Concerns Grow Amid Conflicts
[The 3rd article in a new Washington Post series on 'The Fall of Enron']
Officials Seek to Limit Probe, Fallout of Deals
By Peter Behr and April Witt
Washington Post Staff Writers
Tuesday, July 30, 2002; Page A01
David B. Duncan, the Arthur Andersen LLP partner in charge of the Enron Corp. audit team, had reason to be nervous when he sat down with two lawyers from a prominent Houston law firm, Vinson & Elkins LLP, on Sept. 5, 2001.
Enron Chairman Kenneth L. Lay had hired the lawyers from Enron's leading outside law firm to look into allegations of deceptive bookkeeping, corrupting conflicts of interest and hidden partnership investments gone dangerously awry.
Sherron Watkins, an Enron vice president and an accountant, put the allegations in an Aug. 15 memo to Lay. They were aimed right at Duncan, 43, a rising star at Andersen who made $700,000 a year. His audit team had approved the risky partnership investments that propped up Enron's finances.
He had reason to be nervous, but he gave composed and reassuring answers.
There was no problem with Enron's accounting, Duncan told the lawyers.
While some of the accounting that troubled Watkins "may look facially questionable, it satisfies the technical requirements," Duncan told V&E lawyers Joseph C. Dilg and Max Hendrick III.
"Unique control features" are in place to protect Enron, top-drawer consultants had reviewed the deals for fairness and decision-makers "from the highest levels" of Enron had approved them, Duncan said.
Duncan didn't mention important facts. Watkins's allegations had reignited a serious dispute inside the accounting firm. Senior experts at the firm complained that Duncan's team had used improper accounting in approving the partnership investments code named the Raptors -- just as Watkins had alleged -- and then created a false paper trail to justify their actions, according to internal Andersen memos.
Duncan said nothing about that in his interview, according to the lawyers' notes.
'A Whitewash'
Five days later the two lawyers met with Watkins. She repeated the outlines of the calamity she had described to Lay:
The Raptors were failing and Enron would be faced with huge losses -- $500 million was at risk. Enron's chief financial officer, Andrew S. Fastow, ran the outside partnership that had created the Raptors with Enron, a conflict of interest that the company's board had approved. Fastow was "blackmailing" banks to invest in the partnership, known as LJM2, and getting rich.
Watkins gave Dilg and Hendrick the names of five Enron executives and managers they should interview. The lawyers didn't question any of them, according to records V&E later released to Congress.
A few days later, the law firm reported to Lay that no further investigation was necessary.
The deals that troubled Watkins did have "bad cosmetics" and carried "a serious risk of adverse publicity and litigation," V&E would write in a private report to Enron.
Still, "The facts disclosed through our preliminary investigation do not, in our judgment, warrant a further widespread investigation by independent counsel and auditors."
Enron's investigation of itself was over almost before it began.
David Stulb, the head of Andersen's New York-based investigative unit, was later called to Houston to help with the Enron situation. He looked at the V&E report and said: "It's a whitewash."
Watkins had urged Lay not to hire Vinson & Elkins to investigate her concerns because its lawyers had worked on some of the very deals she challenged. Dilg, who was running the investigation, was the point man for V&E on the Enron account -- which paid the firm $35 million that year.
But Lay not only hired V&E, he authorized the firm to conduct a limited, preliminary inquiry that would neither "second guess" Enron's accounting nor engage in a full-scale independent examination of company documents, a report by the law firm later said.
V&E lawyer Harry M. Reasoner, former managing partner, defended his firm's work. "We were not given the opportunity to do due diligence," Reasoner said, noting that his firm's lawyers had not had unfettered access to Enron employees and records. "You go back to Plato's question of who watched the watchers? You have to be able to trust somebody. In our investigation, Enron made the determination that they could rely on Arthur Andersen's accounting. That seemed very reasonable to us."
Duncan's reference to "control features" and approval from the "highest levels" amounted to the unspooling of a long alibi chain. Everybody associated with Enron was covered -- the lawyers, the accountants, the executives and members of the board. Each could argue they had relied upon the advice and actions of the others as they went along with the deals being questioned.
Watkins had warned that nothing less than a full investigation could save the company. The alibi chain would not hold.
"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," Watkins, a former Andersen accountant, had cautioned in her memo. "None of that will protect Enron if these transactions are ever disclosed in the bright light of day."
Incapable of Deceit
Ken Lay was ill-prepared to manage the kind of crisis that Enron now faced. Lay, 59, had a PhD in economics from the University of Houston and a national reputation as a business innovator. He was deeply involved in some of Enron's biggest challenges, including the California energy crisis and its troubled power project in India. But he had not really run Enron's daily operations since the early 1990s.
By September 2001, he was more accustomed to striding the corridors of power than handling the controls of a Fortune 500 company.
In Enron's early years, he turned day-to-day management over to Richard D. Kinder, a lawyer with an exacting eye for costs. Kinder was nuts and bolts; Lay was big-picture. Both agreed that ultimate success depended on Wall Street, not the oil patch.
To keep its stock price high, Enron had to meet Wall Street's profit expectations.
Kinder was the stern taskmaster who implemented the Wall Street strategy.
"He would be screaming at us," recalled David G. Woytek, an accountant and former vice president for finance. " 'How can your earnings be down!' Everyone was intimidated. Even if prices were down, somehow you had to come up with earnings . . . because we can't disappoint the Street."
Even in its early years, Enron relied on some aggressive accounting to boost its reported earnings, Woytek said. "So many people would look the other way," said Woytek, who complained and was eventually pushed out. "I got ulcers."
Kinder, who left Enron in 1996, declined through a spokesman to comment on his tenure at the company.
As Kinder minded the store, Lay increasingly looked outward. He became known as a powerful lobbyist and prolific fundraiser for political and charitable causes. He enjoyed the perks of power.
He wanted everything to be first-class. Michael Muckleroy, former chairman of Enron Liquid Fuels Inc., once occupied one of the four corner offices on the 50th floor of Enron's headquarters in Houston, a mirror image of Lay's. A self-described "plug horse," Muckleroy was so embarrassed by the grandiosity of his top-floor office, with its 23-foot high ceiling, that he refused to meet clients and vendors there.
Lay moved steadily to the top of Houston's business and civic elite.
"Nothing of significance that was going on in Houston was not touched by Enron and Ken Lay," said James D. Calaway, president of the Center for Houston's Future, a civic organization.
When James W. Crownover, a former McKinsey & Co. executive in Houston, headed the city's United Way campaign in 2000, he asked Lay to take charge of major gifts. "He gave $100,000 and challenged five other people to do the same, which they did."
Willie J. Alexander, an African American owner of a small human resources consulting firm, didn't crack Houston's stratified business establishment until he met Lay through Republican Party activities.
Lay became Alexander's mentor, arranged consulting contracts with Enron and sat down with him once a year for brainstorming sessions. To Alexander, Lay was caring, spiritual and incapable of deceit.
'I Need Their Earnings'
Lay's record at Enron was not so spotless.
At various times over the years, Enron's affable founder had ignored warnings, sidestepped problems and tolerated misdeeds, former executives said.
Fifteen years earlier, Muckleroy warned that two Enron executives working out of an office in Valhalla, N.Y., were making oil trades far larger than Enron had authorized.
But Lay brushed him off, Muckleroy said. "Ken was the kind of fellow, he did not like dissension. He did not like hostility. He did not like facing up to the music."
Eventually, internal auditors substantiated reports of fraudulent trading, but Lay wouldn't fire the traders. That shocked and angered Woytek, one of the internal auditors. "I was in the audit committee of the board of directors," Woytek recalled, "when Ken Lay said, 'I have decided not to terminate them. Instead we are going to put in controls to keep this from happening in the future. . . . I need their earnings.' "
Lay didn't fire the trading executives until their operation came up more than 50 million barrels of oil short and cost the company roughly $140 million, almost destroying Enron, Muckleroy and other former executives said. The traders pleaded guilty to fraud and tax evasion.
In a written response to The Washington Post, Lay's spokeswoman, Kelly Kimberly, did not address Woytek's account of that meeting. But she noted that Lay and Enron's board responded to early signs of trouble in Valhalla by auditing the operation repeatedly.
James Alexander, former chief financial officer of Enron Global Power & Pipelines LLC, recounted another incident.
In 1995, he heard that employees who closed energy deals received bonuses based on their own dubious estimates of future profitability.
"Effectively, they could get away with whatever numbers they felt like," Alexander said.
When he approached Lay, he "didn't react at all," Alexander said. "He said, 'We'll have to talk to Rich [Kinder] about this.' . . . They say they investigated it. I never heard about it again."
Alexander said people were subsequently transferred out of his division, and he left Enron in 1996.
"Ken has always been hands off even in his best days," he said. "My surmise is he didn't want to be informed. His attitude was, 'I don't want to know.' "
Lay's spokeswoman responded that "to his knowledge, the matter was referred to Mr. Kinder, who did investigate the concerns. Mr. Lay is not aware of any retaliation against Mr. Alexander."
Eight Dollars Away
The Sept. 11 terrorists attacks on New York and Washington killed more than 3,000 people, stunned the nation and shut down Wall Street for four days. When trading resumed on the 17th, stock prices plunged. The Dow Jones industrial average lost more than 684 points.
Anxiety was general, but Enron had particular reason to worry.
Enron had committed 30 million shares worth about $2 billion to the LJM2/Raptor deals. By using the Raptors as hedges, Enron had protected more than $1 billion in profits it had already reported on its portfolio of start-up companies' stocks.
But the Raptors had been continually on the verge of failure because the Enron stock that supported them had been falling in value all year. Under its agreement with LJM2, Enron had to pledge more stock to the deals to prop them up.
Now the post-Sept. 11 stock drop threatened catastrophe.
If the stock price dropped below $20 a share, the obligation to the Raptors would become so great that the company would not have enough available shares to honor its pledge.
For every dollar the stock dropped below $20, Enron would be facing $124 million in losses, according to an internal Enron document.
On Sept. 18, Enron shares closed at $28.08. Disaster was eight dollars and change away.
Enron and its auditor were facing that disaster together.
The relationship was so close that Andersen's partners working on Enron had offices in the client's 1400 Smith St. tower alongside their Enron counterparts. Eighty-six Andersen people had left the firm to work for Enron since 1989. Among them: Watkins and Chief Accounting Officer Richard A. Causey, Duncan's regular golfing buddy. People at Enron referred to Andersen as "Enron Prep."
Causey described the relationship as a kind of collaboration, saying Andersen "gets all the documents and they walk down the path with Enron all the way." He liked to brag that Enron was so nakedly honest with its accountants that their relationship was "open kimono."
In fact, Andersen auditors had long been signing off on Enron accounting practices that pushed the envelope. And in some cases in-house experts said the Enron audit team had gone over the line, according to internal Andersen e-mails. Duncan and other Andersen partners later testified that their accounting decisions were not illegal or fraudulent.
When disputes arose -- particularly on the Raptors transactions -- Enron executives expected to get their own way, Andersen partners complained. Some described Enron's aggressive attitude as the "push back."
Patricia Grutzmacher, an Andersen employee, would later testify that she was told not to press her challenge to an Enron action. "It is what it is," she said a superior told her. "The higher-ups [at Enron] had already decided that it was going to be done."
Andersen's attitude changed when word of Sherron Watkins's warning reached the firm. Andersen was soon engaged in tense self-examination and finger-pointing.
'Intelligent Gambling'
Andersen experts had long expressed concern about Enron's accounting.
In February 1999, at a meeting of the Enron board of directors' audit committee in the Four Seasons Hotel in London, Duncan gave a detailed presentation on Enron's accounting, saying it was "high risk" in several categories with a high probability it could be questioned.
"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," Duncan wrote on the margin of one of his presentation papers.
Two years later, on Feb. 5, 2001, 14 Andersen senior partners gathered by teleconference to discuss whether Enron was too risky a client to keep. A memo written the next day recited the concerns: Fastow's conflict of interest with LJM; Enron's reliance on LJM to meet the financial targets demanded by Wall Street; and Enron's use of "mark-to-market" accounting, which allowed arbitrary estimates of future-year profits to be counted as current income. Andersen partners called this practice "intelligent gambling."
They also discussed whether their fees -- at the time $50 million year -- compromised their independence. They noted, "It would not be unforeseeable that fees could reach a $100 million per year amount."
In the end, Andersen kept the client. The firm concluded that "it appeared that we had the appropriate people and processes in place to serve Enron and manage our engagement risks," the memo stated.
A $710 Million Loss
By September 2001, the Enron-Andersen relationship was coming apart under the combined pressures of Sherron Watkins and the failing Raptor investment vehicles.
When the Raptors had gotten in trouble earlier, Enron and Anderson had always been able to come up with accounting and financing solutions.
Duncan's team had approved these fixes, most recently in March 2001, overriding the unit of senior partners named the Professional Services Group, which concluded that the solutions violated accounting rules. The PSG experts didn't like a temporary fix that "cross-collateralized" -- or linked -- the debts and assets of all four Raptors vehicles, but only for 45 days.
"I did not see any way this worked," Carl E. Bass, an accounting expert with the PSG, wrote on March 4, 2001. "In effect, it was heads I win, tails you lose."
Inside Andersen, the PSG's word was supposed to carry the day. But Duncan's team had sided with Enron.
After too many "fiesty" memos, Causey got Andersen to remove Bass in March 2001 from his oversight role on the Enron audit, Andersen partners confirm. The action angered and embarrassed Bass.
Now Watkins's memo raised the specter of public exposure of the accounting issues. Andersen's top partners took another look at the Raptors in September and, seeing the same facts, reached a different conclusion.
Operating in the climate created by Watkins, the firm reversed course and backed the PSG experts: Bass and the PSG team had been right; the Raptor fixes were improper.
As the Andersen partners pored over the Raptor files, Bass and the PSG made a stunning discovery: their original objections had been omitted from official memos, giving the appearance of a tacit endorsement.
When Andersen communicated its new opinion of the Raptors to Enron in September, it left Enron with few options, none of them good.
Andersen "made several key changes to the guidance that they originally provided" on the Raptors formation and the March 2001 fix of the Raptors, an internal Enron memo stated.
On Sept. 18, Causey briefed Lay and Enron's new chief operating officer, Greg Whalley, about the growing Raptor crisis. Whalley urged Lay to simply shut the Raptors down, and Lay agreed. The decision meant that Enron would be forced to report a $710 million pretax loss -- $544 million after taxes -- for the financial quarter ending in 12 days.
There was more bad news. Andersen, in its search through the Raptor files, had discovered it had made an unrelated error. Enron would have to acknowledge that it had overstated the value of its business to its shareholders -- its net worth -- by $1.2 billion when it fixed the Raptors in the spring of 2001. But Enron executives and Andersen partners agreed that the error wasn't material because it was a net zero -- merely removing equity that had never been there in the first place.
Andersen accountants were getting stricter on a number of accounting fronts in September 2001. In addition to its Raptors reversals, the accounting firm was zeroing in on a crucial Enron strategy used to raise cash.
The firm's accountants seemed to be worried about Enron's extensive use of "prepay" financing -- cash that Enron received from J.P. Morgan Chase & Co. through an off-shore company named Mahonia.
At the time, Enron listed the Mahonia deals on its books as energy transactions, but they were in effect loans from the bank that Enron did not disclose, Senate investigators later contended. Bank officials stated that Mahonia was created to carry out these transactions and is legally independent from the bank.
Andersen was insisting that Enron have documentation showing that Mahonia was independent of the bank, a required condition for that kind of deal.
"Andersen is pushing back," Enron employee Michael Garberding said in a taped telephone call that month with bank officials.
In the same conversation, another Enron official said the bank should "make sure that Mahonia seems independent." A third executive told the bankers to ensure that the paperwork in the deal "doesn't have Chase showing up anywhere on the fax letterhead."
The 'Stretch'
On Sept. 19, Causey began a long-scheduled off-site brainstorming session at a Galveston, Tex., hotel with his staff. He calmly conducted business as usual, recalled Robert J. Hermann, then the company's top tax attorney and a managing director.
In preparation for the meeting, Causey handed out articles about the role of the chief financial officer in corporate life. Reading them, it was clear to Hermann that Enron didn't have a real CFO, someone responsible for all company finances including the accounting and income statements. Enron just had someone with the title: Fastow.
"I realized that there was nobody doing any planning in that company," Hermann said. "They were just managing it day to day and trying to get earnings for the quarter."
Hermann, like other senior executives, was under constant pressure to produce income to help Enron meet its earnings targets.
Hermann called it "the stretch" -- the gap between the sum managers knew they could deliver to the bottom line and what the bosses demanded.
By mid-September, the stretch had become intolerable. Hermann resolved to take the problem to Lay.
His tax department made a huge and unique contribution to Enron's bottom line. Members of his staff, working with some of the most prominent banks and law firms in the nation, engineered a series of intricate tax-reduction transactions that had boosted Enron's reported profits by nearly $1 billion between 1995 and 2000.
The exotic deals were crafted to comply with the U.S. tax code, Hermann said. Former Enron chief executive Jeffrey K. Skilling approved them in small meetings attended by Hermann, Causey and another Enron tax attorney, Hermann said. The company disclosed the transactions, if somewhat cryptically, in footnotes to its financial statements.
But the magnitude of the tax department's contribution to reported earnings was a closely held secret, even inside Enron. When a tax lawyer generated a bar graph illustrating the combined impact of the deals, Causey ordered him not to disseminate it, Hermann said.
In 2000 alone, $296 million, or 30 percent of the profit that Enron recorded in its annual report to shareholders, came from one-time tax-saving strategies rather than the company's energy supply and trading businesses, according to company records obtained by The Washington Post.
In one deal, code-named Teresa, Enron increased its reported profit by $225 million. At the center of the deal was a convenient circularity: Enron lent itself money to boost its investment in its headquarters building so it could claim a huge depreciation deduction. Investors reading Enron's financial statements could not detect that this one-time windfall had not come from its business operations.
By September 2001, Hermann felt the pressure to do more had gotten out of hand. So many business divisions at Enron had failed to meet their earnings targets that Causey asked if the tax department could double its 2001 contribution to $600 million, Hermann said.
Although he figured he could pull it off, he wondered why he should have to. Somebody at Enron should be figuring out how to make real money.
He telephoned Lay's secretary and asked for an appointment to talk about what was happening in the tax department and beyond.
"Every damn year the stretch kept going up," Hermann would later explain. "It just kept getting bigger and bigger. That to me was evidence of the fact we don't know what we're doing here. It bothered me. I wanted to tell him what was happening."
A week went by. Lay's secretary called Hermann back and said Mr. Lay was busy and would be unable to meet with him.
Hermann wondered: Unable or unwilling?
Lay's spokeswoman said recently that Lay has an open-door policy and "did attempt to set a meeting, but their calendars could not be matched for quite some time."
Life Savings
On the morning of Sept. 26, Lay led an Internet chat with Enron employees, many of whom had their life savings tied up in company stock. At the beginning of the year, Enron's 401(k) employee savings plan had $2.1 billion in assets -- two-thirds of it Enron stock.
The stock had dropped to $25 a share from $90 a year before.
Lay said he was buying Enron stock and urged his workers to do the same.
He did not mention that he had transfered 556,055 shares to Enron in August and September to repay $20 million in cash advances from the company. That year, his total compensation was $103,559,793 in salary, bonuses, incentives, annuities and cash advances. (Lay said he received $234,139,766 from sales of Enron stock between 1998 and late 2001.)
"My personal belief is that Enron stock is an incredible bargain at current prices, and we will look back in a couple of years from now and see the great opportunity that we currently have," Lay told employees.
Lay later said through a spokeswoman that he did not mislead the employees and still owns more than 1.2 million shares of Enron stock, which has lost nearly all its value.
'We'll Be Honest'
As Enron raced to shut down the Raptor transactions by the end of quarter, Vince Kaminski discovered that Enron's finance department had deceived his research team about the deals. He was livid.
Kaminski supervised a team of finance whizzes who calculated the likely future gains and losses in stock and commodities trading. They took great professional pride in getting their numbers right. They were Enron's monks, removed from the company's super-competitive deal-making environment.
Kaminski had never liked Enron's strategy of using its own stock to hedge its tech investments in deals with Fastow's private partnerships. He thought the risk involved and Fastow's conflict of interest created a situation where "heads the partnership wins, tails Enron loses."
Now Kaminski and two of his key associates discovered that they had been given incorrect and misleading data, which had distorted some of the team's earlier analyses of the Raptors deals.
And they'd recently been asked to perform calculations on some LJM deals without being told their work related to LJM or the Raptors.
By late September, Kaminski had become uncomfortable with the entire structure of the Raptors and concluded he was dealing with an accounting scam, he and two colleagues later told investigators for Enron's board.
It was clear to Kaminski that the Raptors had been used to hide losses and engage in illegal earnings management, he said. He called it "an act of economic self-gratification."
Kaminski told his former boss, Chief Risk Officer Richard Buy, that he would not do any more Raptor or LJM work, even "if it meant he would be fired," Kaminski later told investigators.
"Buy responded that [Kaminski] would not be fired because the new post-Skilling mantra was 'We'll be honest,' " Kaminski recalled.
In response, Skilling's attorney, Bruce A. Hiler, said that "the claim that my client was involved in anything questionable or illegal -- which he was not -- is fantasy."
An Enron Ritual
The Enron deal factory was still open for business.
As the Andersen partners noted with concern earlier that year, Enron was relying on deals with its complex private partnerships and high-risk accounting maneuvers to meet its profit targets.
Most of the company's profits in 2001 came from these arcane deals, not its regular ongoing business operations, board investigators concluded.
The deal-making was particularly intense at the end of each financial quarter.
The Raptors were becoming extinct, but Enron was busy on other fronts.
With September and the third quarter winding down, Enron executives raced to get earnings and cash in ways that had worked before.
Hermann's tax department prepared new transactions to generate tax savings.
Other Enron executives contacted J.P. Morgan Chase about doing a prepay deal that would deliver $350 million to Enron before the quarter ended. An Enron manager told the bank that Enron would "take any money [it could get] now, even if it's on one-year basis," according to an e-mail obtained by Senate investigators. The prepay deal was closed on Sept. 28.
Enron had long sold off assets such as pipelines, power plants and fiber-optic networks, magnifying the gains with accounting maneuvers.
In late September, Enron finally finished negotiations with Qwest Communications International Inc. in Denver on a deal to exchange capacity on fiber-optic Internet networks and telecommunications services.
The value of those networks had plunged during a broad downturn in the telecommunications industry. The Qwest deal would cut Enron's losses on its network.
There was little if any business reason behind the exchange, one former Enron manager said. Qwest was buying non-operating network circuits from Enron that it didn't need. Enron had agreed to buy telecommunications services from Qwest over a 25-year period at a time when its own telecom operations were collapsing. Andersen was the accountant for both companies.
On the day the quarter closed, the companies finally made their deal, exchanging checks for $112 million as initial payment.
Between Friends
In shutting down the Raptor transactions, one final step remained: Enron's buyout of the banks and other investors in LJM2.
Fastow had left LJM2 two months before, selling his interest to his former Enron colleague and friend, Michael J. Kopper. Some Enron employees were puzzled at how Kopper could have afforded to buy Fastow out. But Enron's lawyers were relieved. They hoped for an end to embarrassing questions about Fastow's conflict.
That conflict hadn't disappeared entirely.
As the Raptors were closed down, Enron had to work out how much it would pay the LJM2 investors. Enron's chief negotiator in the matter was none other than Fastow, who sat across the table from Kopper, representing LJM2. Fastow and Kopper declined to be interviewed. The Raptors had already been a good deal for LJM2, whose investors had been paid $162 million -- the full amount of their initial investment plus a profit of $40 million.
But that was not enough.
The two friends, Fastow and Kopper, agreed that Enron would pay LJM2 an additional $35 million "termination fee." For Enron, the Raptors deal ended in a $544 million loss.
Heads LJM2 wins, tails Enron loses.
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Staff researchers Margot Williams and Lucy Shackelford contributed to this report.
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