicates
that these controls were poorly designed and implemented, and
the Board itself paid insufficient attention to the LJM
partnerships.
The Board relied on Enron management to develop and
implement the day-to-day controls needed to monitor LJM, and
limited its own oversight to less frequent and more generalized
reviews. The nature and extent of the LJM controls actually put
into place by Enron management varied over time. The original
LJM1 presentation in June 1999 did not specify any
controls.\77\ The LJM2 presentation in October 1999 specified
just one control--that Chief Accounting Officer Richard Causey
``approve all transactions between Enron and LJM.'' \78\ The
LJM3 presentation 1 year later, in October 2000, recited a
longer list of controls: Mr. Causey, Mr. Buy, and Mr. Skilling
would ``approve all Enron-LJM transactions''; the Audit
Committee would conduct an annual review of LJM transactions in
February; and Mr. Fastow's ``economic interest in Enron and
LJM'' would be presented to Mr. Skilling for his review.\79\ At
that same October 2000 meeting, the Finance Committee decided
to institute two more controls, to begin a quarterly review of
LJM transactions by the Finance Committee and to conduct a one-
time review of Mr. Fastow's LJM compensation by the
Compensation Committee.
---------------------------------------------------------------------------
\77\ Hearing Exhibit 19, ``Project LJM Board Presentation'' (6/28/
99).
\78\ Hearing Exhibit 20, ``LJM 2 Summary'' (10/11/99).
\79\ Hearing Exhibit 56h, ``LJM3 presentation to the Finance
Committee'' (10/6/00), Bates EC 25378. An LJM presentation to the Audit
Committee in early 2001, Hearing Exhibit 24, ``Review of LJM procedures
and transactions completed in 2000'' (2/12/01) at 2B-4, identified many
of the same controls as those listed in October 2000.
---------------------------------------------------------------------------
The Powers Report, which examined Enron management's actual
implementation of the day-to-day controls over the LJM
transactions, determined that the controls were structurally
flawed and poorly executed.\80\ On paper, prior to Enron's
engaging in a transaction with LJM, Enron personnel were
supposed to complete a Deal Approval Sheet (DASH) that set out
the major elements of the transaction and a LJM Approval Sheet
with a checklist of items intended to ensure arms-length
transactions and fair prices. These documents required
signatures from two or more high level Enron officials, such as
Mr. Causey, Mr. Buy, and Mr. Skilling. The Powers Report found,
however, that ``the process was not well-designed, and it was
not consistently followed.'' \81\ Some LJM transactions took
place without any DASH or LJM Approval Sheet, others relied on
a DASH or LJM Approval Sheet that did not contain the required
signatures, and still other deals were closed before the
documentation was completed.\82\ The Powers Report found that,
in at least 13 instances, the persons negotiating the Enron-LJM
deals--on both sides of the table--reported to Mr. Fastow, and
that Mr. Fastow, on occasion, ``pressur[ed]'' them ``to obtain
better terms for LJM.'' \83\
---------------------------------------------------------------------------
\80\ Powers Report at 165-66.
\81\ Id. at 170. See also Hearing Exhibit 61, internal Enron
memorandum from Jordan Mintz, legal counsel, to Mr. Buy and Mr. Causey
(3/8/01), criticizing LJM transaction approval process, Bates VEL524-28
(``[T]he Company needs to improve both the process it follows in
executing such transactions and implement improved procedures regarding
written substantiation supporting and memorializing the Enron/LJM
transactions. . . . [F]irst is the need for the Company to implement a
more active and systematic effort in pursuing non-LJM sales
alternatives before approaching LJM . . .; the second is to . . .
impose a more rigorous testing of the fairness and benefits realized by
Enron in transacting with LJM.'') (Emphasis in original.)
\82\ Powers Report at 170.
\83\ Powers Report at 166.
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The interviewed Board members told the Subcommittee staff
that, after the October 2000 meeting in which the Finance
Committee was told that Mr. Causey, Mr. Buy, and Mr. Skilling
would ``approve all Enron-LJM transactions,'' they assumed Mr.
Skilling was actively reviewing the Enron-LJM transactions. Mr.
Skilling testified at a House hearing, however, that he had
been unaware of any obligation to review the LJM transactions
and did not, as a matter of course, review them for fairness or
sign the relevant documents.\84\ Mr. Causey and Mr. Buy have
indicated that each reviewed the LJM transactions and signed
the relevant documents, but considered only narrow procedural
or risk issues; neither reviewed the transactions for their
overall fairness to Enron.\85\
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\84\ See Hearing before the U.S. House of Representatives
Subcommittee on Oversight and Investigations of the Committee on Energy
and Commerce (2/7/02) (hereinafter ``House Hearing'') (Mr. Skilling:
``I was not required to approve those transactions.''). The minutes
indicate that Mr. Skilling was present at the October 2000 Finance
Committee meeting when Mr. Fastow stated that Mr. Skilling, as well as
Mr. Causey and Mr. Buy, were reviewing the LJM transactions, but Mr.
Skilling testified that he did not recall hearing that statement at the
meeting. The LJM Approval Sheets frequently listed Mr. Skilling as a
required signatory, and Enron's legal counsel Jordan Mintz attempted on
several occasions to obtain Mr. Skilling's actual signature for
particular LJM transactions, but was unsuccessful. Mr. Skilling
testified at the House hearing that he never received the documents to
sign them. Mr. Mintz' March 2001 memo, cited above, Hearing Exhibit 61,
called for ``[b]etter contemporaneous involvement by the [Office of the
Chairman] regarding review and approval of Enron's transacting with
LJM, i.e. sign-off by Jeff Skilling on a more regular basis.'' See also
Powers Report at 169 (``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.'')
\85\ See Powers Report at 168.
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The LJM compensation controls at Enron were even more
haphazard. The Subcommittee is unaware of any standard form or
procedure that was developed by Enron management to review Mr.
Fastow's compensation, and it is unclear whether any
compensation review ever took place by any Enron officer.\86\
During their interviews, many Board members indicated that the
Board had assumed Mr. Skilling, who was Mr. Fastow's immediate
supervisor, was reviewing Mr. Fastow's LJM compensation. Mr.
Skilling has indicated, however, that he never examined or
requested specific information about Mr. Fastow's actual LJM
compensation.\87\
---------------------------------------------------------------------------
\86\ See discussion in Powers Report at 163-65.
\87\ See House Hearing (2/7/02), in which Mr. Skilling testified
that the only LJM compensation review he performed was in October 2000,
after a Board meeting directing him to review Mr. Fastow's ``economic
interest'' in the company. Mr. Skilling testified that, in response to
the Board request, he reviewed a handwritten document provided by Mr.
Fastow projecting his possible LJM returns over a 5-year period using
certain assumptions, the 5-year total of which Mr. Skilling recalled
was ``something on the order of $5 million.'' When asked whether it was
true that Mr. Fastow had already obtained $30 million from LJM in its
first year of operation, Mr. Skilling testified, ``I don't know. . . .
I have no first-hand knowledge of that.'' See also Powers Report at
164-65.
---------------------------------------------------------------------------
The Powers Report concludes that the LJM controls ``were
not effectively implemented by Management, and the conflict [of
interest] was so fundamental and pervasive that it overwhelmed
the controls as the relationship progressed.'' \88\
---------------------------------------------------------------------------
\88\ Powers Report at 171.
---------------------------------------------------------------------------
Inadequate Board Oversight of LJM Transactions With Enron.
The Enron Board failed to uncover the deficiencies in the LJM
controls or to make up for them through its own oversight
efforts.
The Audit Committee was charged by the Board with
performing an annual review of the LJM transactions. This task
was apparently assigned to the Audit Committee, because its
charter included ensuring compliance with Enron's code of
conduct and the LJM transactions were being reviewed to ensure
that Mr. Fastow was complying with his fiduciary obligations to
Enron.
On paper, the Audit Committee conducted two annual reviews
of LJM transactions in February 2000 and February 2001. In
reality, these reviews were superficial and relied entirely on
management representations with no supporting documentation or
independent inquiry into facts. At the first review in 2000,
the Audit Committee was given a single sheet of paper listing
the names of eight transactions that LJM had entered into with
Enron in 1999.\89\ The only information provided for each
transaction was the name of the ``investment,'' the
transaction's approximate dollar value, and a description of
the transaction in ten words or less. The Committee spent
between 15 and 30 minutes reviewing the list with Mr.
Causey.\90\ The Audit Committee did not go into the details of
any specific transaction, nor did it review any Deal Approval
Sheet (DASH) or LJM Approval Sheet, even though these documents
were typically only a few pages long and would have provided
key information. In fact, the Audit Committee members admitted
they never requested or reviewed a single DASH or LJM Approval
Sheet for any LJM transaction with Enron.\91\
---------------------------------------------------------------------------
\89\ Hearing Exhibit 22, ``LJM Investment Activity 1999'' (2/7/00).
\90\ Hearing Record at 66-67; Subcommittee interviews of Audit
Committee members. See also Powers Report at 162 (``the reviews were
brief, reportedly lasting 10 to 15 minutes'').
\91\ Hearing Record at 71; Subcommittee interviews of Audit
Committee members; House Hearing (2/7/02) (testimony by Dr. Jaedicke).
---------------------------------------------------------------------------
The Audit Committee's second review of LJM transactions was
equally cursory. In February 2001, the Audit Committee received
a two-page list of LJM transactions in 2000, again with minimal
information, and again spent between 15 and 30 minutes going
over it with Mr. Causey.\92\ Twelve LJM transactions with Enron
were listed. The only information provided for each transaction
was the name of the ``investment,'' a dollar value, and a short
description of the transaction.\93\ Again, no DASH or LJM
Approval Sheet was requested or reviewed by any Audit Committee
member.
---------------------------------------------------------------------------
\92\ Hearing Exhibit 24, ``Review of LJM procedures and
transactions completed in 2000'' (2/12/01).
\93\ The largest transaction on the list involved ``$127 million''
and was identified as ``Raptors I, II, III, IV''--a particularly
interesting description, since the Board has steadfastly maintained it
knew of only three Raptor transactions and was never informed of the
Raptor involving Enron's warrants for stock in The New Power Company
(TNPC). See, for example, Hearing Record at 15; Powers Report at 116.
Had the Audit or Finance Committee asked why four Raptors were listed,
the Board might have learned of the Raptor transaction involving
Enron's TNPC stock.
---------------------------------------------------------------------------
The Finance Committee also looked at LJM on several
occasions. In May 2000, the Finance Committee received a
general ``LJM2 Update'' reciting the overall benefits that LJM2
had provided to Enron in its first 6 months of operation.\94\
This update reported that LJM2 had produced over $2 billion in
``Funds flow'' for Enron, over $200 million in ``Earnings,''
and ``8 days/6 deals/$125 million'' for Enron in the fourth
quarter of 1999. Although these figures are remarkable for any
new business, there was apparently no discussion of how LJM2
was able to produce such large benefits for Enron in so short a
time period. The update also reported that LJM2 had a projected
internal rate of return of about 18 percent. This figure is
much less than the 69 percent that LJM would claim in its
October report to investors, but, as mentioned earlier, the
Board members relied on Enron management for its information on
LJM and none requested or reviewed a copy of LJM's first annual
report.\95\
---------------------------------------------------------------------------
\94\ Hearing Exhibit 23, ``LJM2 Update'' (5/1/00).
\95\ Compare Hearing Exhibit 23, the LJM2 presentation to the
Finance Committee on 5/1/00, with Hearing Exhibit 25, LJM's
presentation to its own investors at its first annual partnership
meeting on 10/26/00.
---------------------------------------------------------------------------
Several directors noted that the May 2000 update given to
the Finance Committee also contained a handwritten note by the
Corporate Secretary stating that Mr. Fastow had indicated he
was spending only 3 hours per week on LJM matters. They said
this figure left the impression that Mr. Fastow was not earning
much money from the operation and that LJM was not very active.
Yet this impression is in direct contrast to the information in
the update itself which reports $2 billion in funds flow for
Enron and $200 million in earnings. One Board member, Mr.
Blake, indicated during his interview that he had taken special
note of the $2 billion figure, which made him well aware of LJM
and its importance to Enron, yet neither he nor any other
director asked how LJM was able to produce such huge funds flow
with such minimal effort by Mr. Fastow.
In October 2000, when LJM3 was proposed to the Finance
Committee, the presentation included another general update on
the benefits that the LJM partnerships were providing to
Enron.\96\ LJM1 was described as having provided ``a gain of
approximately $175 million for Enron'' and the purchase of a
``minority interest in Cuiaba so that Enron could deconsolidate
the project.'' LJM2 was described as having invested over $400
million in 21 transactions with Enron. It was after receiving
this update, showing multiple high dollar transactions, that
the Finance Committee decided to impose the two additional
controls--a quarterly review of LJM transactions by the Finance
Committee, which was to be in addition to the annual Audit
Committee review, and a one-time review of Mr. Fastow's
compensation by the Compensation Committee.
---------------------------------------------------------------------------
\96\ Hearing Exhibit 56h, ``LJM3 presentation to the Finance
Committee'' (10/6/00), Bates EC 25373-80.
---------------------------------------------------------------------------
The Subcommittee learned, however, that the Finance
Committee subsequently conducted only one quarterly review of
LJM transactions, which took place in February 2001. This
review was as superficial as that conducted by the Audit
Committee. The Finance Committee used the same two-page list of
LJM transactions as the Audit Committee and spent about the
same amount of time on the document.\97\ There was no detailed
discussion of the transactions, and no Finance Committee member
could recall seeing any DASH or LJM Approval Sheet for any LJM
transaction, even though some exceeded the $25 million
threshold for DASHs provided to the Finance Committee for
review.\98\
---------------------------------------------------------------------------
\97\ Hearing Exhibit 24, ``Review of LJM procedures and
transactions completed in 2000'' (2/12/01).
\98\ Hearing Record at 71; Subcommittee interviews of Finance
Committee members; House Hearing (2/7/02) (Mr. Winokur: ``We saw DASH
sheets, but never the LJM approval sheets. And we didn't see DASH
sheets that related to the LJM transactions, to the best of my
knowledge.'').
---------------------------------------------------------------------------
The Finance Committee did not conduct any other quarterly
review of LJM transactions. When asked why the Finance
Committee did not conduct a quarterly review at the next
Finance Committee meeting in May 2001, Mr. Winokur indicated
that he had not received a quarterly report from Enron and had
assumed without checking that no LJM transactions had
occurred.\99\ When asked why the Finance Committee did not act
at the next meeting in August 2001, Mr. Winokur said that he
was told at the August meeting that Mr. Fastow had sold his
interest in the LJM partnerships in June, the ``related party
aspect'' of the LJM transactions had disappeared, and no more
reviews were necessary.\100\ Mr. Winokur admitted, however,
that neither he nor any other Board member had inquired about
who bought Mr. Fastow's interest in LJM, in order to verify
that no conflict of interest remained.
---------------------------------------------------------------------------
\99\ Id. at 72.
\100\ Id. at 71. Fastow actually sold his LJM interest in July
2001. See Hearing Exhibit 38c, excerpt from Enron's 10-Q filing for the
third quarter of 2001 (11/19/01) at 1; Powers Report at 73.
---------------------------------------------------------------------------
In fact, in a puzzling display of disinterest, none of the
interviewed Board members recalled making any inquiry into
LJM's new ownership despite LJM's having just generated $2
billion in funds flow for the company. Had anyone inquired,
they would have learned that the new owner of LJM2 was Mr.
Fastow's former top staffer, Michael Kopper, whose personal
knowledge of Enron finances and longstanding close association
with Mr. Fastow raised a similar set of conflicts of interest
concerns.\101\ Mr. Winokur testified at the hearing that, had
he known of Mr. Kopper's role, he ``would have wanted to
continue the reviews'' to ensure LJM's dealings with Enron were
fair.\102\
---------------------------------------------------------------------------
\101\ Mr. Kopper had been an Enron employee, working for Mr.
Fastow, until he resigned in July 2001, after purchasing Mr. Fastow's
stake in LJM2. Mr. Kopper had also been actively involved with JEDI,
Chewco and LJM1.
\102\ Hearing Record at 73.
---------------------------------------------------------------------------
Inadequate Board Oversight of Fastow's LJM Compensation.
The Board's role in overseeing Mr. Fastow's LJM compensation
was even more lax. For the first year, the Board apparently
relied on Mr. Skilling to review Mr. Fastow's LJM-related
income and asked no questions. In October 2000, after LJM1 had
been operating for more than 1 year and the Finance Committee
was told that LJM1 and LJM2 were engaging in multiple, high
dollar transactions with Enron, the Finance Committee asked the
Compensation Committee to conduct a one-time review of Mr.
Fastow's compensation.
Dr. LeMaistre, then Chairman of the Compensation Committee,
was present at the Finance Committee meeting, and attempted to
obtain the requested information on Mr. Fastow's LJM
compensation. He indicated during his interview and at the
hearing that, after the Finance Committee meeting, he asked
Enron's senior compensation officer, Mary Joyce, to provide him
with information on the outside income of all of Enron's
``16(b) officers,'' a reference to top company officials
identified according to an SEC regulation.\103\ He said during
his Subcommittee interview that he did not specifically name
Mr. Fastow to Ms. Joyce because he did not want to start any
office gossip. Ms. Joyce did not provide him with the
information he requested. He said that he asked her a second
time to obtain the information, but she again did not do so. He
admitted that he never actually named Mr. Fastow to her or
insisted that she obtain information about his LJM
compensation. Instead, Dr. LeMaistre let the matter drop.
---------------------------------------------------------------------------
\103\ Hearing Record at 68-69.
---------------------------------------------------------------------------
At the hearing, Subcommittee Chairman Levin and Dr.
LeMaistre had the following exchange.
``Dr. LeMaistre: I asked Mary Joyce about it.
Sen. Levin: And what did she tell you?
Dr. LeMaistre: She said she did not have the
information.
Sen. Levin: Did you say, well, I want it?
Dr. LeMaistre: She knew that I wanted it . . .
Sen. Levin: Did you get it?
Dr. LeMaistre: I did not.
LSen. Levin: This is the heart of the problem. You have
got a Board that says, I want it. You have got a
request for it. It does not come and you do nothing.
That is an approach which is unacceptable for a
Board.'' \104\
---------------------------------------------------------------------------
\104\ Id. at 68.
One year later, despite the Finance Committee's directive,
Dr. LeMaistre had not obtained any information about Mr.
Fastow's LJM compensation. Nor had any other Board member taken
any steps to obtain this information. In October 2001, a Wall
Street Journal article was published detailing Enron's
transactions with LJM and alleging that Mr. Fastow had received
compensation from LJM business transactions in excess of $7
million.\105\
---------------------------------------------------------------------------
\105\ Hearing Exhibit 44b, ``Enron CFO's Partnership Had Millions
in Profit,'' Wall Street Journal (10/19/01).
---------------------------------------------------------------------------
In response, the Board directed two of its members, Dr.
LeMaistre and John Duncan, to telephone Mr. Fastow and obtain
information about his LJM investment and compensation. During
his interview, Dr. LeMaistre told the Subcommittee staff that
he asked the General Counsel of Enron, James Derrick, to draft
specific questions for him to use in his conversation with Mr.
Fastow. Mr. Derrick faxed a document with the questions to Dr.
LeMaistre, who was then in Colorado.\106\ After changing the
order of the sentences to put the reference to ``[w]e very much
appreciate your willingness to visit with us'' first, Dr.
LeMaistre told the Subcommittee that he used the document as a
script in his conversation with Mr. Fastow, as follows:
---------------------------------------------------------------------------
\106\ Hearing Exhibit 24b, script and handwritten notes of
conversation between Dr. LeMaistre, John Duncan, and Mr. Fastow in
October 2001. John Duncan was in Houston during the telephone call with
Mr. Fastow and did not request or use the document faxed to Dr.
LeMaistre.
``We very much appreciate your willingness to visit
with us. Andy, because of the current controversy
surrounding LJM I and LJM II, we believe it would be
helpful for the Board to have a general understanding
of the amount of your investment and of your return on
investment in the LJM entities. We understand that a
detailed accounting of these matters will soon be done
in connection with the response to the SEC inquiry. In
responding to our questions with respect to your
interest in the LJM entities, we would appreciate your
including any interest . . . that the members of your
family may have had in the entities.'' \107\
---------------------------------------------------------------------------
\107\ Hearing Exhibit 24b.
When Chairman Levin asked Dr. LeMaistre why his tone was so
deferential to Mr. Fastow, Dr. LeMaistre said that the language
had been drafted by legal counsel and he was concerned about
seeking information from a special purpose entity that was
supposed to be separate from Enron.
Dr. LeMaistre's handwritten notes on the document indicate
that Mr. Fastow admitted receiving LJM compensation totalling
$45 million, $23 million from LJM1 and $22 million from LJM2. A
handwritten note in the margin of the document states
``incredible,'' which Dr. LeMaistre said was his reaction to
the compensation total, which was much greater than he had been
expecting. Dr. LeMaistre also noted that Mr. Fastow declined to
provide information related to his LJM investment return and
promised to provide that information the next day. Mr. Duncan
said during his interview that when Mr. Fastow failed to
telephone with the information at the time promised, Mr. Duncan
called him and was told by Mr. Fastow that he had not had the
chance to obtain the requested information and would provide it
later. Mr. Fastow apparently never provided that information to
the Board.
Dr. LeMaistre and Mr. Duncan reported the October 23
conversation to the other Board members in a telephone Board
meeting the next day. The other directors expressed surprise at
the large amount of compensation, and the decision was made to
place Mr. Fastow on leave immediately. Mr. Fastow was placed on
leave on October 24, 2001.
During his interview, Dr. LeMaistre noted that he asked Mr.
Fastow whether any Enron employee other than Mr. Fastow and Mr.
Kopper had ``any economic interest in or derive[d] any benefit
from'' the LJM partnerships.\108\ He said that Mr. Fastow had
replied ``no,'' which the Board later discovered to be untrue.
He and other Board members said that it was during the Powers
investigation that they first learned of the Southampton
partnership, which Mr. Fastow had established with five other
Enron employees to invest in LJM1 and enabled these additional
Enron employees to benefit financially at Enron's expense.
---------------------------------------------------------------------------
\108\ Id.
---------------------------------------------------------------------------
LJM Profits at the Expense of Enron. Records indicate that
LJM was a very profitable venture. Its 2000 annual partnership
meeting report boasts of 23 investments with Enron and a 69
percent rate of return in its first year of operation, which
Enron Board members with investment experience told the
Subcommittee staff was a very high rate of return.\109\ These
Board members observed that all of LJM's transactions with
Enron had turned a profit for LJM, which they said was also
unusual for an equity fund. According to LJM, some of the
transactions, such as the Raptors, had produced returns as high
as 2,500 percent. Mr. Fastow told the Board that he had earned
$45 million on a $5 million investment in LJM1 and LJM2 in just
2 years.\110\ Other Enron employees also admitted to
significant LJM returns in a short period, including two who
received immediate returns of $1 million each on individual
investments of $5,800.\111\
---------------------------------------------------------------------------
\109\ Hearing Exhibit 25, ``LJM Investments Annual Partnership
Meeting'' (10/26/00). For example, both Mr. Belfer and Mr. Savage
described the LJM returns as unusually lucrative.
\110\ Hearing Exhibit 24b, script and handwritten notes of
conversation between Dr. LeMaistre, John Duncan, and Mr. Fastow in
October 2001.
\111\ These Enron employees were members of the Southampton
partnership that purchased LJM1's key subsidiary. Powers Report at 93
and 95.
---------------------------------------------------------------------------
LJM transacted business with essentially one company,
Enron, which meant that virtually all of its profits were at
Enron's expense.\112\ Its purchase of Enron assets was, on more
than one occasion, followed by an Enron buyback at a higher
price.\113\ Its investment in Enron's Osprey and Yosemite
projects earned LJM lucrative returns on projects
collateralized with Enron stock. When Enron unwound the Rhythms
transaction with LJM1, Enron paid LJM1 a $30 million
termination fee, even though the Rhythms ``hedge'' should have
resulted in LJM1's paying Enron millions of dollars.\114\ The
same thing happened when Enron unwound the Raptors; Enron paid
LJM2 a termination fee of $35 million, even though the poor
performance of the assets ``hedged'' in the Raptors should have
resulted in LJM2's paying money to Enron. Instead, Enron
recorded a $710 million loss in earnings and a $1.2 billion
reduction in shareholder equity.\115\ While Enron appeared to
benefit in the near-term from its dealings with LJM, its
benefits were primarily paper gains in the form of increased
funds flow, lower debt levels, and inflated earnings on its
financial statements. In the long-term, it was LJM that
benefited financially at Enron's expense.
---------------------------------------------------------------------------
\112\ The Subcommittee has identified only two LJM transactions, in
August and September of 2000, that were with a counterparty other than
Enron.
\113\ For example, in 1999, LJM1 purchased an interest in the
Cuiaba power plant project in Brazil which allowed Enron to move the
project off its balance sheet while recognizing certain earnings. In
2001, Enron repurchased LJM's interest at a much higher price,
notwithstanding the project's having experienced in the interim severe
construction problems, cost overruns and legal difficulties.
\114\ The Powers Report describes this termination payment as a
``huge windfall'' for LJM1. Powers Report at 89.
\115\ See Hearing Exhibit 27, ``The Raptors,'' prepared by the
Subcommittee. See also Powers Report at 129.
---------------------------------------------------------------------------
Board members justified allowing Mr. Fastow to manage and
own an equity stake in the LJM partnerships in part by
stressing the controls established to ensure that his and LJM's
dealings with Enron would be fair. But those controls were
poorly implemented, and the Board itself exercised poor
oversight of LJM's transactions and Mr. Fastow's compensation.
The result was that hundreds of millions of dollars that should
have stayed with Enron shareholders instead lined the pockets
of LJM investors and Mr. Fastow.
A number of Board members claimed that the Board had been
misled or misinformed regarding key aspects of the LJM
partnerships. For example, Board members said they were not
told how many Enron employees held ownership interests in LJM,
how much time Enron employees were spending on LJM deals as
representatives of LJM, how many deals LJM had underway with
Enron, how the deals were being negotiated, and how much profit
LJM was making at Enron's expense. While the evidence seems to
bear out the claims that the Board did not have complete
information about LJM's owners, employees, transactions and
profits, the facts also establish that the Board members were
given ample information about the conflicts of interest
underlying the LJM partnerships, the many related party
transactions that went on between LJM and Enron, and the huge
amounts of money flowing through the LJM structures. The
information it had should have triggered a demand for more
detailed information and, ultimately, a change in course. But
the Board allowed the LJM-Enron transactions to go forward with
few questions asked. All of the consequences that followed,
including the Raptor debacle, flowed from the initial Board
decision to allow the LJM partnerships. While the Board was
advised that Enron management and Andersen supported going
forward, the final decision on whether to allow Mr. Fastow to
form, manage and profit from the LJM partnerships rested with
the Board itself. The Board cannot shift the responsibility for
that decision to any other participant in the Enron tragedy.
Finding (4): The Enron Board of Directors knowingly
allowed Enron to conduct billions of dollars in off-
the-books activity to make its financial condition
appear better than it was, and failed to ensure
adequate public disclosure of material off-the-books
liabilities that contributed to Enron's collapse.
Enron's multi-billion dollar, off-the-books activity was
disclosed to the Enron Board and received Board approval as an
explicit strategy to improve Enron's financial statements. In
fact, Enron's massive off-the-books activity could not have
taken place without Board action to establish new special
purpose entities, issue preferred Enron shares, and pledge
Enron stock as the collateral needed for the deals to go
forward. In the end, the Board knowingly allowed Enron to move
at least $27 billion or almost 50 percent of its assets off-
balance-sheet.\116\
---------------------------------------------------------------------------
\116\ Hearing Exhibit 39, ``Private Equity Strategy'' (Finance
Committee presentation, 10/00).
---------------------------------------------------------------------------
During their interviews, only one Board member expressed
concern about the percentage of Enron assets that no longer
appeared on the company balance sheet; the remaining Board
members expressed little or no concern. At the May 7 hearing,
the three accounting and corporate governance experts testified
that they were unaware of any other public company with such a
high percentage of its assets off-balance-sheet. Mr. Sutton,
former SEC chief accountant, said his ``experience is that
Enron is at the top of the scale in terms of the extent'' of
its off-the-books activity.\117\ Mr. Campbell, who has
extensive corporate and Board experience, testified that he
``had never seen that amount, proportion of a company's assets
on off-balance-sheet. Sometimes it is appropriate to have some
items off-balance-sheet . . . but never to that extent.'' \118\
---------------------------------------------------------------------------
\117\ Hearing Record at 104.
\118\ Id.
---------------------------------------------------------------------------
Whitewing. The Board's awareness and approval of Enron's
off-the-books corporate strategy is illustrated by its years-
long involvement in the establishment, financing, and use of
Whitewing.
Whitewing was established by Enron, run by Enron personnel,
and dealt exclusively with Enron in its business transactions.
Whitewing changed its status over time from a consolidated to
an unconsolidated Enron affiliate. From late 1999 until 2001,
Enron pledged preferred stock and promissory notes valued at
nearly $2.5 billion as collateral for Whitewing debt, and
Whitewing purchased over $2 billion in Enron assets.
Documentation reviewed by the Subcommittee shows that the Enron
Board was informed, consulted, and exercised ongoing oversight
of Whitewing, with full awareness of its increasing use as an
off-the-books vehicle that Enron used to enhance its financial
statements.
Whitewing and its related entities, such as Nighthawk and
Osprey, are repeatedly mentioned in Board minutes and
presentations.\119\ In December 1997, minutes from a Board
meeting show Board approval of the establishment of Whitewing
as a business entity which was to be 50 percent owned by Enron
and 50 percent owned by Nighthawk, a new special purpose entity
set up for outside investors. The Board approved Enron's
contributing to Whitewing $500 million in cash and Enron stock
(later increased to $560 million), which Nighthawk investors
matched with a contribution of $500 million in cash, most of
which was borrowed from a Citibank-related entity.\120\ The
Board also approved issuance of $1 billion in Enron convertible
preferred shares to be sold to Whitewing in exchange for the
cash and Enron stock. Because Enron gave Whitewing preferred
shares rather than a promissory note, Enron characterized the
$500 million in cash that Whitewing received from the Nighthawk
investors as an equity investment, rather than a loan. In
addition, because at that time Whitewing was a consolidated
affiliate included in Enron's financial statements, Enron was
able to use the $500 million for ``general corporate purposes''
without showing any new debt on its balance sheet.
---------------------------------------------------------------------------
\119\ Hearing Exhibit 11, ``Specific References to Whitewing/
Nighthawk/Osprey in Enron's Board/Committee Presentations,'' prepared
by the Subcommittee.
\120\ Hearing Exhibit 12 (Board minutes from 12/9/97) and Hearing
Exhibit 15 (Whitewing/Nighthawk/Osprey materials faxed to Board members
on 9/17/99 for special Board meeting the same date).
---------------------------------------------------------------------------
About 1 year later, in February 1999, Board minutes show
that the Board approved a resolution to expand Whitewing's
capacity to purchase Enron assets.\121\ In September 1999, the
Board approved a resolution to restructure Whitewing as an
``unconsolidated affiliate'' that could be removed from Enron's
books.\122\ At the same time, the Board approved establishment
of a special purpose entity called the Osprey Trust to invest
in Whitewing, and authorized Osprey to issue $1.4 billion in
debt instruments that could be secured by a second series of
Enron preferred shares. By taking this action, the Board
simultaneously moved Whitewing off Enron's balance sheet, while
pledging Enron stock to secure Whitewing's debt. These debt
instruments were subsequently sold to investors as bonds paying
an 8 percent return, collateralized with Enron stock. Whitewing
then used the funds to purchase Enron assets, injecting
substantial cash into Enron which, in turn, reported that cash
on its financial statements as funds flow from asset sales and
investments.
---------------------------------------------------------------------------
\121\ Hearing Exhibit 13 (Board minutes from special meeting on 2/
1/99).
\122\ Hearing Exhibit 14 (Board minutes from special meeting on 9/
17/99) and Hearing Exhibit 15 (Whitewing/Nighthawk/Osprey materials
faxed to Board members on 9/17/99 for special Board meeting the same
date).
---------------------------------------------------------------------------
Altogether, Whitewing entered into at least 11 transactions
with Enron from 1999 through 2001, to buy at least $2 billion
worth of Enron assets.\123\ These sales were part of Enron's
``asset light'' strategy to reduce debt levels on its financial
statements and move assets with relatively low returns into
unconsolidated affiliates that Enron effectively controlled.
---------------------------------------------------------------------------
\123\ Hearing Exhibit 16, ``Whitewing, 1997-2001,'' prepared by the
Subcommittee.
---------------------------------------------------------------------------
Board and Committee presentations show that the Board
continued to monitor and support Enron transactions with
Whitewing and Osprey throughout 2000 and 2001. A Finance
Committee presentation in August 2000, for example, reported
$561 million in Enron asset sales to Whitewing, with plans for
additional sales of $389 million.\124\ Whitewing is described
in the document as an ``[o]ff balance sheet vehicle to purchase
assets from Enron.'' An Enron Deal Approval Sheet (DASH), given
to Finance Committee members the same month reported
refinancing Enron's interests in three power plants by selling
them to Whitewing. This deal is explained as allowing ``Enron
to keep the interests it holds in the assets through Whitewing
off-blance sheet.'' \125\ A December 2000 presentation to the
Finance Committee and February 2001 presentations on LJM to the
Finance and Audit Committees reported LJM's sale of an interest
in Yosemite trust investments to Whitewing. They also alerted
Board members to LJM's participation in the ``Osprey Add-On,''
an effort to further increase Whitewing's capitalization
through the issuance of over $1 billion in Osprey notes and
certificates.\126\ This additional $1 billion enabled Whitewing
to buy still more Enron assets which, in turn, enabled Enron to
show additional ``positive funds flow'' on its 2000 balance
sheet.\127\
---------------------------------------------------------------------------
\124\ Hearing Exhibit 17, ``EGF Execution Schedule; 2000 Balance
Sheet Management'' (Finance Committee presentation, 8/00).
\125\ ``Enron DASH: Project Margaux'' (8/7/00), Bates RB1934-35.
See also Hearing Exhibit 24a, ``Review of LJM procedures and
transactions completed in 2000,'' (Audit and Finance Committee
presentation, 2/12/01) at 2B-2.
\126\ LJM1, LJM2, and Chewco each acquired interests in Osprey at
various dates. LJM2 eventually acquired about 35 percent of the voting
equity in Osprey, while Chewco acquired about 7 percent. In 2000, LJM2
purchased about $30 million of Osprey debt certificates. See, for
example, Enron's draft response to SEC questions (11/01) at 14.
\127\ Hearing Exhibit 24a, ``Review of LJM procedures and
transactions completed in 2000'' (Audit and Finance Committee
presentation, 2/12/01).
---------------------------------------------------------------------------
The evidence indicates that the Enron Board also understood
that Whitewing posed some risks for Enron. An April 2001 chart
requested by Finance Committee Chairman Winokur shows that he
understood, and made sure that other Committee members
understood, that millions of Enron shares had been pledged as
collateral for Osprey debt.\128\ The chart notes that, ``Osprey
matures in 2003 . . . Osprey shares trigger in 2003.'' Finance
Committee members got a further update at an October 2001
meeting in which they were told that ``the Whitewing structure
. . . included $2.4 billion of assets and that bonds related to
the structure would require funding in September of 2002.''
\129\ Full Board minutes from the next day state that the
Finance Committee Chairman, Mr. Winokur, ``reviewed the
maturities and refinancings planned'' for Whitewing.\130\
---------------------------------------------------------------------------
\128\ Hearing Exhibit 32, ``Stock Price Risk in Financings;
Potential Required Future Equity issuance'' (Finance Committee
presentation, 4/01).
\129\ Hearing Exhibit 56 l (Finance Committee minutes, 10/8/01),
Bates E106602, at 2.
\130\ See also Watkins' letter to Board Chairman Lay (8/15/01),
warning of Enron's ``very aggressive'' accounting and ongoing risk in
connection with the ``Condor vehicle'' whose unwinding would require
the company ``to pony up Enron stock,'' attached to this report as
Appendix 2 on page 57. ``Condor'' is a reference to Whitewing and the
Osprey debt certificates. See Hearing Exhibit 15.
---------------------------------------------------------------------------
These documents establish that, step by step, the Enron
Board allowed the establishment of Whitewing, supported it with
Enron stock, restructured it as an off-the-books entity,
approved its use as an off-balance-sheet vehicle to purchase
Enron assets, monitored billions of dollars in Enron asset
sales to Whitewing, and monitored Whitewing's impact on Enron's
financial statements and its claims on Enron stock. For years,
Whitewing improved Enron's financial statements by creating the
appearance of increased equity investments and lower debt
ratios, and by generating more funds flow than Enron likely
would have achieved in dealing with an unrelated party. No
Board member claimed that Enron or Andersen personnel misled or
misinformed the Board about Whitewing in any way. Rather, the
evidence indicates that the Board made its Whitewing decisions
with full information and realization of Enron's extensive off-
the-books dealings with this entity.\131\
---------------------------------------------------------------------------
\131\ The current status of Whitewing is unclear. After Enron
declared bankruptcy in December 2001, the Enron stock pledged as
collateral for Whitewing's debt lost its value. Whitewing, however, did
not declare bankruptcy, but carried on as a separate entity.
Nevertheless, the Subcommittee staff has been told that Whitewing has
not made any payments to its debtholders since July 2001, and it is
unclear whether its assets--apart from the Enron stock collateral--will
be sufficient security for the amounts owed on the bonds. As of this
writing, Whitewing debtholders have not taken legal action to collect
on the debt. At the same time, Enron has apparently indicated that it
plans to include some of the assets securing the Whitewing debt in any
reorganized company that emerges from its bankruptcy.
---------------------------------------------------------------------------
LJM Partnerships. The Board also knowingly allowed Enron to
establish the LJM partnerships, as explained earlier. Like
Whitewing, LJM1 and LJM2 were explicitly established and run by
Enron personnel. Unlike Whitewing, the LJM partnerships were
set up from the beginning to function as off-the-books entities
intended to transact business with Enron and improve Enron's
financial statements.
Over the course of 2 years, Enron entered into over two
dozen transactions with LJM1 and LJM2 involving hundreds of
millions of dollars. LJM1's first transaction, which was
presented to and approved by the Board at its June 1999
meeting, was the Rhythms stock ``hedge'' whose sole purpose was
to protect Enron's income statement from loss if the stock were
to drop in price.\132\ The first seven LJM2 transactions, all
of which took place in 1999, consisted of Enron's selling
poorly performing assets to LJM2, which enabled Enron to move
debt off its books and show inflated earnings and cash flow
from the asset sales on its 1999 financial statements. An
``Update'' provided by Enron management to the Finance
Committee reported that five different Enron business units had
made the seven asset sales to LJM2, allowing Enron to book over
$200 million in earnings and over $2 billion in funds
flow.\133\
---------------------------------------------------------------------------
\132\ Hearing Exhibit 19, ``Project LJM Board Presentation'' (Board
presentation, 6/28/99).
\133\ Hearing Exhibit 23, ``LJM2 Update'' (Finance Committee
presentation, 5/1/00).
---------------------------------------------------------------------------
During 2000 and the first half of 2001, Enron management
entered into many more transactions with LJM1 and LJM2. Some
were assets sales; others were more complex financial
transactions. In more than one instance, a transaction was
followed by Enron's repurchasing an asset or interest that had
earlier been sold to LJM. The final list of Enron-LJM
transactions included: Enron sales of turbines, Nigerian
barges, and dark fiber to LJM2; LJM1 and LJM2's participation
in Whitewing and the Osprey debt certificates; monetization
deals in which LJM1 or LJM2 purchased interests in Enron power
plants in Brazil, Poland, and elsewhere; LJM2's purchase of two
tranches of Enron North America Credit Linked Obligations (ENA
CLO); LJM2's participation in prepay transactions called
Yosemite and Bob West Treasure; and LJM2's participation in the
four Raptor transactions.\134\ The Enron Board clearly
supported Enron's strategy to use the LJM partnerships to make
Enron's financial condition appear better than it was through
asset ``sales'' and other complex financial transactions that
appeared to eliminate Enron debt and generate earnings or cash
flow for Enron's financial statements.
---------------------------------------------------------------------------
\134\ See, for example, Hearing Exhibit 22, ``LJM Investment
Activity 1999'' (Audit Committee presentation, 2/7/00); Hearing Exhibit
24a, ``Review of LJM procedures and transactions completed in 2000,''
(Audit and Finance Committee presentation, 2/12/01); Hearing Exhibit
38c, excerpt from Enron's 10-Q filing with the Securities and Exchange
Commission (describing LJM transactions with Enron). As explained
elsewhere, many of these transactions appeared to benefit Enron in the
near-term, but not in the long-term, after Enron bought back from LJM
assets like the Cuiaba power plant interest and ENA CLO tranches, or
allowed LJM to exit the Rhythms and Raptor transactions with
substantial profits, even when the economics of the alleged ``hedges''
indicated LJM should have owed money to Enron.
---------------------------------------------------------------------------
Whitewing and the LJM partnerships are just two examples of
off-the-books entities that were known to and approved by the
Enron Board. JEDI, Chewco, and the Hawaii 125-0 Trust are
additional examples of ``unconsolidated affiliates'' that Enron
helped to establish and run. Each has its own history of multi-
million-dollar transactions with Enron.\135\ Board minutes
indicate Board approval of still other off-balance-sheet
transactions involving billions of dollars. For example, a
Board resolution in December 1999, approved the issuance of
$2.2 billion in preferred Enron stock to an unidentified
``outside investor group.'' \136\ Not a single Board member
interviewed by the Subcommittee remembered this transaction,
despite its multi-billion dollar size.
---------------------------------------------------------------------------
\135\ See the Powers Report at 41-67, for a detailed discussion of
JEDI and Chewco. See also, for example, Hearing Exhibit 17, ``EGF
Execution Schedule; 2000 Balance Sheet Management'' (Finance Committee
presentation, 8/00), showing the Hawaii 125-0 Trust engaged in hundreds
of millions of dollars in transactions with Enron.
\136\ Hearing Exhibit 56d (Finance Committee minutes, 12/13/99) at
3; Hearing Exhibit 56e (Board minutes, 12/14/99) at 15. For another
example, see Hearing Exhibit 56g (Finance Committee minutes, 8/7/00) at
6 (Committee approval of Project Tammy involving the formation of a new
company, Enron Finance Partners, LLC, ``to own certain of the Company's
assets,'' assume ``$1.047 billion of the Company's intermediate and
long-term debt,'' and obtain financing by selling $500 million in
preferred securities to ``outside investors''); (Board minutes, 8/7/00-
8/8/00) at 7 (Board approval of ``Project Tammy'').
---------------------------------------------------------------------------
In October 2000, the Finance Committee reviewed the chart
showing that $27 billion out of $60 billion of Enron's assets,
or almost 50 percent, were held off Enron's books in
``unconsolidated affiliates.'' \137\ No Board member objected
to this corporate strategy or urged Enron to change course.
---------------------------------------------------------------------------
\137\ Hearing Exhibit 39, ``Private Equity Strategy'' (Finance
Committee presentation, 10/00).
---------------------------------------------------------------------------
The Raptors. One important example of Enron's undisclosed,
off-the-books activity that had a dramatic, negative impact on
the company is the Raptor transactions.\138\ The Enron Board
knowingly authorized the Raptor transactions, despite their
high risk accounting, lack of economic substance, and
significant potential claim to Enron stock and stock contracts.
The Board also failed to ensure adequate public disclosure in
Enron's financial statements of Enron's ongoing contingent
liability for the Raptor transactions.
---------------------------------------------------------------------------
\138\ The Powers Report describes the Raptor transactions as having
had ``the greatest impact on Enron's financial statements'' of all the
transactions it examined. See Powers Report at 97.
---------------------------------------------------------------------------
The Raptors are a series of four complex transactions that
began in mid-2000 and terminated a little over a year later in
2001. They were presented to the Board by Enron management as
ingenious accounting devices that might attract ``accounting
scrutiny'' but had been scrutinized and approved by
Andersen.\139\ The Powers Report described them as an improper
attempt by Enron to use the value of its own stock to offset
losses in its investment portfolio, and ``a highly complex
accounting construct that was destined to collapse.'' \140\
---------------------------------------------------------------------------
\139\ Hearing Exhibit 28b, ``Project Raptor; Hedging Program for
Enron Assets'' (Finance Committee presentation, 5/1/00) at 25.
\140\ Powers Report at 98 and 132.
---------------------------------------------------------------------------
In each of the Raptor transactions, Enron orchestrated the
establishment of a special purpose entity (SPE) and arranged
for LJM2 to provide the SPE with $30 million which Enron
deemed, with Andersen's concurrence, to be the independent
equity from a third party needed to qualify the SPE for
separate accounting treatment from Enron. Enron explicitly
assured LJM2 that it would recoup its money plus an additional
$10 million within 6 months of each SPE's establishment. Enron
then arranged for the Raptor SPEs to appear to hedge millions
of dollars in volatile investments held by Enron, and made the
SPEs appear to be creditworthy on paper--despite withdrawal of
the LJM funds--by pledging as collateral hundreds of millions
of dollars worth of Enron's stock, contracts to buy Enron stock
in the future, or warrants to buy stock in a related company
called The New Power Company (TNPC).
Enron claimed, again with Andersen's concurrence, that it
could use the so-called Raptor hedges to offset mounting losses
in its investments which Enron otherwise would have had to
report on its income statement and subtract from its earnings.
In the space of 1 year, Enron used the alleged Raptor hedges to
offset--or, in the words of the Powers Report, ``conceal from
the market''--losses of almost $1 billion.\141\
---------------------------------------------------------------------------
\141\ Id. at 4, 99, and 133. The Powers Report states at page 4
that Enron concealed losses in its 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.''
---------------------------------------------------------------------------
Among other problems, the ``hedges'' created by the Raptor
SPEs had a structural defect that became evident within months
of their creation. First, the assets that were supposedly the
object of the ``hedges'' continued to fall in value. Then, the
value of Enron stock and stock contracts supporting the Raptor
SPEs' creditworthiness also began to drop. The value of the
assets and collateral continued to decline throughout 2000 and
2001. These declines meant that the Raptor SPEs had little or
no economic substance--no assets or capital--to support the so-
called hedges, other than claims on Enron's own stock or stock
contracts. To shore up the SPEs' creditworthiness on paper,
Enron concocted, with the assistance of Andersen, several
complex financial arrangements with the Raptor SPEs including
placing a ``collar'' on the Raptor ``hedges'' in October
2000,\142\ creating a 45-day cross guarantee arrangement to
support all four Raptor transactions in December 2000, and
restructuring the Raptors in March 2001, by placing additional
Enron shares at risk to support them.
---------------------------------------------------------------------------
\142\ A collar is created when a security holder purchases a put
option at a strike price below the current market price of the security
and sells a call option at a price above the current market price of
the security. The collar sets limits on the gain and loss that the
security holder can realize on the security.
---------------------------------------------------------------------------
In August 2001, Enron employee Ms. Watkins identified and
openly discussed the problems associated with the Raptors with
an Andersen partner outside of the Enron engagement team.\143\
In September, an Enron internal memorandum announced that
Andersen had ``changed their opinion of the proper accounting''
for the Raptors and no longer supported the capacity of the
Raptor SPEs to continue to ``hedge'' Enron's investment
losses.\144\
---------------------------------------------------------------------------
\143\ Hearing Exhibit 67, internal Andersen email from James A.
Hecker to David Duncan and others (8/23/01), forwarding a draft of a
memorandum to the file by him describing his telephone conversation
with Ms. Watkins, Bates AAHEC(2)192.1-3.
\144\ Hearing Exhibit 64, memorandum to the Files by Enron
employees Ryan H. Siurek and Ron Baker (9/01), regarding ``Project
Raptor--Addendum,'' Bates E12613-22.
---------------------------------------------------------------------------
The result was that, in October, at the end of the third
quarter of 2001, Enron terminated the Raptor ``hedges'' and
recorded a $710 million charge to earnings and a $1.2 billion
reduction in shareholder equity. The earnings charge reflected
the investment losses that the Raptors no longer concealed,
while the equity reduction reflected an accounting change that
Andersen made after determining that an earlier methodology it
had used for the Raptors did not comply with generally accepted
accounting principles. The media reported the losses, as well
as a decision by one credit rating agency, to ``put Enron's
long-term debt on review for a possible downgrade.'' \145\
Investors reacted by selling Enron shares. The resulting stock
price decline triggered Enron's credit rating downgrades and
its eventual bankruptcy. In many ways, the Raptors were the
accounting gimmick that finally brought down all of Enron.
---------------------------------------------------------------------------
\145\ Hearing Exhibit 44, ``Partnership Spurs Enron Equity Cut,''
Wall Street Journal (10/18/01).
---------------------------------------------------------------------------
Enron Board members acknowledged that they were informed of
and explicitly authorized the Raptor transactions on three
occasions in 2000, but contend that key problems were hidden
from them. The Raptors were first presented to the Finance
Committee in May 2000. The presentation on Raptor I is five
pages long.\146\ One page states the purpose of the
transaction: ``Establish a risk management program in order to
hedge the Profit & Loss volatility of Enron investments.'' The
next page discusses the Raptor transaction in terms of how it
could provide ``P&L protection'' to Enron. A handwritten note
taken by the Corporate Secretary during Committee consideration
of the Raptors states: ``Does not transfer economic risk but
transfers P&L volatility.'' The final page lists three risks
associated with the Raptors. The first risk is ``Accounting
scrutiny''; the second is ``Substantial decline in the price of
[Enron] stock''; and the third is ``Counterparty credit.''
---------------------------------------------------------------------------
\146\ Hearing Exhibit 28b, ``Project Raptor; Hedging Program for
Enron Assets'' (Finance Committee presentation, 5/1/00). The
Subcommittee has also obtained evidence that Enron management personnel
briefed individual Board members, including Mr. Winokur and Mr. Blake,
at length about the proposed Raptor transactions prior to the Finance
Committee meeting.
---------------------------------------------------------------------------
The Raptor I presentation contains all the information
necessary for a Board of ``experts in areas of finance and
accounting,'' as Mr. Duncan described his fellow Board members,
to understand that the Raptor transactions were designed to
function, not as a true hedge, but rather as an accounting
gimmick whose sole purpose was to improve Enron's financial
statements. The goal of the transactions was to allow the
company to claim that losses on investments placed in the
Raptor ``hedge'' were offset by the alleged hedge, so that none
of the losses would have to be reported on Enron's income
statements. But the presentation also directs the Board's
attention to the key factor that makes it clear the Raptor
transaction did not offset the losses by actually transferring
economic risk to a third party--it tells the Board that the
Raptor transaction relies in part on Enron stock which is
essentially pledged as collateral to secure the ``hedge.'' And
it alerts the Board to the fact that the third party in the
``hedge,'' the Raptor SPE, is a credit risk, since it is
intended to be thinly capitalized with few real assets.
The Powers Report, which examines the Raptors in detail,
sums them up with these words: ``In effect, Enron was hedging
risk with itself.'' \147\ The key to this analysis is
understanding that each of the Raptor SPEs was funded with only
two types of assets: $30 million provided by LJM2, and stock
and stock contracts provided by Enron. Moreover, the $30
million provided by LJM2 was only a temporary asset. Each
Raptor transaction provided that, within 6 months, a payment of
about $40 million was to be made to LJM2. That payment--which
actually took place as promised in all four Raptor
transactions--gave LJM2 not only its $30 million, but also
about $10 million in profit on each deal.\148\ Afterward, the
primary asset left in each of the Raptor SPEs was the SPE's
claim on Enron stock and stock contracts. That meant, in the
event one of the SPEs were required to pay funds to Enron, the
primary asset available to provide those funds would be the
SPEs' claims on Enron stock and stock contracts. Enron's
liability for the Raptors was further increased in March 2001
by a restructuring of the transactions that committed
additional Enron shares. The resulting risk to Enron was
significant, because Enron was effectively required to provide
as many Enron shares as necessary to satisfy the Raptor
``hedges.'' \149\
---------------------------------------------------------------------------
\147\ Powers Report at 97.
\148\ See also Powers Report at 102 (``Put another way, before
hedging could begin, LJM2 had to have received back the entire amount
of its investment plus a substantial return.'')
\149\ See, for example, Hearing Exhibit 38c, excerpt from Enron's
10-Q filing with the SEC (11/19/01) at 7 (Raptor SPEs were
``capitalized with Enron stock and derivatives which could have
required the future delivery of Enron stock. . . . In the first quarter
of 2001, Enron entered into a series of transactions with the Raptor
SPEs that could have obligated Enron to issue Enron common stock in the
future in exchange for notes receivable. These transactions, along with
a transaction entered into in 2000, obligated Enron to deliver up to 30
million shares of Enron common stock to the Raptor SPEs in March
2005.''); Hearing Exhibit 68, Enron's draft response to SEC questions
(11/01) at 26 (``Enron contributed [to the Raptor SPEs] a promise to
deliver shares and an obligation to provide more shares if the value of
the Enron shares declined.'') See also Hearing Exhibit 27, ``The
Raptors,'' prepared by the Subcommittee.
---------------------------------------------------------------------------
The evidence indicates that the Board was informed of the
risk to Enron stock when it first approved Raptor I and as the
Raptor transactions unfolded. Evidence of the Board's knowledge
lies, first, in the initial Raptor presentation. That
presentation states clearly that a key risk associated with the
Raptors is a ``substantial decline in the price of [Enron]
stock.'' The suggested mitigant for this risk is to terminate
the Raptor program ``early,'' in other words for Enron to pull
out of the so-called hedge. This statement of risk shows that
the Board was told from the beginning that Enron stock was at
risk in the Raptor transactions and that more stock would be at
risk if the stock price declined. A true hedge transfers risk
to a third party--that is the purpose of a hedge. But the
Raptors ``hedge'' transferred Enron's risk to an SPE with no
assets other than Enron stock and stock contracts. In the end,
only Enron remained liable for the Raptor ``hedges,'' and the
Board was told of that risk from the inception of the
transactions.
The Board approved Raptor I, as well as the other Raptor
transactions, despite the fact that the Raptor ``hedges'' did
not transfer risk to a third party. It did so apparently
because, as explained in the presentation on Raptor I, the
purpose of the Raptor ``hedge'' was not to ``transfer economic
risk'' but to transfer ``P&L volatility.'' In other words, the
sole purpose of the Raptor transaction was to protect Enron's
income statement from losses by allowing Enron to claim on its
financial statements that its losses were offset, dollar for
dollar, by the Raptor ``hedge.'' It was a paper hedge designed
to achieve favorable financial statement results, not a
substantive hedge that was intended actually to transfer
Enron's risk of loss to an unrelated party.
A second document demonstrating that the Board understood
the true nature of the Raptors is an April 2001 chart requested
by Mr. Winokur, then Chairman of the Finance Committee.\150\
Entitled, ``Stock Price Risk in Financings; Potential Required
Future Equity issuance,'' this chart shows the number of Enron
shares at risk in the Raptor transactions if Enron's stock
price were to decline. At the time the chart was shown to the
Finance Committee, Enron's stock price was about $60. The chart
shows that for Raptors I, II, and IV, if Enron's stock price
were to decline to $40 per share, and the Raptor SPEs' own
assets fell to zero so that the SPEs would have to call on
Enron's stock, Enron would be required to produce about 35
million shares.\151\ In a true hedge, Enron would not have
retained this type of contingent liability. But the Raptors
were an accounting gimmick, not a true hedge. The chart shows
that the Board was well aware of Enron's ongoing contingent
liability for them, yet allowed the Raptors to continue.
---------------------------------------------------------------------------
\150\ Hearing Exhibit 32, ``Stock Price Risk in Financings;
Potential Required Future Equity issuance'' (Finance Committee
presentation, 4/01).
\151\ The chart also notes that the ``Raptor vehicle share
issuances are triggered by date'' and refers to a ``restructuring''
that took place in the first quarter of 2001. Enron Board members have
denied knowing about the March 2001 restructuring that placed
additional Enron shares at risk in the Raptor hedges. Had anyone
inquired about the chart's reference, the restructuring would have been
disclosed in April 2001, a month after it had taken place. It is
difficult to credit the position of the Finance Committee members that,
despite having requested the chart, no explanation was requested or
provided regarding its references to triggering dates and a 2001
restructuring.
---------------------------------------------------------------------------
During the hearing, Mr. Winokur was asked about Enron's
ongoing liability for the Raptors. He admitted knowing that
Enron had retained a risk despite setting up the Raptor
``hedges,'' but declined to admit that Enron shares had been
pledged as collateral.\152\ He stated that the Board had
pledged ``forward positions on Enron stock,'' and not Enron
stock itself.\153\ But the difference between pledging Enron
stock directly and pledging contracts enabling Enron to buy its
own stock at a specified price in the future makes no
difference in the liability problem that confronted Enron and
that was communicated to the Finance Committee in April 2001--
either way the Raptor SPEs had an ongoing claim on Enron stock.
In the end, the number of Enron shares needed to support the
Raptor ``hedges'' became so great, that the company chose to
terminate them and acknowledge on its income statement instead
the investment losses that the Raptors had been masking.\154\
---------------------------------------------------------------------------
\152\ Hearing Record at 76-79.
\153\ Id. at 76.
\154\ See, for example, Enron's explanation for terminating the
Raptor hedges in Hearing Exhibit 38c, excerpt from Enron's 10-Q filing
with the SEC (11/19/01) at 7 (``[A]s a result of deterioration in the
credit quality of the Raptor SPEs caused by the decline in Enron and
[The New Power Company's] stock price, the increase in Raptor's
exposure under derivative contracts with Enron and the increasing
dilutive effect on Enron's earnings per share calculation, Enron . . .
terminated the entities.'') See also Hearing Exhibit 44, ``Partnership
Spurs Enron Equity Cut,'' Wall Street Journal (10/18/01), quoting
Kenneth Lay in a conference telephone call with financial analysts
indicating that, at the time of termination, the Raptors involved ``55
million'' Enron shares.
---------------------------------------------------------------------------
During their interviews, the Board members said that they
first learned of the Raptor termination at an October 8, 2001
Board meeting, when Enron officers announced that the company
had decided to terminate the Raptors and take an $800 million
earnings charge. The final charge actually recorded on Enron's
third quarter financial statement was about $710 million.\155\
The interviewed Board members indicated that they had not felt
deep concern about the charge at the time, despite its size,
because it was a one-time event. Most said that they had left
the October meeting thinking that the company was still on
track, and its earnings were strong enough to withstand the
charge.
---------------------------------------------------------------------------
\155\ Enron's 10-Q filing with the SEC for the third quarter of
2001 (11/19/01) (pre-tax charge was $711 million; after-tax charge was
$544 million).
---------------------------------------------------------------------------
The October 2001 meeting was also when the Directors first
learned of the Watkins' letter, although she was never
identified by name to the Board, no Board member requested her
identity, and the letter's strong warnings about the Raptors
apparently were not disclosed to the outside directors. The
interviewed directors said that Enron officers referred to the
letter during the Board meeting as coming from an anonymous
employee. They said it was discussed during an Audit Committee
meeting first and then during the full Board meeting. The
company's outside legal counsel, Vinson & Elkins, made the
primary presentations and indicated that their preliminary
investigation of the employee's concerns had found nothing
worth further investigation. The interviewed directors said the
employee's concerns were characterized as having to do with LJM
and related party transactions, and no mention was made of the
Raptors. The Chairman of the Board, Mr. Lay, participated in
both the Committee and Board discussions, but apparently did
not disclose to his fellow Board members the Raptor and
accounting concerns expressed in the letter he had received.
The interviewed directors said that they saw neither the letter
itself nor the Vinson & Elkins report on it until after Enron
had begun to collapse and the Powers investigation was
launched. Had they seen the letter, the outside Board members
would have learned that Ms. Watkins had told Mr. Lay in mid-
August that she was ``incredibly nervous that [Enron] will
implode in a wave accounting scandals''; that ``Enron has been
very aggressive in its accounting--most notably the Raptor
transactions and the Condor vehicle''; and that ``the Raptor
and Condor deals . . . unwind in 2002 and 2003 [and] we will
have to pony up Enron stock and that won't go unnoticed.''
\156\
---------------------------------------------------------------------------
\156\ Watkins' letter to Board Chairman Lay (8/15/01) at 1,
attached to this report as Appendix 2 on page 57. The ``Condor
vehicle'' is a reference to Whitewing and the Osprey debt certificates
secured with Enron stock.
---------------------------------------------------------------------------
During their interviews, the Directors were unanimous in
stating that, while Enron disclosed the prospective $800
million earnings charge at the October 8 Board meeting, Enron
management did not disclose at that meeting that the Raptors
termination would also require a reduction in shareholder
equity of $1.2 billion. Most of the Directors recalled learning
of the $1.2 billion after a Wall Street Journal article quoted
the figure following Mr. Lay's disclosure of it during a
financial analyst call on October 17.\157\ Most of the
Directors said they had been shocked and angry, not only at the
loss in shareholder value, but also by learning of it from the
media instead of Enron management. Board members later learned
the reduction was due to an accounting correction that Andersen
required after determining that the accounting methodology it
had advocated for the Raptors was in violation of generally
accepted accounting principles and had to be changed. Several
directors said this $1.2 billion reduction was the first event
that made them realize Enron was in trouble.
---------------------------------------------------------------------------
\157\ Hearing Exhibit 44, ``Partnership Spurs Enron Equity Cut,''
Wall Street Journal (10/18/01).
---------------------------------------------------------------------------
Despite the huge dollars involved and the significant risk
to Enron, some Board members stated they had only a limited
understanding of the Raptor transactions or stressed that key
information had been withheld from them. For example, many of
the Board members indicated they had not been told that LJM2
had been promised, after contributing $30 million to each
Raptor SPE, to be paid $40 million within 6 months. But the
initial Raptor presentation and the April 2001 chart are strong
evidence that the Board knew that Enron stock, not LJM2 funds,
were at risk in the Raptor transactions. Another key document,
the Enron Deal Approval Sheet (DASH) for the Raptor
transactions, characterized Enron's financial obligation as
providing ``a guaranty'' for the ``hedges'' and made it clear
that LJM2 was to be paid its funds at the earliest possible
date. In explaining the Raptor profit distributions, for
example, the Raptor DASHs state: ``First, $41 million to
LJM2.'' \158\ The dollar value and unusual nature of the Raptor
transactions should have ensured that each of the Raptor DASHs
went to the Finance Committee for review, in addition to the
Raptor presentations, but no Finance Committee member recalled
seeing one or requesting a copy.
---------------------------------------------------------------------------
\158\ Hearing Exhibit 31, ``Enron Deal Summary'' for Raptor I (4/
18/00).
---------------------------------------------------------------------------
The Board members also asserted that they had been informed
of only three Raptor transactions and never knew about the
Raptor ``hedge'' collateralized with Enron's warrants to
purchase TNPC stock. Lack of knowledge of one of the Raptors,
however, does not explain or excuse the Board's decisionmaking
with respect to the other Raptors. Nor does it excuse the
Board's failure to find out about all four Raptors when a
February 2001 list of LJM transactions, shown to both the Audit
and Finance Committees, identified all four and stated they had
a combined value of $127 million, far larger than any other LJM
transaction on the list.\159\
---------------------------------------------------------------------------
\159\ Hearing Exhibit 24, ``Review of LJM procedures and
transactions completed in 2000'' (Audit and Finance Committee
presentation, 2/12/01) at 2.
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Board members recited a litany of other Raptor facts that
were not brought to their attention. For example, Board members
told Subcommittee staff that they had not been told that
Andersen had raised repeated concerns about the Raptors, or
that the Raptors began experiencing severe credit impairment
problems just months after they were created. They said they
had not been told about the October 2000 ``collar'' or the
December 2000 45-day cross guarantee. The Board members also
said they did not know that Enron had placed additional Enron
shares at risk in a restructuring of the Raptors in March
2001--even though, 1 month later, the Finance Committee
requested a chart analyzing Enron's stock risk and the chart
itself refers to the restructuring. The Board members indicated
that Enron management and Vinson & Elkins also withheld the
information that the Watkins' letter from August 2001, had
described the Raptor transactions as a possible ``accounting
scandal'' and enumerated their problems. The Board also said
they did not know that the Raptor transactions provided LJM2
with some of its highest returns on any investment, information
it could have obtained if any Board member had reviewed LJM's
first annual partnership report in October 2000.
The Board's lack of knowledge of certain aspects of the
Raptor transactions, however, does not justify its handling of
these transactions. At best, it demonstrates a lack of
diligence and independent inquiry by the Board into a key Enron
liability. It does not excuse or explain the Board's approval
of the Raptors based upon what they did know. It also does not
excuse the Board's failure to ensure adequate public disclosure
of Enron's ongoing liability for the Raptor transactions.
Inadequate Public Disclosure. When asked about Enron's
extensive off-the-books activity, one of the Board members, Mr.
Blake, stated during his interview that transferring assets off
a company's books ``is not immoral as long as disclosed.'' But
here, too, the Enron Board failed in its fiduciary duty to
ensure adequate public disclosure of Enron's off-the-books
assets and liabilities.\160\
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\160\ Enron's Board members signed the company's 10-K filings with
the Securities and Exchange Commission, and the Audit Committee was
consulted about related party disclosure issues in both the 10-K
filings and the company's proxy statements. See discussion in Powers
Report at 181-83.
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Enron's initial public disclosures regarding its dealings
with its ``unconsolidated affiliates'' such as JEDI, Whitewing,
LJM, and the Raptor SPEs are nearly impossible to understand
and difficult to reconcile with the transactions now known to
have taken place. The Powers Report calls the disclosures
``fundamentally inadequate'' and castigates Enron for proxy
statement and financial statement disclosures that fail to
``disclose facts that were important for an understanding of
the substance of the transactions'' Enron entered into with
related parties.\161\
---------------------------------------------------------------------------
\161\ Powers Report at 178 and 187. See also Powers Report at 197.
---------------------------------------------------------------------------
Ms. Watkins also focused on the lack of adequate public
disclosure of the company's involvement in the Raptor
transactions in her August 2001 letter to Mr. Lay. Her letter
states that ``a lot of smart people'' are examining the Raptor
transactions and ``a lot of accountants including [Andersen]
have blessed the accounting treatment. None of that will
protect Enron if these transactions are ever disclosed in the
bright light of day.'' \162\ The letter continues:
---------------------------------------------------------------------------
\162\ Watkins' letter to Board Chairman Lay (8/15/01) at 2,
attached to this report as Appendix 2 on page 57.
``The overriding principle of accounting is that if you
explain the ``accounting treatment'' to a man on the
street, would you influence his investing decisions?
Would he buy or sell the stock based on a thorough
understanding of the facts? If so, you best present it
correctly and/or change the accounting. My concern is
that the footnotes don't adequately explain the
transactions. If adequately explained, the investor
would know that the ``Entities'' described in our
related party footnote are thinly capitalized, the
equity holders have no skin in the game, and all the
value in the entities comes from the underlying value
of the derivatives (unfortunately in this case, a big
loss) AND Enron stock and N/P.'' \163\
---------------------------------------------------------------------------
\163\ Id.
Her comments apply not only to Enron's failure to disclose
clearly the nature and extent of the Raptor transactions and
the company's contingent liability for them, but also to
Enron's dealings with its other ``unconsolidated affiliates.''
The disclosure problem is illustrated by a comparison of
the related party disclosures in Footnote 16 of Enron's 10-K
filings for the years 1999 and 2000, with the disclosure
provided by Enron on November 19, 2001, its 10-Q filing for the
third quarter of 2001, filed more than 1 month after media
reports began describing Enron's off-the-books activities.\164\
The 1999 and 2000 footnotes, each of which is about one page in
length, provide extremely brief descriptions of LJM, JEDI,
Whitewing, and the Raptor transactions. The footnotes provide
minimal information about the entities themselves, their
relationship with Enron, and the extent of their business
transactions with the company. The 2000 footnote, in
particular, is nearly unintelligible, and certainly fails to
convey meaningful information about Enron's expanding business
activities with LJM, JEDI, and Whitewing, and its participation
in and ongoing liabilities associated with the Raptor SPEs. In
contrast, Enron's 2001 filing provides a nine-page description
of Enron's transactions with these entities and contains
information which is much more extensive and understandable.
The Raptor transactions, for example, are identified by name,
and the nature and extent of Enron's liabilities for them are
set out in relatively straightforward terms. So are a number of
Enron's transactions with LJM1 and LJM2. The 10-Q filing
demonstrates that Enron was quite capable of meaningful public
disclosure when motivated. The Enron Board failed to provide
that motivation.
---------------------------------------------------------------------------
\164\ Hearing Exhibits 38a, 38b, and 38c, Enron's 10-K filings for
1999 and 2000, and 10-Q filing for the third quarter of 2001.
---------------------------------------------------------------------------
Once public disclosure was made of Enron's off-the-books
activities and liabilities, credit rating agencies, financial
analysts, and investors began to reconsider their view of the
company, and many investors reacted by selling Enron stock.
Enron's hidden activities and liabilities clearly damaged
investor confidence in the company and contributed to its
collapse.
Finding (5): The Enron Board of Directors approved
excessive compensation for company executives, failed
to monitor the cumulative cash drain caused by Enron's
2000 annual bonus and performance unit plans, and
failed to monitor or halt abuse by Board Chairman and
Chief Executive Officer Kenneth Lay of a company-
financed, multi-million dollar, personal credit line.
Enron provided its executives with lavish compensation. On
more than one occasion, it paid tens of millions of dollars to
a single executive as a bonus for work on a single deal. Stock
options were distributed in large numbers to executives. One
executive, Lou Pai, accumulated enough stock options that, when
he exercised them and sold the underlying stock in 2000, he
left the company with more than $265 million in cash. Mr. Lay,
alone, accumulated more than 6.5 million options on Enron
stock.\165\ In 2000, Mr. Lay's total compensation exceeded $140
million, including $123 million from exercising a portion of
his Enron stock options,\166\ an amount which exceeded average
CEO pay at U.S. publicly traded corporations by a factor of ten
and made him one of the highest paid CEOs in the country.\167\
---------------------------------------------------------------------------
\165\ ``Office of the Chair Compensation Summary'' (10/31/01),
Bates WP1797.
\166\ Hearing Exhibit 52, ``Confidential for Enron Board of
Directors, Public Relations, Investor Relations & HR Use Only;
Potential Questions--Enron Proxy 2001'' (4/13/01), Bates CL410-14, at
1.
\167\ See, for example, annual executive compensation survey by
Business Week (4/16/01), which determined that average CEO pay in 2000
at 365 publicly traded companies in the United States was $13.1
million. In February 2001, Mr. Lay resigned his CEO post in favor of
Mr. Skilling, but reclaimed it in August 2001, after Mr. Skilling left
the company.
---------------------------------------------------------------------------
The Enron Board, through its Compensation Committee, was
not only informed of the company's lavish executive
compensation plans, it apparently approved them with little
debate or restraint. One Board member said during his interview
that Enron's philosophy was to provide ``extraordinary rewards
for extraordinary achievement''; others claimed that the
company was forced to provide lavish compensation to attract
the best and brightest employees. Dr. LeMaistre testified that
he ``did not worry'' about high levels of compensation because
he checked regularly with the Board's compensation consultant,
Towers Perrin, and was informed that Enron was ``right on
target'' in its compensation practices.\168\ The evidence
suggests that keeping up with competitor pay, rather than
overseeing existing compensation plans, was the central
objective of the Enron Compensation Committee.
---------------------------------------------------------------------------
\168\ Hearing Record at 46.
---------------------------------------------------------------------------
One example of the Compensation Committee's lavish
compensation philosophy, combined with its failure to conduct
adequate compensation oversight, involves its May 1999 decision
to permit Mr. Lay to repay company loans with company stock.
The Compensation Committee had already given Mr. Lay a $4
million line of credit which, in August 2001, it increased to
$7.5 million. During their interviews, the Committee members
said that they knew of the line of credit, but had been unaware
that, in 2000, Mr. Lay began using what one Board member called
an ``ATM approach'' toward that credit line, repeatedly drawing
down the entire amount available and then repaying the loan
with Enron stock. Records show that Mr. Lay at first drew down
the line of credit once per month, then every 2 weeks, and
then, on some occasions, several days in a row.\169\ In the 1-
year period from October 2000 to October 2001, Mr. Lay used the
credit line to obtain over $77 million in cash from the company
and repaid the loans exclusively with Enron stock.\170\ Several
directors confirmed that Mr. Lay still owed the company about
$7 million.
---------------------------------------------------------------------------
\170\ An Enron filing in Federal bankruptcy court in June 2002,
listing payments to Enron officers during 2001, states that, altogether
in 2001, the company loaned Mr. Lay over $81 million.
\169\ Hearing Exhibit 36a, ``Ken Lay's Repayment of Cash Loans by
Transferring Enron Stock Back to Enron,'' prepared by the Subcommittee
based upon subpoenaed documents provided by Mr. Lay, an example of
which appears in Hearing Exhibit 36b.
---------------------------------------------------------------------------
The interviewed Board members said they had been unaware of
these transactions at the time and agreed that they could
fairly be characterized as stock sales. They indicated that
they had been unaware at the time that, by characterizing the
stock transfers as loan payments rather than stock sales, Mr.
Lay bypassed requirements for reporting insider stock sales on
a quarterly basis and instead delayed reporting the
transactions to the SEC and investing public until the end of
the calendar year in which they took place.
At the hearing, when Dr. LeMaistre, former Compensation
Committee Chairman, was asked whether his Committee should have
been monitoring the credit line, he testified that, ``We never
had any responsibility to monitor this.'' \171\ When asked
whether he would agree that Mr. Lay had ``abused'' his credit
line, Dr. LeMaistre testified that ``it was not a term I care
to use'' and that he would stop short of characterizing Mr.
Lay's actions as an abuse ``because I do not know the
circumstances.'' \172\ Mr. Blake, another Compensation
Committee member, stated, ``I do not want to go close to the
word `abuse', but I would say that as a CEO, it is not what you
say, it is what you do. Sale of a stock in the nature that took
place was inappropriate. . . . I was absolutely shocked by
this. . . . [I]f we had a chance to have known that occurred,
we would have taken immediate and corrective action to ensure
that behavior would not happen again.'' \173\ Both Dr.
LeMaistre and Mr. Blake seemed to deny responsibility for
monitoring the CEO's credit line, even though the Board's
Compensation Committee is charged with overseeing CEO
compensation and no one other than the Board had the authority
to monitor or restrict the Chief Executive Officer's actions.
Mr. Lay used his credit line to withdraw $77 million in cash
from the company in 1 year, replaced the cash with company
stock, and never mentioned his borrowings or stock sales to the
Board or the public. Despite learning of his conduct after the
fact, the Board members at the hearing were reluctant to
express strong criticism of Mr. Lay.
---------------------------------------------------------------------------
\171\ Hearing Record at 90.
\172\ Id. at 89.
\173\ Id. at 90.
---------------------------------------------------------------------------
A second example of the Compensation Committee's poor
compensation oversight involves the huge annual and special
bonus plans it approved for Enron executives. During their
interviews, the Compensation Committee and other Board members
indicated that they had been unaware of the total amount of
bonuses paid in early 2001 for work performed in 2000. That
year, Enron executives received about $430 million in annual
bonuses under Enron's normal bonus plan. In addition, in
exchange for meeting certain stock performance targets, a
special program called the Performance Unit Plan paid bonuses
to about 65 Enron executives totaling another $320 million.
Board members indicated that they had been unaware that the
company had paid out almost $750 million in cash bonuses for a
year in which the company's entire net income was $975 million.
Apparently, no one on the Compensation Committee had ever added
up the numbers.
The Compensation Committee appeared to have exercised
little, if any, restraint over Enron's compensation plans,
instead deferring to the compensation plans suggested by
management and the company's compensation consultants. During
their interviews, the Committee members said it had not
occurred to them that, by giving Enron executives huge stock
option awards, they might be creating incentives for Enron
executives to improperly manipulate company earnings to
increase the company stock price and cash in their options. One
Board member admitted, however, that Enron was a culture driven
by compensation. Another said, when asked why Enron executives
misled the Board and cheated the company, that he ``only can
assume they did it for the money.''
Finding (6): The independence of the Enron Board of
Directors was compromised by financial ties between the
company and certain Board members. The Board also
failed to ensure the independence of the company's
auditor, allowing Andersen to provide internal audit
and consulting services while serving as Enron's
outside auditor.
Board Independence. At the May 7 hearing, the expert
witnesses testified that the independence and objectivity of
the Enron Board had been weakened by financial ties between
Enron and certain directors. These financial ties, which
affected a majority of the outside Board members, included the
following.\174\
---------------------------------------------------------------------------
\174\ Hearing Exhibit 43, ``Enron Board of Directors--Financial
Ties to Enron,'' prepared by the Subcommittee.
--LSince 1996, Enron paid a monthly retainer of $6,000
to Lord John Wakeham for consulting services, in
addition to his Board compensation. In 2000, Enron paid
him $72,000 for his consulting work alone.\175\
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\175\ Enron 2001 Proxy.
--LSince 1991, Enron paid Board member John A. Urquhart
for consulting services, in addition to his Board
compensation. In 2000, Enron paid Mr. Urquhart $493,914
for his consulting work alone.\176\
---------------------------------------------------------------------------
\176\ Id.
--LEnron Board member Herbert Winokur also served on
the Board of the National Tank Company. In 1997, 1998,
1999, and 2000, the National Tank Company recorded
revenues of $1,035,000, $643,793, $535,682 and $370,294
from sales to Enron subsidiaries of oilfield equipment
and services.\177\
---------------------------------------------------------------------------
\177\ Enron 2000 and 2001 Proxy.
--LIn the past 5 years Enron and Kenneth Lay donated
nearly $600,000 to the M.D. Anderson Cancer Center in
Texas. In 1993, the Enron Foundation pledged $1.5
million to the Cancer Center. Two Enron Board members,
Dr. LeMaistre and Dr. Mendelsohn, have served as
president of the Cancer Center.\178\
---------------------------------------------------------------------------
\178\ M.D. Anderson Cancer Center records.
--LSince 1996, Enron and the Lay Foundation have
donated more than $50,000 to the George Mason
University and its Mercatus Center in Virgina.\179\
Enron Board member Dr. Wendy Gramm is employed by the
Mercatus Center.
---------------------------------------------------------------------------
\179\ New York Times, 11/30/01.
--LSince 1996, Enron and Belco Oil and Gas have engaged
in hedging arrangements worth tens of millions of
dollars.\180\ In 1997, Belco bought Enron affiliate
Coda Energy.\181\ Enron Board member Robert Belfer is
former Chairman of the Board and CEO of Belco.
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\180\ Enron 2001 Proxy.
\181\ Enron 1998 Proxy.
--LCharls Walker, a noted tax lobbyist, was an Enron
Board member from 1985 until 1999. In 1993-1994, Enron
paid more than $70,000 to two firms, Walker/Free and
Walker/Potter that were partly owned by Mr. Walker, for
governmental relations and tax consulting services.
This sum was in addition to Mr. Walker's Board
compensation.\182\ Enron was also, for more than 10
years ending in 2001, a major contributor of up to
$50,000 annually to the American Council for Capital
Formation, a non-profit corporation that lobbies on tax
issues and is chaired by Mr. Walker.\183\
---------------------------------------------------------------------------
\182\ Enron 1994 and1995 Proxy.
\183\ Subcommittee staff interview of Mr. Walker.
A number of corporate governance experts contacted by the
Subcommittee staff identified these financial ties as
contributing to the Enron Board's lack of independence and
reluctance to challenge Enron management. At the May 7 hearing,
Charles Elson, Director of the Center for Corporate Governance
at the University of Delaware, testified that public company
directors should have ``no financial connection to the company
whatsoever'' other than their Board compensation, but the Enron
Board was ``problematic'' because a number of directors ``were
service providers or recipients of corporate largess in some
way, shape, or form.'' \184\ He testified:
---------------------------------------------------------------------------
\184\ Hearing Record at 94-95.
``By taking those fees, you are effectively becoming
part of the management team, and I think there is a
real problem with exercising independent judgement vis-
a-vis what the management has done if you feel part of
that team, either through participating in the
development of management plans and strategies or the
fear that if one objects too strenuously, those
consulting fees may disappear. . . . You may take what
they are telling you at face value without being more
probative because of the relationship. . . . [I]f a
director's role is as a consultant, hire the director
as a consultant. If the director's role is to be a
director, hire them as a director. You cannot blend the
two.'' \185\
---------------------------------------------------------------------------
\185\ Hearing Record at 106-107.
Robert H. Campbell, retired Chairman and CEO of Sunoco,
Inc., who presently sits on the Boards of several large
corporations, testified that ``consulting arrangements with
directors is absolutely incorrect, absolutely wrong'' because
directors are already paid a substantial fee to be available to
management and provide their perspective on company
issues.\186\
---------------------------------------------------------------------------
\186\ Hearing Record at 107.
---------------------------------------------------------------------------
The three experts at the May 7 hearing also criticized the
compensation paid to the Board members, noting that $350,000
per year \187\ was significantly above the norm and that much
of the compensation was in the form of stock options which
enabled Board members to benefit from stock gains, without
risking any investment loss.\188\ Mr. Elson criticized stock
options because ``[t]here is no real downside. The worst you
can lose is the expectancy of great riches.'' \189\ All three
experts urged companies to reconsider awarding excessive Board
compensation and urged them to award compensation in the form
of stock rather than stock options.
---------------------------------------------------------------------------
\187\ See Hearing Exhibits 35a and 35b, on Enron Board Member
compensation, prepared by the Subcommittee.
\188\ Hearing Record at 110-112.
\189\ Id. at 111.
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Auditor Independence. The hearing experts also criticized
the Enron Board and its Audit Committee for inadequate
oversight to ensure the independence and objectivity of
Andersen in its role as the company's outside auditor. The
Audit Committee formally reviewed Andersen's independence
annually, and Committee members told the Subcommittee staff
there had never been any sign of a problem. The evidence
suggests, however, that the Audit Committee did not probe the
independence issue, nor did it initiate the type of
communications with Andersen personnel that would have led to
its discovering Andersen concerns with Enron accounting
practices.
The Audit Committee had very limited contact with Andersen,
essentially communicating with Andersen personnel only at Board
meetings. The Audit Committee Chairman for more than 10 years
was Dr. Jaedicke. Despite his long tenure on the Audit
Committee, the interviews disclosed that Dr. Jaedicke had
``rarely'' had any contact with Andersen outside of an official
Audit Committee or Board meeting. None of the other interviewed
Audit Committee members had ever contacted anyone from Andersen
regarding Enron outside of an official Enron Committee or Board
meeting. None had ever telephoned Andersen directly.
The Audit Committee members indicated that they had thought
Andersen and Enron had a good working relationship, and taken
great comfort in knowing that Andersen was more than Enron's
outside auditor, but also provided Enron with extensive
internal auditing and consulting services, combining its roles
into what Enron called ``an integrated audit.'' Dr. Jaedicke
maintained that it was a significant benefit to Enron for
Andersen to be involved with Enron's activities on a day-to-day
basis and to help the company design its most complex
transactions from the start. Although one Board member, Lord
Wakeham, indicated that he had been concerned that this high
level of involvement meant Andersen might be too close to Enron
management, most Board members indicated that issue had not
been a concern. No Board member expressed any concern that
Andersen might be auditing its own work, or that Andersen
auditors might be reluctant to criticize Andersen consultants
for the LJM or Raptor structures that Andersen had been paid
millions of dollars to help design.\190\
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\190\ See, for example, Powers Report at 5 (``Andersen billed Enron
$5.7 million for advice in connection with the LJM and Chewco
transactions alone, above and beyond its regular audit fees.'') and 132
(``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.'').
---------------------------------------------------------------------------
In contrast, the accounting and corporate governance
experts at the May 7 hearing condemned the very concept of an
integrated audit, not only for diluting the outside auditor's
independence, but also for reducing the effectiveness of an
outside audit by allowing the auditor to audit its own work at
the company. Mr. Sutton called it a ``terrible idea,'' while
Mr. Campbell called it a ``horrible practice and I do not think
it should be permitted.'' \191\
---------------------------------------------------------------------------
\191\ Hearing Record at 105 and 106.
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Enron Board members told the Subcommittee staff that they
had been unaware of any tensions between Andersen and Enron and
unaware of the many concerns Andersen had with Enron's
accounting practices. The interviewed Board members said that
they had not been informed and were unaware of a February 2001
visit paid by the head of Andersen, Joseph Berardino, to
Enron's headquarters and did not know why the meeting took
place or what was discussed. They also said they were unaware
that, shortly after the visit, in March 2001, a senior Andersen
partner, Carl Bass, was removed from his Enron oversight role
at Enron's request. The Board members observed that they had
given Andersen regular opportunities outside the presence of
Enron management to communicate any concerns about the company,
including whether company officials were pressuring Andersen
accountants who raised objections to company proposals. They
expressed shock and dismay that Andersen had never conveyed its
many concerns about Enron's accounting and transactions to the
Enron Board.
The interviewed Board members indicated that they had not
considered whether Andersen might be reluctant to express
serious concerns about Enron accounting practices out of an
unwillingness to upset Enron management or endanger its fees. A
number of the interviewed directors discounted the importance
of Andersen's fees, even though Enron was one of Andersen's
largest clients and, during 2000, paid Andersen about $52
million or $1 million per week for its work. Andersen's
consulting fees at Enron exceeded its auditing fees for the
first time in 1999, and, in 2000, totaled about $27 million
compared to auditing fees of about $25 million.\192\
---------------------------------------------------------------------------
\192\ Hearing Exhibit 7b, ``Summary of Fees--Activity Overview''
(Audit Committee presentation, 5/1/00).
---------------------------------------------------------------------------
When asked by Senator Collins at the hearing if he had
``ever known an auditor to come in and say, we are not
independent, we are too close to management,'' Dr. Jaedicke
said no, ``[t]hey would not last very long if they did that.''
Senator Collins responded:
``Exactly my point. . . . When you are making over $40
million a year, the auditor is not likely to come to
the Audit Committee and say anything other than that
they are independent. Is it not the job of the Audit
Committee to make sure that the auditor truly is giving
full, accurate, and appropriate advice to the Board?''
The facts suggest that the Enron Audit Committee went through
the motions of asking Andersen about its independence, relied
on what it was told, and did little more to evaluate the
relationship between the auditor and the company. Had it dug
deeper, the Enron Audit Committee might have uncovered the
ongoing tensions between the company and its auditor and the
many misgivings Andersen expressed internally while going along
with Enron's high risk accounting.
CONCLUSION
Enron's Directors protest that they cannot be held
accountable for misconduct that was concealed from them. But
much that was wrong with Enron was known to the Board, from
high risk accounting practices and inappropriate conflict of
interest transactions, to extensive undisclosed off-the-books
activity and excessive executive compensation.
At the hearing, the Subcommittee identified more than a
dozen red flags that should have caused the Enron Board to ask
hard questions, examine Enron policies, and consider changing
course. Those red flags were not heeded. In too many instances,
by going along with questionable practices and relying on
management and auditor representations, the Enron Board failed
to provide the prudent oversight and checks and balances that
its fiduciary obligations required and a company like Enron
needed. By failing to provide sufficient oversight and
restraint to stop management excess, the Enron Board
contributed to the company's collapse and bears a share of the
responsibility for it.
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