U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

1

80–393 PDF

" ! COMMITTEE PRINT 107th Congress

2d Session

S. PRT.

2002

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

JULY 8, 2002

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

JOSEPH I. LIEBERMAN, Connecticut, Chairman

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

FRED THOMPSON, Tennessee

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel

RICHARD A. HERTLING, Minority Staff Director

DARLA D. CASSELL, Chief Clerk

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

CARL LEVIN, Michigan, Chairman

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

SUSAN M. COLLINS, Maine

TED STEVENS, Alaska

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

ELISE J. BEAN, Acting Staff Director and Chief Counsel

KIM CORTHELL, Minority Staff Director

MARY D. ROBERTSON, Chief Clerk

(III)

C O N T E N T S

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

(1)

THE ROLE OF THE BOARD OF

DIRECTORS IN ENRON’S COLLAPSE

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.

2

1Two 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.

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

The second panel consisted of three experts in corporate 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.

3

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-thebooks 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.

4

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:

(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;

(b) prohibit conflict of interest arrangements that

allow company transactions with a business owned or

operated by senior company personnel;

(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;

(d) prevent excessive executive compensation, including by ——

(i) exercising ongoing oversight of compensation

plans and payments;

(ii) barring the issuance of company-financed loans

to directors and senior officers of the company; and

(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

(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:

(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;

(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

5

2 ‘‘Statement on Corporate Governance,’’ The Business Roundtable (9/97) at 3. 3Gearheart Industries v. Smith International, 741 F.2d 707, 719 (5th Cir. 1984).

(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

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

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 concluVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
6

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.’’)

sive. The ‘‘critical test,’’ the Court said, is ‘‘whether the financial

statements as a whole fairly present the financial position’’ of the

company.4

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 enterVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
7

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.

prise 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.’’

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

8

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. 7 Hearing Record at 14.

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.’’ 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.

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

9

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 includVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
10

ing, 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

11

8See 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. 9See ‘‘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). 10See, for example, Hearing Exhibit 44, ‘‘Partnership Spurs Enron Equity Cut, Wall Street

Journal (10/18/01). 11Form 8–K filed by Enron Corporation with SEC (4/22/02). 12See, 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.

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

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

12

13See ‘‘Enron’s Other Strategy: Taxes; Internal Papers Reveal How Complex Deals Boosted Profits by $1 Billion,’’ Washington Post (5/22/02). 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. 15 ‘‘Is Enron Overpriced?’’ by Bethany McLean, Fortune (3/5/01). 16See 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. 18Sherron Watkins’ letter to Board Chairman Kenneth Lay (8/15/01) at 1, attached to this

report as Appendix 2 on page 57.

billions of dollars in company earnings through the use of complex

tax shelters.13

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.

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

13

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.

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.

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

14

20See Powers Report at 24. 21 Hearing Record at 14–15. 22 Id. at 18. 23 Id. at 19.

prevented or detected at an earlier time had the Board been more

aggressive and vigilant.’’ 20

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

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

15

24 Hearing Record at 109. 25 Id. at 109. 26 Hearing Exhibit 47b, ‘‘Enron Corp. Audit and Compliance Committee Charter’’ (2/12/01),

Bates CL382–84. 27See Hearing Exhibits 2 through 9, Andersen presentations to Enron Audit Committee. 28 Hearing Exhibit 2b (Audit Committee minutes from 2/7/99).

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

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:

—‘‘[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

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

16

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). 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.

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.

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 subissues. 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.

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,’’ meanVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
17

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. 33 Hearing Exhibit 5, letter dated 5/2/02 from Bauer’s legal counsel to the Subcommittee. 34See 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.

ing each had been rated as a high risk. A handwritten note by Mr.

Duncan in the lower right-hand corner of the document states:

‘‘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

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

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 SecVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
18

36 Hearing Exhibit 8a (Audit Committee presentation, 2/12/01). 37 Hearing Exhibits 10a and 10b, excerpts from Andersen’s 1999 and 2000 annual client risk

analysis of Enron Corporation.

retary 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.

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:

‘‘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 testVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
19

38 Hearing Record at 30–31. 39 Id. at 29 and 32.

ing 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:

‘‘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

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

20

40Form 8–K filed by Enron Corporation with SEC (4/22/02). 41 Id. at 2–3. 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. 44See, 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.

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

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 ninepage 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

21

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.’’) 46See, 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). 47During 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. 48See, 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. 49Powers Report at 4. 50 Id. at 4–5.

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

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

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:

22

51 Hearing Exhibit 23, ‘‘LJM2 Update’’ (Finance Committee presentation, 5/1/00). 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. 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’’). 54 Hearing Exhibit 60, ‘‘Major Transactions; Largest 10 Transactions (June 30-December 31)’’

(Finance Committee presentation, 12/11/00), Bates EC24832. 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.

—LJM1 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

—A 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

—The 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

—Enron’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

—Even 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

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

23

56The 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–

93.57See Hearing Exhibit 26, ‘‘Enron Code of Ethics’’ (7/00) (‘‘Business Ethics’’) at 12:

‘‘Employees 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.’’

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

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

24

58 Hearing Exhibit 26 (‘‘Conflicts of Interest, Investments, and Outside Business Interests of

Officers and Employees’’) at 57: ‘‘[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. 60 Hearing Exhibit 55, ‘‘Defendant Andersen Exhibit 763,’’ U.S. v. Arthur Andersen (USDC SD

Texas, Criminal Action No. H–02–0121). 61 Id. ‘‘Defendant Andersen Exhibit 764.’’ Andersen personnel also had significant accountingrelated 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. 62 Hearing Exhibit 19, ‘‘Project LJM Board Presentation’’ (6/28/99).

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:

‘‘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

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

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 NetConVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
25

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. 64 Hearing Exhibit 56a (Board minutes 6/28/99). 65 Id. 66The 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

Continued

nections, 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

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

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

26

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. 68 Hearing Exhibit 20, ‘‘LJM 2 Summary’’ (10/11/99). 69 Id. 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. 72 Hearing Record at 64.

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.

About 3 months later, in October 1999, the Board was asked to

approve a second LJM partnership, LJM2, described as a ‘‘[f]ollowon 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.

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

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 indiVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
27

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). 75Powers Report at 9. 76See, 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.

cated 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.

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.

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

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.

28

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. 80Powers 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.) 82Powers Report at 170.

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.

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.

29

83Powers Report at 166. 84See 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.’’) 85See Powers Report at 168. 86See discussion in Powers Report at 163–65. 87See 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. 88Powers Report at 171.

Fastow, on occasion, ‘‘pressur[ed]’’ them ‘‘to obtain better terms for

LJM.’’ 83

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

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

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

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.

30

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). 92 Hearing Exhibit 24, ‘‘Review of LJM procedures and transactions completed in 2000’’ (2/12/

01). 93The 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. 94 Hearing Exhibit 23, ‘‘LJM2 Update’’ (5/1/00).

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

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.

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

31

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. 96 Hearing Exhibit 56h, ‘‘LJM3 presentation to the Finance Committee’’ (10/6/00), Bates EC

25373–80. 97 Hearing Exhibit 24, ‘‘Review of LJM procedures and transactions completed in 2000’’ (2/12/

01).

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

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.

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

32

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.’’). 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. 101Mr. 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.

though some exceeded the $25 million threshold for DASHs provided to the Finance Committee for review.98

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.

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

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 regulaVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
33

103 Hearing Record at 68–69. 104 Id. at 68. 105 Hearing Exhibit 44b, ‘‘Enron CFO’s Partnership Had Millions in Profit,’’ Wall Street Journal (10/19/01). 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.

tion.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.

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.

Sen. 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

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

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:

‘‘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 reVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
34

107 Hearing Exhibit 24b. 108 Id. 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.

sponse 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

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.

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

35

110 Hearing Exhibit 24b, script and handwritten notes of conversation between Dr. LeMaistre,

John Duncan, and Mr. Fastow in October 2001. 111These Enron employees were members of the Southampton partnership that purchased

LJM1’s key subsidiary. Powers Report at 93 and 95. 112The Subcommittee has identified only two LJM transactions, in August and September of

2000, that were with a counterparty other than Enron. 113For 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. 114The Powers Report describes this termination payment as a ‘‘huge windfall’’ for LJM1.

Powers Report at 89. 115See Hearing Exhibit 27, ‘‘The Raptors,’’ prepared by the Subcommittee. See also Powers

Report at 129.

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

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.

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

36

116 Hearing Exhibit 39, ‘‘Private Equity Strategy’’ (Finance Committee presentation, 10/00). 117 Hearing Record at 104. 118 Id.

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

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

Whitewing. The Board’s awareness and approval of Enron’s offthe-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.

37

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). 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).

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.

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

38

123 Hearing Exhibit 16, ‘‘Whitewing, 1997–2001,’’ prepared by the Subcommittee. 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. 126LJM1, 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). 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.

its financial statements as funds flow from asset sales and investments.

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.

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

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.

39

130See 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. 131The 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. 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).

Winokur, ‘‘reviewed the maturities and refinancings planned’’ for

Whitewing.130

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

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

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

40

134See, 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. 135See 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’’). 137 Hearing Exhibit 39, ‘‘Private Equity Strategy’’ (Finance Committee presentation, 10/00). 138The 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.

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.

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.

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.

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

41

139 Hearing Exhibit 28b, ‘‘Project Raptor; Hedging Program for Enron Assets’’ (Finance Committee presentation, 5/1/00) at 25. 140Powers Report at 98 and 132. 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.’’

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.

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

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

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

42

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. 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. 145 Hearing Exhibit 44, ‘‘Partnership Spurs Enron Equity Cut,’’ Wall Street Journal (10/18/01). 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.

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.

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

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.

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.’’ The Raptor I presentation contains all the information necessary

for a Board of ‘‘experts in areas of finance and accounting,’’ as Mr.

43

147Powers Report at 97. 148See 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.’’) 149See, 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.

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

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

44

150 Hearing Exhibit 32, ‘‘Stock Price Risk in Financings; Potential Required Future Equity

issuance’’ (Finance Committee presentation, 4/01). 151The 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. 152 Hearing Record at 76–79. 153 Id. at 76.

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.

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

45

154See, 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. 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).

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

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.

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

46

156Watkins’ 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. 157 Hearing Exhibit 44, ‘‘Partnership Spurs Enron Equity Cut,’’ Wall Street Journal (10/18/01). 158 Hearing Exhibit 31, ‘‘Enron Deal Summary’’ for Raptor I (4/18/00).

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

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.

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.

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, identiVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
47

159 Hearing Exhibit 24, ‘‘Review of LJM procedures and transactions completed in 2000’’

(Audit and Finance Committee presentation, 2/12/01) at 2. 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. 161Powers Report at 178 and 187. See also Powers Report at 197.

fied all four and stated they had a combined value of $127 million,

far larger than any other LJM transaction on the list.159

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

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

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

48

162Watkins’ letter to Board Chairman Lay (8/15/01) at 2, attached to this report as Appendix

2 on page 57. 163 Id. 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.

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:

‘‘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

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.

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

49

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. 167See, 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. 168 Hearing Record at 46.

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

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.

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’’ toVerDate 11-MAY-2000 12:07 Sep 12, 2002 Jkt 000000 PO 00000 Frm 00053 Fmt 6633 Sfmt 6633 80393.TXT SAFFAIRS PsN: SAFFAIRS
50

170 An Enron filing in Federal bankruptcy court in June 2002, listing payments to Enron offi- cers 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. 171 Hearing Record at 90. 172 Id. at 89. 173 Id. at 90.

ward 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.

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.

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

51

174 Hearing Exhibit 43, ‘‘Enron Board of Directors—Financial Ties to Enron,’’ prepared by the

Subcommittee. 175 Enron 2001 Proxy. 176 Id.

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

—Since 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

—Since 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

—Enron 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

52

177 Enron 2000 and 2001 Proxy. 178M.D. Anderson Cancer Center records. 179 New York Times, 11/30/01. 180 Enron 2001 Proxy. 181 Enron 1998 Proxy. 182 Enron 1994 and1995 Proxy. 183Subcommittee staff interview of Mr. Walker. 184 Hearing Record at 94–95.

from sales to Enron subsidiaries of oilfield equipment

and services.177

—In 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

—Since 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.

—Since 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.

—Charls 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

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:

‘‘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

53

185 Hearing Record at 106–107. 186 Hearing Record at 107. 187See Hearing Exhibits 35a and 35b, on Enron Board Member compensation, prepared by

the Subcommittee. 188 Hearing Record at 110–112. 189 Id. at 111.

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

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

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.

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

54

190See, 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.’’). 191 Hearing Record at 105 and 106. 192 Hearing Exhibit 7b, ‘‘Summary of Fees—Activity Overview’’ (Audit Committee presentation, 5/1/00).

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

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

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, dur- ing 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

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

55

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.

56

57

58

59

60

61

62

63

Æ