What happened?
In October 2001, Enron announced a $544 million after-tax charge against earnings and a $1.2 billion reduction in shareholders’ equity related to transactions with LJM2, an investment partnership created and managed by CFO Andrew Fastow. It soon restated financial statements for 1997 through 2001 over accounting errors involving LJM1 and Chewco, and filed for Chapter 11 on December 2.
Just before that, on October 28, Enron’s Board created a Special Investigative Committee to examine the related-party transactions. Its February 1, 2002 Report of Investigation, commonly known as the Powers Report, is the sole primary report used in this article.
The Report was not an investigation of every cause of Enron’s bankruptcy. Its central subjects were transactions involving Chewco, LJM and the Raptors, the conflicts of interest around them, Board oversight, the response to an internal warning, and public disclosure.
Background: Enron (Wikipedia)
10 passages that stood out
Enron allowed its own CFO to operate investment partnerships that traded with the company, and approval forms carried pre-printed check marks declaring compliance. People could not explain a substantial fee, Board reviews were reported to last only minutes, and an employee’s warning triggered a narrowly limited inquiry. These ten passages focus on what the documents and people actually recorded.
The Powers Report is an original English-language report. Page references use its printed page numbers. The source link points to an identical copy of the original report hosted by the University of Chicago.
The Board approved its own CFO running the counterparty that would transact with Enron
Enron’s Board knowingly approved CFO Andrew Fastow’s role managing the LJM partnerships while those same partnerships would enter into transactions with Enron.
The Board believed that controls could contain the obvious conflict: committee reviews, management approvals and review of Fastow’s compensation were among the safeguards.
The Report also says that important information was withheld from the Board, including Raptor III and the later Raptor restructuring, which were not brought to it for approval.
The two Powers Committee members who evaluated the Board’s actions concluded that the decision was “fundamentally flawed”: the Board substantially underestimated the severity of the conflict and overestimated the ability of controls to contain it.
The CFO's family foundation put in $25,000 and received $4.5m about two months later
During the unwind of an LJM1-related transaction, Enron employees and Fastow’s family foundation participated through a partnership called Southampton Place.
The Fastow Family Foundation contributed $25,000. Documents reviewed by the Committee showed that it received $4.5 million on May 1, 2000, roughly two months later.
Enron employees Ben Glisan and Kristina Mordaunt each contributed $5,800 and separately told the Committee that each received approximately $1 million within one or two months.
Glisan and Mordaunt were also working on Enron’s side of transactions with LJM2 during this period. The Report explicitly says it did not know what Kathy Lynn and certain other investors received.
A $400,000 'nuisance fee' had no basis anyone interviewed could identify
In December 1998, Enron paid Chewco $400,000.
The payment was described in different materials as a “restructuring” fee, an “amendment” fee and a “nuisance” fee.
The Committee wrote that none of the people it interviewed could identify a basis for the payment.
Enron sold seven assets near quarter-end, then bought five back after the reporting period
Near the ends of the third and fourth quarters of 1999, Enron sold interests in seven assets to LJM1 or LJM2. The deals happened quickly, removing assets from Enron’s balance sheet and, in some cases, allowing gains to be recorded.
After the financial reporting period closed, however, Enron bought back five of the seven assets, in some cases within a matter of months.
The LJM partnerships also made a profit on every one of the seven transactions, including cases in which the asset appeared to have declined in market value.
The Committee said the events after the sales called into question whether the risks and rewards of ownership had truly been transferred. It also acknowledged plausible, more innocent explanations for some repurchases; it did not find that all seven sales were shams.
The Board heard 30% annualized; investor materials listed Raptor returns up to 2,500%
Materials Fastow presented to LJM2 investors in October 2000 listed internal rates of return for the four Raptors of 193%, 278%, 2,500% and a projected 125%.
By contrast, the annualized return described to Enron’s Finance Committee when Raptor I was presented in May 2000 was 30%.
The Report said the extremely large returns resulted from rapid transfers of about $41 million per Raptor to LJM2, each in less than six months.
The counterparty supposedly hedging Enron's losses was, in the Report's words, Enron itself
The Raptors were used as purported hedges against declines in the value of Enron merchant investments.
A conventional hedge transfers risk to an independent counterparty capable of paying when the protected asset loses value. But three of the four Raptors were supported principally by Enron’s own stock or contracts to receive it. Raptor III held rights equivalent to stock in The New Power Company, the very investment it was supposed to hedge.
The Report therefore described Enron as hedging its investments “not with a creditworthy counter-party, but with itself.”
As the stock supporting each structure declined, the entities meant to absorb losses lost their own capacity to do so.
May 2000 — Handwritten note on Finance Committee materials (author attributed tentatively by investigators)
Does not transfer economic risk but transfers P&L volatility.LJM deal approval forms came with compliance check marks already printed on them
Enron used an “LJM Deal Approval Sheet” as part of the control process for transactions with LJM.
The Committee found that the form contained pre-printed check marks in boxes signifying compliance with several controls and disclosure concerns.
A signature was then supposed to certify that the pre-printed checks were accurate.Some transactions had no approval sheet the Committee could locate; others lacked required signatures; and some transactions closed before the approval sheets were completed.
The Committee said that in practice the sheets appeared to be a formality providing little control.
Board reviews meant to police the CFO conflict reportedly lasted 10 to 15 minutes
The Board allowed the Fastow conflict on the condition that Board committees periodically review Enron’s transactions with LJM. Those reviews were a significant part of the control structure.
In practice, the Report says, the reviews were brief, reportedly lasting ten to fifteen minutes.
The specific economic terms and the benefits to LJM1, LJM2 or Fastow were not discussed. Procedures also called for a review of Fastow’s compensation from the partnerships, but the Board’s review apparently did not occur until October 2001, after press reports focused attention on his LJM role.
The preliminary whistleblower review excluded second-guessing Andersen's accounting and detailed review of LJM deals
In August 2001, Enron employee Sherron Watkins warned Ken Lay about serious concerns involving the Raptors and related accounting.
Enron retained Vinson & Elkins for a preliminary investigation.
But Enron General Counsel James Derrick and the law firm agreed that the review would not include questioning the accounting treatment and advice from Arthur Andersen, or a detailed review of individual LJM transactions.
The preliminary review concluded that a further widespread investigation by independent counsel or auditors was not warranted. At the same time, it noted the “bad cosmetics” of the Raptor related-party transactions and the serious risk of adverse publicity and litigation.
The two Committee members responsible for evaluating Vinson & Elkins, Raymond Troubh and Herbert Winokur, said Watkins’ letter provided a road map to a number of the troubling Raptor issues, and that the V&E result was largely predetermined by the scope and nature of its investigation.
August 2001 — Sherron Watkins’ letter to CEO Ken Lay (excerpt)
I am incredibly nervous that we will implode in a wave of accounting scandals.Financial footnotes left out the CFO's name, calling him only 'a senior officer'
Enron’s proxy statements did identify Fastow by name. Its financial-statement footnotes used different wording.
The second-quarter 1999 10-Q said that “a senior officer of Enron” was the managing member of LJM1’s general partner.
The Report notes that the footnote did not identify Fastow as that senior officer, nor did later financial-statement disclosures identify him by name.From the second quarter of 2000 forward, the financial-statement disclosures also stopped identifying LJM1 and LJM2 by name, referring to the partnerships generically as the “Related Party.”
The Powers Committee concluded that the related-party footnotes failed to communicate the essence of the transactions clearly enough for a reader to understand what was going on.
What the report says about the background
The Powers Report did not frame the problem simply as personal enrichment by Fastow and other employees. Enron knowingly authorized a fundamental conflict of interest and expected controls to contain it. The Committee concluded that Board reviews, deal approval sheets, compensation review and management oversight did not function effectively, and that the conflict eventually overwhelmed the controls around it.
The Committee also documented limits on its own investigation. Fastow, Michael Kopper and Ben Glisan were among important former employees who declined interviews on all or most issues, and the Committee had only limited access to Arthur Andersen workpapers. This article stays within the facts and evaluations the Powers Report itself supports.
Corrections to this article
Corrected the conflated Southampton investor name to Kristina Mordaunt and identified Glisan’s and Mordaunt’s reported receipts as their own accounts. Distinguished the three Raptors backed by Enron stock or contracts from Raptor III’s rights equivalent to TNPC stock. Attributed the Vinson & Elkins assessment to Committee members Troubh and Winokur, preserved qualifications concerning information withheld from the Board and apparently formal approval sheets, and expanded source pages for amounts, assessments and disclosures.