January 2002 Newsletter
Issue One, Volume Three

THE TRUTH ABOUT ENRON

By Mike Gasior

There have been many of you that have written me over the past several months wondering why I was ignoring the Enron story. Headlines were, and are, shouting out from the newsstands about “The Largest Bankruptcy in American History”. Reporters of every imaginable media outlet seem to want to talk about some angle of this drama. Even while I sat down to watch the State of the Union address reporters were speculating whether or not the President would touch upon Enron or perhaps even mention the whole spectacle by name. Thankfully the President chose not to mention them, and I have put this whole thing off for as long as I could. The story is still long from complete but enough is now known and the major facts seem reasonably clear and I feel inclined to discuss what seems clear.

Rather than succumb to all the hype, which seems to overwhelm the common sense of journalists (please notice I am giving them credit for at least having some common sense there) I will approach this story in my usual deliberate and factual way. Yes...it’s a big story. I will not deny you that. There is just too much hype and too much misinformation floating around at this point and it needs to be worked through.

FIRST AN ENRON JOKE (OR METAPHOR PERHAPS)

Two Enron auditors walk into a bar. The bartender asks them if capitalism failed Enron or Enron failed capitalism.

First auditor says, "Capitalism is when you have two cows. You sell one cow and buy a bull. Your herd multiplies and the economy grows. You sell the herd and retire on the income."

Second auditor says, "Enron capitalism is when you have two cows. You sell three of them to your publicly listed company, using letters of credit opened by your brother-in-law at the bank. You then execute a debt/equity swap with an associated general offer so that you get all four cows back, with a tax exemption for five cows. You then transfer the milk rights of six cows via an intermediary to a Cayman Island company secretly owned by the majority shareholder of your publicly listed company who sells the rights to all seven cows back to your publicly listed company. The Annual Report to Shareholders says the company owns eight cows, with an option on one more.

(This joke was forwarded to me by a good friend literally hours before I was to send this newsletter out and I couldn’t keep myself from including it. Sadly for Enron employees and shareholders there is a little too much truth contained in it.)

THE FACTS ABOUT ENRON

Enron continues to be a very confusing company to many people and I know this because of the questions I have been fielding myself for several months about “what did they do anyway?”

Enron was an energy company, but they were much more than that. While they were a huge player in natural gas, electricity and oil, they also ventured into all sorts of disparate businesses like fiber optics and more. They have owned power plants and actually produced natural gas, but the larger part of their business tended to be the “trading” of these things. This simply means acting as the “middle man” between someone looking to buy some electricity and someone else looking to sell some then making a profit by marking up the transaction somewhat. Their actual businesses were nothing unusual and many other companies effectively pursued the same exact markets and strategies on a smaller scale.

The problems with the Enron story revolve around questionable transactions and questionable accounting methods. Indeed, I am being extraordinarily generous with the word “questionable”. Better adjectives might be ridiculous, illegal, arrogant, stupid and aggressive. More on all that shortly. The true downfall for Enron started when they began to behave more like an investment fund rather than an energy company.

THE BUSINESS PRACTICES

I have read what seem now to be endless accounts of what happened at Enron and three basic and major themes have jumped out at me that should have drawn more attention to the potential for failure of the company. I hate Monday morning quarterbacks and I refuse to become one in this case, but some of these things seem glaring and causes me to wonder how Wall Street failed to notice them. I want to keep this newsletter somewhat short of War and Peace proportions, but I need to at least address these problems. Here are the items which immediately seem troubling.

--The huge reliance on “energy trading” for profits. These trading activities accounted for about 80% of Enron’s earnings.

--The acceleration of large, unrealized, non-cash gains into their current earnings even though it was hugely likely that none of these gains would actually materialize.

--The now famous partnerships and special purpose vehicles, which hid debt and were controlled by company insiders.

Let’s start with the energy trading. This alone was enough to make me stand up and take notice. I have been around the trading of energy futures and other contracts during my entire career and even I know that this is a pedestrian business with extremely small margins. Whenever you have a marketplace as large and as efficient as the one for energy, connecting buyers with sellers will only yield, even the largest players, razor thin profit margins.

With such a large contribution to earning coming from trading, the only reasonable assumption had to be that Enron was make large (huge perhaps) speculative bets on the direction of energy prices and was winning. The natural gas shortage and resulting electricity crisis in California and other markets only helped feed these profits, but when the markets stabilized and then began to drop the situation at Enron began to turn hard for the toilet as well. Nearly every major financial disaster of the past decade seems to contain some degree of arrogant speculation, which went horribly wrong: Orange County, Barings, Proctor & Gamble et al. All I see here is more of the same.

Try to follow this logic for a moment. We enter into a contract where you agree to buy 100,000 megawatt hours of electricity from me annually for the next 20 years at $75 per megawatt hour. Next year the price that I have to pay for the electricity drops to $35 and my profit margin is suddenly $40 per megawatt hour; which sounds pretty damn good right there. But wait one minute and think this over. What if I were to take the $40 per hour profit, multiply it times 100,000 and take that total and multiply the result by the 19 years left on our contract?? That totals up to be $76,000,000; which I decide to recognize THIS year as part of my earnings for the current period. Have I actually received any of this money? No. Do I have any idea if the current profit margin of $40 will continue for even another day? No. Does this sound like the stupidest and most aggressive thing you have ever heard? Yes.

You have heard this story from me BEFORE and nobody listened to me then when I was trying to warn people about some of the accounting practices rampant in the Internet industry. Do yourself a favor and go back and read the newsletter I wrote nearly two years ago in April of 2000 and see if you don’t find a VERY familiar theme at work here:

http://www.afs-seminars.com/newsletter_Apr_2000.html

Next, let’s think about the partnerships and special purpose vehicles which hid much of Enron’s troubles from public view. Please keep in mind that these structures, in and of themselves, are not bad things. What is bad in this circumstance is how Enron used them to hide things. In footnotes contained in the 10-K and 10-Q filings by Enron there were mentions of “related party” transactions with some senior company official which was not named, but was later discovered to be the company CFO who made over $30,000,000 running these outside entities. How could these deals possibly have been arms length transactions? Of course they couldn’t be, and all that was really happening was Enron moving debt and assets off it’s own balance sheet and into these partnerships and booking a profit by doing just that.

The troubles were that Enron then appeared to be in less debt even though they were effectively still on the hook for every dime of the debt AND there were often no actual cash profits from these transactions. Just more unrealized gains. To add insult to injury, the assets, which were often “sold” into these partnerships, weren’t worth a hell of a lot either and Enron usually was on the hook for losses on the assets too. Basically it was a lose/lose deal for Enron.

THE EXECUTIVES

Here I want to be very brief since it may take years to find out exactly who knew what, and when they knew it. There are, however, some extremely obvious things which can be looked at.

When the CEO, Jeffrey Skilling, abruptly resigned in August, there should have been a clear message sent that something was terribly wrong. Between January and August of last year Skilling sold off about $20 million of Enron stock and then quit. It is now surprising how easily investors and analysts accepted his dopey reasons for the resignation. There is no reasonable doubt now why he resigned and it is also reasonable that he knew something dirty was going on.

I watched the recent interview with Ken Lay’s wife on television and I completely and totally understand her standing by her husband. There is no room here for Lay to wiggle out of lots and lots of blame. It seems he will claim that he knew nothing of all the bogus deals which were mentioned in the footnotes, all the risks being assumed by the trading areas and the aggressive accounting treatments being used across the company’s businesses. It seems obvious to me that he has to be lying and that will most likely be a criminal matter that we will be hearing about for years to come. The only other explanation is that he is a moron, which although is not technically illegal, certainly prevented him from fulfilling his fiduciary responsibility to know what the hell is going on in the company that he was the Chief Executive of. He had to be dirty here. And he’s most certainly not “broke” in the same sense as the employees who were screwed out literally everything they had.

I’ve had a hard time discerning exactly why Cliff Baxter felt it necessary to take his own life last week. He most certainly was well within the “loop” so that he would have had knowledge of the dirty activities. The problem I have is that his last job at Enron was the impotent and dead-end job of Vice Chairman, which seems to be an improbable place for him to have had any authority over big decision-making. Mostly I feel bad that he left a widow and two children with no father. Whatever his respective guilt at Enron is, it most likely pales in comparison to his peers.

The Enron vice president, Sherron Watkins, who wrote the now famous memo about the company “imploding due to accounting scandals” was probably among lots of employees who knew the real story. Now that all these employees have lost their jobs, retirements and life savings you can be certain that they are plenty angry enough to tell anyone who will listen their story. You can be completely certain that Congress will be salivating to have them testify there.

THE ACCOUNTANTS

This is the most difficult part of the story for me to write since auditors and accountants make up a large component of my client base and the population of my seminars. Arthur Andersen has sent many people through my programs over the years and I certainly don’t wish to be viewed by them, or anyone else, as someone biting the hand that feeds them. There does seem to be issues which Andersen themselves has, or will acknowledge were wrong, and they will be forced to face the music for those decisions sooner or later. I do not wish to speak for the accounting industry here, and they are likely to wish I wouldn’t either, but I can only imagine a common thought throughout the industry is “There for the grace of God go I.”

This story could have involved plenty of companies other than Andersen, but the dice rolled and Andersen lost. Unfortunately they have be linked to a couple of spectacular disasters in recent years which will make their future more difficult than it needed to be.

I have watched in the past decade as clients have increasingly pushed their accountants to sign-off on activities that made them uncomfortable. When a client is paying you major fees, and can fire you at any moment, the pressure is consistently on to keep the client happy without landing yourself in jail. I have always remembered a comment made to me by a lawyer friend of mine (yes...I have those) that when push comes to shove in the legal profession; if anybody is going to end up in jail it is definitely going to be the client and not their lawyer.

Andersen made mistakes on many fronts here. First of all, deciding to act as the internal auditors, external auditors and also consultants makes it difficult to keep your objectivity. At this point you are nearly in business with the client and you have built a very delicate house of cards.

Normally the external auditors check the work of the internal auditors who are employees of the company. In this circumstance, if the external auditors found any fault it would have actually been the fault of Andersen and not the client and how do you explain your initial mistakes then? Basically, you are auditing your own work. Secondly, some of the accounting decisions made by the client company may have been the result of consulting advice you gave the client which means if your auditors think it’s an aggressive practice, they are criticizing your own people again. This is simply a vicious circle and you have only put yourself into a very difficult position that may come back to haunt you later.

Then there is the issue of shredding documents. This may prove to be their worst decision; but in a perverse way it may work out for them. It really is as simple as this; they knew that the shredding of these documents was going to be viewed as dirty and illegal and there would ultimately be a price to be paid for the activity legally. If, however, the shredding actually destroyed evidence of even more serious troubles, then the ramifications of the shredding might look mild in comparison to the might have happened if the evidence in the destroyed files came to light. What Andersen has to be concerned with is did they get rid of all the important stuff.

In summary, there is already no doubt that Andersen had concerns about Enron as a client and also seemed to know something about them was dirty. They have already fired a bunch of people connected with that client and are hoping the whole thing is viewed as an isolated incident. The only trouble is that there seems to be knowledge of what was going on at Enron at the highest levels of Andersen so where do the heads stop rolling? This part of the story might play itself out for the longest amount of time.

If I can inject one more thing to worry about, I think there will be a wave of other client companies who might be also be dirty, who will now fire Andersen, or whoever their auditors are, and intimate that the accountants were not to be trusted. This will only give those companies a longer timeframe to conceal or change their own shady accounting practices and the accounting profession will bear the brunt of the blame.

I heard yesterday on CNBC that some very recent survey of Americans now showed that people view accountants in lower esteem than journalists or politicians. That actually made me very sad to hear since I have the opportunity to personally meet thousands and thousands of accountants on an annual basis and they quite frankly are some of the nicest, most honest and hardest working people on earth. Whenever you compare someone to politicians, them’s fighting words. You can always count on me to come to the defense of my friends and accountants worldwide are my friends, and I’d appreciate it if journalists would not screw with them right now. Yes...Andersen did some dirty stuff in this case, but lets resist the urge to throw the baby out with the bathwater. Enough said.

THE POLITICIANS

There’s no story here. Period. Paragraph.

Yes indeed, Enron gave buckets and buckets of money to politicians including giving George W. something like $400,000 for his inauguration. The most recent count I’ve read was that 70 out of 100 Senators got money from them too including a majority of Congress as well. I would wager a guess that if you did similar research with regard to any company Enron’s size you would see a similar pattern of giving money to politicians in this proportion. That’s the American way in politics and unless there is some actual campaign finance reform on the horizon, it will continue for as far as the eye can see.

If there is any story here at all, it lies in the fact that not a single politician from either party stepped to the plate to help Enron even a tiny bit. Actually, this is what I find totally fascinating since it might even make the politicians look somewhat noble. Imagine that you’re Ken Lay and you’ve given these elected officials millions and millions of dollars and when you call needing some real and serious help, every single one of them tells you basically “go scratch”. For that, I give politicians credit for being at least able to protect their own a** in what turned out to be a disaster of epic proportion.

One story I have not followed that closely is the GAO asking Dick Cheney and the White House for information on meetings that took place with representatives from the energy industry. My thought on the matter might be overly simple, but the President and Vice President, along with Senators and members of Congress are entitled to have private conversations with anyone they’d like and offer these people advice or seek advice. If I was a politician and knew that any conversation I might have with anyone regarding literally anything might be subject to subpoena and could turn up on CNN, well I wouldn’t talk to anybody ever. How is the heck are you supposed to govern in an environment like that? The issue seems to be ridiculous to me and we will find out how things turn out. It sounds as though this issue has been debated before with mixed results and I will be keeping my eye on this one.

K-MART AND GLOBAL CROSSING

K-Mart and Global Crossing were two more monster bankruptcies and I can promise you that they will definitely not be the last either. The K-Mart situation is going to make worse the situation in commercial real estate, which was already suffering after September 11th. The Global Crossing story also has the senior executives cashing out of hundreds of millions of dollars of stock fairly recently and the shareholders left holding the empty bag. This story might make some interesting reading also.

But PLEASE remember what I said here. There will be more large and surprising bankruptcies in the coming months of 2002 and the recession is going to linger for a while longer.

NEXT MONTH

I have been doing some very interesting research regarding a looming crisis in the pension markets in both the U.S. and in Europe whose situation is even more dire. I think you will be surprised by what I found.

NEW YORK CITY SEMINARS

I was sad to hear that the College of Insurance would be unable to host our programs in 2002 due to the events of September 11th. However, we are very excited to announce our new facility for all of our New York City seminars, The Madison Towers Hotel on the corner of Madison Avenue and 38th Street. Our new location is extremely convenient to the airports, PATH and most subways. The hotel has just undergone an extensive (and expensive) renovation and is absolutely stunning. Their information will be added to our website shortly.

Our first program will be Mortgage & Asset Backed Securities on February 25th and 26th and there will be over 20 programs held in Manhattan this year. All these programs will be held at The Madison Towers Hotel and you can register for all our sessions and the M&ABS Seminar by calling my office at (860)347-6568 or by visiting our website:

http://www.afs-seminars.com

If you would like to receive a copy of our 2002 schedule or our brand new course catalog that includes 10 new programs for this year, please call my office at (860)347-6568. You can also request one by e-mail at the following address:

info@afs-seminars.com

I hope to see you sometime this year, and please feel free to contact me if there are any questions I can answer.

http://www.afs-seminars.com

Copyright 2003, Michael Gasior. All Rights Reserved.

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