FW: Text of Letter to Enron's Chairman After Departure of Chief

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Business/Financial Desk; Section C
Text of Letter to Enron's Chairman After Departure of Chief Executive

01/16/2002
The New York Times
Page 6, Column 1
c. 2002 New York Times Company

Following is the text of an unsigned letter written in August to
Kenneth L. Lay, the chairman of the Enron Corporation, after Jeffrey K.
Skilling resigned unexpectedly as chief executive on Aug. 14. Its author
was later identified as Sherron S. Watkins, a vice president for
corporate development at Enron. The House Energy and Commerce Committee
released excerpts of the letter on Monday and the full letter yesterday:

Has Enron become a risky place to work? For those of us who didn't
get rich over the last few years, can we afford to stay?
Skilling's abrupt departure will raise suspicions of accounting
improprieties and valuation issues. Enron has been very aggressive in
its accounting -- most notably the Raptor transactions and the Condor
vehicle. We do have valuation issues with our international assets and
possibly some of our EES MTM positions.

The spotlight will be on us, the market just can't accept that
Skilling is leaving his dream job. I think that the valuation issues can
be fixed and reported with other good will write-downs to occur in 2002.
How do we fix the Raptor and Condor deals? They unwind in 2002 and 2003,
we will have to pony up Enron stock and that won't go unnoticed.

To the layman on the street, it will look like we recognized funds
flow of $800 million from merchant asset sales in 1999 by selling to a
vehicle (Condor) that we capitalized with a promise of Enron stock in
later years. Is that really funds flow or is it cash from equity
issuance?

We have recognized over $550 million of fair value gains on stocks
via our swaps with Raptor. Much of that stock has declined significantly
-- Avici by 98 percent from $178 million, to $5 million; the New Power
Company by 80 percent from $40 a share, to $6 a share. The value in the
swaps won't be there for Raptor, so once again Enron will issue stock to
offset these losses. Raptor is an LJM entity. It sure looks to the
layman on the street that we are hiding losses in a related company and
will compensate that company with Enron stock in the future.

I am incredibly nervous that we will implode in a wave of accounting
scandals. My eight years of Enron work history will be worth nothing on
my resume, the business world will consider the past successes as
nothing but an elaborate accounting hoax. Skilling is resigning now for
''personal reasons'' but I would think he wasn't having fun, looked down
the road and knew this stuff was unfixable and would rather abandon ship
now than resign in shame in two years.

Is there a way our accounting guru's can unwind these deals now? I
have thought and thought about a way to do this, but I keep bumping into
one big problem -- we booked the Condor and Raptor deals in 1999 and
2000, we enjoyed wonderfully high stock price, many executives sold
stock, we then try and reverse or fix the deals in 2001, and it's a bit
like robbing the bank in one year and trying to pay it back two years
later. Nice try, but investors were hurt, they bought at $70 and $80 a
share looking for $120 a share and now they're at $38 or worse. We are
under too much scrutiny and there are probably one or two disgruntled
''redeployed'' employees who know enough about the ''funny'' accounting
to get us in trouble.

What do we do? I know this question cannot be addressed in the
all-employee meeting, but can you give some assurances that you and
Causey will sit down and take a good hard objective look at what is
going to happen to Condor and Raptor in 2002 and 2003?

Summary of Alleged Issues:

RAPTOR Entity was capitalized with LJM equity. That equity is at
risk; however, the investment was completely offset by a cash fee paid
to LJM. If the Raptor entities go bankrupt LJM is not affected, there is
no commitment to contribute more equity.

The majority of the capitalization of the Raptor entities is some
form of Enron N/P, restricted stock and stock rights.

Enron entered into several equity derivative transactions with the
Raptor entities locking in our values for various equity investments we
hold.

As disclosed in 2000, we recognized $500 million of revenue from the
equity derivatives offset by market value changes in the underlying
securities.

This year, with the value of our stock declining, the underlying
capitalization of the Raptor entities is declining and credit is pushing
for reserves against our MTM positions.

To avoid such a write-down or reserve in quarter one 2001, we
''enhanced'' the capital structure of the Raptor vehicles, committing
more ENE shares.

My understanding of the third-quarter problem is that we must
''enhance'' the vehicles by $250 million.

I realize that we have had a lot of smart people looking at this and
a lot of accountants including AA & Co. have blessed the accounting
treatment. None of that will protect Enron if these transactions are
ever disclosed in the bright light of day. (Please review the late 90's
problems of Waste Management -- where AA paid $130 million plus in
litigation re questionable accounting practices.)

The overriding basic principle of accounting is that if you explain
the ''accounting treatment'' to a man in the street, would you influence
his investing decisions? Would he sell or buy the stock based on a
thorough understanding of the facts? If so, you best present it
correctly and/or change the accounting.

My concern is that the footnotes don't adequately explain the
transactions. If adequately explained, the investor would know that the
''entities'' described in our related party footnote are thinly
capitalized, the equity holders have no skin in the game, and all the
value in the entities comes from the underlying value of the derivatives
(unfortunately in this case, a big loss) AND Enron stock and N/P.
Looking at the stock we swapped, I also don't believe any other company
would have entered into the equity derivative transactions with us at
the same prices or without substantial premiums from Enron. In other
words, the $500 million in revenue in 2000 would have been much lower.
How much lower?

Raptor looks to be a big bet if the underlying stocks did well, then
no one would be the wiser. If Enron stock did well, the stock issuance
to these entities would decline and the transactions would be less
noticeable. All has gone against us. The stocks, most notably Hanover,
the New Power Company and Avici are underwater to great or lesser
degrees.

I firmly believe that executive management of the company must have a
clear and precise knowledge of these transactions and they must have the
transactions reviewed by objective experts in the fields of securities
law and accounting. I believe Ken Lay deserves the right to judge for
himself what he believes the probabilities of discovery to be and the
estimated damages to the company from those discoveries and decide one
of two courses of action:

1. The probability of discovery is low enough and the estimated
damage too great; therefore we find a way to quietly and quickly
reverse, unwind, write down these positions/transactions.

2. The probability of discovery is too great, the estimated damages
to the company too great; therefore, we must quantify, develop damage
containment plans and disclose.

I firmly believe that the probability of discovery significantly
increased with Skilling's shocking departure. Too many people are
looking for a smoking gun.

Summary of Raptor Oddities:

1. The accounting treatment looks questionable.

a. Enron booked a $500 million gain from equity derivatives from a
related party.

b. That related party is thinly capitalized with no party at risk
except Enron.

c. It appears Enron has supported an income statement gain by a
contribution of its own shares.

One basic question: The related party entity has lost $500 million in
its equity derivative transactions with Enron. Who bears that loss? I
can't find an equity or debt holder that bears that loss. Find out who
will lose this money. Who will pay for this loss at the related party
entity?

If it's Enron, from our shares, then I think we do not have a fact
pattern that would look good to the S.E.C. or investors.

2. The equity derivative transactions do not appear to be at arms
length.

a. Enron hedged New Power, Hanover and Avici with the related party
at what now appears to be the peak of the market. New Power and Avici
have fallen away significantly since. The related party was unable to
lay off this risk. This fact pattern is once again very negative for
Enron.

b. I don't think any other unrelated company would have entered into
these transactions at these prices. What else is going on here? What was
the compensation to the related party to induce it to enter into such
transactions?

3. There is a veil of secrecy around LJM and Raptor. Employees
question our accounting propriety consistently and constantly. This
alone is cause for concern.

a. Jeff McMahon was highly vexed over the inherent conflicts of LJM.
He complained mightily to Jeff Skilling and laid out five steps he
thought should be taken if he was to remain as treasurer. Three days
later, Skilling offered him the C.E.O. spot at Enron Industrial Markets
and never addressed the five steps with him.

b. Cliff Baxter complained mightily to Skilling and all who would
listen about the inappropriateness of our transactions with LJM.

c. I have heard one manager-level employee from the principal
investments group say, ''I know it would be devastating to all of us,
but I wish we would get caught. We're such a crooked company.'' The
principal investments group hedged a large number of their investments
with Raptor. These people know and see a lot. Many similar comments are
made when you ask about these deals. Employees quote our C.F.O. as
saying that he has a handshake deal with Skilling that LJM will never
lose money.

4. Can the general counsel of Enron audit the deal trail and the
money trail between Enron and LJM/Raptor and its principals? Can he look
at LJM? At Raptor? If the C.F.O. says no, isn't that a problem?

Condor and Raptor Work:

1. Postpone decision on filling office of the chair, if the current
decision includes C.F.O. and/or C.A.O.

2. Involve Jim Derrick and Rex Rogers to hire a law firm to
investigate the Condor and Raptor transactions to give Enron
attorney-client privilege on the work product. (Can't use V & E due to
conflict -- they provided some true sale opinions on some of the deals).

3. Law firm to hire one of the big 6, but not Arthur Andersen or
PricewaterhouseCoopers due to their conflicts of interest: AA & Co.
(Enron); PWC (LJM).

4. Investigate the transactions, our accounting treatment and our
future commitments to these vehicles in the form of stock, NP, etc., For
instance: In the third quarter we have a $250 million problem with
Raptor 3 (NPW) if we don't ''enhance'' the capital structure of Raptor 3
to commit more ENE shares. By the way: in Q. 1 we enhanced the Raptor 3
deal, committing more ENE shares to avoid a write-down.

5. Develop cleanup plan:

a. Best case: Clean up quietly if possible.

b. Worst case: Quantify, develop P.R. and I.R. campaigns, customer
assurance plans (don't want to go the way of Salomon's trading shop),
legal actions, severance actions, disclosure.

6. Personnel to quiz confidentially to determine if I'm all wet:

a. Jeff McMahon

b. Mark Koenig

c. Rick Buy

d. Greg Walley

To put the accounting treatment in perspective I offer the following:

1. We've contributed contingent Enron equity to the Raptor entities.
Since it's contingent, we have the consideration given and received at
zero. We do, as Causey points out, include the shares in our fully
diluted computations of shares outstanding if the current economics of
the deal imply that Enron will have to issue the shares in the future.
This impacts 2002-2004 earnings-per-share projections only.

2. We lost value in several equity investments in 2000, $500 million
of lost value. These were fair-value investments; we wrote them down.
However, we also booked gains from our price risk management
transactions with Raptor, recording a corresponding PRM account
receivable from the Raptor entities. That's a $500 million related party
transaction -- it's 20 percent of 2000 IBIT, 51 percent of NI pretax, 33
percent of NI after tax.

3. Credit reviews the underlying capitalization of Raptor, reviews
the contingent shares and determines whether the Raptor entities will
have enough capital to pay Enron its $500 million when the equity
derivatives expire.

4. The Raptor entities are technically bankrupt; the value of the
contingent Enron shares equals or is just below the PRM account payable
that Raptor owes Enron. Raptor's inception-to-date income statement is a
$500 million loss.

5. Where are the equity and debt investors that lost out? LJM is
whole on a cash-on-cash basis. Where did the $500 million in value come
from? It came from Enron shares. Why haven't we booked the transaction
as $500 million in a promise of shares to the Raptor entity and $500
million of value in our ''economic interests'' in these entities? Then
we would have a write-down of our value in the Raptor entities. We have
not booked the latter, because we do not have to yet. Technically we can
wait and face the music in 2002-2004.

6. The related party footnote tries to explain these transactions.
Don't you think that several interested companies, be they stock
analysts, journalists, hedge fund managers, etc., are busy trying to
discover the reason Skilling left? Don't you think their smartest people
are poring over that footnote disclosure right now? I can just hear the
discussions -- ''it looks like they booked a $500 million gain from this
related party company and I think, from all the undecipherable half-page
on Enron's contingent contributions to this related party entity, I
think the related party entity is capitalized with Enron stock.'' . . .
. ''No, no, no, you must have it all wrong, it can't be that, that's
just too bad, too fraudulent, surely AA & Co. wouldn't let them get away
with that?'' ''Go back to the drawing board, it's got to be something
else. But find it!'' . . . . ''Hey, just in case you might be right, try
and find some insiders or 'redeployed' former employees to validate your
theory.''

Chart: ''Terms of the Business''
AA & CO. -- Arthur Andersen & Company, Enron's auditor.
AVICI -- A maker of data networking systems.
BAXTER, CLIFF -- Vice chairman of Enron before he resigned in May.
BUY, RICK -- Enron's chief risk officer.
CAUSEY, RICHARD -- Enron's chief accounting officer.
CONDOR -- An off-balance-sheet partnership.
DERRICK, JIM -- General counsel of Enron.
EES MTM -- Enron Energy Services, mark to market, a way of accounting
for the value of contracts.
ENE -- Stock symbol of Enron.
EPS -- Earnings per share.
HANOVER -- Hanover Compressor, a provider of natural gas compression
services.
IBIT -- Income before interest and taxes.
LJM -- Partnerships with Enron that were controlled by Andrew S. Fastow,
the company's chief financial officer until he was ousted on Oct. 24.
KOENIG, MARK -- Enron executive vice president for investor relations.
McMAHON, JEFF -- Enron's chief financial officer.
N/P -- Note payable.
NI -- Net income
NEW POWER -- An energy company.
RAPTOR -- An off-balance-sheet partnership.
ROGERS, REX -- Assistant secretary general counsel of Enron.
SWAPS -- An exchange of one investment for another.
V & E -- Vinson & Elkins, Enron's law firm.
WHALLEY, GREG -- Enron's president