Meltdown Is Deja Vu for Some at Enron

There were massive financial losses and ousted executives. Finger-pointing at the company’s auditor, Andersen, for not ringing alarm bells. An executive who warned of what could lie ahead but was unheeded.

And ultimately, a corporate collapse.

The story is Enron Corp.’s. But it is also that of MG Corp., a German conglomerate’s U.S. subsidiary that suffered its own high-profile meltdown in the early 1990s.

And in a tale of intertwining fates, Enron executives who warned about Enron’s practices last year had worked at MG and seen it all before.

Jeffrey McMahon, promoted last week to Enron president and chief operating officer, was MG’s internal auditor. In 1993, he warned his bosses of poor internal controls in the months before MG began to fall, copies of the audits obtained by The Times show.

Sherron S. Watkins, the Enron vice president whose memo to former Enron Chairman and Chief Executive Kenneth L. Lay last summer predicted the company would “implode in a wave of accounting scandals”--and pointed to McMahon as equally concerned--also had worked at MG.

That experience, according to one friend and former colleague of Watkins, helped her foresee how fast and hard Enron could fall.

The crises that battered both companies are far from identical. MG--which is still alive, but no longer owns any operating businesses--was done in by an ill-fated bet on oil futures. Enron’s slide was triggered in part when losses hidden in off-balance-sheet partnerships suddenly were disclosed.

*

Both Turned to Derivatives

But among the striking similarities is that both companies took risky forays into so-called derivatives that pushed the envelope of conventional finance, economists familiar with the companies said.

Derivatives are financial contracts whose value is derived from the price of an underlying stock, commodity or index. They can be used to make high-octane market bets or to hedge against market moves.

Both firms also used aggressive “mark-to-market” accounting. The goal of mark-to-market accounting is for companies to list the true value of their assets at prevailing market prices. But experts say the technique can be abused in thinly traded markets where companies can arbitrarily assign high values to their assets.

In addition, both companies displayed a hubris during their peak years that stood out against their humbling descents, one source said.

For those who were in both workplaces, the parallels are all too strong.

“I can see anyone who had been at MG saying, ‘Hey, I’ve been here before,’” said Philip K. Verleger Jr., an energy economist who served as an expert witness for MG’s parent company in the subsequent litigation. “It must have become increasingly uncomfortable.”

MG unraveled in late 1993, when a sudden plunge in world oil prices left it with gaping losses in energy derivatives.

Until that time, MG had been aggressively signing long-term contracts with energy distributors and marketers to supply them with gasoline and other oil products. Because it promised deliveries at fixed prices, MG sought to guard against a sudden rise in oil prices.

To do that, MG invested in oil futures contracts and other derivatives that would increase in value if oil prices rose. Theoretically, the gains in derivatives would offset any losses on the energy contracts. But rather than rising, oil prices sank abruptly. MG incurred steep losses on its large derivatives holdings.

*

Hypothetical Profit on Books

Meanwhile, the cash flow from the long-term contracts MG signed to supply gasoline to energy firms was dwarfed by the short-term losses on the derivatives. And in some cases, MG had structured the contracts so customers didn’t have to take any supply, or make any payments, for a decade. Yet MG already had recorded expected long-term profit from the energy-supply contracts on its books.

MG’s losses eventually reached $2.7billion. The bankruptcy of its parent, Metallgesellschaft, once Germany’s 14th-largest company, was averted only by a bailout by German banks.

The parent company underwent an aggressive restructuring and eventually liquidated its U.S. oil trading unit.

Neither Watkins nor her attorney returned calls for comment on her three-year stint at New York-based MG Corp.’s financing arm--MG Trade Finance Group--which she left in 1993 to join Enron.

Watkins was not at the center of the MG storm, which involved MG Refining & Marketing Inc. But one friend said she had mentioned her experience with that company’s debacle when sounding alarms at Enron.

McMahon was closer to the crisis. As internal auditor of MG, he issued several internal audits that raised concerns about the oil trading unit.

An August 1993 report concluded that the unit’s risk-management procedure “requires improvement” and that the overall risk-management system was “somewhat informal.”

*

Warning Ignored by Executives

Apparently referring to the increasingly large and risky derivatives positions that the unit was taking on, McMahon wrote that the exposure to losses was “much larger than anticipated in the original business plan.”

McMahon said through Enron spokesman Mark Palmer that he had attempted to alert his superiors to potential problems at the trading unit.

McMahon “found a lot of problems,” Palmer said. “They just didn’t have the governance structure to manage the trading positions.”

The audits “fell on deaf ears” until the losses mounted in late 1993, said New York attorney Bob Bernstein, who represents Metallgesellschaft, now known as MG Technologies.

“Jeff’s reports ... were quite prescient,” Bernstein said. “Was he the most important person? No. Was Jeff McMahon an important person? Yes.... He’s a person of honor and integrity who saw things that were wrong and alerted people to that.”

At Enron, McMahon has emerged as one of a handful of executives who allegedly was concerned by off-balance-sheet partnerships headed by former Chief Financial Officer Andrew S. Fastow.

According to Watkins’ memo, McMahon was “highly vexed over the inherent conflicts of [the partnerships]. He complained mightily to Jeff Skilling.”

Days later, Watkins wrote, Skilling offered McMahon a different job heading another Enron unit. With Skilling and Fastow both gone by fall, McMahon became CFO.

*

Finger-Pointing Followed Collapse

As with Enron, MG’s collapse was held forth as having broad implications for corporate governance, financial controls and derivatives trading.

There were allegations that German board members--who claimed they were kept in the dark about the U.S. trading unit’s problems--were too close to the company. Similar concerns swirl around Enron’s board.

There also were questions about accounting firm Andersen. According to published reports, the German parent pointed a finger at the firm for supporting MG’s interpretation of its numbers and replaced Andersen by 1994.

Patrick Dorton, an Andersen spokesman, said MG’s problems were due to the big swing in oil prices.

“This is simply the case of a company caught on the wrong side of a dramatic slide in oil prices, like many other companies were at that time,” Dorton said, refusing to comment further.

In Enron’s case, Andersen is under investigation for shredding Enron-related documents after the Securities and Exchange Commission had launched an investigation of the energy trader. The firm has denied that it authorized shredding.

The companies’ financial practices also bear similarities. MG has been described in academic papers as a derivatives “horror story.” Now, there are signs that in Enron’s hands derivatives evolved into tools of fiscal concealment and manipulation, some experts say, allowing Enron to inflate the value of assets while understating the risks involved.

Palmer rejected the notion that the company’s problems are tied in any way to derivatives. Enron’s trading operation suffered when the company’s credit rating was cut, not by the trading itself, which he said was profitable.

Nonetheless, both MG and Enron entered long-term contracts whose ultimate values were difficult to predict and booked the hypothetical long-term profit from those contracts in the present. That mark-to-market accounting has emerged as a trouble spot in both cases, said John Parsons, a financial economist at Charles River Associates in Boston.

“People are marking to what their own opinion is of the value,” Parsons said. If those opinions are wrong, the financial consequences can be severe.

As it turned out, Enron and MG became directly linked: Eighteen months ago, Enron bought the company’s London-based metals trading operation, and the Enron and MG logos are side by side in Madison Avenue office space.

That relationship is now ending. Sempra Energy last week announced its purchase of the metals business.

The similar fates of MG and Enron strike some observers as eerie.

“It’s almost identical,” economist Verleger said. “I think that Enron inadvertently blundered into the same corporate model that caused the collapse of MG.”