NOVEMBER 12, 2001 

FINANCE 
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 this year, the California Attorney General had to get a court order to collect documents in an industrywide investigation into energy price fixing. And when an analyst challenged former CEO Jeffrey K. Skilling in a conference call to produce Enron's balance sheet, Skilling called him an "ass----." Still, even some Enron executives worried that the company had gone too far with two complex partnerships set up in 1999 to buy company assets and hedge investments. With Enron's then-chief financial officer acting as general manager of the partnerships and in a position to personally benefit from their investments, the potential for a conflict of interest and backlash from investors 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 revealed a $35 million charge to earnings to reflect losses on those partnerships and was forced to knock $1.2 billion off its shareholders' equity, the company's stock has plunged 60%. The Securities & Exchange Commission is investigating 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 Investors Service has already downgraded the company's debt. Enron says it is meeting with credit agencies to calm their fears, and analysts say Enron is working on a turnaround plan that would likely include accelerating asset sales, issuing shares, and obtaining new credit lines. Enron's board has set up a special committee to look into its controversial partnerships. But analysts also worry that Enron's trading partners could pull the plug if they lose 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 company announced on Oct. 24 that CFO Andrew S. Fastow, architect of the controversial 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 tense meeting held at a Houston hotel after the latest financial disclosures, soft-spoken Chairman and CEO Kenneth L. Lay faced 1,600 employees, with another 5,000 hooked up via the Web. One irate worker asked if he was "on crack." Lay, an economist by training, turned over day-to-day management in 1997. 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 flames. This is just awful," says one friend.

On the surface, at least, Enron's off-balance-sheet maneuvering hardly seems 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 million a year in investment-banking fees. Fastow's involvement in the partnerships, which bought assets from Enron, including stakes in telecom and energy, was supposed to make the deals simpler for the investment bankers and thus cheaper. They were also meant, according to sources close to the company, to hedge Enron's investments in potentially risky assets while allowing it to maintain some control over them. Enron says Fastow made money for himself on some of the deals, but insiders insist there were less controversial ways to enrich him if that were the aim. Fastow did not return calls seeking comment. Lay, who declined to comment for this story, has said that the partnerships were properly vetted by Enron's attorneys and internal and external auditors and were approved by its board. A source familiar with Enron agrees: "We had the best lawyers in the world saying, `It looks fine."'

But whatever Enron's reasons for creating the LJM partnerships, the problems were compounded by scanty disclosure. The deals were first revealed in a 1999 proxy, raising concerns from investors and analysts. By this summer, when Enron's stock was falling and its bets in broadband were souring, complaints about LJM grew louder. So in June, Fastow pulled out of the partnerships. When the write-offs came, Enron enraged analysts and investors further by failing to disclose the hit to equity in its third-quarter earnings press release. Instead, Lay mentioned it in a conference call with analysts. "We found it disconcerting that the company waited to disclose the additional $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 have been lobbying for years for more information about how and where Enron makes 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 and its stock was returning 500% during the same six-year period, Enron's aggressive, even arrogant managers could ignore Wall Street's complaints with impunity. But after its stock price collapsed this year (chart), the company's attitude and operational missteps quickly caught up. And there was plenty to worry about. The company's $3 billion power plant in India wasn't paying 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 Azurix Corp. has already cost Enron at least $574 million in write-offs.

These bad bets and the expensive LJM shock have investors worried about what 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 credibility 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 producers. Analysts and sources close to the deals say there's no particular risk in these to Enron shareholders. Other interconnected entities, such as Whitewing, 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, freeing capital and credit for the core energy business and ventures like broadband (table).

To entice institutional investors such as pension funds and insurers into these 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 half-dozen others in the energy and telecom industries, including El Paso (EPG), Williams, and Dominion, says Standard & Poor's director Todd A. Shipman. "Nobody's going to find anything that's particularly unique or below board" in such deals, says one investment banker specializing in the energy business.

Worst case, which Shipman considers unlikely, Enron could be on the hook for 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 Sanders 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 investment grade, says Shipman.

HUGE HIT. Fastow's LJM, a private equity fund, was a different kind of animal, according to sources familiar with the arrangements. It bought energy and other assets from Enron, which booked gains and losses on those deals. LJM was also involved in complex hedging that was supposed to reduce the volatility of some of Enron's investments, including stakes in high-tech and telecom 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 successful 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, rival traders are wary. "We certainly have taken a closer look at Enron in the 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, CEO of power and gas trader Aquila Inc. (ILA )

"SPEEDING TRAIN." Still, with the stock battered and rating agencies considering further downgrades, that could rapidly change. In recent days, the uncertainty about Enron's future has reduced investors' appetite for Enron debt. "No one wants to speculate on the direction or their likelihood of survival," 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--some even believe that Enron could be a takeover target for the likes of GE Capital or Royal Dutch/Shell Group. (RD ) Both declined to comment. Would Enron sell? One source close to the company says Enron has talked about possible mergers and strategic alliances in the past with Royal Dutch/Shell, among 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 strengths," says William N. Adams, senior energy analyst at Banc of America Capital Management, a major shareholder. But that's a far less exciting place than Enron's energy cowboys ever hoped to roam. 

By Stephanie Anderson Forest and Wendy Zellner in Dallas, with Heather Timmons in New York



NOVEMBER 12, 2001 

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

That's financial marketspeak for insurance on bonds and bank loans. Their owners pay a premium for coverage that reimburses them for any losses they have 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 estimate 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 sheets such as J.P. Morgan Chase (JPM  ), Merrill Lynch (MER ), and Deutsche Bank (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 million and $700 million worth of CDSs so far this year, it had ambitious plans 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 seeking comment.

Of course, neither Enron nor others will have to pay out unless the loans and bonds they're insuring turn bad. Trouble is, this year is potentially a doozie for losses on corporate debt. Corporate defaults could reach a record 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 billion 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. 

By Heather Timmons in New York


NOVEMBER 12, 2001 

FINANCE 
By Mike McNamee

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

Enron's political clout and close ties to President George W. Bush create real 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 campaign. A Bush appointee, Pitt is attempting a delicate balancing act. He has made it clear he wants to speed up the SEC's enforcement, in part by rewarding companies that cooperate with probes. But he insists the SEC will still come down hard on true corporate miscreants--and knows that any signs of let-up could jeopardize the rest of his reform agenda.

Enter the Enron probe. The fine shadings of securities enforcement--where most cases are settled by negotiated penalties, not court-imposed fines--often make it hard for outsiders to tell whether the SEC is being tough or lenient. 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 any other, less connected company.

For now, top SEC aides say that's happening. The SEC Enforcement Div. in Washington 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 commissioners 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 Gramm, top Republican on the Senate Banking Committee. And Enron spreads its lobbying budget--$2.13 million in 2000--across both parties. Just this year it hired four lobbying firms with Democratic roots. Enron says it lobbies heavily 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 joined the SEC out of law school in 1968, "remembers how the [Nixon-era] SEC tainted itself by turning a blind eye to [fugitive financier] Robert Vesco," says an agency veteran. Pitt has too much riding on the Enron probe to let its connections sway his judgment. 

McNamee covers finance in Washington.