Enron and the Powers Report: An Examination of Business and Accounting Failures

Enron and the Powers Report: An Examination of Business and Accounting Failures

FEI Research Foundation

Issues Alert

April 2002

Enron and the Powers Report: An Examination of Business and Accounting Failures Purpose This report provides a synopsis of the Powers Report, paying particular attention to Enron’s failures in executing the transactions involving Special Purpose Entities. It emphasizes oversight shortfalls at many levels and by many parties, including conflicts of interest and corporate governance issues.

The Powers Report The Executive Summary of the “Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.” provides a thorough description of the series of failures that led to Enron Corporation’s downfall: The tragic consequences of the related-party transactions and accounting errors were the result of failures at many levels and by many people: a flawed idea, self-enrichment by employees, inadequately-designed controls, poor implementation, inattentive oversight, simple (and not-so-simple) accounting mistakes, and overreaching in a culture that appears to have encouraged pushing the limits. Our review indicates that many of those consequences could and should have been avoided.

Though the quotation from what is recognized more widely as the Powers Report brings to mind the cliché of 20/20 hindsight, it effectively summarizes the financial issues with which the business community has been struggling over the past several months. Most of the Enron transactions leading to the restatements of $569 million and $1.2 billion in income and equity, respectively, involve the use of Special Purpose Entities (SPEs). A company may treat an SPE as an independent entity for accounting purposes if certain minimum requirements are met. An owner independent of the company must make an equity investment of at least 3% of the SPE’s assets (however, it is important to note that the SEC maintains that in some instances, more than 3% is required). In addition, the owner must control SPE activities and the investment must remain at risk throughout the transaction.

Key SPEs Used by Enron The Chewco Transactions According to the Powers Report, Enron either liberally interpreted or disregarded the minimum requirements. Consider the example of Chewco Investments L.P. (Chewco), a limited partnership managed by Michael J. Kopper, an Enron employee who reported to then-Executive Vice President and CFO Andrew S. Fastow. Chewco (reportedly the first SPE run by an Enron employee) was formed to purchase California Public Employees’ Retirement System’s (CalPERS) interest in the Joint Energy Development Investment Limited Partnership (JEDI), an Enron joint venture. Enron and CalPERS jointly controlled JEDI, thus it was not consolidated into Enron’s financial statements. However, once CalPERS sold its interest, Enron had to consolidate JEDI— unless another investor surfaced; enter Chewco. The problem was that Chewco was financed primarily with Enron debt, rather than at-risk equity from an outside investor. The Powers Report estimates that Chewco was more than 50% short (at least $6.6 million) of the 3% required equity.

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Revenue recognition problems also resulted from Enron’s accounting for Chewco. Fees from Chewco and JEDI reflected treatment that was inconsistent with generally accepted accounting principles (GAAP). Specifically, guaranty and management The FEI Research Foundation

fees typically recognized over an entire service period, were almost immediately recognized. Enron also recognized income from its interest in JEDI using the equity method of accounting. Recall, however, that JEDI’s assets consisted of 12 million shares of Enron stock. Thus, Enron’s accounting for the stock held by JEDI was counter to GAAP, which provides that a company cannot recognize income from increases in the value of its own stock. In late 2000, Arthur Andersen’s work papers reflected that Enron could no longer recognize income from JEDI’s Enron stock. However, when the value of Enron stock declined in early 2001, a loss was not recorded. According to the Powers Report accounts, “...Enron was no longer recording increases in Enron stock held by JEDI and therefore should not record decreases.”

The LJM Transactions An analysis of the transactions with the LJM partnerships, LJM Cayman, L.P. (LJM1) and LJM2 Co-Investment, L.P. (LJM2) provides further insight to Enron’s attempts to cast its financials in a favorable light. Formed in 1999, Enron was involved in more than 20 transactions with LJM1 and LJM2, most of which were structured as asset sales or investment hedges. Sales to the LJMs involved assets that Enron wanted removed from its balance sheet and typically occurred toward the end of reporting periods. LJM1 was formed in June 1999 based on a proposal Fastow presented to Kenneth Lay and Jeffrey Skilling, Enron’s former Chairman and Chief Executive Officer. LJM1 and Enron transacted on three occasions: a hedge on Enron’s investment in Rhythms NetConnections (Rhythms), an Internet service provider; a partial purchase of Enron’s interest in a Brazilian power project (Cuiaba); and a purchase of certificates in another SPE called Osprey Trust. Fastow was able to raise $15 million from ERNB Ltd. (reportedly affiliated with Credit Suisse First Boston) and Campsie Ltd. (understood to be affiliated with National Westminster). Though the outside investments appeared to have fulfilled the equity requirements to prevent consolidation and the Powers Report admits “arguments could be made both for and against consolidation based on Fastow’s control of the partnerships,” problems eventually arose. In the Rhythms hedge, Enron exchanged 3.4 million shares of its stock for a $64 million note payable from LJM1. Another SPE, LJM Swap Sub L.P. (Swap Sub), capitalized by 1.6 million Enron shares and $3.75 million in cash from LJM1, gave Enron a put option on 5.4 million shares of Rhythms stock. The option allowed Enron to require Swap Sub to purchase the Rhythms stock in June 2004. However, if both Enron and Rhythms stock decreased, the hedge would fail since Swap Sub would have enough to fulfill the put. The Powers report also notes that Swap Sub had negative equity—which questions whether Swap Sub qualified for non-consolidation. Indeed, in its November 8 announcement, Enron confirmed Swap Sub should have been consolidated, leading to some of Enron’s restatements. LJM2 was created later in 1999. Fastow represented to the Board that LJM2 would raise at least $200 million of institutional private equity that could be used to purchase Enron’s assets. (Indeed, the investigative committee believes that LJM2 may have had up to 50 limited partners, although this has not been verified.) The Board approved LJM2’s formation, though according to Enron Finance Committee minutes, Chairman Herbert S. Winokur, Jr. noted that there would be no obligation between Enron and LJM2. Regardless of this lack of obligation, LJM2 and Enron entered into several transactions, the most notable involving four SPEs known as the Raptors.

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The Raptor SPEs used Enron stock or contracts for delivery of stock to hedge against a substantive portion of its investment portfolio. LJM2 provided the equity to prevent consolidation of the Raptors into Enron’s financials. In reality, however, the SPE acted as nothing but an improper accounting hedge in which Enron still bore the majority of risk. Namely, if the both the value of the investments and Enron stock dropped, the Raptors would not have enough to pay Enron and the hedges would fail. In late 2000 and early 2001, this is exactly what happened. Rather than take a loss of more than $500 million, the Raptor SPEs were restructured. Later in 2001, when the Raptors’ credit problems could no longer be solved, the transactions were unwound— leading to Enron’s October 16, 2001 announcement of a $544 million charge against earnings.

Conflicts of Interest The accounting failures at Enron illustrate conflicts of interest at all levels. Several Enron employees were enriched primarily through small investments in the various SPEs. Fastow and Kopper alone made $30 million and $10 million, respectively, through their investments and other “management” fees. The negotiations between Chewco and Enron for CalPERS’ interest in JEDI clarified Fastow’s and Kopper’s conflicts of interest. Fastow pushed Enron’s negotiator (who was also Fastow’s subordinate) to close the deal at terms proposed by Kopper. The subordinate told the investigative committee that he was uncomfortable the terms. He said that Chewco would receive greater benefit than required and that Enron’s position could have improved if negotiations continued. Regardless, the deal was closed. Enron management represented to its Board that the LJM partnerships and Fastow’s direct involvement as general partner would permit Enron to execute transactions in a quick and cost-effective manner. Based on current evidence, it appears that though the Board was aware of the inherent conflict of interest, it was never fully aware of the degree to which Fastow and other employees benefited from their SPE arrangements. While the employee conflicts were clear-cut, the external-party conflicts of interest also contributed to Enron’s problems. Company management reported to the Board that “Enron’s accounting treatment was determined with extensive participation and structuring advice from Andersen,” the company auditors. Based on Enron’s records, Andersen billed $5.7 million for advice in connection with LJM and Chewco. Though an internal Andersen e-mail allegedly suggests that Andersen had reservations about the SPE transactions, apparently, these concerns were not brought to the attention of Enron’s Board.

Corporate Governance Issues: Beyond the Accounting A larger problem of corporate governance and management surfaced beyond Enron’s accounting practices. The poor controls and inattentive oversight cited in the Powers Report allowed the aggressive financial treatments to continue. Though several employees owned partnership interests in various SPEs, a clear violation of Enron’s Code of Conduct of Business Affairs, it appears that only Fastow obtained necessary permission required by that code. Both Enron’s in-house counsel and external counsel, Vinson & Elkins, were made aware of Chewco. Counsel subsequently advised that Fastow’s involvement in Chewco required proxy disclosure and approval from the Chairman and CEO under the Code of Conduct.

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Since he was not a senior manager, Kopper’s substitution as Chewco’s manager circumvented proxy disclosure, but still required Chairman approval. Yet, the investigative committee could not locate evidence that Kopper’s role was either disclosed to or approved by Lay or the Board. Regarding the LJM partnerships, the Board’s approval and acknowledgement of Fastow’s conflict of interest signified its belief that senior management and Board oversight was sufficient in limiting risk. This oversight included review and approval of all LJM transactions by Richard Causey, the Chief Accounting Officer; Richard Buy, the Chief Risk Officer; and Skilling. The Audit and Compliance Committee and the Finance Committee were also charged with conducting annual reviews of all LJM transactions. Since no one in management accepted primary responsibility for conducting reviews or brought issues to the Board’s attention, the controls did not appear to be developed nor executed adequately. In fact, the Audit and Compliance Committee’s annual reviews appear to have consisted of short management presentations that did not have a thorough evaluation required to fully understand the transactions. Though during a May 2000 Finance Committee meeting, a statement was made that a Raptor transaction raised a risk of “accounting scrutiny,” it did not illicit action. Furthermore, though the Compensation Committee was required to review Fastow’s partnership compensation, no one asked any questions until October 2001. Andersen, as well as Enron’s internal and external counsel, Vinson & Elkins, reviewed and approved SPE transactions disclosures. They were opaque and failed to show the extent of employee involvement and the substance of what was really happening. Enron even stated that the related-party transactions were reasonable in comparison with other thirdparty transactions, yet provided no substantive evidence of this assertion. Regardless of the final outcome of the ongoing investigations of Enron, an analysis of both the accounting and management failures at Enron can help companies take proactive steps in the development of appropriate controls. Furthermore, once such controls are defined, proper implementation and enforcement of accounting, ethics and communication policies will only strengthen the corporate governance process. Report authored by Cheryl de Mesa Graziano, CPA Copyright © 2002 by Financial Executives Research Foundation, Inc. All rights reserved. No part of this publication may be reproduced in any form or by any means without written permission from the publisher. Financial Executives Research Foundation, Inc. is the research affiliate of Financial Executives International. The purpose of the Foundation is to sponsor research and publish informative material in the field of business management, with particular emphasis on the practice of financial management and its evolving role in the management of business.

Related FEI Research Reports: • Enron: An Accounting Analysis of How SPEs Were Used to Conceal Debt and Avoid Losses (March 2002) • Audit Committees and Financial Literacy - Three Steps to Meet Higher Standards ( March 2002) • Special Purpose Entities: Understanding the Guidelines (Issues Alert, January 2002) This and other Research Foundation publications can be ordered by logging on to www.fei.org/rfbookstore/ PubOrder.cfm Discounts available to FEI members and Foundation donors. 10 Madison Avenue PO Box 1938 Morristown, NJ 07962-1938 973.898.4608 www.fei.org

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