Letter from Sherron Watkins to CEO Ken Lay
Vice president/ corporate development
Aug. 14. 2001
======================================================
Has Enron become a risky place to work? For those of us who didn't get rich over the last few years, can we
afford to stay?
Skilling's abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has
been very aggressive in its accounting — most notably the Raptor transactions and the Condor vehicle. We do
have valuation issues with our international assets and possibly some of our EES MTM positions.
The spotlight will be on us, the market just can't accept that Skilling is leaving his dream job. I think that the
valuation issues can be fixed and reported with other good will write-downs to occur in 2002. How do we fix
the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to pony up Enron stock and that
won't go unnoticed.
To the layman on the street, it will look like we recognized funds flow of $800 million from merchant asset
sales in 1999 by selling to a vehicle (Condor) that we capitalized with a promise of Enron stock in later years.
Is that really funds flow or is it cash from equity issuance?
We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor. Much of that
stock has declined significantly — Avici by 98 percent from $178 million, to $5 million; the New Power
Company by 80 percent from $40 a share, to $6 a share. The value in the swaps won't be there for Raptor, so
once again Enron will issue stock to offset these losses. Raptor is an LJM entity. It sure looks to the layman on
the street that we are hiding losses in a related company and will compensate that company with Enron stock
in the future.
I am incredibly nervous that we will implode in a wave of accounting scandals. My eight years of Enron work
history will be worth nothing on my résumé, the business world will consider the past successes as nothing but
an elaborate accounting hoax. Skilling is resigning now for "personal reasons" but I would think he wasn't
having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than
resign in shame in two years.
Is there a way our accounting guru's can unwind these deals now? I have thought and thought about a way to
do this, but I keep bumping into one big problem — we booked the Condor and Raptor deals in 1999 and
2000, we enjoyed wonderfully high stock price, many executives sold stock, we then try and reverse or fix the
deals in 2001, and it's a bit like robbing the bank in one year and trying to pay it back two years later. Nice
try, but investors were hurt, they bought at $70 and $80 a share looking for $120 a share and now they're at
$38 or worse. We are under too much scrutiny and there are probably one or two disgruntled "redeployed"
employees who know enough about the "funny" accounting to get us in trouble.
What do we do? I know this question cannot be addressed in the all-employee meeting, but can you give
some assurances that you and Causey will sit down and take a good hard objective look at what is going to
happen to Condor and Raptor in 2002 and 2003?
Summary of Alleged Issues:
RAPTOR Entity was capitalized with LJM equity. That equity is at risk; however, the investment was
completely offset by a cash fee paid to LJM. If the Raptor entities go bankrupt LJM is not affected, there is no
commitment to contribute more equity.
The majority of the capitalization of the Raptor entities is some form of Enron N/P, restricted stock and stock
rights.
Enron entered into several equity derivative transactions with the Raptor entities locking in our values for
various equity investments we hold.
As disclosed in 2000, we recognized $500 million of revenue from the equity derivatives offset by market
value changes in the underlying securities.
This year, with the value of our stock declining, the underlying capitalization of the Raptor entities is declining
and credit is pushing for reserves against our MTM positions.
To avoid such a write-down or reserve in quarter one 2001, we "enhanced" the capital structure of the Raptor
vehicles, committing more ENE shares.
My understanding of the third-quarter problem is that we must "enhance" the vehicles by $250 million.
I realize that we have had a lot of smart people looking at this and a lot of accountants including AA & Co.
have blessed the accounting treatment. None of that will protect Enron if these transactions are ever disclosed
in the bright light of day. (Please review the late 90's problems of Waste Management — where AA paid
$130 million plus in litigation re questionable accounting practices.)
The overriding basic principle of accounting is that if you explain the "accounting treatment" to a man in the
street, would you influence his investing decisions? Would he sell or buy the stock based on a thorough
understanding of the facts? If so, you best present it correctly and/or change the accounting.
My concern is that the footnotes don't adequately explain the transactions. If adequately explained, the investor
would know that the "entities" described in our related party footnote are thinly capitalized, the equity holders
have no skin in the game, and all the value in the entities comes from the underlying value of the derivatives
(unfortunately in this case, a big loss) AND Enron stock and N/P. Looking at the stock we swapped, I also
don't believe any other company would have entered into the equity derivative transactions with us at the same
prices or without substantial premiums from Enron. In other words, the $500 million in revenue in 2000 would
have been much lower. How much lower?
Raptor looks to be a big bet if the underlying stocks did well, then no one would be the wiser. If Enron stock
did well, the stock issuance to these entities would decline and the transactions would be less noticeable. All
has gone against us. The stocks, most notably Hanover, the New Power Company and Avici are underwater
to great or lesser degrees.
I firmly believe that executive management of the company must have a clear and precise knowledge of these
transactions and they must have the transactions reviewed by objective experts in the fields of securities law
and accounting. I believe Ken Lay deserves the right to judge for himself what he believes the probabilities of
discovery to be and the estimated damages to the company from those discoveries and decide one of two
courses of action:
1. The probability of discovery is low enough and the estimated damage too great; therefore we find a way to
quietly and quickly reverse, unwind, write down these positions/transactions.
2. The probability of discovery is too great, the estimated damages to the company too great; therefore, we
must quantify, develop damage containment plans and disclose.
I firmly believe that the probability of discovery significantly increased with Skilling's shocking departure. Too
many people are looking for a smoking gun.
Summary of Raptor Oddities:
1. The accounting treatment looks questionable.
a. Enron booked a $500 million gain from equity derivatives from a related party.
b. That related party is thinly capitalized with no party at risk except Enron.
c. It appears Enron has supported an income statement gain by a contribution of its own shares.
One basic question: The related party entity has lost $500 million in its equity derivative transactions with
Enron. Who bears that loss? I can't find an equity or debt holder that bears that loss. Find out who will lose
this money. Who will pay for this loss at the related party entity?
If it's Enron, from our shares, then I think we do not have a fact pattern that would look good to the S.E.C. or
investors.
2. The equity derivative transactions do not appear to be at arms length.
a. Enron hedged New Power, Hanover and Avici with the related party at what now appears to be the peak
of the market. New Power and Avici have fallen away significantly since. The related party was unable to lay
off this risk. This fact pattern is once again very negative for Enron.
b. I don't think any other unrelated company would have entered into these transactions at these prices. What
else is going on here? What was the compensation to the related party to induce it to enter into such
transactions?
3. There is a veil of secrecy around LJM and Raptor. Employees question our accounting propriety
consistently and constantly. This alone is cause for concern.
a. Jeff McMahon was highly vexed over the inherent conflicts of LJM. He complained mightily to Jeff Skilling
and laid out five steps he thought should be taken if he was to remain as treasurer. Three days later, Skilling
offered him the C.E.O. spot at Enron Industrial Markets and never addressed the five steps with him.
b. Cliff Baxter complained mightily to Skilling and all who would listen about the inappropriateness of our
transactions with LJM.
c. I have heard one manager-level employee from the principal investments group say, "I know it would be
devastating to all of us, but I wish we would get caught. We're such a crooked company." The principal
investments group hedged a large number of their investments with Raptor. These people know and see a lot.
Many similar comments are made when you ask about these deals. Employees quote our C.F.O. as saying
that he has a handshake deal with Skilling that LJM will never lose money.
4. Can the general counsel of Enron audit the deal trail and the money trail between Enron and LJM/Raptor
and its principals? Can he look at LJM? At Raptor? If the C.F.O. says no, isn't that a problem?
Condor and Raptor Work:
1. Postpone decision on filling office of the chair, if the current decision includes C.F.O. and/or C.A.O.
2. Involve Jim Derrick and Rex Rogers to hire a law firm to investigate the Condor and Raptor transactions to
give Enron attorney-client privilege on the work product. (Can't use V & E due to conflict — they provided
some true sale opinions on some of the deals).
3. Law firm to hire one of the big 6, but not Arthur Andersen or PricewaterhouseCoopers due to their conflicts
of interest: AA & Co. (Enron); PWC (LJM).
4. Investigate the transactions, our accounting treatment and our future commitments to these vehicles in the
form of stock, NP, etc., For instance: In the third quarter we have a $250 million problem with Raptor 3
(NPW) if we don't "enhance" the capital structure of Raptor 3 to commit more ENE shares. By the way: in Q.
1 we enhanced the Raptor 3 deal, committing more ENE shares to avoid a write-down.
5. Develop cleanup plan:
a. Best case: Clean up quietly if possible.
b. Worst case: Quantify, develop P.R. and I.R. campaigns, customer assurance plans (don't want to go the
way of Salomon's trading shop), legal actions, severance actions, disclosure.
6. Personnel to quiz confidentially to determine if I'm all wet:
a. Jeff McMahon
b. Mark Koenig
c. Rick Buy
d. Greg Walley
To put the accounting treatment in perspective I offer the following:
1. We've contributed contingent Enron equity to the Raptor entities. Since it's contingent, we have the
consideration given and received at zero. We do, as Causey points out, include the shares in our fully diluted
computations of shares outstanding if the current economics of the deal imply that Enron will have to issue the
shares in the future. This impacts 2002-2004 earnings-per- share projections only.
2. We lost value in several equity investments in 2000, $500 million of lost value. These were fair-value
investments; we wrote them down. However, we also booked gains from our price risk management
transactions with Raptor, recording a corresponding PRM account receivable from the Raptor entities. That's
a $500 million related party transaction — it's 20 percent of 2000 IBIT, 51 percent of NI pretax, 33 percent
of NI after tax.
3. Credit reviews the underlying capitalization of Raptor, reviews the contingent shares and determines whether
the Raptor entities will have enough capital to pay Enron its $500 million when the equity derivatives expire.
4. The Raptor entities are technically bankrupt; the value of the contingent Enron shares equals or is just below
the PRM account payable that Raptor owes Enron. Raptor's inception-to-date income statement is a $500
million loss.
5. Where are the equity and debt investors that lost out? LJM is whole on a cash-on- cash basis. Where did
the $500 million in value come from? It came from Enron shares. Why haven't we booked the transaction as
$500 million in a promise of shares to the Raptor entity and $500 million of value in our "economic interests" in
these entities? Then we would have a write-down of our value in the Raptor entities. We have not booked the
latter, because we do not have to yet. Technically we can wait and face the music in 2002-2004.
6. The related party footnote tries to explain these transactions. Don't you think that several interested
companies, be they stock analysts, journalists, hedge fund managers, etc., are busy trying to discover the
reason Skilling left? Don't you think their smartest people are poring over that footnote disclosure right now? I
can just hear the discussions — "it looks like they booked a $500 million gain from this related party company
and I think, from all the undecipherable half-page on Enron's contingent contributions to this related party
entity, I think the related party entity is capitalized with Enron stock." . . . . "No, no, no, you must have it all
wrong, it can't be that, that's just too bad, too fraudulent, surely AA & Co. wouldn't let them get away with
that?" "Go back to the drawing board, it's got to be something else. But find it!" . . . . "Hey, just in case you
might be right, try and find some insiders or `redeployed' former employees to validate your theory."
Sherron S. Watkins
Vice president/ corporate development
Aug. 14. 2001 |
