Business Week: The Enron Debacle

NOVEMBER 12, 2001=20

FINANCE=20
Business Week
The Enron Debacle
Byzantine deals have shattered the energy outfit's credibility
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Executives at high-flying Enron Corp. (ENE ) never seemed overly concerned =
with how the rest of the world viewed their business practices. Earlier thi=
s year, the California Attorney General had to get a court order to collect=
documents in an industrywide investigation into energy price fixing. And w=
hen an analyst challenged former CEO Jeffrey K. Skilling in a conference ca=
ll to produce Enron's balance sheet, Skilling called him an "ass----." Stil=
l, even some Enron executives worried that the company had gone too far wit=
h two complex partnerships set up in 1999 to buy company assets and hedge i=
nvestments. With Enron's then-chief financial officer acting as general man=
ager of the partnerships and in a position to personally benefit from their=
investments, the potential for a conflict of interest and backlash from in=
vestors seemed overwhelming. "Internally, everybody said this is not a good=
idea," says a source close to the company.

But no one could have predicted such a jaw-dropping outcome for the nation'=
s largest and most innovative energy trader. Since Oct. 16, when Enron reve=
aled a $35 million charge to earnings to reflect losses on those partnershi=
ps and was forced to knock $1.2 billion off its shareholders' equity, the c=
ompany's stock has plunged 60%. The Securities & Exchange Commission is inv=
estigating Enron's accounting for its partnerships and whether it properly =
disclosed them to investors.

Suddenly the company, which brought high-tech and complex finance to energy=
trading, is essentially trying to avoid a run on the bank. Moody's Investo=
rs Service has already downgraded the company's debt. Enron says it is meet=
ing with credit agencies to calm their fears, and analysts say Enron is wor=
king on a turnaround plan that would likely include accelerating asset sale=
s, issuing shares, and obtaining new credit lines. Enron's board has set up=
a special committee to look into its controversial partnerships. But analy=
sts also worry that Enron's trading partners could pull the plug if they lo=
se confidence that it can honor its trades.

"ON CRACK?" Inside Enron, once-cocky employees are reeling. They were still=
puzzling over the abrupt Aug. 14 departure of CEO Skilling when the compan=
y announced on Oct. 24 that CFO Andrew S. Fastow, architect of the controve=
rsial private LJM investments--which got their name from the first initials=
of his wife and children--was removed from his post and on leave. In a ten=
se meeting held at a Houston hotel after the latest financial disclosures, =
soft-spoken Chairman and CEO Kenneth L. Lay faced 1,600 employees, with ano=
ther 5,000 hooked up via the Web. One irate worker asked if he was "on crac=
k." Lay, an economist by training, turned over day-to-day management in 199=
7. Until Skilling quit, citing personal reasons unrelated to Enron, Lay was=
talking about retirement, sources say. Now he is facing his biggest fight =
ever. "Ken is looking at a 30-year career of accomplishment going down in f=
lames. This is just awful," says one friend.

On the surface, at least, Enron's off-balance-sheet maneuvering hardly seem=
s the stuff that would crater a company. Amazingly, sources close to Enron =
claim that one rationale for Fastow's deals was to save an estimated $30 mi=
llion a year in investment-banking fees. Fastow's involvement in the partne=
rships, which bought assets from Enron, including stakes in telecom and ene=
rgy, was supposed to make the deals simpler for the investment bankers and =
thus cheaper. They were also meant, according to sources close to the compa=
ny, to hedge Enron's investments in potentially risky assets while allowing=
it to maintain some control over them. Enron says Fastow made money for hi=
mself on some of the deals, but insiders insist there were less controversi=
al ways to enrich him if that were the aim. Fastow did not return calls see=
king comment. Lay, who declined to comment for this story, has said that th=
e partnerships were properly vetted by Enron's attorneys and internal and e=
xternal auditors and were approved by its board. A source familiar with Enr=
on agrees: "We had the best lawyers in the world saying, `It looks fine."'

But whatever Enron's reasons for creating the LJM partnerships, the problem=
s were compounded by scanty disclosure. The deals were first revealed in a =
1999 proxy, raising concerns from investors and analysts. By this summer, w=
hen Enron's stock was falling and its bets in broadband were souring, compl=
aints about LJM grew louder. So in June, Fastow pulled out of the partnersh=
ips. When the write-offs came, Enron enraged analysts and investors further=
by failing to disclose the hit to equity in its third-quarter earnings pre=
ss release. Instead, Lay mentioned it in a conference call with analysts. "=
We found it disconcerting that the company waited to disclose the additiona=
l $1.2 billion charge to equity in a fleeting comment in the middle of its =
conference call," says UBS Warburg analyst Ronald Barone.

BAD BETS. Still, Enron's credibility did not vanish overnight. Analysts hav=
e been lobbying for years for more information about how and where Enron ma=
kes its money in its often byzantine trading business. While the company's =
revenues were soaring from $9.2 billion in 1995 to $100.8 billion in 2000 a=
nd its stock was returning 500% during the same six-year period, Enron's ag=
gressive, even arrogant managers could ignore Wall Street's complaints with=
impunity. But after its stock price collapsed this year (chart), the compa=
ny's attitude and operational missteps quickly caught up. And there was ple=
nty to worry about. The company's $3 billion power plant in India wasn't pa=
ying its bills amid a political controversy; its highly ballyhooed business=
for trading high-speed communications capacity was crippled by the telecom=
industry meltdown; and its calamitous foray into the water business with A=
zurix Corp. has already cost Enron at least $574 million in write-offs.

These bad bets and the expensive LJM shock have investors worried about wha=
t else might be lurking at Enron. Many aren't sticking around to find out. =
"I think the lack of disclosure on their financial engineering killed the c=
redibility of the management team," says Richard A. Giesen, who manages the=
Munder Power Plus fund, which dumped its Enron shares about a month ago.

It's not clear just how many off-balance-sheet financing vehicles Enron has=
used over time. Some were created years ago to finance oil and gas produce=
rs. Analysts and sources close to the deals say there's no particular risk =
in these to Enron shareholders. Other interconnected entities, such as Whit=
ewing, Osprey, Atlantic Water Trust, and Marlin Water Trust, were a way to =
get assets no longer central to Enron's strategy off its balance sheet, fre=
eing capital and credit for the core energy business and ventures like broa=
dband (table).

To entice institutional investors such as pension funds and insurers into t=
hese deals, Enron promised to kick in equity if asset sales weren't enough =
to cover debt. Such "mandatory equity" deals have been used by at least a h=
alf-dozen others in the energy and telecom industries, including El Paso (E=
PG), Williams, and Dominion, says Standard & Poor's director Todd A. Shipma=
n. "Nobody's going to find anything that's particularly unique or below boa=
rd" in such deals, says one investment banker specializing in the energy bu=
siness.

Worst case, which Shipman considers unlikely, Enron could be on the hook fo=
r about $3 billion in its mandatory-equity deals. That could mean diluting =
its shares by more than 25% at today's prices. Analyst John E. Olson at San=
ders Morris Harris Inc. (SMHG ) figures a 9% dilution is more likely. Even =
if this $3 billion in debt were included on Enron's balance sheet now, the =
debt-to-capital ratio would climb to 54% from about 49% at the end of June.=
Such a change would pressure Enron's credit rating but not push it below i=
nvestment grade, says Shipman.

HUGE HIT. Fastow's LJM, a private equity fund, was a different kind of anim=
al, according to sources familiar with the arrangements. It bought energy a=
nd other assets from Enron, which booked gains and losses on those deals. L=
JM was also involved in complex hedging that was supposed to reduce the vol=
atility of some of Enron's investments, including stakes in high-tech and t=
elecom businesses and an interest in New Power Co., which markets power to =
consumers. When Enron terminated these deals in September, it took the $1.2=
billion hit to equity.

But the more immediate question is whether trading partners will stick with=
the company. The first place that might show up is in Enron's highly succe=
ssful online platform, which trades everything from gas and electricity to =
weather derivatives. To reassure its partners, Enron is scrambling to shore=
up its liquidity. It has already tapped $3 billion in credit lines and is =
trying to arrange another $1 billion. Shipman says he has seen no signs of =
massive customer defections or drastically worsened credit terms. Still, ri=
val traders are wary. "We certainly have taken a closer look at Enron in th=
e last week to 10 days and will continue to manage the credit risk, but we'=
re still doing business with the company as usual," says Keith G. Stamm, CE=
O of power and gas trader Aquila Inc. (ILA )

"SPEEDING TRAIN." Still, with the stock battered and rating agencies consid=
ering further downgrades, that could rapidly change. In recent days, the un=
certainty about Enron's future has reduced investors' appetite for Enron de=
bt. "No one wants to speculate on the direction or their likelihood of surv=
ival," says a credit-derivatives salesperson. "It's really difficult to get=
in front of a speeding train."

Even if Lay can calm his trading partners, he and his management team face =
a much tougher task of restoring their credibility on Wall Street. With the=
stock now hovering around $14--down from a high of $90 in August, 2000--so=
me even believe that Enron could be a takeover target for the likes of GE C=
apital or Royal Dutch/Shell Group. (RD ) Both declined to comment. Would En=
ron sell? One source close to the company says Enron has talked about possi=
ble mergers and strategic alliances in the past with Royal Dutch/Shell, amo=
ng others. "If they're really worried about liquidity, they might take the =
easy way out," he says.

If Enron does pull through this crisis, some suspect it will be a humbler, =
more risk-averse place. The company that once believed it could expand its =
trading and logistics empire to all manner of commodities--from advertising=
space to steel--will be forced to scale back its grandiose visions. That's=
something some investors applaud. "The company should focus on its strengt=
hs," says William N. Adams, senior energy analyst at Banc of America Capita=
l Management, a major shareholder. But that's a far less exciting place tha=
n Enron's energy cowboys ever hoped to roam.=20

By Stephanie Anderson Forest and Wendy Zellner in Dallas, with Heather Timm=
ons in New York

NOVEMBER 12, 2001=20

FINANCE=20
Business Week
Derivatives Danger?
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Lately, owners of Enron's (ENE) equity, bonds, and loans have been struggli=
ng to understand how exposed the company is to risks of losses that they di=
dn't know about before. Now, as a fuller picture of Enron's entanglements w=
ith partnerships begins to emerge, investors have something else to worry a=
bout: credit default swaps, known as CDSs for short.

That's financial marketspeak for insurance on bonds and bank loans. Their o=
wners pay a premium for coverage that reimburses them for any losses they h=
ave if their investments go bad. The CDS market has existed only for about =
two years, but it's growing fast. Goldman, Sachs & Co. (GS ) and others est=
imate that bonds and loans with a face value of between $1 trillion and $1.=
5 trillion are covered. Not surprisingly, big banks with hefty balance shee=
ts such as J.P. Morgan Chase (JPM ), Merrill Lynch (MER ), and Deutsche Ba=
nk (DB ) dominate the market.

Enron, however, is a player--and the only significant one that isn't also a=
bank. Competitors say that although Enron has issued only between $500 mil=
lion and $700 million worth of CDSs so far this year, it had ambitious plan=
s to offer them online. "They don't belong in this market," says one trader=
. "They don't understand the implications." Enron did not return calls seek=
ing comment.

Of course, neither Enron nor others will have to pay out unless the loans a=
nd bonds they're insuring turn bad. Trouble is, this year is potentially a =
doozie for losses on corporate debt. Corporate defaults could reach a recor=
d of $100 billion, says Standard & Poor's, like BusinessWeek a unit of The =
McGraw-Hill Companies. Regulators say shaky bank loans hit a record $193 bi=
llion by early October.

If Enron has insured any of the bad debt, it might have to take charges for=
losses if they exceed the premiums it has been getting. With all that has =
been happening in recent weeks, that's the last thing it needs.=20

By Heather Timmons in New York

NOVEMBER 12, 2001=20

FINANCE=20
By Mike McNamee

Commentary: Enron's Clout Won't Sway the SEC=20
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For Securities & Exchange Commission Chairman Harvey L. Pitt, the SEC's inv=
estigation into Enron Corp. (ENE) could hardly have come at a worse time. T=
he future of Pitt's ambitious agenda of reforms in securities regulation co=
uld depend on how well he handles this case.

Enron's political clout and close ties to President George W. Bush create r=
eal risks for the SEC. Enron CEO Kenneth L. Lay is a longtime Bush backer, =
and the company was the biggest corporate contributor to the President's ca=
mpaign. A Bush appointee, Pitt is attempting a delicate balancing act. He h=
as made it clear he wants to speed up the SEC's enforcement, in part by rew=
arding companies that cooperate with probes. But he insists the SEC will st=
ill come down hard on true corporate miscreants--and knows that any signs o=
f let-up could jeopardize the rest of his reform agenda.

Enter the Enron probe. The fine shadings of securities enforcement--where m=
ost cases are settled by negotiated penalties, not court-imposed fines--oft=
en make it hard for outsiders to tell whether the SEC is being tough or len=
ient. But Pitt must go out of his way to make it clear that the Enron case =
is handled by the book--getting the same strict scrutiny from the SEC as an=
y other, less connected company.

For now, top SEC aides say that's happening. The SEC Enforcement Div. in Wa=
shington is looking into whether Enron adequately disclosed to shareholders=
the risks of its complex deals with Andrew S. Fastow, the company's former=
chief financial officer. Agency insiders say Pitt and his fellow commissio=
ners will be briefed on the case as it proceeds. But they insist Pitt hasn'=
t heard from the White House or Enron's other political allies.

TOP LOBBYIST. Enron's connections are numerous. Besides Lay's links to Bush=
, an Enron director, Wendy Lee Gramm, is the wife of Texas Senator Phil Gra=
mm, top Republican on the Senate Banking Committee. And Enron spreads its l=
obbying budget--$2.13 million in 2000--across both parties. Just this year =
it hired four lobbying firms with Democratic roots. Enron says it lobbies h=
eavily because it operates in regulated industries. It notes that electric =
utilities outspend it 35 to 1.

On Oct. 31, a special committee of Enron's board hired William R. McLucas, =
former SEC enforcement director, to represent it. McLucas should know that =
any attempt to muscle the stock cops is likely to backfire. Pitt, who joine=
d the SEC out of law school in 1968, "remembers how the [Nixon-era] SEC tai=
nted itself by turning a blind eye to [fugitive financier] Robert Vesco," s=
ays an agency veteran. Pitt has too much riding on the Enron probe to let i=
ts connections sway his judgment.=20

McNamee covers finance in Washington.