The Letter to Ken Lay Text of the letter from
Enron executive Sherron Watkins to Chairman Kenneth Lay
as released by the House Energy and Commerce Committee
FORTUNE.COM
Tuesday, January 16, 2001
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Dear Mr. Lay,
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 resume, 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 5 steps he thought should be taken if he was to remain as
treasurer. 3 days later, Skilling offered him the C.E.O. spot at Enron Industrial Markets and
never addressed the 5 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 CFO 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 CFO and/or
CAO.
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 EPS
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% of
2000 IBIT, 51% of NI pretax, 33% 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."
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