William Powers, Jr.
Member of the Enron Board of Directors and Chairman of the Special Investigation Committee
3600 Murillo Circle Austin, TX 78703 512-232-1120
February 1, 2002
To the Members of the Board of Directors
Enclosed is a copy of the Report of the Special Investigation Committee.
William Powers, Jr.
BOARD OF DIRECTORS OF ENRON CORP.
William C. Powers, Jr., Chair
Raymond S. Troubh
Herbert S. Winokur, Jr.
Counsel. Wilmer, Cutler & Pickering
February 1, 2002--
TABLE OF CONTENTS
EXECUTIVE SUMMARY AND CONCLUSIONS 1
I. BACKGROUND: ENRON AND SPECIAL PURPOSE ENTITIES 36
II. CHEWCO 41
A. Formation of Chewco 43
B. Limited Board Approval 46
C. SPE Non-Consolidation "Control" Requirement 47
D. SPE Non-Consolidation "Equity" Requirement 49
E. Fees Paid to Chewco/Kopper 54
F. Enron Revenue Recognition Issues 56
1. Enron Guaranty Fee 56
2. "Required Payments" to Enron 57
3. Recognition of Revenue from Enron Stock 58
G. Enron's Repurchase of Chewco's Limited Partnership Interest 60
1. Negotiations 60
2. Buyout Transaction 62
3. Returns to Kopper/Dodson 64
4. Tax Indemnity Payment 64
H. Decision to Restate 66
III. LJM HISTORY AND GOVERNANCE 68
A. Formation and Authorization of LJM Cayman, L.P. and LJM2 Co-Investment, L.P 68
B. LJM Governance Issues 75
IV. RHYTHMS NETCONNECTIONS 77
A. Origin of the Transaction 77
B. Structure of the Transaction 79
C. Structure and Pricing Issues 82
1 . Nature of the Rhythms "Hedge 82
2. SPE Equity Requirement 83
3. Pricing and Credit Capacity . 84
D. Adjustment of the "Hedge" and Repayment of the Note 85
E. Unwinding the Transaction 87
1 . Negotiations 87
2. Terms 89
3. Financial Results 89
F. Financial Participation of Enron Employees in the Unwind 92
V. THE RAPTORS 97
A. Raptor I 99
1 . Formation and Structure 99
2. Enron's Approval of Raptor I 105
3. Early Activity in Raptor I 107
4. Credit Capacity Concerns in the Fall of 2000 110
B. Raptors H and IV 111
C. Raptor III 114
1 The New Power Company 115
2. The Creation of Raptor III 115
3. Decline in Raptor III's Credit Capacity 118
D. Raptor Restructuring 119
1 . Fourth Quarter 2000 Temporary Fix 119
2. First Quarter 2001 Restructuring 121
a. The Search for a Solution 121
b. The Restructuring Transaction 122
E. Unwind of the Raptors 125
F. Conclusions on the Raptors 128
VI. OTHER TRANSACTIONS WITH LJM 134
A. Illustrative Transactions with LJM 135
1. Cuiaba 135
2. ENA CLO 138
3. Nowa Sarzyna (Poland Power Plant) 140
4. MEGS 141
5. Yosemite 142
6. Backbone 143
B. Other Transactions with LJM 145
VII. OVERSIGHT BY THE BOARD OF DIRECTORS AND MANAGEMENT 148
A. Oversight by the Board of Directors 148
1 . The Chewco Transaction 149
2. Creation of LJM1 and LJM2 150
3. Creation of the Raptor Vehicles 156
4. Board Oversight of the Ongoing Relationship with LJM 158
B. Oversight by Management 165
C. The Watkins Letter 172
VIII. RELATED-PARTY DISCLOSURE ISSUES 178
A. Standards for Disclosure of Related-Party Transactions 178
B. Enron's Disclosure Process 181
C. Proxy Statement Disclosures 184
1 . Enron's Disclosures 184
2. Adequacy of Disclosures 187
D. Financial Statement Footnote Disclosures 192
1 . Enron's Disclosures 192
2. Adequacy of Disclosures 197
E. Conclusions on Disclosure 200
EXECUTIVE SUMMARY AND CONCLUSIONS
The Special Investigative Committee of the Board of Directors of Enron Corp. submits this Report of Investigation to the Board of Directors. In accordance with our mandate, the Report addresses transactions between Enron and investment partnerships created and managed by Andrew S. Fastow, Enron's former Executive Vice President and Chief Financial Officer, and by other Enron employees who worked with Fastow.
The Committee has done its best, given the available time and resources, to conduct a careful and impartial investigation. We have prepared a Report that explains the substance of the most significant transactions and highlights their most important accounting, corporate governance, management oversight, and public disclosure issues. An exhaustive investigation of these related-party transactions would require time and resources beyond those available to the Committee. We were not asked, and we have not attempted, to investigate the causes of Enron's bankruptcy or the numerous business judgments and external factors that contributed it. Many questions currently part of public discussion-such as questions relating to Enron's international business and commercial electricity ventures, broadband communications activities, transactions in Enron securities by insiders, or management of employee 401(k) plans-are beyond the scope of the authority we were given by the Board.
There were some practical limitations on the information available to the Committee in preparing this Report. We had no power to compel third parties to submit to interviews, produce documents, or otherwise provide information. Certain former Enron employees who (we were told) played substantial roles in one or more of the
transactions under investigation - including Fastow, Michael J. Kopper, and Ben F. Glisan, Jr. - declined to be interviewed either entirely or with respect to most issues. We have had only limited access to certain workpapers of Arthur Andersen LLP ("Andersen"), Enron's outside auditors, and no access to materials in the possession of the Fastow partnerships or their limited partners. Information from these sources could affect our conclusions.
This Executive Summary and Conclusions highlights important parts of the Report and summarizes our conclusions. It is based on the complete set of facts, explanations and limitations described in the Report, and should be read with the Report itself. Standing alone, it does not, and cannot, provide a full understanding of the facts and analysis underlying our conclusions.
On October 16, 2001, Enron announced that it was taking a $544 million after-tax charge against earnings related to transactions with LJM2 Co-Investment, L.P. ("LJM2"), a partnership created and managed by Fastow. It also announced a reduction of shareholders' equity of $1.2 billion related to transactions with that same entity.
Less than one month later, Enron announced that it was restating its financial statements for the period from 1997 through 2001 because of accounting errors relating to transactions with a different Fastow partnership, LJM Cayman, L.P. ("LJM I"), and an additional related-party entity, Chewco Investments, L.P. ("Chewco"). Chewco was managed by an Enron Global Finance employee, Kopper, who reported to Fastow.
The LJM1 and Chewco-related restatement, like the earlier charge against earnings and reduction of shareholders' equity, was very large. It reduced Enron's reported net income by $28 million in 1997 (of $105 million total), by $133 million in -1998 (of $703 million total), by $248 million in 1999 (of $893 million total), and by $99 million in 2000 (of $979 million total). The restatement reduced reported shareholders' equity by $258 million in 1997, by $391 million in 1998, by $710 million in 1999, and by $754 million in 2000. It increased reported debt by $711 million in 1997, by $561 million in 1998, by $685 million in 1999, and by $628 million in 2000. Enron also revealed, for the first time, that it had learned that Fastow received more than $30 million from LJM l and LJM2. These announcements destroyed market confidence and investor trust in Enron. Less than one month later, Enron filed for bankruptcy.
Summary of Findings
This Committee was established on October 28, 2001, to conduct an investigation of the related-party transactions. We have examined the specific transactions that led to the third-quarter 2001 earnings charge and the restatement. We also have attempted to examine all of the approximately two dozen other transactions between Enron and these related-party entities: what these transactions were, why they took place, what went wrong, and who was responsible.
Our investigation identified significant problems beyond those Enron has already disclosed. Enron employees involved in the partnerships were enriched, in the aggregate, by tens of millions of dollars they should never have received-Fastow by at least $30 million, Kopper by at least $10 million, two others by $1 million each, and still two more
by amounts we believe were at least in the hundreds of thousands of dollars. We have seen no evidence that any of these employees, except Fastow, obtained the permission required by Enron's Code of Conduct of Business Affairs to own interests in the partnerships. Moreover, the extent of Fastow's ownership and financial windfall was inconsistent with his representations to Enron's Board of Directors.
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 from 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 LJMI 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. In virtually all of the transactions, Enron's accounting treatment was determined with extensive participation and structuring advice from Andersen, which Management reported to the Board. Enron's records show that Andersen billed Enron $5.7 million for advice in connection with the LJM and Chewco transactions alone, above and beyond its regular audit fees.
Many of the transactions involve an accounting structure known as a "special purpose entity" or "special purpose vehicle" (referred to as an "SPE" in this Summary and in the Report). A company that does business with an SPE may treat that SPE as if it were an independent, outside entity for accounting purposes if two conditions are met: (1) an owner independent of the company must make a substantive equity investment of at least 3% of the SPE's assets, and that 3% must remain at risk throughout the transaction; and (2) the independent owner must exercise control of the SPE. In those circumstances, the company may record gains and losses on transactions with the SPE, and the assets and liabilities of the SPE are not included in the company's balance sheet, even though the company and the SPE are closely related. It was the technical failure of some of the structures with which Enron did business to satisfy these requirements that led to Enron's restatement.