enron

The Enron Saga - The Rise and Fall ______________________________________________________________________________

Abstract

It is a matter of great sadness that a company that was once recognized as pristine in the annals of corporate America is today used as an illustration of almost everything that could possibly go wrong in an organization – corporate governance or should I say misgovernance, poor risk management, lack of independence, ignorant and lackadaisical management with lack of transparency, misuse of discretion that is allowed in accounting rules and standards, weak regulatory oversight and poor auditing and process-evaluation. Even after almost five months since Enron Corporation filed for bankruptcy, I feel that we are not anywhere closer to the truth of what the entire cycle of events were than at the time the company sought protection under Chapter 11.

If asked to summarize what the crux of the problem was, I would say it is lack of control in almost every sphere. I do not think we can blame one party as the perpetrator of this collapse though senior management of the company has to take more than an equal share of blame for this episode. Regulators, lawmakers, auditors, external and internal counsel, standard-setters, analysts, investors and the market have all played a dubious role in the fall. While these constituencies have been great contributors to the economy, only the negative consequences of their actions are presented here. With the proliferation of the Internet, there is a plethora of information that is available on the Enron debacle. With governmental hearings and the news media coming up with more information every day, this paper represents an effort to fit the different pieces of the puzzle together. In some sections of the paper, I could probably be displaying a tendency towards what behavioral scientists label as “hindsight bias” or post-event rationalization.

Organization of this Paper

I start by presenting an overview of the collapse, my reason for the study and the fall timeline. I introduce Enron, the business units and the industry in brief. Subsequent to this, an analysis of the infamous off-balance sheet transactions and the role played by various groups has been presented. This is followed by a detailed section on evidence of red flags that are drawn from both financial statements, the circumstances surrounding the business and various SEC filings. Other sections are selected excerpts from Senate Committee hearings, and a critique on the views expressed by analysts. I have also included a section on post-Enron as also some primers on accounting and disclosure rules. Financial statements, tables and graphs have been used to add clarity to the document.

Acknowledgments

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I was very fortunate to work under the guidance of Maureen F McNichols, the Mariner S Eccles, Professor of Public and Private Management. Professor McNichols guided me extensively through the project, and took great efforts to help me whether it was in clarifying an accounting standard or in locating academic materials for me.

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Part I - Enron Business Overview and Strategy

History & Business Overview

Enron Corporation (“Enron”) traces its history to two well-established natural gas companies: InterNorth and Houston Natural Gas (HNG). InterNorth began in 1930 as Northern Natural Gas, a Nebraska-based gas pipeline company. By 1950, the company had doubled capacity, and in 1960, it started processing and transporting natural gas liquids. The company was renamed Inter North in 1980 and bought Belco Petroleum three years later. InterNorth also helped build the Northern Border Pipeline to link Canadian fields with US markets. HNG, formed in 1925 as a South Texas gas distributor, started developing oil and gas properties in 1953. It bought Houston Pipe Line Company in 1956 and Valley Gas Production in 1963. HNG sold its original distribution properties to Entex in 1976. In 1984 HNG, faced with a hostile takeover attempt by Coastal, brought in former Exxon executive Kenneth Lay as CEO. He refocused HNG on natural gas and added Transwestern Pipeline (California) and Florida Gas Transmission. By 1985, HNG operated the only transcontinental gas pipeline. In 1985, InterNorth bought HNG for $2.4 billion, creating the US's largest natural gas pipeline system. Ken Lay became CEO of the new company, called Enron Corporation (“Enron”), and the company moved its headquarters from Omaha to Houston. Laden with debt, Enron sold off portions of Citrus Corporation (owner of Florida Gas Transmission, 1986), Enron Cogeneration (1988), and Enron Oil & Gas (1989).

The company bought Tenneco's natural gas liquids and petrochemical operations in 1991. The next year Enron and three partners acquired control of a 4,100-mile pipeline in Argentina. Enron bought several gas businesses from gas giant Williams in 1993, and as electricity markets worldwide began deregulating, began its power marketing business. In 1997 Enron bought its own electric utility, Portland General Electric (PGE). The next year Enron began power trading in Australia, became the first power marketer in Argentina and also gained control of a Brazilian utility. The company continued to build its US portfolio in 1998, buying interests in power plants near New York City.

In 1999, the company acquired UK firm Wessex Water and formed Azurix, a global water business, to own and operate its water and wastewater assets. Enron took Azurix public in 1999, retaining a 69% stake. The same year, Enron traded most of its stake in Enron Oil & Gas (now EOG Resources) for cash and the natural gas company's properties in China and India. In 2000, Enron contributed its retail residential energy business to The New Power Company (now New Power Holdings), which would compete in deregulated US markets. It also purchased international metals marketer MG plc in a $2 billion deal.

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Enron’s rapid growth (especially between 1999 and 2000) has been highlighted in Figures 1 to 3. The company grew to become the #5 in Fortune 500, #31 in Fortune’s list of 50 Fastest Growing Companies and #89 in Financial Times’ Global 500, and was the recipient of several accolades1. Note that over the past couple of years, Enron was focusing on developing a portfolio of complementary energy businesses to take advantage of the opportunities arising from the deregulation of the electricity industry and the increasing convergence of the gas and electricity markets.Business Strategy

Initially, Enron’s broad strategy was to build a set of energy businesses designed to take advantage of the near-term structural and regulatory changes in the gas and electricity markets. The company started-off in the US natural gas industry, where it was active in nearly every aspect of the gas business. When US gas markets were deregulated in the 1980s, Enron started focusing on the competitive side of the industry and became a wholesale marketer of natural gas. The company brought its experience with regulation and its market-making ability into the electricity industry on its deregulation in the 1990s. A brief overview of energy deregulation has been outlined in the following table:

Table 1 – Energy Deregulation in the USBefore After and Impact

Generating Power Utilities owned stations and sold directly to customers

Plants sold; New owners compete to sell to utilities. Impact was mixed. Critics attacked removal of strategic planning

Distributing Power Monopolies tightly controlled to protect consumers

Utilities compete to win customers and contracts on basis of price. Enron and others created new markets focusing on energy trading

Regulating the industry Special commissions monitor prices charged to customers

Market competition theoretically to set prices but some controls remain. Mixed political reaction; some legislators oppose unhindered markets

Source: BBCi

In subsequent years, the company shifted its primary emphasis to financial trading and marketing of energy-related products such as natural gas and 1 Some ratings were as follows: Fortune Magazine: Most Innovative Company in North America, 1999; Quality of Management ranking # 1, 1999; Employee Talent ranking # 2 1999; Best Places to Work in America – top 25, 1999

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electricity. Besides, the company adapted its strategy to characteristics of the market. For e.g. in markets with a highly-developed energy infrastructure, the company was focusing on energy marketing and market-making with support from the ownership of some physical assets such as power plants and significant amounts of contractual access to assets. In developing markets, Enron was helping to create the physical infrastructure necessary to facilitate energy trading and marketing and was initially adopting a more asset-intensive strategy.

The problems arose when the company’s success in market-making spurred Enron to look for adding additional businesses in the energy and other network-based industries where the development of liquid-traded commodity markets could help eliminate inefficiencies and create profit opportunities. The marked shift in strategy from physical assets to trading came about in 1999 when the company outlined its strategy in the annual report as follows: “Physical assets play a strategic, but not central role in the way we earn our money, and this reduced emphasis on merely earning a return on physical assets allows us to divest non-strategic assets and redeploy capital into higher-growth and stronger-return businesses”. In accordance with this strategy, the company disposed certain ‘non-core’ assets in 1999 (refer to Figure 4 for Enron’s business segments). The company stated that its primary competitive advantage lay in its company’s ability to identify opportunities, gain a first-mover advantage in the new business segment and hold onto the lead.

In 2000, when the company’s net income reached a record $1.3 billion, the company stated that its “strong” businesses – wholesale services, retail energy services, broadband services and transportation services – could be significantly expanded and extended to new markets. Enron believed that it had a $4.7 trillion market opportunity that could be exploited and this comprised: the wholesale gas and power business for $1.7 trillion, the broadband market for $1.4 trillion. The remaining $1.6 trillion was expected to accrue from forest products, metals, steel, coal and air-emission credits.

Business Segments

Enron had five principal businesses (as illustrated in Figure 4) of which one business, the Exploration and Production business was spun-off in July 1999. Also, note that Portland General Electric was sold to Sierra Pacific Resources for $2 billion in cash plus the assumption of $1 billion in debt in 2001; however, please note that though the deal was struck in 2000, the sale of PGE did not take place, as the company explained, due to “the effects of events in 2000 in California and Nevada on the buyer”. Subsequently, Portland General Electric was sold to another buyer in 2001. All of Enron’s businesses operated in unregulated markets except for its regulated interstate pipeline businesses. A brief overview of Enron’s businesses is provided below:

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Wholesale Energy Operations & Services: This is a business that focused on wholesale energy marketing and included a diverse portfolio of energy-related assets on five continents. The company traded and marketed large volumes of energy-related products and services and its assets included power plants, gas pipelines, and gas and electric distribution networks. The company was the premier player in its gas merchant business in the United States and Canada and was also the market-leader in wholesale electricity in the United States. The company also developed a liquid market in coal and was the largest coal market maker in the United States. Besides, the company was also involved in pulp and paper, trading of emission credits, crude petroleum products and weather derivatives. During the period 1995-2000, the company’s wholesale services earnings had grown at an average compounded growth rate of 48% annually. This was the largest business segment of the company (refer to Figures 5-8 for analysis by business segment). Enron’s dominance of the market can be gauged from the fact that the company delivered more than two times the natural gas and power volumes as did its nearest energy competitor. Figure 9 depicts the growth of the energy business; note that data for 2001 has not been provided as the same was not disclosed.

Exploration and Production: These activities were conducted by Enron Oil & Gas Company, which also produced natural gas in Trinidad and India. EOG’s 1998 finding costs averaged $0.42 per thousand cubic feet equivalent (Mcfe) and its all-in costs of $1.40 per Mcfe were among the lowest in the industry. The company was also extending its exploration activities to China. Surprisingly, the company sold a major part of EOG in 1999 for $ 1 billion – an area where Enron was clearly the best in class (refer to Figure 10).

Retail Energy Services: Enron Energy Services was a leading retail energy services business in the US and its business was subsequently expanded to cover Europe, South America, Mexico and Canada. The company was the provider of energy outsourcing products for the commercial and industrial consumer markets. In this business, Enron aided commercial and light industrial customers lower their commodity expenses, improve their facilities’ operations and identify necessary capital improvements. The business was based on the premise that few companies had the expertise to approach energy strategically, and often energy infrastructure and equipment were not adequately maintained and updated. Enron’s services included commodity supply and management of commodity price risk, provision of labor g and facilities management and structuring and syndication of financial transactions. Over 1998-99, this segment experienced rapid growth as illustrated in Figure 11.

Transportation and Distribution: Enron Gas Pipelines operated one of the largest natural gas pipelines and storage systems in the US and comprised

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Enron’s Gas Pipeline Group and Portland General. The Gas Pipeline Group included Enron’s interstate natural gas pipelines, including the Northern Natural Gas Company, Transwestern Pipeline Company, a 50% interest in Florida Gas Transmission Company and its interests in Northern Border Pipeline and EOTT Energy Partners L.P. Enron’s electric utility, Portland General Electric (which was finally sold in the latter half of 2001) serviced a fast-growing territory while its subsidiaries contributed to Enron’s global power assets and transmission capabilities. Enron had a 32,000-mile interstate and intrastate network across 21 states that accessed virtually every major supply basin in North America and supplied 15% of US natural gas in 1999. Figure 12 shows that growth in this segment was fairly flat though this represented the business segment with the highest margins. Was this a case of misplaced priorities?

New Businesses: A brief description of these businesses are provided below:

Enron Broadband Services: Amongst Enron’s new business was Enron Broadband Services that proved to be disastrous for the company. This venture represented the “invincibility myth” which was portrayed by Enron management – the ability to succeed anyplace, anytime and anyhow. This business was working to interconnect fiber-optic networks and improve network efficiency through the introduction of standard bandwidth commodity contracts. Enron expected to be the first company to provide broadband connectivity on a global basis through the Enron Intelligent Network; this operated as a “network of networks” providing switching capacity between independent networks for low-cost scalability. Enron had ambitious plans to be the world’s largest marketer of bandwidth and network services and the largest provider of premium content delivery services. Note that Enron also entered into the $30 billion a year data storage business and in April 2000, Enron signed an agreement with Blockbuster Video to deliver movies over the Enron Intelligent Network. Personally, I felt that the company was moving too quickly.

As I said earlier, the company was convinced that it could replicate the development that it carried out in the natural gas industry in the mid-1980s when the industry had inflexible and rigid business relationships and contracts, which caused shortages and inefficiencies. The idea was to exploit an increasing demand for bandwidth; the company forecasted a 150% CAGR for broadband through 1999-2004. Accordingly, the company planned to make a market in bandwidth trading and executed the first bandwidth trade in 1999; the company also expected bandwidth intermediation to grow from $30 billion in 2000 to $95 billion in the year 2004. Refer to Figure 13 for growth of the Broadband Services.

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EnronOnline: The pride of the company, EnronOnline was in Enron’s words, “immensely successful and destined to exceed the value transacted on any current eCommerce web-site”. By the end of 2000, EnronOnline had executed 548,000 transactions with a notional value of $336 billion and had achieved the position of the world’s largest web-based eCommerce system. Two years after its launch in November 1999, the platform was averaging 6,000 transactions a day worth an average $2.5 billion. Different financial products – 2,100 in all were on offer to traders across four continents in 15 different currencies. There was no commission and no subscription fee but there was one catch. Enron made itself the trading partner in every deal unlike most online trading sites that work by pairing up buyers and sellers out of a whole range of companies. This led to a spiraling of Enron’s power and influence. The other point is that Enron did not disclose as to whether these operations were making money and chose to keep it a secret. While its supposedly pioneering platform enabled it to win Financial Times’ “Boldest Successful Investment Decision” award, it is unclear as to what it contributed to the wallet.

Water and Waste Management: Enron also established a new global water business, Azurix, through the acquisition of U.K based Wessex-Water. The idea was to push Azurix towards becoming a major global water company in a $300 billion market for the modernization of water and wastewater infrastructure. This was yet another burden on Enron’s wallet with significant asset write-downs as illustrated later.

Enron Wind Corporation: Enron believed that with the technological advancements and lower costs associated with more efficient wind turbines, wind-power costs were becoming competitive with fossil-fuel generation. The company achieved $460 million of revenues for 2000 in this business and with its usual exuberance, forecasted doubling of revenues in the next year. It is not known how much this business contributed in 2001 as the same was not disclosed.

Other Businesses: In line with Enron’s strategy to apply its market-making skills to other large, fragmented industries and products, Enron acquired MG Plc, the world’s leading merchant of non-ferrous metals. The company set-up Enron Credit that provided real-time updates of credit ratings of more than 10,000 companies on its web site and also provided a bankruptcy product for corporations to hedge their risk (it could make use of that today!). Enron’s weather unit provided weather derivatives (one example of such a derivative is a hedge on precipitation that provides financial compensation linked to natural gas prices if precipitation fell below a minimum) and executed 1,629 transactions in 2000, a five-fold increase from 321 the year before. Enron’s crude oil business provided crude deliveries to 240 customers in 46 countries, and was establishing a liquefied natural gas (LNG) network to create merchant LNG opportunities. Enron had also ventured into forest products and acquired

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Garden State Power Company in 2000 that made it the seventh-largest producer of newsprint in North America. The company was trying to get into the steel business. In short, the company was moving in all directions to grow revenues as opposed to being focused. Many of these businesses lacked strategic spillover effects onto other businesses and there was no common thread linking them except for perhaps, the desire to make a market.

Competitive Advantage

The company felt that Enron was the best positioned to take advantage of continuing energy deregulation and consumers’ demand for reliable delivery of energy at predictable prices. Many markets were experiencing tighter supply, higher prices and increased volatility, and there was increasing interdependence within regions and across commodities. Perhaps, Enron had some competitive advantage in terms of: its robust network of strategic assets that the company owned or had contractual access to, its market-making abilities that could result in price and service advantages as well as its innovative technology such as Enron Online. The latter ensured that Enron could deliver products and services easily at the lowest possible cost.

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Part II - Energy Marketing and Trading & Competitive Overview

While Enron competed across several lines of business, only an overview of energy marketing and trading which was the focus area of the company has been provided here. This section has almost no relevance to what we are trying to understand about what happened at Enron and I only included this to provide a flavor as to the dynamics of the industry. Presented below are the trends noted in this sector during the third quarter of 2001. (Refer to Appendix I for a brief description of technical terms used in the energy sector)

Volumes: Most of the volume growth during the third quarter came on the electricity side, where increases in power sales were far more common than flat or declining figures. Total power volumes for the top 20 were 1443.9 million MWh (Mega Watt Hour; 1 MWh 1= 1,000 KWh), up 51% year-over-year from 956.7 million MWh. Note from Figure 14 that Enron’s domination increased significantly over this period: from 17% of the total to 20% of the total. On the gas side, volumes of the top 20 marketers increased 19.5% to 184 Billion Cubic Feet / Day from 154. Enron’s domination was less pronounced here and in fact, declined a percentage point to 15% year-over-year as can be seen from Figure 15.

Spark Spreads: On average, the spark spread decreased from the beginning of the third quarter to the end of the third quarter. Note that prices have a seasonal trend and in all regions of the United States, the summer peak is during the months of June-September and highest prices accrue during the month of August. As can be observed from Figure 16which presents a comparison of five regions and the national average, the spark spread during the third quarter of 2001 declined by $31.54 as compared to the same period during the prior year, a decline of 47%.

Price Levels: As can be observed from Figures 17 and 17A, the Price-Earnings multiples of the energy sector were trading at a discount to the S&P 500. Note that the data has been presented as of October-end, 2001. The majors category includes the following companies: Duke Energy, Dynergy, Enron Corporation and Kinder Morgan. Further, as of October 2001, the Natural Gas & Power group was down 22.1% underperforming the 16% decline in the S&P 500. Looking at the price-performance for various companies which reflects the appreciation in share price as shown in Figure 18, there is no doubt that Enron’s price appreciation was one of the highest and as we shall see later, in the peer comparison, Enron’s stock was clearly over-valued.

Competitive Overview

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Given that the competitive landscape is not significant to our trying to unravel the Enron downfall, I do not intend to provide a very detailed competitive overview. This section is intended to provide a brief overview of companies in the power sector and Enron’s position within this sector :

Dominion Resources: This company is an integrated electric and natural gas company and it acquired Consolidated Natural Gas in the first quarter of 2000. The company owned oil and gas exploration and production business; and independent power generation units and operations were primarily in the United States and Canada.

Duke Energy: This Charlotte, North Carolina-based company is one of the largest power producers and energy marketers in the US. The company's regulated utilities generate electricity that is distributed to 2 million customers in the Carolinas. Duke added more than 1.1 million natural gas customers in Canada with its 2002 acquisition of Westcoast Energy. Although the Carolinas have not deregulated their utilities yet, Duke is slugging it out in competitive markets throughout North America. Through its Duke Energy North America and Duke Energy Merchants units and its trading and marketing venture with Exxon Mobil, Duke markets natural gas, electricity, and other commodities to local utilities, industrial users, and power generators in the US and Canada. Duke also invests in merchant plants throughout the US and it has power plants, pipelines, and marketing operations in Europe, Latin America, and the Asia-Pacific region. The company provides global engineering and construction services for power projects primarily through its Duke/Fluor Daniel joint venture, which is a top builder of fossil-fuel plants in the US.

Duke also owns and operates a 12,000-mile interstate natural gas pipeline system, which links the Gulf Coast to northeastern US markets. The company is one of the largest US natural gas liquids (NGLs) producers. Duke and Phillips Petroleum have merged their gas gathering and processing and NGL operations into Duke Energy Field Services.

Dynegy: Houston-based Dynegy (short for "dynamic energy") has evolved from a natural gas marketer into a multidimensional energy provider. The company's operations include energy trading, marketing, and generation; natural gas liquids production; electricity and natural gas transmission and distribution; and telecommunications. Dynegy would have become the world's largest energy trader had it completed its purchase of troubled rival Enron; however, the deal was canceled. Dynegy's Wholesale Energy Network unit markets and trades electricity, natural gas, and coal in the US, Canada, the UK, and continental Europe. The company also has alliances with regional utilities to compete in deregulated retail marketplaces. Dynegy also operates fiber-optic telecommunications networks in the US and Europe through subsidiary Dynegy

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Global Communications. Note that ChevronTexaco owns nearly 27% of Dynegy, and CEO Chuck Watson owns 5%

El Paso Corporation: The Houston-based company, formerly known as El Paso Energy, is a top US energy trader and marketer and owns the largest gas pipeline system in the US. The company also gathers and processes natural gas, generates electricity, and engages in oil and gas exploration and production. El Paso has expanded by buying diversified energy group Coastal. The $24 billion acquisition (completed in 2001) helped boost the company's proved reserves to more than 6 trillion cu. ft. of natural gas equivalent. El Paso's energy marketing arm, El Paso Merchant Energy, sells and trades gas, electricity, crude oil, and other commodities in North America and operates power plants.

Kinder Morgan: Kinder Morgan pipes in profits by operating more than 30,000 miles of natural gas and product pipelines throughout the US. The company also distributes natural gas to 233,000 customers in the Midwest, and it is adding gas-fired power plants along its pipelines. Through Kinder Morgan Management, it controls Kinder Morgan Energy Partners, which transports refined products and operates more than 30 bulk terminals that handle materials such as coal and coke. Kinder Morgan, formed in 1997 when Richard Kinder and William Morgan bought an Enron pipeline unit, expanded dramatically in 1999 through a reverse merger with troubled natural gas pipeline giant K N Energy. Kinder, an ex-Enron employee who is the Chairman and CEO Kinder owns 21% of the company. The Williams Companies: This Tulsa, Oklahoma-based company is a major energy producer and the operator of one of the largest gas pipeline systems in the US. The company's Williams Energy Services unit is engaged in exploration and production, primarily along the Gulf Coast, in the East Texas Basin, and in the Rockies. Williams Energy Services also gathers, stores, and processes natural gas and natural gas liquids (NGLs). It operates refineries, ethanol plants, and terminals, as well as about 60 truck stops (Williams Travel Centers). Previously part of Williams Energy Services, the company's energy trading and marketing operations became a separate business unit in 2001. Some Williams pipeline assets are held by publicly traded Williams Energy Partners. Williams has spun off former subsidiary Williams Communications Group. Williams Communications has suffered in the telecom industry downturn, and concerns about Williams' obligation to make good on some of the communications company's debt prompted Williams to re-examine its own balance sheet in 2002.

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Part III – Special Purpose Entities and Select Transaction Review

Rationale for Use of Special Purpose Entities (“SPE”)

There is no better way to understand what happened at Enron than through jumping headlong into Enron’s use of SPEs. While this may represent a sudden transition for some readers from what we discussed earlier, it is better to deal with this first, as this was the crux of the whole collapse.

Enron’s rapid growth necessitated large capital investments that would not generate significant earnings or cash flow in the short-term. This created pressure on Enron’s balance sheet and as the company was already well-leveraged, funding the new investments through debt issuance was not a great alternative for two reasons: first, it could have possibly resulted in a downgrade of its credit rating that was crucial for its energy trading business and second, lower cash flows could have made debt servicing difficult. Equity financing could have resulted in significant dilution, particularly in the early years of its investment. The attractive solution was to use SPE’s that could provide the company flexibility in terms of investment, management of risks and obtaining rewards. Some transactions were structured using joint ventures and some others involved both SPEs and joint ventures. However, one problem was the ability of these outside entities to raise capital; again Enron came to the rescue though providing guarantees and credit support to these entities. Of course, it goes without saying that the company chose not to consolidate some of these entities on its Balance Sheet.

Accounting for SPEs

Note that this is but a brief review and interested readers could look up Appendix II for a more detailed explanation.

The history of SPEs can be traced to sale and leaseback transactions where the SPE acquired an asset and leased it back to the company. In this case, the synthetic lease was used with the objective of financing an asset acquisition while keeping the corresponding debt off the company’s balance sheet. Subsequent uses of such SPEs were also done with a view to achieving the same result. An SPE could take several legal forms such as corporation, partnership or trust. However, it may be difficult to determine whether en entity is an SPE or not.

Over time, the Financial Accounting Standards Board (FASB) came up with several principles relating to such transactions, in particular, the principle relating to such consolidation. The basic principle espoused was “ there is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one

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of the companies in the group directly or indirectly has a controlling financial interest in the other companies”2. Consolidation is not considered mandatory if the following conditions are satisfied:

(i) An independent owner or owners of the SPE must make a substantial capital investment in the SPE and that investment must have substantive risk and rewards during the entire course of the transaction. While the definition of substantive capital depends on the circumstances of each case, the SEC has taken a position that 3% of total capital is the minimum acceptable investment by an outside entity and this equity needs to be maintained through the course of the investment. The idea of a 3% stake seems somewhat ludicrous and the fact that FASB and SEC are taking a closer look at this rule post the Enron debacle is gladdening. Note that investments supported by a guarantee on the initial investment are not considered to be at risk.

(ii) The independent owner must exercise control over the entity. While this is a subjective statement, it is clear that control is determined not only with respect to ownership but also by reference to relative rights of investors.

If the above considerations are rebutted i.e. there is no independent entity as documented above, then the transferor of assets to the SPE needs to consolidate the SPE into its statements.

The Players

Before analyzing the transactions, it would be useful to understand the various persons at Enron and the roles they played. The following is a description of the key players in the management and conduct of transactions of Enron Corporation:

Table 2 – The Players Name Designation DescriptionAndrew Fastow

Chief Financial Officer

Being the manager of several of the off balance-sheet entities and the CFO, Andrew Fastow had major conflicts of interest; he was involved on both sides of transactions with partnerships/special purpose entities. Over time, he neglected his fiduciary duties to the company, placed his personal interests over that of the company, misrepresented transactions to the Board of Directors and influenced employees engaging in transactions with partnerships by offering lucrative interests in the partnerships to such employees

Kenneth Chairman / Chief Ken Lay3 did not appear to have directed attention to the

2 FASB Statement No. 51, Consolidated Financial Statements, 19593 Ken Lay took over HNG in 1984 and doubled the size of HNG by acquiring Florida Gas within six months of taking over the reins. He hired Jeff Skilling and as Enron grew, his

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Lay Executive Officer transactions involving off-balance sheet partnerships and failed to implement controls to ensure that conflicts of interest were not abused for employees’ personal benefit. He approved Fastow’s participation in related-party transactions with Enron.

Jeffrey Skilling

President & Chief Operating Officer; Chief Executive Officer

Skilling personally supported the Board’s decision to permit Fastow to undertake transactions that were in conflict of interest. Like Lay, Skilling failed to exercise his oversight responsibilities and ensure that an appropriate system of internal controls was in place. He also failed to investigate concerns raised by a whistle-blower, Jeffrey McMahon, the Treasurer ; on the contrary, he claims that the former did nor raise any concerns.

Richard Causey

Chief Accounting Officer

Causey’s accounting, notwithstanding the approval of the auditors, was extremely aggressive. While he was charged with the responsibility of approving Enron’s deals with some partnerships and review these with the Audit and Compliance Committee, he did not perform due-diligence on these transactions.

Richard Buy

Senior Risk Officer

Like Causey, Buy was entrusted with the responsibility of overseeing Enron’s transactions with partnerships. However, he did not appear to have interpreted his responsibilities and did not review economic terms of such transactions carefully

Jeffrey McMahon

Treasurer The post-bankruptcy President of Enron Corporation (resigned a few weeks ago) was the Treasurer of the company in the hey-days and during the fall. He has been touted as a hero in recent times in that he was one of the two employees besides Sherron Watkins whom (we know) questioned Enron’s practices. In particular, McMahon seemed to be uncomfortable with the conflicts of interest and expressed his uneasiness to Skilling. However, I noted his presentation to credit rating agencies in 2000 that explained why Enron’s rating should be higher (covered in detail later). Besides, recent news articles have also covered his involvement in some sales made by Enron in 19994 which artificially inflated profits, and his

involvement in politics, civic projects and charity increased. Under Lay, Enron contributed more than $2 million to President George Bush and there was talk that he would return to Washington as a cabinet member. Ken Lay was CEO for all but six months during the period 1984 till he resigned in January 2002; for a six month period, he remained Chairman while Skilling took over the CEO role. It is now known that Ken Lay supported the creation of the first of two unusual partnerships involving conflict of interest (involvement of Andrew Fastow, the CFO). Lay trusted Skilling with “blind optimism” so long as earnings and the stock price were climbing. Source: Wall Street Journal, April 26, 2002. 4 Now referred to as the Nigerian barge deal. In this transaction, Enron created a special purpose entity to buy its three barges off Nigeria with $21 million of debt and $7 million equity from Merrill Lynch. Merrill now says that it did the deal to please the client as it represented some sort of bridge financing till Enron found a true buyer; apparently McMahon said that a true buyer could be found on completion of negotiation of an

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unsuccessful attempt in 2000 to set-up an off balance-sheet partnership. In his presentation, he said his disclosure was a kitchen-sink disclosure but it hid several facts. He was also bullish about the company (in public) in September and October 2001.

Other Employees

Some employees of the company failed in their fiduciary duty to the company and did not obtain the Board’s approval prior to transactions that involved conflict of interest. In particular, Kopper violated the company’s Code of Conduct5 through purchasing unauthorized personal investments in some partnerships and also offering stakes to another employee. Kopper made $10 million from a $125,000 investment in Chewco. Some other employees in the Finance, Accounting and Legal areas also violated Code of Conduct by accepting unauthorized interests in a partnership.

Board of Directors

The Board failed to carry out its oversight duties with diligence; in particular, the Board did not fully understand the severity of the conflict of interest and had an improper understanding of the adequacy of internal controls. The Board failed to demand adequate information and many of its members could not comprehend the economics and risks of some transactions. While the Audit and Compensation Committee did some reviews, the scope of such reviews was too narrow and did not serve their intended function.

Vinson & Elkins

Outside Counsel Enron’s Audit and Compliance Committee and the in-house counsel relied on Vinson & Elkins for its role in documentation, preparation of disclosures in proxy statements and footnote disclosures.

Andersen Auditors Andersen did not carry out its professional duties with care during its tenure at Enron. One, its audits were inadequate and its assessment of Enron’s internal controls was dismal. Secondly, the company was paid for its advice in transaction structuring ($5.7 million for the LJM and Chewco transactions) but failed to provide the correct interpretation of accounting rules. While an internal e-mail in February 2001 raised red flags about related party transactions, these were ignored.

Note: The role of Sherron Watkins has been covered in a separate section

agreement with the Nigerian Government. This quick deal allowed Enron to book $12 million of earnings. 5 Enron’s Code of Conduct states that “ no full-time or officer should own an interest or participate, directly or indirectly, in the profits of any other entity which does business with or is a competitor of the company, unless such ownership or participation has been previously disclosed in writing to the Chairman of the Board and Chief Executive Officer of Enron Corporation and such officer has determined that such interest or participation does not adversely affect the best interests of the company”

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Analysis of Select SPE Transactions

The Chewco Transactions

Entity Formation: Chewco, a limited partnership formed in 1997, was the first time that Enron used an SPE run by an Enron employee to keep transactions off Enron’s financial statements. This limited partnership managed by Kopper6

was formed as an offshoot of Joint Energy Development Investment Limited Partnership (“JEDI”). The partnership referred to involved a $500 million equal joint venture between Enron and the California Public Employees’ Retirement System (CALPERS) during 1993-96 called the “JEDI”. Given that Enron wanted CALPERS to participate actively in a new JEDI II partnership, Enron had to buy-out CALPERS and find a new limited partner. This led to the formation of Chewco as a Delaware limited liability company at a short notice.

Entity and Financial Structure: In fact, in the case of Chewco, neither Enron nor the general partner in Chewco could find an outside entity to contribute at least 3% of the equity; Enron put together a bridge financing arrangement under which Chewco could raise $383 million (to pay CALPERS) in the following manner: (1) a $250 subordinated loan to Chewco from a bank that was guaranteed by Enron (2) a $132 million revolving credit arrangement between LJM and Chewco and (3) equity contribution of $11 million by Chewco though the source of this was unclear. Notwithstanding the fact that there was no equity but just debt, Enron chose not to consolidate the transaction in its accounts. In fact, during the negotiation of the Enron-Chewco contract, Fastow directed the Enron negotiator to accept Kopper’s terms though Enron could have improved its position through negotiation. Further, there is no evidence that the Board of Directors approved the participation of Kopper in this entity.

Since this entity raised questions as to whether Enron controlled Chewco through Kopper, the company was then converted to a limited partnership where Kopper became the general partner and the structure was changed as documented in Figure A. Further, the entity’s financial structure presented in Figure B makes it clear that Enron should have, in fact, consolidated Chewco in its financial statements from the outset. During the period October – November 2001, after a close review, both the company and Andersen decided to consolidate Chewco on a retrospective basis from 1997-2001 that resulted in the re-statements that are detailed later.

Payments: The transactions made through Chewco highlighted several cases where large management fees were paid to the general partners without being specific as to how these fees were arrived at and the nature of services

6 Kopper was chosen to manage the entity instead of Fastow as the latter’s participation would warrant a disclosure in the proxy statement.

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rendered to the partnership. For example, the entity SONR#1 was paid $1.6 million in fees over a three-year period though hardly any management was required.

Revenue Recognition: Many of the transactions between Chewco, JEDI and Enron did not seem to have an underlying economic rationale and seemed to have been entered into with the sole purpose of accelerating revenue recognition at Enron. A brief descriptive of some of these transactions has been provided in the table below:

Table 3 – Select Transactions of ChewcoNature of Revenues

Payer/ Payee

Amount

Funds Flow

Remarks

Guarantee Fees for Enron’s guarantee to Barclays

Chewco Enron

$17.4 million

JEDI Enron

First, it is unclear as to why JEDI had to clear Chewco’s liability. Secondly, the fee did not take into account any of the transaction risk dynamics. Lastly, Enron recognized these transactions as “structuring fees” and took these into income up-front instead of amortizing these payments over the period of the guarantee.

Management Fees

JEDI Enron

$25.7 million

JEDI Enron

Enron recognized the payment immediately as revenues in March 1998. This was improper due to the following reasons: the payments were made for services to be rendered by Enron to JEDI over 1998-2003 and it was incorrect to recognize the fees one-shot before even the services were rendered

Revenue Recognition

$126 million

JEDI held 12 million shares of Enron stock and accounted for all its assets under the fair value method. Therefore, any appreciation in value was taken as unrealized gains into its income statement. During the period when Enron stock’s was appreciating, JEDI recognized significant gains. Enron, which accounted for JEDI under the equity method, took gains on appreciation of its own stock! While the exact amount is unclear, it looks like $126 million was taken in one quarter during 2000. What is surprising is when

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the stock lost value in 2001, Enron did not recognize its share of loss that amounted to $90 million.

Buy-Out of Chewco: Sometime in 2000, Enron executives decided that JEDI was expensive as an off-balance sheet vehicle and decided to bring it back onto its books. In effect, Chewco had to be bought out and protracted negotiations were settled in March 2001 at a contract price of $35 million; it is unclear as to how this price was arrived at. There was an equally complex settlement that is documented in figure C.

The Restatement: During the period October – November 2001, after a close review, both the company and Andersen decided to consolidate Chewco on a retrospective basis from 1997-2001 which resulted in the re-statements that are detailed subsequently.

The LJM Transactions

LJM1

Formation: Like all other partnerships, these entities were apparently formed to transfer risk from Enron. The first of the two entities LJM Cayman L.P (“LJM1”) was created in 1999 with Andrew Fastow as the general partner to enable Enron to substantially hedge its investment in Rhythms NetConnections, Inc (“Rhy”). The Board of Directors approved Fastow’s participation in the partnership and the subsequent conflict of interest that would be created.

Entity and Financial Structure: Similar to the Chewco case, the ownership and financial structure of this vehicle was fairly complex and is illustrated in Figure D. Both the LJM1 case and the LJM2 case detailed below raise significant corporate governance issues. Unlike Kopper, Fastow was a senior employee of Enron and the argument that can be put forth is that if he controlled LJM1 and LJM2, it could be presumed that Enron controlled both entities that would require consolidation. Whether Fastow, in fact, controlled the two entities is a moot point. The fact that an individual is a general partner cannot lead to the assumption that the general partner controls the partnership, especially where the general partner’s investment authority is limited by limited partners and the latter could resolve to remove the former. Considering that there were limitations on Fastow’s role as a general partner, there could be arguments for and against consolidation.

LJM2

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Formation: Andrew Fastow proposed the creation of LJM2 in October 1999 through raising $200 million of institutional private equity to create an investment partnership that could purchase assets that Enron wanted to syndicate. Given the inherent conflict of interests with Fastow serving as a general partner through various intermediaries, he proposed that all transactions be approved by both the Chief Accounting and the Chief Risk Officers as well as be reviewed by the Audit and Compliance Committee.

Entity and Financial Structure: The diagram for the structure of the partnership is provided in figure E. LJM2 solicited prospective investors through a Private Placement Memorandum that detailed the partnership as an unusually attractive investment to outside investors7. The list of LJM2’s 50 limited partners included illustrious names such as Merrill Lynch, Citigroup, JP Morgan, Deutsche Bank, G.E Capital and Dresdner Kleinwort Benson who together with the general partners contributed $394 million. Another aspect to be noted is that Enron agreed to LJM2’s using other Enron employees for some of its activities.

The LJM partnerships had 20 transactions with Enron. The first transaction, which was one of the most interesting and complex ones, related to the hedge pertaining to Rhy. This transaction is detailed below:

Rhythm NetConnections(“Rhy”):

Transaction Structure: Enron had invested $10 million in the company and over one year starting March 1998, Enron’s investment value reached a peak of $300 million. Though management’s ability to sell the stock was constrained by a lock-up agreement, it was surprising that Enron accounted for the stock as part of its trading portfolio and took the unrecognized gains into its income statement through a mark-to-market on the investment. At the same time, Enron had a forward contract with an investment bank to purchase its own stock and given the appreciation in the stock price, the contract was in-the-money. Since a company is not allowed to recognize the gain in appreciation of its own stock, Enron’s management hitched upon a plan to realize the appreciation in value through LJM1 (by transferring restricted stock to the latter) in exchange for a note receivable. With LJM1 adequately capitalized, Enron could now enter into a hedge to avoid taking losses on the volatility of the Rhy stock (Refer to Figure F). The Board voted in favor of this transaction

7 The Private Placement Memorandum repeatedly emphasized the role of Andrew Fastow as Enron’s CFO and that LJM2’s day-to-day affairs would be managed by Fastow, Kopper and Glisan. It stated, amongst other things that: “the partnership expects that Enron will be the primary source of investment opportunities”; “it expects to benefit from such opportunities that will normally not be available to outside investors” and “access to Enron’s information pertaining to potential investments will contribute to superior returns”.

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and Fastow’s role in it with the latter declaring that he would not received any money on Enron’s current and future stock appreciation. It is to be noted that this transaction was not in the true nature of a hedge because the hedging vehicle used (Swap Sub) ability’s to service the put option was dependent on the value of the Enron stock only. In a situation where both stocks i.e. Enron and Rhy declined, the hedge would fail. Consequently, it was unclear how this Swap Sub could be used as a counter-party to hedge risk. Subsequent to the first hedge, Enron entered into four more derivative transactions on Rhy stock (with put and call options) with LJM1 to get the economics close to a swap.

Accounting Issues: Again, the 3% rule that has been discussed in detail earlier comes into play. Looking at the transaction, Swap Sub had assets of $3.75 million in cash plus 1.6 million shares of restricted stock from Enron while its liabilities was $104 million; even at the outset, it appeared that Swap Sub had a negative net worth which meant that the outside equity rule was in no way adhered to.

Payments Made: The details of the payment made under this deal between Enron and LJM1 is indicated below:

Table 4 – Rhythms TransactionDate Payer / Payee Amount RemarksDecember 1999

LJM1 Enron $64 million plus interest

It is unclear how LJM1 was able to pay this amount to Enron when it had an equity of only $16 million. Further, in September 1999, LJM1 had purchased an interest in Cuiaba for $11.3 million. It is unclear whether LJM1 sold the shares transferred by Enron in violation of the agreement or obtained loans using the shares as a collateral

Hedge Liquidation: Enron took a decision to liquidate its Rhy position given the expiration of the lock-up period, the decline in Enron’s stock value and the value of the Rhy investment. Further, the probability that the hedge would fail was increasing at the same time. Subsequently, in negotiations conducted between Fastow and Causey, it was decided that the transaction be unwound at a cost of $30 million to Enron (including the $3.75 million cash initially provided to Swap Sub). The terms of the close-out agreement in March 2000 can be summarized as follows: (1) options on Rhy were to be terminated and Swap Sub would return the Enron shares that it had received from LJM18 (2) Enron would pay a sum of $26.7 million in cash and the final consideration. At

8 Note that subsequent to the transfer in August 1999, there was a stock-split in the ratio 2:1 which means that Swap Sub held 3.2 million shares and LJM1 held 3.6 million shares post-split as opposed to half the amounts earlier.

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the time of unwinding the transaction, the Rhy options in the money were in the money and worth $207 million while Swap Sub received $27 million in cash and returned shares worth $234 million (if the valuation was computed on an unrestricted basis). While Enron was represented by Causey, Fastow represented a new entity Southampton LP which was described as the owner of Swap Sub.

There were several incorrect aspects associated with the transaction: Firstly, the Board of Directors was unaware of these transactions and no internal approvals were obtained for the unwinding. Secondly, given the four year sale restriction on the Enron shares, it was highly improper that the shares were valued on an unrestricted basis; assuming a discount (due to the sale restriction) and amortizing the discount for the period from June 1999 till March 2000 on a straight-line basis, $72 million of discount would have been left-over. Consequently, the shares returned by Swap Sub would have been worth only $162 million while Swap Sub received $234 million, an amount in excess by $72 million. Andersen raised no questions as to the unfair valuation of the returned shares.

The next question to address is the fate of the Enron shares that were still held by LJM1 (3.6 million shares post-split); LJM1 retained them for its own benefit! Probably, some of these shares were sold to pre-pay the $64 million note to Enron but even after accounting for such disposal, it seemed like LJM1 still benefited by about $200 million.

Employees Personal Aggrandizement: The number of employees who benefited from these transactions without obtaining internal approvals under the Code of Conduct is shocking. First, Fastow’s representation to the Board that he would not benefit from these transactions was incorrect. Second, several employees formed a limited partnership named Southampton Place LP that acquired the interest of another limited partner of LJM1; the general partner of this partnership was Big Doe LLC which was managed by Kopper. Other limited partners were the “Fastow Family Foundation” and several other employees. During the subsequent investigation, several employees have traded allegations and have cited that they had no reason to know that LJM1 traded with Enron and hence, did not obtain internal management consent. Further, it is unclear as to how Southampton acquired Swap Sub and what consideration was paid. While the “Fastow Family Foundation” received $4.5 million on its $25,000 investment, some others received $1 million for their $6,000 investment and that too within a two-month period.

Re-Statement: In November 2001, Enron announced that as Swap Sub was inadequate in its capitalization, the entity would have to be consolidated and the financial statements re-instated for the period 1999-2001; this impacted net income by $95 million in 1999 and $8 million in 2000.

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Empresa Productora de Energia Ltda (EPE)

The company also entered into some transactions in the nature of sale of its stake in other companies with off-balance partnerships with a view to avoiding consolidation of accounts and at the same time, retaining an ability to recognize mark-to-market gains in transactions with the other companies (earlier these gains could not have been recognized as these companies would have been subsidiaries). Most of these dispositions were done with LJM, as it was difficult for Enron to find a buyer. A few examples of these transactions are provided below:

Asset Disposal: Enron owned 65% of EPE, a Brazilian company and had control over the appointment of three out of four persons on the Board of Directors. When the company wanted to reduce its stake in this company, there were no takers. Of course, there was always LJM1 to help out: LJM1 bought a 13% stake in the company plus the right to appoint a director on the board for $11.3 million. Also, LJM1 was guaranteed a return of 13% or 25% depending on when Enron could find another buyer to bailout LJM1 from its investment. Thereafter, Enron wrongly claimed that it no longer exercised control over EPE and did not have to consolidate this investment as a subsidiary; this line of reasoning permitted Enron to recognize mark-to-market gains (on what should have been eliminated as inter-corporate transactions) with EPE amounting to $65 million in 1999.

Repurchase: Though the project controlled by the company ran into serious problems and the value of the investment definitely decreased, Enron took LJM1’s return into consideration and repurchased the investment by paying $1 million over and above its initial sale price in 2001, providing a 13% return.

Enron North America – Collateralized Loan Obligations

Asset Sale: This transaction related to a securitization of $324 million of notes and equity by Enron North America (ENA) (technically known as collateralized loan obligations (CLOs)). These tranches have a certain order of re-payment which implies that the last tranches are usually the lowest-rated. Again, when Enron found it difficult to sell its lower tranches, LJM2 came to the rescue and purchased a $12.9 million tranche for $32.5 million. LJM2 obtained this money through a loan from another affiliate. Given that these securitizations were without recourse, Enron did not have any credit exposure. However, Enron seemed to have promised its investors that it will make good the loss through various “means” and when several of the loans defaulted, Enron provided a put option for a notional value of $113 million to the Trust which housed these loans. This option was subject to an “artificial hedge” using a Raptor vehicle (discussed below).

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Repurchase: Probably one of the reasons Enron made such informal guarantees to investors was to ensure that future loans could continue to be sold to investors. Subsequently, Enron repurchased the loans at par and also paid accrued interest.

The Raptors

Formation: Once the basic structure of using the value of its own equity9 to hedge value fluctuations of its merchant investment was created, Enron quickly expanded this concept to multiple merchant investments. Enron did not truly transfer the risk as it could have done with an external counterparty but simply bore the economic risk itself and accounted for it in the name of an SPE. Under the Raptors transaction, Enron created an accounting hedge such that when the value of the merchant investment declined, the hedge’s value would go up; this increase would offset the loss on the income statement. Like the previous transaction, the hedge depended on the value of Enron’s stock and would certainly fail if the value of Enron’s stock came tumbling down; in effect, the stock appreciation was used to shield income statements from losses on merchant investments.

Given the extreme complexity of these transactions, only Raptor I is being discussed in detail here. Raptors II and IV had the same structure except that Raptor IV involved the stock of The New Power Company instead of Enron:

Formation and Structure: The first Raptor (“Raptor I”) was created in April 2000 through an SPE called Talon LLC (“Talon”). Refer to Figure G for the structuring of the transaction. Apart from the details noted in the figure, the agreement also provided that Talon will not write any derivatives till LJM2 received a 30% annualized return or $41 million whichever was greater; it also stated that if LJM2 did not receive its return, Enron would be obligated to purchase its interest at the unrestricted value of its stock and contracts – terms very parochial towards LJM2. Further, the guaranteed return implied that LJM2 did not have the risk of loss, a condition necessary for non-consolidation of an SPE. Thus, even before the entity started transacting, LJM2 was assured of its return with virtually no risk of a loss.

9 Note that Enron contributed to Raptor I a contingent forward contract held by wholly-owned subsidiary, Peregrine, under which Peregrine had the right to receive Enron stock on March 1, 2003 from Whitewing. This was also the same arrangement under Raptor II and IV. The delivery rules were as under Raptor IRaptor IIRaptor IV3.9 million shares7.8 million shares6.3 million sharesPrice in March 2003 should not be greater than $53 a share and not less than $50Price in March 2003 should not be greater than $63 a share and not less than $53Price in March 2003 should not be greater than $76 a share and not less than $63

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Payments: First, Enron had to create an income of $41 million for distribution to LJM2 to enable Talon to commence its derivatives trading; the way this was done was to purchase a put option on Enron’s stock with a premium of $41 million. The put was structured as follows: strike price of $57.50, six months tenor, closing price on that day was $68. Given that Enron’s stock was expected to appreciate for the next six months, it looked like this option would not be exercised, thereby enabling Talon to pocket the premium income and distribute to LJM2. Further, it is quite an anomaly to enter into a put for 7.2 million shares of Enron valued at almost $500 million with an entity that had $71 million of assets which meant if the share price went down, the option was doomed to fail! In effect, the put only provided a $10 per share downside protection to Enron for 7.2 million shares for which it paid $41 million! In fact, the option was way out-of-the-money and was settled in August 2000 with Talon returning $4 million to Enron. With LJM2 paid $41 million, Talon could now start trading derivatives!

Derivatives & Credit Risks: Almost all the derivative transactions between Enron and Talon were structured on the following lines: Talon would receive the value of any future gains in the merchant investments but would have to pay Enron any losses. Several of the transactions were back-dated depending on the fall in value of the merchant investments thereby enabling Enron to keep several losses off its books. In all these transactions, LJM2 had little interest in transaction structuring as it had already recouped the return prior to the derivatives trading.

Enron’s merchant investments were not faring well in 2000 and Talon’s liability to Enron increased; if Talon’s liabilities exceeded its assets, Enron would have had to take credit write-offs based on Talon’s weak credit worthiness. Consequently, Enron had to protect Talon against any decline in Enron’s stock price on which Talon relied and hence, constructed a costless collar in agreement with Talon. The collar provided that at stock prices below $81, Enron would pay Talon the loss and at stock prices above $116, the vice-versa will hold; there was no obligation for the intervening $81-$116 range. However, this arrangement in October 2000 did not protect Talon for long.

Restructuring the Raptors: As mentioned below, the Raptors kept losses off Enron’s books through offsetting the losses with corresponding gains to Enron (and losses to Raptors). During the fourth quarter of 2000, the company noted that with losses mounting, the stock of Enron not appreciating and the collar providing little support, Talon was stretched on its credit worthiness (as assets were almost lower than liabilities) and Enron had to rescue Talon. This was crucial to Enron, as any credit stretch would mean recognizing a credit reserve against gains from the Raptors. Through cross-guarantees between the four Raptors (I, II, III and IV), the company effectively leveraged the unused credit capacity of Raptors II and IV by merging the credit capacities. With Andersen’s

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approval, the company decided not to recognize any credit reserve till the credit capacities of all four entities aggregated together was exceeded. However, this remained at best, a temporary solution given that Enron’s stock price and the values of merchant investments continued to fall.

The Second Restructuring: Though the circumstances warranted a $500 million pre-tax charge in the first quarter of 2001, Enron chose not to do so and the Board was not informed of the situation. Instead, the company restructured Raptors again. In March, the company restructured the Raptors through cross-collateralization and by transfer of more Enron stock contracts. In effect, the cross-collateralization gave a Raptor the right to use the proceeds from the termination of another Raptor instead of passing the funds back to Enron and this would give the weak Raptors another chance to survive. Around this time, the Enron’s stock was trading at $55 and under the stock contracts discussed earlier, shares had to trade at or above $50 in March 2003 for Raptors to have access to the shares. To revive the Raptors, Enron escalated its commitment by going through the rigmarole again. It sold restricted shares at a discount to the market value in return for notes receivable fully realizing that the notes receivable issued by Raptors could be worthless and the company entered into costless collars again to increase protection to Raptors; further, the company did not obtain a fairness opinion for these transactions. This restructuring reduced the credit reserve loss to $36 million.

Realization of “Mistakes” & Impact: When the stock price boom lasted, the Raptors enabled Enron to avoid reflecting a $1 billion of losses in its income statement over five quarters through the third quarter of 2001; while it is not certain what Enron could have done to mitigate losses, non write-off of these losses resulted in overstating income by 72%. Raptors’ contribution to Enron’s earnings are indicated in the table below:

Table 5 – Raptors Contribution to Enron’s EarningsQuarter Reported

Earnings($ in

millions)

Earnings without Raptors

($ in millions)

Raptors Contributio

n to Earnings

($ in millions)

% Contributio

n to Earnings

3Q, 2000

364 295 69 19

4Q,2000 286 (176) 462 1621Q, 2001

536 281 255 48

2Q,2001 530 490 40 83Q,2001 (210) (461) 251 N.M

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As discussed, the company would come to grief if the stock value declined beyond a point. In fact, the decline in stock price in the first quarter of 2001 caused the company to restructure the vehicles; even here, Enron chose to design the entity such that it avoided a massive credit reserve. In August 2001, Andersen realized that the accounting treatment for the Enron stock and stock contracts contributed to the Raptors was incorrect – the company had inflated shareholders’ equity by $1 billion by debiting notes’ receivable.

In September 2001, Andersen and Enron concluded that the prior accounting entries were wrong and the proper accounting was to show the notes receivable as a reduction to shareholders’ equity. In mid-September, the company decided that the position of the Raptors vehicle was no longer tenable and the company decided to liquidate the vehicles; the company paid LJM2 about $35 million (again, through private negotiations) and accounted for the buy-out as purchase accounting. The Raptors’ combined assets were $2.5 billion while its liabilities were $3.2 billion. The company took a charge of $710 million in its third quarter financial statements; it is to be noted that the company had recorded income of $1.07 billion during 2000 and 2001 income through these vehicles; thus notwithstanding the losses, Enron still recorded pre-tax earnings of $367 million.

In November 2001, the company re-stated its prior financials and included a correction for the overstatement of shareholders equity by $1.2 billion (Of this, $1 billion pertained to the aforesaid transaction while the other $200 million related to the difference between notes receivable and stock and stock contracts transferred to the Raptors).

Issues: The following were the problems associated with the Raptors transactions:

Vicious Cycle: There is a resemblance of the vicious cycle –the plan was to use the appreciating stock price to keep losses off its books; this would further strengthen the stock which meant that the loss bearing capacity of these off-balance sheet vehicles was enhanced.

Internal Approvals: Internal regulations regarding approval from the management were violated and the transactions did not receive a formal approval from either management or the Board for several weeks subsequent to the formation of the entity. Further, disclosures made to the Finance Committee were not complete and excluded some critical details of the transaction. For e.g. while the Finance Committee was told that the LJM2 partnership was to earn an internal rate of return of 30%, the actual rate of return earned was 193%, 278%, 2500% and 125% from the four Raptors! In my opinion, LJM2 was not paid for its role in these hedges but for allowing Enron to use its name for creating hedges and avoiding accounting rules.

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Choice of Assets: The assets which were introduced into the derivatives trading were the ones whose values were declining – which provides a suspicion that the company was in fact trying to reduce a drag on earnings. Also, the terms of the collar were in contravention with the fundamentals of the original transaction which provided a 35% discount on the stock due to its restricted nature. The collar agreement now implied that Enron had to remove, in part, the restriction on the stock to enable fair valuation of the stock.

No Third-Party Risk: Through the tenor of the transaction, the 3% outside equity rule was completely violated ; this is because LJM2 was provided a return on its capital at the outset prior to the commencement of derivatives trading. This, in effect means that the off-balance sheet partnership should have always been consolidated.

Computation of Credit Capacity: In the case of Raptors III, the company did not subtract the notes receivable of $259 million provided by the entity to Enron from the net assets of the vehicle with the effect that the credit capacity of the vehicle was computed in excess by this amount.

No Independence of Auditors: The issue of lack of independence of auditors has been debated at length over the past few months; the problem in the case of Enron is reflected by the fact that Andersen offered its advice to the company at every step and besides, charged $1.3 million for the structuring of these transactions.

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Part IV – Roles of Various Constituencies – Board of Directors, Management and Auditors

The Board of Directors’ Role:

The Board failed in its oversight responsibility to the shareholders. First of all, the Board’s approval of the Chief Financial Officer’s (CFO) involvement in very significant third-party partnerships cannot be condoned. Second, it seemed like the Board lacked a questioning approach to its discussion of transactions10

and employees seemed to be successful at hiding information from it. For example, the Board (barring Skilling ) was unaware of the fact that Kopper, an Enron employee, was involved in Chewco. Consequently, no approval for overriding the Code of Conduct of the company was obtained. Even in the case of LJM2, the Board did not know that other employees had a financial stake in the company.

In the case of the LJM transactions, the Board was lackadaisical in its approach as it thought it was giving its post-facto approval to an already negotiated transaction; its main considerations were a fairness approval by PriceWaterhouse Coopers on the transaction and that Fastow should not unduly benefit from the transaction. While the second control is praiseworthy, the problem was that the Board did not set-up a procedure for monitoring the benefits earned by Fastow. The other point relates to the market perception of the fact that the CFO had a dual role in the form of managing partnerships that transacted with Enron. While the Board thought that partnerships such as LJM1 and LJM2 would provide a buyer for Enron and implicitly assumed that business units that were profit-centers would ensure the best terms, this assumption was misplaced and did not ensure arms’ length transactions.

Several directors also relied on Andersen’s responsibility to detect control failures. Management informed the Board that it adopted a number of controls to protect Enron’s interests. One control was that Skilling, the CEO, Causey, the Chief Accounting Officer, and Buy, the Chief Risk Officer would approve transactions between the company and LJM2. Further, the Audit and Compliance Committee was to review all transactions annually and make recommendations. Examples of controls that were supposedly to be in place included the following: Skilling was to review Fastow’s economic interest in Enron and in LJM, the Finance Committee was to review transactions quarterly and the Compensation Committee would look at compensation received by 10 In the case of Raptor I, the Board was informed that the hedge was not economic in nature but would transfer profit and loss volatility and that the company risked accounting scrutiny. Further, when Enron purchased a put on its stock, it meant that it was betting against the value of its own stock! Despite these two red-flags, the Board did not examine the issues in detail.

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Fastow11 from LJM and Enron. In summation, numerous controls were adopted including some relating to restrictions on negotiation.

The list of controls adopted could well be cited as an example of various kinds of controls: preventive, detective, supervisory, and compensatory. However, note that most of these controls failed due to lack of emphasis on control enforcement and lack of attention to detail throughout the organization12. Some members of the organization took advantage of this scenario through concealing information13 Of course, the lack of disclosure of information to the Board and problems with integrity of some employees14 hampered controls. I also attribute such control failures to an improper system of checks and balances and weak risk management within the organization that allowed certain people to dominate the transactions. Ironically, the fact that so many controls had to be adopted speaks to the risks involved in allowing conflicts of interest to permeate transactions and the dangers inherent in related party transactions. My perspective is that if a dozen people have to supervise a transaction, there is something risky that it is questionable to undertake the transaction in the first.

Management’s Role

The main issue was that several of these transactions were not entered into with a view to achieve bona fide economic objectives or to transfer risk but were designed to accomplish favorable financial results. Other transactions were created to conceal very large losses resulting from Enron’s investments; while these transactions appeared as a hedge with a third-party obligated to pay Enron some of the losses, in reality, the third party was an entity in which Enron had a substantial economic stake. These transactions resulted in the company reporting an excessive $1 billion in earnings over the period October 2000-2001.

Nearly three years ago, a top Enron Corporation risk management official, Vince Kaminiski, began warning top executives of the improprieties of some of 11 Preliminary investigations by the Powers Committee have indicated that Fastow’s partnership capital increased by $31 million over 1999-2000 and that he received distributions of $19 millions in 2000. 12 Note that most of the Finance and Audit and Compliance Committees were very brief and lasted not more than fifteen minutes; besides, there was no probing with respect to Causey’s representation that the transactions were at arms-length. Note that the Board should have exercised more due-diligence given the fact $229 million out of $549 million of Enron’s profits came from the LJM transactions. 13 For example, the Board was kept in the dark about the formation of Raptor III and the Raptor restructuring. 14 For instance, Causey presented to the Committees a list of transactions with LJM1 and LJM2: the 1999 list had eight instead of ten transactions and the 2000 list also excluded some transactions

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the company’s off-balance-sheet partnerships. By last September, the official was arguing that the partnership arrangements had gone from being merely “stupid” for Enron and its shareholders to being fraudulent. In response to his criticisms, Kaminiski and his research team were for a time cut-off from certain financial information about the partnerships by top management, including the then President Jeffrey Skilling. This demonstrates that these outside partnerships were matters of concern and controversy within the company well before they became a focus of public and government scrutiny beginning last October.

Management was delegated responsibility by the Board of Directors for implementing and exercising the controls designed to ensure that the employees did not take undue advantage of their conflicts of interest in their roles in the outside partnerships. However, management miserably failed in controlling these transactions.

At the outset, it should be pointed out that the conflicts inherent in the transactions were of high magnitude; it is a different matter if the transactions were one-off. However, given the frequency of occurrence of transactions as also the extent of information that people like Fastow were privy to, it would have been very difficult to control the situation. In several instances, Fastow clearly knew the quality of assets that Enron was trying to dispose off and used these to his advantage in securing the best terms for LJM. Also given the fact that Enron provided services to LJM, there were people sitting next to each other in the office but working for two different entities – Enron and LJM15.

Controls were instituted which required that only those individuals who did not report to Fastow could negotiate the transactions on behalf of Enron. These were ignored and investigations reported at least 13 transactions where Fastow’s subordinates negotiated with him in Enron-LJM transactions16. Further, while the Board relied on review of transactions by Causey, Chief Accounting Officer and Buy, Chief Risk Officer, these two managers did not review the transactions as closely as they were expected to. In fact, some of the transactions were not even reviewed by these officers. Similarly, Skilling did not sign-off numerous deal sheets though his approval was required; even in cases where he signed-off, he had made no independent assessment of the transactions and had relied on Causey and Buy’s judgement. Ken Lay who was the CEO at that point in time was not kept appraised of the partnerships’ activities. Of course, this does not excuse him from being guilty of inadequate supervision. Some transactions were closed before the approval sheets were completed; these sheets also did not evidence that Enron had, in fact, sought

15 Source: William Powers Report 16 In fact, McMahon claims that he highlighted this concern to Skilling, the CEO but the latter ignored his warnings, Source: William Powers Report

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any buyer other than LJM for its assets and as to whether the sale price of assets constituted a fair price.

Apart from the above, it was clear that the fundamental basis on which these transactions were based were flawed. The hedging transactions merely transferred profit and loss volatility from Enron’s books while the disposal of assets was structured with a view to getting assets off Enron’s books and recognizing mark-to-market gains in transactions with companies that were effectively subsidiaries.

The company was also warned by an anonymous letter17 which stated that “Enron had been very aggressive in its accounting – most notably the Raptor transactions”; the letter stated that the collapse of the company was impending18. Subsequently, Watkins identified herself as the author of the letter and met with Ken Lay, the CEO, in August 2001. It is very pertinent for me to quote some statements made in the letter (refer to Exhibit I for text of the letter): “Enron has been very aggressive in its accounting – most notably the Raptor transactions and the Condor vehicles. We do have valuation issues with our international assets and possibly some of our Enron Energy Services mark-to-market positions. How do we fix the Raptor and Condor deals? We have recognized over $550 million of fair value gains on stocks via our swaps with Raptors. Much of that stock has declined significantly - Avici by 98%, the New Power Company by 80%. 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 the day. Cannot use Vinson & Elkins due to conflict – they provided true sale opinions on some of the deals”

Note Lay’s statement when Skilling resigned (shown in Exhibit II): “I want to assure you that I have never felt better about the prospects of the company. Our performance has never been stronger; our business model has never been more robust…We have the finest organization in American business today”. The company appointed Vinson & Elkins to investigate the letter. It is an irony that the same legal firm that was involved in the structuring of the Raptor and the LJM transactions also investigated the possible anomalies. In October, Vinson & Elkins made its presentation regarding its investigation into four areas: (1) conflict of interest (2) accounting for the Raptor transactions (3) adequacy of public disclosures and (4) impact on Enron’s financial statements.

The firm concluded that Enron’s procedures for monitoring LJM transactions “were generally adhered to” and the transactions were “uniformly approved by 17 Sharon Watkins, an accountant, who worked eight years at Andersen and worked with Enron for over eight years, wrote the letter. 18 The letter concluded: “I am incredibly nervous that we will implode in a wave of accounting scandals”

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legal, technical and commercial professionals..”. On the conflict issues, the firm stated, “none of the individuals interviewed could identify any transaction between Enron and LJM that was not reasonable from Enron’s standpoint or that was contrary to Enron’s best interests”. On the accounting issues, the external legal counsel noted that “the accounting treatment on the Raptor transactions was creative and aggressive but no one has reason to believe that it is inappropriate from a technical standpoint”. Overall, Vinson & Elkins concluded that the preliminary investigation did not indicate “ a further widespread investigation by independent counsel or auditors”. However, the firm noted that the “bad cosmetics” of the Raptor transactions in conjunction with the poor performance of assets sold to Raptors exposed Enron to “a serious risk of adverse publicity and litigation”. While Waktins was highly accurate in predicting the course of things, the reason Vinson & Elkins was not successful in coming to the same conclusion was its lack of depth in its investigation – the company spoke to the same people who had substantial stakes in the transactions. Again, the lack of a questioning approach led to its weak conclusions.

Andersen Under Fire

Andersen had revenues of $9.34 billion for the year-ended August 31, 2001 and employed 85,000 personnel worldwide of which 28,000 personnel were in its US Offices; revenues in North America at $4.49 billion represented 47% of total revenues. Enron represented yet another problem for Andersen, examples of other problems being Sunbeam Corporation, Baptist Foundation19

and Waste Management Inc. In fact, the SEC is also examining whether Andersen was advising firms to use aggressive accounting at Global Crossing, Qwest Communications International Inc. and WorldCom Inc20. Andersen is considered by some in telecom and accounting circles to have been instrumental in helping to develop accounting treatments for swaps in network-capacity that may have improperly inflated revenues.

The Enron episode may well represent the demise of the company; some of its offices in Asia and Europe and some of its affiliates have already defected and are sealing arrangements to merge with other reputed audit firms while Deloitte & Touche may buy the U.S tax and consulting business21. The company had almost sealed its merger agreements with Deloitte & Touche Tomatsu when the latter withdrew given the legal risks to Andersen22. I also read that Andersen’s advisers came up with a bold solution: the company would file for Chapter 11 bankruptcy protection, and then execute a merger or sale under 19 Recently, Andersen paid $217 million to settle lawsuits arising of its audits of the foundation, Source: Wall Street Journal, March 4, 200 20 Source: Wall Street Journal, March 22, 2002 21 Ibid22 Ibid, March 18, 2002

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court protection; this plan was dropped as the strategy was untested when it came to a service company. Note that since the Enron episode, the firm has lost about 150 public clients in the U.S23 and is expected to lay-off between 5,000 to 8,000 employees24. It’s Chief Executive, Joseph Beradino, resigned on March 26th of this year, just 14 months after taking over the post.

Criminal Indictment: Arthur Andersen was charged with a single felony count of obstruction of justice by “knowingly, intentionally and corruptly persuading employees to alter, destroy, mutilate and concealing audit-related documents”. While the SEC moved swiftly to reassure Andersen clients that it would continue to accept financial statements audited by Andersen, the company lost its prime clients25 representing millions of dollars in revenues26. Note that in the 212-year history of US financial markets, no company had ever survived a criminal indictment. The company’s problems have worsened, as David Duncan, the partner in charge of Enron, has pleaded guilty in federal court to obstruction of justice. The partner’s co-operation has given prosecutors new information and could bring more indictment of other current and former Andersen employees. This was a sudden turn in Duncan’s attitude as for months, he contended that he had no intent to commit any criminal act. Duncan’s statement said “On October 23rd, I instructed local people at Arthur Andersen to begin destroying documents. I knew they would be unavailable to the SEC”27. The problem for Andersen is Duncan’s crime could be attributed to Andersen if he was acting within the scope of his employment (under agency law).

Document Shredding: As expected, the accounting firm pleaded not guilty to the criminal indictment that it had obstructed justice for shredding documents in connection with the Enron Corporate debacle including workpapers pertaining to the Enron audits. The fact remains that the supervisor of Andersen’s document shredding room testified that she had destroyed more than 5,000 pounds of documents28. The firm is now arguing on the grounds that it brought document shredding to the notice of regulators and only a few individuals were involved; the Government, however, contends that the obstruction was much more institutionalized and spilled over to offices in London, Chicago and Portland. Andersen’s lawyers said that the pace of documents destruction picked up on October 23rd 2001, the day after top Andersen auditors met with Enron executives and learned that they expected

23 In fact, a news article said that Andersen is being mentioned as a risk factor in some IPO prospectus, Ibid, April 21, 200224 Ibid, April 8, 200225 Clients lost include Freddie Mac, Delta Airlines, Fedex, Household International and Sun Trust Banks, Source: Wall Street Journal, March 15, 200226 Ibid, March 15, 200227 Ibid, April 10 200228 Ibid, March 21, 2002

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to receive a letter from the SEC asking for accounting-related material relating to the Enron partnerships.

External and Internal Audits: In the course of an investigation stemming from a lawsuit from Oasis Pipeline Co. recently, Andersen disclosed that it received $54 million in fees from Enron for the period 1988-1991 including consulting fees of more than $13 million a year. Soon Andersen hitched upon a strategy to provide internal auditing services to customers who wanted to outsource the duties. The push to outsource oversight of Enron’s internal audit function came out of discussions from Enron’s audit committee in the early 1990s. The committee felt that this was a good idea because Andersen’s expertise would provide more “real-time analysis” of whether Enron’s controls were effective29. Once it won the contract, instead of establishing “Chinese Walls” between the external and internal audit teams working at Enron, Andersen encouraged a “culturalization” of the work teams, bringing the internal and external auditors together on the same floor at Enron.

Ignored Red Flags: Enron’s auditors knew about the Watkins allegations long before the company’s audit committee did. On August 21st, Sherron Watkins, the whistle-blower, had a conversation with an Andersen audit partner who was not assigned to Enron and he passed on a “very troublesome scenario” to several auditors (refer to Exhibit III). By October 9th, Andersen analysts had determined that there was a heightened risk of financial-statement fraud at Enron but the company later claimed that this test was conducted on an experimental basis using software that was found to be “flawed”.

Focus on Consulting: It has been reported that Andersen realized that the way to accrue revenue was to focus on consulting as opposed to auditing. Fees for auditing began to fall in the 1980s as firms began to outbid one another aggressively for audit engagements – the lowest bidder usually won the contract; this gave incentives for partners to attract non-audit business from their clients. The pressure on revenues also built-up as Andersen Consulting (now Accenture) separated from Andersen after paying the latter just $1 billion. The problems with focusing on consulting are evident in Andersen’s biggest accounting blow-ups. For e.g., in the case of Waste Management, the company billed the company $7.5 million in audit work during 1991-97 but also received $17.8 million in consulting work, including $6 million for Andersen Consulting. For this case, SEC fined Andersen $7 million. Amongst other recommendations issued by Paul Volker, former Federal Reserve Chairman, now appointed to implement changes at Andersen, are to break-up the 88-year firm into separate auditing and consulting practices.

29 Statement made by Neil Eggelston, attorney for Robert Jaedicke, Enron Audit Committee Chairman

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Note that for its work, Andersen billed Enron $25 million in audit fees in 2000 and an even larger amount of $27 million for its non-audit fees. According to congressional testimony from former Enron executives, Andersen signed-off on Enron’s accounting treatment of the complex partnerships that kept debt and obligations off its books. The firm’s role has sparked criticism that accountants are not tough enough on audits before they fear losing lucrative consulting work. Of course, Andersen denies those charges.

Liability: Initially Andersen offered about $575 million in mid-February for a settlement of civil claims related to Enron; last week Andersen slashed that offer to $375 million, a reflection of the firm’s dimming long-term revenue prospects (as clients leave daily and as partners transfer their capital as non-US offices merge with other firms)30.

Reason to Know: The sad part of this entire episode is what I would characterize as Andersen’s reason to know and actually knowing part of the problems (refer to Andersen memo in Exhibit IV). This memo indicates that Andersen discussed the whole host of issues including LJM, Fastow’s conflict of interests; the audit firm concluded that Enron’s mark-to-market earnings was “intelligent gambling”. The firm decided to continue as they felt they had an appropriate audit system in place manned by suitable people. While the meeting concluded that the firm would investigate as to whether LJM would be viewed as an affiliate from an SEC perspective, I am not sure as to whether this actually passed through the looking glass. Other news articles have indicated that Andersen was pandering to the whims of Enron - Carl Bass, a member of Andersen’s Professional Standards Group that offers specialist expertise on difficult accounting issues, was removed from his Enron oversight role on March 12, 2001 in response to complaints by Richard Causey about the former’s resistance to the company’s accounting practices31. The problem was relating to the use of the aggregated impairment-test methodology while writing down losses at the Raptors vehicles.

Further, I read that during the early part of 2001, Enron’s Chief Executive, Joseph Bernardino, received a warning from a top Enron executive that the energy company was doing a lot of complex financial transactions and needed more auditing expertise than it was getting32. The CEO, along with a few top executives, met with Enron’s chief accounting officer, Dick Causey; however, the meeting was a meet-and-greet session and did not discuss the issues raised at Andersen’s internal meeting. This was surprising as only two weeks before, Andersen’s partners were debating as to whether Enron should be retained as a client. Instead, Andersen’s CEO received a request from the Enron official

30 Ibid, March 20, 200231 Ibid, April 3, 2002 32 Source: Washington Post, March 28, 2002

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asking that more expertise be devoted to the account to “get decisions faster” and “keep pace with the business they were doing”.

Not Provided Information?: In his testimony before the Committee on Financial Services in February 2002, the CEO of Andersen, alleged that the firm was not provided details on Enron’s arrangements with Barclays whereby the company provided a guarantee to the financial institution for providing outside equity capital into Chewco. In fact, Barclays provided the equity interest through purchasing yield certificates from two intermediary entities, Big River Funding LLC and Little River Funding LLC.

Integrated Audit – Asset or Liability? : Andersen’s concept of “integrated audit” which it carried out at Enron and which it marketed it to other clients has recently landed the company in more trouble. The videotapes recovered show that Andersen was virtually an arm of Enron. With Andersen needing to be close to Enron’s offices, Skilling said that given that the company was moving too quickly, Andersen had to be involved in the business. More than 100 employees of Andersen eventually worked at leaded space in Enron’s Headquarters. Just as Enron hired some Andersen people, Andersen hired Enron internal auditors.

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Part V - The Ugly Impact of Off Balance Sheet Entities - Restatements

The company made several re-statements to its accounting records and financial statements over the last quarter of 2001. Most of these re-statements pertained to transactions with the off-balance sheet partnerships. The company announced on October 16th, 2001 that it was taking a $544 million after-tax charge against earnings relating to transactions with LJM2 Co-Investment, L.P (“LJM2”), a partnership managed by Andrew S Fastow – the ex-Chief Financial Officer, and a write-down in shareholders’ equity of $1.2 billion33. In its 8-K filed on November 8th 2001, the company determined that the financial transactions of Chewco L.P which was an investor in Joint Energy Development Investments Limited Partnership (JEDI) should have been consolidated in November 1997, those of JEDI where Enron was an investor and was consolidated in the first quarter of 2001 should have been consolidated in November 1997 and that of LJM1 should have been consolidated effective the beginning of 1999.

The company had to re-state its financial statements during the period 1997-2001 owing to “accounting errors”. The extent of the re-statement is presented in the table below34:

Table 6 – Restatements Made by EnronComponent Year Before ($

in millions)

After ($ in millions)

% Change

Net Income 1997 105 77 -271998 703 570 -191999 893 645 -282000 979 880 -10

Shareholders Equity 1997 5618 5360 -51998 7048 6657 -61999 9570 8860 -72000 11470 10716 -7

Debt 1997 6254 6965 111998 7357 7918 81999 7151 7836 102000 8550 9178 7

Source: Enron Annual Reports

33 Management explained these write-offs as follows: “related to losses associated with certain investments, principally Enron’s interest in the New Power Company, broadband and technology investments, and early termination during the third quarter of certain structured transactions with a previously disclosed entity”34 Intention to restate was provided in 8-K filing on November 8, 2001 and more disclosure was provided in the form 10-Q on November 19th, 2001. The company collapsed and filed for relief under Chapter 11 of the United States Bankruptcy Code on December 2nd, 2001.

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While Enron was badly hurt, the various off-balance sheet partnerships proved to be extremely beneficial to Enron employees – Fastow received $30 million for his dubious role, Kopper became richer by at least $10 million and a couple of other employees reached the millionaire landmark.

Note that the full extent of the restatement and audit adjustments have been provided in Table A included in Appendix III. Below each restatement, I have provided a comparison of the prior and the restated figures through presenting the percentage change in the item being analyzed. I have also presented the revised debt-equity ratio. A summary of the impact of the restatements is given below:

Net Effect on Debt Equity Net IncomeChewco Consolidation LJM1 Subsidiary

A brief overview of the restatements is given below :

Reduction in Shareholders Equity: The reduction in shareholders’ equity by $1.2 billion was explained as an accounting error made in the second quarter of 2000 and the first quarter of 2001. Enron had issued common stock to the Raptor entities (detailed earlier) and had received notes receivable in consideration; instead of reflecting the notes receivable as a reduction to shareholders equity, the company presented separate notes receivable and shareholders equity. The effect of such accounting was to increase shareholders equity by $172 million in 2000 and another $828 million in 2001.

Chewco Transactions: Enron’s decision to consolidate Chewco retrospective November 1997 was based on information that Chewco did not meet the accounting criteria to qualify as an unconsolidated SPE. As a result of Chewco’s failure to meet the criteria, JEDI, in which Chewco was a limited partner, also did not qualify for non-consolidation treatment. The end result was that Enron’s net income would be further reduced, as income from JEDI revenues allocated to Chewco would be eliminated on consolidation. This, in effect, reduced Enron’s share of JEDI earnings.

LJM Transactions: Enron and Enron-related entities entered into 24 business relationships in which LJM1 or LJM2 participated. These relationships included :(1) sales and reverse sales of assets from Enron to LJM (2) purchases of debt / equity interests in Enron’s SPEs by LJM (3) purchases of debt or equity interests by LJM in Enron affiliates or other entities in which Enron was an investor (4) purchases of equity investments by LJM in SPEs designed to mitigate risk in Enron’s investments (5) the sale of call option and put option by LJM on physical assets and (6) a subordinated loan to LJM from an Enron affiliate. The decision to consolidate the LJM1 subsidiary (related to Enron’s

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investment in the stock of Rhythms Interconnections) was done because Enron re-assessed the transactions and noted inadequate capitalization.

A transaction related to dark fiber optic cable that will provide an idea to the reader as to the level of complexity involved in the transaction is presented in Figure H.

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Part VI - Evidence of Red Flags

The next question that arises is whether the downfall of Enron could, in fact, have been foreseen. Given the level of complexity involved, I doubt whether the downfall could have been foreseen a couple of years ago. However, events over the last three years had built-up a stream of red-flags which in aggregate provided several warning signals; an approach to question the company in its progress could have been more beneficial. This section provides an overview of red-flags which could have been noted:.

Prior to reading this section, refer to Appendix IV for a brief overview on SEC rules.

Corporate Governance: Note that this is not a red flag by itself. There is no doubt that the issue of board independence and corporate governance will be receiving renewed focus now. Enron’s audit committee could be at best described as insipid and is alleged not to have even challenged a single transaction. Several people in the media and industry observers have said that the audit committee lacked independence and judgement and did not appear to have been consistent in their attendance. Half the members of the audit committee lived abroad and some of them (example billionaire Ronnie Chan) missed more than 25% of committee meetings during 1996, 1997 and 2000. Interestingly, when I reviewed the second quarter of 2001 10-K, I noted that the ratio of approving to non-approving shares for Ronnie Chan’s election was 5.4:1, with the next lowest ratio that of Wendy Gramm was at 45:1. Notwithstanding apparent “disapproval” from shareholders, the company went ahead with the retention of Chan. The following table provides a background of the members of the audit committee and selected information that has been reported in the media:

Table 7 – Profile of Audit Committee of EnronPerson Background RemarksDr. Robert K Jaedicke

Emeritus Professor of AccountingFormer Dean, Graduate School of Business, Stanford University

Headed committee since 1985; too long a tenure critics say

Ronnie Chan Chairman of Hang Lung Group, Hong KongDirector of Motorola and Standard Chartered

Missed 25% of meetings in some years as noted above

John Mendelsohn President, M.D Anderson Cancer Center, University of Texas

Enron or related entities have donated $1.6 million to Center since 1995

Paulo Ferraz Executive Vice-President of Reported to have won his

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Periera Grupo Bozano Enron director position through a personal relationship

Lord John Wakeham

Member, U.K House of Lords Earned $72,000 a year as consultant for Enron Europe since 1996

Wendy Gramm Director, Regulatory Studies Program, Mercatus Center, George Mason University

Enron has contributed $50,000 to the Center since 1996.

The committee did not appear probing in its approach and was under the impression that the conflict of interest issue was not material as the partnership was a one-off transaction. The committee is also alleged to have not been involved when deciding which law firm would investigate the warning signals raised by Sherron Watkins. What’s more surprising, the audit committee was not in the know regarding the whistle-blowing activities and Andersen did not inform the board till November 2nd and even then, the board was just informed “of possible illegal acts within the company concerning one partnership”. The reason for this delay in informing the board can possibly traced to the fact that the comptroller normally recommends to the audit committee regarding auditor appointment and the latter usually had a more intense working relationship with management than the once-a-quarter rendezvous with the audit committee. This was despite the fact that the 1999 annual report states that “Independent public accountants have direct access to the audit committee, and they meet with the committee from time to time, with and without financial management present, to discuss accounting, auditing and financial reporting matters”.

Stock Price and Credit Rating Criticality: While this point is not a red-flag by itself, it reflects on why Enron considered a high stock price and improved credit rating as important: In the 1998 Annual Report, Enron states that Enron was a party to certain financial contracts which contained a provision for early settlement in the event of a significant market price decline in which Enron’s common stock falls below certain levels (prices ranging from $15 to $37.84 per share) or if the credit ratings for Enron’s unsecured senior long-term debt obligations fell below investment grade. These disclosures reflect that a sharp fall in the stock price could create a collapse by triggering a “run” on the company.

Description of Counterparties: The description of counterparties was less than satisfactory in some statements. For e.g. in the 1998 annual report, Enron stated that “counterparties to forwards, futures and other contracts entered into primarily for the purpose of hedging the impact of market fluctuations on assets, liabilities, production or other contractual commitments are equivalent to investment grade financial institutions”. This is a statement that can be described vague at best.

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Little Disclosure: Levels of disclosure by Enron were abysmal and could have been questioned by analysts. For example, the 1998 annual report states “Enron issued approximately 3.8 million shares of common stock in connection with the acquisition of certain assets”. It is extremely unclear what assets were acquired given that no stock was issued in connection with the acquisitions made in 1998. Certainly, this does not relate to fixed assets as the amount of increase reflected in the balance-sheet together and that stated in the cash flow statement almost match.

Moving Off Balance Sheet: There were several mentions in the annual report that provided a hint that Enron was moving its debt off-balance sheet through deconsolidation / use of special-purpose entities:

The 1999 annual report provides that “Enron’s debt-capitalization ratio declined from 42% to 38% primarily through the issuance of 27.6 million shares of common stock, and increased preferred stock outstanding following the deconsolidation of Whitewing Associates L.P”. The report also mentions that “Enron is a party to certain financial contracts which contain provisions for early settlement in the event of a significant market price decline in which Enron’s common stock falls below certain levels..The impact of this early settlement could include the issuance of additional shares of common stock”. While the first statement is clear as to the use of off-balance sheet partnerships, the second statement is vague and could possibly have alluded to the need to support the limited partnerships if the stock price collapsed through additional shares.

Movements in Shareholders Equity: Some of the movements in shareholders equity were pretty obvious. For e.g. if we look at shareholders equity statement (in Table B in Appendix III) for 1999, equity in the form of mandatorily convertible junior preferred stock increased by $1 billion. However, if we look at cash flows for the same year, issuance of common stock is recorded at $852 million that is also reflected under sales of common stock in the shareholders equity – an addition of $839 million. Consequently, it looks like no cash consideration was received for the issuance of shareholders equity. In a subsequent section, the company stated that these shares represented an exchange of other Series A preferred stock held by Whitewing; I could not find any Series A preferred stock held by the company as of the beginning of the year.

Again looking at shareholders’ equity for 2000, the contradiction comes out. While common stock as reflected in Table B is shown to increase from $6.6 billion to $8.34 billion, a closer analysis indicates $330 million under “other” and $966 million relating to “issuances relating to benefit and dividend reinvestment plans”. Treasury stock also reflects a $251 million re-issuance under “benefit and dividend reinvestment plans”. The cash flow statement

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shows a $307 million under issuance of common stock. While it is almost impossible to reconcile the differences in cash flow, I would have questioned the sudden $708 million or a 274% increase under the dividend and benefit reinvestment plan. There are no further disclosures in the report on this issue.

I reviewed the movements in shareholders’ equity in the first quarter of 2001. Note that the company had excluded the statement of changes in shareholders equity in its 8-K filing. Hence, I am left to making my deductions from cash flows and the shareholders equity line in the balance sheet. I could relate the huge increase in Treasury stock of almost $1 billion to a $785 million inflow of Enron stock due to the re-consolidation of JEDI and another $226 million in the cash flow relating to acquisition of stock. The problem lies in the issuance of common stock: Common stock balance increased by $1.1 billion while the inflow in the cash flow statement came in at $119 million. The increase came through an offset to notes receivable. As the 10-K states “Enron has entered into agreements with entities formed in 2000 to deliver 12 million shares..and in exchange, Enron received notes receivable of approximately $827.6 million. The transactions resulted in non-cash increases to non-current assets and equity”.

Limited Partnerships: Continuing from where we left-off in the above point, there were some disclosures pertaining to limited partnerships which could have triggered some thoughts in the mind of analysts and rating agencies as follows:

1999

(i) The company states in its annual report that Enron entered into a series of transactions involving a third-party and LJM Cayman LP and goes on to say that the same was a private investment company which engages in acquiring or investing in primarily energy-related investments.

(ii) Conflicts of interest were also apparent as the company stated, “a senior officer of Enron is the managing member of LJM’s general partner”. While the company also stated that the Enron officer would have no pecuniary interest in Enron common shares provided to the entity, and would be restricted from voting on matters related to such shares, two points come to my mind: First, the analysts and rating agencies should have looked at the apparent conflict of interest closely and questioned the company as to the need for such conflict of interest. Secondly, with Enron representing an investment grade credit risk, there would definitely be genuine counterparties who would be willing to take on such risk and the need for such a partnership was not clear. Further, while the company outlined a few controls as mentioned earlier, there were no

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disclosures as to how the conflicts of interests would be mitigated though such disclosures are not mandatory.

Overall, Enron’s disclosures relating to third-party transactions were inadequate. First of all, these disclosures did not provide enough information for investors to understand the economics of the transaction. Secondly, while the company mentioned that a senior officer had interests in some entities with which Enron transacted, the company did not disclose the name or position of the person, the amounts of such transactions, the economic benefits that the CFO derived from such transactions nor the purposes of these transactions. An incomplete assertion was also made that the transactions were at arms-length between the two entities. This contravenes the SEC rules that are briefly explained below:

Item 404 of the SEC Regulation S-K lays down the requirements for disclosures relating to third-party transactions in the non-financial portions of SEC filings, including proxy statements and the annual reports on Form 10-K. This item under sub-section (a) requires disclosure of transactions exceeding $60,000 in which an executive officer of the company has a material interest, “naming such person and indicating the person’s relationship to the registrant, the nature of such person’s interest in the transaction (s), the amount of such transaction (s) and, where practicable, the amount of such person’s interests in the transaction (s)”. The section also provides that “the materiality of any interest is to be determined on the basis of the significance of the information to investors in light of all the circumstances of the particular case. The importance of the interest to the person having the interest, the relationship of the parties to the transaction with each other and the amount involved in the transactions are among the factors to be considered in determining the significance of the information to investors”.

(iii) The use of Enron’s stock as a hedging mechanism came out clearly in the disclosure. To quote “LJM received 6.8 million shares of Enron common stock subject to certain restrictions and Enron received a note receivable and certain financial instruments hedging an investment held by Enron. LJM repaid the note receivable in December 1999”. While the credit to shareholders equity was not incorrect if funds had been received from LJM, the cash flow statement did not testify to this statement from the company. Second, the fact that Enron’s stock supported the hedge is obvious and this conveyed that the hedge was just notional.

(iv) Yet another conflict of interest is clear from JEDI where the company stated “ An officer of Enron has invested in the limited partner of JEDI and from time to time acts as an agent on behalf of the limited partner’s management”. For a passive investment in an SPE, I am unable to comprehend as to why an officer of Enron needs to act as an agent and further, make an investment in JEDI.

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(v) The point regarding conflict of interests was accentuated WITH disclosures regarding contract with affiliates. The annual report discloses “From time to time, Enron has entered into various administrative services, management, construction, supply and operating agreements with its unconsolidated affiliates”. While management went on to state that these agreements were at arms’ length, I wonder whether analysts and others questioned management as to why the company needed to provide administrative support to unconsolidated affiliates.

2000

(i) The company’s intention to further support its off balance-sheet limited partnerships was made apparent through its disclosure: Under a share settlement agreement formed with Whitewing L.P, Enron was obligated under certain circumstances to deliver additional shares of common stock or Series B Preferred Stock for the amount that the market price of the converted Enron common stock was less than $28 per share. In the year 2000, Enron increased the strike price to $48.55; this was done ostensibly “in exchange for an additional capital contribution to Whitewing by third-party investors”. Given the average share price of $82 in 2000, there was just a 30% buffer for Enron before Whitewing could enforce the agreement. I am unable to comprehend as to why Enron needed to support a third-party investor in Whitewing. Further, if a third-party investor is supported, is the capital provided by the third-party really at risk as required for not consolidating an SPE.

(ii) The disclosures also seemed to “mandate” the need for Enron to acquire the third-party interests in Whitewing L.P or else the latter could liquidate its assets and thereby, pass on its losses, if any, to Enron. As the annual report stated “Enron has the option to acquire the third-party investors’ interests. If Enron does not acquire the third-party investors’ interests before January 2003, Whitewing may liquidate its assets and dissolve”.

(iii) The extent of performance guarantees provided for third parties and in particular unconsolidated equity affiliates was quite staggering. These guarantees are crucial because for one, the affiliates may not be in a position to repay Enron if the guarantees were exercised by the beneficiary and second, guarantees are normally subject to International Chamber of Commerce regulations which provide for simple documentation for drawing upon guarantees – just a statement that the affiliate / third-party had defaulted. Also, unlike financial institutions which provide risk-based capital for guarantees and other off balance-sheet liabilities, industrial corporations are not obligated to do so. One of the data points that I examined was comparing the debt-equity ratios of Enron with the inclusion and exclusion of guarantees (Refer to Figures 19 and 20). I looked at two scenarios where I risk-weighted

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guarantees with 100% and 50% (given that guarantees are contingent liabilities which may not be drawn upon). While some of the guarantees were collateralized, prudent financial analysis requires that such obligations also be looked at especially when the history of the third-parties/ affiliates is unknown. Note that there is almost a 25% difference to the debt-equity after considering guarantees.

(iv) The numbers involved in the related party transactions were astounding and seemed to represent the same pattern as in the previous year. I have tried to portray the detailed transactions in diagrams in Figure I; while save for my few comments the diagrams have not added any more clarity to the transactions, a few things struck me as I drew this out: First, the few disclosures highlighted the incredible complexity of the transactions. Even the expert investor cannot gain any insight without being privy to more information regarding transactions. Second, the SEC clearly needs to enact additional legislation to ensure that relevant and easily comprehensible information is available. Third, there is more onus on analysts to go beyond the information contained in financial statements to arrive at the truth.

(v) The other red flags which were apparent to me from these disclosures were as follows: First, the capacity of these related parties to be a valid counterparty for derivatives with a notional amount of $2.1 billion is suspect. With an investment grade risk like Enron, it seems doubtful that a limited partnership had to be formed to off-load risk. I am sure there could have been genuine counterparties willing to take-on risk. Second, some of these transactions appear to be the same as those of prior years – exchange of stock for notes receivable with a commitment to provide further stock when the market price declined. Thirdly, there were reversals of transactions as detailed in the diagram that seemed to be done with the purpose of providing an assurance of return to the related party. For e.g. Enron purchased an out-of-the-money option for several millions of dollars. Fourth, the fact that Enron used the limited partnerships to sell assets sets me thinking on the true purpose. For e.g. Enron sold some optic fiber inventory to a partnership – was this because they could not find another buyer for an asset which management knew was not worth anything. Fifth, the earnings derived from off balance-sheet partnerships were amazing: $560 million of earnings that would be more than a quarter of 2000 EBIT. Sixth, in terms of basic math, the diagram shows that Enron received $1.5 billion of notes receivable (which may or may not have been realized) in exchange for $2.1 billion of assets – a shortfall of $600 million.

(vi) The 8-K report filed for 2000 provided some disclosures regarding transactions with LJM2. The report stated that Enron entered into a number of transactions with LJM2, a private investment company, which was managed by Andrew Fastow, the Chief Financial Officer. The report went on to state that

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Fastow was entitled to receive a percentage of the profits of LJM2 in excess of his capital. The amazing part of the disclosure which could not be missed is that the entire $2.1 billion notional value of derivatives entered into by Enron was with just one limited partnership – LJM2 which draws my attention to the ability of a single-party to hedge all these contracts. While the company mentioned that these transactions were negotiated at an arms length basis with senior officers of Enron other than Fastow, this was untrue, as we know subsequently. Further, management failed to detail the controls that they had in place to mitigate this conflict of interest. Also, note that the 1999 report also provided some disclosures relating to LJM1.

Quarter 1, 2001

(i) The first defensive approach of Enron Corporation came to light in the first quarter’s 10-K where the company stated “all transactions with the Related Party are approved by Enron’s senior risk officers as well as reviewed annually by the Board of Directors”. Specifically, I do not know what circumstances necessitated the changed disclosure by the company – to include controls in place regarding third-party transactions.

Quarter 2, 2001

(i) The extent of revenues derived from unconsolidated affiliates was interesting. The 10-K disclosure provides that “Enron recognized revenues from transactions with unconsolidated equity affiliates of approximately $1,111 million in the first half of 2001, including $125 million related to commodity contracts entered into the second quarter”. The second part of the disclosure was more significant “During the first half of 2001, Enron recognized net revenues of $241 million (of which $5 million related to the second quarter), primarily related to the change in the market value of the derivative instruments entered into with the Entities in 2000 to hedge certain merchant instruments and other assets”. Enron recognized $63 million and $10 million of interest income and interest expense, respectively, on notes receivable from and notes payable to the entities”.

Given that the hedges are made to offset losses, it may be more appropriate to consider net revenues as direct flows to the bottom-line rather than use the net margin as we do with other revenues. Looking at the operating income in the first quarter of 2001, we see that out of $676 million, 36% came through these hedges. This practice of recognizing these revenues seemed to have stopped in the second-quarter or was the company applying the non-involvement of its senior officer (and thereby it was not a related party) with retrospective effect.

(ii) The other interesting bit of disclosure states “During the second quarter of 2001, Enron did not recognize material revenues or income from transactions

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with the limited partnerships discussed below. Additionally, the senior officer, who previously was the general partner of these partnerships, sold all of his financial interests as of July 31, 2001 and no longer has any management responsibilities for these entities. Accordingly, such partnerships are no longer related parties to Enron”. This was the second consecutive quarter where Enron had made such defensive disclosures. If there was nothing wrong with these entities and with the senior officer’s involvement, why discontinue the practice and also state that there were no material earnings from these partnerships? Given the date of filing of the 10-K on August 14th and that Jeff Skilling, the CEO, resigned the same day, were the additional disclosures linked to Skilling’s resignation?

Quarter 3, 2001

(i) One of the more intriguing parts of the disclosure in the 10-K for the third quarter related to the claim that Fastow had discontinued his involvement in the partnerships (the statement mentions that these interests held by Fastow were sold on July 31st, 2001). However, what was not disclosed was that the interests were not sold to any third-party but to Kopper who worked for Fastow. Notwithstanding the fact that Kopper resigned from Enron before he purchased these interests, his involvement in earlier partnerships and his contacts with Enron officials could have given him an unfair advantage.

(ii) Some of the statements made by Enron in the course of this filing made it clear that the derivative contracts and hedges with the limited partnerships did not transfer economic risk but were merely used to hedge profit and loss volatility. As the report mentions “Enron and LJM established a series of SPEs to mitigate market exposures on Enron investments. Three of the Raptors vehicles were also capitalized with Enron stock and derivatives that could have required the future delivery of Enron stock. The derivatives and options generally were intended to hedge Enron’s risk in certain investments having an aggregate notional amount of approximately $1.9 billion. In the first quarter of 2001, Enron entered into a series of transactions with the Raptor SPEs that could have obligated Enron to issue common stock in the future in exchange for notes receivable. In the third quarter of 2001, as a result of deterioration in the credit quality of the Raptor SPEs caused by the decline in Enron and New Power Company’s stock price, the increase in Raptor’s exposure under derivative contracts with Enron and the increasing dilutive effect on Enron’s earnings per share calculations, Enron terminated the entities. In total LJM1 and LJM2 invested $191 million and received $319 million”. As can be clearly seen the SPEs were mainly capitalized through Enron stock that restricted their ability to provide a true economic hedge. Secondly, note that the LJM partnerships received $319 million for their investment at an IRR of almost 67%.

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Dismal Results in Quarter 3, 2001: Note that the filing of the 10-K for the third quarter 2001 was delayed. The company announced dismal results on October 16th 2001 and filed an 8-K indicating an adverse change in the company. The company announced recurring net income of $393 million for the third quarter, “non-recurring charges” totaling $1.01 billion after-tax, resulting in a net loss of $618 million or $0.84 a share as opposed to net income of $292 million or $0.34 per diluted share during the same period in 2000. The 8-K indicated that Enron was re-stating its financial statements for the period 1997-2000 and had formed a Special Committee to conduct an investigation of transactions between Enron and certain related parties. (Note that despite all these events, the consensus ratings of analysts were 1.2, 2.1 and 2 on subsequent days after the filing where 1 = Buy, 3 = Hold and 5 = Sell). While the analysts may have been encouraged by the potential Dynegy merger, for a company which re-states earnings for four years, is subject to SEC investigation and has established a Special Committee to investigate, the full extent of the problems could have been unknown and a buy decision could not have been justified!

Segment Analysis: I am briefly outlining my review of Enron’s third-quarter results through segment analysis; note that Enron yet again changed its segment reporting. This was one problem that I faced through the analysis – the tendency to change business segments – and such frequent changes do not facilitate cross-period comparison. In addition, if reporting lines were also changed within the organization, it adds stress to the organization. Looking at the segment performance for the third-quarter of 2001 and 2000 (refer to Figures 21-24), margins for the Wholesale Americas business fell to 2.48% from 2.62%, that of Europe and even this performance was only due to energy price volatility during the 2001 quarter. Yet another point I could not reconcile was the fact that Enron presented its revenues during the first three quarters of 2001 as $85 billion, more than two times of the same period in 2000 ($40 billion); this was despite the fact that Enron disposed off five peaking power plants.

The margin of the European business was a negative 0.13% from 0.74%, and that of retail services almost halved from 5% to 2.79%. Portland General’s results also dipped to a negative 1.89% from a profitable 33%, primarily due to unfavorable conditions: increased power costs from purchases made in prior periods while settling sales at lower prices in that period. As expected, the performance of Global Assets’ was disastrous and this included $287 million asset impairment by Atlantic Water Trust, parent of Azurix Corporation. Enron Broadband Services hijacked the performance of other segments with a whopping $357 million loss on a negative revenue base of $125 million. With continuing weak conditions in the broadband and communications sectors, the business took charges of $287 million for the content business ($160 million), restructuring services ($83 million) and asset write-downs ($34 million). The

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Corporate and Other segment’ loss was in connection with the acquisition of the Raptor vehicles. Ironically, the performance of the natural gas pipelines business was still strong illustrating to Enron that it needed to regain its past focus on this business.

Downgrade in Credit Rating: More than the poor performance and the restatements during the third quarter of 2001, the crucial point was the downgrade in credit rating of Enron’s long-term debt rating to BBB- and Baa3 (the lowest level of investment grade). The reason for this being crucial was that Enron and its trading counterparts regularly made deposits to collateralize some of their trading obligations and a rating below investment grade could have significantly increased the level of cash deposits and margin levels. Further, since Enron had provided guarantees and surety bonds, a further downgrade in credit rating could have potentially triggered collateral requirements. In fact, the downgrade triggered the payment of a notes receivable for $690 million. If Enron were to lose its investment grade rating and the stock price fell further, the company may also have had to repay or cash collateralize additional facilities aggregating $3.9 billion. Non-payment or non-fulfillment of its obligations could have caused a stampede effect and accelerated the road to bankruptcy. As management stated “An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron’s ability to continue as a going concern”.

Trigger Events: I think it is important to review the debt tripwires to understand whether Enron was close to filing for bankruptcy. Prior to that, let me briefly discuss the Whitewing L.P. and Marlin entities. Whitewing L.P was an entity formed by Enron and various investors, and it invested through an entity named Osprey to acquire and own energy-related assets and other investments. Osprey’s net worth was a negative $2.2 billion with an obligation from Enron to support the entity through a stock issuance / cash funding. While Enron was still evaluating the fair value of Whitewing’s assets at the time of filing the statement, it looked like this value may not be very significant judging from the wording in the statement; besides, Enron also had an obligation to Whitewing for $2.1 billion including $1 billion of MIPS. We also need to consider the debt to an entity named Marlin that was formed for acquiring Azurix and this aggregated to $195 million. Note that the trigger events were as follows: (1) Enron’s senior unsecured debt rating falls below investment grade (by any of the three major rating agencies) concurrent with an Enron stock price below $34 per share for Marlin and $59 for Osprey and or (2) failure to deposit funds for redemption of the notes due in 2003. If the triggers were enforced, Enron had a 21-day period to file a registration statement for equity issuance to repay the notes.

At this time, Enron’s credit rating was just one sub-grade above investment grade and its stock price was $9. If Enron’s rating were downgraded, Enron

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would have been forced to raise equity. But raising equity was not an feasible in the public markets given that the filing of re-stated financials for previous years were not completed and would not be completed till the Special Committee finished its investigation. The way out was to do a private placement of equity but there may not have been enough takers given the state of the company; the other alternative was to sell its assets but this could have accelerated the company’s downfall given that a panic reaction was possible.

Liquidity Event: I did a quick back of the envelope calculation to understand whether there was a liquidity event facing the company and have represented this in Table D. For this analysis, I assumed that Enron’s rating could be downgraded one more notch in the fourth quarter of 2001 to below investment grade given that the rating agencies had placed the company’s ratings on a negative watch. While this may be conservative, note that I do not have enough information to determine whether the company’s long-term debt covenants could be violated and whether this would accelerate maturities. The sources of funds are assumed to be cash balance of $1.2 billion, further credit lines from JP Morgan and Citigroup that may not have been possible if these companies did not want to increase their exposure, net sale of assets and the equity infusion from Dynegy. Note that there was a $5.4 billion deficit at the minimum. Enron may have needed to sell further assets including those of Whitewing LP and Atlantic Water Trust (that owned Azurix) though the latter was unlikely to yield much given the continued asset impairment charges. While I would not have ruled out the possibility of Enron getting out of this mess, there was no doubt that the liquidity environment facing the company was challenging to say the least! Ultimately, if there was a contagion effect on creditors, the company had to seek recourse to Chapter 11 if only to obtain automatic protection from creditors.

A Shadow Company: Note that my reading of the 10-K for the third quarter of 2001 gave me an impression that Enron was but a mere shadow of its former self and it would require a concerted effort to remerge as a leading company. Words such as “restructuring plan”, “loss of investor confidence” and “reviewing and strengthening corporate governance” were used in the filing. Management was also in the process of dividing its businesses into core, non-core and businesses under review. Not surprisingly, the core business only included its erstwhile strong businesses such as gas and power business, coal business, retail and natural gas pipeline businesses in North America and Europe.

There was no mention as to what management proposed to do with its trading businesses and new businesses such as water management and wind though the silence may have provided a cue. Even if Enron wanted to continue its trading activity, it would have been difficult as counterparties may not have been willing to take Enron risk, particularly in longer-tenor transactions. Note

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that multiple class action lawsuits had been filed against Enron and current and former officers and/or directors for material misrepresentations related to the business and for also artificially inflating the price of Enron stock. Other legal cases filed since October 16th 2001 included numerous shareholder derivative lawsuits and an allegation that Enron’s directors breached their fiduciary duties to shareholders by agreeing to sell Enron for inadequate consideration. Some of the existing lawsuits that Enron had to contend with related to fraud and misrepresentation in connection with a marketing program in 1996, violation of state regulatory requirements and certain gas purchase contracts and class-action lawsuits related to Azurix.

Further, management clearly stated that the merger agreement with Dynegy had a material adverse change clause that could have the effect of voiding the agreement. It was not a very difficult task to foresee that event given that the trigger point for such voiding was about $3.5 billion in litigation liabilities net of insurance and reserves. This breach would have been feasible given the substantial loss of shareholder confidence. But, on the other hand, it would be best for shareholders to not pursue any lawsuits that could have the effect of voiding the merger. Further, the filing stated that the SEC had also commenced an investigation into Enron regarding certain related third party transactions. The company’s statements also mentioned “it is too early to determine the exact impact these events will have on Enron’s fourth quarter 2001 results. It is possible that the Special Committee’s investigation will identify additional or different information concerning these matters and Enron cannot predict what impact the information gathered by the Special Committee may have on the financial information included in this report”.

Auditors Conflict of Interest: The apparent conflict of interest of the role of Andersen came out quite clearly in the various annual reports that I reviewed. For e.g. the 2000 report mentioned “Andersen was also engaged to examine and report on management’s assertion about the effectiveness of Enron’s system of internal controls”. This illustrates without doubt that Andersen had the role of internal and external auditor of the corporation and this could have raised a red flag as to whether the checks and balances that were in place were actually adequate. Interestingly, the 2000 8-K report also supported the conflict of interest theory by providing the fee structure for Andersen. To quote, “Andersen’s Principal Auditor Fees was $25 million, Financial Information Systems and Design Implementation Fees was $0 and All Other Fees was $27 million. Other fees primarily related to business process and risk management consulting, tax compliance and consulting, due diligence procedures related to acquisitions or other activities, work performed in connection with registration statements and various statutory or other audits”.

Lower Credit Reserves: As is apparent from Table E, the level of credit reserves was deteriorating and came down from 8% in 1997 to 6% in 1999.

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While a lower credit reserve by itself may not be alarming, if we read this in conjunction with the lower proportion of investment grade exposure in the price risk asset portfolio from the same table from 83% to 78% over 1998-99, this could be of concern. Similarly, if we look at the figures for 1999 and 2000, we see a similar trend: investment grade level in the portfolio came out almost flat at 78% while the extent of credit reserves were at 2% in 2000, a further deterioration from the 6% in the previous year. This at a time, when Enron mentioned in its annual report that it had entered into wholesale power utilities in California that could file for bankruptcy protection given the situation in California where wholesale prices were increasing but customer rates were frozen. At the least, this could be a pointer to more aggressive recognition of earnings by management.

Discontinued Operations: Another piece of evidence regarding Enron’s non-compliance with accounting policies is regarding discontinued operations. Note that though Enron announced an agreement with Sierra Pacific Resources in November 1999 to sell Portland General Electric, the results of Portland General were neither reflected in earnings from discontinued operations nor were the assets reflected separately in the balance sheet. As per accounting standards, in the event of the sale or abandonment, earnings from discontinued operations should be reflected as a separate post-tax line item in the income statement from the date of an intention to discontinue; further, assets and liabilities should be reflected as a net item in the balance sheet. For 1999 and 2000, Portland accounted for 15% and 13.6% of Enron Corporation’s EBIT figures.

Sudden Acceleration of Price-Risk Management Activities: This point that I am making is not a typical red flag by itself but is a crucial indicator as regards the dangerous areas where Enron was heading. Looking at Table F, it is apparent that the fair-value of assets and liabilities from price-risk management increased by 300% over the years 1999-2000. Note that income from price-risk management accounted for almost 95% of the income in the year 2000, a significant increase from those of prior years. In the first quarter of 2001, revenues from derivatives trading with entities and interest income from these entities was $255 million – if we assume as before that a major part of these revenues would have flown to the bottom-line, we get something like 60% of net income from these activities.35

Subsequent to my analysis, I read that Enron had an entity called ECT Investments that was an internal hedge fund; this group was launched in 1996, averaged annual returns of more than 20% and was trading about $145 million of Enron’s money before the company filed for bankruptcy. One of the problems associated with this business that could have made it difficult for

35 As one person said, “Enron was a giant hedge fund sitting on top of a pipeline”.

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analysts was the lack of disclosure about the group’s activities. Apparently, ECT made profits of $50 million in 1999; this money flowed into other Enron business units as a profit but was not broken out in the financial statements36.

Low Income Taxes: One point that would have highlighted the use of about 900 subsidiaries and offshore tax havens (which incidentally has not even been mentioned in the annual report) is the low-level of income taxes. Looking at Table C, we see that income-tax expense ranged from 2.4% of revenues or 28% of EBT in 1997 to just 8% of EBT in 1999. I reviewed the reconciliation between the statutory tax rate and the effective tax rate and have presented the same in Figure 25. Note that the effective tax rates were especially low during 1998 and 1999 and were at just 20% and 9% respectively. The reasons for the low tax-rate could be traced to two points: basis and stock sale differences and equity earnings. The former could relate to the tax-benefits that companies receive when employee stock options are exercised and given the appreciating stock price, there were significant options exercises. The second point relates to earnings of foreign affiliates that are retained abroad and that the company does not plan to repatriate to the US. This is also borne out by the 1999 annual report that states, “US and foreign income taxes have been provided for earnings of foreign subsidiary companies that are expected to be remitted to the US. Foreign subsidiaries’ cumulative undistributed earnings of approximately $1.2 billion are considered to be indefinitely reinvested outside the US and accordingly, no US income taxes have been provided thereon. I also charted the tax payments during 1998-2000 and have included this in Figure 26. This is even more surprising in that the company did not pay more than $70 million of taxes in any year. One other reason for the low-tax payments could be the operating loss carry forward of $2.9 billion that Enron mentions in its annual report; the report also mentions that this would expire starting 2011. I was not able to verify as to whether these losses occurred. Nevertheless, the point remains that the number of subsidiaries would have been staggering to have such low tax rates.

Compensation Feature: While Enron’s base salary and bonus seemed to be on the same base as those of other companies, I looked closely at long-term incentive grants. One interesting disclosure was in the 1999 Schedule 14A filing which states that “approximately 75% of the total compensation of Enron’s most senior executives is at risk based strictly upon the performance of Enron relative to stated recurring after-tax net income targets, stock price performance and total shareholder return”. Note that while this aligns management objectives with the objective of increasing shareholder return, there could be a short-term incentive to push up the stock price.

36 Source: Wall Street Journal, April 11, 2002

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The 14A filing for 2001 states that in 2001, awards would be made one-half in non-qualified stock options and the other one-half in restricted stock with a performance accelerating feature. Stock options vest over a four-year period with 25% on the date of grant and 25% on each anniversary thereafter. While restricted stock would vest four years from date of grant, this vesting could be accelerated based upon Enron’s annual cumulative shareholder return relative to the S&P 500.

It was noteworthy that the company accelerated the vesting percentage to 25% each year as opposed to 20% sometime during this period. I am not very concerned with this change, as it is normal to have a 25% vesting period. The more intriguing part is that the report mentions that “total shareholder return for 1998 and 1999 was at least 120% of the S&P 500 and hence, 26.7% vested on December 31, 1998 and 26.7% vested on December 31, 1999”. I have graphed the figures reported by the company in Figure 27 and it is quite apparent that Enron’s performance was not superior to the S&P 500 for the years mentioned. When I looked back at the comparisons made by the company, it claims “this method of calculating shareholder return is different from the method that Enron uses for purposes of its Performance Unit Plan while it does display a similar trend”. It is perplexing as to why the company chooses to use two different methods of computing shareholder return and a more beneficial method for compensating its executives.

I reviewed total compensation for Ken Lay and Jeff Skilling for the years 1998-2000 and have presented it in Figure 28. Note that total compensation jumped significantly from 1999 to 2000 due to the non-granting of restricted stock awards in 1999. As far as components of compensation are concerned, the base salary just constituted 7% of the total compensation. Further, I tried to analyze as to whether the compensation was correlated with performance; however, I did not expect it to be significantly correlated as this has been demonstrated in studies done in corporate America. The graph in Figure 29 was interesting as it showed that though the change in EBIT in 2000 vs. 1999 and 1999 vs. 1998 was not significantly different, compensation increased significantly over the first period while it dropped over the second period.

The other bit of interesting information that I obtained was an accelerating vesting decision made by the Board. To quote, “In February 2000, Mr. Lay’s employment agreement was amended and all unvested options related to the December 1997 grant vested”. This amounts to about 200,000 shares. Similarly, the report said, “For Mr. Skilling, the Committee approved accelerated vesting such that 904,866 stock options vested on February 7, 1999 and the remaining options vested as scheduled on October 13, 1999”. For a comparison, I looked at the stock price and saw that the stock rose 25% between February-October 1999. We may never know the reason for such an accelerated schedule given that Enron did not outperform the S&P as

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promised. Could this have been done to take advantage of the steep rise in the stock price for personal benefit?

Insider Trading: In recent times, a lot of the discussion has centered around the extent of insider trading of stock where the company executives have profited themselves through sales of the stock and that too in the situation, where employees who had the stock in their benefit plans had to lock-up the stock. As graphed in Figures 30 and 31, there is no doubt that Enron executives had personally enriched themselves. My analysis also indicated that Lay and Skilling by and large sold the stock when the price was up. The other bit of analysis that I did with respect to insider trading concerned the extent of sales and exercises made; note that SEC rules existing at the time of the transactions provided a delay upto 40 days of stock sales in the market by executives and upto 410 days when stock was not sold in the market but back to the company. I have discussed the proposed rule changes in a subsequent section. However, I figured out a way by which the same could be tracked. What I did was to use the proxy statements (14-A) for two years; I could obtain the opening balance of stocks held and stock options exercised during the year and compare the same with the balance at the beginning of the next year. This would provide an idea of the number of stocks sold during the year. Prior to presenting this analysis, I would like to demonstrate another analysis that I did. This is illustrated in Figure 32. Note that for both Skilling and Lay, the number of exercisable options went-up during 2000 probably due to higher options grant together with an accelerated vesting period but the number of exercisable options came down in 2000, particularly for Skilling. Further, as can be seen from Figure 33, the number of shares that could have been held at the beginning of 2000 and 2001 were much higher than the actual number of shares held, thus showing that Lay and Skilling were consistently selling their stock. Of course, this analysis could be done only once a year when the proxy statements are filed but nevertheless, this can be done despite the limitations imposed by the SEC rules.

Drew Wealthy Investors:. Articles in the media have given me to understand that brokers informed wealthy investors that investing in partnerships like LJM2 would have assured wealthy investors great returns as the Enron officials running the partnership would “cherry pick the deals”37. The confidential offering memo provided to investors said that the “new partnership would get a chance to invest in deals that would not be otherwise available to outside investors” and promised returns exceeding 30% per annum. The list of investors included the Jon and Catherine McArthur Foundation, the Arkansas Teacher Retirement System, American International Group, employees of Merrill Lynch and JP Morgan, and CIBC. Of course, the concept of “Chinese 37 Statement made by Joseph Marsh relating what his Merrill Lynch broker had told him, Washington Post, March 22, 2002. In fact, Andrew Fastow is believed to have called the potential investor.

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Walls” may be a hindrance in disclosing such activities to analysts. However, this could have been surmounted for two reasons: first, the off-balance sheet transactions related to the limited partnerships and not to Enron and second, the analysts could have always been brought “over the wall” for a short period of time. A recent news article highlighted the role of Wall Street in building up the complex financial structure of Enron; two CSFB bankers who helped design some of the financial vehicles served as directors of one of those entities38.

Revenue Recognition: As far as this point is concerned, I am not sure as to how much of this information was available to analysts. Reports have stated that Enron used various ingenious methods to recognize revenue. For e.g. in a deal signed with Quaker last February, Enron Energy Services (EES) agreed to supply 15 Quaker plants with their energy needs from natural gas to workers and guaranteed that Quaker could save $4.4 million on its energy bill. Enron forecasted $36.8 million in profits; however, it used mark-to-market accounting to book $23.4 million in profits before even delivering on the contract. Normally, activities such as broiler maintenance are not subject to mark-to-market accounting, as forward contracts do not exist for such activities. These are supposed to be booked on an accrual basis as and when the service is delivered and payments become due. The company used a method called “revenue allocation”. What the company did was to simply redefine as commodities most of the services that it was rendering to Quaker. Under the system, Enron’s internal accountants created a category called “allocated revenues” where revenues were not based on what Quaker had historically paid for energy commodities and service contracts but on what the open market value was of the commodities. In reality, Enron would have only made small margin on supplying gas and power to Quaker; in fact, these could have been loss making due to the discount given to Quaker.

Further, Enron would deliberately under-estimate the commodities’ prices in the latter years of a contract to lower Enron’s cost; these estimates were difficult to debate as for one, Enron was the market-maker and these markets were illiquid and secondly, it was difficult to estimate future prices. Also, the company took into profits right away the amount of “efficiency gains” it would make during the course of implementation of the project at Quaker.

Media Warning: I came across an interesting article in Fortune dated March 2001. The article stated that Enron was being valued at 55x earnings at that time (Refer to Figure 34 which demonstrates the fact that Enron’s multiples were increasing during 1997-2000; Figure 35 has the stock price trends) but the company felt that the stock should have been valued at $126 or 150% of the then trading price. The article also questioned as to how Enron made money. As the reporter stated “Enron remains largely impenetrable to


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outsiders..and the numbers that the company presents are often extremely complicated”. The report also highlighted that the company had changed the way it earned money; note that I have highlighted this earlier. In 1990, around 80% of its revenues came from the regulated gas and pipeline business while through the latter part of the decade, the company was selling off its core assets and derived more than 80% of its profits from “wholesale energy operations and services”. This was usually described in vague, grandiose terms like the “financialization of energy”. People, in fact, referred to Enron as the “Goldman Sachs of Energy Trading”. The surprising part of all this was that Enron dismissed any notion that it was a trading company. It distinguished its trading activities from those of Wall Street firms by stating that Enron delivered a physical commodity and did not thrive during volatility. The company also had 1,217 trading “books” for different commodities but was steadfast in not disclosing where it made money39.

Cross-Company Comparisons: Enron has, over the past few years, been referred to as the “Goldman Sachs” of Energy Trading. I thought it might be interesting to analyze the compare the performance of Enron with other global giants. I looked at Tyco and GE that are conglomerates similar to what Enron was aspiring to be, and Goldman Sachs, and JP Morgan and Citigroup that are diversified financial services companies. Note that this type of analysis has its limitations given the different returns in an industry, varied business cycles, and business models as also the benefits accruing to an investor through portfolio diversification. Nonetheless I compared the price-earnings multiples, relative earnings multiples to industry levels, net income margins and return on equity and return on invested capital. I have presented the comparison in Figures 36 to 41. As can be seen from the figures, Enron’s net income margins pales in comparison to those of other companies which implies that we need to go further and look at Enron’s performance vis-à-vis competitors in the energy industry. Similarly, its ROE of 8.5% in 2000 looks poor when reviewed with other companies such as GE and Tyco that provide 25% and that of Citigroup at 21%40. When I reviewed the price-earnings multiples, Enron’s peak multiples of 78 are amongst the highest in the group save for that of Tyco. Looking at the lower-range and current multiples are quite meaningless given that Enron is a Chapter 11 company while others are formidable going-concerns. I could have also looked at average multiples but data was not available. Before I move on, I need to warn the reader that there could be some inconsistencies in computation as data for other companies have been derived from Dow Jones while I have calculated the figures for Enron.

39 In fact, Andrew Fastow boldly said “We do not want anyone to know what’s on those books. We do not want to tell anyone where we are making money”.40 Skilling’s explanation of this low return was that Enron had made huge investments in plants and other assets and that the company was shedding its underperforming old-time assets as soon as possible and getting onto new businesses whose returns were higher.

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Peer Group Comparisons: I felt that a peer group comparison was mandated to understand whether Enron was much further ahead of its competitors as commonly professed and here, the “miles-ahead” notion was just a myth. The comparisons have been presented in Figures 42 to 47. Prior to going further, the reader should note that, in these comparisons, Enron’s figures for 2001 are for the first three quarters (except for the ratios that have been annualized) while those of other companies are for the full year. The one point that stands out clearly is that Enron towered above its competitors in terms of sheer size as indicated by Enron’s revenue for 2000 which was more than 2x that of Duke Energy and more than 3x that of Dynegy (subsequently, I have noted that some of this revenue presentation of Enron was “artificial” through counting all trading contracts towards “gross revenues” instead of just taking the mark-to-market gains/losses as is done normally by trading firms). In terms of multiples, Enron was trading at a premium when compared to that of its competitors. For e.g. the five-year high multiples indicated that Enron traded at 13% premium over Dynegy and 74% over average of four other companies. However, if you look at ROE, Enron’s performance does not standout from that of other companies. Over the period 1998 till 2001, Enron’s ROE was not the highest amongst peer companies and in fact, was below the average for the comparables during the periods 1998 to 2001. Similarly, net income margins for Enron have been dismal when compared to those of the peer group and except for 1999, was much lower than the average.

Enron Broadband Services: Not much needs to be said about this segment as Figure 47A illustrates what a misadventure this turned out to be! One forecast was provided by Jeff Skilling who told an audience of 170 analysts and investors that Enron’s biggest immediate opportunity was its plan to trade broadband capacity. Based on his analysis, he said that Enron’s broadband business was worth $36 billion or $40 a share (a comment taken at face value by analysts as we shall see later). This comment was made when the stock was trading at $82 and during the time-period when the broadband segment lost $60 million on $408 million of revenues in 2000.

Enron’s Financial Statements: I am analyzing the financial statements of Enron under the following headings: readings from the ratios, deductions from the income statement and balance sheet and the cash flows. Refer to Table D for ratio analysis, Table C for the income statement, Table G for the balance sheet and Table H for the cash flows.

(i)_ Ratios: These ratios do not indicate great improvements in performance over the years at Enron. Refer to Figures 48-50 for graph on the ratios. Speaking of the liquidity ratios, both the current and liquidity ratios remained static but adequate. Interest coverage ratios were steady and liquidity did not appear to be a concern till 2001. While total debt to equity ratio was largely under control in 1998-2000, the ratio started rising during the first quarter of

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2001 and was dangerously high at 1.45 during the third-quarter. Analyzing the long-term debt to equity is an interesting exercise as it provides an indicator as to how MIPS can help “camouflage” the true debt-equity ratio. In almost all years examined, MIPS helped “reduce” the debt-equity ratio by at least 10%. Over 2000, we note that the leverage ratio seemed to have increased significantly. At first, looking at the debt-equity ratio, we do not see an alarming increase and the ratio also seems to be contradictory but a closer review indicates the reason for the sudden jump; a huge increase in price-risk management. Note that assets from price-risk management increased 445% while liabilities increased 471%. Around this time, Enron also commenced its entry into the conflict of interest issues. This was a definite pointer to a changing profile of the company while relied more on trading as opposed to core energy operations. I have talked about ROE in the earlier section and do not want to dwell on that.

Going on to the asset turnover ratios, there were massive improvements from 1999 to 2000 and from 2000 to the first quarter of 2001. Over these two periods, asset-turnover increased by 107% with 59% and 48% increase over these two periods. The reason for this is that turnover was no longer dependent on physical assets but on financial assets built-up through the trading activities of Enron. This analysis is also supported by the ratio of plant and property as a proportion of total assets that declined from 40% in 1997 to about 17% in 2001. However, return on assets did not show any improvement during the periods 1998-2000 and in fact, declined 7% over this period. The same trend applied to gross margins, net margins and EBIT which declined by over 50% over three years.

(ii) Cash Flows: Free cash flows to equity holders have been computed as cash flows from operations minus capital expenditures plus net inflows from debt-holders. The extent of free cash flows per share shows some fluctuations though there does not seem to be an alarming trend except for the first and second quarters of 2001 when these figures were negative. However, a closer look at the cash flow statements brought out an interesting point. The operating cash flow portion of the statements includes proceeds from sales of merchant investments. The more appropriate way to present the cash flow statements would be to compute the operating cash flows excluding proceeds from sales of merchant investments, as this would typically be an investing activity. In any case, proceeds from sales cannot be considered as part of operating cash flows though technically gains on sales can be construed part of operating cash flows if we consider investing to be a core operating business. Giving Enron the benefit of doubt that investing is a core business, I recast the free cash flows through excluding proceeds from sales but including gains on sales i.e. the reverse of what was presented before and have depicted this in Figure 51. As can be seen from this figure, the trends in the revised free cash flows revised are alarming.

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The other aspect that I considered worth examining that was the difference between net income and the extent of cash flow from operations as very often, unrealized gains could be used to beef up income while not resulting in incremental cash flows. We see evidence of this in Table F that shows a burgeoning difference especially in 2001 and the causal element could be due to movements in customers’ deposit requirements. For e.g. in early 2001, the changes in working capital as stated in the cash flows was an increase of $3.1 billion while the components of changes presented in the statement were $800 million. The difference of $2.3 million refers to movements in deposits with counterparties. From the disclosures made by Enron, it looked like it was return of deposits to counterparties though I do not understand what caused such a huge return of deposits.

(iii) Income Statement: The critical element that I looked at was the extent of unrealized gains and realized gains as reflected in Figure 52. While the former provides an idea of the extent of mark-to-market accounting, the latter helps us understand the extent of reliance on investment activities. I computed the extent of unrealized and realized gains and compared it to income before tax. Note that the denominator of this ratio may be under-stated as this computation implicitly assumes that no interest expense is allocated to these investment activities. Using this ratio as a benchmark, there is no doubt that the extent of unrealized gains has been crucial in boosting the fortunes of Enron and has been more than 80% during the period 1997-2000.

The first think that is striking when looking at the income statement during the years 1999 and 2000 was the dramatic increase in revenues that increased by 151% in 2000 as compared to the previous year. While management stated that Enron had a fantastic year, they never explained about the bottom-line. While operating margins were at 4.41% in 1998 and declined to 2% in 1999, the same further declined to 1.94% in 2000. In effect, for a 150% increase in revenues, the company just produced an 8% increase in net profits. If we look at the break-up of revenues provided in the annual report and summarized in Figures 6 to 8, the EBIT margins of almost all business segments were down – wholesale services’ margins came down from 3.63% to 2.37% while that of retail services declined from 34% to 25%. Note that wholesale services’ revenues increased by 160% over this period and this was proclaimed as the result of the fantastic success of EnronOnline but as can be seen from the above analysis, this did not translate into a favorable bottom-line impact.

The other line that interested me in the break-up provided on the face of the income statement was Enron Metals. All of a sudden, the company presented a revenue base of $9 billion that accrued perhaps through the acquisition of MG plc in July 2000. While this new acquisition accounted for almost 10% of the expanded revenues, the company did not quite care to provide the profitability

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of this new venture. I looked at the Business Acquisitions Section to garner further details on this acquisition. MG plc was acquired for $2.1 billion including $413 million paid in cash. This company was a “leading international markets metal-making business that provides financial and marketing services to the global metals industry”. If the company was focused on trading, we would expect to see huge goodwill and we see about $963 million of goodwill booked. However, what was most surprising was the lack of presentation of any pro-forma information. In fact, the company did not even mention whether it used the purchase or the pooling method though we know that with the high use of cash, the company should have used the purchase method. While reporting rules mandate the presentation of pro-forma information from the beginning of the year, Enron made no such disclosure.

The analysis presented above is by no means exhaustive and has been presented for the years 1999-2000 only. This just goes on to illustrate that analysts and investors need to go through financial statements and the variances from year-to-year with a toothcomb to review for unusual changes. One of the problems that I faced with looking with Enron was with respect of segment disclosures. First, there were frequent changes in the aggregation of business segments; whether this was done with a supported rationale or for hiding “unfavorable results” is unclear though given the turn of events, I would presume it is the latter. Secondly, Enron lumped together various businesses under the category of “wholesale services” which comprised 95% of year 2000 revenues. However, when it came to sub-segment disclosures, Enron just provided broad-disclosures in the form of Income Before Income Taxes for Commodity Sales and Services, Assets and Investments and Unallocated Expenses for these businesses and the physical volumes transported. It is extremely difficult to comprehend as to which sub-segment grew and what factors induced growth (efficiency? cost controls? price increase?). However, it would be unfair to be critical of just Enron for this lack of disclosure. With companies like GE, and Tyco, the problems are far worse!

(iv) Balance-Sheet: For this analysis, similar to what I did for the income statement, I am primarily looking at changes that took place over the period 1999-2000. On both the assets side and the liabilities side of the balance sheet, the striking figure relates to assets and liabilities for price-risk-management that increased by 445% and 471% respectively as compared to the previous year. Other assets also display a significant increase with levels increasing by 511% as compared to the previous year. The main reason behind such an increase was deposits that increased from $81 million to $2.4 billion; deposits relate to margins required by counterparties for margin purposes. The fact that deposits increased almost 30-fold is a pointer to the fact that Enron’s trading increased to dizzy levels; this could also imply that with the trading levels of Enron, counterparties may have felt uncomfortable and required

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additional collateral balances. I could not see any other point from the balance sheet per se.

Enron – The Latest

Enron filed a 8-K statement with the SEC on April 22, 2002. Management reported that several ongoing investigations and the absence of an auditor has hampered the company’s progress towards reviewing the adjustments needed and preparing the financial statements as of December of last year. Note that management has stated that they believe that a significant write-down of assets to the tune of $14 billion may be needed; some of this could be attributed to the need for distress sales of assets that were not previously for sale. In addition, a material portion of such estimated amount, would relate to valuations of several assets the historical values of which current management believes may have been overstated due to possible accounting errors or irregularities. This disclosure could add to Andersen’s woes and raises serious concerns as to the quality of their auditing work. In addition to these write-downs, management also raised questions concerning certain price risk management assets that could go downward. These adjustments could result in an additional $8-$10 billion write-down. Altogether, it looks like almost 40% of the company’s asset base is worthless.

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Part VII - Role of Rating Agencies

As can be seen from Figure 53, Moody’s downgraded unsecured debt of Enron (there were other debt categories and commercial paper also; unsecured debt has only been used as an illustration) below investment grade (below Baa) only in November 2001. Note that credit ratings are issued as a relative measure of risk, with the likelihood of default increasing with lower ratings. In a testimony to the Committee on Governmental Affairs in March 2002, the Managing Director of Moody’s stated that the late downgrade could be attributed to the nature of Enron’s activities, Enron’s weak public disclosures and misleading and incomplete answers to requests for specific information. He also justified that at all times, Moody’s had consistently taken a cautious view in rating Enron’s debt obligations and beginning 1989, Moody’s had assigned the lowest possible investment grade rating to Enron

Note: Baa implies that the debt is considered as a medium-grade obligation; it is neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact, have speculative characteristics as well.

In the fall of 1999, Enron began a concerted effort to obtain an upgrade to its credit rating; when Moody’s requested for information, Enron responded by providing what Enron’s executives termed a “kitchen sink” disclosure, which deemed to present all significant financial information about the company. Moody’s Managing Director, John Diaz has now stated that these disclosures did not include the Rawhide, Raptor and Braveheart partnerships. He also alleged that Moody’s provided inaccurate information. Given the information presented, the company upgraded Enron’s ratings from Baa2 to Baa1. The official also stated that even following the resignation of Jeffrey Skilling in August 2001, in response to a concern expressed by the rating agency, Enron denied that any write-offs were forthcoming. Therefore, only after the third-quarter results was announced on October 16th 2001, Enron’s ratings were placed on review for downgrade and Moody’s pressed Enron for further information. The ratings were lowered a notch on October 29th 2001 and placed on review for a further downgrade. The investment grade ratings were justified on the likelihood of acquisition by Dynegy and promised infusion of significant equity.

Moody’s review of the merger agreement and the presence of a Material Adverse Change (MAC) clause almost caused a decision to downgrade debt to below investment-grade status to Ba2 but discussions with Enron and Dynegy officials and Enron’s lead banks kept the ratings above investment-grade. On

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November 9th, instead, Moody’s downgraded the debt rating to Baa3 with a possible review for further downgrade. The decision to assign a rating below investment-grade was made on November 27th when the revised merger deal term-sheet provided lesser equity and non-willingness by banks to up the credit lines for Enron.

I reviewed the presentation made by Jeffrey McMahon, Enron’s Treasurer on January 29th 2000. The initial part of the presentation emphasized on Enron’s improving financial ratios and towards the middle of the presentation, Enron reviewed its off balance-sheet debt and structured finance. The company stated that its non-recourse debt was, of course, non-recourse; Enron also included a kitchen sink disclaimer that read “Enron does not recommend using this analysis for anything other than illustrative purposes and for the purpose of concluding that the off-balance sheet obligations are not material to Enron’s consolidated credit analysis. Cigarette smoking may be harmful to your health”.

Enron mentioned its equity as $10.4 billion which was $1 billion more than what it ended up in 1999; its debt as $7.8 billion which was $700 million more than what its debt was at 1999 end. However, I was perplexed that debt/capital worked out to 39.6%. Probably, Enron computed the ratio with the aggregate of debt and equity in the denominator but even that works out to 43% even if only long-term debt is considered. The only way this ratio could be below 40% was if MIPS were considered equity but it is not! The more surprising aspect is that it mentions off-balance sheet debt as an additional $7.3 billion but the debt/capital ratio only goes up 8 percentage points to 47.7%. I do not know whether I am missing out something! The company also mentioned the equity of the off-balance sheet entities as $4.2 billion but did not mention what this equity was comprised of.

Further, when talking about guarantees of unconsolidated subsidiaries that were not collateralized, Enron mentioned this as $324 million and aggregate guarantees as $924 million. Firstly, this figure is incorrect as guarantees amounted to about $2.2 billion. Secondly, even for collateralized guarantee, if there is insufficient margin, the values of collateral may fluctuate and may not be sufficient to cover the guarantees. Finally, for uncollateralized guarantees, Enron has applied a 5.4% default rate that is an average rate for BB bonds. While a BB rating implies that the rating is less vulnerable in the near-term but may face ongoing uncertain economic conditions, a rating in the arena of “CCC” or so may have been more appropriate for entities that were solely dependent on Enron’s stock price for meeting its commitments. Thinking further, it is puzzling for me as a neutral observer to rationalize as to why the fact that an Enron officer managed these partnerships was not emphasized. While this was stated in its 1999 annual report as a “positive”, I would have

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expected the company to state this “control” was being used to maintain a tight leash on these entities.

Ironically, the company also listed its top ten reasons as to why Enron was under-rated. Amongst these (in reverse order) reasons were: 10-years since the last upgrade, proactive management, premier risk management system, successful equity issuance, major initiatives, low-risk business strategy, favorable ratios, A- risk weighting, no secrets policy, and necessity of a strong credit rating to maintain its market share position. Of these, only the first and last mentioned factors had a grain of truth!

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Part VIII - The Enron – Dynegy Deal

The last straw in the hat for Enron was when the merger agreement with Dynegy failed to go through. Enron agreed to be acquired by Dynegy for approximately $24 billion and the latter would also take-over approximately $13 billion of Enron’s outstanding debt. The deal was also supported by Chevron / Texaco, owner of 26% of Dynegy, which contributed about $1.5 billion in equity to Enron to enable the latter to tide over the liquidity situation. Chevron was also to contribute an additional $1 billion to Dynegy to maintain its equity interest. The transaction was structured as a stock-for-stock exchange. Enron shareholders would receive 0.2685 Dynegy shares for each share of Enron common stock, or approximately $10.40 per share. With the deal, Dynegy shareholders would own approximately 64% of the combined company while Enron shareholders would own about 36%. Dynegy also gave $1.5 billion in cash in exchange for options to purchase Enron’s interest in Northern Natural Gas.

The proposed merger gave a new lease of life to Enron. Since the announcement of the third quarter financial results, Enron’s financial flexibility was crushed with the steep decline in the stock price and a liquidity crunch due to lack of access to credit markets; its credit ratings were lowered by all three credit rating agencies – Standard & Poor’s, Fitch and Moody’s to BBB-/BBB-/Baa3 respectively and the SEC had launched a formal investigation into some transactions. Despite the announcement of the merger agreement, both Moody’s and Standard & Poor’s reduced Enron’s credit ratings by one grade to reflect the restatement of Enron’s financial statements and significant loss of investor confidence.

Dynegy expressed an interest in acquiring Enron with a view to marrying Dynegy’s focused energy convergence strategy with Enron’s wholesale energy business and interstate natural gas pipelines that transported 15% of the nation’s natural gas demand. Enron’s capabilities in information technology including its EnronOnline system and leading energy market making capabilities, were the key drivers behind Dynegy’s interest in Enron’s wholesale energy franchise.

Dynegy killed the merger deal just hours after Standard & Poor’s branded Enron with a junk-bond rating41. When the news of Dynergy’s pullout reached the market, the Enron stock plunged almost 85% from $3.50 to 61 cents that meant that the game was over42. Dynegy blamed Enron for “breaches of misrepresentation, warranties, covenants and agreements in the merger 41 The lower rating would have made it not only expensive for Enron to borrow money, but would have also forced Enron to immediately pay almost $4 billion out of its $13 billion debt.

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agreement”. The company pulled out of the deal following Enron’s filing of its third-quarter 10-Q on November 19th, 2001 that disclosed previously undisclosed financial facts about the company. It is believed that during the negotiation with Dynegy, Enron supplied the former with fraudulent financial statements and inflated asset values. In fact, the Dynegy CEO said that he thought that Enron had about $3 billion in cash but it turned out that the latter had only $1 billion at the time of filing. While Enron kept the $1.5 billion and the Northern Natural Gas Company, it filed a $10 billion suit against Dynegy for breach of agreement on the day it filed the bankruptcy43.

Part IX - Review of Analysts Reports

Table I provides a detailed exposition of the content of analysts reports and comments on where the analysts could have erred or provided more fundamental information (Refer to Figures 62-65). However, some points deserve mention at this stage:

First, it was striking to note that some analysts have not used fundamental methods of analysis such as the use of discounted cash flows; what’s more interesting is the lack of use of even comparables let alone the justification of use of comparables of companies more established in a given line of business. Secondly, some of the research reports did not even have a section on the possible investment risks that an investor could face in investing in a company like Enron that was making its foray into several new businesses, some of which were either unproven or where Enron had little expertise.

Thirdly, I noted that Enron’s share price rose about 100% in 1999 and about 68% during the first five months of 2000. I conclude that even assuming a semi-strong form of efficiency in the market, much of this movement was a positive reaction to the unveiling of two new communications and technology initiatives: EnronOnline, its internet-based commodity trading portal and Enron Broadband Services, its communication business. While the technology laden NASDAQ Composite Index declined by about 35% over one month from April-May, the market did not erase the gains made by Enron’s stock. While I am not saying that there could not have been any other upside to Enron stock, other than that recognized by the market, I surmise that much of the gains could have already been factored into the burgeoning stock price. In summation, I am skeptical of the terrific upsides forecasted by some of the analysts for the stock and conclude that the stock could have already been trading at or near its fair value.

42 In that session, 346 million shares of Enron – more than one of every eight shares traded on the New York Stock Exchange changed hands – a single day trading record for any US stock.43 Note that Dynegy has now taken over ownership of the Northern Natural Gas Company.

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Finally, I was surprised to see that hardly any analysts had used sensitivity tools while providing a valuation for the company’s shares. This is important for several reasons including providing investors a sense of the impact of change in business conditions on valuation components. While I am not aware of the kind of assumptions used by a majority of analysts (given that detailed projections have not been provided), my rough calculations indicated that the broadband valuation of even $15 a share (note some analysts have used even upto $40 a share), would require revenues increasing more than over 100-fold over a five-year period.

While some of the blame can be attributed to analysts’ not highlighting red flags associated with the company, Enron also duped analysts (for e.g. by putting up stage-managed trading rooms). The event was allegedly rehearsed the day before analysts visited the room, in the presence of Jeff Skilling and Ken Lay. In fact, the company spent about $500,000 reconstructing the Enron Energy Services office to make it appear a “slick” trading operation. The purpose was to convince analysts that Enron Energy Services, a unit set-up to sell to customers that had been by local utilities under deregulation, was profitable44.

I came across a media report that Enron’s officials had influence beyond the company and caused a broker at UBS Paine Webber to be fired last summer after he had warned customers to sell Enron stock45. Apparently, on August 21st, the broker emailed 73 clients and told them to sell Enron stock as he felt the stock was in financial trouble. However, at that time, the firm was rating Enron a strong buy though the stock was trading at 50% of its levels earlier in the year. The act was treated a violation of company policy and the employee was fired. Note that the firm handled the account of many employees including that of Ken Lay. In the footnote below, I have included comments of some analysts agreed that it was almost impossible to figure out the company46.

44 Source: Wall Street Journal, February 20, 2002 45 Source: Washington Post, March 27, 200246 As Todd Shipman of S& P said to a journalist “If you figure out Enron makes money, let me know” and Ralph Pellecchia, Fitch analyst said “Do you have a year (to figure it out)”, Source: Fortune, March 5, 2001. In the same article, Chris Wolfe, equity market strategist at JP Morgan’s private bank said, “Enron is an earnings-at-risk story”. Another analyst commented, “Enron is a big black box”. Commerzbank analyst Andre Meade who had a hold rating on the stock at that time said “We are concerned they are liquidating their asset base and booking it as recurring revenue, especially in Latin America”. However, some analysts were also extremely positive like Goldman Sachs’ Fleischer who said “Enron is no black box; that’s like calling Michael Jordan a black box just because you don’t know what he is going to score every quarter”. However, most of Enron’s business outlook was as follows: the market is at x, it will grow 3x and we will get y%; y% of 3x gives us z that is huge. The problem, as most dot-coms have sadly experienced, is that x may not translate into 3x and market potential may remain unfulfilled. Further, there could be execution risks and profitability issues.

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Notwithstanding these comments in the media, the saga continued to roll and roll it did, but downhill!

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Part X - Excerpts from Senate Committee Hearings

Note: This section summarizes the Senate Committee hearings from those with the analysts, subject-matter experts such as Howard Schilit, and past SEC Chairmen, and Enron employees - Sherron Watkins, Jeffrey Skilling and Jeffrey McMahon. There have been other hearings with Arthur Andersen and the law firm, Vinson & Elkins that have not been summarized below. Rather than attribute statements to specific people, I have summarized what each interest group stated. Further, these testimonies ran into several hours each and only the main points have been cited.

Tuning into the Senate Committee hearings, my first impression was that with so many allegations and counter-allegations being traded in and outside the hearings, it would be so difficult to zero-in on the truth.

Senate Committee: The impact of Enron’s collapse was mainly presented using the fact that investors may have lost upto $200 billion. The committee emphasized the fact that analysts continued to recommend the stock even when it was apparent that the company was sinking. Two-thirds of the analysts rated the stock a buy/strong-buy even on November 8th 2001, three weeks after the note of the third-quarter loss appeared in the media and two weeks after the SEC investigation was noted. To re-iterate the comments, the Committee pointed to the analysis done by their staff which showed that no matter what the market did, analysts seemed to say buy or hold; in fact only 1% of all stocks were rated a sell. Analysts’ independence was questioned frequently in support of this opinion, the Committee cited that analysts’ compensation was linked to the investment banking business they attracted. They were critical of the fact that analysts paid no attention to stock sales by executives (this could be partly attributed to SEC rules on the same as noted later). The recommendation terminology was called into question with a citation that the familiar “hold” rating actually meant, “sell”. Thoughts expressed to remedy the situation included separation of investment banking and research functions, and the delinking of analysts’ compensation from those of investment banking47.

The SEC may also come in for significant overhaul if the Committee has their say; SEC staffing and budget had not increased significantly though over the past decade, market-filings had increased 6.6 times. While more than the 33% staff turnover was noted, I felt that the important point was in getting really talented people to join the SEC. The issue of auditors’ independence was explored at length with concerns regarding audit personnel joining as 47 Enron is said to have spread wealth across all Wall Street firms. For e.g. in May 2001, Enron used six banks to manage a $151 million offering for Northern Border Partners LP while it is normal only to have four bankers for deals of such small size

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employees of their clients. The Committee also questioned the decision of SEC to grant an exemption to Enron under the Investment Company Act; in effect, this allowed Enron to shift debt off its books with foreign operations and also allowed employees to invest in Enron partnerships.48

The Committee was particularly incisive in questioning Skilling who they said made inaccurate statements on the broadband market, sold his stock when he was actually exhorting employees to invest in the stock and was derisive in his comments about the California energy crisis. (In reality, Enron overbooked the power lines so that the price of power would go up).

Analysts: Four analysts testified before the Committee – Anatol Feygin of JP Morgan Chase, Richard Gross of Lehman Brothers, Carl Launer of CSFB and Raymond Niles of Salomon Smith Barney (SSB). I have taken up a detailed analysis of reports of the analysts of JP Morgan and SSB and partial analysis of CSFB’s reports. Analysts blamed Enron’s inadequate, misleading and inaccurate disclosures and seemed to hint that Regulation FD had its adverse effects. Reasons cited for their support of Enron were a sound business model, successful core business of trading of energy, deep and talented management and the fact that the Dynegy merger agreement was encouraging. Further, the analysts also tried to draw support from their “sub-ratings” such as “speculative buy”, “neutral buy” and “long-term buy”

Howard Schilit: The Director of the Center for Financial Research and Analysis indicated that even a cursory perusal of the filed statements would be supportive of red flags and felt that analysts did not display a willingness to rock the boat. Further, he alluded to the fact that brokerage and investment-banking fees ensured that research notes were positive.

Others: Charles Hill – Thomsun First Call, Frank Torres Consumer Union Legislative Council: The testimony further supported the Senate Committee’s concerns by stating that 33% of recommendations were strong buys, another 33% were buys and only 2% were sells and strong sells. Further, they indicated that on the eve of the third quarter results, 13 analysts had strong buys, three had buys and zero had sell ratings despite the numerous red-flags from the results announced on October 16th. This may sound a little dramatic but even one month after the $1.2 billion write-off and the media reported off balance-sheet partnerships, three weeks after the CFO was fired, two weeks after the SEC investigation commenced and four days after a $600

48 However, when accounting rule makers proposed requiring companies to disclose more information about off-the-books deals, Enron Corporation and Andersen complained to FASB saying the proposed move would contribute to a disclosure overload. Note that Enron was not the only company that restated earnings because of accounting for assets and income from securitization. Other companies included PNC Financial Services in 2002 for $155 million and Dollar General in 2001 that lowered earnings by $199 million.

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million restatement, eight analysts rated the stock a strong-buy, three with buy, one with hold and none with a sell rating.

While these people agreed that financial analysis was more an art than science, they felt that analysts should be more regulated and a strict personal investment policy should have been enforced. Amongst other recommendations stated were to include all firms’ recommendations in a particular analyst report, new rules for analyst compensation, the need to create a certification system for analysts, the need to have a uniform rating language and a quantification of the investment banking company’s exposure to the company. Former SEC Chairmen – Arthur Levitt, 1993-2000; Richard Breeden, 1989-1993; Harold Williams, 1977-1981 and Rod Hill, 1975-1977: The former Chairmen agreed that the collapse presented an opportunity to repair trust of investors and on the obsessive zeal in the form of “gamesmanship culture” to report earnings through financial maneuvers. Corporate governance received considerable focus with comments that – Boards do not confront management with tough questions, and independence was somewhat lacking in the Board of Directors. Also, the CEO nominated Board Members and the audit committee. For e.g. the experts mentioned that at least three so-called independent Board members were not independent. The role of FASB and SEC was also criticized on the grounds that it was not wholly “politically” independent and its decisions were slow. As one individual mentioned, it takes SEC four years to write a rule against all odds including lobbying and just four minutes by an investment banker to get around it.

These former Chairmen also indicated that the proposed SEC rules on separation of auditing and consulting was not implemented due to political pressure and recommended that the Audit Committee of the Company should pre-approve auditing firms’ consulting contracts. They also emphasized the fact that auditing standards needed to be improved, and that auditing is now being treated more as a commodity. To tackle this problem, they recommended that audit firms be rotated every five-seven years. On the need to make auditing more independent, a proposal to make the audit firm be terminated only by the audit committee. The need for a new accounting oversight board was also mentioned. They were highly critical of outsourcing internal audit functions to external auditors, thereby robbing the investors of checks and balances.

On conflict of interests, these experts felt that the CFO was the “heart and soul” of the company and the 8-K should have heightened disclosure requirements for such conflict of interests. The issue of the number of restatements growing was also taken-up and part of this was attributed to aggressive revenue recognition methods and looking at profits using “models”. Waiver of the Code of Conflict and Ethics needed to be tightened.

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Enron Employees: Enron officials who took refuge under the Fifth Amendment included Ken Lay, former CEO, Andrew Fastow, former CFO, Michael Kopper, former Global Finance chief, Richard Causey, Chief Accounting Officer and Richard Buy, Chief Risk Officer. While in many quarters, including in the testimony by the now-famous Sherron Watkins, the innocence of Ken Lay is being proclaimed, recent documents indicate otherwise. An internal document unearthed recently shows that Ken Lay had approved a deal-sheet for a transaction between Enron and the LJM2 partnership49. Another memo dated in 1997 showed that Lay, Skilling and Fastow were members of the Executive Committee that were aware of the Chewco transaction50. This brings to light a new fact that Ken Lay was more involved in these deals than was previously believed. While Skilling portrayed himself as a distant figure who relied on others, employees such as Jeff McMahon testified that Skilling was a towering, intimidating figure who was an “intense, hands-on manager”. While McMahon’s notes revealed telling Skilling that he was being “pressurized to do a deal that I do not believe is in the best interests of the shareholders”, Skilling remembered a minor pay dispute. During a Board meeting in Florida when the Directors were told about partnerships that did not take on any economic risk but were only set-up to prevent profit and loss volatility, Skilling said that he did not recall the meeting and said, “I may have stepped out”. Enron employees remembered Andrew Fastow as a mean-tempered bully who tried to fire lawyers who did not approve of the deals he was transacting with his partnerships. McMahon remembered a slanging match with Fastow after the latter learned of the whistleblower letter written by Sherron Watkins and accused McMahon of “ghost-writing the letter”.

Sherron Watkins: This Vice-President wrote an anonymous letter on August 15th 2001 to Ken Lay; later she identified herself as the author of this letter and met the CEO twice in October to further share her concerns and request re-statement of the financial statements. Watkins was hired by Enron in October 1993 and also had about eight years experience with Arthur Andersen. During her tenure, her responsibilities included the Calpers partnership called JEDI, a role in Enron International, Enron Broadband Services and working under Andrew Fastow. Her reluctance to discuss her concerns with either Skilling or Fastow stemmed from a fear about retaining a job, an attribute to the “power culture” at Enron. Her understanding included the facts that Andersen and Vinson &Elkins helped structure these transactions and that Ken Lay and the Board were duped, a fact that I do not agree with. The surprising piece of information that is now known to us is that at least a dozen people in the company were concerned about its aggressive accounting practices – revealed in Lay’s survey over Labor Day Weekend.49 Source: Wall Street Journal, February 13, 2002 50 Source: Wall Street Journal, February 1, 2002

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According to Watkins, Lay seemed to lack the initiative to tackle the concerns expressed and it looked like someone else behind him seemed to direct his decisions. In fact, when Watkins said that it was not a good idea to use Vinson & Elkins for the investigation, Lay went ahead and used the external counsel. Imagine someone investigating his/their own work! People thought that discussing accounting was a subject off-limits and Skilling seemed hell-bent on keeping the multiples up in fear of being forced to take write-downs if the multiples contracted. In fact, Watkins was concerned about her personal safety. Her testimony confirmed that management sometimes misrepresented to analysts regarding Raptors and that these vehicles hid some of the losses. For e.g. Enron Broadband Services actually lost about $200 million in 2000 but was reported at $60 million while Enron Energy Services’ losses were not disclosed till 2001.

Jeffrey Skilling : A man suspected of being the mastermind of transaction structures, Skilling was the all-powerful brash, and arrogant CEO of the company who all of sudden quit in August 2001, ostensibly for personal reasons. While I thought Skilling was brave to testify when others did not, I felt that Skilling was articulate when he wanted to be but who fell silent when provoked, a fact that was not lost on the Committee. For e.g. while the man known for his razor-sharp intellect was questioned as to whether he did not know that the company’s stock could not be used to inflate profits, he said he was not an “accountant”; yet just an hour later, he lectured profusely to the Committee on derivatives, hedges and what-have-you. Skilling blamed accountants and in particular, Andersen for approving structures, the Board for approving conflict of interests, professed a poor memory and the meltdown for the bandwidth debacle. Some of his statements bordered on the ridiculous – he blamed the presence of material adverse change clauses in contracts and banks for causing a run on companies. He said that his line of reasoning when Enron stock was used for hedging was that stock options could be used to boost profitability by reducing compensation. When questioned about his reasons for resignation, he cited personal exhaustion and said he offered to come back to the company at no compensation in October 2001. He felt the three reasons as to why Enron went down were the dispute regarding the Dabhol plant in India, the broadband market and litigation.

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Part XI – Impact of the Collapse and Life Post Enron

Impact of Enron Collapse

I have detailed the impact on the collapse of Enron in the prelude to this paper and in the section below. While the collapse caused a definite lull in the market, it definitely caused other energy companies’ stocks to fall as indicated in Figures 54-58.

Congressional investigators are now turning up the heat on JP Morgan and have asked the bank to turn over documents related to troubled transactions that may have allowed Enron to borrow money without the debt appearing on its balance sheet as a loan. The letter focused on a controversial yet little known vehicle known as Sequoia Financial Assets, a complex entity mentioned in a lawsuit between JP Morgan and Enron. Under Sequoia and other entities, JP Morgan provided about $500 million in financing to Enron. The loan apparently was designed in such a way that on the last day of each month, it was reported as repaid in full, though the repayment never occurred. Since balance sheets are generated as of the last date of the month, these loans were never reported. Insurance companies have also filed a lawsuit against JP Morgan over an offshore vehicle called Mahonia through which the bank arranged loans but the same were disguised as trades. Another class-action lawsuit was filed which alleged that nine major banks and securities firms and two national law firms participated with Enron’s management to defraud Enron’s shareholders and creditors. The list of firms reads like a who’s who with CSFB, Merrill Lynch, Citigroup, Deutsche Bank, JP Morgan, and Bank of America included. (Refer to Figure 66 for the graph that depicts the largest unsecured creditors).

Post Enron

Probably the most disturbing impact of Enron’s collapse is the lack of confidence in financial reporting across a diverse range of sectors and companies with the result that investors are almost questioning every statement that managements make. As more than 10 congressional committees pursue inquiries, 32 Enron-related bills ranging from auditors’ conflict of interest to an unregulated derivatives market are in the process of being enacted. From now on, investors are unlikely to take the validity of audited accounting statements for granted. On top of the confidence impairment in financial reporting and the auditing profession, the adequacy of Generally Accepted Accounting Standards (GAAP) and Financial Accounting Standards Board (FASB) standards is being questioned. The debate is whether the rules produce relevant, and useful information and whether these standards are successful in representing the true economics of the transaction. The role of

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the SEC has also come under close scrutiny and corporate governance is also likely to be a focus area. Last but not the least, the auditing profession is also likely to be the subject of further regulation and the separation of auditing and consulting functions is likely to be a voluntary step by many companies, even if lawmakers choose not to regulate such separation.

As far as the Enron collapse is concerned, the blame cannot be pointed in one direction; instead, management, analysts, accountants, auditors, regulators and lawmakers have a share in the saga of Enron. Numerous factors can be identified for the collapse including off-balance sheet financing and the lack of regulation concerning such financing, the role of mark-to-market accounting and insufficient disclosures. Other problems include board and auditor independence as also the view of audits as probably a mandatory step rather than an exercise to identify control, accounting and reporting issues. The accounting profession and the standards-setting body appeared to be aware of these issues but were slow to react.

History Repeats Itself: The current “tirade” against the auditing and financial reporting process is not new. Corporate bankruptcies and unraveling frauds were among the hallmarks of the 1930s following the 1929 crash. One favorite accounting trick then was to create a web of holding companies that hid the others’ financial weaknesses, similar to what Enron did with its partnerships! One high-flying utilities company, Middle West Utilities, collapsed. In the 1970s, ‘nifty fifty’ stocks collapsed, Peat Marwick Mitchell – a prominent audit firm was disciplined by the SEC and prominent collapses such as National Student Marketing, U.S Financial and Equity Funding and Stirling Homex occurred during the economic cycle. The crash of 1987 was followed by the continuing insider-trading scandals, a savings-and-loan crisis and the collapse of Milken’s junk bond firm Drexel Burnham Lambert. Note that since January this year, about a dozen companies delayed their planned earnings report – at least half specifically cited accounting issues. In fact, one Houston energy company Reliant Resources said that it was restating earnings for the second and third quarters of last year owing to some mark-to-market accounting problems.

One viewpoint is that bubbles create greed on part of the investors but they also encourage avarice on part of management51. I am discussing below my perspectives about select areas of financial reporting and accounting and have drawn on views expressed by analysts. Note that I have not covered: the impact on credit derivatives market (which has shown resilience despite the Argentina crisis and Enron), the changes in the approach of credit rating agencies (which are likely to be more introspective with a tightening of credit tripwires), the impact on the power market (where amazingly the contagion 51 Quote by Jeremy Grantham, a co-founder of Boston money-management firm, Grantham Mayo, Source: Wall Street Journal, February 11, 2002.

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effect has not been widespread and the liquidity void was filled by other players). There could also be impact to other industries including liability insurance for directors and officers and surety exposure that could tighten credit and risk assessment standards.

Auditor Independence: As mentioned several times in this paper, major changes could be expected in the accounting business, especially on two fronts. One of the fundamental concerns that has been raised in the past few months relates to the question of auditor independence and the need to separate auditing and consulting practices; however, the SEC Chairman, Harvey Pitt, said that he opposed banning accounting firms from providing consulting services to their clients fearing that it may result in worse audits52. This separation was proposed by his predecessor, Arthur Levitt, who later withdrew his proposal in the face of intense pressure from Congress and the accounting industry. In the end, the SEC adopted watered-down independence standards and listed about a dozen consulting services that accounting firms already understood would be improper to offer, such as bookkeeping. However, there is increasing pressure that some limitations on consulting practices be adopted; while the industry will fight aggressively against a complete ban on consulting, it would prefer limits imposed through SEC rules, which are easier to amend than legislation.

In the senate, one bill to watch is being introduced (by Democratic Senators Christopher Dodd and Jon Corzine). It would consolidate a broad range of accounting initiatives, including authorizing the creation of a new independent auditor oversight board, possible restrictions on audit partners joining their client companies and limits on consulting practices. The bill also calls for a complete ban on auditors’ cross-selling consulting services to corporate audit clients. There are also likely to be changes to the nation’s pension and retirement laws.

Regulating Analysts: I am summarizing the salient features of the NASD rules as follows: No research analyst may be subject to the supervision or control of any employee of the member’s investment banking department. A member may not submit a research report to the subject company before its publication except for verifying the factual accuracy of the report. No member may pay any bonus, salary or other form of compensation to a research analyst that is based upon a specific investment banking services transaction. No company may publish a research report regarding a subject company for which the member acted as a manager or a co-manager of an initial public offering fir 40 calendar days following the date of the offering. Regardless of the rating system that a member employs, a member must disclose in each research report the percentage of all securities rated by the member to which the

52 Ibid

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member would assign a “buy, hold/neutral, or sell” rating. The member must disclose in research reports the valuation methods used to determine a price target. The research reports must disclose if the company was making a market in the subject company’s securities at the time the research report was published. A member must disclose in research reports if the research analyst principally responsible for preparation of the report received compensation that is based upon the member’s investment banking revenues. For the full text of the report refer to the following: http://www.sec.gov/rules/sro/34-45526.htm

I have also heard proposals in the course of the Senate Committee hearings that aim at segregating investment banking and research units so as to force investment-banking companies to buy research from their specialized research units. However, I was dismayed at proposals that aim at altering the current “Chinese Wall” regulations; such a move would precipitate the situation as opposed to improving it. The recent NASD proposals for analysts coverage of stocks has been criticized on grounds that it does not go far enough in regulating analysts. The proposals also do not address some fundamental problems such as setting uniform rating guidelines. There are so many different rating systems that are employed, all of which are not readily discernible to the common investor. There are reports where analysts juggle around with terms such as “accumulate”, “long-term buys”, “maintain/aggressive”, “trading buys”, “aggressive buys” and the famous “hold ratings”; in fact, institutional investors may interpret a hold rating as a sell rather than an opinion to retain the stock. To be fair to analysts, some firms include a glossary that explains what the ratings mean. For e.g. there are obscure ratings used by Merrill Lynch that rates Jones Apparel Group a C-1-1-9 that means above average risk, long-term strong buy, short-term strong buy and no dividend. One observer mentioned recently that he stumbled across a report in which the analyst rated a stock “near-term hold” and “long-term accumulate”53.

I noted a recent judgement by a New York court which ordered Merrill Lynch to: disclose whether the firm has or intends to have an investment banking relationship with the company covered in its research notes and state the number of buy-and-sell recommendations in its sector coverage54.

Financial Reporting : I have read that there has been a vast improvement in the quality of financial reporting that has occurred over the past 25 years55. Then, there was very little useful information in a company’s financial 53 Quote by Kei Kianpoort, Investar.Com in the Wall Street Journal, February 8, 2002. 54 A recent investigation found that some analysts in the company’s Internet group were pessimistic about a company in private though the stocks were rated neutral. Source: Wall Street Journal, April 9, 2002 55 Source: View expressed by Bear Sterns analyst, Pat McConnell

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http://www.sec.gov/rules/sro/34-45526.htm

http://www.sec.gov/rules/sro/34-45526.htm


statements. There were very few footnotes; further the SEC requirement for a “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” section in SEC filings was nonexistent. The availability of improved quality of financial information enables more rigorous analysis and use of better valuation methodologies. However, there are still a number of adjustments that are required to be made to understand the true position of the business (e.g. stock options). Further, the use of economic rationale and political interference (as witnessed in the FASB proposed stock options accounting rules) in standard setting has not helped financial reporting. However, it is remarkable to note that General Electric’s 93-page annual report in 2001 is said to have 30% more financial information than the earlier report; in one of the most striking changes, GE included a special section about its use of special purpose entities and went out of its way to distinguish its off-balance-sheet practices from those of Enron56.

Financial Instruments: We may well see some regulation in the use and issuance of some financial instruments: one such instrument innovated by Goldman Sachs in 1993 was the Monthly Income Preferred Securities (MIPS). The advantage of this instrument lies in its quasi-debt and quasi-equity feature. For the tax authorities, it resembled debt and its interest could be deductible from income and for rating agencies, it took on the form of equity. While Treasury and the Internal Revenue Services (which tried to disallow interest payments on Enron’s MIPS in 1998) tried to regulate this instrument, it was beaten back by a coalition of investment banks, law firms and corporate borrowers. It would be an exaggeration to blame Enron’s collapse on MIPS but this provided an avenue to shield some of Enron’s transactions.

In the first of several deals, Enron set-up a subsidiary Enron Capital LLC in 1993 in Turks and Caicos, a Caribbean tax haven. This entity sold $214 million in MIPS at 8% to investors through Goldman Sachs and lent the proceeds back to the parent company. While Enron deducted $24 million in interest payments to Enron Capital in its income statement, it reported the MIPS issue as “preferred stock in subsidiary companies”. What the MIPS provided was a double-edged tool – deduction of interest and at the same time, boost the debt-to-equity ratio to achieve a better credit rating. Standard & Poors’ was quick to see through this and in its first rating of the MIPS 1993 deal, cautioned Enron that its financial maneuvers were “aggressive and not supportive of credit quality”. Enron ultimately issued $1 billion in MIPS and paved the way for other companies such as Texaco to indulge in it57. While Treasury persuaded SEC to ensure that companies stopped this practice, SEC did little except to recommend the way companies described these securities. SEC suggested that these securities be noted as “company-obligated mandatorily 56 Source: Wall Street Journal, March 11, 200257 In all, $180 billion of trust preferred stock is outstanding, Source: Wall Street Journal, February 4, 2002.

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redeemable security of subsidiary holding solely parent debentures”. The market changed the name of MIPS to trust-originated preferred securities, coined by Merrill Lynch in 1994. In 1998, the Internal Revenue Service challenged Enron’s MIPS tax-deductions in 1998 only to back down after industry lobbying and protests.

Off-Balance-Sheet Financing: Overall, it has been difficult for accounting standard-setters to keep pace with rapid innovation in financial engineering. Today, off-balance sheet financing can take several forms such as the use of leases, sale and lease back, securitization of assets, use of non-consolidated joint ventures, manipulation of ownership stake and control to avoid consolidation, investments in partnerships. These are but a few examples of such financing. However, the use of Special Purpose Entities and the use of the “3% outside equity” rule are likely to get much attention in FASB and IASC deliberations.

Special Purpose Entities (SPEs): SPEs could be used to move debt off-balance sheet, finance the purpose of as asset, creating “notional” hedges (as Enron did), be created to move research and development expenses off-line (example Dura Pharmaceuticals and Alza Corporation) and for securitization. Much of the growth in off-balance-sheet financing mentioned in the media can be attributed to growth in securitization of financial assets58.

Finance companies often employ securitization of receivables, primarily to avoid the provision of additional risk-based capital on its balance sheets. Under securitization, the assets of the company are moved off-balance sheet, bundled into securities and sold to third-party investors; the cash flows from the assets of the SPEs are used to service interest and principal payments to investors. The accounting treatment for an SPE used to securitize financial assets is laid out in FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, a FASB September 2000 standard. This replaced the “gain on sale accounting” FAS 125 by the same name. Note that there are not many differences between FAS 125 and 140.

FAS 140 lays down the rules that an SPE must fulfill to be labeled a “Qualifying SPE” and thereby avoid consolidation in the books of the seller of the financial assets. The most important of these criteria is that the SPE should be distinct from the seller of the assets and its activities should be significantly limited to the purposes specified in the legal documents governing the securitization. There are significant disclosure requirements for a company not consolidating an SPE such as stating the principal amount outstanding.

58

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Other SPEs not governed by FAS 140 are to be accounted for by GAAP. These rules mandate that majority owned subsidiaries are to be consolidated. To avoid the problem of a majority owner transferring voting interest to a third party for little or no consideration so as to circumvent consolidation (while retaining the economic benefits and the risks), a crucial rule was introduced: the majority owner of the SPE must be an independent third-party that has made a substantive investment in the SPE, has control over the entity and also truly bears the economic risk and rewards of the SPE. In practice, a minimum of 3% has represented “substantive” capital investment. This implies that consolidation can be avoided with a 3% ownership provided this is accompanied by a majority voting interest. Whether 3% is a substantive investment to avoid consolidation is debatable especially given the Enron experience. My understanding is that FASB is moving to regulate SPEs that do not fall within the purview of FAS 140 and also debating on the definition of whether a company should be required to consolidate entities where effective control was exercised59. The new proposals debated by FASB represent a significant step on two fronts: it would require that an SPE in order to qualify for off-the-books treatment by the parent company, contain at least 10% of outside equity, up from the current 3%; further, the new rule would also contain broad language requiring the outside entity to be really at risk60.

The potential problems with SPEs arise when the transferred assets do not look as valued as promised, and the transferring company promises to investors in the SPEs to make up for the shortfall as Enron did a number of times. Note that improper accounting for securitization has played a role in the collapse of several banks/specialty finance companies such as Nextbank in 2002 and Superior Federal Savings Bank in 2001.

Expense Recognition / Revenue Recognition: Standard-setters also need to tighten norms for expense recognition and revenue recognition. Under conventional accounting rules, companies are allowed to defer costs while bidding on a contract but these costs had to be written-off when the contract was lost. Enron apparently avoided writing-off costs on more than 75 power plants and pipeline projects and had a burn-rate of $1 million a month for such expenses. Enron Corporation called this “snowballing”, recognition that project costs needed to be watched and controlled or they could be run over by the company. Note that Enron filed for bankruptcy despite achieving revenues of $139 billion over three quarters in 2001, well above its $101 billion in four quarters in 2000. One of the reasons for this huge acceleration in revenue in 59 FASB plans to revisit separately the disclosure requirements for the particular type of SPEs used by financial institutions. Note that these guarantees for the SPEs are called upon at the worst possible time: when the entity is failing.60 Source: Wall Street Journal, March 7, 2002.

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2000 and also 2001 is the recognition of “gross contracts” as revenues. Normally, when a company trades, it would have a trading gains/loss line on its income statements referring to mark-to-market effects on these contracts. But with Enron, things were different. The entire contract value was booked in revenues, with the cost of natural gas (for example) as an offset and the net was gain. This explains why Enron’s margins did not rise with huge acceleration in its revenues as its trading did not make high margins. Enron’s example was followed by other energy companies and in 2001, we saw Idaho with a 454% revenue increase, American Electric with a 347% and Calpine with a 233% jump in revenue; not to leave out Mirant which was spun-off by Southern Company but achieved an astonishing $31.5 billion in revenues. FASB needs to re-visit its revenue and expense recognition guidelines!

Fair Value Accounting: Another area that has come under intense deliberation is the use of fair value accounting, also known as mark-to-market accounting. Under this method, financial instruments are carried in the balance sheet at their market or fair value and the income statement includes unrealized gains or losses (save for available-for-sale securities where a separate valuation allowance is recorded under other comprehensive income in shareholders equity). I am of the opinion that fair value is much superior to historical cost for several reasons for one, it provides more relevant economics of the firm’s operations; further, some transactions such as derivatives do not find a place in the balance-sheet and it is extremely important for investors to understand earnings / losses from them. Consider a scenario when there is no fair value accounting. If management wanted to smooth earnings, it could sell an asset when it knows it would realize a profit and not sell assets that could only be disposed at a loss. However, the problem in fair-value accounting lies in measuring the fair value especially when a liquid market is not available for the instrument. As a result, independent appraisers are often used to measure fair value. I do not see the prohibition of fair-value accounting as an “Enron consequence” though there could be restrictions on reporting of some unrealized gains.

Pro-forma Earnings: The biggest area where path-breaking regulation is the need of the hour is pro-forma reporting. Currently, there are no standards so far as pro-forma reporting is concerned with the result that this provides a useful tool for “earnings management”. We have seen terms such as recurring non-recurring charges, earnings and expenses relating to discontinued operations / restructuring / acquisition charges and cash earnings which is often computed as earnings before interest, taxes, depreciation and amortization. While I do not dispute that depreciation and amortization do not impact cash flows immediately, these are normal operating expenses especially for asset-intensive businesses and are triggers for asset replacement (while result in cash outflows). I find it interesting to draw your attention to a Bear Stearns study summarized in Figure 59 that shows a widening disparity

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between pro-forma and reported earnings. In fact, the SEC issued a statement in December last year that “intended to caution companies on their use of pro-forma financial information and alerts investors to the potential dangers of such information”. At least, we need to be able to see a GAAP-numbers and pro-forma earnings reconciliation. Refer to Figure 60 that looks at pro-forma to GAAP earnings as a percentage of last twelve months’ sales and the use of pro-forma by technology companies is especially striking.

Reporting Insider Trading: One of the easiest areas to fix is regarding reporting of insider trading. Current SEC rules imply that a company could wait for a period ranging from 10 days to 410 days prior to reporting the transaction. Note that current regulations require that transactions such as sales of stock by directors and executives in the market are due within 10 days after the close of the month in which the transaction occurs; this would imply a delay ranging from 10 to 40 days. Further, transactions between the company and the directors and executives are due within 45 days after the company’s fiscal year creating a delay of upto 410 days. The reason as to why the rule needs to be amended is that it is extremely deceiving. For e.g., Ken Lay gave Enron investors and employees a misleading account of the stock but the fact of the matter was that he exercised stock options sold the stock at huge profits. In fact, Lay did not report any sales after July 31st because after that, rather than selling stock in the market, he sold stock back to the company. On August 21st he sold $4 million of Enron shares, sold more than $12 million by the end of the month and kept selling through October 26th.

The SEC has proposed amending form 8K to provide that companies with the particular class of equity securities need to report information about Directors and executive officers’ transactions in company equity securities (including derivative securities transactions and transactions with the company) within two business days of the transactions if the amount exceeds $100,000. Further, transactions with a value between $10,000 and $100,000 are to be reported within the close of the business of the second business day of the following week.

SEC Initiatives: I went through the testimony by Harvey Pitt, the SEC Chairman before the U.S House of Representatives in February 2002 that provides an insight into the initiatives that the SEC is working on. Amongst these initiatives are requirement for providing material information in real time, public company disclosure of significant current “trend” and “evaluative” data, improved standard setting, creation of a Public Accountability Board to assume responsibility for accountant and auditor discipline and control, and new rules for analyst recommendations. Congress’ first legislative response to the auditing end of Enron Corporation was to push the makeup and authority of a new industry-oversight board to the SEC for implementation. The bill gives

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the SEC discretion in setting up the new five-member board and directs the SEC to impose restrictions on audit firms consulting for corporate clients.

Dynegy Inc- Complex Accounting: Dynegy is alleged to be working on a project called “Project Alpha” to improve its financial profile61. Energy traders sometimes tend to inflate the values of their contracts to buy and sell natural gas and other commodities in the future. The problem with doing this is that the difference between cash flows and income grows, as this mark-to-market flow does not translate into cash inflows, at least not immediately. Project Alpha has been helped through a $300 million from Citigroup and boosted cash flows by $300 million and reduced the tax bill by $80 million in 2001. The intriguing thing about this project is the attempt to improve cash flow and reduce tax bill but doing little of economic value. The company is said to have paid $33 million in fees for this structuring to Citigroup and Vinson & Elkins, familiar names from the Enron deals. I have briefly detailed the way this structure works below:

Citigroup provided a loan of $300 million to a special-purpose entity called ABG Gas Supply. (Incidentally, when Citigroup did its credit appraisal for ABG, it may have considered the loan to be Dynegy risk and probably obtained a guarantee/letter of support from the latter company). Dynegy owned an interest in ABG through a partnership called DMT Supply LP. Note that Dynegy had an interest in DMT through another subsidiary. ABG entered into a five-year gas supply contract with DMT. During the first nine months of the contract, ABG sold gas to DMT at below-market prices resulting in DMT booking profits (as DMT resold the gas subsequently at profits). ABG’s losses on these deals were funded through the $300 million loan. In the subsequent periods, the transaction was reversed. DMT bought gas at above market prices booking losses while ABG booked profits. DMT allocates losses to Dynegy. The benefits to Dynegy are as follows: the unrealized losses passed-on by DMT could be used to reduce taxes and also through reducing unrealized gains, narrows down the difference between net income and the cash flows. Thereby, cash flows appear to rise. Further, the net value of derivative contracts would be lower. According to an analysis by an investment manager, without Project Alpha, Dynegy’s cash flows would have been adjusted downward by $164 million in 2001 while with Project Alpha, Dynegy’s cash flows were boosted by $130 million – a difference of $300 million.

Note that the SEC has commenced investigation into this accounting structure. The company reported a $140 million loss during the first quarter and attributed this to a $300 million write-down of its telecommunications ventures. Moody’s rating of Dynegy is in the lowest-rung in the investment-grade category and has been placed on review for a possible downgrade.


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Appendix – I

Basics of Wholesale Energy Markets

Heat Rate: Power plants have a very predictable transfer function called the “heat rate” which defines the plants’ efficiency. Heat rate is measured in terms of the British Thermal Units (BTUs) required to produce one kilowatt-hour (kWh) of electricity (this is equivalent to the electricity required for 10 *100 W light bulbs on for one hour). There are approximately 1,000 BTUs in one cubic foot of natural gas (CH4 or methane) (One BTU is equivalent to the energy required to raise one pound of water one degree Fahrenheit).

Example: Plant “A” has a heat rate of 20,000 BTUs/KWh that implies that it requires 20 cubic feet of gas to produce a kWh while another plant, Plant “B”, required 10,000 BTUs/KWh. This implies that the latter plant is twice as efficient. If the cost of gas is $5/Mcf, the marginal cost of electricity can be computed as follows:

Plant A- 20 cf/KWh x $5/Mcf x 1,000 KWh/MWh = $100/MWhPlant B -10 cf/KWh x $5/Mcf x 1,000 KWh/MWh = $50/MWh

Spark Spread: The spark spread represents the difference between the cost of natural gas and the market price of power. The definition means that the more efficient the company, the wider the spark spread.

Trading and Risk Management: Locking into a spark spread margin represents the basis of trading and risk management. For example, given the control of a plant with a heat rate of 6,000 BTU/KWh, gas prices in the spot market and the forward market for the next three years at $4/Mcf and power prices in the spot and forward markets at $35/MWh, one can today lock into a gross profit of $11/MWh. This can be computed as follows:

Gas Cost per MWh produced: 6 Mcf/MWh x $4/Mcf = $24 / MWhMargin per Mwh produced: $35 / MWh - $24 / MWh = $11 / MWh

Trading Upsides: There is an additional potential for upsides given that the gas and power markets are not perfectly correlated; even in a gas-intensive power market like Texas, gas and power prices have a correlation of just 0.52. The potential volatility in the market provides opportunity for additional gains: for example, if the price of gas rises and this is higher than the price of power, we could use the gas that we purchased under the example above at $4 / Mcf (the long gas position) and sell it in the market at a higher price. Our commitment to sell $35 worth of power (short power position) could be fulfilled through purchasing from the market. Even if there is no volatility, we could still earn our $11 / MWh that we locked into earlier. In other words, volatility

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could create an option value with additional pay-offs as illustrated in the following table:

GasPower

$2.00 $4.00 $6.00

$50 -$27 -$15 -$3$35 -$12 0 $12$20 $3 $15 $27

Arbitrage Opportunities in Reality: In reality, arbitrages such as the one presented above are very short-lived since everyone is aware of such risk-less opportunities and also because the markets for power and gas are liquid and transparent. The following components are very essential for the existence of informational asymmetry: nationwide network of trading hubs, control of infrastructure assets, physical delivery capability and a multi-commodity platform. These components are needed because opportunities are unlikely to revolve around a single plant and its supply and purchase contracts. It is more likely to be due to difference in power prices at two distant locations and taking advantage of this requires execution of a number of structured trades. For e.g. the company may have to purchase hydroelectric power in the Northwest in the US, move the power to meet the obligations of a gas-fired plant in the West, move the gas to be converted into power in the Midwest and sell power in the Northeast for a profit. With a nationwide network, the number of combinations amongst the locations could be virtually limitless and afford arbitrage opportunities.

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Source: Presentation by Utilities Agency in Pennsylvania

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Appendix II

Earnings of the Energy Merchants – An Accounting Primer

Accounting for the energy sector is complex to say the least. Energy companies have marketing and trading for energy as also earnings based on physical assets such as oil and gas pipelines. While the latter is accounted for under the accrual method, the former is subject to what has come to be known as mark-to-market accounting (under Emerging Issues Task Force Note 98-10). Further FAS133 governs accounting for derivatives and hedging activities.

When comparing mark-to-market accounting with the accrual method, the former generally allows for an accelerated path to earnings recognition while the latter is more closely linked with cash flows. While mark-to-market accounting has its limitations, it provides investors with a way of assessing the value of contracts.

Note: Selected excerpts from these statements are presented in Appendix III.

Mark-to-Market Accounting (MTM_ - EITF 98-10)

Energy trading activities are accounted for by using the MTM methodology and this requires that all such activities be marked to market or recognized at fair value each reporting period. Companies are required to recognize their unrealized income from changes in the fair value of their energy trading derivatives in the current period and any new transactions that were introduced in the current period.

An Example of MTM Accounting

Period Transaction Balance Sheet Income Statement

Period 1 An energy trader wants to hedge a natural gas sale two-years forward by purchasing 200 MMBtu of natural gas for $4/MMBtu two-years forward. On the last day of the period, assume that the natural gas sale also closes at the same price.

Trading Asset 0Trading Liability 0

Operating Income 0

Period 2 Assume that the two-years forward sale


Operating Income 200

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contract closes now at $5/MMBtu. Note that the seller has locked into the purchase contract’s price.

The net position of the contracts increases by 200 ($5-$4 for 200 MMBtu) for which a net asset is created. The asset value is $1000 while the liability value is $800

Period 3 The natural gas contract representing the sale now declines to $2/MMBtu.


The company now records a loss since the asset value is $400 while the liability value is $800.

Operating Income (600)

Note that the reversal to operating income is equivalent to the difference between the values of assets over the two periods i.e. $1000 - $400.

Note that the above range of transactions will continue till the contract is settled. The example above demonstrates a hedge for the purchase of a natural gas contract. Note that though no cash flows are exchanged till actual settlement, notional gains and losses are recognized. While this may result in accelerated earnings recognition, note that this provides an estimation of gains and losses that may not be transparent to the investor. This is but a simple example of MTM recognition and ignores present values, contract reserves and volatility.

Accrual Accounting

Accrual accounting is normally applied to physical assets as opposed to trading activities. Given our level of familiarity with this form of accounting, I do not wish to write an exposition on its use and methodology but a few points are worth a mention: revenues are recognized with product delivery and expenses are allocated to revenues based on a matching concept, value of agreements are not reflected on the balance-sheet and the concept of Value at Risk (VAR) does not extend to physical assets. Further, earnings under this method are highly dependent on asset turnover as opposed to trading revenues that are a function of new transactions and volatility. Lastly, assets and liabilities are normally accounted for under a historical cost method except for employment of fair-values as in the case of acquisitions.

Hedge Accounting

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This is complex in its simplest form and applies to account for derivatives that hedge cash flows of transactions associated with physical assets and for fair values of assets and liabilities. FAS133 details two types of hedges: cash flows and fair values hedges. While there are many criteria for a transaction to qualify as an accounting hedge, the principle is that the change in the derivative value should closely correlate the value of the hedged item within an 80%-120% range. The hedge can be classified into its effective portion and ineffective portion.

Effective Hedge: This refers to the portion of the hedge that is 100% inversely related to a change in the value of the underlying asset being hedged. For example, if a producer hedges production cost and the price declines by say, $2, then if the associated hedge instrument also increases by the same amount, this is referred to as an effective hedge.

Ineffective Hedge: This refers to the portion of the hedge that is not 100% inversely related to a change in the value of the underlying asset being hedged. In the above example, if the hedge instrument increases by $3 while the underlying asset declines by $2, then $1 would be the ineffective portion of the hedge and $2 would be the effective hedge portion.

Cash Flow Hedge

These are used to hedge variability in future cash flows from probable future transactions, which can be attributed to a particular commodity risk. One example of such a hedge is electricity sales from generation facilities. Cash flow derivatives are recorded on the balance sheet as trading assets and trading liabilities and are marked-to-market. When such a hedge is created, the company should internally note that the transaction is a cash flow hedge, designate items included in the cash flow hedge, the percentage of the item being hedged, hedging instrument and the period of the hedge. Cash flow hedges also have an effective and an ineffective portion:

Effective Portion: This portion is recorded as part of other comprehensive income, net of deferred taxes. Other comprehensive income is reported separately as a component of shareholders equity in the balance sheet. Any adjustment to the amounts in other comprehensive income is run through retained earnings as opposed to MTM that runs through the income statement. When the derivative matures and is recognized, the amount in other comprehensive income related to the derivative instrument that was a hedge of the cash flow from the matured transaction is removed and moved to the income statement as operating income.

An Example of Cash Flow Hedge Accounting

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Period Transaction Balance Sheet Income Statement / Shareholders Equity

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Period 1 An energy trader wants to lock in the spark spread from a contract. In this case, both the sale of power and the purchase of gas have to be locked. The spark spread is reflective of the cash flows from the contract and a lock-in of the spark spread qualifies as a cash flow hedge.

Let us assume that the hedge is 100% effective. An energy trader wants to hedge a natural gas sale two-years forward by purchasing 200 MMBtu of natural gas for $4/MMBtu two-years forward thereby locking the spark spread. On the last day of the period, assume that the natural gas sale also closes at the same price.


Operating Income 0Other Comprehensive Income 0

Period 2 Assume that the two-years forward sale contract closes now at $5/MMBtu. Note that the seller has locked into the purchase contract’s price. Assume a tax rate of 40%

Trading Asset 200Trading Liability 0Deferred Tax Liability 80Shareholders Equity 120

The net position of the contracts increases by 200 ($5-$4 for 200 MMBtu) for which a net asset is created. The asset value is $1000 while the liability value is $800

Operating Income 0Other Comprehensive Income 120

Period 3 The natural gas contract representing the sale now declines to $2/MMBtu.

Trading Asset 0Deferred Tax Asset 160Trading Liability 400

Note that a trading

Operating Income 0Other Comprehensive Income (240)

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liability is created since the liability is $800 while the asset is $400. Other Comprehensive Income becomes $240. This is computed as follows:

$600 is the decline in asset values over the two periods. With a tax rate of 40%, the other comprehensive income declines by $360 but we already had a balance of 120 credit, which now becomes $240 debit.

The deferred tax asset of $240 is netted with a deferred tax liability of $80 and a net tax asset is recorded.

The difference between cash flow hedges and mark-to-market lies in the fact that the former is associated with cash flows arising from physical assets while the latter is used for energy trading activities. Further, mark-to-market adjustments flow through the income statement while cash flow hedges are accounted for through other comprehensive income.

Fair Value Hedges

A derivative that is designated as a hedge of the change in fair value of an existing asset or liability is accounted for as a fair value hedge. In fair value hedge accounting, the derivative instrument as well as the hedged asset or liability are marked-to-market while in a cash flow hedge, the asset receives accrual treatment and the derivative instrument is put on the balance sheet. In the case of fair value hedges, unrealized gains and losses are listed on the balance sheet through netting changes in the values of both the derivative and the assets or liabilities associated with them. A trading asset or liability is represented depending on whether the net amount is a gain or loss respectively. Accounting for subsequent reporting periods is the same as demonstrated before with the effects flowing through the income statement. On maturity of the transaction, the income statement for that period will reflect only changes in fair value from the beginning of the current period through settlement, the rationale being that changes prior to that date have already been considered.

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Value At Risk (VAR)

VAR is used to determine the value of the trading portfolio that could be reduced using a given confidence level over a defined period. This is normally discussed in the notes to financial statements and a higher VAR implies a greater potential reduction. While there is some variance as to how VAR could be computed, it is used to determine overall risk tolerance and position limits. Energy merchants normally include only their trading activities for computing VAR.

Problems with Long-Term Trading Assets and Liabilities

One of the problems with long-term trading assets is a difficulty in assessing their values given that there may not be a market for the tenure of the assets and liabilities. Hence, it becomes difficult to assess as to how conservative or aggressive the company’s valuation assumptions are. In general, the longer the tenor and the larger the long-term assets and liabilities, the greater the possibility of variances in performance from the assumptions.

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Appendix III

FAS 57 Disclosures of Related-Party Transactions:

Financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include:

a. The nature of the relationship(s) involved b. A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements c. The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period d. Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement

Transactions involving related parties cannot be presumed to be carried out on an arm's-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm's-length transactions unless such representations can be substantiated. 4. If the reporting enterprise and one or more other enterprises are under common ownership or management control and the existence of that control could result in operating results or financial position of the reporting enterprise significantly different from those that would have been obtained if the enterprises were autonomous, the nature of the control relationship shall be disclosed even though there are no transactions between the enterprises.

FAS 95 – Statement of Cash Flows

Cash Flows from Investing Activities: Investing activities include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets, that is, assets held for or used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory).

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Cash inflows from investing activities are: a. Receipts from collections or sales of loans made by the enterprise and of other entities' debt instruments (other than cash equivalents) that were purchased by the enterpriseb. Receipts from sales of equity instruments of other enterprises and from returns of investment in those instrumentsc. Receipts from sales of property, plant, and equipment and other productive assets.

Cash outflows for investing activities are:a. Disbursements for loans made by the enterprise and payments to acquire debt instruments of other entities (other than cash equivalents)b. Payments to acquire equity instruments of other enterprisesc. Payments at the time of purchase or soon before or after purchase

FAS 140: Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

A transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. b. Each transferee (or, if the transferee is a qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor.c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call.d. This Statement requires that a liability be derecognized if and only if either (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is legally released from being the primary obligor under the liability either judicially or by the creditor. Therefore, a liability is not considered extinguished by an in-substance defeasance.

A qualifying SPE is a trust or other legal vehicle that meets all of the following conditions:

a. It is demonstrably distinct from the transferor 98


b. Its permitted activities (1) are significantly limited, (2) were entirely specified in the legal documents that established the SPE or created the beneficial interests in the transferred assets that it holds, and (3) may be significantly changed only with the approval of the holders of at least a majority of the beneficial interests held by entities other than any transferor, its affiliates, and its agents

c. It may hold only: (1) Financial assets transferred to it that is passive in nature (paragraph 39)(2) Passive derivative financial instruments that pertain to beneficial interests (other than another derivative financial instrument) issued or sold to parties other than the transferor, its affiliates, or its agents (3) Financial assets (for example, guarantees or rights to collateral) that would reimburse it if others were to fail to adequately service financial assets transferred to it or to timely pay obligations due to it and that it entered into when it was established, when assets were transferred to it, or when beneficial interests (other than derivative financial instruments) were issued by the SPE (4) Servicing rights related to financial assets that it holds

A qualifying SPE is demonstrably distinct from the transferor only if it cannot be unilaterally dissolved by any transferor, its affiliates, or its agents and either (a) at least 10 percent of the fair value of its beneficial interests is held by parties other than any transferor, its affiliates, or its agents or (b) the transfer is a guaranteed mortgage

A transferor that has a right to reacquire transferred assets from a qualifying SPE does not maintain effective control if the reclaimed assets would be randomly selected and the amount of the assets reacquired is sufficiently limited (paragraph 87(a)), because that would not be a right to reacquire specific assets.

Some commentators asked whether the qualifying SPE criteria apply to entities formed for purposes other than transfers of financial assets. The Board decided that the description of a qualifying SPE in paragraph 26 of Statement 125 should be restrictive. Transfers to entities that meet all of the conditions in paragraph 26 of Statement 125 may qualify for sale accounting under paragraph 9 of Statement 125. Other entities with some similar characteristics also might be broadly described as “special-purpose.” For example, an entity might be formed for the purpose of holding specific non-financial assets and liabilities or carrying on particular commercial activities. The Board decided that those entities are not qualifying SPEs under Statement 125 nor under this Statement and that the accounting for transfers of financial assets to SPEs should not be extended to transfers to any entity that does not satisfy all of the conditions in paragraph 26 of Statement 125.

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Appendix IV

Brief Overview of SEC Disclosure and Other Rules

Regulation S-X: This governs the form and content of and requirements for financial statements (including all notes to the statements and related schedules) to be filed with the SEC under the various acts. The level of disclosures required by Regulation S-X is considered to be a minimum standard.

Related Party Transactions: Such transactions should be identified and the amounts should be stated on the face of the balance sheet, income statement or statement of cash flows. The SEC staff has interpreted the term related parties to include principal owners, management and directors, affiliates, equity investees, management-directed employee trusts, parties who have an ownership of more than five percent beneficial voting ownership interest in the registrant, and promoters or any member of the immediate family of any of the immediate family of any of the foregoing persons. In fact, Item 404 of Regulation S-K requires the disclosure of: (i) transactions involving more than $60,000 in which certain specified persons have a material interest (ii) transactions involving the company and its executive officers and (iii) transactions involving the “immediate family” of such specified persons.

The related-party disclosures required in accordance with generally accepted accounting principles are set forth in FAS57, Related Party Disclosures. Paragraph 57 of FAS57 defines related parties as “affiliates of the enterprise; trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; principal owners of the enterprise; its management; members of the immediate families of principal owners of the enterprise and its management; and other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own interests. Another party also is a related party if it can significantly influence the management or operating policies of the transacting parties or if has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its interests”. The SEC rule goes beyond this standard by requiring that related-party amounts be stated separately on the face of the financial statements.

Information required to be disclosed for material related party transactions is as follows: (i) the nature of the relationship of the related parties (ii) a description of the transactions, including amounts and other pertinent information necessary for an understanding of the effects of related party

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transactions (related party transactions of no or nominal amounts must also be disclosed) (iii) the dollar amount of transactions for each period in which an income statement is presented; also, the effects of any change in terms between the related parties from terms used in prior periods and (iv) if not apparent in the financial statements, the terms of the transactions, the manner of settlement and the amount due to or from related parties. Note that Enron was not complying with most of these requirements.

Notes and Other Receivables from Affiliates: Staff Accounting Bulletin 4-E clearly states that receivables from the sale of stock, as well as any deferred compensation arising therefrom, should be presented on the balance-sheet as a deduction from shareholders’ equity. Amounts due and collected prior to the issuance of the financial statements may be classified as assets. Staff Accounting Bulletin 4-G discusses the position with respect to the balance sheet presentation of notes and other receivables evidencing a promise to contribute capital from affiliates of corporate general partners in a limited partnership offering. While these notes and other receivables evidencing a promise to contribute capital are legally enforceable, they seldom are actually paid. In summation, the SEC staff has determined that these receivables are equivalent to unpaid subscriptions receivable for capital shares, which Regulation S-X requires to be deducted from the dollar amount of capital subscribed.

Gain recognition on sale of business to a highly leveraged entity: SAB Topic 5-U discusses the appropriateness of recognition of gains on sale of a business or operating assets accounted as a divestiture to a highly leveraged entity. The staff state that immediate gain recognition may be questionable when significant uncertainties exist about the seller’s ability to realize non-cash proceeds in a transaction in which the purchaser is a newly formed, thinly capitalized, highly leveraged entity and particularly if its assets primarily consist of those purchased from the seller. Amongst the criteria that are considered by the staff to review gain recognition are facts such as the newly formed entity does not have significant equity capital other than that provided by the registrant and that contingent liabilities exist requiring the company to infuse cash into the other entity. The SEC staff are of the opinion that such deferred gain should not be taken into income unless cash flows from operating activities of the new entity are sufficient to fund debt service or dividend requirements and the company has no further obligation to make additional investments into the new entity.

Generally Accepted Auditing Standards (GAAS): I had a brief look at the generally accepted auditing standards. While there is no definition of what independence is, the standards mention the following: audit is to be performed by persons who have adequate technical training with an independent mental attitude and due professional care is to be exercised in the planning and

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performance of the audit and in the preparation of the report. The standards mention that independence is a subjective term and two facets of independence are independence in fact and independence in appearance. A member in public practice is also required to be independent in the performance of professional services as required by standards promulgated by bodies designated by AICPA Council. It was surprising to find the following clarification on ethics and extended services that are interpretations of Rule 101 of AICPA Standards:

“Member Providing Advisory Services

.015 Question—A member has provided extensive advisory services for a client. In that connection, the member has attended board meetings, interpreted financial statements, forecasts and other analyses, counseled on potential expansion plans, and counseled on banking relationships. Would the independence of the member be considered to be impaired under these circumstances?

.016 Answer—Independence of the member would not be considered to be impaired because the member's role is advisory in nature”

Independence will not be impaired

Independence will be impaired

Business risk consulting Provide assistance in

assessing the client's business risks and control processes.

Recommend a plan for making improvements to a client's control processes and assist in implementing these improvements.

Make or approve business risk decisions.

Present business risk considerations to the

Regulation FD: Fair Disclosure was an issuer disclosure rule that addresses selective disclosure. The SEC adopted this rule effective October 2000. The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities

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who may well trade on the basis of the information), it must make public disclosure of that information. The timing of the required public disclosure depends on whether the selective disclosure was intentional or non-intentional; for an intentional selective disclosure, the issuer must make public disclosure simultaneously; for a non-intentional disclosure, the issuer must make public disclosure promptly.

Under Rule 100(a)(2), when an issuer makes a covered non-intentional disclosure of material nonpublic information, it is required to make public disclosure promptly. Rule 101(d) defined "promptly" to mean "as soon as reasonably practicable" (but no later than 24 hours) after a senior official of the issuer learns of the disclosure and knows (or is reckless in not knowing) that the information disclosed was both material and non-public. "Senior official" was defined in the proposal as any executive officer of the issuer, any director of the issuer, any investor relations officer or public relations officer, or any employee possessing equivalent functions. Under the regulation, the required public disclosure may be made by filing or furnishing a Form 8-K, or by another method or combination of methods that is reasonably designed to effect broad, non-exclusionary distribution of the information to the public. Rule 10b5-1 addresses the issue of when insider-trading liability arises in connection with a trader's "use" or "knowing possession" of material nonpublic information. This rule provides that a person trading "on the basis of" material nonpublic information when the person purchases or sells securities while aware of the information.

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Table I – Abstract from Analysts’ Reports

Prior to reading this section, please refer to Figures 62-65 and in particular, note the optimism of the analysts throughout (though the company was sinking). Through this section, I have attempted to analyze reports of analysts from JP Morgan, Salomon Smith Barney in detail and have also reviewed few of CSFB ‘s reports. I chose JP Morgan and Salomon Smith Barney and CSFB because analysts from these companies testified before the Senate Committee. To provide a flavor as to how a research-oriented firm did, I have provided excerpts from research reports of A E Edwards. Note that there have been other analysts covering the stock and I have covered but a few.

I have presented abstracts from analysts' reports, the time-period of analysis, the rating, stock price and target price where available. If the analysts have presented any investment risks, I have included them in the “Risks” column. The column titled “Valuation Methodology” highlights the way the stock has been valued as also my comments on the report.

Note that the reports presented are those I could locate on FirstCall; even in this search, I may have inadvertently omitted some research notes. Further, there could be some reports that have not been filed on FirstCall. Accordingly, analysts may have presented investment risks / more details in other reports that may not be captured here. Through this section as also some of the previous ones, I may exhibit some tendency of “hindsight bias”. I agree that it may be easy for me to rationalize post the event as to what the normative analysis should have looked like. I do appreciate and greatly respect the value added by analysts as also the incredible effort needed to grasp the business model, financials and operations a company the size and complexity of Enron. Further, as I have referred to, Enron did not justify its position as a premier company at least through its accounting disclosures.

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Analyst Date;Rating;Stock Price &Target

Comments (Abstract from Report) Valuation Methodology Risks Highlighted

JP Morgan

June 99Buy$78/$91

We see no other company in our universe that offers such impressive, sustainable and controlled growth as Enron. Enron’s core strengths include scale and scope, financial expertise, technological know-how, intellectual capital, and global presence and reach. Its portfolio offers global exposure that is almost entirely in low-risk energy and infrastructure projects and is managed for superior risk-adjusted returns. It boosts a management team that is capable, deep and supported by an enviable pool of talent. Enron has a culture that is aggressive and opportunistic, yet knows how to manage and mitigate risk. Guidelines require executives to own one to five times their base pay in stock, depending on their level within the company. As Enron accumulates risk, it sells that risk off-to various counterparties. Enron Communications showcases Enron’s ability to recognize and build a billion-dollar business basically from scratch. (Note that the analysis also included case studies of Enron’s ability to capitalize on profitable opportunities)

Price target was arrived at by applying a Price-Earnings multiple of 32.5 to 2000 earnings estimate; this multiple was much higher than Enron’s peer group multiple of 22 times earnings. Valuation of the company has been done using sum-of-the-parts analysis for different business units. Note that valuation of different business units has not been done using cash flows but using comparables of different companies and affording some discounts to comparables.

Comments: Some of the valuations were too optimistic. For e.g. though a 48% haircut was applied to the valuation of Enron Communications, analysts based their value on a 4.7 times multiple of Plant and Equipment (industry average which included bandwidth companies like AT&T and MCI) though Enron had little proven ability in this field and its infrastructure in terms of miles constructed was not even 10% of that of AT&T.

Few risks were highlighted. Some of these were as follows: For e.g. Enron Capital & Trading has significant flexibility in structuring contracts and hence booking earnings. As such contracts can be structured to recognize the economic value of projects long before they are operational and cash is coming in the door. For e.g. Sutton Bridge, a power plant that will start operations in the second quarter of 1999, hit Enron’s bottom-line in 1997. Further, there is an agency cost problem in the sense management may pursue projects that have a lottery-like pay-off structure

JP February Our 12-month target price for Enron is $85 The company forecasted revenues of No risks were presented

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Morgan 2000Buy$66/$85

with Enron Broadband Services (formerly Enron Communications) valued at $25 per share. The company’s 15,000-mile nationwide system is a state of the art, legacy-free system that was designed to move data. Bandwidth trading is already a reality, and we foresee this market growing faster than the wholesale energy markets. We believe that at no point did Enron’s energy businesses enjoy such sound prospects both domestically and internationally, across the retail and wholesale sectors. Enron is the only player with a full array of skills necessary to compete and win in this space. Enron offers such a compelling value proposition to clients that it will be the broadband provider of choice for the majority of players. We see Enron Broadband Services dominating the space in the foreseeable future.

more than $22 billion from Broadband Services in 2005 from an estimated $342 million of revenues in 2000. Net Income from Broadband was estimated to be $979 million in 2005 with Broadband contributing $1.26 EPS. The existing energy businesses were expected to be $60 and the Broadband Services were worth $25 a share. These services were valued at $25 using three components: intermediation, content delivery and physical networks using trading multiples.

Comments: Given that the company had not garnered revenues from broadband services at the time of the report, a CAGR of more than 130% a year seemed very excessive. This report sharply contrasted with the report detailed above which valued energy services at $90 a share. No explanation was given as to how the value of energy services could dip by $30 a share or $11 billion within a year’s time! While a haircut was applied to the comparables used for Broadband Services, again it seemed

regarding Enron’s foray into the Broadband Services market.

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very optimistic! It was really surprising to read that the analysts rated Enron ahead of seasoned telecommunications players like AT&T and MCI Worldcom.

JP Morgan

November 2000Buy$77/$130

Enron’s management has a clear understanding of the hurdles that need to be cleared in order for a broadband marketplace to materialize and to build systems to overcome them. A handful of industry verticals are ripe for commoditization and we are confident that Enron has the skills and expertise to catalyze these transformations. While margins may decay in these new verticals over time, the liquidity and transparency enable the creation of derivative instruments and the ability to hedge margins create financial engineering opportunities – Enron’s core competencies.

(Note: The analysis focused almost exclusively on Enron’s newest business unit (Networks) that aimed at creating marketplaces through verticals. The assumption made was that Enron could extrapolate its expertise in power and gas trading and its scale and scope advantages to other commodities as well).

The analysts raised the 12-month price target to $130 from $115. The original price target was based on a $70 a share for wholesale and $45 for broadband. The potential upside of $15 was, according to analysts, a discounted cash flow based valuation of two businesses that Enron’s newest business unit – Enron Networks – the company had committed to entering: pulp and paper and non-ferrous metals. In fact, the analyst felt that other verticals could add another $29 a share.

Comments: One of the analysts’ ideas on other possible verticals for Enron i.e. commoditizing an automobile sounds very far-fetched. The idea was that once Enron integrated steel, metals, plastic and rubber into its trading infrastructure, hedging forward sedans were

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practical! While discounted cash flows have been presented for verticals, many of the assumptions were outright aggressive and forecast a complete Enron domination by Year 6. For e.g. in data storage, Enron would have a 25% market share while in agricultural chemicals and building materials, market share would be 45% and 46% respectively.

JP Morgan

October 9, 2001Buy$33/$90

We see Enron as our “focus list” pick, our best buy in the space. Over the next six months, we expect the stock to appreciate more than its peers. Enron should rebound from historically low valuation levels, as investor confidence is shored-up through greater transparency and track record of performance. In addition, we believe Enron is well positioned to achieve further corporate clarity and continued earnings growth. Enron will be an important player in North American energy markets, especially if global geopolitical events create fuel disruptions. Enron has delivered on many promises this year, including shedding non-core assets. With the leadership of Ken Lay, Enron’s CEO for all but six months over the last decade,

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Mark Frevert and Greg Whaley, we are confident that Enron will continue to deliver on its promise of increasing returns on capital, greater transparency and sustainability of earnings growth.

JP Morgan

October 24, 2001Long-Term Buy$20/$50

We are downgrading Enron Corporation to a Long-Term Buy from a Buy in the wake of lingering concerns regarding the company’s credit situation and management disclosure of liabilities stemming from off-balance sheet financing vehicles. Although we do not believe that earnings are at risk at this point, if the problem persists, earnings forecasts may be revisited. In our view, management’s conference call yesterday morning was a missed opportunity to disclose the necessary information to assuage investor concerns. The call was anticipated to be a candid and open discussion of financial dealings and future anticipated downside risk. Although management affirmed Enron should be able to meet all of its obligations, we think investors were largely unconvinced. We believe this is largely due to a lack of information to substantiate their claim. The dynamics of the conference call conveyed a different message to investors as management made

Comments: In my view, the note provides an excellent overview of the analysts’ perception regarding lack of disclosure by management; however, the analyst did not drill down deeper. If the analyst felt that investors were not convinced with management’s explanations, then I do not understand how the analyst felt the stock would gain traction and appreciate 250% in a 12-month time-period. Second, the analyst failed to comment as to why management was defensive when questioned. Given that Enron was supposedly streets ahead of competitors, then the lack of disclosure cannot be attributed to safeguard information that could be detrimental to the company’s interests; the company’s reluctance to come clean can be at best viewed as circumspect especially given the events in the October timeline.

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its case. For instance, on yesterday’s call, management became defensive when an investor attempted to drill down into one of the trusts. In our view, management has appeared to question investors’ independent analysis or possibly indicated that Enron would rather not disclose the information due to fear of further punishment in the equity markets. Until management can effectively “open their books” to investors, we expect a continued depression of its stock price. Until management can be more available to investors, we believe investors will be reluctant to rush back into the stock despite a compelling valuation based on historical levels.

JP Morgan

October 30, 2001Long-Term Buy$14/N.A

Enron continues to underperform in the capital markets but there is scant evidence of business impairment. Liquidity, especially short-term, is not an issue in our view. The core energy trading franchise is holding up relatively well with only scant reports of exposure to Enron by counterparties. We continue to believe that if this situation is adequately addressed, the permanent impact on Enron’s franchise will be limited. We see ample liquidity in the near to medium term.

Comments: While no valuation methodology and target price was provided, the analyst mainly provided cash flow forecasts to meet the required cash payments of $575 million which could be met through $ 1 billion cash on hand, $450 million balance of credit facilities, $659 million of asset sales and $1.38 billion forecasted cash from operations in Q4. Note that these

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The Moody’s downgrade makes it more difficult and expensive for Enron to raise capital. Enron’s challenge lies in raising additional, unsecured capital that will not be dilutive to current equity holders. With that in mind, we reiterate our strong belief that Enron’s asset dispositions and cash from operations will be able to provide ample liquidity through this so-called liquidity crunch.

forecasts were provided after the SEC investigation into the company commenced and after the company took a $1.2 billion charge to equity. The analyst did not mention any of these problems as red flags in assessment of the company. It also seemed ridiculous for the analyst to assume that notwithstanding the accounting problems that had surfaced, Enron could be successful in raising even more capital. Note that my analysis presented earlier indicated a definite liquidity crunch

JP Morgan

November 21, 2001Long-Term Buy$7/

The release of Enron’s 10-Q has brought additional disclosures and restatements that have caught Enron investors off-guard. The company disclosed that its ratings downgrade to BBB- by S&P triggered an obligation to repay or restructure a $690 million note payable by November 27th. Fundamentally, we do not see liquidity as a concern if Enron can restore confidence in its core business. However, if counterparties continue to unwind positions with Enron and/or require more margins, it could create a cash demand that exceeds current liquidity. Enron still has not drawn down the $1 billion in secure

Comments: A fairly bullish note about a company, which filed for Chapter 11 about ten days subsequent to the note! While I am not aware of the nature of financing that Enron could draw down, I wish to point out that such financing lines may be contingent on a Material Adverse Change (MAC) not occurring. The analyst fails to point out that a MAC clause in the financing arrangements could prevent Enron from availing its credit facilities. Second, note that

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financing that it obtained in mid-November. The cash flows since September 30th show $2.1 billion. Finally, while Enron’s trading volumes have clearly been impacted by negative counterparty perception, the seasonality of Enron’s trading business should allow for strong cash flows from operations in quarter 4. On paper, Enron does not face a liquidity crunch, as we believe many of its coming maturities will not result in cash outflows anticipated by investors.

Enron’s short-term obligations schedule reflected dues of $6.9 billion and the analyst presumes restructuring of these obligations to financing vehicles. Given that the financing vehicles may have already sunk given that the only assets were Enron stock, which was almost under water, there was little possibility of restructuring. Thirdly, given the poor position, there could also be a run on Enron by its various debtors and the only recourse to Enron could have been to obtain automatic protection from creditors under bankruptcy.

JP Morgan

November 29, 2001Suspending Rating$0.61/N.A

After credit downgrades to below-investment grade by all major rating agencies and a cancellation of a merger deal with Dynegy, Enron’s core wholesale and marketing business suspended trading electronically. In addition, most players in the energy marketplace ceased trading with the company. As its operations can no longer function and are tied so closely to the health of its balance sheet, Enron’s core wholesale business is debilitated. We are therefore suspending our rating, target price and earnings per share estimates.

Comments: I do not have much to say on this two-page note except that I am amazed that the analyst continued to laud the role played by Enron’s traders and managers. For a company that shrouded its disclosure in secrecy and where no one had the complete picture of where things went wrong, being bullish on Enron’s managerial talent was unwarranted, in my opinion.

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We expect the company to file for bankruptcy court protection in days, leaving management and creditors to the task of liquidating any remaining physical assets. The downgrade also triggered a $3.9 billion debt obligation from off-balance sheet vehicles. Most major players in the market had net exposures of less than $100 million each to Enron. Although Enron’s trading operations was orders of magnitude larger than most of its competitors, the best and brightest Enron traders and managers will no doubt be offered an opportunity to replicate their efforts elsewhere. The best in class practices that were cultivated at Enron will fertilize the rest of the industry in the long run, to the benefit of competitors and Enron’s old customers.

AG Edwards

October 2000$80/$70Maintain /Aggressive

Enron is the premier energy trading company in the nation. What’s more, the company has identified new product lines (communications, metals etc), new trading mediums (EnronOnline) and new markets (Europe and Asia) that should allow it to maintain its growth rate for the foreseeable future.

No valuation models were provided regarding the target price of $70

Comments: The analysts’ reports in October 2000 (and April 2001detailed below) seem to indicate that the stock is overvalued and represent a costly buy at the prevailing price. However, no justification was provided as to why

Enron’s shares trade at 48.5 times its forward earnings, a higher multiple than just about any company that can be reasonably considered a peer. Further, the risks of broadband were also included as indicated in the column below.

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the analysts had this viewpoint. No valuation models were provided.

AG Edwards

April 2001$61/$60Maintain/Aggressive

Enron has a strong track record of meeting or beating the targets it sets. This is part of the reason the shares of Enron trade at a high valuation multiple. We believe that, with a company as large as Enron, disappointing results will occasionally surface. We also believe investors must accept a certain air of mystique with Enron given the nature of Enron’s business and the sensitive nature of its contracts. Instead, investors must look at Enron’s track record when assessing whether adequate reserves have been taken or whether top-line growth will continue.

One aspect of the valuation used by analysts is the use of comparables: the peer group multiples based on 2001 and 2002 earnings estimates were 17.8 and 16.3 times respectively; Enron’s multiples based on the analysts estimates at the prevailing stock price were 34 and 30 times respectively for 2001 and 2002 respectively.

Comments: Though the earnings during the first quarter of March 2001, was $795 million i.e. an increase of 27% over the same period the previous year, the composition of earnings was very different. The analysts failed to highlight that 98% of earnings came through sales and services volumes of the Wholesale Energy unit while the same unit contributed only 41% the previous year. It was also surprising that while the analyst recommended a target price of $60, no attempt was made using discounted cash flows or other

Enron is spending $5 billion to create a broadband trading market that currently does not exist. To do so, it must establish trading hubs capable of receiving, storing, categorizing and coordinating information flow. Enron has large multibillion-dollar projects overseas.

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methodology to justify the target price.

AG Edwards

October 19, 2001$26/N.AHold / Speculative

The shares of Enron has declined sharply in recent days following a disclosure by the SEC that Enron significantly reduced its equity to unroll a partnership arrangement with a partially owned subsidiary formerly run by the CFO. This arrangement, which was not discussed in past SEC filing, has led to a growing distrust of the company by the financial community. In our opinion, the market is most likely overreacting to the news being disseminated over the last few days. However, we can give no assurances that all the problems at Enron have been fully disclosed. Consequently, we are lowering our rating on the shares of Enron to Hold and changing our suitability rating on the shares to Speculative from Aggressive.

AG Edwards

October 25 2001$17/N.AHold / Speculative

Core operations are performing well. However, the company took a $1.01 billion after-tax charge to write-down various non-core assets. A $1.2 billion reduction of equity relating to the LJM partnership was later disclosed in a WSJ article. Our 2001 and 2002 estimates for Enron remain unchanged, as we believe these issues are mainly balance sheet related. In our

Comments: In my opinion, this looked to be one of the better analyst reports and highlighted problems faced by the company in October as also the lack of disclosure by the company regarding problems in

The analyst cared to mention that they could give no assurances that all of the problems at Enron have been fully disclosed. The report highlighted investment concerns for the company such as inter-company transactions, further write-

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opinion, the market is most likely overreacting to the news being disseminated. The future of Enron’s stock is more dependent upon its ability to clean up the balance sheet and unroll various limited partnerships than it is to report good earnings. We recognize as analysts that we must rely on the company reputation to some extent; however, we were disturbed to learn of the full impact of the transactions within 24 hours after the company has held an earnings conference call with analysts without mentioning the transaction. The company also has about $3 billion of troubled assets that are susceptible to writedowns; however, the company’s ability to write-down assets may be constrained as higher charges could trigger certain debt covenants that could be onerous to earnings.

transactions with partnerships. However, the note failed to mention the dismissal of Andrew Fastow, the CFO and the man behind the conflict of interests, a few days earlier.

downs of assets, an unproven communications strategy and international risks.

Salomon Smith Barney

July 2000$77/$100Buy – High Risk

We reiterate our Buy rating on Enron following announcement of second quarter EPS of $0.34 per diluted share, up 26% from $0.27 last year and ahead of $0.32 estimate. In our view, Enron Broadband Services is the key new value creation driver for the company. We view Enron Networks as an extension of Enron’s Risk Merchant business model, employed in

The price target was arrived at by attributing a value of $60 for Enron’s energy merchant platform and $40 for bandwidth trading and other extensions of their risk franchise (within 5 years, the analysts saw the value of bandwidth trading exceeding the entire value of energy marketing).

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trading gas, power and bandwidth. We have witnessed Enron’s success at transforming illiquid and inefficient markets into thriving liquid commodity markets in the past, and think Enron is well positioned to successfully leverage this model into new commodity markets.

Comments: Again no fundamental backing for the valuation has been provided. While the analyst was very positive about Enron’s prospects for bandwidth trading, no attempt was made to lay out the business models as also the numbers behind the analysis. On the contrary, the analyst seemed to have accepted the line of reasoning provided by the company. The note did not highlight the nature of capital expenditure requirements to attain the value per share.


October 22, 2001$29/$55Buy High Risk

We are cautious near-term on Enron after untangling part of a complicated story involving their balance sheet, cash flow and business practices. Although we think that we have bounded the most important issues facing Enron, we cannot rule out that our long-term view may have to change, due to the complexity of off balance-sheet financing vehicles and the uncertainty and magnitude of potential write-offs. The chief issue facing Enron, in our view, is the weakening of their credit standing following $2.21 billion in write-offs, announced last week. Moody’s has

Comments: Several interesting points emerge from this note: First, the analyst continued to rate the stock a buy but high risk, despite the $2.21 billion write-downs which amount to two years’ profits. Secondly, a debt downgrade by two notches (to BBB- from the then BBB+/Baa1) would have had disastrous consequences for the company; while the analyst recognizes this, neither the rating

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placed Enron’s debt on notice for possible downgrade. Offsetting these concerns: cash flows appear solid over the balance of the year and 2002; and their core Merchant-operating performance is solid. Of the $2.2 billion in charges, $1 billion consisted of a writedown of several non-Merchant investments, while the remaining $1.2 billion consisted of an unwinding of LJM, an off-balance sheet financing vehicle of which Enron’s CFO was general partner. Enron still has on its books several items that may have to be written-off in part. The problems, in our view, stem from Enron venturing too aggressively in areas outside its core skills. All of the write-offs appear to be in these non-core, non-Energy Merchant areas. Backstopping these vehicles, in some cases, was a contingent claim on shareholders equity.

nor the stock prices get impacted. Thirdly, the analyst blames Enron for its venturing into non-core areas; this is in sharp contrast to earlier notes where the analyst has touted Enron’s bandwidth strategy as a great value-add (refer above). Fourth, the circumstances surrounding the write-down are more important than the write-downs themselves; erosion of shareholders equity through unwinding of off balance sheet vehicles is very concerning. Finally, the analyst says that the stock was used as a backstop for some vehicles; at that very moment, it was clear that the hedges were indeed notional and done to reduce profit volatility; this was not addressed by the analyst.


October 25, 2001$16/$30Buy Speculative

We change our rating on Enron to Buy-Speculative from Buy-High Risk reflecting our concerns that lingering uncertainty over financial practices may begin to impair Enron’s commercial operations. This is the least likely outcome, in our view – probability 10%-15% - but one whose likelihood has increased over the last week as questions continue to be asked. We are

Comments: I could not comprehend what went wrong on October 25th

that compelled the analyst to issue another note the next day lowering the rating from a Buy-Speculative to a Neutral-Speculative; the share was trading at almost the same price on these two days (please see report on

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long-term believers in the Merchant Energy story and Enron. Should the company make it through the current travails, the unusually low valuation, coupled with their leadership position in the industry, justifies maintenance of our “Buy” rating. We also base our Buy rating because of what we know about Enron’s financial situation. We are unwilling to change this solely because of speculation in the marketplace. What we know suggests to us that Enron has “hidden leverage” on its balance sheet. Attempting to pierce through these known off-balance sheet vehicles, we estimate that Enron is effectively operating at a debt-to-capital ratio in the low 60% range.

October 26th below). It is puzzling that the analyst retained the same rating on October 25th though Andrew Fastow, the CFO and the architect behind these partnerships, was sacked the previous day though the company had endorsed him a few days prior. The analyst also failed to mention this dismissal in the note.

Further, in the second note (see below), the analyst does not mention as to why the rating was lowered even though the first note mentioned that SSB was unwilling to speculate and would continue to appraise the stock based on known information. Given that the market did not seem to react adversely, I wonder whether the analyst had “special information” which he used to downgrade the stock. I do not mean to be critical about the downgrade but am just questioning the lack of disclosure to investors regarding the reasons for the downgrade. The analyst also seemed to totally miss the point regarding off-balance sheet financing – one, this could impair Enron’s

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credit rating that is crucial as far as trading is concerned and two, whether the off balance-sheet financing was localized to Enron or whether this is widespread in the marketplace.


October 26, 2001$16/$14Neutral - Speculative

Enron is the industry dominant player in the energy merchant industry; their business performance remains intact and should continue unimpeded if current concerns over credit and liquidity are addressed. We believe this is the most likely outcome. However, until management completely clarifies these issues, particularly the use of off-balance sheet financing, we think growing credit concerns could put increasing strain on Enron’s commercial relationships. Concern over a now higher probability “worst-case” outcome drives our speculative rating. A low-end price target of $10 assumes 1x our estimate of book value based on known off-balance sheet financing with upside potential to $24. Our estimates of book value adjust for Whitewing/Osprey and Marlin Water, the two principal off-balance sheet vehicles.

Comments: While the analyst has made a mention of near-term uncertainty regarding the company’s shares, it would have been more appropriate to disclose the concerns including the SEC’s demand for more information from Enron as also the $1.2 billion equity write-downs. No mention was made regarding the asset write-down. I was also surprised that the analyst made no mention of the LJM2 partnership as also the conflict of interest with the CFO’s participation in these partnerships.

Salomon Smith

November 28,

We suspend our earnings estimates on Enron following downgrades of Enron’s

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Barney 2001$4/$0.25Suspend

debt to non-investment grade today. The non-investment grade rating triggers the obligation by Enron to repay a minimum of $3.9 billion in debt, and has largely shut down their trading desk. The ongoing earnings power of Enron was driven by their trading operations. Without that, we have little basis to make a call on earnings.

Credit Suisse First Boston

October 2000$80/$115Strong Buy

Based on the third quarter 2000 results, specifically the higher-than-expected results in wholesale and energy services, we increased our estimate for Enron to $1.40 from $1.35 per share for 2000 (versus $1.18 for 1999). We maintain our estimate for $1.65 for 2001, which we consider to be conservative. Our target price is $115 and our rating is strong buy.

The target price was arrived at through valuation of $55 a share in wholesale energy, $30 a share in energy services, $25 a share in broadband and $5 a share in pipelines

Comments: While the analyst again harps on the performance of the wholesale sector, not much attention has been paid to the significant jump in EBIT. For e.g. the wholesale business had a 66% jump in EBIT in the third quarter of 2000 as compared to the same period the previous year. The commodity sales and services segment experienced a whopping 134% jump in EBIT though volumes had increased by 80% for natural gas and only 52% for power.

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The high valuation attributed to the company seems to be based on the company’s ability to build on its dominance in energy trading and services into other commodities. While this may be so, it is difficult to envisage a situation where there would not be any execution risks. Further, there is no explanation as to where the multiples of earnings have been derived from.


October 29, 2001$15/$54Strong Buy

We maintain our Strong Buy rating for the company. Our expectation is that additional capital raising and potential equity issuance will begin to solve the balance-sheet dilemma for the company, further disclosures of off-balance sheet vehicles will become less threatening and the establishment of near-term liquidity will restore some confidence that Enron’s wholesale and service businesses can continue to operate normally. On October 24, Enron announced that it had drawn down $3 billion of previously unused credit lines. We view this move as an establishment of liquidity to counter recent speculations to the contrary. We see a possible scenario in which Enron may issue shares to support its of-balance sheet debt

Comments: An excessively optimistic report that toes the company’s line of reasoning without presenting an analytical approach. First, the fact that the Board, auditors and lawyers approved LJM partnerships does not exonerate the company’s accounting methodology and the conflict of interest issues. Second, while the analyst mentions that the CFO’s involvement was only till July 2001, it fails to consider that the company replaced the CFO as also the fact that the CFO could have been involved in many other partnerships. Third, the report fails

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and investment grade ratings. Enron’s debt-ratings are generally three steps above “junk” status. We regard Enron’s credit ratings and balance sheet issues as unlikely to worsen materially. As previously discussed, the LJM partnership was approved by Enron’s board, outside lawyers and auditors. The involvement of Enron’s CFO ended in July 2001. Dealings with the partnerships have been unwound with charges and equity reductions in the third quarter reports

to mention that the LJM partnership may only be the tip of the iceberg as far as off-balance sheet partnerships are concerned!


November 20, 2001Strong Buy$9 /$25

Enron’s third-quarter 10Q provided information ranging from updates on accounting restatements, balance sheet details and discussions of off-balance sheet obligations. The MAC clause in the Dynegy-Enron deal was described as considered if other Enron liabilities (primarily litigation) exceed $2 billion net of insurance or reserves. If an additional $1.5 billion in liabilities is assessed, a MAC is deemed to have occurred. In assessing a 90% probability that the deal will be completed, we note that Enron is not a going concern without it.

Comments: Though the research note continued to rate Enron a Strong Buy and is overtly optimistic on the Dynegy-Enron going through, the analyst correctly identified that Enron was not a going-concern without the Dynegy acquisition.

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