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80–300 PDF 2002

S. Hrg. 107–511

THE ROLE OF THE BOARD OF DIRECTORS IN

ENRON’S COLLAPSE

HEARING

BEFORE THE

PERMANENT SUBCOMMITTEE OF INVESTIGATIONS

OF THE

COMMITTEE ON

GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

MAY 7, 2002

Printed for the use of the Committee on Governmental Affairs

(

(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 Staff Director

ROBERT L. ROACH, Counsel and Chief Investigator

KIM CORTHELL, Minority Staff Director

MARY D. ROBERTSON, Chief Clerk

(III)

C O N T E N T S

Opening statements: Page

Senator Levin .................................................................................................... 1

Senator Collins ................................................................................................. 6

Senator Lieberman ........................................................................................... 9

Senator Durbin ................................................................................................. 11

Senator Bunning ............................................................................................... 12

Senator Fitzgerald ............................................................................................ 42

Senator Carper ................................................................................................. 46

WITNESSES

TUESDAY, MAY 7, 2002

John H. Duncan, former Executive Committee Chair, Board of Directors,

Enron Corporation, Houston, Texas ................................................................... 13

Herbert S. Winokur, Jr., Finance Committee Chairman, Board of Directors,

Enron Corporation, Greenwich, Connecticut ..................................................... 16

Robert K. Jaedicke, former Audit and Compliance Committee Chair, Board

of Directors, Enron Corporation, Bozeman, Montana ....................................... 19

Charles A. LeMaistre, M.D., former Compensation and Management Development Committee Chair, Board of Directors, Enron Corporation, San Antonio, Texas .............................................................................................................. 21

Norman P. Blake, Interim Chair, Board of Directors, Enron Corporation,

Rosemont, Illinois ................................................................................................. 25

Charles M. Elson, Director, Center for Corporate Governance, University

of Delaware, Newark, Delaware ......................................................................... 93

Michael H. Sutton, former Chief Accountant, Securities and Exchange Commission, Williamsburg, Virginia ......................................................................... 96

Robert H. Campbell, former Chairman and Chief Executive Officer, Sunoco,

Inc., and Current Board Member of Hershey Foods, CIGNA, and Pew

Charitable Trusts, Coronado, California ............................................................ 99

ALPHABETICAL LIST OF WITNESSES

Blake, Norman P.:

Testimony .......................................................................................................... 25

Prepared statement .......................................................................................... 181

Campbell, Robert H.:

Testimony .......................................................................................................... 99

Prepared statement with an attachment ....................................................... 195

Duncan, John H.:

Testimony .......................................................................................................... 13

Prepared statement .......................................................................................... 113

Elson, Charles M.:

Testimony .......................................................................................................... 93

Article submitted for the Record ..................................................................... 185

Jaedicke, Robert K.:

Testimony .......................................................................................................... 19

Prepared statement with attachments ........................................................... 155

LeMaistre, Charles A., M.D.:

Testimony .......................................................................................................... 21

Prepared statement with an attachment ....................................................... 176

Sutton, Michael H.:

Testimony .......................................................................................................... 96

Prepared statement .......................................................................................... 191

Page

IV

Winokur, Herbert S., Jr.:

Testimony .......................................................................................................... 16

Prepared statement with attachments ........................................................... 116

EXHIBITS

MAY 7, 2002

1. Red Flags Known to Enron’s Board, chart prepared by the Permanent

Subcommittee on Investigations ...................................................................... 203

2. a. Selected Observations, 1998 Financial Reporting (Source: February 7,

1999, Andersen Presentation to Audit Committee.) ................................. 204

b. Draft Minutes, Meeting of the Audit and Compliance Committee of

the Board of Director, Enron Corporation, February 7, 1999 .................. 205

3. Selected Observations, 1998 Financial Reporting (Source: February 7,

1999, Andersen internal document related to presentation to Enron Audit

Committee.) ....................................................................................................... 208

4. Transcription of handwritten note of David Duncan on Exhibit #3

(above.) ............................................................................................................... 209

5. Letter from Arnold and Porter to Permanent Subcommittee on Investigations, dated May 2, 2002, regarding Tom Bauer and handwritten notes

on Exhibit #3 (above.) ....................................................................................... 210

6. High Priority Financial Reporting Risk Areas, Ongoing—1999 Specific

(Source: May 3, 1999, Andersen Presentation to Enron Audit Committee.) ............................................................................................................... 211

7. a. High Priority Financial Reporting Risk Areas, Ongoing—2000 Specific

(Source: May 1, 2000, Andersen Presentation to Enron Audit Committee.) .......................................................................................................... 212

b. Summary of Fees—Activity Overview (Source: May 1, 2000, Andersen

Presentation to Enron Audit Committee.) ................................................ 213

c. Draft Minutes, Meeting of Audit and Compliance Committee of the

Board of Directors, Enron Corporation, May 1, 2000 ............................... 214

8. a. 2000 Audit Update, Selected Observations—Financial Reporting

(Source: February 12, 2001, Andersen Presentation to Enron Audit

Committee.) .................................................................................................. 218

b. 2000 Audit Update, Status and Required Communications (Source:

February 12, 2001, Andersen Presentation to Enron Audit Committee.) ......................................................................................................... 220

9. High Priority Financial Reporting Rish Areas, Ongoing—2001 Specific

(Source: April 20, 2001, Andersen Presentation to Enron Audit Committee.) ............................................................................................................... 221

10. a. Approval Report, May 18, 2000, Andersen Internal Assessment of

Enron ............................................................................................................ 222

b. FS Misstatement Risk, November 22, 1999, Andersen Internal Assessment of Enron .............................................................................................. 226

11. Specific References to Whitewing/Nighthawk/Osprey in Enron’s Board/

Committee Presentations, table prepared by the Permanent Subcommittee

on Investigations ............................................................................................... 228

12. Minutes, Meeting of the Board of Directors, Enron Corporation, December

9, 1997 ............................................................................................................... 231

13. Minutes, Special Meeting of the Board of Directors, Enron Corporation,

February 1, 1999 ............................................................................................... 240

14. Minutes, Meeting of the Board of Directors, Enron Corporation, September

17, 1999 ............................................................................................................. 244

15. September 17, 1999, Facsimile to Members of the Board of Directors

regarding Condor flowcharts: Condor Transaction, Step 1—December 1997

and Condor Transaction, Step 2—September 1999 (Source: September

1999, Presentation to the Board of Directors.) ............................................... 253

Page

V

16. Whitewing, 1997–2001, chart prepared by the Permanent Subcommittee

on Investigations ............................................................................................... 256

17. EGF Execution Schedule, 2000 Balance Sheet Management (Source: August 2000, Finance Committee Presentation.) ............................................... 257

18. References to LJM Controls and Waivers in Board/Committee Presentations, table prepared by the Permanent Subcommittee on Investigations ................................................................................................................... 258

19. Project LJM Board Presentation, June 28, 1999: Economics of ENE Stock

Positions; Current ENE Stock Positions of Little Value to Enron; Transaction Summary; Direct Value to Enron; Benefits to Enron; A. Fastow

Involvement; Key Elements of Transaction to be Approved; Transaction

Structure; Steps to Complete the Transaction ................................................ 261

20. LJM2 Summary (Source: October 11–12, 1999, Finance Committee Presentation.) ........................................................................................................... 271

21. LJM2 Co-Investment, L.P., Private Placement Memorandum, Merrill

Lynch & Co. (Source: October 1999, LJM2 Co-Investment, LP Private

Placement Memo.) ............................................................................................ 272

22. LJM Investment Activity, 1999 (Source: February 7, 2000, Audit Committee Presentation.) ........................................................................................ 277

23. LJM2 Update (Source: May 1, 2000, Finance Committee Presentation.) .... 278

24. a. Enron Corp, Review of LJM procedures and transactions completed

in 2000, February 12, 2001; LJM Investment 2000 Activity With Enron;

Related Party Transactions—LJM 2000, Internal Policies and Procedures, (February 2001) (Source: February 12, 2001, Audit and Finance

Committee Presentation.) ........................................................................... 279

b. Notes of Dr. LeMaistre regarding call to Andrew Fastow on LJMrelated compensation .................................................................................. 283

25. LJM Investments, Annual Partnership Meeting, October 26, 2000 (Source:

October 26, 2000, LJM Investments Partnership Meeting Presentation.) .. 284

26. Enron, Code of Ethics, July, 2000 ................................................................... 291

27. The Raptors, 2000–2001, chart prepared by the Permanent Subcommittee

on Investigations ............................................................................................... 300

28. a. Minutes, Meeting of the Finance Committee of the Board of Director,

Enron Corporation, May 1, 2000 ................................................................ 301

b. Project Raptor, Hedging Program for Enron Assets; Purpose; Vehicle

Structure; Project Raptor—Risks, Mitigants; (Source: May 1, 2000,

Project Raptor Finance Committee Presentation.) ................................... 306

29. Minutes, Meeting of the Board of Directors, Enron Corporation, May 2,

2000 .................................................................................................................... 311

30. a. Minutes, Meeting of the Board of Directors, Enron Corporation, August

7–8, 2000 ....................................................................................................... 319

b. Project Raptor II (Source: June 22, 2000, Executive Committee Meeting, Project Presentation.) .......................................................................... 327

31. Enron Deal Summary (Raptor). (Source: April 18, 2000, Enron and LJM2

Deal Approval Sheets: Raptor.) ....................................................................... 328

32. Stock Price Risk in Financings, Potential Required Future Equity

Issuance. (Source: April 2001, Finance Committee Presentation.) ............... 334

33. a. October 2–5, 2001, E-Mails regarding Enron Stock transactions (REDACTED by the Permanent Subcommittee on Investigations) ............... 335

b. SEALED EXHIBIT: October 2–5, 2001, E-Mails regarding Enron

Stock transactions (UNREDACTED) ........................................................ *

34. The Luntz Research Companies, October 19, 2001, Memorandum to Ken

Lay, Grey Whalley, and Mark Frevert, regarding Initial Focus Group

Observations & Recommendations .................................................................. 339

35. a. Enron Board Member, Total Compensation—Fiscal Year 2000, chart

prepared by the Permanent Subcommittee on Investigations ................. 348

Page

VI

b. Enron Board of Directors, Estimated Equity Compensation, 1991–2000,

chart prepared by the Permanent Subcommittee on Investigations ...... 349

36. a. Ken Lay’s Repayment of Cash Loans By Transferring Enron Stock

Back to Enron, chart prepared by the Permanent Subcommittee on

Investigations ............................................................................................... 350

b. Interoffice Memorandum from Kenneth L. Lay, dated November 20,

2000, regarding $4 Million Enron Line of Credit ..................................... 351

c. Letter from Kenneth Lay to Paine Webber, Inc., dated November

20, 2000, regarding sale of 49,950 Enron shares for repayment of

$4 million line of credit ............................................................................... 352

37. Enron’s Many Strands: Executive Compensation; Enron Paid Huge Bonuses in ’01; Experts See a Motive for Cheating, March 1, 2002, New

York Times ........................................................................................................ 353

38. a. December 31, 1999, Excerpts from SEC Form 10–K, Enron Footnotes,

Related Party Transactions ......................................................................... 359

b. December 31, 2000, Excerpts from SEC Form 10–K, Enron Footnotes,

Related Party Transactions ........................................................................ 360

c. September 30, 2001, Excerpts from SEC Form 10–Q, Enron, Description of Restatement Items ............................................................................ 362

39. Private Equity Strategy (Source: October 2000, Finance Committee Presentation.) ........................................................................................................... 370

40. Summary of Investment Portfolio as of March 31, 2001 (Source: April

2001, Finance Committee Presentation.) ........................................................ 371

41. a. Portfolio Summary as of March 31, 2001 (Source: April 2001, Finance

Committee Presentation.) ........................................................................... 372

b. Portfolio Summary as of June 30, 2001 (Source: August 13, 2001,

Finance Committee Presentation.) ............................................................ 373

42. Finance Related Asset Sales, Prepays and 125 Sales (Source: August

2001, Finance Committee Presentation.) ........................................................ 374

43. Enron Board of Directors—Financial Ties to Enron, chart prepared by

the Permanent Subcommittee on Investigations ........................................... 375

44. a. Partnership Spurs Enron Equity Cut, October 18, 2001, The Wall

Street Journal .............................................................................................. 376

b. Enron CFO’s Partnership Had Millions in Profit, October 19, 2001,

The Wall Street Journal ............................................................................. 378

45. Minutes, Meeting of the Board of Directors, Enron Corporation, October

7, 2000 ............................................................................................................... 380

46. 2001 Proxy Statement for Enron Corp. with list of Directors ....................... 383

47. a. Corporate Governance Guidelines of The Board of Directors of Enron

Corp. ............................................................................................................. 385

b. Enron Corp. Audit and Compliance Committee Charter (As Amended

February 12, 2001) ...................................................................................... 393

c. Enron Corp. Finance Committee Charter .................................................. 396

d. Enron Corp. Compensation Committee Charter ....................................... 398

e. Enron Corp. Nominating Committee Charter ........................................... 401

48. Enron Corp. Business Risk Management Process Overview, chart prepared

by Arthur Andersen .......................................................................................... 403

49. Audit and Compliance Committee Calendar of 2001 Activities .................... 404

50. Arthur Andersen Report to the Audit Committee of the Board of Directors,

Enron Corp., August 2000 ................................................................................ 405

51. Application of Mark-to-Market and Fair Value Accounting, October 11,

1999, Arthur Andersen Presentation to Enron Corp. .................................... 407

Page

VII

52. Letter to Enron Corp. Compensation & Management Development Committee Members, dated April 13, 2001, regarding Potential Proxy Q &

As, attaching table entitled Confidential For Enron Board of Directors,

Public Relations, Investor Relations & HR Use Only, Potential Questions—Enron Proxy 2001 .................................................................................. 416

53. Enron Interoffice Memorandum to Enron Corp. Board of Directors, dated

November 2, 2001, regarding Management Committee Compensation

Summary and attaching copy of November 2, 2001 letter to Enron Compensation Committee from Towers Perrin regarding observations regarding the Ken Lay insurance swap approved by Enron’s Compensation Committee ................................................................................................................. 422

54. Enron Corp. Compensation Committee 12/20/01 meeting, Agenda Item

No. 6, Other Business—6(a) Employment Agreement Summaries; 6(b) Kenneth L. Lay, changes To Current Employment Agreement Provisions .......... 425

55. Defendant Andersen Exhibit 763 and 764 (Arthur Andersen email, May

and June 1999, re: Enron), U.S. v. Arthur Andersen (USDC SD Texas,

Criminal Action No. H–02–0121) .................................................................... 428

56. a. Excerpts from Minutes, Special Meeting of the Board of Directors,

Enron Corp., June 28, 1999 ........................................................................ 432

b. Minutes, Meeting of the Finance Committee of the Board of Directors,

Enron Corp., October 11, 1999 ................................................................... 436

c. Minutes, Meeting of the Board of Directors, Enron Corp., October 11–

12, 1999 ........................................................................................................ 444

d. Minutes, Meeting of the Finance Committee of the Board of Directors,

Enron Corp., December 13, 1999 ................................................................ 448

e. Minutes, Meeting of the Board of Directors, Enron Corp., December

14, 1999 ........................................................................................................ 452

f. Draft Minutes, Meeting of the Audit and Compliance Committee of

the Board of Directors, Enron Corp., February 7, 2000 ............................ 458

g. Draft Minutes, Meeting of the Finance Committee of the Board of

Directors, Enron Corp., August 7, 2000 ..................................................... 462

h. Minutes, Meeting of the Finance Committee of the Board of Directors,

Enron Corp., October 6, 2000 ..................................................................... 468

i . Minutes, Meeting of the Board of Directors, Enron Corp., October 7,

2000 .............................................................................................................. 481

j . Draft Minutes, Meeting of the Audit and Compliance Committee of

the Board of Directors, Enron Corp., February 12, 2001 .......................... 500

k. Minutes, Meeting of the Finance Committee of the Board of Directors,

Enron Corp., February 12, 2001 ................................................................ 506

l. Minutes, Meeting of the Finance Committee of the Board of Directors,

Enron Corp., October 8, 2001 ..................................................................... 511

m. Draft Minutes, Meeting of the Audit and Compliance Committee of

the Board of Directors, Enron Corp., November 2, 2001 .......................... 517

57. Letter from PriceWaterhouseCoopers LLP, dated August 17, 1999, to

Enron Capital Management, regarding fairness opinion between Enron

Corp. and LJM Cayman, L.P., for put option on Rhythms NetConnections

Inc. stock ........................................................................................................... 520

58. LJM2 Co-Investment, L.P., Supplement Number One To Private Placement Memorandum, December 15, 1999 ......................................................... 525

59. a. Arthur Andersen Memorandum, December 31, 1999, regarding LJMII

Partnership Structure .................................................................................. 526

b. Arthur Andersen Memorandum, December 31, 1999, as amended October 12, 2001, regarding LJMII Partnership Structure ............................. 529

60. Major Transactions, Largest 10 Transactions (June 30-December 31)

(Source: August 2000, Finance Committee Presentation.) ............................ 532

Page

VIII

61. Enron Interoffice Memorandum, March 8, 2001, regarding LJM Approval

Process—Transaction Substantiation .............................................................. 533

62. Enron Interoffice Memorandum, March 28, 2001, regarding Related-Party

Proxy Disclosures .............................................................................................. 538

63. Arthur Andersen Memorandum, February 9, 2001, regarding LJM Related Party Transactions .................................................................................. 540

64. Draft Enron Corp. Memorandum, September 2001, regarding Project

Raptor—Addendum .......................................................................................... 542

65. Enron Corp. Interoffice Memorandum, August 16, 2000, regarding EITF

Issue Update ...................................................................................................... 544

66. Enron Corp. email, December 12, 2000, regarding EITF 00–19 Year End

Implications ....................................................................................................... 546

67. Arthur Andersen email, August 23, 2001, regarding Documentation of

Client Call ......................................................................................................... 550

68. Enron Corp. draft responses to the Securities and Exchange Commission’s

questions on the LJM transactions, November 2, 2001 ................................ 553

69. Raptor Hedging Strategy Analysis, Enron Corp. Risk Assessment and

Control Presentation, 2001 .............................................................................. 556

70. Enron Global Markets, Enron’s Funds Flow Targets, March 2001 .............. 562

71. Enron Global Assets and Services, Equity Value Schedule, As of June

2001 .................................................................................................................... 564

72. Summary Notes from Enron Corp. Board of Directors Meetings, November through December 2001 ............................................................................. 565

73. Arthur Andersen documents related to Joseph Berardino’s visit to Enron

Corp. in February 2001, decision to retain Enron Corp. as a client, and

removal of Carl Bass from Enron Corp. engagement team in March

2001 .................................................................................................................... 566

74. Additional materials from Arthur Andersen, some with David Duncan’s

handwriting, related to Enron Corp. accounting practices ........................... 589

75. Stoel Rives LLP Memorandum, December 8, 2000, regarding Traders’

Strategies in the California Wholesale Power Markets/ISO Sanctions, provided by Enron Corp. ........................................................................................ 592

76. Seth Vance, Schroder Salomon Smith Barney, email, October 2001, to

Andrew Fastow ................................................................................................. 600

77. a. Memorandum of the Special Committee of Enron’s Board of Directors,

January 8, 2002, Interview of Herbert S. Winokur, Jr. ........................... 601

b. Memorandum of the Special Committee of Enron’s Board of Directors,

January 11, 2002, Interview of Dr. Robert Jaedicke ............................... 612

c. Memorandum of the Special Committee of Enron’s Board of Directors,

January 14, 2002, Interview of John Mendelsohn .................................... 621

d. Memorandum of the Special Committee of Enron’s Board of Directors,

January 30, 2002, Interview of Norman Blake ........................................ 623

e. Memorandum of the Special Committee of Enron’s Board of Directors,

January 21, 2002, Interview of Ronnie Chan ........................................... 629

f. Memorandum of the Special Committee of Enron’s Board of Directors,

January 10, 2002, Interview of Paulo Ferraz Pereira .............................. 634

g. Memorandum of the Special Committee of Enron’s Board of Directors,

January 14, 2002, Interview of Wendy Gramm ........................................ 638

h. Memorandum of the Special Committee of Enron’s Board of Directors,

January 10, 2002, Interview of Lord John Wakeham ............................. 644

78. Remarks by Securities and Exchange Commission Chairman Arthur

Levitt, ‘‘The Numbers Game,’’ September 28, 1998 ....................................... 645

79. a. Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ......................... *

Page

IX

b. Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, Overview

and Recommendations section .................................................................... 652

80. Clarifications and supplemental questions and answers for the record

of Messrs. John Duncan, Herbert Winokur, Norman Blake, Dr. Charles

LeMaistre and Dr. Robert Jaedicke ................................................................ 665

81. Supplemental questions and answers for the record of Michael H. Sutton . 684

82. Supplemental questions and answers for the record of Robert H. Campbell ..................................................................................................................... 690

83. Statement for the Record of Ira M. Millstein, Co-Chairman of the Blue

Ribbon Committee on Improving the Effectiveness of Corporate Audit

Committees ........................................................................................................ 696

84. Report of Investigation by the Special Investigative Committee of the

Board of Directors of Enron Corp., William C. Powers, Jr., Chair, Raymond S. Troubh, Herbert S. Winokur, Jr., February 1, 2002, (‘‘Powers

Report’’) .............................................................................................................. *

85. The Outside Directors’ Response to the Permanent Subcommittee on Investigations’ Report: The Role of the Board of Directors In Enron’s Collapse ................................................................................................................... 715

86. Institutionalizing Good Governance: Keys to Success, article by Rosemarie

B. Greco in Director’s Monthly, the official newsletter of the National

Association of Corporate Directors, January 2002 ......................................... 751

* May be found in the files of the Subcommittee

(1)

THE ROLE OF THE BOARD OF DIRECTORS IN

ENRON’S COLLAPSE

TUESDAY, MAY 7, 2002

U.S. SENATE, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC.

The Subcommittee met, pursuant to notice, at 9:37 a.m., in room

SH–216, Hart Senate Office Building, Hon. Carl Levin, Chairman

of the Subcommittee, presiding.

Present: Senators Levin, Lieberman, Durbin, Carper, Collins,

Bunning, and Fitzgerald.

Staff Present: Elise J. Bean, Acting Staff Director and Chief

Counsel; Linda J. Gustitus, Chief of Staff for Senator Levin; Mary

D. Robertson, Chief Clerk; Stephanie E. Segal, Professional Staff

Member; Ross Kirschner, Deputy Investigator; Jamie Duckman,

Majority Accountant; Kim Corthell, Republican Staff Director; Alec

Roger, Counsel to the Minority; Claire Barnard, Investigator to the

Minority; Jim Pittrizzi, Detailee/General Accounting Office; Joyce

Rechtschaffen, Staff Director and Counsel, Governmental Affairs

Committee; Marianne Upton (Senator Durbin); Joe Bryan (Senator

Levin); Bill Weber (Senator Durbin); Cindy Lesser (Senator

Lieberman); Kathleen Long (Senator Levin); Holly Schmitt (Senator Bunning); Anne Fisher (Senator Cochran); Bob Klepp and

Trent Kittleman (Senator Thompson).

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. Good morning, everybody. The Subcommittee will

come to order.

On December 2, 2001, the seventh largest corporation in America collapsed. Its stock, having plummeted from $80 a share to practically nothing in less than 10 months, the reins of what was once

a high-flying company of $100 billion in gross revenues and 20,000

employees were handed over to a Federal bankruptcy judge. That

collapse has rolled like a tidal wave across the corporate boardrooms of America, across Wall Street, and across the entire investing community, which now includes over half of U.S. households.

With this tidal wave, we are all asking two questions: What happened at Enron, and could it happen again? Today, we hope to help

answer the first question in order to ensure that the answer to the

second question will become ‘‘no.’’

One of the key players responsible for overseeing the operations

of our publicly held corporations is the Board of Directors. Directors are charged by law to be the fiduciaries, the trustees who proVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
2

tect the interests of the corporate shareholders. In that capacity,

they are supposed to exercise their best business judgment on behalf of those shareholders. They are supposed to be independent.

And while they are not expected to be detectives, they are expected

to ask tough questions of management, to probe opaque answers,

and to display sufficient skill and fortitude to say no to transactions that do not look right.

Along with management and the auditors, the Board shares the

responsibility to provide to the company’s shareholders a financial

statement that is a fair representation of the financial position of

the company. As the Second Circuit Court of Appeals held in a

widely quoted opinion, technical compliance with Generally Accepted Accounting Principles may be evidence of acting in good faith,

but it is not necessarily conclusive: The ‘‘critical test,’’ the court

said, is ‘‘whether the financial statements as a whole fairly present

the financial position’’ of a company. Enron’s financial statements

did not, and the Board’s role in that failure is before us.

Today, we have five key members from the Enron Board of Directors to tell us what they knew about the financial condition of

Enron, when they knew it, and what they did about it. In other

words, what role did the Board play in these events?

The Subcommittee issued over 50 subpoenas for documents to

Enron, Arthur Andersen, members of the Enron Board, and officers

of Enron. Staff has reviewed about 300 boxes of documents to date,

and conducted interviews with 13 current and past Board members. Each Board member complied with the document subpoenas

and willingly appeared for interviews. We appreciate their cooperation and their voluntary appearance today.

We have found that when you pare down the hundreds of incredibly complex financial transactions that were the hallmark of

Enron, you realize that many were nothing more than smoke-andmirrors bookkeeping tricks, designed to artificially inflate earnings

rather than achieve economic objectives, to hide losses rather than

disclose business failures to the public, to deceive more than inform.

The decisions to engage in these accounting gimmicks and deceptive transactions were fueled by the very human but unadmirable

emotions of greed and arrogance. Putting a growth gloss on the balance sheet pumped up the stock price, and the rise in stock price,

regardless of the underlying true value of the company, was, for

many, the measure in the 1990’s for judging corporate success. The

Board that was supposed to be the check on the greed and the arrogance, in fact, was not. Here is how it happened.

Enron was in transition from an old-line energy company, with

pipelines and power plants, to a high-tech global enterprise engaged in energy trading and international investment. It experienced large fluctuations from quarter to quarter in its earnings.

Those large fluctuations affected the credit rating Enron received,

and the credit rating affected Enron’s ability to obtain low-cost financing, attract investment, and increase its stock price.

In order to smooth out its earnings and avoid the natural dips,

Enron engaged in a variety of complicated transactions that relied

on structured finance, derivatives, and other arrangements that,

while legal if done right, are nonetheless designed to massage a

3

company’s financial statement to make its financial condition look

better than it really is.

While it is not uncommon for a company to use these devices,

they are also used somewhat sparingly. Enron, however, made

them a high art form and used them aggressively, and in some

cases, improperly. When used extensively and when they become

dominant, when they involve billions of dollars, $27 billion in assets at Enron’s peak, the real impact of these complex transactions

on a financial statement is to cover up reality with a glitzy coat of

paint. The financial statement becomes a fiction, and that is what

happened at Enron.

Step by step, Enron shifted a larger percentage of its assets into

these structured finance arrangements, not for any real business

purpose, but in order to make Enron look more profitable than it

really was. Funds flow and the appearance of funds flow became

the Enron mantra in order to keep Enron’s credit rating up and its

stock price climbing, and the Board of Directors went along with

it.

In many actions starting in 1997, when the Board first approved

Whitewing, through the summer of 2001, just before things fell

apart publicly, the Board of Directors went along with management’s wishes. The Board relinquished its role of questioner and

adopted the role of facilitator. It succumbed to the Enron ether of

invincibility, superiority, and gamesmanship in manipulating

Enron’s financial statement to keep the Enron stock price soaring.

This is a company, we are told, that had televisions in its elevators

in order for employees to monitor Enron’s stock price at all times.

The financial transactions that the Board approved were used to

make debt look like equity, to make loans look like sales, to make

poorly performing assets look like money makers, and to make

Enron-controlled entities look like legitimate third parties. By the

time of the collapse, Enron held almost 50 percent of its assets off

its books, and what started as a useful tool to address specific business problems had become a way of life.

As long as Enron’s stock was rising, these elaborate financial

structures did what they were designed to do, make Enron’s financial condition look better than it was. But once Enron stock started

falling, these financial structures collapsed on themselves like a

house of cards, revealing at the end that there was no ‘‘there’’

there. These transactions involved a number of deceptions that

pushed the limit of accepted accounting practices and, at times, exceeded them. And parenthetically, if it turns out that Generally Accepted Accounting Principles allow such deceptions, then those accounting principles need to be changed.

One type of deception that Enron used was to report on the company’s financial statements the sale of an asset despite an understanding that Enron would buy it back after the financial statement was filed, or despite a hidden guarantee that the entity buying the asset would receive a certain rate of return. Five of the

seven assets sold this way to the LJM partnership at the end of

the last two quarters of 1999 were bought back by Enron, sometimes within 6 months’ time. But those guarantees did not show on

Enron’s books as a liability. Only the sales showed as funds flow.

4

1See Exhibit No. 1 which appears in the Appendix on page 203.

Another type of deception made what was essentially a loan look

like a sale, so the company’s financial statement reflected the

transaction as income or cash flow instead of debt.

A third type of deception inflated the value of the assets that

Enron held for sale. For example, Enron would buy a power plant

on day one for $30 million, and within a month or so would begin

carrying it on Enron’s books as an asset worth $45 million. Two

weeks ago, Enron filed a statement with the SEC declaring that it

is going to write down its assets by another $14 to $24 billion, a

staggering sum, due to overvaluations on the books and ‘‘accounting errors or irregularities.’’ Another type of deception, the Raptors, used Enron stock to

backstop a risk that the LJM partnership and its investors were

supposed to be assuming for Enron, and the risk retained by Enron

was not disclosed on the company’s financial statements in a meaningful way.

As these structured financial transactions grew in number, size,

and frequency, and as 50 percent of Enron’s assets were moved off

Enron’s books, no one on the Enron Board said that their fiduciary

duty required them to blow the whistle and prevent a deceptive

picture of Enron’s financial situation from being presented to the

public.

During the 13 interviews, the Board members told us that they

had not been aware of the depth of Enron’s problems or the extent

of these structured transactions and accounting gimmicks, and

most said they had no inkling that Enron was in troubled waters

until mid-October 2001. But look at this chart that the Subcommittee staff has put together,1 identifying numerous red flags

presented to the Board of Directors from February 1999 on, that

signaled the risks Enron was taking, and that should have alerted

the Board to probe and then to change course.

The staff has identified well over a dozen of these red flags, but

I am just going to highlight a few. In February 1999, the Board’s

Audit Committee was told by Arthur Andersen directly that

Enron’s accounting practices were high risk and pushed limits.

In June 1999, the Board approved at a special meeting and without prior Finance Committee consideration the creation of the LJM

partnership, and waived the conflict of interest provision of the

Enron code of conduct. The Enron Chief Financial Officer, Andy

Fastow, served as the managing partner of LJM, something no

Board member had ever approved or heard of prior to this. The

Board was to approve a code of conduct waiver for Fastow three

times over the next 16 months.

In September 1999, the Board approved moving off the Enron

balance sheet a $1.5 billion joint venture called Whitewing, which

was established by the Board in December 1997 to get a loan that

looked like equity, and then used from 1999 on to purchase assets

that Enron wanted to move off its books.

In May 2000, the Board approved the first Raptor transaction, a

vehicle designed to hedge Enron investments by using Enron stock

to backstop the hedge, which amounted to Enron hedging with

itself.

5

By October 2000, the Board knew that Enron had $27 billion in

assets, almost half of its assets, off its balance sheet.

In April 2001, the Enron Board knew that 64 percent of Enron’s

assets were troubled or not performing and that 45 million shares

of Enron stock were at risk in Raptors and Whitewing.

Starting with the creation of Whitewing in 1997 and with its

deconsolidation in 1999, the Board started to wade into dangerous

waters. With the establishment of the LJM partnership and the

waiver of the code of conduct, they were up to their necks, and with

the Board’s approval of the Raptors, the Board was swimming way

over their heads. In the end, Enron drowned in its own debt. As

the chart shows, the Board had ample knowledge of the dangerous

waters in which Enron was swimming and it did not do anything

about it.

The Board told the Subcommittee staff that because each of

Enron’s transactions was approved by Enron management, whom

they saw as some of the most creative and talented people in the

business, and because the transactions had been approved by Arthur Andersen, a top auditing firm, and by Enron’s lawyers and

private law firms like Vinson and Elkins, by the credit rating agencies, or by investment bankers who had a significant stake in a lot

of these transactions, the Board assumed that the transactions

were OK. Now, I can see why you might rely on a company auditor

or an outside attorney, but the Board must exercise independent

judgment. The Board is not supposed to be a rubber stamp for

auditors or attorneys.

Also, the people that the Board relied on were conflicted in their

roles involving Enron, and the Board knew it. First, the Board

knew that Enron’s management handed out bonuses like candy at

Halloween. Employees were given huge bonuses for closing deals,

and many of these deals proved damaging to Enron. For instance,

two executives closed a deal on a power project in India, which is

now a financial disaster, and got bonuses in the range of $50 million. The head of one Enron division who was moved out of the

company walked away with more than $250 million in the year

that he was shown the door. The temptation to self-enrichment at

Enron was overwhelming.

Arthur Andersen was conflicted, because it served Enron as both

an auditor and a consultant, and, for 2 years, it also served as

Enron’s internal auditor, essentially auditing its own work. Enron

was Andersen’s largest client, and in 2000, Andersen earned over

$50 million in fees from the company. Employees of Andersen routinely crossed over to work for Enron, and an Andersen employee

who actually questioned Enron practices while serving on the audit

team was promptly reassigned to another client at Enron’s urging.

Relying on outsiders, conflicted or not, does not relieve the Board

from the ultimate responsibility to make sure that at the end of the

day, Enron was operating properly and Enron’s financial statement

was a fair representation of Enron’s financial condition. The Board

failed in that responsibility.

The structured debt and guarantees overwhelmed Enron’s ability

to pay, and that meant bankruptcy for the corporation, huge pension losses for employees, investment losses for stockholders, and

business losses for hundreds of small companies that did business

6

with Enron, while the officers of the corporation walked away with

fortunes.

Today, we are going to go over the decisions that the Board made

on a number of these transactions, as well as the decisions that

they made with respect to compensation. We will also look at the

interlocking financial relationships that some members of the

Board had with Enron.

Following the Board, we will hear in a second panel from several

experts in the field of corporate governance, and I expect that we

will be taking a break for lunch sometime around 12 or 12:30.

Senator Collins.

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. Thank you, Mr. Chairman. Today is the first

in a series of hearings to be held by the Permanent Subcommittee

on Investigations into the events that led to the bankruptcy of the

Enron Corporation. As a result of the company’s downward spiral

and ultimate bankruptcy, shareholders, both large and small, individual and institutional, lost an estimated $60 billion. This includes more than 15,000 Enron employees and retirees who had a

significant proportion of their pension funds invested in the company’s stock. They lost an astounding $1.3 billion. The collapse of

Enron caused thousands of Americans to lose their jobs, to lose savings, and to lose confidence in corporate America.

Unraveling the complexities of what happened, determining who

is responsible, and prosecuting those individuals will take the Department of Justice, the Labor Department, and the Securities and

Exchange Commission many months and possibly years. The Subcommittee’s job is not to duplicate those efforts, but rather to examine the actions taken by all of the players who contributed to

Enron’s demise in order to illuminate the public policy issues. By

doing so, the Subcommittee can help focus the debate in Congress,

in State legislatures, and in corporate board rooms across the Nation on what measures should be taken and by whom to minimize

the chances of another Enron-like debacle.

In this first hearing, the Subcommittee will examine the role

played by Enron’s Board of Directors in the company’s bankruptcy.

I want to acknowledge the Board’s full cooperation with this investigation. I also want to take a moment to praise Senator Levin and

the dedicated both Majority and Minority Subcommittee staff who

have been tireless in their efforts to unravel a very tangled web of

conflicts of interest, unusual transactions, and lax oversight.

Corporate boards play an essential role in the American economy. They are the single most important guardians of a company’s

shareholders, and as such, they have a fiduciary duty to promote

the interests of the corporation, to act in good faith, and to exercise

their best judgment.

When Korn/Ferry, a major corporate recruiter, polled corporate

directors in 2001 to determine the outstanding capabilities of board

members, it identified one single trait that stood significantly

above all the others. That trait is a willingness to challenge management decisions when necessary.

There is no question that directors generally should be able to

rely on the representation of management and independent exVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
7

perts. But directors have an obligation to do more than simply accept what they are told, occasionally ask whether there are any

problems, and inquire whether the accountants agree on the propriety of actions presented for their approval. Prudent directors retain their objectivity and to some degree, a healthy skepticism.

They must be willing to ask the tough questions of management,

recognize those situations where independent expert advice should

be sought, and exercise heightened diligence when a company is

pursuing unfamiliar or new territory.

Enron was a company that prided itself on its innovation. CEO

Jeffrey Skilling often boasted of Enron’s pioneering efforts as it

transformed itself from a traditional energy company to a global

enterprise creating new markets and businesses. In contrast, it appears that the Board of Directors continued to perform its duties

as if Enron were still an old-line, conservative energy company, at

a time when it appears they should have been far more probing,

given Enron’s metamorphosis into an energy trading company.

Serving as a director for a corporation as complicated as Enron

obviously is not an easy task. Enron was one of America’s largest

corporations. It had thousands of partnerships, joint ventures, and

other special purpose entities, many of which were engaging in

transactions that can only, and barely even then, be followed with

the aid of complex diagrams. In fact, the Board members interviewed by the staff appear to have been unaware that Enron has

some 3,000 related entities, including 600 using the same post office box in the Cayman Islands. I would argue that should have

been another red flag.

The complexity of the responsibility is precisely why Enron’s Directors were paid hundreds of thousands of dollars per year in

cash, stock, and options. While the exact amount of compensation

can be difficult to determine, depending on how one calculates the

value of stock options, there is no question that Enron’s Board

members were among the most highly compensated in the world.

Today, we will ask five Enron Directors what they did to protect

shareholders and why they believe that they failed in doing so. We

will also hear an evaluation of their efforts from some of the leading experts on corporate governance. I am particularly interested

to learn more about the Board’s response to the large stock sales

engaged in by Enron’s management, its reaction to the departure

of a CEO who left after only 6 months on the job, and its decision

to approve a waiver of Enron’s code of conduct to allow the Chief

Financial Officer to engage in business deals with the company.

This latter decision is the Board action that I find among the

most inexplicable. During the investigation, the Subcommittee

spoke with many experts on corporate governance, and not a single

one had ever heard of a public company ratifying a similar proposal.

I want to understand also the Board’s view of what now appears

to be the obvious conflicts of interest that contributed to Enron’s

collapse and to explore whether the Board, and its Audit Committee in particular, believed that they acted prudently in monitoring the outside auditor, Andersen. Actually, Andersen, as we

know, was more than the outside auditor, which is another issue

in and of itself. The Board, with Andersen’s endorsement, approved

8

many of the transactions described by Senator Levin that enabled

the company to paint a false picture of its financial health and

Enron employees to enrich themselves at the expense of the corporation, its shareholders, and ultimately its creditors.

We are still working to unravel the complexities of these transactions, which has proven to be a monumental task. It is troubling

to me that in staff interviews, Board members have provided little

insight into major transactions. For example, not one Board member could explain or recall a $2.2 billion Board resolution that approved the issuance of preferred Enron stock to an outside investor.

Now, I certainly do not expect the Board members to have perfect

recall of every deal that they approved, but I would hope that

transactions that rise to the threshold of multiple billions of dollars

would be memorable to at least someone on the Board.

In addition, we will discuss some of the alleged conflicts of interest created by some of the Board members’ other relationships with

Enron. Was the Board’s vigilance dulled by large consulting fees,

corporate contributions to their favorite charities, and other business relationships? Every corporate governance expert with whom

we spoke was critical, for example, of any Board member having

a consultant contract with Enron. At a minimum, such relationships do not foster the appearance of propriety and financial independence of Board members.

Mr. Chairman, the Enron case is uncannily similar to another

business failure that occurred some 70 years ago. In the early

1930’s, an electric holding company called Middle West Utilities

collapsed under the weight of stock fraud and cooked books. Middle

West was comprised of so many interlocking boards that it took the

Federal Trade Commission 7 years to fully comprehend its structure, which involved 284 affiliates. Underneath its incredibly complex structure lay an immense amount of debt taken on as it expanded in the 1920’s. Ironically, Middle West’s auditor was a relatively new firm named Arthur Andersen.

There is, however, one significant difference between Middle

West’s and Enron’s executives. The Middle West CEO’s considerable fortune of around $150 million was tied up in Middle West

holdings and disappeared with the company. In contrast, many of

Enron’s managers were making tens and, at least in one case, hundreds of millions of dollars by dumping their Enron stock before

the corporation’s collapse.

Although imperfect, it is important to remember that today, our

systems of accounting and financial regulation are the best in the

world. That makes the Enron case all the more troubling, because

it simply should not have happened. It represents a colossal failure

of virtually every mechanism that is supposed to provide the

checks and balances on which the integrity of our capital markets

depend. And in that system, the Board of Directors is supposed to

provide the first line of defense by overseeing the conduct of management.

There are already encouraging signs that many directors in the

wake of Enron’s collapse are taking their roles much more seriously. As we seek answers in the Enron case, we should be careful

not to act precipitously without understanding the true nature and

extent of the problems underlying the corporation’s bankruptcy.

9

The testimony we will hear this morning about the role of the

Board of Directors should provide some answers. It should also

yield valuable lessons for strengthening our free enterprise system,

restoring public confidence in our capital markets, and ensuring

that small investors, in particular, have access to complete and accurate information to guide their investment decisions.

Senator LEVIN. Thank you very much, Senator Collins.

The Chairman of our full Committee, Senator Lieberman.

OPENING STATEMENT OF SENATOR LIEBERMAN

Senator LIEBERMAN. Thank you, Senator Levin. Thanks to you

and Senator Collins and your staff of the Permanent Subcommittee

on Investigations for holding this important hearing, which really

does initiate the next phase of the Senate Governmental Affairs

Committee’s investigation of the scandalous collapse of the Enron

corporation.

Over the past 6 months, we have all heard many reports about

who failed Enron’s shareholders and employees leading up to the

company’s fall. Obviously, the company’s management has been

cited, Arthur Andersen, government watchdogs, stock analysts, and

even rating agencies. There were bad decisions, breakdowns, and

some betrayals at several points and links in the oversight chain.

Today, we focus on another group that must accept some of the

blame for failing to uncover the crookedness in the company’s behavior and books, and that is the Board of Directors.

Textbooks tell students that the board of directors is a group of

people elected by the shareholders to watch over the management

of a corporation on behalf of the shareholders. Board members are,

in that sense, like trustees or guardians for the shareholders and,

in a larger sense, for the integrity and reliability of our economic

system.

In fact, because of their essential role, directors by law owe special duties to the corporation and particularly to its shareholders,

duties of loyalty and care. Loyalty, meaning freedom from conflicts

of interest—in other words, serving shareholders and only shareholders with independence and undivided attention. Care, meaning

doing their work responsibly, thoroughly, and in good faith.

By all appearances, unfortunately, Enron’s Board of Directors

failed their shareholders on both counts.

First, about the Directors’ loyalty to their shareholders, even

though a majority of Enron’s Board was made up of outside directors, meaning directors not in Enron’s management, a stunning 10

of the 15 most recent outside Directors had conflicts of interest, including contracts with Enron, common ties or contributions to charities, and memberships on the board of other companies doing business with Enron.

For example, charities close to some of the Directors were supported heavily by Enron and its officers. Two Directors earned

more than $6.5 million in consulting fees from Enron since 1991.

One Director served on the board of a company that in 1999 signed

a $1 billion energy management agreement with an Enron affiliate.

Arrangements like these can divide or even redirect a director’s

loyalties to the hand that feeds them, management, and away from

their single-minded responsibility to the shareholders. Consulting

10

contracts or large donations to favored charities, just as a matter

of human nature, can whittle away the objectivity directors must

bring to every decision they make and leave shareholders without

the protectors that they need.

Second, regarding the Directors’ duty to take care and be diligent

in overseeing the management of the company, my colleagues have

spoken to this, and the fact is, unfortunately, that the more we

look, the more evidence we find of inadequate oversight. In 1999,

as has been said, the Board went so far as to suspend Enron’s Code

of Ethics on two separate occasions to allow the company’s Chief

Financial Officer, Andrew Fastow, to run partnerships that would

enter into deals with Enron. That, to me, was extraordinary, and

extraordinarily irresponsible. Rather than raising a red flag, the

Board gave a green light to Mr. Fastow to, as Sherron Watkins put

it in her testimony before the Senate Commerce Committee, ‘‘put

his hands in the Enron candy jar.’’ As the shareholders’ elected representatives, it seems to me that

the board of directors has an affirmative obligation to ask questions

and get answers, and these Directors were and are qualified individuals, very qualified, with a professional understanding of industry. They had impressive credentials—former Chairman of the Executive Committee of Gulf and Western Industries, former Chairman of the U.S. Commodity Futures Trading Commission, former

Secretary of State for Energy of the United Kingdom, professor of

accounting and former Dean of the Stanford Business School.

The question is, why all that experience and so much more accomplished so little for the shareholders of Enron in the end.

To me, the Directors’ lack of due diligence is even more troubling

in light of the fact that some of them profited so much from their

positions as Board members. In stock sales alone over the years

studied by our staff, some made hundreds of thousands of dollars

and a few made more than $1 million. In that sense, I am sad to

say that the Board of Directors did not just fiddle while Enron

burned, some of them toasted marshmallows over the flames, even

as those flames shook our economy and engulfed the dreams of

thousands of dedicated Enron employees who lost not only their

jobs, but their retirement security.

The failures of Enron’s Board of Directors are a warning that we

must heed, particularly because of the more than 100 million

Americans who are now, in one way or another, stock investors,

owners of stock, particularly those millions of middle-class Americans who entered the market over the last 20 years. They are shaken and they are asking, if the distinguished Board of Enron failed

in this case, as they did, to represent the shareholders adequately,

how many other boards of how many other American corporations

might be similarly negligent?

After all, investment capital is the lifeblood of our free market

economy. So the belief that directors are failing their shareholders

is a threat to the health of our economic system. We cannot let it

grow or go untreated. We all must work together now to restore investors’ confidence, and quickly.

There are many proposals of potential reforms that have been

made to strengthen directors’ accountability. I believe we should

give the SEC new powers to remove negligent directors from their

11

boards and prohibit them from future service on the boards of any

other public companies. I am also very interested in proposals that

have been made to ban or limit company stock sales by directors

for the duration of their terms on the boards and to impose mandatory term limits on directors.

I strongly support the call to the stock exchanges to adopt listing

requirements that would obligate companies to limit the number of

insiders who can serve on boards, to restrict directors from serving

on more than a given number of boards, and to prohibit behavior

such as that we have all described this morning by Enron’s Directors, some Enron Directors, that amounts to conflicts of interest.

As usual, self-regulation by the companies and by the stock exchanges would, in my opinion, be the most direct and effective path

to reform. But if there is inadequate self-regulation, there is no

question that some government action will be necessary to prevent

the most egregious abuses of responsibility by boards of directors.

Mr. Chairman, about 100 years ago, the famous satirist Ambrose

Bierce defined a corporation as, ‘‘an ingenious device for obtaining

individual profit without individual responsibility.’’ Let us work together now to make sure that cynical joke does not become a

prophecy. Let us make sure that directors are accountable and vigilant, that they act as the shareholders’ first line of defense against

corporate negligence, mismanagement, or corruption, and that they

give investors the confidence our economy needs to grow as

robustly as we all want it to. Thank you very much.

Senator LEVIN. Thank you very much, Senator Lieberman. Senator Durbin.

OPENING STATEMENT OF SENATOR DURBIN

Senator DURBIN. Thank you, Mr. Chairman. I will be very brief

and I thank you for this hearing.

I think it is fair to say that the Enron experience has shaken corporate America to the core. I think it has shaken America to the

core because of the victims. Those victims are scarcely represented

at these Congressional hearings, not only employees that have lost

their jobs at Enron and related companies, but the investors, the

pensioners, all of those victims will only have the comfort of reading these transcripts or watching C–SPAN. That is as close as it

gets.

The theory behind corporate governance is that the board of directors is supposed to be defending them, too. But as we look at

the report from the Powers Committee and others, it is not very

encouraging in terms of the role of the Board of Directors at Enron.

In fact, the Powers Report says point-blank, ‘‘The Board of Directors failed, in our judgment, in its oversight duties.’’ That is a stunning condemnation.

Enron has called into question corporate governance and corporate honesty. It appears now when you look at the salaries being

paid to some of the people who were clearly deceiving everyone in

sight, they were being treated like corporate royalty in a Nation

which long ago decided that royalty was not going to be part of our

future.

I am going to be asking these Board members, some of whom I

know and have worked with and respect very much, whether they

12

were misled, whether or not as directors of a corporation of this

size and importance they had the tools or gave the time that was

necessary to do their job right.

I am always fascinated by how many people express an interest

in how many boards of directors they serve on, and I just wonder

if that is a real service, a real dedication, and a real commitment,

or just another notch on your gun, another line on your resume,

whether or not members of boards of directors of important companies really take that job as seriously as they should if this system

is to work.

I think that as we look at the challenge we have before us, that

this hearing of this Subcommittee will lead us to ask some hard

questions, lead us to, I hope, pass some important legislation, because if all of these hearings on Capitol Hill are just about face

time on the nightly news, we have failed those employees and those

pensioners and the people that count on this government to enact

laws to protect them. Thank you, Mr. Chairman.

Senator LEVIN. Thank you very much, Senator Durbin. Senator

Bunning.

OPENING STATEMENT OF SENATOR BUNNING

Senator BUNNING. Thank you, Mr. Chairman. Enron’s collapse

has not only affected its shareholders and employees, but it will

continue to have tremendous ramifications on the markets, specific

sectors of the economy, and in the way stock analysis, credit rating

agencies, and accounting firms do business. The status quo in

many of these industries is no longer acceptable, and I suspect

Congress and Federal agencies will be making several reforms over

the next couple of months and years to prevent another company

from slipping through the cracks. Congress will never be able to

prevent another Enron from happening, but we can make it more

difficult.

Today, we will be looking at the role Enron’s Board of Directors

played in the company’s collapse. As has been said before, the Powers Report that was published in February is fairly critical about

some actions taken by Enron’s Board of Directors, while also acknowledging that critical information was withheld. I hope this

Subcommittee can get answers today to some important questions

about decisions the Directors made and their relationships with the

company’s management and outside contractors.

What is striking about the Enron collapse is that so many people,

both inside and outside the company, failed to ask the questions

that needed to be asked. Enron’s failure did not occur because one

person dropped the ball. Instead, it was an across-the-board failure

of many individuals. In hindsight, I am sure that many of them

wish that they had done more.

Thank you for coming today. I appreciate the time you have

taken, and I am looking forward to hearing from you today on the

Enron collapse. Thank you.

Senator LEVIN. Thank you, Senator Bunning.

We will now introduce our first panel of witnesses this morning

who are either current or former members of the Board of Directors

of Enron Corporation. These are the five men that we have at our

witness table.

13

1The prepared statement of Mr. Duncan appears in the Appendix on page 113.

John Duncan, the former Executive Committee Chair for Enron

Corporation; Dr. Herbert Winokur, Enron Corporation’s Finance

Committee Chair; Robert Jaedicke, former Audit and Compliance

Committee Chair for Enron; Dr. Charles LeMaistre, former Compensation Committee Chair; and finally, Norman Blake, who is the

Interim Chairman of the current Board of Directors and a former

member of the Compensation and Finance Committees.

Pursuant to Rule VI of this Subcommittee, all witnesses who testify before the Subcommittee are required to be sworn. I now would

ask our witnesses to please stand and raise your right hand.

Do you solemnly swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and

nothing but the truth, so help you, God?

Mr. DUNCAN. I do.

Mr. WINOKUR. I do.

Mr. JAEDICKE. I do.

Dr. LEMAISTRE. I do.

Mr. BLAKE. I do.

Senator LEVIN. We are going to use a timing system today. About

a minute before the red light comes on, you will see the light

change from green to yellow, which will give you an opportunity to

conclude your remarks. We have your written testimony, which will

be printed in the record in its entirety, and so we would ask that

you limit your oral testimony to no more than 10 minutes.

Mr. Duncan, let us start with you.

TESTIMONY OF JOHN H. DUNCAN,1 FORMER EXECUTIVE COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, HOUSTON, TEXAS

Mr. DUNCAN. Chairman Levin, Senator Collins, and Members of

the Subcommittee, good morning and thank you for the opportunity

to address this Subcommittee. My name is John Duncan. From

1967 to 1985, I was a Director of Enron’s predecessor company,

Houston Natural Gas, and I was there when Enron began in 1985.

I have served as the Chairman of the Executive Committee since

1986. Thus, I am the Enron Director who has served the longest

period of time. Until the Fall of 2001, I considered Enron one of

the great companies of this country, and I was proud to be one of

its directors. I resigned from the Board in March 2002.

After receiving my bachelor’s degree in business administration

at the University of Texas, I set out to become a businessman, to

start and run my own company. With the exception of the first job,

in a family business, and a stint in the U.S. Air Force during the

Korean War, I have not drawn a paycheck from a company of

which I was not either the founder or the co-founder.

As co-founder and President of Gulf and Western and founder of

Gulf Consolidated Services, both companies had small beginnings

and wonderful success stories. During the course of my career, I

have served on the board of seven New York Stock Exchange Companies, and, Senator Durbin, not all at one time. I have also served

and chaired the boards of several important Texas institutions, including the Chancellor’s Council of the University of Texas System,

14

Southwestern University in Georgetown, Texas, the Board of Visitors at M.D. Andersen Cancer Center, and all the metropolitan

Houston YMCAs.

I provide that background to the Subcommittee to respectfully

suggest that I have had substantial experience and exposure to the

workings and to the role and to the duties of a board of directors.

I also know a board’s limitations. That is what I want to talk about

today. In particular, I want to focus on what I believe are the elements of an effective board and why I believe the tragic events of

Enron occurred.

First, I believe the directors must be individuals who possess integrity and intelligence. They also should collectively bring a broad

spectrum of knowledge and experience in the areas of business and

finance and in the particular fields that the company is in. People

usually acquire this experience by having operated a company with

a significant budget or by having obtained unique experience from

other professions that are relevant to the company’s mission.

The Directors of the Enron Board certainly possess, in my opinion, these qualities. My colleagues are highly ethical and of good

character. As far as intelligence goes, I can simply say that if education is any measure, I believe I was one of only two directors who

did not have a master’s degree or a doctorate degree. Our directors

are experienced, successful businessmen and women, experts in

areas of finance and accounting, and have had experience in leading large institutions. Others, like our overseas directors, brought

experience in certain areas of the world in which Enron saw great

business potential.

Second, I believe the board must be dedicated and diligent in addressing the matters that are presented to it. The directors need

to do their homework, analyze the issues, ask penetrating questions, and make decisions that are always in the best interest of

the shareholders.

In my opinion, the Enron directors met this criteria. We worked

hard. We prepared for meetings. We asked probing questions and

imposed specific controls and procedures that management and

outside advisors were required to follow. I know that my colleagues

here today will address those items in more detail. We were also

willing to say ‘‘no’’ to management when we did not agree with its

recommendations.

A good example of exercising a board’s responsibility and to act

independently in the company’s best interest occurred only last

September, when all the indicators that we had were still positive

and before any of the outside directors was aware that Enron was

in trouble. We were presented two transactions at the Executive

Committee and the Board; management requested to authorize the

purchase of two pulp paper mills at a price in excess of $300 million cash. We did not approve these acquisitions because we were

concerned about a prior acquisition in the same field; we did not

like the purchase price; and we wanted to preserve our financial

flexibility in the light of the September 11 tragedies. We postponed

our decision, but we now know that subsequent events soon overtook us and the company.

I did not sit on the Audit Committee or the Finance Committee,

but I did sit in as a guest at a number of their meetings. I witVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
15

nessed my colleagues asking probing questions of management and

independent accountants. In my opinion, these committees and

these members thoroughly executed their duties.

Third, I think that a board cannot be successful unless it feels

comfortable relying on the intelligence and integrity of the management, as well as other advisors who present matters to the board.

With over 20,000 employees working at the company, with over 200

lawyers writing contracts every day, and with over 400 accountants

posting the daily books, we, the directors, had to rely on the reports

given to us by the officers of the company. Frankly, there is no

other way that we could direct effectively a company of that size.

We felt confident relying on the senior management of the company, as we truly believed we had hired some of the best and the

brightest in the industry. National, independent publications

lauded the Enron officers for their intelligence, leadership, and creativity.

Finally, I believe the management and other advisors reporting

to the board must tell the truth. They must tell the complete truth,

good or bad, in order for the board to make informed decisions. We

now know this did not happen at Enron. The Board had implemented mechanisms and controls to ensure, at the very least, it obtained early warning signals of any impending problem. Among

other procedures, we created a risk management officer position,

and we staffed that department with nearly 100 employees. That

officer and that department was responsible for reporting to the

Board the most significant concerns and credit issues that faced

the company. That did not happen.

It is now quite clear that significant information about related

party transactions was withheld from us. We were not aware, for

example, of the problems of Chewco. They were withheld from us

for years. We were not informed about Raptor III. We were not told

about the $800 million recapitalization of the Raptors in late 2000

and 2001. We were not told that employees, in addition to Andy

Fastow, were participants in a number of partnerships, and we

were unaware of their substantial windfall profits.

As late as the August 14, 2001 Board meeting, the Board was

briefed on the financial condition of the company. Your staff has

that briefing. The report was—earnings were up, balance sheet was

stable, except maybe a credit rating improvement in the year 2002.

Various Power Point slides given at that same meeting indicated

to the Board that the company’s good business was still improving

as usual. The Powers Report and the reports we now have read in

the press indicate that for many months, if not years, certain members of management and our outside auditors were well aware of

the problems facing the company, and they did not tell us.

In sum, I do not believe that Enron’s fall would have been avoided had the Board asked more questions, implemented more controls, or avoided certain financing projects, because they were too

complicated or risky. Rather, I believe if management had implemented the Board’s controls, as they assured us they had, if just

one of the Board’s officers or employees had fulfilled his or her corporate duty to reveal these problems or to any one director, or if

the outside auditors had executed their obligation to convey to us

16

1The prepared statement of Mr. Winokur appears in the Appendix on page 116.

concerns they privately expressed and documented amongst themselves, that I and we would not be here today.

I thank you for allowing me to make this statement.

Senator LEVIN. Thank you very much. Dr. Winokur.

TESTIMONY OF HERBERT S. WINOKUR, JR.,1 FINANCE COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, GREENWICH, CONNECTICUT

Mr. WINOKUR. Chairman Levin, Senator Collins, Members of the

Subcommittee, good morning and thank you for the opportunity to

address you. My name is Herbert S. Winokur, Jr. I currently am

a member of the Board of Directors of Enron Corporation. I have

served as Chairman of the Finance Committee of the Board of Directors and have been a member of the Board since the mid-1980’s.

I volunteered for and served as a member of the Board’s special investigative committee, the Powers Committee, to understand what

happened at Enron.

I appreciate the opportunity today to talk with the Members of

this Subcommittee about the involvement of Enron’s Directors in

the related party transactions that have received so much attention

and about our oversight of Enron more generally.

In my opinion, and it is only my opinion, one of the principal

causes of Enron’s failure was the loss of lender and investor confidence that resulted from the three significant restatements to

Enron’s financial statements presented in October and November

2001. Two related to earnings restatements for 4 and 2 years, respectively, and the third, a significant reduction in shareholder equity. While a related party was involved in each transaction, the

related party aspect does not appear to have been a factor in any

of the accounting errors.

In none of these three restatements did the Board or its Audit

Committee have prior knowledge of the errors that were required

to be corrected. In each case, Enron’s management had approved

the original financial statement presentations, and as appropriate,

Arthur Andersen had certified or reviewed them.

With that in mind, I would like to discuss three areas. First, how

Enron’s Board of Directors and Finance Committee discharged its

obligations; second, the specific circumstances in which we approved the LJM structures and the controls we put in place; and

finally and very briefly, certain of the hedging transactions that the

Board approved.

Enron’s Finance Committee reviewed regularly the company’s financial ratios and liquidity. At our meetings, Enron management

routinely presented Enron’s actual and projected financial ratios

and near-term liquidity, a report on relationships and meetings

with the credit rating agencies, and an analysis of Enron’s borrowing costs relative to those of its competitors, which informed us

of the market’s contemporaneous view of Enron. Between meetings,

we also received and read reports on Enron from Wall Street equity

and debt analysts, including the analysts’ detailed financial projections.

17

Let me turn to the Finance Committee’s involvement in the approval and oversight of the LJM partnerships. The press and others have reported repeatedly that Enron’s Board waived the code

of conduct when it permitted Enron’s Chief Financial Officer, Andy

Fastow, to serve as general partner of LJM1 and LJM2. The Board

did not.

For many years, Enron has maintained a code of conduct with

which every employee must comply. It also permits the Chief Executive Officer to make a determination that an officer’s investment ‘‘presents no probability of any conflict of interest.’’ When the Board approved LJM1 in June 1999, the Board adopted and ratified the determination by the Office of the Chairman

that Andy Fastow’s participation as managing partner ‘‘will not adversely affect the interests of the company.’’ The Board was told

that PricewaterhouseCoopers would be rendering a fairness opinion

on the transaction between LJM and Enron with which we were

presented and that Mr. Fastow would have no direct pecuniary interest in the Enron stock, which was used as part of that transaction as credit support. Enron publicly disclosed this transaction,

including the related party aspect, and Arthur Andersen reviewed

it as part of its 10–Q review in June.

At the October 1999 Finance Committee and Board meetings,

Mr. Fastow recommended to obtain quick, flexible equity to Enron

with reduced transaction costs, that he be permitted to organize

and serve as managing partner of LJM2, a newly formed fund with

outside investors that would be an alternative and optional source

of private equity. There would be no requirement that Enron trade

with LJM2. He proposed that the Chief Accounting Officer review

and approve all transactions between Enron and LJM2.

The Finance Committee, after questioning, learned that Arthur

Andersen was fine with the partnership structure and that LJM2’s

limited partners were expected to be institutional investors who

would be able to remove Mr. Fastow without cause. The Finance

Committee augmented these controls by requiring that the Chief

Risk Officer also review and approve all transactions and that the

Board’s Audit Committee review all transactions annually and

make any recommendations it deemed appropriate. The Board ratified the Office of the Chairman’s determination that Mr. Fastow’s

participation would not adversely affect the interest of the company. Enron publicly disclosed LJM2 as a related party transaction.

Updates given to the Finance Committee about the LJM transactions were positive. At the May 2000 Finance Committee meeting, Mr. Fastow reported that he was personally devoting approximately 3 hours a week to the investment vehicles. We were also

told that LJM2’s investments had a projected rate of return of

17.95 percent. Mr. Causey, the Chief Accounting Officer, told us

that Arthur Andersen was comfortable with the governance structure of LJM. We, of course, now know that the LJM2 investors received much higher returns.

The minutes of the October 2000 Finance Committee also show

that the Committee continued to focus on Mr. Fastow’s dual role.

Mr. Fastow described to the Committee six of the mechanisms that

had been put in place to mitigate any potential conflicts, one of

18

which was that Messrs. Buy, Causey, and Skilling approve all

transactions between the company and LJM funds. A second was

that Mr. Fastow maintain his fiduciary duty to Enron. In addition

to these controls that Mr. Fastow described, the Committee instructed management that the Board’s Compensation Committee

review Mr. Fastow’s compensation and that the Finance Committee, in addition to the annual review by the Audit Committee,

conduct a quarterly review of the transactions between the company and the LJM funds.

The Finance Committee received its first quarterly and the Audit

Committee its second annual report on the related party transactions with LJM on February 12, 2001, from Mr. Causey. Mr.

Causey discussed the Board-established guidelines for transacting

with LJM. He then told the Board that the company had adopted

certain procedures and controls in response to the Board’s direction

and reviewed the checklist review complemented by the adoption of

additional controls. Mr. Causey informed the Finance Committee

that the controls ‘‘had been discussed with the Audit and Compliance Committee and commented that the process was working effectively.’’ The preceding, I submit, illustrates that the Board applied

Enron’s code of conduct when it ratified management’s recommendation regarding LJM1 and LJM2 and added substantial

additional controls to ensure that all of the Enron LJM transactions would be in the best interest of the company. The record

also indicates that the directors regularly monitored the LJM

transactions and management’s involvement. We asked for and repeatedly received reports informing us that the controls were working and that there were no concerns raised either by management

or our outside auditors.

Let me turn to the financing. Enron has been criticized for its

use of off-balance-sheet financing or special purpose vehicles to

raise debt and equity. This practice is common and permitted by

the accounting rules, if structured correctly. For example, leasing

companies and reinsurance companies exist to provide off-balancesheet financing to their customers. The Board also has been criticized for authorizing hedge transactions involving these vehicles

that made use of Enron stock for credit support. Let me respond.

Enron owned certain highly volatile high-technology investments.

That combination of volatile investments and required mark-tomarket accounting had the potential to create instability and unpredictability in Enron’s income statement. Putting in place hedges

to mitigate these risks made good business sense. In fact, companies have been sued by their shareholders because they failed to

put in place hedges on significant and volatile investments.

Management wanted, appropriately, to use the significant unrealized value and forward contracts on Enron stock most effectively

for the benefit of Enron’s stockholders. It informed the Board that

the proposed hedge transactions did so. Outside auditors concurred,

or in one case, provided fairness opinions.

In conclusion, what happened at Enron has been described as a

systemic failure. I see it instead as a cautionary reminder of the

limits of a director’s role. A director’s role, by its nature, is a parttime job. By force of necessity, we could not know personally all of

19

1The prepared statement of Mr. Jaedicke with attachments appears in the Appendix on page

155.

Enron’s employees. As we now know, key managers and employees

whom we thought we knew proved to disappoint us significantly,

and outside advisors whom we believed to be critical components

of an effective oversight role failed in their duty. Arthur Andersen’s

failure to disclose its concerns to the Board, as well as management’s marked disregard for the required internal controls and lack

of candor with respect to information owed to us deprived the

Board and deprived me of the ability to deal proactively with these

problems. We cannot, I submit, be criticized for failing to address

or remedy problems that had been concealed from us.

Three months ago, days after the release of the Powers Committee report, I appeared before a House subcommittee. At that

time, I was deeply disturbed and disappointed with what I had

learned. I also squarely disagreed with certain conclusions, particularly about the directors’ judgment and oversight, presented in the

report, which disagreement I expressed during my testimony.

Even with the benefits of a few more months to review these

issues, I remain resolute in my belief that we were diligent and

dedicated to our charge. Based on the recommendations, advice,

and information we received from management and our advisors,

we, the directors, acted in good faith and attempted to pursue the

best interests of Enron and its shareholders. However, I deeply

wish that at least one person in management, an employee, or an

outside advisor, someone had come forward to the Board with his

or her concerns when we could have addressed them.

I am prepared to respond to any questions from the Subcommittee. Thank you.

Senator LEVIN. Thank you very much. Dr. Jaedicke.

TESTIMONY OF ROBERT K. JAEDICKE,1 FORMER AUDIT AND

COMPLIANCE COMMITTEE CHAIR, BOARD OF DIRECTORS,

ENRON CORPORATION, BOZEMAN, MONTANA

Mr. JAEDICKE. Chairman Levin, Senator Collins, and Members of

the Subcommittee, good morning and I also thank you for the opportunity to address the Subcommittee. My name is Robert

Jaedicke. I served as the Chairman of the Audit Committee of the

Board of Directors of Enron Corporation. As part of an overall restructuring of the Board, I recently resigned as a director, having

served since the mid-1980’s.

Let me tell you very briefly about my background. I joined the

faculty of the Stanford Graduate School of Business in 1961. I

served as Dean of the school from 1983 to 1990. At that time, I returned to the faculty of the Business School, and I retired from the

university in 1992.

Throughout my tenure as Chairman of the Enron Board’s Audit

Committee, I was committed to ensuring that it was an effective

and actively functioning body. Over the last few years, we undertook to review and strengthen our already vigorous control systems. In 1999, we began a number of initiatives to ensure that we

remained a ‘‘best practices’’ audit committee. Throughout 2000 and

into 2001, our committee worked with Arthur Andersen to make

20

sure that we complied with the recommendations of the Securities

and Exchange Commission, the New York Stock Exchange, and the

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. That effort culminated in February 2001,

when the Audit Committee drafted a new charter that was approved by the full Board.

The lifeblood of the work of any audit committee is the development and implementation of adequate controls, many of which

cross-check each other. The committee’s responsibility is to review

reports from management and the outside auditors, to review the

adequacy of internal controls, and to oversee the filing of financial

statements. The committee’s effective oversight also depends on the

full and complete reporting of information to it. Without full and

accurate information, an audit committee cannot be effective. The

audit committee does not manage the company and does not do the

auditing.

It is my understanding that audit committees of most corporations, like Enron, typically meet for a few hours several times a

year. Warren Buffet wrote to the New York Stock Exchange Chairman and CEO Richard Grasso in 1999, and I quote, ‘‘An audit committee that meets for a few hours several times a year is simply

not going to pick up anything that is missed by the outside auditors. Therefore, the task of the audit committee should be to hold

the feet of the outside auditors to the fire.’’ In that same letter, Mr.

Buffet also stated, and I quote, ‘‘Simply put, audit committees cannot act as auditors. Their true job, and I would argue the only important function that they can adequately discharge, is to make

sure that the auditors do their job instead of becoming subservient

to management.’’

I agree. We held regular meetings at least four or five times a

year; always four, usually five. At meetings, we received reports

from a broad range of senior management and Arthur Andersen

personnel. Audit Committee meetings regularly included three Arthur Andersen partners, Enron’s Chief Accounting Officer, Chief

Risk Officer, General Counsel, Chief Internal Auditors, Mr. Lay,

Mr. Skilling, and other senior officers and outside advisors, as appropriate. We were entitled to rely on these reports. We asked

questions. We provided oversight. We received several special reports on accounting policies. And we continually discussed the adequacy of our internal controls. I respectfully submit that we did our

job.

At each Audit Committee, it was my invariable practice to hold—

or at least offer to hold—an executive session with the Arthur Andersen representatives where they could meet with us without

management present. There, Arthur Andersen could freely report

to the committee any matters of concern that made the auditors

uncomfortable, including whether they had any significant disagreements with management, whether they had full cooperation of

management, whether reasonably effective accounting systems and

controls were in place, whether there were any material systems

and controls that needed strengthening, and whether they had detected instances where company policies had not been fully addressed.

21

1The prepared statement of Dr. LeMaistre with an attachment appears in the Appendix on

page 176.

Arthur Andersen did not raised concerns about the partnerships

in these executive sessions. In fact, they normally reported to us

that the structures and transactions were complex, they required

judgment, but that they were in at an early stage to understand

and review the transactions and that they were comfortable with

the accounting treatment.

Last February, Alan Greenspan testified before the Congress, ‘‘I

have served on too many audit committees to know that even

though I would consider myself independent, I would consider myself knowledgeable, I did not know what questions to ask the Chief

Financial Officer during meetings to find out what it is that conceivably is wrong in the corporation, and he was not about to tell

me.’’

I agree with Mr. Greenspan. We did everything possible to ensure that our controls and procedures were being followed. To my

knowledge, we were one of the few major corporations that required Arthur Andersen or their outside auditor to give an attest

opinion on the management’s assertions that our controls were adequate.

What happened at Enron, as my colleague has indicated, has

been described as a systemic failure. I agree with him as it pertains to the Board. I see it as a cautionary reminder, also, of the

limits of the director’s role. We served as directors of what was

then the seventh-largest corporation, which required us to confine

our attention to the broad policy decisions. At meetings of the

Board and its committee, in which all of us participated, these

issues were considered and decided on the basis of summary reports, corporate records, upon which we were entitled to rely. We

also relied on the honesty and integrity of management, their subordinates and advisors, and on the integrity of the information we

were receiving. At the time, we had no doubt—we had no reason

to doubt the integrity of either the management or the advisors.

We did all this and more. Sadly, despite all that we tried to do

in the face of all the assurances that we received, we had no cause

for suspicion until it was too late.

Thank you very much, and I am prepared to respond to questions

from the Subcommittee.

Senator LEVIN. Thank you very much, Dr. Jaedicke. Dr. LeMaistre.

TESTIMONY OF CHARLES A. LeMAISTRE,1 M.D., FORMER COMPENSATION AND MANAGEMENT DEVELOPMENT COMMITTEE

CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, SAN

ANTONIO, TEXAS

Dr. LEMAISTRE. Chairman Levin, Senator Collins, Members of

the Subcommittee, we are delighted to be here to participate in

your investigation. Senator Durbin, I want to assure you that we

were shaken to the core, also. It is a very good description of what

happened by the events that we first learned about on October 17,

that our controls were not being followed. The Board thereafter

took immediate action on several fronts, one of which was very valVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
22

uable to you in your investigation, the no-holds-barred Powers Report, which enlightened all of us as to where the problems were.

My name is Charles LeMaistre. I am a physician by profession.

I am also President Emeritus of the University of Texas M.D. Anderson Cancer Center and former Chancellor of the University of

Texas System. For 17 years, I have served on the Enron Board. For

most of those years, I have held a position as Chairman of the

Compensation and Management Development Committee. I resigned in March 2002 as a part of the restructuring of that Board.

I would like to directly address some of the questions that have

been raised regarding compensation and the bonus process for executives. The Compensation Committee’s basic responsibility is to

assure that the senior executives of the company are compensated

effectively in a manner consistent with the compensation strategy

stated to the shareholders. The Committee considered internal equity, competitive compensation practices, and the requirements of

appropriate regulatory bodies.

The philosophy behind the executive compensation is to reward

executive performance that creates long-term shareholder value, in

essence, a pay-for-performance philosophy that benefits the shareholder. Executives had the opportunity to earn up to the 75th percentile or higher of the compensation rates at comparable competitive companies, subject to obtaining a performance at 75th percentile or higher.

As a first step in this process, we received the recommendations

from management and discussed their justifications fully. We also

relied almost always on the outside executive firm, Towers Perrin,

to independently review the recommendations and give us advice

and a recommendation regarding the various compensation issues

brought to the committee. Based on that advice, the committee arrived at proposals for presentation to the Board, and they deliberated on these very carefully and for long hours in order to arrive

at a common position.

In recent years, the Compensation Committee was dealing with

Enron’s evolution from a pipeline company to an energy trading

company that engaged in sophisticated and complex financing

structures. Enron sought out different talent for its management in

the energy trading business. To hire and successfully retain these

highly-sought individuals, Enron needed to offer compensation

packages equivalent to, and sometimes better than, those offered

by the competition. Enron believed that the talented individuals

leading the company were one of the most valuable assets the company had and critical to its success. Towers Perrin was often asked

to craft compensation packages, stress test the executive compensation plan, and conduct surveys of competitive practices to be sure

Enron was well positioned in the marketplace.

Let us go into some compensation-related issues. First, with regard to Ken Lay, the media and others have raised many questions

about Mr. Lay’s compensation. In particular, I would like to address the $141 million he received in total compensation for the

year 2000. It has been suggested that this level of compensation

was unreasonably high and over 10 times the average received by

the CEOs of the top 200 companies.

23

First, I believe that comparing Mr. Lay’s total compensation

against the average salary of the CEO in a top 200 company does

not necessarily yield an accurate picture. Because Mr. Lay’s compensation placed him in the top 10 highest-paid CEOs, I believe

that comparing his compensation to those in that category is more

accurate. Within the top ten, Mr. Lay was ranked seventh that

year. Enron, coincidentally, was ranked as the seventh largest company. The average compensation for the top 10 CEOs was about

$169 million. The top compensation was $293 million. I have attached a chart to my statement that presents this information.

Second, I think it is important to break out what comprises Mr.

Lay’s total compensation package to determine the actual cost to

the company for that year. A very large portion of the total compensation is at risk under the pay-for-performance philosophy. The

portion at risk depends upon meeting competitive criteria for the

future value from stock options exercised to be realized and from

restricted stock payouts to be realized. For this portion at risk, the

executive is rewarded only if the shareholder is rewarded.

If the ‘‘at risk’’ portion is subtracted from the total, you arrive at about $10 million, which I believe is a more accurate representation of what Mr. Lay’s 2000 compensation cost the company that

year. I also note that 2000 was an extraordinary year for Enron

and its shareholders, which accounts for the large increase in

bonus for that year. That is roughly $10 million, including his base

salary of $1.3 million and a bonus of $7 million. Mr. Lay’s compensation was disclosed and footnoted and detailed in the proxy

statement each year.

Next, Andy Fastow’s salary from the LJM partnerships. On October 19, 2001, the Wall Street Journal reported that Mr. Fastow and possibly some of his partnership associates received more than $7

million in compensation from the LJM partnerships. Let me comment on what I know about his LJM compensation.

On October 19, a special meeting of the full Board was called to

discuss Mr. Fastow’s compensation from the LJM and other related

matters. We went into it in some detail, and on October 22, 2001,

the Board authorized Mr. Duncan, Chairman of the Executive

Committee, and myself, as Chairman of the Compensation Committee, to inquire directly of Mr. Fastow as to his compensation

from the partnerships. Enron’s General Counsel drafted the questions we would ask. I called Mr. Fastow on October 22 and arranged for a conference call the very next day.

On that call, Mr. Duncan and I asked Mr. Fastow about the

amount of his investment in LJM1 and LJM2 and his return on

those investments. Mr. Fastow responded that his commitment in

LJM1 and LJM2 was $1 million and $3.9 million, respectively. He

stated that his income from LJM1 was $23 million, and approximately $22 million from the LJM2. On October 24, the very next

day, the Board met. Mr. Fastow was relieved of his responsibility

as Chief Financial Officer.

I do not believe that the Board of Directors would ever have approved Mr. Fastow’s participation in the partnerships if we had

known he would be generating such compensation. Indeed, we were

told just the opposite. Very conservative yields should come from

the formulas that were presented to the Board. If management had

24

instituted the controls that the Board authorized, Mr. Fastow’s

compensation would have been reported to Mr. Skilling, the Audit

Committee, the Finance Committee, and the Compensation Committee.

On October 6, 2000, the Finance Committee meeting minutes

clearly show from his own presentation that Mr. Fastow was aware

of the six controls imposed by the Board on his participation in

LJM, including his responsibility to review with Mr. Skilling ‘‘his

economic interest in the company and the LJM funds.’’ Following

Mr. Fastow’s presentation, the Finance Committee then added to

the existing controls a quarterly review of the LJM transactions

and a review by the Compensation Committee of Mr. Fastow’s LJM

compensation. That meant there would be two full reviews by the

Finance Committee and the Audit Committee, one on a quarterly

basis and the other on an annual basis, through which that information should have come in addition to the newly authorized review by the Compensation Committee.

Enron’s Performance Unit Plan has been confusing to many. I

would like to comment briefly on it. Prior to 1999, Enron granted

performance units to corporate and certain operating company executives who were not in an Enron long-term incentive plan at that

time. These operating company executives were, for the most part,

in commercial support and in the pipeline business. Enron was a

highly decentralized company at that time.

The first performance units were awarded in 1987 and the last

in 1998. The units have a life of 4 years, so the payouts could still

be continuing as of last year. Awards were based on Enron’s total

shareholder return over the 4 years. The participants were nominated by the Office of the Chairman and approved by the Compensation Committee. There was a limit of three million performance units per individual. Performance was measured against that

of a performance of peer group of companies with a payout scale

of one to seven. Each unit was assigned a valuation of $1. A ranking of one had a payout of $2, twice the value, and a ranking of

seven did not pay out anything. In the event that the total shareholder return did not exceed the cumulative percentage for the 90-

day Treasury Bill, a performance unit would have no value.

In conclusion, I believe that our Committee and the Enron Board

endeavored to manage carefully and effectively Enron’s executive

compensation while the company was rapidly evolving, growing,

and undertaking new business opportunities. The Committee

sought and relied on the advice of outside executive compensation

experts to ensure our recommendations and decisions were consistent with the marketplace. Although the Board was willing to

award compensation that was competitive and deserved, it certainly did not approve and was not made aware by management

that some individuals reaped huge profits at the company’s expense

or that others abused certain benefits in ways for which they were

not designated.

Thank you very much for your attention. I will be pleased to answer your questions.

Senator LEVIN. Thank you very much, Dr. LeMaistre. Mr. Blake.

25

1The prepared statement of Mr. Blake appears in the Appendix on page 181.

TESTIMONY OF NORMAN P. BLAKE,1 INTERIM CHAIR, BOARD

OF DIRECTORS, ENRON CORPORATION, ROSEMONT, ILLINOIS

Mr. BLAKE. Thank you, Mr. Chairman. It is good to be here, Senator Collins and Members of the Subcommittee. It is certainly a

privilege to be here and I thank you for the opportunity.

My name is Norm Blake. I am Interim Chairman of the Board

of the Enron Corporation. I have been a Director of Enron since

1993. Since the onset of bankruptcy, five members of the Board

and I have been actively engaged in the development of a newly

constituted Board of Directors in cooperation with Enron’s Creditors Committee. It is the intention of these Board members and me

to resign from the Board once an orderly and effective transition

of authority has taken place. We are now serving on a pro bono

basis in recognition of our responsibility to serve the interests of

Enron’s stakeholders and employees.

My background can essentially be characterized as having extensive management and leadership experience in a variety of industries, with significant involvement in financial services. Over the

last 12 years, I have been Chairman and CEO of three different

Fortune 500 companies and held board membership positions in

others. Much of my earlier business career was with the General

Electric Company, with my latest position in 1984 being Executive

Vice President of Financing Operations for the General Electric

Credit Corporation.

My colleagues in their statements today will discuss the Board’s

and its committees’ respective roles and involvement in the related

party transactions. I would like to focus on certain issues that have

been raised with respect to the Board and the outside Directors as

a collective unit.

I will begin by saying unequivocally that I am proud to have

served as a member of the Board with such capable, hard working,

intelligent, and ethical individuals. Personally, I believe while we

may have initially just been a collection of individuals, we have

now evolved into a very cohesive and collegial group. Moreover, in

my view, this Board has remained diligent and dedicated to its responsibilities throughout the process.

Although we, at the time, had much confidence and respect in

the abilities of the management of the company, we did, in fact, operate independently and did, in fact, exert our influence, and at

times, contrary to the wishes of management. For example, the decision made by the majority of the Board to acquire Wessex and

form Azurix was made over the dissention of two Directors and abstention of another. More recently, management’s intention to acquire a pulp mill in October of last year was resisted by the Board

to the extent that the decision was not made to make the acquisition.

Allow me to put Enron into perspective over the last couple of

years, and as cited by many of you this morning. By 2000, Enron

was one of the 10 largest companies in the United States. Enron

had begun a transformation from a traditional pipeline and energy

company with substantial fixed assets to an innovative energy

26

trading company that showed tremendous potential but required liquidity and creditworthiness.

My personal focus as a member of the Board and its Finance

Committee had been Enron’s liquidity and financial leverage in furtherance of this strategy. As a Board, we were attentive to and

working with management and outside experts to realize this mission. We believed that the company was successful in moving in

that direction. In late 2000 or early 2001, no one had predicted by

the end of 2001, Enron would file for bankruptcy. In fact, as late

as October 2001, we were informed by management that we were

ahead of plan in terms of earnings and that creditworthiness and

liquidity issues were manageable.

A central issue at hand involves Enron’s intentions in establishing SPEs. I would like to provide an opposing point of view to

that held by many that the intention of Enron in establishing these

partnerships was to manufacture earnings. To the contrary, it is

my opinion that the primary purpose of these partnerships was to

improve liquidity and get debt off our balance sheet. The LJM partnerships were specifically constituted for that purpose, and by the

way, I would contend that many companies establish SPEs for exactly such a purpose.

Of course, now, with the benefit of hindsight, committees of Congress, the media, government officials, financial experts, and others

have tried to dissect and examine what went wrong at Enron. Over

the past several months, several questions have been raised with

respect to the Directors as a group. In particular, people ask if the

Board failed in its oversight duty, whether Enron was moving so

quickly that independent directors could not keep up.

I think not. We worked hard. We worked very hard. We came

prepared and we asked questions. We were sent materials in advance of meetings and it seemed that each Director reviewed them

and came to the meetings prepared. Sometimes before a Board

meeting, after spending many hours in preparation for these meetings, I would speak with Mr. Skilling about the balance sheet

issues or with the Chief Risk Officer, Rick Buy, about liquidity, leverage, and credit issues.

I know that my fellow Director Pug Winokur, who is here today,

spent time with Enron’s Chief Financial Officer, Andy Fastow, before meetings, asking him a variety of questions. And Dr. LeMaistre, who is also appearing with us today, spent much of his

time in advance of upcoming Compensation Committee meetings

with Enron’s human resource and compensation staff, as well as

external consultants, to ensure himself that he understood all the

technical aspects of Enron’s compensation plans and to be in a position to evaluate recommendations made by management. He took

his job very seriously, as we all did. In short, I believe, judged by

any standard, that this Board executed its duties to the company

and its shareholders.

During Board and committee meetings, we did, in fact, question

management. For example, during October 1999 Finance Committee, in which we discussed the LJM2 partnership, the Board

material discloses that I specifically asked whether Arthur Andersen had reviewed the partnership. We were told by the Chief Accounting Officer that Arthur Andersen was, ‘‘fine with it.’’ If we

27

1See Exhibit No. 2 which appears in the Appendix on page 204.

had been told that Arthur Andersen had not reviewed the structure

or that Arthur Andersen had reservations, this Board would never

have approved it.

The first Raptor transaction was brought to the Finance Committee, in May 1, 2000. The minutes reflect the Chief Accounting

Officer told us that, ‘‘Arthur Andersen LLP had spent considerable

time analyzing the Talon structure and the governance structure of

LJM2 and was comfortable with the proposed transaction.’’ This

advice was critical to our decision to authorize this transaction.

Some commentators have since suggested that the structure of this

transaction was inappropriate on its face. This is not the advice

that we received. My fellow directors asked questions pertaining to

propriety and the oversight of these transactions. We did not rubber stamp management’s recommendations and requests.

Even with the benefit of hindsight, I cannot speculate as to what

else we could have done to ensure that our controls and procedures

were followed. We put the right controls in place and we asked the

right questions. These directors were a smart and talented group

of people who brought a diversity of experience and expertise to the

Board. Unfortunately, I believe that we were uninformed because

management and outside experts who reported to us failed in their

jobs and did not give us full and complete information.

Again, I thank you for being here today. I welcome the opportunity to answer your questions. Thank you, sir.

Senator LEVIN. Thank you very much, Mr. Blake.

Let me start with you, Dr. Jaedicke. You were Chairman of the

Audit Committee. The Audit Committee got an annual briefing

from Andersen about its accounting policies and its practices, as

you have testified. We have a number of excerpts from those briefings in the exhibit book, and I wish you would turn to Exhibit 2.1

Mr. JAEDICKE. Yes, sir.

Senator LEVIN. Exhibit 2 is part of the Andersen briefing on February 7, 1999. It relates to the Enron financial reporting in 1998,

which was the previous year that had just finished. Now, this was

an unusual Audit Committee meeting, because instead of taking

place in Houston, it took place in London. Do you remember this

meeting in London?

Mr. JAEDICKE. Yes, I do.

Senator LEVIN. Thank you. The Board’s minutes reflect that

David Duncan, the Andersen partner who headed the Enron audit

team, and that Tom Bauer, who was also on the audit team, and

that Steve Goddard, who was head of the Andersen office in Houston, were in attendance. Those were the three Andersen partners

who typically dealt with your Audit Committee and the Board, and

the minutes show that all of the Audit Committee members were

there, as well as another Andersen employee and several members

of Enron management, including Mr. Lay and Mr. Skilling.

Now, this chart, or this document that you’re looking at says at

the top ‘‘Risk Profile,’’ which means the risk to Enron that its accounting practices may not be found to be in compliance with

sound accounting practices. And you will see there the letters ‘‘H’’,

28

‘‘M’’, and ‘‘L’’, and those letters stand for high, medium, and low

risk. So ‘‘H’’ stands for high, ‘‘M’’ for medium, and ‘‘L’’ for low risk.

Andersen was telling your Audit Committee about the risks, and

the first item you will see on the list is highly structured transactions. These are the elaborate transactions which I talked about

in my opening statement. And the chart here shows high risk, ‘‘H’’, circled for emphasis, in all three categories, including accounting

judgments. So the document indicates—and this is a document

from your files, so we know you were shown this document—that

Enron was engaging in high-risk accounting practices when it came

to those structured transactions. Do you remember that presentation?

Mr. JAEDICKE. Yes, I do. Would you like me to comment on it,

sir?

Senator LEVIN. Feel free to do that.

Mr. JAEDICKE. I think the way—the interpretation—this was a

template given to the Audit Committee to try to help us—to help

us understand the kinds of accounting policies that were important

to the company.

Now, maybe ‘‘risk’’ is a poor term, but if you look, for example,

at highly structured transactions, I think the way to read this, and

I think the comments generally support this, is to say energy asset

securitizations—now, this is in 1998—that the accounting judgments—read ‘‘H’’ as important. They are important because there

is a risk that——

Senator LEVIN. I am going to read ‘‘H’’ for what it stands for,

which is high.

Mr. JAEDICKE. The risk, the judgments, they are complex. They

need to be made very carefully.

Senator LEVIN. Are you denying that ‘‘H’’——

Mr. JAEDICKE. Now just let me—— Senator LEVIN. Excuse me. Are you denying that ‘‘H’’ means

high?

Mr. JAEDICKE. OK, high. Disclosure judgment, the importance is

high. The risk is high. It needs to be done carefully. The rule

change—risk in the sense of rule change, I think simply means

there is a high probability that the rules in this area will develop

and can change, and they did.

Now, if you just allow me to contrast that with something like

purchase accounting down in the middle of the page, to judge

whether the purchase accounting can be used instead of, say, a

pooling of interest, that is an important, in your terms, high-risk

area. You need to make a very careful judgment. But then if you

move over, the disclosure is ‘‘M’’. I would assume that is medium.

And it is because that issue has been around for a long time and

there is a fair amount of guidance on it. It was already in existence

in 1998. And if you go to the rule change, under ‘‘L’’, some rule

change coming along, the odds were fairly low. About the only one

at that time that was under consideration was to do away with

pooling.

And so I think what this is and what we used it for was a way

of saying, well, where are the sensitive areas, what are their disclosure characteristics, and what are the odds that rule changes will

come along and somehow change what either we have to do or the

29

1See Exhibit No. 3 which appears in the Appendix on page 208.

2See Exhibit No. 4 which appears in the Appendix on page 209.

way we have to disclose or the way in which the accounting has

to be done. That is my interpretation, sir.

Senator LEVIN. Well, these are not my terms. These are Arthur

Andersen’s terms and they are circled. The ‘‘H’’ is not my term. It

stands for high. You can say that the ‘‘H’’ under rule changes

means there is a high risk that the rule may change, and I fully

agree with you, but by that same logic, the ‘‘H’’ under accounting

judgments means there is a high risk involved in that judgment.

So, Dr. Jaedicke, these are not my terms. These are the documents presented to you with ‘‘H’’, high risk, circled by Arthur Andersen in 1999.

Next, Exhibit 3.1 The handwriting on this document belongs to

David Duncan.

Mr. JAEDICKE. Yes.

Senator LEVIN. It is his handwriting on it, and this is basically

Andersen’s version of the previous exhibit, with the same matrix,

but now it is a document with their talking points for the presentation that was made to you at that London Audit Committee

meeting.

I would like to direct your attention to the handwritten note in

the lower right-hand corner. It is hard to read, so we put it up on

the board here and made that Exhibit 4.2 This is what that note

says at the bottom. ‘‘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.’’ High-risk profile. This is Duncan’s note

on this document. Then it lists those various accounting practices

which you also see on Exhibit 4.

So not only was the Audit Committee told by Andersen that although Andersen was on board, that many of Enron’s accounting

practices, in the words used there, his note, ‘‘push limits,’’ and that

others could view them as outside of compliance with Generally Accepted Accounting Principles. Now, do you remember David Duncan telling that to the Audit Committee on February 7, 1999?

Mr. JAEDICKE. I do not remember David Duncan telling us this

particular note. 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.

He also would, on occasion, try to indicate to us how much guidance was available on those. But in terms of—and 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 please, sir, keep in mind, that was one reason

that Enron paid Arthur Andersen some pretty hefty fees, to try to

be in on the beginning of these transactions so that those accounting judgments, they understood the transaction and that the accounting judgments would be properly made.

Senator LEVIN. You do not remember David Duncan notifying

your Committee that these were high-risk accounting approaches?

30

1See Exhibit No. 5 which appears in the Appendix on page 210.

2See Exhibit No. 10 which appears in the Appendix on page 222.

3See Exhibit No. 10a which appears in the Appendix on page 222.

Mr. JAEDICKE. I remember these—this chart, sir. I cannot say

that I remember this quote that is in the bottom of his—the lower

right-hand corner of the—— Senator LEVIN. If he had told you that they were high-risk accounting approaches, would you remember it?

Mr. JAEDICKE. I think I would. I do not quite—we knew these

were important transactions.

Senator LEVIN. I am using the words ‘‘high risk.’’ You can try to

change that from a ‘‘H’’ to an ‘‘I’’. I am saying that the ‘‘H’’ was circled. It was Andersen’s word. It was presented to you in the document in Exhibit 2. We have Duncan’s note saying specifically that

these push limits. Those are his words on his copy of the document,

and you are saying you do not remember him using the words

‘‘push limits,’’ is that correct?

Mr. JAEDICKE. I do not remember the words ‘‘push limits.’’ Senator LEVIN. OK. Let me just keep going, then. Now, Andersen

also rated the accounting risks that Enron was taking. They did

their own rating, which is reflected in the documents which you

have just seen. This analysis is done at accounting firms for a number of reasons, and the Andersen analysis upon which those first

two documents were based are Exhibits 10a and 10b. If you could

look now at Exhibits 10a and 10b—— Mr. JAEDICKE. Exhibits 10a and 10b—— Senator LEVIN. Let me go back. I missed a document that I wanted to show you, Exhibit 5,1 so if I could just interrupt the flow here

for a moment—— This is a letter that we received last week from legal counsel representing Arthur Andersen’s partner, Tom Bauer, who was at that

London meeting and participated in the discussion. Here is what

this letter says, and this, again, is Exhibit 5 in the book. ‘‘Certain

risk areas were described as pushing the limits, as reflected in Dr.

Duncan’s note, or as being at the edge.’’ So now we have Exhibit 2, which you acknowledge was before

you, with that circled ‘‘H’’ for high-risk accounting approaches. We

have Exhibit 3, which has Duncan’s note as to what he was telling

you. And now we have an exhibit which supports those two earlier

exhibits. This is a letter which says that Mr. Bauer remembers

that, ‘‘Certain risk areas were described as ‘pushing the limits,’ as

reflected in Mr. Duncan’s notes, or as being ‘at the edge’.’’ So now we have got that memory of Bauer, which is added to Exhibits 2 and 3. So now your memory differs also with Bauer as well

as with the exhibit itself.

Now I want to move you over to Exhibit 10.2 This is a document

which was Arthur Andersen’s internal document, but upon which

Exhibits 2 and 3 had either been based, or it is similar to a document in which those conclusions were reached.

First, if you would turn to Exhibit 10a.3 This is for the year

2000. This is for a later year, and I am going to give you this and

then go back to 1999. Take a look, if you would, at the line which

is marked on the first page there in which it says, ‘‘Accounting and

Financial Reporting Risk—Very Significant.’’ ‘‘Management PresVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
31

1See Exhibit No. 10b which appears in the Appendix on page 226.

sures’’—do you see that, on driver number five? Do you see that on

the front page? ‘‘Management Pressures—Very Significant.’’

This document, signed by David Duncan, this risk classification

offers several comments which justify their conclusion. On the front

page, under ‘‘Management Pressures,’’ ‘‘Enron has aggressive earnings targets and enters into numerous complex transactions to

achieve those targets.’’ Also on the front page, ‘‘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.’’

The 1999 risk analysis is Exhibit 10b and it uses similar—let me

get you to the third page of Exhibit 10a before we turn to Exhibit

10b. It’s under ‘‘Risk Classification and Rationale.’’ It says, ‘‘Risk

Classification: Maximum.’’ Do you see that there?

Mr. JAEDICKE. I see it.

Senator LEVIN. Do you see where it says ‘‘Prior Year Risk Classification,’’ and it says ‘‘Maximum’’ ? Now, these are risk classifications.

Mr. JAEDICKE. I see it.

Senator LEVIN. Now we will go back to 1999 and Exhibit 10b.1

And again, these are further evidence not only that Andersen considered Enron to be engaged in high-risk accounting and had management pressure, but they also substantiate the Duncan note, the

Bauer letter, and Exhibit 2 which was directly presented to you

and which talked about high-risk accounting transactions.

But if you will look now on Exhibit 10b, you will see under ‘‘Complex/risky transactions,’’ where it says, ‘‘Form over substance transactions.’’ ‘‘Form over substance transactions’’—this is 1999, now, we

are talking about. The box that they check is ‘‘Very Significant.’’ So

your auditor viewed Enron accounting practices as being high risk.

They said that the use of form over substance transactions was

very significant and that very strongly supports the Duncan note

as to what he told you in London in 1999 and Exhibit 2, which was

directly handed to you and which said that your accounting practices were high-risk practices.

And despite all of that, what you are saying is you do not remember or you deny that your auditor told you in 1999 and 2000

that you were engaged in high-risk accounting practices, is that

correct?

Mr. JAEDICKE. We knew that the company was engaged in highrisk and innovative transactions. But if you contrast this, if David

Duncan had given this to the Audit Committee, my guess is the

discussion would have been a lot different than it was.

If you go back and you look at the Audit Committee, the various

meetings, Senator, you would find that on almost every agenda,

there were listed—you would look at what were the audit emphases of the past quarter and what were the audit emphases of the

quarter coming up, and they would almost always list related party

transactions, structured transactions, securitizations, and mark-tomarket and fair value. Those were almost always areas of emphasis.

32

Now, when we would ask them, 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 or whatever this is. If the information in this

kind of a document had been conveyed to us in the terms that it

showed here, the template that you showed me, the ‘‘H’’s were almost always interpreted, at least by me, as saying if you want a

template of those accounting areas that are important to Enron

and deserve our emphasis, that is where you would look, and the

‘‘H’’s were no surprise. Those were almost always on the agenda of

the Committee.

Now, this kind of information, where you say pushing the limits

or whatever—form over substance, I never, ever heard that term

used.

Senator LEVIN. The reason that——

Mr. JAEDICKE. That I recall.

Senator LEVIN. The reason that is so important is because what

was presented to you were the ‘‘H’’s, not ‘‘I’’s, not ‘‘M’’s, not ‘‘L’’s,

‘‘H’’s, high-risk accounting judgments. You acknowledge that. Now

the question is, well, wait a minute. Did that mean what it said?

Then you have got a note contemporaneously from Duncan, as well

as from the other witness who was there, saying you, in fact, were

informed that these were pushing the limits at that meeting. You

deny hearing that, but there is very strong evidence that, in fact,

that occurred—the evidence: Contemporaneous notes, statement of

another witness, and the internal documents of Arthur Andersen—

show that was, indeed, their conclusion.

You put all that together, and the evidence is pretty strong that

you were informed these were high-risk accounting practices but

that you did not act on those notes and that information. That is

what jumps out from these exhibits and from this testimony. So

weigh that against ‘‘you do not remember’’—it seems to leave me

with one conclusion. You may not remember—— Mr. JAEDICKE. All I said was I do not remember the particular

wording of the comment that you showed me on that particular—

on that slide.

Senator LEVIN. Thank you. Senator Collins.

Senator COLLINS. Thank you, Mr. Chairman.

Dr. Jaedicke, in an interview with the Subcommittee staff, Lord

Wakeham indicated that he had been concerned that Andersen’s

high level of involvement with the company meant that Anderson

might be too close to Enron’s management. As Chairman of the

Audit Committee, did you ever have a similar concern?

Mr. JAEDICKE. Well, Senator, we—on the independence issue, for

the last couple of years, we had a very sort of set pattern of trying

to assure ourselves that, in fact, Arthur Andersen was independent. It worked like this.

There is a series of criteria and guidelines that are set forth by,

for example, the Independent Standards Board. We would discuss

those usually in the August meeting and we would also hear from

Arthur Andersen how their internal processes on affecting the

independence issue worked, and those stemmed all the way from

saying, well, how do you monitor and handle the relationships of

family members, all the way over to saying, what do your internal

33

dispute resolutions look like for partner disputes? How do they

work at the local level? How do they work at the Chicago level?

How do they work worldwide? And they would go over in August

with us all of the—sort of their internal processes for assuring

independence.

And then in the February meeting, when we reviewed the financials and we had to make a recommendation to the auditors, we

heard a representation from the Arthur Andersen engagement

team that the firm had assessed its independence using these procedures and criteria and that they believed they were independent.

So in February, we would receive their independence—or, excuse

me, their representation.

Senator COLLINS. I understand that the Audit Committee accepted the representation of Andersen that it was independent, but I

do not understand why the Audit Committee would accept that assertion given that Andersen had consulting, and internal and external auditing roles for Enron. Essentially, was not Andersen passing

judgment on its own work? We have talked with numerous experts

who are very critical of having the outside auditor also do some internal auditing as well as consulting work. Does that not set up a

situation that is just ripe for conflicts of interest?

Mr. JAEDICKE. Let me speak to the so-called integrated audit,

which is commonly phrased as doing the internal auditing. You

have to keep in mind that Enron probably had about on the order

of twice as much internal auditing as Arthur Andersen did. We had

a Risk Control Group that consisted of, I do not know, 100 people

or more. We had the Enron Assurances Group, which were a group

of internal auditors that had internal auditors in each business

unit, and we had an Information Technology Auditing Group.

Now, that alone would be a sizeable amount of internal auditing.

What the integrated audit tried to do, two things. One is to say,

Arthur Andersen, you have to review the adequacy of internal controls in order to make a judgment on the fairness of the financial

statements. What we would like you to do is to go farther than that

and do enough internal auditing on the adequacy of the internal

controls, where you control the scope, not management, such that

you can give us an attest opinion on management’s assertion that

the controls are adequate.

Now, I was in favor of that because otherwise, you get the assertion that says, we do not know of any material weaknesses. It is

a very positive opinion.

But the other thing I wish to emphasize is they were not auditing their own work. For example, my colleague Dr. Winokur, and

I, worked for a couple of years responding to drafts from the management who was working on a risk management policy, not only

for the trading, but for liquidity and many other things. When the

Board adopted that policy, it was our policy, but what we wanted

Arthur Andersen to tell us is, we have done enough auditing to assure you that it is the management’s contention that it is adequate

and we also will be able to tell you it is being followed. That is

what we were after.

Senator COLLINS. Were you aware that the fees paid to Andersen had increased dramatically, from $29.6 million in 1998 to $46.4

million in 1999?

34

Mr. JAEDICKE. That is total.

Senator COLLINS. That is total.

Mr. JAEDICKE. Yes. Well, we were reported the fees, but I think

about half of that, Senator, would be the baseline and the integrated audit—the baseline integrated audit and the fees that they

charged us to express an accounting opinion on the transactions.

Senator COLLINS. My point is that this work was pretty lucrative

for Andersen and Andersen was playing more and more of a role

and passing judgment on transactions that were risky, to say the

least. Should it not have been a red flag to the Audit Committee,

given how lucrative this business was, that Andersen might not be

as forthcoming as it should have been? You have been very critical

of Andersen for not sharing information. Should these not have

been red flags that Andersen was playing more and more of a role,

such that Lord Wakeham raised a concern about it?

Mr. JAEDICKE. Are you asking for my opinion?

Senator COLLINS. I am.

Mr. JAEDICKE. In my opinion, I did not see it as a red flag. I saw

it actually as some comfort that said the management is willing to

pay fees large enough to get Arthur Andersen to tell us in a positive way whether our internal controls are adequate and functioning, rather than to have an internal auditor working for the

company do it, which was always, to me, a problem.

Senator COLLINS. Let me ask you this question. The SEC had a

blue ribbon commission in 1999 and 2000 that made several suggestions to ensure the independence of auditors. Are you familiar

with those?

Mr. JAEDICKE. Well, I am familiar with some of their rules.

Senator COLLINS. Let me ask you about a specific one, if I may.

One of the recommendations that the SEC made was that the

Audit Committee obtain a written statement from the auditor listing all of the relationships between the auditor and the company,

and that the Audit Committee should then discuss each of those relationships and pass judgment—the Audit Committee should pass

judgment, not the auditor passing judgment on itself—on whether

or not any of those relationships compromised the independence of

the auditor. Was that done?

Mr. JAEDICKE. The review of independence in August, I think,

would have included that, because I think one of the criteria or one

of the issues that you had to look at had to do with those relationships, and they reported to us on, well, what are the firm’s policies

when you have people go to work for Enron? They also reported to

us at one point, and I would have to look at the details because

I have forgotten it, that there was a small joint venture, I believe

on some software, and I really have to go back and look at it and

see what the details were. It was considered to be immaterial, but

it was disclosed to the Audit Committee.

Senator COLLINS. Dr. Jaedicke, you have a lot of experience.

Have you ever known an auditor to come in and say, ‘‘we are not

independent,’’ or ‘‘we are too close to management’’ ?

Mr. JAEDICKE. No, I guess—— Senator COLLINS. Is it not the job to be—— Mr. JAEDICKE. They would not last very long if they did that.

Senator COLLINS. Exactly my point.

35

Mr. JAEDICKE. I agree.

Senator COLLINS. When the auditor is making over $40 million

a year, the auditor is not likely to come to the Audit Committee

and say anything other than that it is independent. Is it not the

job of the Audit Committee to make sure that the auditor truly is

giving full, accurate, and independent advice to the Board?

Mr. JAEDICKE. I think the way we tried to do that, Senator—I

agree, we should try to do it—was to say OK and once a year, at

least, lead us through all of the controls that the firm has in place

to help assure their independence. Again, an Audit Committee’s

work is on the adequacy not only of the company’s controls but also

of the controls of their outside advisors, and we did that.

Senator COLLINS. As the Chairman of the Audit Committee, you

were the Board member most responsible for ensuring that there

was full and complete and accurate communication between Andersen and the Board. In your tenure as Chairman, how often did Andersen tell you of problems that concerned Andersen with the management of Enron?

Mr. JAEDICKE. Well, they would usually—let me define problems.

They would usually—these would usually come out in the form of

saying, for example, we are engaged in a review of the internal controls of the new businesses, and then we would—and so they

would—there was reason to believe you needed to concentrate on

the controls. There was need for, for example, some pre-measurement type of controls in Enron Energy Systems at one point. We

were concerned about were there access issues in Enron On-Line.

Now, things of that nature would come out in talking to the Audit

Committee and then we would follow that.

And if you looked, for example, at the minutes, you would find

that the next meeting, they would say, significant progress has

been made in these areas. And so they did—the types of problems

that they talked to us about were usually in connection with their

auditing emphases or the controls that were inherent in a particular business unit or things like that, and they brought those to

our attention.

Senator COLLINS. Mr. Duncan, in February 2001, Fortune magazine ran an article about Enron and questioned whether its stock

was overpriced. According to the story, the company was described

by one analyst as impenetrable, a black box to outsiders. Another

said the lack of clarity was a red flag. You told the Subcommittee

staff that you remembered the article, that it was not flattering,

that you were concerned about it. Did you ask Andersen to take a

look at the allegations in the article?

Mr. DUNCAN. I did not. You must remember, I was not on the

Audit Committee. But to answer your question, I did not ask Andersen to take a look.

Senator COLLINS. Did you bring it up in your role as Chair of the

Executive Committee to any of the executives of Enron?

Mr. DUNCAN. I do not remember doing so.

Senator COLLINS. Dr. Jaedicke, did you bring it up to the other

members of the Audit Committee or to Andersen and ask them to

look into it? Fortune magazine is a well-regarded publication and

these were pretty serious criticisms of the business for which you

were on the Board. Did you take any action in response to it?

36

Mr. JAEDICKE. Not in response to that particular article, ma’am,

no.

Senator COLLINS. Mr. Duncan, in October 2001, and I actually

want all of the panel to answer this question, the Board became

aware that an Enron employee had written an anonymous letter to

Ken Lay. We now know this as Ms. Watkins’ memo. Mr. Lay advised you that he had met with the employee and turned the matter over to Vinson and Elkins for further review. He obviously

thought the charges were serious enough to warrant a review, but

then he reported to you that there was no substance to the charges.

I would like to ask each of you, and since my time is fast running

out, if I could just get a quick answer, did you ask to see the Watkins memos? Mr. Duncan.

Mr. DUNCAN. I did not.

Senator COLLINS. Dr. Winokur.

Mr. WINOKUR. I did not.

Senator COLLINS. Dr. Jaedicke.

Mr. JAEDICKE. We asked for a written report after they gave us

an oral report and they had characterized the essence of Ms. Watkins’ comments in that oral report, and we asked for a written report afterwards, which we got, but not until fairly late.

Senator COLLINS. Did you see her memo which warned that the

company could implode in a wave of accounting scandals?

Mr. JAEDICKE. The first time we asked for the report, at least the

Audit Committee did not get the memo. Now, I am talking about

December.

Senator COLLINS. Right. But did you ask—— Mr. JAEDICKE. Then we asked for the memo.

Senator COLLINS. When did you ask for the memo?

Mr. JAEDICKE. When we got the written report from Vinson and

Elkins, which turned out to be—you have got to remember, a lot

of things happened—which turned out to be at the December Board

meeting in 2001. That is when I got the memo.

Senator COLLINS. Dr. LeMaistre.

Dr. LEMAISTRE. My recollection is exactly like Dr. Jaedicke’s. We

got the memo after we heard the report. We only had an oral report saying that there was going to be an investigation. When the

investigation was reported, we asked to see the memo.

Senator COLLINS. Mr. Blake.

Mr. BLAKE. Mine is very similar, and I do specifically remember

asking for a written—we did not have a copy of the letter at the

time that the report was given to the Board and we specifically

asked also for a copy of the letter as well as a report from Vinson

and Elkins.

Senator COLLINS. Dr. Jaedicke, former SEC Chairman Rod Hills

has said very strongly that he feels the Audit Committee should

have engaged an outside firm to review the allegations in the

memo rather than leaving it up to the CEO. Could you comment

on that?

Mr. JAEDICKE. Yes, I could comment on that, Senator. The memo

was—actually, memos. There were, I think, two of them, a letter

and a memo that were given to Mr. Lay, in August at some point.

Mr. Lay handled those as they would have been handled under the

code of conduct. They would have required an investigation. And

37

we did not hear about the results of that investigation. We did not

hear there was an investigation underway until about the time of

the October Audit Committee meeting. By that time, the investigation had been completed.

The investigation turned up no new information. I can come back

to that if you like. But it also—some of the issues that she had

brought up were not even verified by the people whom she had

named, or at least who were thought to know something about

them. The investigation was completed and it did not say, I do not

think, that there was nothing, there were no problems. I think

what it said is that no further investigation seems warranted.

Senator COLLINS. That really is not my point. My point is that

the CEO chose the firm to do the investigation of the allegations

against the firm, and Rod Hills says, as a former SEC Chair, and

I agree with him, that it would have been better and would have

allowed for a more thorough review of the allegations for the Audit

Committee to control that.

But let me move just quickly to another point, if I may.

Senator LEVIN. I wonder if I could just intervene for one

second——

Senator COLLINS. Please go ahead.

Senator LEVIN [continuing]. Because I want to just pursue one

aspect of the point which Senator Collins just raised to make sure

I understand your answer. No one on the Board saw a copy of the

Watkins memo until after the Powers Committee report was completed, is that correct?

Mr. JAEDICKE. No. I do not think——

Senator LEVIN. In that case, I will let your answers stand the

way they were.

Senator COLLINS. Thank you.

Dr. LeMaistre, you attended the October 6, 2000, Finance Committee meeting in which Mr. Winokur suggested that Andrew

Fastow’s compensation should be reviewed by the Compensation

Committee, is that correct?

Dr. LEMAISTRE. That is correct.

Senator COLLINS. And I believe Dr. Winokur proposed that review as a control to mitigate Mr. Fastow’s conflict of interest. Yet,

it is my understanding that the Compensation Committee did not

at that time follow through on that recommendation. Can you explain why?

Dr. LEMAISTRE. Yes. The Compensation Committee was aware

that there had been controls put in place for Mr. Fastow to report

his compensation. They were aware of the fact that his approved

compensation on both LJM1 and LJM2 was to be modest.

Second, we knew there were reports coming on an annual basis

and on a quarterly basis and we expected information to come

through these reports and that management, as they should have

done, bring that to the Compensation Committee. I inquired on two

occasions of our staff, after the first quarterly report subsequent to

that, whether we received any information on a 16(b) officer outside compensation. The answer was no. The second time I inquired

was a few months later, in August or September, I believe, and we

still had not received the information. With all of the events that

38

transpired, the next trigger became, of course, the October 17 or 19

revelation that he was alleged to have made $7 million.

Senator COLLINS. That was the story in the Wall Street Journal.

Dr. LEMAISTRE. Yes Ma’am, that is correct.

Senator COLLINS. So it took a story in the Wall Street Journal

to prompt your going back. You had asked twice, had not gotten

the information. But it was only when the Wall Street Journal

learned that there was an important issue here and actually gravely understated the amount of money that Mr. Fastow was making

that you pursued this?

Dr. LEMAISTRE. That is correct.

Senator COLLINS. Thank you, Mr. Chairman.

Senator LEVIN. Senator Lieberman.

Senator LIEBERMAN. Thanks, Mr. Chairman. Thank you, gentlemen.

Yesterday, attorneys for Enron provided several documents to

the Federal Energy Regulatory Commission which related to what

I would consider to be highly questionable trading strategies used

by Enron in the California and Western electricity markets in the

year 2000 energy crisis, and apparently continuing into 2001.

These documents, which, as I am sure you know, have now been

made public by FERC and which I had a chance to look over this

morning were prepared for Richard Sanders, a senior official of

Enron, by attorneys from both inside and outside the company, apparently in anticipation of possible regulatory sanctions, investigations, and litigation arising out of the crisis, or perhaps, I suppose,

just as notification to the traders.

They are very interesting documents because they describe a

range of different strategies with very colorful names, such as

Death Star, Get Shorty, Wheel Out, Fat Boy, Ricochet, and others

by which Enron’s traders maximized profits while gaming the system and taking advantage of the energy crisis in California.

One memo which I have looked at, dated December 8, 2000, specifically discusses the California market regulations against gaming and other predatory market behavior after it describes the

strategies that the Enron traders were following, and in my opinion, may have been violating, although the memo is, in that sense,

as I read it, you might say value neutral. It does not make a recommendation. It describes the strategies and then the sanctions

that can be applied by the California—against Enron should the activities be discovered, and that is a direct quote, ‘‘should it discover

such activities, a California system operator could take these actions against Enron.’’ So I want to ask a series of questions about that. First, was the

Enron Board of Directors aware of the trading practices and strategies used by Enron’s traders in the California and Western markets? Mr. Duncan or Mr. Blake?

Mr. BLAKE. No, sir. We were not aware of those specific strategies, and if I may add, the first time I was aware of those strategies was when Pug Winokur and I, who are on the Restructuring

Committee of the Board, were given those documents 2 weeks ago

to this day and I subsequently, as Acting Interim Chairman, set up

a Board meeting for that following Thursday, at which time we discussed it with the Board. I think, in fairness, the predisposition

39

was to make this disclosure as responsibly and as quickly as possible. We instructed our counsel to investigate further because Rob

Walls, who Mr. Walls is the now-current General Counsel, but was

not there before, just came upon these memos.

Subsequently, the following week, last week, there was further

discussion of this report by counsel, actually last Sunday morning,

by counsel and the management and we, as a Board, moved to direct specifically the release of that information yesterday.

Senator LIEBERMAN. I appreciate the speed with which you did

move. What was your reaction when you saw the documents 2

weeks ago?

Mr. BLAKE. I was extremely upset and disappointed.

Senator LIEBERMAN. Did you read them as I did, that they

seemed to be both descriptions of strategies that were questionable

and then an indication of what the penalties were, but almost a directive about how to avoid the law instead of how to comply with

it? Am I overreaching, or was that part of your reaction?

Mr. BLAKE. Well, in candor, my reaction was very much similar

to yours. It certainly appeared on its face, although it was sort of

a description of the practices, but from what I could discern, certainly questionable practices, seemingly gaming the system—I

think those are the exact words I used at the Board meeting—very

offensive to me personally and members of the Board.

Senator LIEBERMAN. I appreciate that answer.

Dr. Winokur, perhaps as Chairman of the Finance Committee it

is appropriate to ask you that question, also.

Mr. WINOKUR. Sir, in terms of the recent 2 weeks, I was exactly

where Mr. Blake was. There were five meetings from October 2000

to August 2001 in which there were reports to the Board of Directors by management about California, and we asked questions, including are we doing anything wrong? There is a lot of bad press.

Are we doing everything that we are supposed to do to comply? We

had reports from our General Counsel on litigation. We had reports

from our Chief Regulatory Executive. We had reports from the senior people. And at no time ever were we given any information or

hint of information that we might be out of compliance with the

trading rules.

Senator LIEBERMAN. So that, again, as far as any of you know,

and particularly the two of you, the Enron Board was not aware

of these memos until 2 weeks ago, and, therefore, aware of any of

the legal and financial liabilities that might be incurred by the

trading strategies, is that correct?

Mr. WINOKUR. Yes, sir, we were not aware.

Senator LIEBERMAN. Right. Let me ask this question about this

matter, and this is as we try to work our way through what is the

appropriate and required role for boards of directors. I mean, ideally—well, I suppose the first question has an answer to itself, which

you have already given. You actually asked questions. I mean,

there was a lot of public commentary when this was going on, particularly from people in California and our colleagues who represent California here in the Senate or the House that Enron was

profiteering, whatever the word was. So you asked questions, then,

of the employees and really got what you now know are inadequate

answers?

40

Mr. WINOKUR. Yes, sir. I lived in Los Angeles for 7 years and

was on the board of UCLA Hospital, so I have a lot of friends there.

I responded to the press statements and said, are we asked questions, are we doing anything wrong? Is there anything we should

be talking about here? We had reports in these five meetings from

our General Counsel, our Chief Regulatory Officer, and the senior

executives, not everybody at every meeting, but in those series of

meetings, all those people reported, and not once did we hear anything that suggested any impropriety in California.

Senator LIEBERMAN. Let me ask it in a different way, a different

kind of question, which is, both stepping back and looking back— and here it sounds to me like you had public notice—you asked the

question, you dispatched your responsibility.

More generally speaking, what can we expect of directors in

terms of their oversight of activities such as trading practices of a

corporation? Let us say it would not have fit the public interest because there was not that much interest in the California price

spikes during that time period, so how would you set a standard

for what directors should expect to know?

Mr. WINOKUR. Sir, I am not sure I was qualified, but it seems

to me that if we ask the senior people responsible for that line of

business and we ask separately the General Counsel to give us reports on what is going on, and we, third, set up a risk system to

measure quantitatively how the trading system has worked, I am

not sure I have any other suggestions. I am sorry.

Senator LIEBERMAN. Anyone else? Mr. Jaedicke.

Mr. JAEDICKE. It is a very thoughtful question. As far as the

trading is concerned, we, of course, paid an awful lot of attention

to the financial measures to say, do not take too much risk. Do not

have too many open positions. We had an elaborate policy on that.

Now, one part of that policy was that we were in the process of

developing even more, was something called operational risk, and

operational risk, we did not have it fully developed in terms of

what all it meant, but surely, whatever it meant, it meant that you

would try to put in control systems that would assure you that you

were complying with the law. Our other compliance systems involving the internal and external legal people, you would expect that

to be part of the systems and to be reported if they were not followed.

Senator LIEBERMAN. Let me move on to one additional area of

questioning. I thank you for that answer. As I am sure you know,

there has been a lot of concern among the employees, former employees, particularly, of Enron, and, of course, that concern has

been expressed over the months since early December by members

of Congress about the inequity, perceived inequity of the bonuses

given to various higher-level employees of Enron at the same time

the 4,000 or 5,000 employees who were laid off were given severance payments that were greatly below what they expected.

In the case of some of the bonuses, I gather that to get and keep

the money, they had to agree to stay for 90 days. Some of the bonuses exceeded $1 million. One was even $5 million. That is contrasted with the employees, who, by my recollection, received an

average of about $4,500 each, which, as I said, was a fraction of

what they had expected in the way of severance.

41

According to Mary Joyce, who I know you know is a VP of Compensation at Enron, the issue of severance was discussed at a

meeting of the Compensation Committee of the Board just before

bankruptcy, but she has said to us that she did not remember the

substance of the discussion. Dr. LeMaistre, you are the Chairman

of the Compensation Committee. I believe, if my records are right,

that Mr. Duncan, Mr. Jaedicke, and Mr. Blake are members of the

Committee.

So my question, obviously, is can you remember and describe for

us what was discussed at that meeting about the severance payments, and particularly, did anyone ask if it was possible to compensate these people more fairly for the employees, that is, the

lower-level employees, for their service to the company?

Dr. LEMAISTRE. Senator Lieberman, I recall that very clearly and

I would ask my colleagues to comment on it, to add additional

things. It is a very important question.

The severance plan presented by management to us required several different areas of interrogation by us of management, and the

plan actually was moot because we went into bankruptcy before it

was acted upon, if we are talking about the same severance plan,

and I assume we are.

The W.A.R.N. (Workers’ Adjustment and Retraining Notification

Act) provisions can be exempted in bankruptcy and all that is allowed to be paid, if the bankruptcy court agrees, is the $4,500 per

employee. So I think that explains the problem.

Yes, we did discuss this. The Board of Directors met on December 2, which I think is the day we went into bankruptcy. The Directors agreed to work without compensation and expressed the desire that our fees go to the employees or to an employees’ fund.

Later, we were told it was too complicated to work that out.

We discussed this because we were very much concerned about

what was happening to the employees. I would remind you, one of

the prime reasons everyone should be concerned about that is as

far as I know now, a very small number of employees created a

major part of the internal problems at Enron and there were more

than 20,000 very honest people there——

Senator LIEBERMAN. Correct.

Dr. LEMAISTRE [continuing]. And those are the ones that suffered.

Senator LIEBERMAN. Who suffered? So am I hearing you correctly, that you would have wanted to give the 4,000 or 5,000 employees something closer to the severance payments they thought

they were entitled to under their agreements, but you could not do

it according to bankruptcy law?

Dr. LEMAISTRE. Well, we were—if I recall correctly, and I would

ask the members of the committee to comment, the first discussion

was on a Saturday, December 1, and I think the next day, Sunday,

December 2, we were ready to propose this. Unfortunately, Enron

had filed for bankruptcy at 2 a.m. in the morning on Sunday, and

so we were governed by bankruptcy law.

But to answer the other part of your question, the high bonuses

that you——

Senator LIEBERMAN. Right.

42

Dr. LEMAISTRE [continuing]. Alleged to be high. Those were for

traders. We felt that the traders were the group that was essential

to hold the company together. In the weeks approaching bankruptcy, we were trying desperately to hold on to them. We were

trying to merge with Dynegy, and the traders were of primary interest to Dynegy. That was really the group they wanted.

Second, we knew that they were being sought by many other

companies because of Enron’s public problems, and, therefore, we

were trying to give them a 90-day stay bonus—— Senator LIEBERMAN. I see.

Dr. LEMAISTRE [continuing]. Which had a draw-back on it. They

had to repay if they did not.

Senator LIEBERMAN. If they—— Dr. LEMAISTRE. If they did not stay.

Senator LIEBERMAN. For the 90 days?

Dr. LEMAISTRE. Yes, that is correct.

Senator LIEBERMAN. So that explains my other concern, which

was why you would give such large bonuses for people who are only

staying 90 days, and you are saying you were doing it because they

were traders and you wanted them for that period of time.

The light is up, so I am going to close in a minute on my time.

Do I take it that bankruptcy law did not similarly prohibit the company from paying the large bonuses—— Dr. LEMAISTRE. That occurred before we were under bankruptcy.

Senator LIEBERMAN. You made the decision before?

Dr. LEMAISTRE. Timing, yes.

Senator LIEBERMAN. OK. My time is up. Thank you.

Senator LEVIN. Senator Fitzgerald.

Senator FITZGERALD. Thank you, Mr. Chairman. This is my first

meeting at the Governmental Affairs Committee and this Subcommittee. I just joined the Committee, and I appreciate you having me on. I think I get assigned to all the committees investigating Enron.

Senator LEVIN. The Chairman, I think, wants the honor of welcoming you——

Senator LIEBERMAN. Yes.

Senator LEVIN [continuing]. But we welcome you to the Subcommittee today, and the Chairman can do that appropriately.

Senator LIEBERMAN. Thank you, Senator. Senator Fitzgerald, we

welcome you here. This is a very interesting Subcommittee with

very significant oversight responsibility and we are delighted to

have you and I am sure you will contribute substantially to our

work.

OPENING STATEMENT OF SENATOR FITZGERALD

Senator FITZGERALD. I am pleased to be aboard, and all of you,

thank you. Some of you, I have met you in the Commerce Committee, which has also had several hearings on Enron.

Some of you may know my theory on Enron. I was the one who

described Enron as a gigantic pyramid scheme or Ponzi operation,

and if I could just explain why I say that. Mr. Blake made mention

earlier of the SPEs being used to improve liquidity and get debt off

the balance sheet. After going through several of those SPE transactions and all the 41 boxes that were delivered to the Commerce

43

Committee, I concluded that what Enron was doing was creating

off-the-books partnerships, instructing those off-the-books partnerships to borrow money, in essence, and then Enron would transfer

assets to the off-the-books partnerships. The partnerships would

borrow money, while Enron had typically guaranteed their borrowings, and then the SPEs or the partnerships would pay Enron

for some asset that Enron had transferred to the SPE.

But Enron had always provided a credit support in all the cases

I looked at for the borrowings of the SPE, and if you really reduce

this to simple terms, Enron was simply borrowing money, filtering

the borrowings through the off-the-books partnerships, and then

booking that borrowed money as income, and that is how you built

up some $20 billion worth of off-the-books indebtedness. But Enron

was contingently liable for that indebtedness, and when you filed

for bankruptcy in December, it was because you had a very familiar problem. You had too much debt. You had several billion dollars

worth of indebtedness coming due and Enron could not pay it.

Now, I think these specific transactions were very well disguised.

I think that the management obfuscated enough, used highfalluting sounding language to describe all these transactions to

make them sound legitimate. I think it would be very difficult, you

would really have to be on your guard to figure out what they were

up to.

But I have also felt that in the hands of management was plenty

incentive to engage in this kind of pyramid scheme, to keep booking fictitious earnings, and that incentive was to keep the stock

price up, and they wanted to do that because many of them had

millions or tens of millions, and in some cases hundreds of millions

of dollars worth of stock options in their hands.

Now, many of the senior managers cashed in their stock options

and got out of the company before it all spun out of control. There

are many people who got out of the company, having successfully

cashed in millions of dollars worth of stock options. I think Mr.

Baxter, who committed suicide, got out a long time ago. Others, the

Army Secretary, got out quite some time ago.

Mr. Skilling tried to get out last summer. He succeeded in cashing in, I think, $78 million worth of his options, of 1.7 million options in 2000 and 2001. He got out. I have heard reports that Mr.

Lay had lined up a job at another company and was planning to

get out. He cashed in in the last 2 years $82 million worth of options. In all, the top 29 executives at Enron cashed in some $1 billion worth of options in the last 3 years, according to reports that

I have read.

I have several questions for you. I notice that the compensation

of the Board, total compensation in fiscal year 2000 for each Board

member was roughly an average compensation of $329,000 per

Board member. Some got less, some got more, depending on what

committees they chaired, what committee meetings they attended.

Only a small portion of that compensation was cash compensation.

The average Board member got $78,000 in cash compensation, but

the average Board member got $250,000 in stock options.

The question I have to ask to you is, your interests were to see

that the stock price kept going up, given that your compensation

was so heavily weighted towards options. Did you all not have a

44

1See Exhibit No. 80 which appears in the Appendix on page 665.

financial interest in seeing those options go up and always be in

the money? I understand you could exercise them—they did not expire for 10 years, and so you did not have pressure to cash them

in right away.

But do you care to comment on that issue? I mean, were your

interests really aligned with the interests of the long-term shareholders? How many shares did each of you own outright in Enron,

excluding options? How many shares? Mr. Blake.

Mr. BLAKE. I cannot quite remember, sir. I bought some initial

shares of both Enron and Enron Oil and Gas and EOTT and Northern Border Partners when I first joined in 1993 as a statement of

interest in the company, and—— Senator FITZGERALD. How much do you think you had——

Mr. BLAKE. I might guess——

Senator FITZGERALD. What was your cost basis?

Mr. BLAKE. Maybe about 3,000 shares, something of that nature.

Senator FITZGERALD. And would that be, like, $30,000, or——

Mr. BLAKE. Yes. Well, I also made a purchase in October 2001 that was $80,000, so I would say probably something in excess of

$100,000.1

Senator FITZGERALD. Dr. LeMaistre.

Dr. LEMAISTRE. I had—I lost approximately $3.5 million in

shares of the restricted stock, which is a gift, of course, and in the

stock options, I cannot give you the exact total, but I would say

something in the order of maybe 40,000, 50,000 of beneficially

owned stock—— Senator FITZGERALD. Forty or 50,000 shares?

Dr. LEMAISTRE. Yes, something like that.

Senator FITZGERALD. That you had bought outright, or had——

Dr. LEMAISTRE. Had bought outright, maybe more than that. I

cannot remember the exact figure——

Senator FITZGERALD. And that you owned in your own account?

Dr. LEMAISTRE. That is right, and—— Senator FITZGERALD. What would your cost basis have been in

that, roughly?

Dr. LEMAISTRE. Well, they were bought all the way back to 1991,

so I would have to recalculate that to tell you that. I would assume—I really could not answer it accurately without looking at

notes. I would be happy to do that.

Senator FITZGERALD. A hundred-thousand dollars, maybe?

Dr. LEMAISTRE. Probably.1

Senator FITZGERALD. About $100,000.

Dr. LEMAISTRE. A little more than that, I think, but——

Senator FITZGERALD. A little more than that?

Dr. LEMAISTRE. Yes.

Senator FITZGERALD. Mr. Jaedicke.

Mr. JAEDICKE. I could give you the information. I would be glad

to send the exact information. My recollection is it would be slightly over 20,000 shares, many of which were taken as part of Board

compensation.

Senator FITZGERALD. But what would your cost basis for what

you had——

45

1See Exhibit No. 80 which appears in the Appendix on page 665.

Mr. JAEDICKE. Well, the cost basis of the shares taken for Board

compensation would be that I was paid ordinary income at the time

I got them. So, I do not know, I suppose it would be between $20

and $30 or $40 a share. I do not know what the average would be.

Again, I can supply that to you.1

Senator FITZGERALD. I would be very interested in that. Dr.

Winokur.

Mr. WINOKUR. Yes, sir. I own approximately 80,000 shares. I have a cost base of about $1.8 million or $1.9 million. Some of

those were shares I bought. Some of those were shares from options that I exercised and did not sell. I have never sold a share

of stock.1

Senator FITZGERALD. So you had some skin in the game, as

SherronWatkins would say?

Mr. WINOKUR. Yes, sir.

Senator FITZGERALD. Mr. Duncan.

Mr. DUNCAN. I now own 167,000 shares. I have owned those

shares from the beginning. I cannot now recall my cost basis. I do

recall that the options that I exercised only last year, and held, I

did pay ordinary income tax on them, so that changes the arithmetic a little. But broad general statement, I lost over $10 million.

Senator FITZGERALD. How much money do you think you had invested, though, your total cost basis—— Mr. DUNCAN. Well, if you go back—— Senator FITZGERALD. Now, did you acquire those shares from

prior companies that Enron merged with?

Mr. DUNCAN. No. When Enron sold for cash—excuse me. When

Houston Natural Gas sold for cash to InterNorth, then I took my

proceeds and invested the proceeds in Enron.

Senator FITZGERALD. OK.

Mr. DUNCAN. At that particular time, if my memory serves me, it was about $1.5 million.1

Senator FITZGERALD. So some of you did have substantial investments in the company, and I would think your personal financial

interests were, for some of you, very closely aligned with those of

ordinary shareholders.

Did any of you think about what kind of temptations, though,

could be in the hands of senior managers when they stood to make

the kind of sums Mr. Skilling and Mr. Lay did by cashing in their

options, because cannot any company fictitiously goose-up its earnings per share to keep its stock price high, for a while, at least,

until other people catch on? When there is so much in options outstanding in the hands of senior management, does that not begin

to worry some of you as Directors that, ultimately, their interests

could no longer be allied with the interests of the long-term shareholders? They could just try to goose the stock price, cash in their

shares, and get out of the company? Would any of you care to comment?

Dr. LEMAISTRE. Let me make a comment, Senator Fitzgerald,

that first, the policy of awarding stock was to ensure that they kept

their eye on the ball and saw that the stock price increased for the

shareholders’ benefit, because that is really what the shareholder

46

does, he invests in a company and wants that stock to increase. So

that over the period of time, to have the stock increase, the employees win, but also the shareholders win. So I think that it is a twoedged sword. If one gets the incentive so high that is all that people are really working for in order to cash out—— Senator FITZGERALD. As Chairman of the Compensation Committee, did you ever worry that maybe the incentives were so high,

there were so many options outstanding, that, boy, maybe we have

a problem here, because some people play a game here?

Dr. LEMAISTRE. I did not worry about it, primarily because I

talked to our Towers Perrin consultant every year about whether

our scale of pay, our programs, including the incentive pay that we

had, especially the incentive pay, was commensurate with exactly

what was being done by companies our size. We had our last report

as of the spring of 2001 that said we were right on target with

where we were supposed to be.

Senator FITZGERALD. Can you think of any other motivation that

management would have had to engage in such aggressive accounting and gimmicks to keep the earnings up, other than to keep the

share price up to keep their options in the money, because they

were getting very rich very quickly on this scheme while everybody

else was—all your other rank-and-file employees were wiped out, pension funds were wiped out, and $60 or $70 billion in market

capitalization was lost, but a lot of your inside management got

very rich and came out very well on the whole thing. Can any of

you think of any other motive that management would have had

for deceiving the Board and deceiving the public?

Dr. LEMAISTRE. Senator, I do not want to monopolize the time,

the other Subcommittee Members may want to speak to this, but

I will say that we thought the integrity and honesty of our employees, especially those in key positions, was intact, and that was the

most important thing. We had quarterly reviews of all of the higher-level echelon officers by Mr. Lay directly to the Compensation

Committee and then a very large review annually in our management development responsibility. So we thought we knew these individuals well. I have no answer for your question except that the

problem was, in my opinion, dishonesty and lack of integrity.

Senator FITZGERALD. Mr. Chairman, I appreciate the Subcommittee’s time, and all of you, thank you for being here today.

Senator LEVIN. Thank you, Senator Fitzgerald, and again, it is

great having you with us. Senator Carper.

OPENING STATEMENT OF SENATOR CARPER

Senator CARPER. Thanks, Mr. Chairman, and to each of you, welcome and we appreciate your time and your testimony today and

your responses to our questions.

Before I was elected as Senator about 2 years ago, I served as

Governor of Delaware for 8 years. One of the things I learned as

Governor was that when things went well, I was wise to share the

credit. When things went badly, I was wise to assume the blame.

One of my frustrations in listening to the testimony here this

morning, and frankly, listening to the comments of those who

served in very senior positions at Enron, relatively few people seem

willing to accept the blame.

47

I, for much of my life, served in the Navy as a Naval flight officer, about 23 years, in fact, on active and reserve duty. In the

Navy, we have a tradition, and a proud tradition, that the captain

of the ship assumes the responsibility when things go badly, or the

commanding officer of the squadron that I served in assumed responsibility, was held accountable and responsible when things

went badly.

Obviously, from your testimony today, you believe that you were

deceived and misled. Who bears the responsibility? If not the

Board, if not the Audit Committee, if not those with whom you

served, if not the Chairman, who does deserve the blame? Who

should step forward and say, this is my fault?

Mr. JAEDICKE. Are you directing that at me?

Senator CARPER. From any of you, please.

Mr. BLAKE. Well, I will speak for all the Board and say that we

feel terrible, what has happened here, and we have scrutinized our

own behavior and we have asked the question numerous times,

what could we have done differently? I am absolutely convinced,

sincerely, honestly convinced that the controls, had they worked,

this would not have happened, and I feel absolutely misled in light,

too, with that question.

I do not know where the fault lies. I mean, I accept the same philosophy as you do, and as the CEO of many companies, it is my

ship and I am totally responsible for its conduct and the companies

that I run. I absolutely philosophically totally agree with you, without exception. I do not know where the fault lies here. I do not

know enough of the information. I do not want to get into personalities today, but——

Senator CARPER. If you do not, and those of you with whom you

serve—excuse me for interrupting, but if you do not know where

the fault lies, how are we going to figure that out?

Mr. BLAKE. We do not know the facts, sir. I do not know what

Ken Lay knew or did not know. I would love to know. I would like

to know what Jeff Skilling knew and what he did not know, because I look to them as leaders of the company, responsible to the

Board in the exercise of their particular responsibility as the chief

executives of the company and responsible for the ship. I want the

answer, too. I do not have an answer. If I had the facts, I would

give it to you, honest.

Mr. WINOKUR. Senator, I served on the Powers Committee, the

special investigative committee, and as that report indicates, there

is considerable ambiguity in exactly who knew what, when, and

how, because our committee was not able, as government agencies

can, to subpoena people, to force them to talk, and so on. So I think

all of the interviews have been provided to you and there are numerous investigations underway by people who have the ability

and the authority to find out answers to those questions.

But I concur with what Norm said. I think we reacted as best

we could to the information we had. We relied on the candor of

management. We relied on our advisors to do their job, which was

to confirm what we were being told, and there is a lot left to be

learned, unfortunately, as the Powers Committee report indicates.

Senator CARPER. Anyone else?

48

Mr. JAEDICKE. I agree with the two statements that have been

made. I guess all I would say to elaborate on that, or to maybe

bring up another point, is to say—and I guess I am speaking from

the viewpoint of an Audit Committee, although I think it would be

the same for a Board, as well, is that there is this classic problem

that the information that the Board needs to do the oversight, not

entirely, but largely comes from management. And so the people

you are supposed to be overseeing do control a great deal of the information.

Now, how do you deal with that? Well, you try to put controls

in place. You also hire an external auditor. We had within Enron

an organization that I thought supported that, those kinds of

checks and balances, because, for example, we had a separate financial officer, a separate accounting officer, and a separate risk

control officer, a separate legal officer. None of those were combined and all of them reported in at the same level.

Dr. LeMaistre makes a very good point, also, with this whole

thing, you hire one of the best accounting firms in the business, or

at least that was their reputation. The same with legal. You try to

assess management, and we had no reason to distrust management

or our outside advisors. Where you feel let down is when you do

not get the information that you need to act, and I do not know

how you can act if you do not have that information.

Senator CARPER. What punishment is appropriate for those who

have led to this debacle? And again, this is for any of you.

Mr. WINOKUR. Senator, I will just speak for myself. I am not a

lawyer, and I am certainly not a criminal lawyer, I am not a civil

lawyer. I do not have any idea what is appropriate. I hope the investigation pursues everything it can to find out everything it can

because I think all of us, you, the Directors, the employees, deserve

to know who knew what, when, how, and why. But I could not comment on the—— Senator CARPER. Anyone else?

Mr. DUNCAN. Only that we share your frustration.

Senator CARPER. I serve on three committees that have conducted parts of the hearings into Enron and we will presumably be

developing a legislative package to address a number of the suggestions that we have heard throughout the course of the last several

months. They include the roles of the auditing firms, the independent audit, whether they should rotate firms, whether we

should rotate lead auditors, issues involving independence of the

board, how many independent directors should there be, what constitutes a breach of independence, issues involving 401(k)’s, how

long people should have to hold their company stock in order to

vest.

Some of the people who have testified to us have said, you should

legislate little. You should let the market force the corrections and

punish those who make the reforms, adopt the reforms, and that

is the better approach. We have heard from people who say the

SEC should do certain things, that the board exchange, the New

York Stock Exchange and others, should push various reforms.

In the end, what should the Congress do? What should we do in

some of the areas that I have mentioned or others that I have not

touched on? What should we do as legislators?

49

Dr. LEMAISTRE. Senator, I would like just to agree with you. I

think there is much the Congress can do once the facts are known.

I think the only thing the Congress can do now, though, is to await

the final understanding of exactly how this happened, how Enron

was brought down and by whom, and where controls need to be

placed, not by the Board but by either law or by the voluntary organizations, and businesses that do this, such as the auditors.

But there is going to be a role for legislation. It may be a midpoint between those that said, leave it alone and let it happen, and

those of us who are a little bit emotional about getting everything

done right now. I think the best thing to do is to let the process

of justice go through here where we will find out everything, and

I am looking forward to that understanding, because I could answer your question better then.

I will say this to you. A Board like this one that has been

through what we have been through would be willing to help you

in any way we can and tell you where we think, in some more detail than we can do today, what really happened and why we were

let down. I think we do not know enough today to tell you more

about what is the real problem.

Mr. BLAKE. Senator, if I could add one thing, I want to go back

to the point you made. It gets down to the leadership. You cannot

legislate leadership. It gets down to what the role of a leader of an

organization is, the culture of the organization he is responsible

for, the discipline and the incentives put in place to encourage

character, honesty and integrity as an offset to greed or whatever

may be the other compelling factor in someone’s mind.

I have been associated with some very successful companies as

an employee and as a leader of that company, and stressing values

above performance, values above compensation, a sense of integrity

and sense of purpose about the company, is what it is all about.

There has to be a higher purpose for that company ultimately to

be successful. It should not be motivated by short-term windfalls

of stock prices. It should be motivated by the vision of the company. It should become sort of imbibed in the person. You know

what I am talking about. That is what real leadership is about.

So I have to say my honest answer to your question, it starts

with leadership. Forget about anything else. It starts with leadership, and if it is not there, then the company will fail.

Senator CARPER. Well, there are certain things we can do. We

are not very good at legislating integrity or character, but that is

obviously what is needed to best ensure that these kinds of things

do not happen again.

Anybody else in terms of—I know my time is expiring.

Mr. DUNCAN. Senator, I would agree that it would be very difficult to legislate integrity. It would be very difficult to write the

law on leadership and character. But there are some issues, in my

opinion, that your Subcommittee and this Congress and this Senate

should consider, and one of them is that stock option problem of

how it is accounted for.

And one of the problems that really is a catch-22, if the Dow had

not moved from 3,000 to 10,000 while these employees had their

options, their 7- and 10-year options, then they would not be so rewarded. But when the whole market moves up and they want to

50

go to work for options and the overhang of the stock is one of the

things that we kept worrying about. We worried that we wanted

to compare ourselves with other companies on the overhang, i.e.,

the amount of options that were out in relation to the total number

of shares of stock, and was that in the ballpark, and if it was in

the ballpark and if we thought we were hiring and were hiring the

youngest, the brightest leaders, then they wanted options and we

would issue options.

But once issued, if they were 10-year options and the whole market triples, then you have a catch-22 there, which is an incentive

to get out, and I do not know the answer to that. If we would have

issued these options in 1970, at the end of the 10-year period, they

would not have any profit because the market did not move. And

so I do not know how you put that into legislation.

I will say that one of the reasons, in my opinion, that the American system has worked so well for the majority of the leaders is

because they had options and they led the company with leadership

and integrity and they made themselves and their families some

money. So if that had to have been removed from the system entirely, I do not think the American economy would be doing as well

as it is today.

Senator CARPER. Thank you for those comments, and Mr. Chairman, thank you for allowing me the time.

Senator LEVIN. Thank you, Senator Carper. Senator Durbin.

Senator DURBIN. Thank you, Mr. Chairman. Let me say at the

outset that I am personally familiar with one of the members of the

panel. Dr. LeMaistre and I became acquainted almost 20 years ago.

Dr. LeMaistre, you are one of my heroes——

Dr. LEMAISTRE. Thank you, sir.

Senator DURBIN [continuing]. What you have done in the field of

public health has saved countless lives, not just in Texas, but in

our Nation and around the world——

Dr. LEMAISTRE. Thank you, Senator.

Senator DURBIN [continuing]. And I am truly sorry that you are

in this predicament now and wearing a different hat, but I wanted

to start off by saying my admiration for you has not been diminished in any way whatsoever by this.

But I want to raise this question. Let me concede at the outset

I am a liberal arts lawyer. I am not a business major, so I struggle

to understand a lot of the things that you talk about, which are

common parlance for people who are involved in business. But occasionally, I rely on folks that I think really get to the core of the

issue for me, and the person that I turn to once a year and make

sure I never miss his views on life is a fellow by the name of Warren Buffet, who puts out the Berkshire Hathaway Annual Report.

It should be ‘‘must’’ reading for everyone in Congress, if not everyone in business, because I think Warren Buffet has proven that you

can do things differently and still be very successful.

Here is what he said in his most recent report to the shareholders of Berkshire Hathaway. He said, ‘‘Though our corporate

performance last year was satisfactory, my performance was anything but. I manage most of Berkshire’s equity portfolio and my results were poor, just as they have been for several years.’’

51

He goes on to say, ‘‘One of my ground rules is applicable. I cannot promise results to partners. But Charlie Munger,’’ who is his

vice chairman, ‘‘and I can promise that your economic result from

Berkshire will parallel ours during the period of your ownership.

We will not take cash compensation, restricted stock, or option

grants that would make our results superior to yours. Additionally,

I will keep well over 99 percent of my net worth in Berkshire. My

wife and I have never sold a share, nor do we intend to.’’ ‘‘Charlie and I are disgusted by the situation so common in the

last few years in which shareholders have suffered billions in losses

while the CEOs, promoters, and other highers-up who fathered

these disasters have walked away with extraordinary wealth. Indeed, many of these people were urging investors to buy shares

while concurrently dumping their own, sometimes using methods

that hid their actions. To their shame, these business leaders view

shareholders as patsies, not partners. Though Enron has become

the symbol for shareholder abuse, there is no shortage of egregious

conduct elsewhere in corporate America.’’ My question to you, because some of you—Mr. Duncan, you

talked about your business experience and your success—and others, as well, have dedicated your lives to American business. You

have taken risks. Some have succeeded and some have failed. For

your successes, you have been rewarded, and that is the nature of

capitalism and free enterprise, as it should be.

But reflect for a moment on what it says to America that we can

step back and look at this viper’s tangle of Enron and judge that Mr. Lay was worth over $140 million a year to create this fraud

on the American public, or that Mr. Fastow was discovered to be

making an additional $15 million which had not quite come to

light. Think about what this says to the rest of America that wants

to believe this is on the square. I do not think it meets the standard and test which Warren Buffet is talking about here.

I think Enron, as I said at the outset, has shaken us to the core.

I do not think any Americans are opposed to success. That is what

America is all about. That is the American dream. But this is not

success, this is fraudulent conduct that has resulted in unjust rewards.

I would like to ask you, Dr. LeMaistre, you deal in your hospital

situations with some of the most gifted men and women in the

world, skilled people who give more of their lives than any of us

even in Congress and receive a tiny fraction of what some of these

corporate officers were receiving. Help me put this in perspective.

Help me understand why we should use as a standard who is making the most in business to decide who is worth an extra dollar.

Dr. LEMAISTRE. Senator, your quote and your question come

right to the point. I think that it is difficult for someone who has

come from a purely academic background to speak to this because

M.D. Anderson is an academic institution and we do not use the

same pay methods that we are talking about.

The real problem, it seems to me, is that we need more disclosure from the leadership of business as to what the principles are

on which they are operating their companies. We had an inquiry

earlier about what went on in California, for example. This Board

was never told of any illicit practices that were going on in CaliVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00063 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
52

fornia. I think that the leadership should be required to tell a

board and the shareholders what their practices are going to be.

We know in medicine exactly what they are going to be and we

have a high standard, and if it is not met, then there is a remedial

action taken.

As a consequence, I would like to see the same stringent approach to the responsibility for leadership, including boards, and

all of business, because I think we can find ways. I think it is going

to require, though, as I said before you came back in, that we really understand thoroughly what happened at Enron. I think the

Powers Report is a first, and a very quick look at that, and until

we get testimony under oath, I do not think we are going to fully

know exactly why charges like gaming are being made in this

thing.

Senator DURBIN. Let me use another illustration and then ask

the other panelists to comment, as well. About a month ago, the

New York Times in the business section published the salaries of

the top 100 executives in the United States and they compared

what they were making to the performance of their corporations.

Now, you have heard this story repeatedly, how boards of directors

have repeatedly given bonuses and extra payment while the company is going into the dirt.

If you are standing on the outside looking in from the viewpoint

of an average citizen or a worker or an investor or someone whose

pension is on the line, you have got to say this is an upside down

world. There must be such a closed culture within American corporations that they believe they are royalty, that they can treat one

another with royal conduct even if they have not performed accordingly. When I look at some of these salaries that are being paid

here, this goes way beyond incentive compensation.

Mr. Duncan, you started long ago. Your opening testimony talked

about your distinguished career in business. You have seen some

dramatic changes in executive compensation, have you not?

Mr. DUNCAN. I certainly have.

Senator DURBIN. Are they fair?

Mr. DUNCAN. What a comp committee has to do in today’s world

is try to determine whether that executive is the best and then determine what he can get if he walks across the street.

When I was President of Gulf and Western, there were two guys

working there, Michael Eisner and Barry Diller. They made a lot

more than I did. Why? Because they could walk across the street

and get more money, and representing the shareholders, we did not

want them to walk across the street.

So one of the catch-22s that you face is that you have to pay the

going rate. Now, the second part of your question, is the going rate

ludicrous? Yes. But when you have a large corporation and you

have 20,000 employees and you want the corporation to succeed,

then you cannot ignore what the going rate is, whether you think

it is right or wrong.

And incidentally, I like Warren Buffet’s approach. He is my hero,

too. But he can talk with luxury because he is the second richest

man in the United States. So he can enjoy saying, ‘‘I am not taking

a dollar.’’ But the young guy who is fresh out of MBA school, who

has kids that are growing up and knows what he can get if he

53

walks down the street, you cannot ignore that, either, and it is a

tough problem, and it is helped by the fact that the Dow keeps

moving and stock options are in the mix. It is really helped by that

fact, because everybody starts reading what the other guy is making.

Senator DURBIN. I could defer to our Chairman on the stock option question. We are both cosponsors of legislation which he has

introduced on this issue.

But Dr. Winokur, would you comment on this executive compensation? What is, I think, brewing in this land is a feeling of disgust about how much people are being paid and how the chasm between the average person who gives his life to Enron, puts his entire pension and future in that Enron 401(k) and sees it disappear

while others are skating away with second and third multi-milliondollar homes, there is a basic injustice here. There is a feeling of

privilege which is not part of the American experience. Could you

comment on that, as well?

Mr. WINOKUR. Yes, sir. I manage a private investment partnership with a number of financial institutions involved and the way

our partners get paid is after our limited partners have been paid

all their money, and a return on their money, and all that cash has

been sent out, then we split what is left if any is left. So I am the

last guy in the food chain, so I am very sympathetic to both you

and Warren Buffet and Charlie Munger’s point.

I would just make one suggestion of an item to consider as the

Chair and you consider the stock option matter. It has seemed odd

to me in the companies in which we invest that if we issue stock,

restricted stock, to the employees, there is a charge to earnings. If

we issue stock options, there is not a charge to earnings, a point

you obviously know well. But if we issue options but the options

vest only on achievement of performance criteria, there is a charge.

Now, it would seem to me it would go the other way around, that

is, that you would want to give people incentives not to receive

compensation unless they have actually performed, as opposed to,

as my colleague, Mr. Duncan, said, have a ride on the market. I

do not know if that is helpful, but it is something that has occurred

to me.

Senator DURBIN. Well, I stopped short of reading the next sentence in Warren Buffet’s report, but I am going to read it now since

it is an open invitation. He says in his annual report, ‘‘One story

I have heard illustrates the all-too-common attitude of managers

toward owners. A gorgeous woman slinks up to a CEO at a party

and purrs, ‘I will do anything, anything you want. Just tell me

what you would like.’ With no hesitation, he replies, ‘Reprice my

options.’ ’’ [Laughter.]

A lot of us believe that this option business has gotten completely

out of hand, not just for tax purposes but as incentives for compensation. I thank you for your testimony today, and Mr. Chairman, thank you for this hearing.

Senator LEVIN. Thank you, Senator Durbin.

We are going to proceed for perhaps 45 minutes to an hour here

and then break, perhaps completing this panel, but perhaps not.

I am absolutely amazed at your denial of any responsibility for

what happened at Enron. From the outside, Enron appears as a

54

case where insiders made fortunes, much of it based on stock options, jacking up share prices, while the shareholders were left

holding an empty bag. That is from the outside. From the inside,

I think there is responsibility just from what we are going to go

into right now and what we have gone into. What the Board knew

should have triggered on the part of the Board a heck of a lot

greater vigilance than it did.

In the words of the Powers Report, which we are going to try to

demonstrate here factually with documents, ‘‘The financial reporting abuses of management could and should have been prevented

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

and vigilant.’’ That is the Powers Report. You deny even that, that

you could have been more aggressive and vigilant. You just point

your fingers at management, and let me tell you, they bear a lot

of the responsibility, plenty of it, and their time will come.

But now, you should step up to the plate. You are the Board. You

are the captain of this ship that went down, and you are denying

any responsibility.

All of those red flags which we are going to go into, you say you

did not see them, they were not there, you were not told. There

were plenty of things you were told and that you knew which

should have triggered much stronger action on your part. I want

to go into some of those right now because I do not think the facts

support your denial of any responsibility, and I just don’t buy it.

There is responsibility in this Board and it should be accepted.

Otherwise, directors are going to duck responsibility in all corporations, blame it on people who did not tell them things, even though

there were warning signals and even though there were facts,

much more than warning signals, facts which we are going to go

into which were brought to the attention of the Board and which

should have triggered action on the part of the Board.

First, I want to talk about Whitewing, one of these complex

transactions. This was an early step which you took as a Board

which waded into dangerous waters.

The strategy of Enron was to become asset-light. That means

selling assets to or syndicating, sharing the liability or risk of assets, with a third party. The money raised from the sale of these

assets was then to be used for new instruments that would offer

a higher return, and the sales would improve your balance sheet.

Enron called these assets that were held for sale merchant assets. I want to talk to you about how Enron set about selling these

assets and finding outside investors to invest in them, and I will

be asking most of these questions of Mr. Winokur, as Chairman,

and Mr. Blake. Both of you were on the Finance Committee.

First, back in 1997, according to the CFO magazine, Enron is

having a challenging year. The debt is the result of enormous

growth. It was higher than was consistent with your credit rating,

and retaining a high credit rating was critical to the success of

your trading business. So with that background, Mr. Blake first,

what can you tell me about Whitewing and Nighthawk?

55

1See Exhibit No. 15, chart entitled ‘‘Condor Transaction,’’ which appears in the Appendix on

page 253.

Mr. BLAKE. Well, as the chart indicates,1 this is a means by

which to substitute equity for debt, and that is the $1 billion that

comes in from Whitewing is proceeds that can be used to pay down

debt, and when you are transferring convertible preferred stock to

Whitewing.

Senator LEVIN. Now, when you talked to our staff, did you tell

them that you did not have much recollection of this?

Mr. BLAKE. That is correct. I did, Senator.

Senator LEVIN. So you have refreshed your recollection since

then?

Mr. BLAKE. Yes, I have.

Senator LEVIN. Fine. Mr. Winokur, what can you tell me about

Whitewing and Nighthawk?

Mr. WINOKUR. Nighthawk, which is really an entity owned by

Citibank, put up $500 million. Enron put up $500 million into

Whitewing, which was an LLC, and that company took the $1 billion and paid it back to Enron, so Enron had net $500 million with

which it could pay down its debt or make further investments.

Senator LEVIN. All right. Now, when you met with my staff, did

you also tell my staff you did not have much recollection of that

transaction?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. Now that you have refreshed your recollections,

Enron was borrowing a half-a-billion dollars from Citibank, but it

did not show up on the balance sheet of Enron as debt but rather

as preferred shares, which looked more like equity than debt. It

was a loan disguised as equity in order to avoid showing debt on

the books. Now, look at page 2 of Exhibit 15.1

Mr. WINOKUR. Sir, I believe it was accounted for as a consolidated subsidiary with a——

Senator LEVIN. Was it shown as a loan?

Mr. WINOKUR. It was shown as—the entity was consolidated and

the $500 million of Citibank was a minority interest.

Senator LEVIN. But was it shown as a loan?

Mr. WINOKUR. No, sir.

Senator LEVIN. That is, in effect, what it was.

Let us go now to 1999. The Board is now getting into deeper and

deeper water. This time, Jeff Skilling tells the Board about his

asset-light strategy, and Andrew Fastow is talking openly about

the determination to sell assets. The market goes for it. Enron’s

stock price continues to go up.

This Nighthawk-Whitewing deal had worked like a charm. Enron

borrowed a half-a-billion dollars in funds without appearing to burden the company with more debt. Now, it needed more money to

invest in broadband and other new ventures, but it did not want

to directly borrow the money and put the debt on the balance

sheet, so now you have to figure out a new way to bring funds into

Enron.

So the second stage of Whitewing comes along. It is a trust called

Osprey. Now, first, Mr. Winokur, did you tell my staff you basically

did not remember much about the Osprey transaction?

56

1See Exhibit No. 15 which appears in the Appendix on page 253.

Mr. WINOKUR. Yes, sir.

Senator LEVIN. And, Mr. Blake, did you also tell my staff you did

not remember much about that transaction?

Mr. BLAKE. Yes, sir.

Senator LEVIN. OK. Now, this was a transaction where Osprey

raised $1.5 billion by selling bonds to outside investors and used

it to buy a stake in Whitewing. Enron deconsolidated Whitewing,

so it took Whitewing off the Enron books. This chart is the second

page of that Exhibit 15.1 It lays out this structure of Whitewing

with Osprey. Basically, what the Board did here was use Enron

stock as collateral for Osprey’s $1.5 billion borrowing.

Mr. Duncan, I believe that you were there when you moved to

approve that transaction, is that correct?

Mr. DUNCAN. That is correct.

Senator LEVIN. And, Mr. Blake, you seconded that?

Mr. BLAKE. That is correct.

Senator LEVIN. A billion-and-a-half dollars. At least when my

staff talked to you, no memory of that. Osprey had come up 15

times in presentations to the Finance Committee and to the entire

Board.

Now, Mr. Winokur, do you know what Whitewing did with the

$1.5 billion that it got from Osprey?

Mr. WINOKUR. Well, it repaid Citibank the $500—actually, $570

million, because that was—there was an accrual, and part of the

reason was that the convertible preferred stock that had been in

Whitewing had appreciated significantly and that was not part of

the consideration to Citibank.

Senator LEVIN. Did it also buy Enron’s assets?

Mr. WINOKUR. It bought merchant assets at no gain or loss.

Those were merchant assets.

Senator LEVIN. All right.

Mr. WINOKUR. And the debt——

Senator LEVIN. Did Enron have to sell these in order to go

through its asset-light strategy? Was that part of the strategy, to

sell these assets?

Mr. WINOKUR. Well, it was part of the strategy to sell the assets

when it was time to sell them. I do not know specifically what the

motivation was behind each individual sale.

Senator LEVIN. But you do remember the meeting where Mr.

Fastow, the Chief Financial Officer, talked openly about the need

to sell assets back in 1999, and Skilling talking about the assetlight strategy? Do you remember that?

Mr. WINOKUR. I understand that strategy, yes, sir.

Senator LEVIN. Do you remember that?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. Was this part of that strategy?

Mr. WINOKUR. Yes, sir. I would also like to say that the bonds

were rated and the equity in affiliates, which is where Whitewing

was then carried, showed the consolidated balance sheet for all of

the equity and affiliate transactions.

57

1See Exhibit No. 80 for clarification which appears in the Appendix on page 665.

Senator LEVIN. Now, were the bondholders—did they have a

guarantee that if the assets did not generate cash to pay them back

on their bonds, that Enron shares would be used to pay them back?

Mr. WINOKUR. Yes, sir, and that was fully disclosed, as well.

Senator LEVIN. These were promises that were made to the bondholders that Enron shares would be used if they did not get——

Mr. WINOKUR. They were made to the bondholders and disclosed

in Enron’s financials, yes.

Senator LEVIN. So they could not lose. The bondholders could not

lose. Enron stock was there to guarantee the return, is that the

bottom line?

Mr. WINOKUR. Well, they could lose if Enron went bankrupt and

could not make good on its——

Senator LEVIN. Right. Other than that, though, Enron stock, no

matter how much was needed, was used to back up that bond return, is that correct?

Mr. WINOKUR. It was not an infinite quantity of stock, as I recall.

It was either convertible preferred stock in a fixed amount or common shares.

Senator LEVIN. You think that there was a limit on how much

stock could be converted or used to pay for those bonds?

Mr. WINOKUR. I think it was convertible preferred stock was

available, as well.

Senator LEVIN. So was there, then, in effect, either through convertible preferred stock or otherwise, a guarantee as long as Enron

was in business that whatever amount of stock of Enron was needed to pay those bond holders, it would be used?

Mr. WINOKUR. It was contingent support, sir.

Senator LEVIN. Contingent?

Mr. JAEDICKE. That would have been disclosed in the footnote.

Senator LEVIN. I am asking you, what was there? Was there any

limit on how much Enron stock, preferred or otherwise, could be

used to back up the payment of those bonds to the bondholders?

That is a simple question.

Mr. JAEDICKE. Was there any limit?

Senator LEVIN. Yes. As long as Enron was in business, was there

any limit to the amount of stock?

Mr. JAEDICKE. I think the only limit that would come into play

would be that there is a transaction approval process on the sale

and purchase of assets and the issuance of stock. It would have had

to come to the Board.

Senator LEVIN. My question is, to repay those bondholders what

they were guaranteed, was there any limit on the number of shares

of Enron stock that had to be or would be sold, if necessary, to pay

them back? That is my question.

Mr. JAEDICKE. The market would have imposed the limit, just

like they would have imposed a limit on how much you can borrow.1

Senator LEVIN. I am talking about the number of shares sold, not

the value of——

Mr. JAEDICKE. I do not think—no——

58

1See Exhibit No. 32 which appears in the Appendix on page 334.

Mr. WINOKUR. Sir, the minutes say that there were reserved 20

million additional shares of common stock and 100,000 preferred

shares of the company for issuance under the share settlement

agreement.

Senator LEVIN. Take a look at Exhibit 32,1 if you would, the ‘‘Stock Price Risk and Financing.’’ Mr. WINOKUR. Yes, sir.

Senator LEVIN. Do you see that risk on Osprey?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. Ten thousand shares if it went down to $40?

Mr. WINOKUR. Ten million shares, yes.

Senator LEVIN. Ten million shares if it went down to $40?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. If it went down to $20, what would be the risk?

Mr. WINOKUR. I cannot do that calculation.

Senator LEVIN. But whatever was necessary?

Mr. WINOKUR. No. The share settlement agreement that I just

read—now, again, I do not have the detailed document—said that

a certain amount of common stock or preferred stock was reserved

for issuance, and that is why I said to you that I believe that there

was a contingent limited guarantee.

Senator LEVIN. You believe it was limited as to how many shares

would be sold to pay back those bondholders, is that what you are

saying?

Mr. WINOKUR. In 1999, when this was done, to the best of my

knowledge.

Senator LEVIN. Let me just make sure here that we are on the

same wavelength. We are talking about the number of shares, not

the amount of the dollars to be repaid. But what I am asking you

again is, was there any limit on the number of shares of Enron

that would be sold to pay back the bondholders? That is my question. You are saying the answer is yes. Is that your answer?

Mr. WINOKUR. To the best of my recollection—this was a transaction that happened 3 years ago—I am referring to the minutes

which says there will be reserved 20 million additional shares of

common stock and 100,000 preferred shares of the company for

issuance under the share settlement agreement. That is my only

recollection, is what is here.

Senator LEVIN. You do not know, then, whether or not there was

any limit?

Mr. WINOKUR. I do not know——

Senator LEVIN. You know how many were reserved, but you do

not know whether there was a limit?

Mr. WINOKUR. Well——

Senator LEVIN. Under the agreement—I am just trying to get an

answer.

Mr. WINOKUR. I only know what is in the minutes, sir.

Senator LEVIN. All right. You do not know, then, whether there

was a limit or not.

Next, LJM. Now getting more and more dangerous and deeper,

here is another off-the-books entity that Enron helped to create

which bought Enron assets. With the Board’s approval of the partVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00070 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
59

1See Exhibit No. 19, entitled ‘‘Key Elements of Transaction to be Approved,’’ which appears

in the Appendix on page 261. 2See Exhibit No. 20 which appears in the Appendix on page 271.

nership, here is what happened. On June 28, 1999, the Board held

a special meeting in which all five of you participated either by

phone or in person. You approved the creation of LJM1, and for the

first time, you waived Enron’s conflict of interest provision in your

code of conduct to allow the Chief Financial Officer, Andrew

Fastow, to take an ownership interest and act as the general partner of the LJM partnership.

Now, Mr. Winokur, under the normal order of business, this matter was not first presented to the Finance Committee, is that correct?

Mr. WINOKUR. Yes, sir. That is correct. It was not presented.

Senator LEVIN. It was not presented to the Finance Committee.

The Finance Committee was skipped. Why was that?

Mr. WINOKUR. Well, this was not a regularly scheduled meeting

of the Board.

Senator LEVIN. You had a lot of special meetings of the Board.

Mr. WINOKUR. Special meeting. I cannot tell you why there was

not a special Finance Committee meeting.

Senator LEVIN. Did you ask?

Mr. WINOKUR. I do not recall asking why there was not a special

Finance Committee meeting, no.

Senator LEVIN. Now, you testified this morning that the Board

did not waive the code of conduct.

Mr. WINOKUR. Yes, sir.

Senator LEVIN. That was your testimony this morning. Take a

look at Exhibit 19, if you would.1

Mr. WINOKUR. Sir, I know that the chart uses the term—— Senator LEVIN. That is your chart, is it not?

Mr. WINOKUR. No, this is management’s chart.

Senator LEVIN. Was it presented to you?

Mr. WINOKUR. It was presented to us, and in the resolution that

the Board approved, we ratified management of the Office of the

Chairman’s decision that permitting Mr. Fastow to participate in

this would not be adverse to Enron.

Senator LEVIN. Well, that is a different issue. The question is

whether or not it was considered inside Enron, as well as by the

rest of us, as a waiver of your code of conduct. Your own document

says, ‘‘waiver of code of conduct,’’ yet you testified this morning

that there was no waiver of a code of conduct. I am just presenting

you with your own document.

Mr. WINOKUR. Sir this is——

Senator LEVIN. It says it was.

Mr. WINOKUR. This was management’s presentation to the

Board. We applied the code of conduct. The Chief Executive has the

ability to make a determination, as I said in my statement this

morning, that permitting Mr. Fastow to make this investment

would not have any probability of conflict of interest, and we ratified that decision, which is applying the code of conduct.

Senator LEVIN. Applying the code of conduct. Let us take a look

at Exhibit 20.2 Now, the second time it is presented to you as a

waiver. It has got the Enron logo on there. Look at the bottom, FiVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00071 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
60

nance Committee, Board of Directors action requested. ‘‘Ratify decision of Office of the Chairman to waive—not apply—waive code of

conduct in order to allow A. Fastow participation.’’ Now, did you tell them, hey, wait a minute, do not present that

to us as a waiver. Present that to us as an application. You did not

tell them that, did you?

Mr. WINOKUR. When we approved it at the Board meeting, that

is what we approved, the application.

Senator LEVIN. I understand that. That was the first time.

Mr. WINOKUR. The resolution following this meeting, which was

in October 1999, has the same language.

Senator LEVIN. Right. I understand. But it is presented on Enron

documents the second time now as a waiver. That is the way it was

viewed inside Enron by the management. That is the way it is

viewed by me. But you are saying, no, we did not waive it, we applied it. I am just asking you this question. When this was presented to the Board as a waiver in the Enron document Exhibit No.

20,1 did you object to the presentation of it to you as a waiver?

Mr. WINOKUR. I did not treat it as a waiver. I did not object to

the words in this document.

Senator LEVIN. You did not tell management, hey, wait a minute.

You are asking us to waive—— Mr. WINOKUR. Yes, sir.

Senator LEVIN [continuing]. For the second time. We are telling

you, we are not waiving. We are applying. Did you do that?

Mr. WINOKUR. We did that in the Board approval.

Senator LEVIN. You told them, this is not a waiver? Did you ever

use the words, ‘‘This is not a waiver’’ in the Board approval?

Mr. WINOKUR. No, sir.

Senator LEVIN. No.

Mr. JAEDICKE. Mr. Chairman, can I—— Senator LEVIN. Sure.

Mr. JAEDICKE [continuing]. Just inject that I think if you—I am

not absolutely sure of this, but I think if you look at the minutes

of that meeting, you will find that Fastow himself says in presentation—this slide does not say it, but that it requires the Board to

ratify the decision of the Office of the Chairman—— Senator LEVIN. Right.

Mr. JAEDICKE [continuing]. That his—it requires a finding and a

recommendation that it will not—that there appears to be a zero

probability that it will be adverse to Enron. Now, he did not use

zero probability, but—— Senator LEVIN. That is his opinion.

Mr. JAEDICKE. But he presented it, I think, properly, is what the

minutes indicate.

Senator LEVIN. He presented it in this document as a waiver.

Was that proper?

Mr. JAEDICKE. The document——

Senator LEVIN. Is that proper?

Mr. JAEDICKE. No.

Senator LEVIN. Thank you. Now, LJM1 is an extremely unusual

arrangement. You set up a private equity fund. You waive the code

of conduct, or in your words, you approve a deviation from it, and

install Enron’s CFO as the managing partner of the fund. Each of

61

you said during your interview that you had never approved a

similar arrangement before and you were unaware of any company

that had its CFO running a private equity fund on the side. So far,

are you with me?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. None of the experts we have contacted have ever

heard of such an arrangement, either. But LJM1 was made after

3 days notice of the proposal, no prior Board discussion with either

Enron management or Andersen, no written legal opinion, no prior

Finance Committee review. Now, some of you told us that the

Board was told that speed is of the essence. Is that your understanding? Was speed of the essence?

Mr. WINOKUR. I do not recall saying that.

Senator LEVIN. You do not remember——

Mr. JAEDICKE. I think I can speak to that.

Senator LEVIN. Is that what you were told, that speed is of——

Mr. JAEDICKE. Well, the meeting took place in the middle of

June. The end of June was the end of the quarter, second quarter.

Shortly after that, you had to issue financial statements. They had

the Rhythms stock. The Rhythms stock had gone up greatly and

they wanted to get it hedged. We thought this was a valid hedge.

We did not—I think the reason they wanted it done by the end of

June is because they did not want to be in the position of having

a fair value investment, a stock on their books, a mark-to-market,

without a hedge. So there was—the hedge should have been put on

by the end of June.

There were other items on the agenda of that June Committee,

sir. I do not know, we had a stock split. There were two or three

other items on the agenda, and I think it was not—I think we can

probably find other decisions were made that necessarily did not go

through a particular committee.

Senator LEVIN. This was an unusual transaction, was it not?

Mr. JAEDICKE. Well, you mean—— Senator LEVIN. No one had ever heard of an equity fund like this

before.

Mr. JAEDICKE. What is the unusual transaction?

Senator LEVIN. To create an equity fund to buy your own assets.

Mr. JAEDICKE. Sir, I am sorry. We approved a specific transaction, which was a Rhythms hedge, and the company—we did it

with Fastow. That was different. But the use of hedges and the use

of at least what I would call less-than-perfect correlation hedges,

was explained in detail in the annual report. I mean, that was part

of the strategy.

Senator LEVIN. But you have said that now the only purpose of

this was to acquire a hedge.

Mr. WINOKUR. Sir, LJM2, which was set up in October, was, in

fact, an alternative optional source of capital.

Mr. JAEDICKE. That was different. I am sorry. I thought you were

talking about LJM1.

Senator LEVIN. I am talking about LJM1. Is it not true that

LJM1, in addition to the hedge, which you said was its only purpose, could negotiate with the company regarding the purchase of

additional assets? Is that not true?

Mr. JAEDICKE. That is true.

62

Senator LEVIN. So it was not just for the hedge. It had an additional purpose, which was to buy assets.

Mr. JAEDICKE. And in the meantime, you would put in the controls that were necessary.

Senator LEVIN. I understand, but you just said a minute ago the

sole purpose——

Mr. JAEDICKE. Sir, I would just like to point out to you——

Senator LEVIN. But you just said a minute ago the sole purpose

was for the hedge. I am just pointing out to you that it had an additional purpose, which was to buy assets.

Mr. JAEDICKE. I told your staff this, that the ironic part of this

is—I have been in a situation recently where I would have been

prepared to have an inside transaction, in this case, with an equity

fund that was run by a very senior—not the CFO, but a very senior

person in the company. It turned out the transaction did not—because I thought in that case, as this case, that you could do it better inside than you could outside. It was cheaper. It was quicker.

It was more efficient. That was the thought on LJM1. And on the

related party, I just happened to be in a similar position with a

very similar fund. It did not take place, but I would have supported

it.

Senator LEVIN. In October 1999, more than 3 months after you

approved LJM1, the Finance Committee was asked to approve

LJM2. Mr. Fastow now was proposing another vehicle that would

complete a large number of deals with Enron and push further the

Enron strategy to move assets off the books.

Mr. Winokur, I believe you told the staff that before the Finance

Committee meets, you typically meet with Enron management to

set the agenda and to discuss the issues, but that did not happen

with LJM2, did it?

Mr. WINOKUR. Well, we had a telephonic meeting in advance to

go over the agenda. I have no reason to believe it did not happen.

Senator LEVIN. Did you not tell us the first time you heard about

this was at the Finance Committee meeting on October 11?

Mr. WINOKUR. I do not recall whether there was a telephone

meeting or not.

Senator LEVIN. When was the first time you heard about LJM2?

Mr. WINOKUR. At the meeting, unless we had a telephonic meeting to describe the agenda. Sir, I do not remember which.

Senator LEVIN. Is not the creation of LJM2 something that you,

as Chairman of the Finance Committee, should have been consulted on before the day that you were expected to make a decision?

Mr. WINOKUR. Well, to make a recommendation, yes, sir.

Senator LEVIN. To make a recommendation. Well, it is a decision

to make a recommendation. But my question is, should you not

have been consulted before the day that you were expected to make

a decision or a recommendation?

Mr. WINOKUR. Sir, I do not recall when I learned of the LJM2

matter, whether it would have been with the material that was

provided in advance of the meeting or in a telephonic conversation

or at the meeting itself.

63

1See Exhibit No. 21 which appears in the Appendix on page 272.

Senator LEVIN. But my question is a little different. Should you

not have been consulted about this transaction, this proposal, prior

to the meeting, as Chairman of that Committee?

Mr. WINOKUR. The principal purpose of a pre-meeting was to

make sure that we had the agenda laid out, not so much necessarily to go through individual items in detail.

Senator LEVIN. Was LJM2 on the agenda?

Mr. WINOKUR. I do not have the agenda here.

Senator LEVIN. Do you remember whether it was on the agenda?

Mr. WINOKUR. Well, I believe it was, yes, sir.

Senator LEVIN. This is a major transaction. We are talking billions of dollars. You are now telling us that you would not normally

have discussed a transaction of that magnitude prior to it appearing on the agenda at the Finance Committee?

Mr. WINOKUR. Sir, we were talking about organizing a fund that

might raise $200 million that would be alternative and optional as

a source of funds for Enron. It did not require—there was no specific transaction being proposed except the organization of the fund

and the ratification of the decision to permit Mr. Fastow to participate in it. There was no sale being discussed.

Senator LEVIN. It was a fund, however, which would openly now

have a member of the Enron management participate in an outside

company whose purpose was to purchase assets, is that correct?

Mr. WINOKUR. Yes, sir. We had a vigorous discussion at the

meeting.

Senator LEVIN. And you decided to let him do it?

Mr. WINOKUR. We decided to ratify the decision of the Office of

the Chairman.

Senator LEVIN. Another off-balance-sheet vehicle, buying assets.

But this time and the time before, this is really interesting, this

time, when we talk about LJM, now you have got a guy who is

management who is on the other side of the table. He is buying assets from you, and he is wearing both hats. He is now playing a

key role in the sale, setting the sale price, and he is also buying

at the same time. You put certain what you call protective devices

in place, but they sure did not work very well.

Mr. WINOKUR. Sir, the concept of LJM was to provide bridge financing for the business unit heads who wanted to sell assets.

They were not required to sell them to LJM2. They had their own

financial incentives. They had their own operational capabilities.

So LJM2 was an alternative and optional source of capital for

them. If they did not like the price LJM2 was offering, they did not

have to use it.

Senator LEVIN. Why did you create LJM2? What was wrong with

Whitewing?

Mr. WINOKUR. Whitewing was a very large vehicle. It was expensive and time consuming and complicated to create. To have an

independent, smaller, private vehicle which would provide bridge

financing for smaller transactions seemed like a perfectly reasonable thing to do.

Senator LEVIN. Let me show you Exhibit 21,1 if you would. This

is the way LJM was being marketed. The first page of the text, in

64

the middle, says, ‘‘Under Mr. Fastow’s management, the Partnership expects to have the opportunity to co-invest with Enron’’ and

then ‘‘acquire existing Enron assets on a highly selective basis.

This access to deal flow should provide the Partnership with unusually attractive investment opportunities.’’ The memo goes on to

say it is going to be managed by a ‘‘team of three investment professionals who all currently have senior level finance positions with

Enron.’’ Then if you look at the end of this document, the last line, ‘‘The Partnership should also benefit indirectly from time spent by

the Principals in evaluating and structuring investments for

Enron, as many of these investments may become candidates for

investment by the Partnership.’’ They are touting their inside information in Enron as they are

selling the interest in that LJM partnership. That conflict of interest is being sold as a plus to people who are investing. Now, did

you ever inquire as to how they were marketing this? Did you ever

ask for any marketing documents like this?

Mr. WINOKUR. We asked and were told that Enron’s counsel, Vinson and Elkins, had reviewed drafts of the document. I did not actually see this document until my work on the Powers Committee,

and we, of course, were never told that Mr. Kopper was a participant. Mr. Glison said in his Powers interview that his name was

erroneously included here.

Senator LEVIN. Mr. Glison was not erroneously included, though.

Mr. WINOKUR. Well, as it turned out.

Senator LEVIN. Right. But what I am saying is, you never asked

to see documents?

Mr. WINOKUR. This was an independent, separately organized

entity. We asked our counsel to review the drafts to make sure the

disclosures were proper.

Senator LEVIN. And did your counsel tell you that it is OK to

tout a conflict of interest as a way to sell something?

Mr. WINOKUR. They did not.

Senator LEVIN. Have you asked them about why they did not?

Mr. WINOKUR. Well, I did not ask Vinson and Elkins, no, sir, but

the Powers Committee report makes it clear that Vinson and Elkins reviewed these drafts. They would have done that and reported

through the Enron legal chain and no one came forward—— Senator LEVIN. And after you heard that they approved this kind

of marketing, using a conflict situation to sell an interest, saying

that: Hey, I have got an inside position. We are in Enron, three of

us. We are in a great position to help this partnership that is buying things from Enron get a good deal. That is being used, touted.

And you are saying your lawyer saw that and approved it. Then

my question to you is, after you heard that he had approved it and

after you now have read this, have you ever asked your lawyer,

how in heaven’s name could you have approved that? That is my

question.

Mr. WINOKUR. Sir, first of all, we knew that a possibility is that

Enron would be selling assets to LJM2. One of the reasons for establishing LJM2 was to provide an optional alternative source of

capital to buy assets from Enron, and the benefit of having Fastow,

who is the only person we knew about, involved in this is that he

would know the assets, and the benefit of having the other people

65

1See Exhibit No. 16 which appears in the Appendix on page 256.

inside Enron who ran divisions to go to Fastow, if they did not like

Fastow’s bid, they did not have to take it. We also had the Chief

Risk Officer and the Chief Accounting Officer reviewing each transaction. So the fact of the conflict was known from the beginning.

Senator LEVIN. Exhibit 16,1 if you will take a look at it, will show

you how you could have sold these assets without that kind of a

conflict. This is the result, though, of what happened. When LJM

bought these Enron assets—now we are talking LJM again—Enron

tacitly agreed to buy some of them back if LJM could not sell them.

Are you aware of that?

Mr. WINOKUR. No, sir.

Senator LEVIN. When that happened, Enron paid more to LJM

than Enron had paid to buy the asset in the first place. Are you

aware of that?

Mr. WINOKUR. No, sir.

Senator LEVIN. In negotiating the sale of assets to LJM, Fastow

clearly had a superior bargaining position over Enron personnel because both sides reported to him. Are you aware of that?

Mr. WINOKUR. Well, the operating divisions did not report to Mr.

Fastow.

Senator LEVIN. Were there people involved on the Enron side

making a decision who did report to Fastow?

Mr. WINOKUR. We later found that was the case. That was not

consistent with the controls that we had put in place.

Senator LEVIN. Those controls were not working very well, were

they?

Mr. WINOKUR. We were told they were and they obviously turned

out not to be.

Senator LEVIN. So that, at a minimum, the controls you put in

place did not function to protect Enron.

Mr. WINOKUR. Well, Mr. Fastow told us in October with Mr. Buy,

Mr. Causey, and Mr. Skilling sitting right there, that the three of

them were reviewing every transaction with LJM.

Senator LEVIN. My question, though, is a little different. My

question is the controls that you put in place did not work very

well.

Mr. WINOKUR. Well, we did not know that.

Senator LEVIN. I am just saying——

Mr. WINOKUR. We were told that they——

Senator LEVIN. They did not work very well.

Mr. WINOKUR. Well, they should have worked, but people did not

do them.

Senator LEVIN. Did LJM investors get a 69 percent return on

their investment?

Mr. WINOKUR. I saw a presentation through my Powers work to

the LJM investors that showed a very high rate of return. I think

that was the number you are quoting.

Senator LEVIN. And would you agree that when LJM was benefitted to that extent, that would be at the expense of Enron?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. And Fastow would profit from that?

66

Mr. WINOKUR. Sir, in May 2000, Mr. Fastow told us he was

spending approximately 3 hours a week on these vehicles and the

vehicles were earning approximately an 18 percent return.

Senator LEVIN. But my question is a little different. Do you agree

that Fastow, when a 69 percent return was obtained by LJM, personally benefitted from that huge return?

Mr. WINOKUR. Absolutely.

Senator LEVIN. OK. That is the outcome of that conflict of interest—one of the outcomes, because you have got a guy on the other

side of the table now who is doing the negotiating who, when he

is putting on the LJM hat, gets a 69 percent return at the expense

of Enron. That is the outcome of the conflict of interest.

Mr. WINOKUR. But his supervisor, Mr. Skilling, and his peers,

Mr. Buy and Mr. Causey, we were told that they were reviewing

each and every transaction. Mr. Causey, Mr. Buy, and Mr. Skilling

had no economic interest in LJM. Their interest was in Enron

stock. If they had known, presumably, they would have taken steps

to make sure that LJM was not making a 69 percent return. We

were told they were on top of each and every transaction.

Senator LEVIN. And when you found out to the contrary, you

asked them about it?

Mr. WINOKUR. I found out the contrary in the Powers investigation.

Senator LEVIN. That is the first time you knew?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. On the LJM transaction reviews, let us go on to

that, Mr. Jaedicke. The Audit Committee had the primary responsibility for reviewing these transactions. It conducted two annual

reviews of LJM transactions, one on February 7, 2000, and the

other a year later in February 2001. First of all, is it true that the

Audit Committee spent no more than 30 minutes at each meeting

going through the LJM transactions?

Mr. JAEDICKE. I am sorry, who said that?

Senator LEVIN. I am asking you, is it true?

Mr. JAEDICKE. Is it true that we spent no more than 30 minutes?

Senator LEVIN. On the LJM transactions during those Audit

Committee meetings.

Mr. JAEDICKE. Well, we did not necessarily review each individual transaction. We reviewed the type of transactions. We asked

pointed questions about are these done at arm’s length or fair to

Enron. We were assured that they were. Arthur Andersen was sitting there. That footnote is in the annual report and it is an

auditable footnote, and neither management nor Andersen—management cannot make that representation to us unless they have

some reason, and Andersen has to audit it.

Senator LEVIN. I understand, but my——

Mr. JAEDICKE. So a half-hour? Yes, I would imagine that was

probably 25 percent of the time in a typical Audit Committee, but

we had the information before, and I do not know how many—I do

not know how much time people spent on the exhibits and so on

when they were given to us.

Senator LEVIN. OK.

67

Mr. JAEDICKE. All I can say is I think the—even though we did

not have the information we needed, we were not told the truth,

in fact, I think we spent a sufficient amount of time—— Senator LEVIN. That was not my question.

Mr. JAEDICKE [continuing]. To carry that out.

Senator LEVIN. My question was, is it true you spent no more

than 30 minutes? It is just a simple, direct question.

Mr. JAEDICKE. I would suppose that would be true.

Senator LEVIN. Thank you. Now, on LJM3, on October 6, 2000,

Fastow proposed LJM3 to the Finance Committee and asked for a

third waiver. The Committee approved that waiver. At the same

time, Dr. Winokur, I believe you proposed that the Compensation

Committee review Fastow’s LJM compensation. Mr. Blake, you proposed that the Finance Committee review Enron’s transactions

with LJM every quarter.

Mr. BLAKE. Yes, sir.

Senator LEVIN. So now I want to focus on the October 6, 2000,

meeting, where Fastow proposes LJM3 to the Finance Committee,

asks for the waiver, and gets it. But now, Dr. Winokur, you are

proposing that there be a review of his compensation, and Mr.

Blake, you are proposing that the Finance Committee review the

transactions every quarter. These proposals were unanimously

agreed to at the meeting. So the Committee now imposes some reviews. Now, let us talk about the follow-through on those decisions.

First, I think I asked Dr. LeMaistre about this one. You attended

the Finance Committee meeting on October 6 when that proposal

was adopted for the Compensation Committee to review Mr.

Fastow’s compensation. But that review was not completed in 2000.

In fact, it was not done that year at all, was it?

Dr. LEMAISTRE. As far as I know, it was not.

Senator LEVIN. Now, why didn’t you promptly do the review

since you had that vote?

Dr. LEMAISTRE. Primarily because we did not have the information, and it was our understanding at the time that Fastow’s compensation was to be under the control of formulas. It was to come

through with the other reports on the quarterly base and the annual base and it did not.

Senator LEVIN. In other words, you are saying it was not intended that you review that compensation immediately? You were

supposed to wait?

Dr. LEMAISTRE. Mr. Winokur’s direct words in that meeting

were, ‘‘Perhaps it would be a good idea to have the Compensation

Committee take a look at information regarding his compensation.’’

It was a remark that would indicate to me that they already had

the compensation there, and that turned out not to be the case at

the end of the first quarter when I checked, and, therefore, that is

basically the reason I did the checking.

Senator LEVIN. When did you do the checking?

Dr. LEMAISTRE. After the first quarter of 2001.

Senator LEVIN. It was reported in the Wall Street Journal—we

have gone into this today—that Mr. Fastow had made millions of

dollars more from LJM. When was that?

Dr. LEMAISTRE. That was on October, 19, 2001.

Senator LEVIN. It was only then?

68

Dr. LEMAISTRE. That was the first time that any of us knew that

there was something wrong going on.

Senator LEVIN. Right, but you had made inquiry about his compensation. Didn’t you ask the Compensation Officer at Enron, Mary

Joyce, about it?

Dr. LEMAISTRE. I asked Mary Joyce about it.

Senator LEVIN. And what did she tell you?

Dr. LEMAISTRE. She said she did not have the information.

Senator LEVIN. Did you say, well, I want it?

Dr. LEMAISTRE. She knew that I wanted it and I asked——

Senator LEVIN. Did you get it?

Dr. LEMAISTRE. I did not.

Senator 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. Those folks are supposed to be reporting to

you. You are the captains. You make a decision. We want to find

out about this compensation. You make an inquiry of an employee

and she says she does not have the information, she will get back

to you. She does not, and nothing happens. There is a Wall Street

Journal article a year later. That is not the way a Board can operate and carry out its fiduciary duties, folks.

Dr. LEMAISTRE. I did have a subsequent conversation to see if

the information had been obtained. It had not, and that is immediately prior to all of the things that unfolded very rapidly in the

fall. But let me make it clear——

Senator LEVIN. Should you have gotten that information?

Dr. LEMAISTRE. Yes, I should have gotten it and I should have

gotten it through channels. It was Mr. Skilling’s responsibility to

have put that through and he did not. It did not come through any

of the transactions. Mr. Fastow, in his declaration of the controls

on him, said he reported that information to Mr. Skilling.

Senator LEVIN. But you had a conversation now with this employee, Mary——

Dr. LEMAISTRE. Mrs. Joyce, yes.

Senator LEVIN. Mary Joyce, and you asked her for

information——

Dr. LEMAISTRE. Yes.

Senator LEVIN [continuing]. And she did not get it to you.

Dr. LEMAISTRE. She had not received it, that is correct.

Senator LEVIN. And did you ask her to get it?

Dr. LEMAISTRE. I asked—I told her I wanted all of the

information on any 16(b) officer that had outside income——

Senator LEVIN. And would that include Fastow?

Dr. LEMAISTRE. Of course, yes.

Senator LEVIN. Sure. That was the reason you called, was it not?

Dr. LEMAISTRE. That is right.

Senator LEVIN. You did not mention his name?

Dr. LEMAISTRE. No, I did not mention his name.

Senator LEVIN. Even though that is why you called?

Dr. LEMAISTRE. That is exactly right, but I wanted it on all 16(b)

officers.

Senator LEVIN. And you did not get it.

69

1See Exhibit No. 24b which appears in the Appendix on page 283.

Dr. LEMAISTRE. I did not get it, but if I had gotten it, I would

have had some other people involved in there, as you now know.

Senator LEVIN. Good. The point is, you did not get it and you did

not act to get it and that is—— Dr. LEMAISTRE. I did not act to get it primarily because it was

supposed to come through with the other reports and it did not.

Senator LEVIN. But did she not tell you she would get it to you?

Dr. LEMAISTRE. No, she did not.

Senator LEVIN. You did not say you wanted that information?

You are doing this report for the Board. You are told, hey we would

like to know more about it, and you just call up and say—— Dr. LEMAISTRE. She said she did not have the information. I

said, well, let me know when it gets there.

Senator LEVIN. And did she?

Dr. LEMAISTRE. She did not let me know, so I asked again a few

months later and she did not have it, and that was in August or

September.

Senator LEVIN. Did you just throw your hands up? I mean, she

does not have it.

Dr. LEMAISTRE. Well——

Senator LEVIN. Why does she not have it? You are a Board member. You are paid a lot of money. You are carrying out a Board direction. You want information. You do not get it. She will call you

when she gets it. She does not call you. Two months later, she still

does not have it.

To me, that is an approach which is totally unacceptable, I have

got to tell you. I think that is what characterized the Board—is

that it was deferential to management. I want to go into another

document on that.

When you were told, finally, after you found out how much

money—if you would take a look at Exhibit No. 24b.1

Dr. LEMAISTRE. All right.

Senator LEVIN. So now it appears in the Wall Street Journal, and

the Board asks, I think, both Mr. Duncan and Dr. LeMaistre to call

Fastow. I think, Dr. LeMaistre, you said in your interview that you

asked the Enron General Counsel to write the questions that you

would ask Mr. Fastow on the phone, and Exhibit 24b is the document that the General Counsel faxed to you with your notes from

that phone conversation, is that correct? We are looking at Exhibit

24b now.

Dr. LEMAISTRE. That is correct, Mr. Chairman.

Senator LEVIN. OK. And here is the note that he typed for you.

‘‘Andy, because of the current controversy surrounding LJM1 and

LJM2, we believe it would be helpful for the Board to have a general understanding of the amount of your investment and of your

return on investment in the LJM entities. We understand that a

detailed accounting of these matters will soon be done in connection with the response to the SEC inquiry. We very much appreciate your willingness to visit with us.’’ This is a guy who is supposed to be working at your direction,

and you cannot get much more deferential and obsequious than

that. And not only that, you then want to make sure that he underVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00081 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
70

stands right up at the front how much you appreciate his willingness to visit with you, and I presume you take a line, circle that,

‘‘We very much appreciate your willingness to visit with us,’’ and

make sure that goes at the top.

Why do you not call up and say, ‘‘What in God’s name is going

on? We just read something in the Wall Street Journal here that

just shakes the heck out of us. Is it true? How much money did

you make? What is your return?’’ That is not what comes out here.

You apparently, when he told you how much money he made,

found it to be—I think this is your handwriting?

Dr. LEMAISTRE. That is correct, sir.

Senator LEVIN. ‘‘Incredible’’ is your word.

Dr. LEMAISTRE. Mr. Chairman——

Senator LEVIN. Yes, please.

Dr. LEMAISTRE. This is drafted by legal counsel and I followed

it directly.

Senator LEVIN. Right. But is not that arrow that puts the, ‘‘We

very much appreciate your willingness to visit with us—’’

Dr. LEMAISTRE. Yes, that is right, because——

Senator LEVIN. That is your writing, is it not?

Dr. LEMAISTRE. Yes, and may I explain it?

Senator LEVIN. Sure.

Dr. LEMAISTRE. The day before when I talked to Mr. Fastow, he

was very cautious at first about this, and finally, he said he would

be glad to talk with us. But it was a decision that he could have

made not to talk to us, and we would have had to go through channels to get it, but we wanted it immediately, that is the reason that

we did it that way.

Senator LEVIN. Why do you have to go through channels? Why

can you not just call up Fastow and say, I want to know right now?

Dr. LEMAISTRE. I could have, but I would have not used language in here had I done that. I would have used—— Senator LEVIN. Why did you not use language that was not in

here?

Dr. LEMAISTRE. Primarily because—— Senator LEVIN. I guess that is what it comes right down to.

Dr. LEMAISTRE. Well, the point is that this is what our General

Counsel told us to use in talking about income to a third party investment, an SPE.

Senator LEVIN. Were you mad?

Dr. LEMAISTRE. I was mad after the answer to the first question.

Senator LEVIN. Did you let him know?

Dr. LEMAISTRE. Yes.

Senator LEVIN. Right there on the phone?

Dr. LEMAISTRE. Yes.

Senator LEVIN. Good. That is a year late, but good.

Now, there were supposed to be quarterly reviews by the Finance

Committee, I believe, because the Finance Committee was supposed to begin quarterly reviews of the LJM transactions, according to the decision of the Committee, and the Finance Committee

agreed. But there is only one quarterly review that was ever conducted by the Finance Committee, which was in February 2001.

So if my recollection is correct, the decision of the Board was October 2000 that these quarterly reviews of these LJM transactions

71

would be conducted, but there was only one, and that was February 12, 2001. Now, why is that?

Mr. WINOKUR. The first meeting after the October meeting was

December, which was about 6 or 7 weeks later, so I think we assumed that a quarterly review would have meant after the year

end, since the October meeting would have been around the end of

the third quarter. After the February quarter, there was not activity, new investments being made, and by June, Mr. Fastow had

sold his interest, so there was no more related party aspect.

Senator LEVIN. We will get to that in a moment, but there were

supposed to be what are called deal approval sheets, or DASHs, for

each of the LJM transactions, I believe, since they were transactions with a related party. Did you ever see those DASHs, those

LJM DASHs?

Mr. WINOKUR. No, sir. There is an LJM approval sheet and a

DASH which is for every transaction. They are separate.

Senator LEVIN. And did you ever see the DASH?

Mr. WINOKUR. The regular DASHs, we saw all the time——

Senator LEVIN. For LJM?

Mr. WINOKUR. No.

Senator LEVIN. Should you have?

Mr. WINOKUR. Those were internal and those, we were told, were

being reviewed by Mr. Skilling, Mr. Causey, and Mr. Buy. There

would have been no reason, unless the size of the investment was

such that it would have normally come through our——

Senator LEVIN. So that was not normally supposed to come to

you?

Mr. WINOKUR. No, sir.

Senator LEVIN. But I believe that, Mr. Jaedicke, those DASHs

should have come to you, is that not correct?

Mr. JAEDICKE. No, sir. We did not—we reviewed the transactions

and the type of transactions and the fairness, but we did not go—

we are not auditors and so we did not go to the level of the deal

approval sheets.

Senator LEVIN. So those deal approval sheets were not supposed

to go to any of the committees, is that correct?

Mr. WINOKUR. Sir, transactions involving Enron’s expending

more than $75 million came to the Board for approval. Transactions more than $25 million but less than $75 were within the

purview of Mr. Lay and Mr. Skilling. So our practice was that the

transactions between $25 and $75, those DASHs were packaged up

and we were sent them after the fact to look at, so we could comment on them. The deals would have been approved, but if any

member of the Committee had any questions, he could bring those

up.

So the only expenditure of cash that we would have seen would

have been above that level of $25 million, and for divestitures, the

level was much higher. So to the extent that Enron was selling assets, the transaction approval process would not have required us

to see those.

Senator LEVIN. Even though there was this conflict of interest

problem?

72

Mr. WINOKUR. The conflict of interest was being dealt with because Mr. Skilling, Mr. Buy, and Mr. Causey were reviewing, according to what Mr. Fastow told us, every transaction.

Senator LEVIN. All right, so that there was no need for a DASH?

Mr. WINOKUR. The only need we had was what we got, and that

was to make sure we were told regularly that the controls we put

in place were working.

Senator LEVIN. You did not need the DASH in order to achieve

that?

Mr. WINOKUR. No, sir.

Senator LEVIN. That is just what I was asking. There was no

need, then, for you, in your judgment, to get one of those DASHs

for these transactions because you had another mechanism that

you thought was doing the control?

Mr. WINOKUR. We were told the people who did review the

DASHs had done so.

Senator LEVIN. Right, which is another mechanism.

Mr. WINOKUR. Yes, sir.

Senator LEVIN. Now, I believe you just testified that when you

learned that Fastow was selling his LJM interest, that there was

no need for a second quarterly review. But the first quarterly review, I believe, was February 12, is that correct?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. When did he sell his interest?

Mr. WINOKUR. I said two things. I said there were no transactions that we knew about that occurred with LJM after the February meeting. He sold his interest, I later learned, in June. That

was disclosed to us in August, I think.

Senator LEVIN. But should there not have been a quarterly review in June? You had one in February——

Mr. WINOKUR. We have a May meeting and an August meeting,

and so we—— Senator LEVIN. A quarterly—— Mr. WINOKUR [continuing]. We did not have one in the May

meeting. At the August meeting, we were told that he had sold his

interest in June.

Senator LEVIN. Right, but since it was supposed to be a quarterly

review, and there was one that occurred in May—there is one that

occurred in February, should there not have been one in June, is

my question.

Mr. WINOKUR. If there were transactions to review, yes, sir.

Senator LEVIN. In other words, when you did not get a quarterly

report, you assumed there were no transactions?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. And did you check?

Mr. WINOKUR. No, sir.

Senator LEVIN. Now, did you know to whom he sold it, by the

way?

Mr. WINOKUR. I did not know then. I learned later.

Senator LEVIN. And who was that?

Mr. WINOKUR. Michael Kopper.

Senator LEVIN. And had you known that, would you have wanted

those quarterly reviews to continue?

Mr. WINOKUR. Well, I did not know——

73

Senator LEVIN. Mr. Kopper was so close?

Mr. WINOKUR. I did not know Mr. Kopper was involved in

Chewco. I did not know he was involved in all the things he was

involved in, and had he complied with the code of conduct, we

would have gotten into that much earlier.

Senator LEVIN. But did you know that he was very close to

Fastow?

Mr. WINOKUR. Well, I knew Andy had a bunch of bright people

working for him. I did not know that Kopper was any closer to him

than anybody else.

Senator LEVIN. But if you had known, if Fastow had told you

that he had sold his interest to Kopper, would you have said,

‘‘whoops, wait a minute; even though Fastow left, given our relationship with Kopper, we better continue——’’

Mr. WINOKUR. Absolutely.

Senator LEVIN [continuing]. Those quarterly reviews?

Mr. WINOKUR. If I had known that the related party relationship

continued informally as well as formally, I would have wanted to

continue the reviews, yes, sir.

Senator LEVIN. Now, when you did find that out, then what happened?

Mr. WINOKUR. Well, I did not find it out until—— Senator LEVIN. August.

Mr. WINOKUR. No, I found out that he sold. I do not believe that

I found out—I do not remember exactly when I found that Kopper

bought it. I thought it was actually during the Powers work that

I found out who bought it.

Senator LEVIN. That was the first time you learned that Kopper

bought it?

Mr. WINOKUR. That is my recollection.

Senator LEVIN. Was it relevant as to who bought his interest?

When you found that he had sold his interest, did it become relevant as to whom he sold it, since if he sold it to another related

party, directly or indirectly, you would want the controls to continue? Should you have asked who he sold it to? Given that history,

should you not have asked who he sold it to is my question.

Mr. WINOKUR. I would have to look back at the August minutes

to see what was said by Mr. Koenig about how it was sold. If it

was said it was sold to an unaffiliated party, then I would not have

thought more about it.

Senator LEVIN. I asked you about whether or not there was an

unwritten guarantee that LJM would not lose money in a deal with

Enron. Were any of you aware of such a guarantee?

Dr. LEMAISTRE. I was not.

Mr. DUNCAN. I was not.

Mr. WINOKUR. No, sir.

Senator LEVIN. Mr. Duncan.

Mr. DUNCAN. I was not.

Senator LEVIN. I think what we are going to do here is take

about a half-hour break. I just want to summarize this one LJM

issue, though, before we leave to sort of tidy this thing up.

The things that really trouble me are the lack of real energy and

effort by the Board in a situation where you are using accounting

methods which are clearly at the margin, high risk. You were so

74

1See Exhibit No. 28b which appears in the Appendix on page 306.

informed early. You know that you are using a lot of off-the-balance-sheet entities, special purpose entities. You are into this

whole area. You decide on a compensation review, and despite a decision in October 2000 to do it, you do not do it.

No one ever saw this LJM initial placement memo. I take that

back. Your lawyer did, apparently, but your lawyer, when he saw

that the conflict of interest is being touted as a reason for investors

to buy LJM apparently was not troubled by that. If I understood

you correctly, Dr. Winokur, you never asked your lawyer as to why.

Mr. WINOKUR. I did not learn that until my work on the Powers

Committee, sir.

Senator LEVIN. Right, but after that, you did not ask your

lawyer——

Mr. WINOKUR. Well, I did not have direct contact with Vinson

and Elkins at that point.

Senator LEVIN. It is not the kind of active control and responsibility that I think we have to expect of Boards; that’s what it comes

down to. That is just on LJM, and we will go into Raptors when

we come back, but let us take a half-hour break now until 2:30.

Thank you.

[Recess.]

Senator LEVIN. The Subcommittee will come back to order.

We now come to the time when the Board dives into perhaps the

most dangerous waters of all, and these are the Raptors, the very

complex set of transactions that the Board knew about and approved, despite questionable accounting and significant financial

risk to Enron.

The Raptor transactions consisted of a series of four complex

transactions, each of which involved Enron, LJM2, and various special purpose entities. In each of the four complex Raptor transactions, Enron placed highly volatile shares of stock from companies in which Enron had invested. Enron did this because it had

already booked as income the increase in the companies’ share

prices, and it wanted to protect itself from any loss if these shares

dropped in price. And so Enron’s goal was to hedge these stocks.

The problem was that no third party would agree to enter into

a hedge to protect Enron from a loss on those shares, so Enron

used LJM2, set up these special purpose entities, and secured each

of the hedges by pledging its own stock as collateral. Through a series of deceptive transactions and improper accounting entries,

Enron recorded earnings on its books of about $1 billion, and another $1.2 billion in increased shareholder equity.

If we could take a look at Exhibit 28b.1 This is the ‘‘Hedging Program for Enron Assets,’’ as it is described, that was presented to

the Board on May 1, 2000. And if you will look at the last page,

where it says ‘‘Project Raptor.’’ When you look at the risks cited

here, this lists the risks involved here, maybe, Mr. Winokur, you

can explain this.

Mr. WINOKUR. Senator——

Senator LEVIN. First of all, did you remember this before——

Mr. WINOKUR. Yes, sir.

75

Senator LEVIN [continuing]. When you were talking to our staff,

did you remember this?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. Details of this? OK. Do you want to explain——

Mr. WINOKUR. To the best of my recollection, I did.

Senator LEVIN [continuing]. What you were told back on May 1

about the risks of Project Raptor, looking at those bullets?

Mr. WINOKUR. Sir, it was Enron’s staff practice when they presented an item for recommendation and approval always to describe the risks of the transaction. Every transaction obviously has

risks and they would set them forward, and for each risk, they

would have a mitigant. In other words, the idea was, this was a

risk, they had already thought about it, and here is how they dealt

with the risk.

And in this case, one of the risks of a complicated structured finance transaction like this was that it would not be properly able

to be accounted for, and the mitigant was, and the minutes suggest

or support this, as well, that Rick Causey, the Chief Accounting Officer, and Andersen had been involved—in fact, Enron paid Arthur

Andersen a fair amount of money for helping to structure this

transaction so that it would conform to the accounting requirements, and so that mitigant meant that the accounting scrutiny

had been dealt with.

Obviously, any time there is a hedge, there is a risk that the

hedge does not work, and the mitigant there, if the hedge did not

work, was to terminate the program. And, in fact, as I believe I

have said here in the House, in the Powers Committee report, it

says had the Raptor transactions been terminated in the first quarter of 2001 when it was clear they did not work, as opposed to their

having been restructured without Board approval, I do not think,

personally, Enron would be in the position it is in today.

‘‘Counterparty credit’’ just means that you have to have enough

credit in the structured transaction to be able to execute the hedges

you propose.

Senator LEVIN. Now, first of all, what was your understanding of

the words ‘‘accounting scrutiny’’? Does that mean that it might not

have complied with Generally Accepted Accounting Principles?

Mr. WINOKUR. No. That meant to me that it was important to

make sure that the transaction was structured in a form that

would pass accounting muster, and because Arthur Andersen had

been paid to help work on the structuring and Rick Causey said

they were comfortable and he was comfortable with it, that meant

that risk was mitigated.

Senator LEVIN. Did the Board understand that this was a true

hedge?

Mr. WINOKUR. Well, I did, and I believe everybody did.

Senator LEVIN. If you believed it was a true hedge, why would

there be any risk to Enron?

Mr. WINOKUR. Well, Senator, we contributed unrealized gains on

forward positions in the stock. In other words, we had an asset

that had not previously been in Enron’s income statement and we

used that in contributing it in this structure as credit support for

the hedge. So any time—if we contributed Exxon stock and the

76

Exxon stock had gone down, that would have been the same issue.

We would have terminated the hedge.

Senator LEVIN. But my question, I think, is a little different,

which is that if it were a true hedge, if you had gotten a third

party to take that risk, your own stock would not have been at

risk, would it?

Mr. WINOKUR. It depends on the structure of the hedge.

Senator LEVIN. If it is a true hedge.

Mr. WINOKUR. Well, as I said, in my example—— Senator LEVIN. Do you not transfer the risk to someone else in

a true hedge?

Mr. WINOKUR. Well, you transfer risk, but if for some reason the

hedge does not work, then it terminates, and that is what I said

in my example. If Enron had contributed Exxon stock and Exxon

stock had gone down, the credit capacity of that vehicle would have

not permitted it to be viable, and so in this case, instead of Exxon

stock, we used unrealized gains in forward positions on Enron

stock.

Senator LEVIN. Did the Board understand that Enron stock

would be at risk under some circumstances here?

Mr. WINOKUR. Yes. In fact, we—— Senator LEVIN. At the time of this deal, you realized that there

was still a risk to Enron?

Mr. WINOKUR. Well, we had a large unrealized gain in these forward contracts, so we understood that realized gain would be at

risk. That was part of the structure.

Senator LEVIN. If, in fact, the stock price went down and the unrealized gain disappeared, did the Board understand that then

Enron would have to—that Enron stock itself would be at risk— not just the gain, but that Enron stock would be at risk, that you

were not transferring the entire risk to a third party? Did the

Enron Board understand that, or did the Enron Board believe that

you were transferring that risk to a third party?

Mr. WINOKUR. If the assets that were being hedged went up in

value, then if the forward position was in decline, it would not have

mattered, or vice-versa.

Senator LEVIN. Yes. Now we are talking going down.

Mr. WINOKUR. The bad outcome was that both the assets and the

forward position went down, that is, Enron stock went down and

Avici or whatever stock was hedged, and in that case, which is exactly what it says here, program terminates early in negotiation of

an early termination agreement. So this was contemplated as a

possibility.

Senator LEVIN. The Board understood, then——

Mr. WINOKUR. That this possibility could occur.

Senator LEVIN [continuing]. That Enron stock was being pledged

as collateral?

Mr. WINOKUR. No, forward positions on Enron stock. It is a derivative instrument.

Senator LEVIN. My question is, did they understand that Enron

stock itself was being pledged as the collateral?

Mr. WINOKUR. Well, my recollection is, and I could look back at

the previous page, was that forward positions were being pledged.

That is my recollection.

77

1See Exhibit No. 80 for clarification which appears in the Appendix on page 665.

Senator LEVIN. Then the answer to my question about Enron

stock being pledged as collateral?

Mr. WINOKUR. We put seven million—from the previous page, we

put stock in and we wrote—well, here, I think this was forward positions, even though it says that—Senator, I am looking at the diagram here. I do not have from 2 years ago the specific terms.

Senator LEVIN. Let me—— Mr. WINOKUR. I believe that it was forward positions on the

stock as opposed to the actual shares.

Senator LEVIN. Forward positions on stock that Enron held in

other companies?

Mr. WINOKUR. No, that Enron was contributing unrealized gains

in its own stock as credit support to get this structure organized.

This structure could then purchase stock in some other

company——

Senator LEVIN. Let me try to ask the question, because it is an

important question. Did the Board realize that Enron stock was

being pledged as collateral for the hedge?

Mr. WINOKUR. I can only answer for myself.

Senator LEVIN. You cannot give me a ‘‘yes’’ or ‘‘no’’ on that?

Mr. WINOKUR. My recollection is that we were using forward— unrealized gains in forward contracts. That is my recollection.

Senator LEVIN. Therefore, the answer is you did not realize that

Enron stock was being pledged as collateral for the hedge? If that

is not your answer—— Mr. WINOKUR. My recollection is just as I said, which is I believed that we were using forward contracts, unrealized gains in

the forward contracts. That is my recollection.

Senator LEVIN. Why is that not then a simple, ‘‘no,’’ that you did

not realize that Enron stock itself was being pledged as collateral

to obtain that hedge?

Mr. WINOKUR. I do not recall that Enron stock specifically was

being pledged——1

Senator LEVIN. OK.

Mr. WINOKUR [continuing]. Over and above the forward positions.

Senator LEVIN. That is good. Now, let me try to put this in a

slightly different way. What did the Board understand to be the

risk to Enron at the time it approved these transactions?

Mr. WINOKUR. The risks that were presented to us were, first,

that the structured finance vehicle might not be structured in a

way to meet the accounting rules, and that was mitigated, we were

told, because Arthur Andersen was involved and Rick Causey approved it.

And second, we understood because of the forward positions in

Enron stock that credit capacity could go away if, in fact, Enron

stock went down, in which case the Raptors would have to be terminated.

Senator LEVIN. Did you understand, then, that if Enron stock fell

in value, that you would have to put up large amounts of Enron

stock in order to pay off the guarantee to others who were willing

to——

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1See Exhibit No. 32 which appears in the Appendix on page 334.

Mr. WINOKUR. No, sir. I understood that we would have to terminate the arrangement because the credit capacity would fall.

Senator LEVIN. OK. Now, when you were shown Exhibit 32,1 you

asked for this, as I understand it, Mr. Winokur, the ‘‘Stock Price

Risk in Financings’’—you asked for a chart showing what would

happen if Enron’s stock kept falling in price. You asked the management for this.

Mr. WINOKUR. Yes, sir.

Senator LEVIN. And by April, Enron stock had fallen from $80 to

$60, and this shows what would happen if it fell to $40. It lists four

deals, Osprey and three of the Raptor transactions, and shows that

Enron would have had to come up with another 45 million shares

of Enron stock to pay these entities. Now, were you surprised by

what you saw?

Mr. WINOKUR. Well, I appreciated being provided the information

I had requested.

Senator LEVIN. But were you surprised when you saw that your

stock was on the hook to this extent? Did that surprise you?

Mr. WINOKUR. Actually, sir, what I read into this was Enron had

about 800 million shares outstanding at this point. So what this

chart said to me is if the stock price falls by another third from

where it is, and at that time, I think that was not considered a

probable event, Enron would have to issue approximately less than

6 percent additional shares. So the dilution to the existing shareholders to top-up these vehicles would have been around 6 percent

if the stock fell by a third.

Senator LEVIN. And you were not surprised that your risk was

that great in the Raptor transactions? That did not surprise you

when you got that chart?

Mr. WINOKUR. Actually, I thought that a 6 percent dilution

matching against a one-third decline in the stock when the stock

was not considered to be overvalued at that point, or not particularly—I do not recall the specifics—was not maximal dilution.

Senator LEVIN. OK. You recognized that impact on Enron, the dilution of its stock which would result from the Raptor transactions

if Enron’s stock value went down, and that did not surprise you?

You realized there was that great a risk in the Raptor transactions

to Enron? That is all I am asking.

Mr. WINOKUR. Senator, in addition, I would like to make the

point that the fully diluted shares in the EPS calculation, Enron

used a model to include these kinds of results in the fully diluted

share calculation, so that the additional shares already were disclosed in Enron’s disclosure documents and already were included.

Senator LEVIN. When the risk was supposedly transferred, which

was the purpose of those transactions, Enron maintained some significant risk, and you are telling me the Board was not surprised

by that retained risk in Enron. Even though it was informed that

this was a hedge transaction to transfer that risk to others, you are

saying that the Board understood the extent of the risk to Enron

that was left following the Raptor transactions, is that what you

are telling me? They understood this?

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1See Exhibit No. 27 which appears in the Appendix on page 300.

Mr. WINOKUR. Sir, the handwritten note, which is a little hard

to read, says, ‘‘Assumption: The value of the other assets,’’ it looks

like it says, ‘‘were zero,’’ so I viewed this as a worst case scenario.

In other words, the assets that were supposed to be hedged went

to zero, and I did say earlier that the one bad outcome is the assets

that were being hedged and the Enron forwards both went down.

So worst case, the other assets are not worth anything—I think

that says zero, the best I can read it—and even in that extreme

case, Enron stock goes down a third and all the assets we put in

these vehicles are worthless, there is only 6 percent dilution and

it has been fully disclosed. I do not think that was a good outcome.

I also did not think it was a very probable outcome.

Senator LEVIN. My question is neither whether it was good or

probable. My question is, did the Enron Board understand when it

was hedging a risk that it was maintaining a risk to that extent,

whatever the extent is? Did it understand that?

Mr. WINOKUR. Well, we assume, because in the previous

exhibit——

Senator LEVIN. Can that not be yes or no? Did it understand that

it was maintaining a risk to this extent under the circumstances

that you just outlined?

Mr. WINOKUR. We understood that if the credit support we

provided for the vehicle was inadequate, the vehicle would have to

be terminated early. That was part of the presentation when we

approved Raptor.

Senator LEVIN. All right. And is not the shorthand for that, the

Board understood that Enron was retaining a risk under the circumstances that you just outlined?

Mr. WINOKUR. A risk, yes, sir.

Senator LEVIN. And this shows the extent of the risk under various circumstances.

Mr. WINOKUR. Under extreme circumstances.

Senator LEVIN. It turned out not to be so extreme.

Mr. WINOKUR. Yes, sir—what were thought to be extreme circumstances at the time.

Senator LEVIN. And I just want to ask the other Board members,

did they understand that this was not a hedge where the risk was

transferred, but that a risk was retained to the extent that Dr.

Winokur just outlined? Did you understand that, Dr. Jaedicke?

Mr. JAEDICKE. Yes, I did, sir, because that hedging strategy is

explained in the annual report and had been used in Enron on

many transactions. They are typically referred to as something like

low-correlation hedges.

Senator LEVIN. On this chart, I think it is Exhibit 27 in your

books,1 when you look at that chart, we see that the payments by

Enron to LJM2 for the Raptors were $197 million. That is up at

the top. Do you see that number?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. And the loss to Enron is at the bottom, $710 million. That is the outcome of this. LJM got $197 million. Enron lost

$710 million on that transaction. Would you agree with that summary, Dr. Winokur?

80

Mr. WINOKUR. Well, I would like to ask Dr. Jaedicke to talk

about the reduction in shareholders’ equity, but as far as the

losses, I do not know where these—I have not seen these numbers

before, obviously. The Powers Committee had some numbers in

them that were prepared by the Deloitte people. Those were not

other than very rough estimates and the Powers Report specifically

said that would assume that Enron had taken no other action and

there is nothing else going on. In other words, it was a number

that is just pro forma, add this and subtract that. It is not a number that has any, at least in the Powers Report, had any backup

that was provided.

Senator LEVIN. Now, this is a number from the Powers Report.

Mr. WINOKUR. As a member of the Powers Committee, I specifically said in my testimony in front of the House that the accounting consulting help that we got was not reviewed by Deloitte and

Touche and did not have any independent verification of it and did

not assume that Enron would have taken any other action in the

interim.

Senator LEVIN. All right. Going back to the $710 million, this is

what Enron put in its SEC filing.

Mr. WINOKUR. Yes, sir.

Senator LEVIN. So can you accept that?

Mr. WINOKUR. Yes, sir.

Senator LEVIN. OK. So Enron showed a reduction in earnings

due to Raptor termination of $710 million. The $197 million was

made by LJM2. That is the outcome, and I am just saying, do you

differ with those numbers?

Mr. WINOKUR. I do not have any disagreement with that.

Senator LEVIN. Would you acknowledge today that the Raptors

were, in hindsight, a disaster for Enron?

Mr. WINOKUR. Sir, what I would say, and I said, I believe, in my

statement this morning, if management had come to us in the first

quarter and said the Raptors did not work, it was a great idea, but

it did not work and we want to cancel them, Enron would have

taken then something like a 50-cent a share charge. Mr. Skilling

told the Powers Committee he did not think at that time, in the

first quarter of 2001, that Enron stock would have been affected

materially because lots of companies were writing off high-tech,

broadband, and other kinds of investments.

So had the Raptors been terminated early, which is what we

thought would have happened in May 2000 when we approved

them if both the assets and Enron’s forwards went down, we would

have had a loss. It would have been a large loss, $400 or $500 million, but it would have been manageable by Enron. And the fact

that the $800 million of additional stock was contributed and the

Raptors were restructured without Board approval also gave rise to

the accounting error that led to the equity write-off, and as I said

this morning, I think that combination turned out to be a very bad

thing.

Senator LEVIN. If a real third party had participated in the

hedge, would the outcome have been different?

Mr. WINOKUR. Well, I do not know the answer to that except for

one thing, and that is a real third party would not have been able,

81

1See Exhibit No. 33a which appears in the Appendix on page 335.

presumably, to restructure itself without Board approval in the

way that this happened. We were not told of the restructure.

Senator LEVIN. OK.

Mr. WINOKUR. And LJM2 had many outside investors. It was a

real third party. It had a related party as an investor, but it was

a creditworthy third party when we dealt with it.

Senator LEVIN. You have seen a number of red flags now along

the way, starting as early as 1999, February 1999, where it was

stated that Enron’s accounting was pushing limits. We have seen

the various ways in which fund flows were generated to move assets off the balance sheet with Whitewing, with LJM, with Raptor,

and the losses that were caused here. Then we see a steady decline,

we saw in that earlier chart, of Enron’s stock from which it is not

going to recover.

During this time, the Board saw no red flags at all, no sense of

trouble that lies ahead until mid-October 2001, and that is when

you learned that Enron would take an equity write-down of $1.2

billion. That was the first time you testified that you saw any sign

of trouble. We have demonstrated, I think, plenty of signs, but

nonetheless, the Board did not see those signs.

But a number of people associated with Enron did see the writing on the wall well in advance of the announced write-down, even

if the Board did not. One example is a senior Enron executive who

left Enron in September 2001, and despite an effective separation

date of November 2001, this individual sent a series of E-mails to

his stockbroker about selling Enron stock. So this is September

2001.

Here is what he said on October 2, a few weeks before Enron’s

problems became public, and this is Exhibit 33a,1 if you wish to follow along. This is a senior Enron executive now. ‘‘I think we may

want to sell some Enron calls in the next few days before earnings

are released. I don’t know anything, but I know how Enron works

and I am sure they will be able to show strong recurring earnings,

. . . and do some housecleaning on some non-productive assets.’’ So

he says he knows how Enron works and will show some strong recurring earnings, and again, this is additional evidence suggesting

that Enron management was deliberately engaged in earnings

management.

Then on October 4, the same person writes, ‘‘I think we should

begin thinking about shorting January calls on, say, 100,000 shares

at or near the money. . . . There are a number of analyst reports

out that are really trying to push up the stock and with a little

help from the market, they may get a few more points out of it over

the next few days.’’ Then later the same day, he writes, ‘‘I believe

[Enron] stock has limited upside in the near term and, in fact, has

some downside exposure.’’ Now, this is a pretty strong statement given the fact that the stock had already fallen from $90 to about $30 a share at the time

that he wrote these E-mails. His comments are deeply troubling.

This is a senior officer at Enron, not yet separated when he begins

selling calls, and a few weeks later, Enron took a $800 million

earnings hit and a $1.2 billion reduction in shareholder equity. We

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cannot release the person’s name at this time. We are still looking

into the matter. But if the facts bear it out, we will be recommending to the SEC that they open an insider trading investigation with regard to this individual.

But in terms of what he knew, what he saw from the inside,

which you did not see until later, I am wondering whether you

have any comments that you want to add. Does anybody want to

add any comment to that?

[No response.]

Let me ask you about Ken Lay’s loans. Let me ask Senator Carper before I get to that.

Senator CARPER. Thank you, Mr. Chairman. We appreciate your

patience and your sticking with us into this afternoon.

Dr. Jaedicke.

Mr. JAEDICKE. I am sorry, sir. I was not paying attention.

Senator CARPER. That is all right. I understand from the introduction today that you ran the business school at Stanford? Did

you?

Mr. JAEDICKE. I was Dean of the business school.

Senator CARPER. You were the Dean of the business school.

When I was in the Navy, we were stationed at Moffett Field, California, not far from where you used to hang your hat, and I lived

in Palo Alto and Menlo Park. In fact, I lived on Santa Cruz Avenue, right up against the Stanford golf course, and I remember as

a younger man going to—I am not Catholic, but I remember going

to a lot of folk masses on Stanford at the campus on Sundays and

very much enjoyed those. I have good memories. One of my best

friends, my roommate for part of the time I was in the Navy out

there, ended up going to the Stanford business school, I think at

the time that you were running it, and from time to time, we

talked about case studies in different businesses, some that did

well, some that did not do so well.

I think we have got a classic here that the business schools, I do

not know about Stanford, but certainly a lot of them will come back

to this one time and again to figure out how they got into trouble

and how a company thought to be as successful and as mighty as

Enron could tumble so quickly.

How would you describe it to the next generation of business

school students at Stanford who say, this is what happened and

this is how they got into this mess and why they could not get out

of it? How would you describe it?

Mr. JAEDICKE. I think, first of all, you would have to say—you

would have to indicate that there was a lot of incomplete information floating around—well, I would not even say floating around,

reported, that a lot of the reports were not accurate, that some of

them were misleading in terms of how good things were or how

much things had been looked at.

I think you would have to say this is a classic case of having lots

of overlapping controls, which I said in my statement, involving

lots of different people, trying to get very good advisors, trying to

cope with the problem—the classic problem that all boards have if

you are supposed to monitor management and management provides you the information. What do you do? You put in place the

best controls you can think of, and these did not work.

83

Then I suppose you could back off and say, well, why do you

think they do not work? We will describe to you the situation and

then you, as students, tell us why you think they did not work.

That is kind of the classic case, I guess, to get them to confront

that problem. I am not sure that I would have any answers for

them other than the integrity of the people and so on that were

supposed to furnish information to us. It was not always what I

would want it to be.

Senator CARPER. We talked earlier about whether or not we can

legislate character or legislate integrity and I think we pretty much

agreed that is a hard thing to do. I did not, but I might have gone

on to say some folks who looked at the situation have suggested

that while the Congress cannot legislate integrity or character, one

of the things we can do is to pass laws that call for punishment

for people who break our laws. The Congress, it is not our responsibility to prosecute and to convict those who have done so, but as

you know, with our system of government, we pass the laws and

then we leave it to the Executive Branch and the Judiciary to ensure that the laws we passed are enforced.

One of my hopes of what is going to come out of these hearings,

and we thank you again for joining us, is that the anger, the frustration that so many Americans feel—and you have heard it and

you have felt it, certainly we have—will be transformed into ensuring that justice is done in these instances.

If I could sort of segue from there, Mr. Chairman, for just a moment, we are going to have, I think, a second panel, I hope later

today, with some very knowledgeable people who know a thing or

two about corporate governance who are going to, I do not know

that they are going to second-guess you, but they are going to come

in and certainly give us their perspective.

I just want to ask you a couple of questions, and I hope to be

able to ask that panel. One of those deals with the independence

of board members and what we can do, given your experience on

this Board and other boards that you have served on, what can we

do? This is for anybody on the panel. What can we do? What ought

we do to better ensure, not just we in the Congress, but we collectively, to ensure that members of boards of directors have the kind

of independence that will better ensure that they make decisions

that represent the interest of the shareholders? Anyone?

Mr. BLAKE. Senator, I think that I would like to respond to some

of the comments that were made this morning, I, frankly, agree

with. I think there has to be scrutiny relative to what extent of involvement a member or director has on a board with a company

and to assess whether that could, in fact, present a conflict of interest situation, in other words, too much vested interest in the relationship with the company such that it cannot be—that person cannot be independent or dispassionate about decisions that need to be

made.

I think, also, that in this case, this Board actually percentagewise has a relatively high level of independent directors on its

Board and I think that is a good thing. There is probably a rationale to have some inside directors, particularly as it relates to continuity and succession of management. It is very common, for example, when one CEO was leaving and there may be a COO or

84

something of that nature, where you want to give exposure of that

potential successor to the board and to have that individual participate in the board. There is real ample justification, perhaps, of

having, say, two, particularly in light of the succession situation.

Otherwise, I would be more inclined to suggest that just the CEO

should be a member, except for the isolated situation.

Senator CARPER. OK. Other thoughts on board independence?

Other comments from any of you with respect to board independence, steps that need to be taken to better ensure board independence?

Mr. JAEDICKE. Senator, I suppose you could give the simplistic

answer and say, well, you could pass legislation or come up with

regulations that would say you cannot have a consulting arrangement. There is a trade-off here. It is disclosed, it is controlled, but

Mr. Urquhart, for example, was an expert in the—ran the power

division of GE. I am sure he gave us a lot of help overseas. It is

like—I suppose you could say, well, maybe that individual should

not serve on the Board. Well, the question is, can you get him?

I do not know how to—I realize that this is my personal answer,

and it is just an opinion. Free enterprise is great because it is free.

Now, if you want to impose constraints on it, there is always a

trade-off. I am not going to tell you that you should not impose

some constraints because maybe your assessment of those tradeoffs is different than mine. That is what makes a system work, I

guess.

Senator CARPER. Let me just interrupt. I do not mean to be

rude—— Mr. JAEDICKE. I do not know how to answer this.

Senator CARPER. This is not a trick question. We have got a lot

of wisdom represented at this witness table and this is an issue we

are going to deal with, and we can make wise decisions or unwise

decisions, and if you have some thoughts, just share them with us

from your heart.

Mr. JAEDICKE. I guess I do not understand what you are asking

me, sir.

Senator CARPER. Anyone else? If not, I could restate the question.

Mr. DUNCAN. Well, I will try that. I agree that every board member should be independent. Those that are not 16(b) officers should

be totally independent, period. That, I agree to.

I would think that a board could do something like we did, and

that is have an annual board appraisal, and in that board appraisal have items that would lead one to conclude that member

is independent. Now, how you write the textbook on that would

take some time.

Senator CARPER. Anyone else?

Dr. LEMAISTRE. I have wondered a great deal about the rotation

of directors. It seems to me that during service on a board, it takes

a good while to get acquainted with the business, especially for a

physician. I can tell you that after a period of time, it would seem

to me that a rotation would serve to give an indoctrination period

to others coming on so that they could learn to be fully effective

while over two-thirds of the board would be experienced. But it is

just a thought. I do not know whether boards do that or not. We

85

did not do it at Enron. I did discuss that with some of the 16(b)

officers as a possibility.

I also feel that in the board’s self-evaluation, there has to be action taken and there has been action taken in the Enron Board.

Senator CARPER. You say there has?

Dr. LEMAISTRE. There has been when a Director was not found

to be effective in representing the shareholders.

Senator CARPER. Dr. Winokur.

Mr. WINOKUR. Sir, my colleagues are knowledgeable and, I think,

articulate about this subject. I would just say that Enron’s Board

was voted one of the five best in the country 2 years ago—because

I still have the plaque somewhere in my office.

Senator CARPER. Hold on to that. [Laughter.]

Dr. LEMAISTRE. But more importantly than that, we did go

through a self-evaluation process and we attempted to conform

with the best practices that the General Motors Pension Fund and

all of the other governance entities did. So I think that independence is important, and I think a board that tries to improve itself

all the time is important.

Senator CARPER. Thank you. Mr. Chairman, I do not want to go

on too long. Do I have time for one more?

Senator LEVIN. Sure.

Senator CARPER. What kind of future, if any, is there for Enron

coming out of bankruptcy? What do the folks who are involved in

still holding shares or the people who are the employees or were

the employees who have the shares in their 401(k)’s, what do they

have to look forward to?

Mr. BLAKE. Senator, not very much, unfortunately. I think the

jury is still out, but as represented by the recent 8(k) filing for the

write-down that I believe Senator Levin mentioned in his comments this morning, there is an imbalance, obviously, in terms of

claims against the estate and assets. We have already stated earlier that there is no specific value and current equity of Enron.

As it relates to employment as contrasts with perhaps an investment in Enron stock, the Board, Pug and I and the Board approved

an organizational plan which we presented to the Bankruptcy

Court last week called OPCO, which basically takes the traditional

assets of the company, pipeline investments, power generating investments, and things of that nature, within which there is some

level of synergy and relationship to the component makeup of that

entity. It is hopeful that we can, essentially, try to sell these various business interests into and through a trust with something

they call a 363 sale. The sale out of bankruptcy of these assets in

a trust would take place whereby all the claims against the estate

would be set aside, until such time that this OPCO company could

then go operate as a stand alone ongoing business.

And the view, with which I personally agree, is that the ongoing

value of the company is better than break up or liquidating value

of assets. Enron is one of the more efficient gasline, pipeline suppliers and operators in the country. It is one of the lowest cost producers. Its reliability is one of the best in the industry. So there

is real value and there are great people in that business.

So the hope is that we will be able to take this collection of assets called OPCO, have it purchased out of bankruptcy into a trust,

86

and as such there would be employment for those employees and

a livelihood to go forward, as contrasts with perhaps liquidating

those assets. Otherwise, I think there are many assets that will be

liquidated, and I do not want to get too far into discussion on that,

but there are a lot of claims still out there and a diminishing level

of assets, unfortunately.

Senator CARPER. All right. Thank you.

Mr. BLAKE. You are welcome, sir.

Senator CARPER. Mr. Chairman, do I have time for one more?

Senator LEVIN. Sure.

Senator CARPER. Just imagine for a moment that you were not

sitting there and meeting the responsibilities that you now hold in

your lives but you sat up here and you wore our hats for a while.

Let me just ask each of you, if you were in the role of a member

of the U.S. Senate, can you think of one thing that you would do,

whether it is with respect to corporate governance or the role or responsibilities of the accounting firms and the way they are managed or governed, or 401(k)’s, one thing that you think needs some

legislative action, needs to be addressed legislatively, not just the

marketplace forcing the changes, compelling the reforms, not just

the SEC, not just the Federal Accounting Standards Board, but

something that we need to do, could you give me an example, each

of you, just one example of something that the Congress needs to

do to better ensure that this sort of thing does not happen again?

Mr. BLAKE. First of all, I think the comment was made earlier

by some of my colleagues this afternoon, this morning, disclosure.

Truth does not hurt, and the more disclosure the better, as far as

I am concerned. That, frankly, is the governing mechanism of offbalance-sheet transactions, is the requirement of disclosure, the

adequacy and completeness of disclosure. I think that is a practice

that probably could be extended beyond where it is today, personally.

I do think there is an accountability that CEOs like myself have

in terms of being honorable to my position and should be accepting

of the consequences if I were to misbehave or I have proven to have

been involved in a wrongdoing. Frankly, I think, personally, having

such an act that would suggest criminal liability, if that was—it is

a gray area in terms of negligence and whether there was really

intent to deceive, but if, in fact, there was an intent to deceive and,

in fact, it was a fraud and that the leader of that company was responsible for perpetrating that fraud, I would hope that there

would be a criminal action against that individual.

Senator CARPER. All right. Thank you.

Mr. BLAKE. That has no application to Enron. It is just a philosophical statement.

Senator CARPER. I understand. Thank you.

Dr. LEMAISTRE. The company’s most valuable asset is its employees. I think the 401(k) should be managed by the employees, but

there should be some oversight to correlate with the top management, the CEO, and the board so that you can be sure that those

employees who are managing the fund know fully what the condition of the company is, especially with regard to stock. But that

does not happen. At Enron, there is no fiduciary responsibility of

the Compensation Committee nor any management responsibility.

87

Our only responsibility is to amend the original plan when amendments are required.

Senator CARPER. Thank you, sir.

Mr. JAEDICKE. Sir, I do not know that I could answer your question. I have been so busy that I do not really think I know enough

about the public policy to say what you should focus on. I have no

disagreement with what my colleagues have said here, but I am

just really not well enough informed on this whole process to suggest to you anything other than something off the top of my head.

Senator CARPER. If something comes to mind and you would like

to share it with us later—— Mr. JAEDICKE. I certainly will.

Senator CARPER [continuing]. We would be delighted to have it.

Mr. JAEDICKE. I certainly will, and I promise you I will think

about it, and if I think I can pass along anything that would be

of any help to you, you will hear from me.

Senator CARPER. Thanks so much.

Mr. WINOKUR. Senator, this is not meant to relate to Enron, because I do not think it would have—I do not think it is particularly

applicable, but I think, going forward, I would find it very helpful— we talked about it a little bit earlier—if the whole issue of stock

versus performance options versus stock options could be simplified

and clarified and made people as agents, because employees are

agents for the shareholders, made their incentives more closely

tied. There are many people, including the chairman, who have

thought a great deal about that. I do not have the specific proposals. But the more there is disclosure and the more the incentives are aligned with the owners, the better things will be.

Senator CARPER. Thank you. Mr. Duncan.

Mr. DUNCAN. Senator, I agree with what my colleagues have

said. The only thing that I would add is that the world goes on at

a faster and faster speed. As the Internet comes into play in bigger

and bigger portions—most of the SEC Act was, what, 1933 or something like that—as that comes into play and derivatives come bigger and bigger into the world, and a cashless society becomes a totally cashless society, the rules might have to be a little different

as you move into that. I do not think that they are overdue, but

I think they will be due.

Senator CARPER. All right, thanks.

Mr. JAEDICKE. Senator, can I make one comment that may sound

a little facetious, but he reminds me. I do not really believe it is

facetious. It seems to me that one of the things—I do not think

management would like this very well because it may disclose

things that really are not vital to the investment decision but

would give away trade secrets or financing secrets or something

like that—I have this vision in the back of my head as an accountant that the way to deal with the disclosure problem is do away,

eventually, in this information age, with the annual report and just

send everybody a compact disk.

And on that compact disk would be all kinds of information, and

then you could maybe imbed in that—now, this sounds harebrained, but I do not think we are too far away from some of these

things—the software that would say, off-balance-sheet does not

mean out of the statements. What it means is you have disclosures

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1See Exhibit No. 36 which appears in the Appendix on page 350.

in different places than the balance sheet and the footnotes. One

of those footnotes would be—you were worrying earlier about the

assets that are off the balance sheet and in the non-consolidated

subsidiaries.

I am sure even I could give you a piece of software so that you

could say, well, here is a statement that is according to GAAP now,

but those subsidiaries are not consolidated. I would like to see

them consolidated. That would be like falling off a log. And then

you can see all of the assets that are in that footnote. That would

be the idea.

Now, I realize that is kind of hare-brained, but my colleague has

reminded me—— Senator CARPER. That is a great idea.

Mr. JAEDICKE [continuing]. That we are in a new age.

Mr. DUNCAN. And it would also save the company money.

Senator CARPER. Mr. Chairman, years from now when it is time

to send out those annual reports and we open up our mailboxes

and out of them fall these CDs, we will know where the idea came

from, right here on this day.

Mr. JAEDICKE. Thank you.

Senator CARPER. Thank you all. Mr. Chairman, thanks.

Senator LEVIN. Let me get back to Ken Lay’s loans. In May 1999,

the Enron Compensation Committee told Ken Lay that—and by the

way, Senator Carper, because you were inquiring, I think, in a very

gentle way, I should be done in about 10 minutes, in case anyone

else is trying to plan a schedule, too. [Laughter.]

I want to take just a moment, though, on Ken Lay’s loans. The

Compensation Committee told Mr. Lay that he could repay his

company loans with stock in May 1999. At that time, he had a line

of credit with Enron of about $4 million, and that was raised to

$7.5 million in August 2001.

But in a 1-year period, from October 2000 to October 2001, Mr.

Lay began using an ‘‘ATM approach’’ to his Enron credit line, as

one Board member put it in his interview. If you look at Exhibit

36,1 Mr. Lay repeatedly withdrew the entire amount available, and

then repaid the loan with Enron stock. First he did this about once

per month, and then about every 2 weeks, and then on some occasions several days in a row. By the end, he had obtained $77 million in cash in exchange for his Enron stock.

Now, every Board member acknowledged to us that these transactions could fairly be described as stock sales. By characterizing

them as loan repayments, though, Lay was able to bypass the rules

for quarterly disclosure of insider stock sales and was able to delay

reporting his stock transfers until the end of the 2001 calendar

year plus 45 days. All the Board members told us that they did not

know that this was going on at the time, and they were shocked

to learn of it later. The facts suggest, and your reactions suggested,

that Ken Lay was abusing his line of credit.

First of all, do you agree that he was abusing his line of credit?

Dr. LeMaistre.

Dr. LEMAISTRE. May I comment on that in two ways. First, just

from what I have seen of the records, this is very unusual behavior.

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This is very clearly a different pattern from what occurred in the

previous years.

Second, the loans were characterized as a line of credit and that

interpretation needs always in the future to be clarified. I think it

is a very important point.

The third thing is that we found out about this only this year.

I believe it was February when we finally learned of this, primarily

because of the point you made, Mr. Chairman, and that is the disclosure does not come periodically forward to the Board or to any

other Federal agency or the SEC.

So the surprise that occurred here was one that really concerned

all of us greatly without any understanding of why it was necessary. The only comment ever made to me personally by Mr. Lay

was that he had found the previous loan useful and that he would

like to have the loan increased to $7 million. Checking with Towers

Perrin, I found that was a mid-line range, that there were loans

much higher than that to executives. We had a lot of experience

at Enron over many years with loans to executives. We have never

seen this before. Therefore, we were very deeply concerned about

this.

Senator LEVIN. In your judgment, did this constitute an abuse of

his line of credit?

Dr. LEMAISTRE. I think it is subject to another concern. With the

confusion over the definition of the terms, you hear terms like ‘‘revolver’’ and all of the other terms that would more characterize this

used interchangeably. It is not a term I care to use, but I have

heard that term—I think the real problem comes in what is the

code of business conduct. One of the lines in the Enron code says

you will do nothing to hurt the interest of Enron, and taking this

much money out and repaying it with stock when the stock is declining certainly is very devious. It is very difficult for me to understand why that did not hurt Enron.

Senator LEVIN. You are stopping a little short of saying that it

was an abuse. Is that intentional?

Dr. LEMAISTRE. It was intentional, yes, because I do not know

the circumstances.

Senator LEVIN. Does anyone else have a comment on that?

[No response.]

OK. Dr. LeMaistre, let me just ask you this. Whose job is it to

monitor and stop that from happening? Whether you call it an

abuse or short of that—I think it is an obvious abuse, but you say

that you were concerned, dismayed—but in any event, whose job

was it, if not yours and your Committee, to monitor that particular

activity of Ken Lay?

Dr. LEMAISTRE. There are three points in this. The Treasurer receives the request and disburses the money. A lawyer in the General Counsel’s office receives the stock back and it is registered

with the person who then must make the filing, unfortunately, 45

days after the yearend.

To correct that, some kind of quarterly reports will be needed. If

the CEO has the loan, the report should come directly to the board

by the people who handle the transations.

Senator LEVIN. But looking back at this now, you do not feel that

you had any responsibility to monitor this?

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Dr. LEMAISTRE. We had never had any responsibility to monitor

this.

Senator LEVIN. Does anyone else want to add anything to that?

Mr. BLAKE. Senator, I would. 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. And, I also personally feel as a member of the

Compensation Committee that I agree with everything that Mickey

said, that we did not know about this until February of this year.

I was absolutely shocked by this. And I would suggest that if 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.

Senator LEVIN. See, what I would hope for would be outrage.

Mr. BLAKE. Well, I can use that, too.

Senator LEVIN. Good. That is what we would hope for. I have not

felt it.

Mr. WINOKUR. Senator, it would be impossible to feel anything

other than outrage, given the amount of money that was lost by

the employees, the amount of jobs that were lost—— Senator LEVIN. I did not hear that. I gave you all a chance to

comment. I said, is it an abuse? Dr. LeMaistre would not go that

far. I am glad to know that once I used the term ‘‘outrage,’’ that

at least that resonates, because I have got to tell you, I did not

sense outrage here.

Mr. BLAKE. You have got it.

Senator LEVIN. I have got it, OK. Good.

Mr. WINOKUR. This made me very angry when I heard it.

Senator LEVIN. Good. I am glad, and I wish that was transmitted.

What stands out here, this is perhaps a harsh thing to say, but

I must tell you that we have learned a lot today in terms of information, but what really stands out to me is the denial of any responsibility on your part—for what happened to Enron. A highlypaid Board not taking any responsibility for the events at Enron,

with a management that was just management gone wild. That

last question was just one of about 20 examples of where we had

this swashbuckling management, this arrogant, greedy management that was stuffing their own pockets with the money of shareholders.

What we need in boards are people who are willing to stand up

to management. You have got the backgrounds to do it. You have

got the experience and knowledge. But what comes out is that you

all say you did not do anything wrong, and what I am afraid of is,

too often, you did not do anything, period. I mean, there were a lot

of warning signs along the way.

You did not hear Andersen say that Enron used high-risk accounting. You did not remember the details of Whitewing as of 3

weeks ago. There was a $2 billion off-the-books vehicle, but no interest in reviewing LJM’s private placement memo. When you

learned about that memo—this is the memo that was touting a

conflict of interest that cost your company that you have the fiduciary duty to protect. It cost your company, that LJM enterprise.

It made a lot of money at your expense. There was a conflict of inVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00102 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
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terest that was inherent right in it, because the guy who was selling, or that you were selling assets to, was on both sides of the negotiating table. He did very well at LJM, while Enron and its

stockholders were getting socked.

But even after the lawyers told you about it or you read about

it in the Powers Report and the lawyers were asked to look at this

document, it touts conflict of interest. That is about the only thing

you can say. It holds out this insider information that these folks

had in Enron while selling partnership interests in LJM. You have

not asked those lawyers, my God, how could you not have brought

that to the attention of the Board?

You did not press to learn Fastow’s LJM compensation for 1 year

after you were supposed to look into it. The Board directed that

you would look into this compensation. A year goes by. An employee of Enron says she does not have the information, she will

get back to you. She does not get back to you. Nothing happens.

You read about it in the newspaper.

You did not ask who bought Fastow’s interest in LJM, even

though LJM meant $2 billion in funds flow for Enron—no inquiry

as to who bought that interest. You knew there was something

wrong there by then, but still, no inquiry, no questions. No questions about the Fortune article.

I do not see any concern about the $27 billion that were represented when half of Enron’s assets were off the books. Sixty-four

percent of Enron’s international investments were underperforming. Forty-five million shares or more of Enron’s stock were at

risk in the Raptor transactions. It does not set off any alarm bells.

This is stuff that you knew.

You did not ask to see Watkins’ letter when it was presented to

the Board. You got the memo summarizing it, but you did not ask

to see that letter itself.

Mr. BLAKE. Sir, I beg to differ. We did ask for the letter.

Senator LEVIN. OK. Did you get it?

Mr. BLAKE. Subsequently, but not right away, yes.

Senator LEVIN. I will stand corrected, then. You got it subsequently.

You really did not know of anything wrong, despite all of that,

until the Wall Street Journal told everybody something was wrong

on October 18 when the world found out. I think that is unacceptable, for a Board to be that out of touch with the reality of their

own company. I think you were taken advantage of, too. I think

your passivity was taken advantage of—I do not have any doubt of

it—by the management.

That placement memo that I made reference to, which has this

touting of this insider information at your expense, was issued on

October 13, 1999, which was just 1 day after the Board approved

LJM2. This is a pretty complicated document here that Fastow put

out. It was obvious he assumed that you would approve this 1 day

before he put it out. He counted on that approval.

It looks like Enron’s Chief Financial Officer saw you as a rubber

stamp. It is just deeply troubling to me, because I know you are

good people. I have no doubt about the fact that you are individually good people. I do not know you personally, but I know your

biographies and I can see that. But this responsibility is placed on

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the shoulders of good people, and sometimes good people do not

carry out that responsibility well.

The shareholders elected you to use independent, tough judgment, to probe for facts, not to accept whatever management gives

you. I do not believe you looked hard. I do not believe you asked

tough questions. I do not think you considered the personal motivations that prompted related party transactions that ultimately did

contribute to your downfall.

We have gone through the warning signs that you knew of.

There were many of them. We have tried to go through some of

them this morning and this afternoon. As I said, directors are not

expected to be detectives. They are not expected to assume that

misconduct pervades the highest reaches of management. But they

are expected to be more than a rubber stamp for management.

They are expected to dig for facts and understand complexities and

to say no to transactions that do not look right.

I think the shareholders deserved better than what they got. Too

often, I believe you were followers and not leaders, not the captains

but followers. The management there had created this corporate

culture where anything goes as long as it could produce apparent

profits, and those profits that appeared on the financial statement

then increased the share price. That was the culture. That was the

environment. That rise in stock price, while I am sure gave great

pride to members of the Board, failed to stimulate even one Director to consider that age-old truism that if something looks too good

to be true, it probably is.

I hope we all learn from the Enron debacle. I hope Congress can

pick up some of the points that are learned, whether here or in

other committees or in the media or through just investigation, to

take appropriate actions to tighten up the accounting standards, to

increase independence of auditors, to give the SEC responsibility to

require the directors and the auditors to be more responsible to the

shareholders.

We have our responsibility. The SEC has responsibility. But the

first line of defense against corporate abuse lies with the Board of

Directors. There is just no substitute for it. We can pass all the

laws in the world and all the regulations can be adopted by the

SEC, but the corporate governance responsibility must rest with

the Board of Directors. I would just hope that in all areas, whether

it is the regulatory area, whether it is the legislative area, or

whether it is that area of corporate culture that so badly needs to

be changed into a fiduciary culture, from a culture of the share

price is a god, to a fiduciary duty is a true obligation, that is the

change that has to be made.

You folks have been participants in an experience which I am

sure has been painful to you. It is painful to the shareholders of

the company that you ran as Directors, and it took a toll on the

economic system. But we are hoping that this hearing and this investigation will contribute to some corrections, that they will be

common-sensical, that they will be thoughtful, that they will try to

avoid unintended consequences. We will keep our focus on what we

can properly do and what the SEC can properly do, and just leave

to our people of integrity that will be on these corporate Boards the

understanding as to that responsibility and that obligation to repVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00104 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
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1The prepared statement of Mr. Elson appears in the Appendix on page 185.

resent the shareholders and to stand up to management when

management gives any indication that they are going in the wrong

direction.

We thank you. It has been a long hearing. We thank you for coming forth. As I said, you have done so voluntarily. You have cooperated with us. You have presented what we have asked for with documents. We would greatly appreciate your continuing cooperation,

and we will now move to the second panel. Thank you all.

The second panel of witnesses are experts in corporate governance and accounting. First, Charles Elson, Director of the Center

for Corporate Governance at the University of Delaware, a leading

expert in corporate governance issues; Michael Sutton, the former

Chief Accountant at the Securities and Exchange Commission from

1995 to 1998; and Robert Campbell, former CEO, Chairman of the

Board of Sunoco, and current Board member of Hershey Foods,

CIGNA, and Pew Charitable Trusts.

It is a distinguished panel. We first of all must tell you how

grateful we are for your staying with us. I do not know whether

we warned you that it might be this long of a wait. If not, I apologize for not alerting you to it, but in any event, we are very grateful that you stayed with us.

As I indicated this morning, pursuant to Rule VI, all of the witnesses who testify before us are required to be sworn, so I would

ask you to please stand and raise your right hand.

Do you swear that the testimony you will give before this Subcommittee will be the truth, the whole truth, and nothing but the

truth, so help you, God?

Mr. SUTTON. I do.

Mr. ELSON. I do.

Mr. CAMPBELL. I do.

Senator LEVIN. We will try that timing system again. If you can

see these lights, 1 minute before 10 minutes is up, the green will

change to yellow. It will let you then conclude your remarks. The

written testimony will be part of the record in its entirety, and we

will start with Mr. Elson.

TESTIMONY OF CHARLES M. ELSON,1 DIRECTOR, CENTER FOR

CORPORATE GOVERNANCE, UNIVERSITY OF DELAWARE,

NEWARK, DELAWARE

Mr. ELSON. Thank you. My name is Charles Elson and I am the

Director of the Center for Corporate Governance at the University

of Delaware in Newark, Delaware, and the Edgar S. Woolard Professor of Corporate Governance at the University of Delaware. I

serve on several commissions of the National Association of Corporate Directors, on director professionalism, director compensation, and various other commissions relating to corporate governance. Additionally, I am Vice Chair of the American Bar Association’s Committee on Corporate Governance and a Director of the

Investor Responsibility Research Center here in Washington, DC.

I am going to talk just a little bit about the red flags, I think,

that were raised for the Enron Board, some of which were talked

about today, a little bit about what corporate governance types look

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for in corporate Boards, what factors should be present, we believe,

and finally, the problems vis-a-vis the Enron Board in meeting

those requirements.

I do not have any knowledge specifically of what occurred within

the Enron Boardroom other than what I have read in the press and

my comments really will be more structural in nature as to the internal workings. That is something that obviously will have to be

developed later on.

There were several flags that came before this Board and one

wonders why they were not responded to. First and really most important was the waiver of the conflict of interest policy. That is a

pretty extraordinary thing for a Board to do. A conflict of interest

policy is laid out for very specific reasons. It lays out what is in

the company’s interest, what is not in the company’s interest, and

waivers from a code of ethics is not a very usual occurrence, and

that is something that, in my view, at least, should have triggered

lots of questions—who, why, when, and where, particularly when

the policy was waived vis-a-vis the company’s Chief Financial Officer. That is your chief control officer, financial control officer, and

it is very unusual to have that officer on both sides of a transaction.

Additionally as a flag, there was a lot of stock selling by executives of the company, again, a flag that apparently was not responded to.

You had, additionally, a number of Directors on the Board who

had financial relationships to the company itself, again, not a

major flag, but something that should have raised some questions,

at least amongst those who did not have those connections.

Finally, vis-a-vis the audit, an auditor, Audit Committee, you

had the independent auditor of the company acting as both the internal and the external auditor. That, from a governance standpoint, is questionable. The independent auditor also was taking

substantial fees from the company from both audit and consulting

work, something, again, governance types should say is not such a

good idea.

And finally, there apparently was a bit of a revolving door between the external auditor and the company’s financial department, again, a flag, something that should have raised questions,

not practices that in and of themselves were problematic, but practices that an independent Board should have been asking questions

about and trying to get to the bottom, and had questions been

asked, perhaps something might have been avoided.

Now, the next issue is, well, OK, these flags were there. Why

were they not responded to? What kind of Board would have responded to it and was this Board somehow deficient structurally in

its composition and its procedures such that these flags were not

responded to?

Corporate governance types will tell you that the most important

aspect of any Board, really two aspects, are that of independence

and equity, independence meaning directors serving on the Board

with no financial connection to the company whatsoever other than

long-term equity ownership in the company, that is, no consulting

arrangements, no business connections to the enterprise, no service

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provision to the enterprise, the only relationship being that of a director who owns equity in the company.

The second important factor is that of equity, that each director

should have a personally meaningful equity position in the company itself, that a director should be compensated in stock and that

the director should personally invest a meaningful amount, meaningful such that the director is aligned with the shareholder interests rather than managerial interests, the key being substantial equity ownership provides that alignment.

Independence is important for a director because it gives the director objectivity. The director’s job is to monitor management for

the sake of the shareholders, and independence gives you the effective objectivity to do that monitoring. Equity gives you the incentive to exercise that objectivity, very important.

The two work together. They work in tandem. An independent

board without equity is not very good to the shareholders. It may

be objective, but there is no incentive to exercise the objectivity. An

equity holding board without independence is no good. They may

have incentive, but no objectivity.

And independence is actually sort of an interesting concept. It is

a two-way concept. Not only is it important vis-a-vis its monitoring

aspects or its creation of objectivity, but it is also important within

the organization itself, because if the board is viewed as independent of management, an employee who believes there is a problem within the organization is much more likely to contact the

board if there are problems. The difficulty with a non-independent

board, a board that is seen as just an arm of management, is that

complaints rarely reach the level of the board. That is why independence, as I said, is important for two reasons.

Independence and equity are really the hallmarks of a good

board, and that is something that corporate governance types have

been calling for for a long time. The two, as I say, reinforce one

another.

Additionally, vis-a-vis qualifications of directors, there is concern

about directors serving on too many boards. An over-Board director

is not a good director because, obviously, he o she is like a jack of

all trades, a master of none. Someone who is on too many boards

does not have the time or energy to focus appropriate attention on

the boards on which he or she serves.

Second, there is concern about the length of directors’ terms. Directors who are on a board for too long, are viewed as becoming effectively tired, not as sharp as they once were in reviewing the

company and much more willing to accept management representations than not. That is why a number of folks have called for term

limits for directors, either through retirement policies or through

actual 10- to 15-year terms, such that, at some point, someone rotates off.

How does this apply to the Enron Board? The Enron Board was

problematic, I think, in the independence issue. There were a number of directors of the company who did not meet that definition

that I described to you, who were service providers or recipients of

corporate largess in some way, shape, or form, and that, I think,

was problematic.

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1The prepared statement of Mr. Sutton appears in the Appendix on page 191.

Additionally, you saw a conflict, I guess, vis-a-vis this Board in

the sense that they held lots of options. There was equity on this

Board, but there were also substantial numbers of company options, and a number of governance folks have suggested, too, that

the way to incentivize a director is not necessarily through an option, which is an expectancy, but through straight equity ownership. An option is terrific on the upside, but on the downside, you

do not lose very much. As an owner of a share of stock, on the

downside, you lose quite a bit. You lose your investment and, obviously, the potential for upside.

I think that was the really primary thing we saw vis-a-vis the

Enron Board, the presence of a number of non-independent Directors or what folks would view as non-independents. Did that mean

they did not exercise independent judgment? Not necessarily. All it

means is that if one is not independent, it is a lot tougher to make

that difficult call with management. You are probably more trusting of management, because, in fact, you have relations to management.

Additionally, the Board of Enron served for a long time. A number of Directors had been there for at least 10 years, and again,

the problem of length of service vis-a-vis being more accepting of

management representations than not, I think, came into play.

In short, there were warning signals that were present. The

warning signals were apparently missed until it was, in fact, too

late. Why did it occur? That will obviously be the subject of your

hearings and review.

But what I can say is from a structural standpoint, there were

reasons, at least in my view, that the flags may, in fact, have been

missed or not responded to early enough, and I think that this is

something that this Subcommittee, and, frankly, the investing public, should demand of our companies, that a substantial majority of

corporate Board members should be: A) independent of management, and B) own personally meaningful equity, long-term equity

stakes in the company, equity stakes that cannot be sold on the

short term but must be retained for the length of the director’s

service on the Board. Thank you.

Senator LEVIN. Thank you very much, Mr. Elson. Mr. Sutton.

TESTIMONY OF MICHAEL H. SUTTON,1 FORMER CHIEF ACCOUNTANT, SECURITIES AND EXCHANGE COMMISSION, WILLIAMSBURG, VIRGINIA

Mr. SUTTON. Chairman Levin, Senator Collins, Members of the

Subcommittee, thank you for inviting me to share my thoughts

with you today.

First, let me comment briefly on my background and experience.

I was Chief Accountant of the Securities and Exchange Commission

from June 1995 to January 1998. Prior to holding that office, I was

a senior partner in the firm of Deloitte and Touche, responsible for

developing and implementing firm policy relating to accounting and

auditing and practice before the SEC. My career with Deloitte and

Touche spanned from 1963 to 1995. As a retired partner, I receive

a fixed retirement benefit from that firm. Presently, I undertake

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from time to time independent consulting and other assignments in

the field of accounting and auditing regulation and related professional issues.

Effective oversight by Boards of Directors is at the heart of the

financial reporting processes that serve and protect the interest of

investors and the public. Without effective oversight, important

checks on the integrity, judgment, and performance of management

are compromised. Without effective oversight, critical safeguards of

the rigor and objectivity of the independent audit are weakened.

As we have seen in the case of Enron, failures of the corporate

governance processes can be devastating and the investing public,

rightly so, is asking, ‘‘Can we rely on corporate governance, oversight by Boards of Directors and audit committees, to ride herd on

management and see to it that auditors do their jobs? ’’

We would like to believe that Enron is an anomaly, that the governance issues raised are isolated to this case, but they are not.

While Enron has become a poster child for a system out of control,

the underlying concerns about the diligence of Boards of Directors

and audit committees reach far more broadly into our corporate

and capital market culture.

As we look at the issues today, it should be abundantly clear that

there is no higher goal for financial reporting than providing useful

and reliable information that promotes informed investment decisions and confidence in the system. It also should be abundantly

clear that without diligent, probing directors and audit committees

and dispassionate, independent auditors, the quality of financial reporting can be and will be systematically undermined. Without

adequate checks that must come from effective governance, conflicts of interest can, and will, go unchallenged.

One of the most practical and effective steps in reforming the financial reporting system, in my view, would be to immediately revisit and rewrite our corporate governance policies and guidelines

to clearly break the bonds between management and the independent auditor and to unmistakably spell out the responsibilities

of boards of directors and audit committees to shareholders and the

investing public. Management should be the subject of, and not the

manager of, the independent audit relationship and process.

The ultimate responsibility for full and fair disclosure to shareholders, and the direct responsibility for the independent audit relationship and the quality of the audit process, should be clearly

fixed with the board of directors and its audit committee. The audit

committee should be made up entirely of independent directors.

For independent auditors, I believe that a brighter future begins

with full acknowledgement of the reality that seems so clear today.

Failures in our financial reporting system are more than aberrations. They seriously undermine investor confidence in the institutions that are supposed to protect them. They ‘‘poison the well.’’

To restore and maintain confidence in the independent audit, I

believe that profession will have to do three things. First, it will

have to embrace a role that is fully consistent with high public expectations. In public capital markets, insiders have an advantage

over public investors, and in that arena, independent auditors are

expected to balance the scales by assuring investors that the finanVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00109 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
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cial reporting gives them a fair presentation of the economic realities of the business.

Second, the auditing profession will have to tackle fraudulent financial reporting as a distinct issue with a distinct goal, zero tolerance. We understand that in life zero defects are almost never realized. Nevertheless, the public expects that the profession will pursue that objective.

Third, it will have to accept and support necessary regulatory

processes that give comfort to the public that the profession is

doing all that it can do to prevent future episodes of failed financial

reporting.

With respect to accounting standards, we simply cannot tolerate

financial reporting that ‘‘hides the ball’’ and we cannot tolerate

processes that are not responsive to critical financial reporting

needs. Current rules for accounting for SPEs, for example, are nonsensical. They can only be explained by accountants to accountants.

More broadly, outdated rules governing consolidation and off-balance-sheet financing have become recipes for masking a company’s

true economic risks and obligations. We have a right to insist that

accounting standards clearly reflect the underlying economics of

transactions and events, and it is not acceptable to sit by while

market innovations outstrip the development of needed guidance.

Criticisms of U.S. standards is beginning to focus on the fact that

they have become increasingly detailed, and arguments have been

made that they should be broader statements of principle, applied

with good judgment and respect for economic substance. I have

sympathy for the desire to break the cycle of the mind-numbingly

complex accounting rules that have become the norm, but to do

that, I think we have to confront realistically the reasons why our

standards have evolved the way they have. Here are some of the

underlying pressures that are at work.

Business managers want standards that provide the greatest

flexibility and room for judgment. They want to be able to manage

reported results, but yet be able to point to a standard that assures

the public that they are following the rules.

Deal makers and financial intermediaries want standards that

permit structuring transactions to achieve desired accounting results, results that could obscure the underlying economics. In that

world, creative transaction structures are valuable commodities.

Auditors are pressured to support standards that their clients

will not take issue with, and they often are restrained in their expected support for reporting that is in the best interests of investors and the public. Others, including legislators, some legislators,

too often lose sight of the fundamental importance of an independent and neutral standard-setting process. Without independence and neutrality, standard setters cannot effectively withstand

the myriad of constituent pressures that they inevitably will face

and make the tough decisions that inevitably are required.

And then standard setters too often seem to pull their punches,

perhaps because of the perceived threat to the viability of private

sector standards setting, perhaps because of the sometimes withering strain of managing controversial change, and perhaps because of a loss of focus on mission and concepts that should guide

their actions.

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1The prepared statement of Mr. Campbell with an attachment appears in the Appendix on

page 195.

As we reexamine the processes, the issue and debate should not

be about whether accounting standards should be detailed or

broad, but rather about what formulation of standards and standard-setting processes best accomplish the goal of providing capital

markets with reliable and decision-useful information. We need to

reenergize our standard-setting processes and the commitment of

capital market participants to support a fully effective, independent

standard setter. We should provide independent funding for the

FASB, funding that does not depend on contributions from constituents that have a stake in the outcome of the process.

We also need a more independent governance process to replace

the current foundation board. The leadership for these changes

should come from visionaries of unquestioned objectivity and demonstrated commitment to the goals of financial reporting and the

public interest.

At the outset, I suggested that the common interest in preserving

and maintaining healthy capital markets far outweighs the concerns or goals of any particular group or special interest. We have

to keep focusing on that fundamental tenet. Only a continuing commitment to that goal will guarantee that we continue to enjoy the

best capital markets in the world.

Thank you again for inviting me. I would be pleased to respond

to your questions.

Senator LEVIN. Thank you very much, Mr. Sutton. Mr. Campbell.

TESTIMONY OF ROBERT H. CAMPBELL,1 FORMER CHAIRMAN

AND CHIEF EXECUTIVE OFFICER, SUNOCO, INC., AND CURRENT BOARD MEMBER OF HERSHEY FOODS, CIGNA, AND

PEW CHARITABLE TRUSTS, CORONADO, CALIFORNIA

Mr. CAMPBELL. Mr. Chairman, ladies and gentlemen, I, too, appreciate the opportunity to testify before this Subcommittee today.

This Subcommittee’s deliberations are extremely important, in my

opinion, because it is a national imperative that we begin the process of restoring the confidence of investors in publicly-held companies.

For your information, my active business career has spanned a

40-year time period, from mid-1960 until June 2000. The entire career was spent with one company, the Sun Oil Company, or Sunoco, as it is known today, or its subsidiaries. In 1991, I was named

President and CEO, and in 1992, Chairman of the Board, and I

held the Chairman and CEO positions until I retired in June 2000.

Before I begin, I need to make two points clear. First of all, any

remarks that I make are my own personal belief and they do not

necessarily reflect the beliefs of the corporations on whose boards

I have served or am currently serving.

And second, you need to understand that my knowledge of Enron

and its Directors or Arthur Andersen and its partners is limited to

what I have read in the print media or seen on television or heard

today. I have no direct knowledge of what has taken place in those

organizations.

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1The list of corporate governance standards appears at the end of Mr. Campbell’s prepared

statement in the Appendix on page 199.

Now, in your letter of invitation to me, you asked that I comment

on whether I thought the governance problems exposed in the

Enron matter are unique or representative of most U.S. publiclytraded companies. My answer is that I certainly do not believe that

the alleged behavior is representative of boards of directors in the

United States today.

In addition to Sunoco, I have been or am currently a Director of

CoreStates Bank, before its acquisition, Hershey Foods, CIGNA,

Pew Charitable Trusts, Rocky Mountain Institute, plus numerous

civic and nonprofit boards. I have chaired audit committees. I have

chaired the compensation committees. I have been on governance

committees, finance committees, and executive committees, and

during those 15 years, I have come to know probably more than

100 directors and can state from personal experience that the allegations that I have read in the print media and seen on television

are not even remotely similar to the director experiences that I

have had. Unfortunately, the general public seems to believe that

Enron is typical, and I think that is terrible and it is part of the

reason that I am here today.

I believe the best way to explain the type of board governance

that I am accustomed to is to cite some of the practices we instituted at Sunoco. The list of governance practices of that corporation

spans four single-line typed pages, and you will be happy to know

that I have absolutely no intention of reading them here this afternoon, but have instead submitted them as an attachment to my

proposed remarks for your information.1

Senator LEVIN. Thank you.

Mr. CAMPBELL. In those remarks that I prepared and submitted

for today’s performance, I briefly outlined the company’s practices

in director independence, director compensation, and director election. I spoke of the company’s approach to the code of ethics and

to conflict of interest policies, the company’s approach to CEO evaluation, director evaluation, and ‘‘board-as-a-whole evaluation. And

finally, I wrote of our experience in changing the independent auditors. Now, I am not going to take the time to read through those

now, but I will be glad to answer any questions that you may have

on my experience with those practices.

You might be interested to know that Sunoco’s approach to governance resulted in several instances of external recognition and

culminated in that board of directors receiving the 1999 National

Board Excellence Award from Spencer Stuart, the executive search

firm, and from the Wharton School of Business at the University

of Pennsylvania.

Now, also in your letter of invitation to me, you asked if I might

have any recommendations for new legislation or regulatory reforms. I will confess to you up front that my business career has

conditioned me to seldom seek more legislation or regulation from

government. However, I do believe that the current situation calls

for strong action on the part of someone, and I would suggest four

areas of focus.

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First, I believe there needs to be a more complete and understandable annual disclosure of the relationship between a director

and the corporation. The typical corporate proxy today issued prior

to an annual meeting and the election of the directors gives a very

brief description of the director standing for election.

I would like to see a much more complete description, on one

page, of each director’s relationship with that corporation, including not only the total compensation received in whatever form it

takes, cash, stock, benefits, or perks, but also any consulting or employment contracts for them or their relatives, any business relationship between their company and the subject company. Are they

a significant supplier or a customer? What are their financial holdings in the company they serve as director, stock, stock equivalents, options, bonds, other forms of debts, loans, etc.? I realize that

some of this information is disclosed in other documents. However,

bringing it all together annually in one place in an easily-read format and publishing it will help ensure complete disclosure of how

independent your so-called independent directors really are.

My second suggestion is that an annual meeting of outside directors, and with that I mean no CEO or other members of management present, be made mandatory, not just a voluntary good practice, and it be followed with an extensive feedback session to the

CEO/chairman. I have instituted that on boards that I have been

on and have found it to be of tremendous value to both the CEO

and the outside or independent directors in surfacing issues early

while they still can be dealt with constructively.

Mr. Chairman, my experience is that you do not get in big trouble in one step. You get there in a series of small steps that progressively take you further and further away from acceptible behavior. It is the so-called slippery slope. That is why there has to

be an extensive, no-holds-barred meeting of independent directors,

regularly scheduled, at least annually, with no management present, because I believe in that discussion the best way to surface the

issues that somehow just do not feel right in your gut as a director

is to have that kind of discussion with your colleagues.

Third, I believe that consideration should be given to limiting the

years an outside auditor can serve a corporation. The need for a

different set of eyes is currently recognized by the existing requirement that the partner in charge be rotated every 7 years. However,

bringing in a new lead partner from the same firm to work with

the existing team from that firm is inadequate, in my opinion. I am

certain that this requirement would be seen as unnecessarily disruptive and expensive by most corporations today, but if an outside

auditing firm knew that 10 years from now, a competing auditing

firm would be looking over and possibly commenting on their prior

work, a whole new dynamic would be introduced in the current

process.

Fourth and finally, since good corporate governance is a constantly evolving process, it would be unwise to legislate or regulate

with too much specificity. What is viewed as good practice this year

may not be viewed as adequate in future years. Boards instead

need to institute a continuous governance review process, and I believe it would be helpful if the following were required by regulators.

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1See Exhibit No. 86 which appears in the Appendix on page 751.

One, corporations should be required to put their governance

practices in writing and publish them annually in their proxy

statements. In that manner, it would be clear to all shareholders

how their corporation is being governed.

And two, a board committee should be identified and held responsible for reviewing and updating a corporation’s governance

practices, similar to the way the audit and compensation committees currently have certain regulatory duties.

One of Sunoco’s current directors, Rosemarie Greco, recently published in the January 2002 edition of National Corporate Directors

Monthly an excellent description of a process which a corporation

can use to institutionalize the best governance practices.1 I strongly recommend you review her offering because it is only when the

governance process is institutionalized that it will continue to be

effective over time.

Again, I thank you for the invitation to be here today and I will

be happy to try to answer any of your questions.

Senator LEVIN. Thank you all for your testimony and again for

your patience.

Enron kept about 50 percent of its assets off its balance sheet, about $27 billion out of $60 billion. It also had off-the-books guarantees that were not reported, major business ventures that were

not disclosed to investors. Now, we have been told there is no way

to know whether the extent of Enron’s off-the-balance sheet activities is typical or unusual for U.S. companies since the activities

are, by definition, off the books and not reported.

How can investors rely on financial statements if a large percentage of a company’s business activities, assets, and liabilities are off

the balance sheet, and what accounting rules need to be changed,

with as much specificity as you are willing to give us, to acquire

that disclosure which you referred to of material off-the-balance

sheet activities, assets, and liabilities? Maybe, Mr. Sutton, we could

start with you.

Mr. SUTTON. Let me offer several—make a few points about that.

Senator LEVIN. If I could interrupt for one second, I think you

said that the current rules on these SPEs are nonsense, so that is

the reason I am starting with you. You have made a very pungent

point about it.

Mr. SUTTON. Let me offer a few comments to help explain why

I said that and what the state of the art is. Off-balance-sheet financing is one of the most valuable commodities on Wall Street because markets tend—or companies perceive that markets tend—to

value companies that have less debt on their balance sheet. Rating

agencies also will do it. The markets, some segments of the markets—tend to view asset-light companies as being more attractive

investment opportunities. That creates an incentive of companies to

get debt off the balance sheet, to get asset-light, so that they will

be looked at and perceived favorably by the market.

What has happened in the standard-setting process, and when I

said we need to understand what the drivers are to understand the

problem, instead of trying to develop standards that say, ‘‘what is

the economic substance,’’ ‘‘who has the risks and the benefits of

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these assets and liabilities,’’ ‘‘who really owns them,’’ the standard

setting has lapsed into a process of ‘‘what rule do I have to comply

with in order to get an asset or a liability off the balance sheet? ’’ So that is the state of the art, and it creates a situation, as in

Enron, where you can have substantial obligations, that you or I

might recognize as liabilities, off the balance sheet, substantial assets that you or I might say, ‘‘well, Enron really has the risks and

benefits of that asset off the balance sheet,’’ and it is accomplished

through accounting standards that, in part, were not complied

with, and in part that were complied with but that were poorly designed.

Senator LEVIN. Before I turn to either of the other two witnesses,

would you have specific changes that you would propose? Because

you are moving from a legalistic to an equitable or to a judgmental

or, not intuitive, but something which is a little less legalistic in

its description to something which is more, hey, who really has

these risks and benefits. How do you put that in a rule?

Mr. SUTTON. You have to first articulate conceptually what you

are trying to accomplish, and then you develop rules to the extent

that you need to develop rules to accomplish that.

Senator LEVIN. Has somebody done that?

Mr. SUTTON. Well, the FASB’s charge is to do that, and I mentioned their mission. That is what they are charged to do. In my

personal opinion, they have not done a very good job of that, particularly in recent years.

Senator LEVIN. Has anybody outside of the FASB made an effort

to design rules which would achieve that objective?

Mr. SUTTON. Well, there is a new body in place now, relatively

new, and that is the International Accounting Standards Board,

that has pledged, in a sense, to take a more principled approach.

I would not suggest in any way that whatever approach you take

is going to be easy because it is like any set of rules that you try

to develop. There are always going to be those who want to game

the rules. But my view is that you ought to develop your rules following the concepts that you believe are best—that give the best

and fairest presentation, the most transparency, and develop those

rules as best you can.

Senator LEVIN. For instance, has any academic tried to design

rules which would correct for the inadequacy of the current rules

relative to these transactions? Is there anyone who has done some

writing in this area in academia?

Mr. SUTTON. There is lots of writing, but there is no magic bullet.

The magic bullet in this is having an independent process of highly

qualified people who are clearly focused on a mission that is in support of what you expect financial reporting to be in the marketplace.

Senator LEVIN. You have said you would give FASB an independent source of financing. You testified to that today. Would you

also have them appointed by a different body than is currently the

case? Would you, for instance, have the SEC appoint any members

of that board?

Mr. SUTTON. Chairman Levin, I have not thought in detail about

how the structure—my view is, we needed to get some really capable visionary thinkers who have thought about this issue a lot and

104

try to develop a consensus view. It may be worthwhile that some

part of the board would be appointed by the SEC. It may be—it

would seem logical to me—that you would want a certain segment

of those members who would clearly be, and clearly be recognized

as, advocates of or sensitive to the needs of the investing community.

Senator LEVIN. Would you give that board additional powers, including subpoena powers? Would you give them also powers to enforce rules, in other words, separate that enforcement function?

Mr. SUTTON. What I had in mind that we were just talking about

would be a body that would set accounting standards. There is a

need for—the other accounting leg of this stool is the accounting

profession, and I would see clearly a need to have another body, an

independent body, oversee the auditing profession, and that body

should have appropriate investigative powers, in my mind.

Senator LEVIN. Mr. Elson, do you have any comments on the subject that I have been talking to Mr. Sutton about?

Mr. ELSON. I am a transparency person. I have always been a

big fan of transparency, and I think the more that is disclosed

about those sorts of things, the better. But vis-a-vis the technical

aspects of on or off-balance-sheet financing, I am a little out of my

field.

Senator LEVIN. OK. Mr. Campbell, did you have any comment on

that?

Mr. CAMPBELL. No. I would agree with Mr. Sutton and Mr.

Elson. Prior to the Enron disclosures, I had never seen that

amount, or proportion of a company’s assets off-balance-sheet.

Sometimes it is appropriate to have some items off-balance-sheet,

where you have an investment and no control, but never to that extent. As to how you would correct that situation, I cannot offer expertise in that, sir.

Senator LEVIN. Mr. Elson, have you ever seen or know of a company that had that many off-balance-sheet entries?

Mr. ELSON. Not that I am aware of. On the other hand, again,

my expertise really is not in that area. It was quite a bit to obviously have it off the balance sheet, and obviously not disclosed.

Senator LEVIN. Mr. Sutton.

Mr. SUTTON. Well, many companies have off-balance-sheet assets

and liabilities, but my experience is that Enron is at the top of the

scale in terms of the extent of it. Airlines, for example, would frequently have much or most of their aircraft off-balance-sheet

through leasing arrangements and that would not be regarded as

unusual.

Senator LEVIN. Thank you. The Enron Board approved Andersen

serving not only as the outside auditor for the company, but also

for a couple of years as the company’s internal auditor at the same

time and paid Andersen also tens of millions of dollars for consulting work. The end result was that Andersen was essentially auditing its own work.

Now, the Board members defended this practice by saying that

it gave them great comfort to know that Andersen was involved in

all of Enron’s transactions from the very beginning. They called it

an integrated audit. What is your reaction to this idea of an inteVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00116 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
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grated audit, in which the same auditor is the company’s consultant, internal auditor, and external auditor? Mr. Sutton.

Mr. SUTTON. Well, in my experience, the term or label ‘‘integrated audit’’ generally referred to a proposal to combine the internal and external auditing, and so a couple of things I would say

about that. One is that it became quite fashionable in the late

1990’s. The second is, I think it is a terrible idea because it does

create the situation where, on the one hand, the auditor is performing a management function, i.e., internal auditing, and on the

other hand is called upon to examine the financial statements.

The other aspect of it that you mentioned is consulting in the

area of transaction structures. That clearly, in my mind, raises

questions about auditing your own work, and it depends really on

what was done and to what extent it was done. If the auditors were

the creative thinkers, if you will, in terms of how do we accomplish

a transaction to accomplish a certain accounting result, to me, that

is over the line. On the other hand, you would expect a company

that is getting ready to enter into a transaction to ask its auditor,

do you have any concerns about this? So there is a line there that,

in my mind, once you cross that, you have a problem.

Senator LEVIN. OK. Mr. Elson.

Mr. ELSON. I guess my answer would be in two parts. First, visa-vis the internal/external audit role, I have always believed that

they should be separated for a very important reason. Those are— they are watchdogs, effectively. An external audit, internal audit

are watchdogs of the company’s financial processes in some way,

shape, or form, and anytime you concentrate two watchdogs in the

same watchdog, you have effectively reduced the effectiveness by

half, if you have one less person there.

Second, the fashion typically today has been to outsource internal audit. Traditionally, it was always internal. That is why they

called it internal audit. But there is some merit, a great deal of

merit, to outsourcing the internal audit function. And when you do

so, I have always felt that there is some benefit to separating the

internal auditor from the external auditor because you have two

different large firms in the company effectively, even if informally,

checking each other’s work.

The presence of a different internal auditor or the presence of a

different external auditor, I think acts as a bit of a check on the

work of either party and that is a pretty—I think it is healthy competition. That is the first point. I have never, frankly, felt that the

two should be combined, and when it was, I think 2 or 3 years ago,

the SEC effectively allowed that, I was rather critical of that at the

time and I still am.

Second, vis-a-vis the consulting, the auditor consulting, when

auditors do consulting, a lot of consulting, the question is, does it

compromise the effectiveness of the audit itself? Can you trace the

presence of heavy consulting work with a busted audit?

I have not been made aware of any empirical data to date that

demonstrates emphatically the correlation between consulting,

heavy consulting, and a busted audit. On the other hand, from an

optical standpoint, a shareholder trust standpoint, putting it in the

same party is problematic. It looks problematic. It looks as though,

even though one can argue there is a Chinese wall, if you will, beVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00117 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
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1See Exhibit No. 43 which appears in the Appendix on page 375.

tween the two functions, there is certainly the public perception of

potential corruption of the audit process by the desire to seek consulting fees, and because of that public concern, I think it is something that I would limit.

Unless you have a really good reason to do it, I do not think I

would have the external auditor doing consulting work, or if they

did consulting work, it ought to be very limited in nature and in

scope and only used when, frankly, you can demonstrate that there

is nobody else out there who can deliver an effective service. In

other words, you do not want the consulting to affect the audit

function and you do not want those, certainly the members of the

public who are relying on the financial statements, to be concerned

that those financial statements are not reliable because someone

was doing both.

Senator LEVIN. I think it is more than optics. Enron paid Andersen $5 million in the year 2000 to help structure LJM, and so it

would seem to me it would be pretty hard for Andersen’s auditors

to say that the Andersen consultants got it wrong. I think that is

the problem. I think it is a real problem, but let me ask Mr. Campbell, do you have any comment on that issue?

Mr. CAMPBELL. I think what was described today as the integrated audit is a horrible practice and I do not think it should be

permitted.

As far as consulting is concerned, I think when you end up with

an auditing firm which, first of all, bids a proposal on the basis of

conducting the external audit and then finds over a period of time

that the non-audit fees continue to grow, in my mind, that does

nothing but continue to reduce, not only optically but in reality, the

independence of those so-called independent auditors. There is no

question, at least recently, there have been pressures to begin to

bring that down because people are focusing on that issue, but it

sure can reduce independence, in my opinion.

Senator LEVIN. Thank you. This is for you, Mr. Elson. You have

written extensively on the importance of independence and you

have testified to that this afternoon. Exhibit 43,1 if you have a book

near there, identifies some of the economic ties between Enron and

some of the outside Directors. The Board members told us that

none of these dollar commitments was large enough to have impaired anyone’s judgment or to sway any Director from being honest and skeptical with Enron management. You can perhaps scan

the amount of dollars that are involved in those items. I am just

wondering what your response is to that.

Mr. ELSON. I think that if amounts for consulting services were

not meaningful, then the individuals would not have taken them

to begin with. Obviously, they had some meaning or they would not

have accepted compensation for services rendered.

The problem with taking separate fees, other than one’s directors’ fees, is I think it creates a linkage between you and management. By taking those fees, you are effectively becoming part of the

management team, and I think there is a real problem with exercising independent judgment vis-a-vis what the management has

done if you feel part of that team, either through participating in

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1See Exhibit No. 28b which appears in the Appendix on page 306.

the development of management plans and strategies or the fear

that if one objects too strenuously, those consulting fees may disappear. That, at least, has been the generic critique of those.

I think, too, the problem with them is that by taking them and

becoming, again, part of management, in a sense, you are much

more reticent to be critical of management, not because you are no

longer ‘‘independent,’’ but because of the relationship you have with

management, that financial management. You may take what they

are telling you at face value without being more probative because

of the relationship that this thing creates.

That is why the National Association of Corporate Directors in

their commission report on director compensation said that if 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. The argument that we could not retain someone’s consulting services unless we made them a director, I have

never felt was a very good argument.

Again, the problem here is either these fees may have affected

their view of what was being presented to them—again, you have

to get each of them here to testify as to whether they did or they

did not, but certainly in the part of those within the organization,

the presence of those relationships might have made the perception

of those directors within the organization viewed as less than independent. If that were the case, it would be tougher for someone

within the organization, if they objected to what was going on in

management, to approach any of these directors because they were

of the view that, gee, they are just part of management anyway,

and that, I think, is the real issue here.

In other words, independence, as I said, is a two-way street, and

I think the presence of these relationships is not a good idea, and

that is why the National Association of Corporate Directors has

strenuously recommended against these sorts of relationships.

Senator LEVIN. This is for Mr. Sutton. You were Chief Accountant at the SEC, and by the way, did either of you have any comment on that last answer before I go on?

Mr. CAMPBELL. Well, I would just like to point out, I think the

consulting arrangements with directors is absolutely incorrect, absolutely wrong. When you accept the directorship of a corporation

and join the board, you are paid a fee, obviously in the case of

Enron, substantial. In my mind, your thoughts, your processes, and

what have you, your support and you are there available to the

management at any time they want to contact you. And if, in fact,

they need you on an ongoing consulting basis, then you should not

be a director of that corporation.

Senator LEVIN. Thank you. Mr. Sutton, now a question about the

Raptor transactions. You were Chief Accountant, as I indicated, for

the SEC and I would like you, if you would, to turn to Exhibit 28b,1

which is the initial Raptor presentation to the Board.

Mr. SUTTON. Exhibit 28—— Senator LEVIN. Exhibit 28b. The first page states that the purpose of the Raptors is to establish a risk management program in

order to hedge the profit and loss volatility of Enron investments.

108

The last page of this Exhibit 28b lists the risks that are associated

with the Raptors. The first one is ‘‘accounting scrutiny.’’ The second

one is ‘‘substantial decline in the price of Enron stock,’’ what would

happen. I am just wondering, what is your reaction to the presentation, in particular, the focus on hedging profit and loss volatility

as opposed to hedging real economic risk?

Mr. SUTTON. Let me couch my response in these terms. Obviously, we do not know what was said at the meeting, and so I am

going—what I give you is more of a reaction based upon my experience and insights.

The first thing that comes to mind is when I see the slide labeled ‘‘Purpose,’’ it says establish a risk management program in order

to hedge the profit and loss volatility of Enron investments. The

first thing that comes to my mind is, ‘‘what does that mean,’’ quite

honestly. What does it mean to say, ‘‘hedge profit and loss volatility? ’’ I had a similar question in listening to the testimony this morning. The term ‘‘hedge,’’ in my mind and experience, refers to transactions that are used to transfer or alter the risk of the company,

so that there is another party out there that you exchange risks

with, or you transfer risk to, that has an economic impact. And this

says ‘‘hedge profit and loss volatility,’’ and I do not know what that

means. That is my first reaction.

What was the other page?

Senator LEVIN. On the last page, you have got a risk list. One

is accounting scrutiny. The other one is a substantial decline in the

price of Enron stock. In other words, in addition to trying to protect

itself against paper losses here, not as you testified, in effect,

against real economic risks, but against paper losses, Enron used

the Raptors to hedge against the decline in value of certain assets,

but that was backed by Enron shares rather than independent

third-party equity. It was Enron shares which were put up for that

hedge, so they are hedging against themselves, are they not, or am

I missing something here?

Mr. SUTTON. Well, all I can interpret from the comment is that

the risk is from a substantial decline in Enron stock, and then the

consequences of that are identified ‘‘as the program terminates

early.’’ I assume that would be at a loss of some kind, and it increases the credit risk, so I assume that is Enron’s credit risk,

but——

Senator LEVIN. The risk here, as I understood it, is since they

put up their stock as the collateral, that if, in fact, that stock declined in price and was called upon, then they would have to put

up a huge amount of their own stock. So they were not transferring

risk, they were using their own stock to cushion against the risk

of their own assets, their own stock holdings going down in value.

Is that a true hedge?

Mr. SUTTON. That is not what I would understand a hedge to be,

and that would also explain, perhaps, the first slide, by what they

meant by ‘‘hedge profit and loss volatility.’’

Senator LEVIN. OK. So it is just not clear to you as to what—— Mr. SUTTON. It is not clear to me.

Senator LEVIN. Does anyone else have a thought on this?

[No response.]

109

1See Exhibit No. 35a which appears in the Appendix on page 348.

All right. What does a board do if they are told that high-risk

accounting practices are being used? What is their fiduciary duty?

We will start with you, Mr. Campbell.

Mr. CAMPBELL. Well, first of all, I cannot imagine going into an

audit committee room and sitting down with the auditors and

being told that we are using high-risk auditing practices and just

agreeing with that. I mean, my experience has been people would

want to know, why are they high risk? How did we get there? Why

are we using them? And what are you going to do to get us out

of it?

Going forward with that kind of an environment, it is what I said

before. It is a little bit like this whole thing turns into one step

after another. You are going down a slippery slope on this thing,

and at what point in time do you yell, enough is enough?

But having an audit committee confronted with the fact that you

have high-risk auditing practices and then having the chairman

take that to the board and report it to the board and have that

board agree that is OK, it is unlike any board that I have ever seen

or heard of.

Senator LEVIN. Mr. Elson.

Mr. ELSON. My first reaction to that would have been an extremely queasy stomach. That is a giant red flag, being told that

you are—for a large publicly traded company, the seventh largest

public traded company in the country—taking serious accounting

risks is a pretty scary thing, just to say the very least.

As a director, under the duty of care, you are being compared to

what would the reasonable director say under similar circumstances, and the reasonable person would certainly say, why

are we doing this? Why is this risky? Is this very smart to be doing

this? What is considered conservative treatment? Why are we not

in conservative treatment? And how do we get ourselves out of

risky treatment, because, obviously, risky treatment has risks.

That is why they call it risky treatment. What are the risks before

us and how do we restore conservative treatment?

At that point, you want to ask an awful lot of questions, and if

you do not get the right answers, then you need to bring in a third

party.

Senator LEVIN. OK, thank you. Mr. Sutton.

Mr. SUTTON. I would just support those comments and say that

from the accountant’s perspective, you would also expect some kind

of dialogue to arise between the audit committee and the independent auditors.

Senator LEVIN. One of the issues which came up had to do with

the compensation of the Board of Directors. Exhibit 35a1 is the

total compensation of Enron Board members for fiscal year 2000.

As you can see, including stock option value which probably represented three-quarters of it, roughly, it was in the range of

$320,000 to $340,000, with the cash compensation being roughly

from $70,000 to $90,000 and the balance in stock option value. This

is a chart from their own sources.

Mr. Elson, you particularly made reference to stock options as

being an expectancy where you do not lose as much on the downVerDate 11-MAY-2000 10:18 Aug 30, 2002 Jkt 000000 PO 00000 Frm 00121 Fmt 6633 Sfmt 6633 80300.TXT SAFFAIRS PsN: SAFFAIRS
110

side, as you put it. Even though it turned out these options were

not worth much in many cases when they held those options, when

they were granted those options, there was a hope and an expectation that they would be worth a tremendous amount of money. This

is what the estimated compensation was, a quarter-million dollars

in the value of those options just in that 1 year.

Doesn’t that create pressure on the Board, basically, to go along

with management or with these far-out, pushing the envelope accounting practices which make the financial statement look good

and then push up stock prices, because their options go up in

value? Now, their answer today, frankly, was not particularly satisfactory to me because what they said is, well, they turned out not

to have any value or they lost money. That is not the issue I am

talking about, whether they ended up losing the value of those options.

What I am talking about is when they were granted those options, those options had real value and great potential value if the

financial statement continued to look good, and one way to make

that financial statement look good was with all these transactions

that we have heard about.

So does that fact not create some subtle, maybe not-so-subtle,

pressure on Board members to go along with the idea that it is the

stock price which is the end-all and be-all, and that is so affected

by the bottom line on a financial statement, then to go along with

accounting standards which are pushing the envelope? That is my

question, Mr. Elson.

Mr. ELSON. Sure. Let me answer in two parts. Part one, share

amount. This is pretty good work here. This is a lot of compensation for being a director. You know the old joke, good work if you

can get it. Three or four hundred thousand dollars a year is quite

a bit for directors. That is quite a bit over the norm in companies

of this size and scale. These compensation amounts would put the

Directors of Enron certainly in the top quartile, or probably higher,

vis-a-vis similar compensated U.S. directors.

The problem with paying a director too much is an obvious one.

If management, as in many companies—I am going to speak generically—controls the proxy process and the compensation scheme

for the directors becomes too high, the fear is the director, because

of the income stream the director is receiving from serving as director becomes so great, that to object to a management proposal and

potentially court non-renomination would not be in the director’s

best financial interest, and that is where compensation that is too

out-of-the-ballpark, if you will, for a director is problematic.

These numbers undoubtedly placed this Board pretty far up

there in the grand compensation scheme. Again, most of the value

was in stock options, but their cash compensation was not small.

It was pretty high, too. But clearly, the real value was in the options.

So the second part of your question, does giving director options

make a director more likely to take risks, if you will, financial

risks, again, that is a two-part answer. I have never been a big fan

of options. I think they are useful in certain circumstances. I think

they are problematic because, traditionally, you cannot charge—

you do not charge them against earnings. I think there is a bill

111

floating around that, Senator Levin, you have been involved in that

would require that there be some charge for granting options. I

think when you cannot charge them against earnings, people are

a lot freer with them than they would ordinarily be if they had to

give restricted stock and they give more of them.

The problem with an option is it has a geometric upside to it, if

you work out the math, even based on mediocre performance of a

company, and that, to me, is problematic. There is no real downside. The worst you can lose is the expectancy of great riches.

There is no real sting on the down. They simply become worthless.

Stock is a different incentive. If a stock falls, you actually have a

wealth decline on the part of the holder of the stock. In this case,

they got a lot of options, and again, the weakness of options, I

think, of potential on the upside rather than on the down, certainly

comes out here.

But your question on does it make you more risky, only if—— Senator LEVIN. Not quite.

Mr. ELSON. Yes?

Senator LEVIN. Does it make it more likely that you would go

along with pushing the envelope on accounting standards which

have the effect of raising that stock price and then raising your option amount? Does that make it more likely or not?

Mr. ELSON. Only if you can sell the stock underlying the option

relatively quickly. I mean, I have always believed that directors

should not sell their stock while they serve on the board unless

there is a very unusual circumstance. In other words, as long as

you are a director, you have got to hold company stock. You cannot

be in the business of selling stock.

I think the ability to sell your stock or exercise an option shortterm and sell it is problematic because there is the risk of the informational disadvantage, if you will. I know that bad things are

going to happen. I push the stock price up. I sell, and then when

the bad things happen, I am long gone and I have taken my profit.

That is the risk.

That really does not have to do with the option, the grant of the

option. It really has to do with the ability to sell the option or exercise the option and sell the stock quickly, or if you give a director

restricted stock, the ability for the director to sell that restricted

stock while that director serves on the board.

I think that is the real issue. It has got to be, and my remarks

earlier had to do with long-term equity holdings. If you give someone stock and give them the ability to sell it quickly, then you have

got a real problem. One, you have got that insider trading potential. And two, it is not very good to the public for a director to say,

gee, I think I have found a better place for my money and it is not

on the company on whose board I sit. It does not look very good.

For that reason, I think the stock holdings have to be long-term.

So in the short, I do not think the fact that they gave options

was problematic here vis-a-vis the question you asked, if, in fact,

you required that the stock underlying the options be held longterm.

Senator LEVIN. So that would cure whatever problem there is

that I have described—— Mr. ELSON. Yes. I just do not like options.

112

Senator LEVIN [continuing]. That prohibition. But there is no

such prohibition, is there?

Mr. ELSON. No, sir.

Senator LEVIN. OK. Now, Mr. Campbell, do you have any comment on that?

Mr. CAMPBELL. I agree that these numbers are high, and, in fact,

if you look at it, this is for year 2000, so if you have multiple years

of compensation and multiple stock options, then they could be

multiples of this. I have never felt that options for directors are appropriate for the exact reasons that Mr. Elson said.

And I would just point out to the Subcommittee that as you are

thinking about where to go from here, part of problem, I am going

to lay at the feet of compensation consults, which invariably come

in and tell board compensation committees, if you want to compensate either your directors or your senior executives and your

CEO at the 75th percentile range or level, then this is what you

need to do. And then they go on to the next company and give the

same talk. That becomes a one-way ratchet and it has occurred

here over the past decade that is off the top of the scale, and I

think we really need to get back to thinking about how do we determine what is really competitive out there.

Senator LEVIN. It is a very important issue and it is essential

that dialogue occur, one way or another.

Mr. Sutton, do you have any comment on this question?

Mr. SUTTON. I do not disagree with anything that either of them

has said. I would just add a thought that while I am not an expert

in ethics, I have done considerable study in connection with the

work at the Commission on Auditor Independence Issues. I would

observe that whether it is selling, the pressures to sell non-auditing

services, whether it is incentives by directors to enter into consulting arrangements, or whether it is what is perceived to be excessive compensation, those arrangements can create incentives

that can interfere with otherwise expected independent behavior.

Ethicists sometimes call that ‘‘gray blindness,’’ meaning that

once you get so co-opted, you cannot tell the difference between

black and white anymore, and there is that risk. Other incentives

can give rise to it, but certainly financial incentives can.

Senator LEVIN. You all have added a very important dimension

to this hearing and to our investigation. The Congress really has

a very heavy responsibility that we are addressing, but we are

playing just a partial role in implementing and taking care of the

problems. But your participation—your staying power is very much

appreciated, and your very thoughtful written testimony, which

will be made part of the record, and your comments in response to

questions are very much appreciated.

Mr. Elson, regards from Senator Carper. He had to go and preside this afternoon or else he would have been here to ask questions.

Mr. ELSON. Thank you.

Senator LEVIN. I want to thank my staff for the enormous effort

they put into going through all of these documents.

We will stand adjourned. Thank you all.

[Whereupon, at 4:55 p.m., the Subcommittee was adjourned.]

(113)

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Æ