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:
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
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
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
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
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
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
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.
signed off on Fastow's participation in a partnership deal called
LJM2, a cloak for, among other things, Enron's ill-advised purchase of
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
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.
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.
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
- The board's attorney, Neil Eggleston,
focused on the report's assessment that some information was withheld
"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