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Enrons Questionable Transactions

An understanding of the nature of Enrons questionable transactions is

fundamental to understanding why Enron failed. What follows is a summary of
the essence of the major important transactions with the SPEs, including
Chewco, LJM1, LJM2, and the Raptors. This summary extends the comments
presented in presented in Chapter 9, The Credibility CrisisEnron, WorldCom, &
Chewco Transactions
Chewco Investments LP(1) " was created in November 1997 to buy the 50 percent
interest owned by CalPERS, the California Public Employees Retirement System,
in a joint venture investment partnership called Joint Energy Development
Investment Limited Partnership (JL.DI). JEDI had operated since 1993 as a
nonconsolidated SPE. (Enron wanted to create a larger unit with capital of $1
billion, and CalPERS asked to be bought out. Chewco was created as a vehicle to
attract a replacement for CalPERS and to buy out CalPERS interest in JEDI).
Originally, Andrew Fastow proposed that he be appointed to manage
Chewco temporarily until an outside investor, or counterparty, could be found.
According to the Powers Report, Enron lawyers advised against this since his
senior officer status would have required proxy disclosure. Instead, Michael
Kopper, who worked at Enron for Fastow, a fact known only to Jeffrey K. Skilling
on the board of directors,(2) was appointed.
Enron planned to guarantee loans for bridge financing to buy out CalPERS
interest in JEDI, which had been valued at $383 million. The intention was to
replace the bridge financing with the investment of an outside investor, but none
was found. Enrons financial year end passed on December 31, 1997; without an
independent, controlling outside investor with at least 3 percent of the capital at
risk, $11.5 million in this case (3 percent of $383 million), the activities of both
JEDI and Chewco had to be consolidated into Enrons financial statements and on
a retroactive basis. Whether through negligence or inability to find a proper
counterparty, the accounts of Enron had to be restated to include the dealings of
In November arid December of 1997, Enron and Kopper created a new
capital structure for Chewco, which had three elements:
$240 million unsecured subordinated loan to Chewco from Barclays Bank
PLC, which Enron would guarantee;
$ 132 million advance from JEDI to Chewco under a revolving credit
agreement; and
$11.5 million in equity (representing approximately 3% of total capital)
from Chewcos general and limited partners. (3)
These financing arrangements are diagrammed in Figure 1.

Essentially, Enron as majority owner put no cash into the SEE. A bank
provided, virtually all of the cash, and in reality the so-called 3 percent
independent, controlling investor had very little investednot even close to the
required 3 percent threshold. Nonetheless, Chewco was considered to qualify for
treatment as an arms-length entity for accounting purposes by Enron and its
auditors, Arthur Andersen. Enrons board, and presumably Arthur Andersen, was
kept in the dark.
Kopper invested approximately $115,000 in Chewcos general partner and
approximately $10,000 in its limited partner before transferring his limited
partnership interest to William Dodson [Koppers domestic partner]. 4 The rest of
the $11.5 million$11.4, to be exactwas loaned by Barclays Bank to
Kopper/Dodson, although the original wording was unusual in that it implied that
the monies were for certificates that would generate a yield. 5
Ultimately, Kopper and Dodson created a series of limited partnerships
(LLPs) and limited companies (LLCs) through which to operate their interests, but
Kopper was de facto the managing general partner of Chewco. This meant there
was no outside investor with 3 percent of equity at risk. Moreover, Barclays
asked that $6.6 million be reserved against the $11.4, and the $6.6 million was
pledged/deposited with them, so that the resulting net of $4.8 million did not
satisfy the 3 percent rule for nonconsolidation. According to the Powers Report,
the existence of the $6.6 million reserve was well known at Enron. 6 However, in
Congressional Committee testimony, the CEO of Arthur Andersen stated that
they had reviewed and approved the financial arrangement as qualifying under
the 3 percent rule, and received $80,000 For this advice. 7 The $6.6 million
reserve was created as part of a transfer of $16.6 million from JEDI through
Chewco to two of the limited partnerships controlled by Kopper and Dodson,
namely Big River Funding LLC and Little River Funding LLC.
The entire complicated structure created for the Chewco financing
transaction can be viewed on page 51 of the Powers Report.
The Powers Report goes on to detail several subsequent transactions that
took place before Enron unraveled in late 2001 that appear not to have been in
the best interests of Enron, including:
Management and other fees paid through to Kopper amounted to $2
million for essentially little work, some of which was done by Fastows
wife; most of the rest of the work was on time that Kopper was being paid
as an Enron employee.
The fee for Enron guaranteeing the Bar-clays loan was under that called
for by the market risk assumed.
When it was decided to liquidate JEDI, the buyout of Chewcos interest was
valued at a premium of $1 million by Jeffrey McMahon (then senior vice
president, finance and treasurer of Enron). He told Fastow, who undertook
to negotiate with Kopper, and came back indicating that Skilling had
approved a $10 million payment. 8 Fastow denied this to the Powers
committee but declined to comment on a handwritten note from Kopper

that confirmed Fastows participation. Ultimately, a premium of $10.5

million was paid. This represented a return of 360 percent.
Kopper demanded later and received $2.6 million in September 2001 as
an indemnification against the tax consequences of the $10.5 million
premium. Enrons in-house counsel had originally declined this request,
but was overruled by Fastow, who told them that Skilling had approved.
Upon closing the repurchase of JEDI, Chewco was not required to repay the
$15 million it had loaned on an unsecured and nonrecourse basis to
Kopper and Dodson for them to invest in Osprey trust certificates. Osprey
was a limited partner in Whitening Associates, another related company
that will be discussed later.
The Powers Report also noted that from December 1997, Enron began to
incorrectly pre-book revenue for services not yet provided in regard to the
Barclays guarantee fee and the JEDI management fee arrangement that
Chewco assumed, in the amounts of $10 million and $25.7 million,
When Enrons affairs began to unravel in public, the board started an
investigation that led to the bankruptcy filing on December 2, 2001. The Powers
Report states:
In late October 2001, the Enron Board (responding to media reports)
requested a briefing by Management on Chewco. Glisan [Ben F. Glisan, Jr., the
Enron transaction support employee with principal responsibility for
accounting matters in the Chewco transaction, signed many of the
documents on Enrons behalf] was responsible for presenting the briefing at a
Board meeting on short notice. Following the briefing, Enron accounting and
legal personnel (as well as Vinson & Elkins) undertook to review documents
relating to Chewco. This review identified the documents relating to the
finding of the Big River and Little River reserve accounts in December 1997
through the $16.6 million distribution from JEDI.
Enron brought those documents to the attention of Andersen, and consulted
with Andersen concerning the accounting implications of the funded reserve
accounts. After being shown the documents by Enron and discussing the
accounting issues with Enron personnel, Andersen provided the notice of
possible illegal acts that Andersens CEO highlighted in his Congressional
testimony on December 12, 2001.
Enrons accounting personnel and Andersen both concluded that, in light of
the funded reserve accounts, Chewco lacked sufficient outside equity at risk
and should have been consolidated in November 1997. In addition, because
JEDIs nonconsolidation depended on Chewcos status, Enron and Andersen ,
concluded that JEDI also should have been consolidated in November 1997.
In a Current Report on Form 8-K filed on November 8, 2001, Enron announced
that it would restate its prior, period financials to reflect the consolidation of
those entities as of November 1997.9

LJM Partnerships and The Raptors: LJM1

On June 28, 1999, the Enron board approved Fastows proposal that he invest $1
million and become the sole managing/general partner of LJM1 (LJM Cayman LP),
which would raise funds from outside investors that could be used to hedge the
possible loss of market value of Enrons investment in Rhythms NetConnections,
Inc. (Rhythms for short), Fastow said that he would receive fees, that the Enron
Code of Conduct would require special action (suspension of the code) by the
chairman, and that his participation would not adversely affect the interests of
Enron.10 The Powers Report continues: LJM1 was formed in June 1999. Fastow
became the sole and managing member of LJM Partners, LLC, which was the
general partner of LJM Partners, L.P. This, in turn, was the general partner of
LJM1. Fastow raised $15 million from two limited partners, ERNB Ltd. ... and
Campsie Ltd. A diagram of the financing of LJM1 can be found on page 70 of the
Powers Report.
LJM1 ultimately entered into three transactions with Enron: (1) the effort
to hedge Enrons position in Rhythms NetConnections stock, (2) the purchase of
a portion of Enrons interest in a Brazilian power project (Cuiaba), and (3) a
purchase of certificates of an SPE called Osprey Trust. 11
The Rhythms hedge transaction is significant because it introduces the
basic form for future hedge transactions. Per the Powers Report on page 77:
In March 1998, Enron invested $10 million in the stock of Rhythms
NetConnections, Inc. (Rhythms), a privately-held internet service
provider for businesses using digital subscriber line technology, by
purchasing 5.4 million shares of stock at $1,85 per share.
On April 7, 1999, Rhythms went public at $21 per share. By the close of
the trading day, the stock price reached $69. By May 1999, Enrons
investment in Rhythms was worth approximately $300 million, but Enron
was 7 prohibited (by a lock-up agreement) from selling its shares before
the end of 1999. Because Enron accounted for the investment as part of
its merchant portfolio, it marked the Rhythms position to market, meaning
that increases and decreases in the value of Rhythms stock were reflected
on Enrons income statement.
Skilling was concerned about mitigating the volatility caused by these mark-tomarket increases and decreases, and Fastow and Glisan devised a hedging
transaction to do so. The arrangement also resulted in Enron recognizing the
appreciation in value of Enrons own stocka recognition that GAAP does not
normally permit except under strict conditions where cash is received for the
stock confirming the market value. Their proposal was to capitalize an SPE with
Enron stock, and have the SPE hedge the value of the Rhythms investment so
that the SPE would pay Enron if the Rhythms investment decreased. This
payment would be shown as revenue by Enron and offset the loss in the Rhythms
investment on Enrons books.

Ultimately, $95 million in lost Rhythms value was offset and Enrons
income was higher as a result. In addition, Enron re-corded profit on the Enron
shares transferred. Unfortunately, LJM1 did not qualify as having 3 percent
invested by an independent, controlling general partner (because Fastow was not
independent), and the Enron stock was paid for by a promissory note, not cash.
Moreover, it became clear that the creditworthiness of the SPE depended upon
the Enron shares transferred, and since the value of Enron shares declined in
2000 and 2001, that creditworthiness was eroded below the level required to pay
Enron its offsets. Enron, it became obvious, was attempting to hedge itself
largely a game of smoke and mirrors in the absence of outside investment to
absorb the economic risk. In spite of these problems, Arthur Andersen and
Enrons law firm, Vinson & Elkins, indicated that the hedge was reasonable, and
that it could go ahead as Fastow and Glisan intended. Ultimately, however, on
reexamination by Arthur Andersen, it was determined (in October 2001) that the
financial statements for 19992001 had to be restated. In November, Enron
announced that it would restate prior period financial statements to reflect the
consolidation retroactive to 1999, which would have the effect of decreasing
Enrons net income by $95 million in 1999 and $8 million in 2000. 12.
The Powers Report describes the Rhythms transaction beginning on page
79, with a diagram on page 81 and a discussion of the hedge beginning on page
82. It is noted on page 83 that the equity of the SPE used for the transaction
(Swap Sub, of which LJM1 owned part) was negative and thus the transaction
could not have qualified for the 3 percent nonconsolidation rule. This sprung
from the fact that: At its formation on June 30, 1999, Swap Sub had negative
equity because its liability (the Rhythms put, valued at $104 million) greatly
exceeded its assets ($3.75 million in cash plus $80 million in restricted Enron
stock).13 This was what Arthur Andersen found upon reexamination in October
2001. Arthur Andersens CEO said:
In evaluating the 3 percent residual equity level required to qualify for nonconsolidation, there were some complex issues concerning the valuation of
various assets and liabilities. When we reviewed this transaction again in
October 2001, we determined that our teams initial judgment that the 3
percent test was met was in error. We promptly told Enron to correct it. 14
Within two weeks after the transaction closed on June 30, 1999, it was
realized that the volatility of earnings had not improved to the degree desired, 15
and four more derivative actions were entered into to make the hedge act more
like a swap. These did not cure the problem sufficiently, and due to the
continuing concern for the erosion of creditworthiness, the decision was made to
liquidate the hedge. In February or March 2000, Vince Kaminski estimated that
there was a 68 percent probability that the structure would default, and he
claims he relayed this to the accounting group. 16
In early March 2000, negotiations to unwind Swap Sub were begun
between Causey and Fastow with Fastow giving the impression that he had no
personal interest in the outcome which he was just negotiating for the limited

partners of LJM1. On March 8, 2000, Enron gave Swap Sub a put on 3.1 million
shares of Enron at $71.31 per share, which was $4.12 over the closing price, thus
conveying approximately $12.8 million in value to Swap Sub. Perhaps this was by
mistake. Subsequently, Fastow proposed that Swap Sub receive $30 million from
Enron for the unwind, and this was agreed to. The unwind was completed per an
agreement dated March 22, 2000, which was not subjected to an independent
fairness examination, nor was the board advised, nor DASH sheets executed.
Arthur Andersen reviewed the deal, but said nothing. Not until later was it
realized that the value ascribed to the shares reacquired by Enron was as
unrestricted shares, and no discounting was employed to reflect that they were
As a result, an estimated $70 million more than what was required was
transferred to Swap Sub, and ultimately to Fastow and his associates. 17 In
addition, LJM1 was allowed to retain 3.6 million post-split Enron shares related to
the original transaction, which, on April 28, 2000, had an undiscounted value of
$251 million at closing price.18
Many of Enrons employees were involved in these transactions, but none
were approved to benefit as required by the Enron Code of Conduct, and the
board apparently did not know of their involvement. However, the employees
benefited mightily, as is detailed later.
In May, as noted earlier, McMahon ex-pressed his reservations about Enron
accounting and deals to Fastow and was reassigned. Glisan became the new
treasurer of Enron.

LJM Partnerships and The Raptors: LJM2

In October 1999, Fastow proposed a second LJM partnership, LJM2 Co-Investment
LP (LJM2), where he would serve as a general partner through intermediaries to
encourage up to $200 million of outside investment that could be used to
purchase assets that Enron wanted to syndicate. This, Fastow said, would provide
Enron the funds needed to grow quickly and at less cost than by other means.
This was not done blindly, as the following shows:
The minutes and our interviews reflect that the Finance Committee
discussed this proposal, including the conflict of interest presented by
Fastows dual roles as CFO of Enron and general partner of LJM2. Fastow
proposed as a control that all transactions between Enron and LJM2 be
subject to the approval of both Causey, Enrons Chief Accounting Officer,
and Buy, Enrons Chief Risk Officer. In addition, the Audit and Compliance
Committee would annually review all transactions completed in the prior
year. Based on this discussion, the Committee voted to recommend to the
Board that the Board find that Fastows participation in LJM2 would not
adversely affect the best interests of Enron. 19

Later, the board reviewed the discussion, and gave their approval. LJM2 was
formed in October 1999, and its general partner was LJM2 Capital Management,
LP. Limited solicitation developed approximately fifty limited partners raising
$394 million including the contributions of the general partner. Again, Fastow
arranged a series of intermediaries as follows: The general partner, LJM2 Capital
Management, LP, itself had a general partner and two limited partners. The
general partner was LJM2 Capital Management, LLC, of which Fastow was the
managing member. The limited partners were Fastow and, at some point after
the creation of LJM2, an entity named Big Doe LLC. Kopper was the managing
member of Big Doe. (In July 2001, Kopper resigned from Enron and purchased
Fastows interest in LJM2.)20