Sunday, February 17, 2002

This is a really sick company:

This personal enrichment of Enron employees, however, was merely one aspect of a deeper and more serious problem. These partnerships---Chewco, LJM1, and LJM2--were used by Enron Management to enter into transactions that it could not, or would not, do with unrelated commercial entities. Many of the most significant transactions apparently were designed to accomplish favorable financial statement results, not to achieve bonafide economic objectives or to transfer risk. Some transactions were designed so that, had they followed applicable accounting rules, Enron could have kept assets and liabilities (especially debt) off of its balance sheet; but the transactions did not follow those rules.

Other transactions were implemented--improperly, we are informed by our accounting advisors--to offset losses. They allowed Enron to conceal ffrom the market very large losses resulting from Enron's merchant investments by creating an appearance that those investments were hedged--that is, that a third party was obligated to pay Enron the amount of those losses---when in fact that third party was simply an entity in which only Enron had a substantial economic stake. We believe these transactions resulted in Enron reporting earnings from the third quarter of 2000 through the third quarter of 2001 that were almost $1 billion higher than should have been reported.

Enron's original accounting treatment of the Chewco and LJM1 transactions that led to Enron's November 2001 restatement was clearly wrong, apparently the result of mistakes either in structuring the transactions or in basic accounting. In other cases, the accounting treatment was likely wrong, notwithstanding creative efforts to circumvent accounting principles through the complex structuring of transactions that lacked fundamental economic substance.

This is a really sick company, on Robert Musil's blog:

The Man Without Qualities continues to believe that it is unlikely that Enron's financial statements were deliberately, intentionally or obviously fraudulent. Of course, that is far from equivalent to asserting that those financial statements (in any form or as of any date) fairly reflect Enron's financial condition. But financial statements may fail to fairly reflect a company's financial condition out of mere negligence or inadvertent error or even good faith disagreement brought on by later experience and re-evaluation.


While such a change of industry-wide standards and opinions did not compel the Enron earnings restatements, a change in Arthur Andersen's opinion related to the then-ongoing rapid decline in Enron's stock price is reportedly exactly what caused Arthur Andersen to demand that Enron put its restatements into effect, and it is by no means necessary to impute fraud or deliberate deceit to account for them.

The first is from the Powers report, or more formally, the report of the Special Investigatory Committee of Enron's Board of Directors, which discusses all manner of financial irregularity at Enron. (It's 10 megabytes of PDF; Adobe's PDF-to-html converter is recommended for those with slow net connections). The second is from yet another Musil apologia for Enron.

Musil starts by noting that there are all sorts of legitimate reasons why a company might take a large charge to rectify its books. But the question at hand isn't why some company might take a charge, it's why Enron actually did. Yet Musil oddly never addresses the specifics of Enron's case.

They aren't hard to discover. Andersen CEO Joseph Berardino's testimony before the House Committee on Financial services has a readable, brief account of some, and there is a more detailed, still perfectly readable, discussion in this Washington Post article which I linked to two months ago.

Let's start with the charges discussed by Berardino. Briefly, Enron made numerous investments, many of which were turkeys, running losses and accumulating debt. To keep some of these turkeys from disfiguring its annual reports, Enron assigned them to another entity, nominally a joint partnership with other parties, named Chewco, for Chewbacca the Wookie. However, side deals with the partners left Enron holding the bag for just about all of the liabilities of the partnership (more than 97%).

So the liabilities of Chewco were, in effect, liabilities of Enron, and should have been carried as such on Enron's books. For about four years, they weren't, which means that Enron's financial statements over that period of time were simply in error.

Why the mistakes? According to Berardino, Andersen was apparently never told of the side deals which transferred almost all of Chewco's liabilities from Enron's partners back to Enron. Knowing failure to tell your auditors about legal agreements which materially affect your financial position is fraud. Enron's CFO, Andrew Fastow, knew first-hand about Chewco; as the Powers report describes, he was directly responsible for setting it up. Are we to believe that Fastow, recipient of CFO Magazine's 1999 Excellence Award for Capital Structure Management, didn't realize that this particular capital structure left Enron entirely on the hook?

(Berardino doesn't discuss another set of charges, covered by the Post article I mentioned above and the Powers report, in which Enron booked as assets, $1.2 billion in promissory notes from entities called the Raptors. The Raptors collapsed when the dotcom bubble popped, and the promissory notes became worthless. At that point the accountants looked things over and decided that since the Raptors were financed through complicated arrangements involving Enron stock, the notes never should have been booked as assets in the first place. But I digress --- back to the partnerships).

Why would partners participate in these deals? That's easy --- participants in Enron's partnership deals were handsomely rewarded. Individuals who participated as partners made millions of dollars, and seem to have incurred essentially no risk, as reported in the Powers report. If large banks were getting the same deal, they would certainly be happy to participate, something Musil seems awfully hung up on. The only parties at risk in a lot of these deals were apparently Enron and its shareholders --- but the banks that entered into Enron's partnerships, and their auditors, had no fiduciary duty to Enron. They were only interested in defending their own interests, and those of their clients, who seem to have made out fine.

(As a sidelight on Wall Street's willingness to engage in shady deals, today's New York Times reports that several banks engaged in derivative deals with Enron which "perfectly replicated loans"; at least one was actually booked as a loan by the bank, Credit Suisse First Boston. But Enron booked them as derivative deals, so they wouldn't show up on its balance sheet as debt, which would have damaged the company's all-important credit rating. Instead, they were reported as derivatives contracts, and financial analysts who inquired were told that the enormous increase in reported derivatives trading was related to "hedging activity". These transactions clearly allowed Enron to present a misleading picture of its financial state on its balance sheet --- but that didn't stop J.P. Morgan, Citigroup, or Credit Suisse from diving in).

Why would Enron's executives approve bogus partnership deals? Because they were among the beneficiaries. Michael Kopper was an Enron employee chosen by Fastow to manage Chewco. He received $2 million in fees for his trouble, according to the Powers report (and another $8 million for participation in some of Fastow's other partnership schemes). Fastow, the architect of these deals (and, once again, recipient of CFO Magazine's 1999 Excellence Award for Capital Structure Management --- read that piece, it's a howler) personally cleared in excess of $30 million from participation as a partner in several of these deals. The conflicts of interest here are stunning.

Beyond that, Enron's executives benefited indirectly from the misstatement of the company's financial condition, which inflated the stock price as they were busy selling shares --- Fastow personally cleared $30 million, Skilling $66 million, and Ken Lay cleared more than $100 million dollars in sales of inflated stock.

Sherron Watkins thinks that Ken Lay was uninformed about the particular deals that lead to the accounting irregularities, or at least, about their consequences. Another Enron employee demurs; where she sees innocent confusion, he sees malign spin, and as Skilling's lawyer notes, she sent a memo to Lay which suggested scapegoating Skilling, Fastow, and other subordinates, exactly as in her testimony.

But with regard to at least one of the partnership deals, he had oversight authority, and went through the motions of exercising it. He explicitly signed off on Fastow's participation in a partnership deal called LJM2, a cloak for, among other things, Enron's ill-advised purchase of unused, "dark", fiber-optic cable. The Powers report --- the official report of the board's own special investigatory committee on Enron's fiscal shenanigans --- acknowledges that Chewco, LJM, and several other dubious partnership deals, were also discussed and approved by the board. In fact, it's full of passages like this:

...the Board, having determined to allow the related-party transactions to proceed, did not give sufficient scrutiny to the information that was provided to it thereafter. While there was important information that appears to have been withheld from the Board, the annual reviews of LJM transactions by the Audit and Compliance Committee (and later also the Finance Committee) appear to have involved only brief presentations by Management (with Andersen present at the Audit Committee) and did not involve any meaningful examination of the nature or terms of the transactions. Moreover, even though Board Committee-mandated procedures required a review by the Compensation Committee of Fastow's compensation from the partnerships, neither the Board nor Senior Management asked Fastow for the amount of his LJM-related compensation until October 2001, after media reports focused on Fastow's role in LJM.

This doesn't even rise to the level of the Sergeant Schultz defense; they can't say "We knew nuffink, nuffink!" because the minutes of the board meetings disclose that they discussed and approved partnership deals which their own investigatory committee's report describes as highly improper. Instead, Enron's "high-quality board" (as Musil would have it) offers the pathetic excuse that management didn't tell them enough, and for some strange reason, they forgot to ask. Did the dog eat their homework?

And how convenient for them that all the real blame for Enron's troubles lies not with them, or their erstwhile confrère Mr. Lay, but with Skilling, Fastow, and others who are no longer with the company.

Fastow may have a different view of the board's involvement. If so, I'm sure we'll be hearing all about it shortly after he reaches his well-nigh inevitable plea bargain --- at which point, if not before, we may also learn the complete list of individuals involved in the partnerships, which was apparently not even available to the authors of the Powers report. But if the board wasn't complicit, they were clearly appallingly negligent.

So much for Musil's presumption of innocence. He goes on to spin more reasons for ignoring suspicious behavior of Enron and Andersen, ignoring relevant facts as usual:

Nor should anyone consider Enron's termination of Arthur Andersen following Enron's bankruptcy to be significant evidence of malfeasance by either Enron or Arthur Andersen. It is neither sinister nor at all unusual for a bankrupt company to terminate its pre-bankruptcy accountants, if only to assure creditors and investors that a new boom has been brought in.

Enron's own press release quotes Ken Lay as saying that Andersen is being dismissed for malfeasance, "including the reported destruction of documents by Andersen personnel." It's almost as if Musil doesn't think Ken Lay's word can be trusted.

Musil winds up with a truly bizarre rant about the Andersen shredding party: it wasn't that serious, though it certainly did justify firing the partner responsible, though on the third hand, it's hard to assess, since we don't actually know what was on the documents that were shredded. (Well, duh. That's why they were shredded).

Musil has denounced the New York Times' coverage of Enron as "hysterical". Yet he writes as if he is ignorant of facts that have been well covered by all sorts of national news outlets, including the Times, which has certainly been all over the story. In particular, he keeps on trying to argue that there was no major financial irregularity at Enron, even after the release of the Powers report, written by members of Enron's own "high-quality" board, which unabashedly states that Enron's books were cooked, and that employees of its finance department, right up to the CFO, were raiding the till. Perhaps the Times is owed an apology?

Update: In his latest entry, Musil has finally taken notice of the Powers report. He still doesn't seem to have read the thing itself, though; instead, he trolls for exculpatory remarks from an article in the Washington Post --- one which isn't even so much about the report, as Ken Lay's failure to testify. Musil crows happily, for instance, over a quote from Professor Donald Langevoort of Georgetown, to the effect that the report is soft on Lay and Skilling. But here are a few quotes from the same Washington Post article which Musil omits:

The [Powers] committee investigated only a handful of the more than 1,000 partnerships Enron established and found that Enron executives manipulated the company's financial condition in several transactions with these partnerships. The committee said some partnerships hid losses from troubled Enron deals, including investments at power plants in Brazil and Poland, and in companies such as Internet service provider Rhythms NetConnections Inc. and networking equipment maker Avici Systems. Deals were done to make the company appear profitable when it was actually losing money and heavily in debt. At the same time, insiders made hundreds of millions of dollars in the sale of Enron stock, at the expense of employees and shareholders.

Lay was portrayed in the report as a lax manager who "bears significant responsibility for those flawed decisions" to create off-the-books partnerships and let others run them.

And again:

Columbia University law professor John C. Coffee said the report lays the groundwork for "an old-fashioned, plain-vanilla fraud case against Kopper and Fastow."

"I think this is going to significantly enhance the prospect of criminal indictments in their cases," Coffee said. If the facts stated in the report are true, "this is into the zone of active fraud," he said.

And again:

The board's attorney, Neil Eggleston, focused on the report's assessment that some information was withheld from directors.

"The board and its committees were repeatedly assured that the controls the board had ordered were adequate and being implemented, but the board was misled," he said.

The Powers report is indeed measured in its discussion of Lay and Skilling, to the extent that it tries to portray them, like the Board itself, as dupes of Fastow. But it is very, very hard on the rest of the company's management, particularly the finance department. Suggestions to the contrary just won't wash.

So much for quoting out of context. Musil also seizes with glee on the Times' acknowledgment that the disguised loans it reported on Sunday did not violate current FASB rules, never mind their deceptive intent. He somehow neglects to mention that those rules are about to change, as disclosed in the very next sentence in the Times article after the one he cites; in the future, any such transaction will have to be reported honestly, as a loan.

Think of it --- Enron's management was actually capable of rigging a deal that didn't violate FASB rules! I guess after Chewco, that's good to know.


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