Memo Warned of Enron’s Setup Being Seen as ‘Hoax’
A detailed road map of Enron Corp.’s aggressive accounting maneuvers and an uncannily accurate prediction of the company’s collapse were laid before Enron Chairman Kenneth L. Lay in August in a lengthy memo that became public Tuesday.
Excerpts of the memo had been released by congressional investigators Monday, but the full extent of the warnings became known only Tuesday with the release of the entire text.
The author of the memo, Sherron Watkins, 42, expressed concern that the company’s vaunted business success would eventually become considered “nothing but an elaborate accounting hoax.” Watkins, a vice president of corporate development at Enron, worked directly under the architect of Enron’s complex and highly questionable financial dealings.
Watkins focused particularly on what were known as the “Raptor” transactions, in which Enron transferred several marginal investments to a putatively independent partnership. The partnership had gone virtually bankrupt by last summer, but Enron still was not disclosing the loss to shareholders, Watkins said.
The full text suggests that Watkins did not believe she was telling Lay much that he did not already know--and that many of the company’s financial transactions were mere accounting shams.
She attempted to persuade Lay either to reverse the offending transactions promptly or to disclose them fully to shareholders and “develop damage containment plans.” Lay did neither.
“Her motivation is not vindication or being proven right or bringing down the company,” her husband, Richard, said Tuesday from the family home in Houston. “She’s a team player.”
Watkins went to work at Enron Tuesday morning as news of her memo was splashed across the front pages.
“It’s a normal day,” said her lawyer, Philip Hilder, although he acknowledged that “it’s very difficult for anybody to go to work under these circumstances.”
Watkins has suffered no retaliation from anyone at the company, the lawyer said, although a source close to her said Watkins has been made to feel “an outcast.”
Sherron Watkins, the daughter of two secondary school educators, grew up in the distant Houston suburb of Tomball and graduated from the University of Texas.
Tuesday morning, television news trucks jammed the street in front of the Watkins home. Later that day, Richard Watkins praised his wife for doing “something quite courageous. She has the strength of her convictions. But she’s very vulnerable.”
A neighbor said the hint of moral indignation in Watkins’ memo to Lay was genuine.
“Clearly she thought it was her moral and professional duty to do what she did,” said Carrie Wood, who also was Watkins’ sorority sister at UT. “Sherron was drawn to the dynamic intellectual challenge of being an Enron vice president. I don’t think she was drawn to the materialistic greed that sprang out of it.”
Word of Enron’s accounting irregularities leaked out slowly during the fall, depressing the company’s already-dropping stock price. Its businesses destroyed and its reputation in tatters, Enron finally filed for Chapter 11 bankruptcy protection Dec. 2.
Watkins wrote her memo on the heels of the surprise resignation Aug. 14 of Enron Chief Executive Jeffrey K. Skilling. The corporate announcement of Skilling’s departure ascribed it to “personal reasons.”
But to Watkins and others inside the company, the move hinted at his deep unease at the accounting irregularities and presaged a difficult period of public scrutiny.
“I think he . . . looked down the road and knew this stuff was unfixable, and would rather abandon ship now than resign in shame in 2 years,” she wrote to Lay. Moreover, she warned, “the probability of discovery significantly increased with Skillings’s shocking departure. Too many people are looking for a smoking gun.”
Many of Enron’s financial maneuvers would not bear that scrutiny, she said, even though they had been formally approved byEnron’s outside auditor, Andersen, formerly known as Arthur Andersen.
‘We’re Such a Crooked Company’
This particularly applied to deals Enron had made with LJM, a partnership that had been set up to trade with Enron and was managed by Enron Chief Financial Officer Andrew S. Fastow. The goal was to move debt and other liabilities off Enron’s books, where they would have a negative effect on the company’s financial picture, and park them with a putatively independent company. As long as these liabilities remained secret, Enron’s reputation, and its stock price, remained buoyant.
The LJM deals inspired deep unease within Enron, Watkins related, quoting one colleague remarking: “I know it would be devastating to all of us but I wish we would get caught. We’re such a crooked company.”
Lay responded to Watkins’ letter by meeting with her personally and persuading the Enron board to commission an internal review by Vinson & Elkins, one of Enron’s Houston law firms.
Robert S. Bennett, Enron’s Washington attorney, defended the company’s response. The nine-page review of Watkins’ concerns by Vinson & Elkins issued Oct. 15 shows “the good faith of Ken Lay and the company. . . . It shows that they meaningfully looked into this.”
Bennett said the law firm interviewed Watkins but that it put “a lot of faith in Arthur Andersen.”
Watkins, however, had specifically warned Lay against allowing Vinson & Elkins to conduct the investigation.
“Can’t use V&E; due to conflict,” she wrote in her memo. “They provided some true sale opinions on some of the deals.”
In other words, she argued that the firm would be ruling on the propriety of legal opinions it had itself issued.
Moreover, the law firm said in its report, written by Vinson partner Max Hendrick III and addressed to Enron General Counsel James V. Derrick Jr., that it was specifically instructed by Enron not to “second guess . . . the accounting advice and treatment” provided by Andersen. The report stated that Enron and Andersen representatives acknowledged that the accounting treatment of the suspect transactions “is creative and aggressive,” but it did not conclude that it was “inappropriate from a technical standpoint.”
Vinson & Elkins spokesman Joe Householder declined to discuss whether it was a conflict of interest for the firm to investigate Watkins’ allegations.
“We are not in a position to talk about our engagements with Enron or any other client,” he said.
As it happens, the firm overruled almost all of Watkins’ substantive objections to the LJM transactions, although it did acknowledge some “awkwardness” arising from LJM’s executives serving as Enron officers.
“Transactions were negotiated between Enron employees acting [for] Enron and other Enron employees acting for LJM,” the law firm’s report stated.
It also noted that within Enron there was widespread suspicion that the Enron employees representing LJM were enjoying special perquisites, including higher compensation. But it said the awkwardness would be eliminated in the future because LJM executives were leaving the Enron payroll and relocating their offices from its headquarters building.
Focus on the ‘Raptor’ Deals
The report did, however, provide indirect evidence of Enron’s custom of minimizing the public disclosure of the nature of its financial maneuvers. Among other things, the company gave its outside lawyers little opportunity to examine closely the financial reports and other documents it was releasing for public consumption.
“Enron’s practice is to provide its financial statements and disclosure materials to V&E; with a relatively short time frame within which to respond with comments,” the report stated.
In her memo, Watkins focused most heavily on several transactions between Enron and LJM known as the Raptor deals. The term referred to a special business entity that Enron had established to hold several investments that were expensive and of possibly marginal value, including ownership in a broadband communications company called Rhythms NetConnections and other technology and energy companies.
To cover the LJM-Raptor acquisition of the investments, Enron pledged shares of its own stock and that of some of its subsidiaries. But it also engaged in a series of complicated derivatives deals aimed at hedging the possibility that the value of Rhythms and the other assets would fall.
In 2000, Watkins noted, Enron went as far as to record more than $500 million in revenue from those derivatives deals. That, she said, presented numerous problems.
For one thing, Enron had not received the $500 million from LJM. Rather, the payment was conditioned on the value of the underlying investments remaining high; if the investments deteriorated, there was an increasing chance that Enron would never receive the money.
Further, it was likely that a truly independent company would not have paid anywhere near $500 million for the investments at issue--meaning that the deal was not legitimately an arm’s-length sale.
Vinson & Elkins acknowledged this, noting in its report that LJM “permitted Enron to close transactions that otherwise could not have been accomplished.”
In fact, as the value of the investments dropped, Enron was obligated to make up the difference by paying LJM more of its own stock.
Throughout 2001 the underlying investments did fall in value--and so did the value of Enron stock. That meant the company had to contribute vastly more shares to LJM than it ever anticipated. That was a contingency that was never fully disclosed to the public or Enron’s shareholders, who stood to lose value in their own shares as more were pledged to LJM.
“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,” Watkins wrote.
Not until Nov. 8 did Enron fully disclose the nature of the Raptor deals--as part of its public announcement that the improper accounting of those transactions and others resulted in its overstating its earnings by $586 million over a nearly five-year period.
The announcement all but destroyed any chance that the company would be able to survive in its existing form.
Addiction to Accounting Tricks
Enron critic Mark Roberts, president of Off Wall Street Consulting Group, a Cambridge, Mass.-based stock research firm, said the Watkins memo adds to the evidence of Enron’s addiction to illegitimate accounting tricks.
The Raptor deals were derivative transactions “with recourse,” meaning deals in which the counter-party would be compensated for any losses, he noted in an interview.
“If the buyer doesn’t have risk, the risk stays with Enron and has to be reflected on their balance sheet,” said Roberts, whose firm sold Enron shares “short,” a bet that they would fall, as early as last May.
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Excerpts From Enron Memo
Highlights of letter from Enron Vice President Sherron Watkins to Chairman Kenneth L. Lay.
THE INTRO
residentresidentDear Mr. Lay,
Has Enron become a risky place to work? For those of us who didnearst get rich over the last few years, can we afford to stay? [Chief Executive Jeffrey] Skillingearss abrupt departure will raise suspicions of accounting improprieties and valuation issues. . . .earsears ..TE: MORE ON SKILLING
residentresidentMy 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successses as nothing but an elaborate accounting hoax. Skilling is resigning now . . . but I think he knew this stuff was unfixible and would rather abandon ship now than resign in shame in 2 years.earsears ..TE: ON IMPENDING SCRUTINY
residentresidentI 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.earsears
ON EMPLOYEE BACKLASH residentresidentI have heard one manager level employee from the [principal] investments group say residentI know it would be devastating to all of us, but I wish we would get caught. Weearsre such a crooked company.ears earsears ..TE: ON THE INVESTIGATION
residentresidentToo many people are looking for a smoking gun.earsears
Full text of the Watkins letter is at latimes.com/enronletter.
Other documents and background are at latimes.com/enron
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Hiltzik reported from Los Angeles, Streitfeld from Houston. Times staff writers Richard Simon in Washington, Nancy Rivera Brooks in Los Angeles and Thomas S. Mulligan in New York contributed to this report.
