STATEMENT OF HERBERT
S. WINOKUR, JR.
Before the
Permanent Subcommittee on Investigations
Committee
on Governmental Affairs
United
States Senate
May
7, 2002
Chairman Levin, Senator
Collins, and Members of the Subcommittee.
Good morning, and thank you for the opportunity to address the
Subcommittee.
My name is Herbert S.
Winokur, Jr. I currently am a member of
the Board of Directors of Enron Corporation.
I have served as the Chairman of the Finance Committee of the Board of
Directors of Enron. I have been a
member of the Board since the mid-1980s.
I volunteered for and served as a member of the Board’s Special
Investigations Committee (the “Powers Committee”) to attempt to understand what
happened at Enron.
I appreciate the opportunity
today to talk with the members of this Subcommittee about the involvement of
Enron’s directors in the related party transactions that have received so much
attention, and about our oversight of Enron more generally. My colleagues will address issues related to
accounting of and internal controls regarding these transactions, management
compensation, and other matters concerning the directors. Attached as an appendix to this statement
are excerpts from Enron’s Board of Directors’ meeting minutes that document
some of my comments in the following paragraphs.
I will discuss shortly the
basis on which the Board approved and sought to control the LJM
transactions. But, in my opinion, one
of the principal causes of Enron’s failure was the loss of lender and investor
confidence that resulted from the three significant restatements to Enron’s
financial statements presented in October and November 2001. Two related to earnings restatements for
four and two years, respectively, and the third a significant reduction in
shareholder equity. The first two
derived from inadequate outside equity capitalization (to permit
deconsolidation) in two special purpose entities of $6 million and $25 million
respectively. The third derived from a
presentation change from grossing up certain assets and liabilities to netting
them. While a related party was
involved in each transaction, the related party aspect does not appear to have
been a factor in any of the accounting errors.
In none of these three
restatements did the Board – or its Audit Committee – have any prior knowledge
(except immediately prior to their disclosures) of the errors which were
required to be corrected. In each case,
Enron’s management had approved the financial statement presentations and, as
appropriate, Arthur Andersen had certified or reviewed the presentations. How and why these errors occurred are the
subjects of several government investigations.
As I said above, I believe that the loss of investor confidence in Enron
and its management that resulted from these accounting restatements was a
significant contributing factor to Enron’s downfall.
With that in mind, I would
like to turn to a general discussion of three areas.
·
The
first is to describe how the Enron Board of Directors and the Finance Committee
went about discharging its obligations.
·
The
second summarizes the specific circumstances in which we approved the LJM
structures and the controls we put in place to ensure that these transactions
remained in the best interests of the Company.
·
Finally,
I will address certain of the hedging transactions that the Board approved and
that have come under so much criticism.
Enron’s Board of Directors
was composed of 12 independent directors and two inside directors, Kenneth Lay
and Jeffrey Skilling. As a Board, we
worked to help move Enron into a new business environment characterized by
increased globalization of investment, increased sophistication in the capital
markets, and rapid regulatory and technological change. This new business environment required us to
make certain business decisions that, at the time, made sound economic sense:
undertaking initiatives in power and water deregulation, entering into
developing markets abroad, and building an extensive broadband network. Enron’s expansions were hailed in the media
as innovative and brilliant. Over the decade of the 1990’s, Enron became the
dominant company in providing electricity and gas to customers around the world.
To some extent, as now has
been learned, by early 2001 Enron’s reach had exceeded its grasp. Business decisions that made sense at the
time, such as the building of an extensive broadband network, or Enron’s entry into
developing energy markets abroad, did not work out. Other broadband companies, such as Level 3 and Qwest, have
experienced severe declines in the price of their stock as the demand for
bandwidth dried up. Global Crossing,
another broadband company, is—like Enron—in bankruptcy. Our initiatives in power and water
deregulation abroad were also less productive than we believed they would
be. Other similar companies such as AES
and Dynegy also have seen significant declines in their stock prices.
I raise this to make an
important point. Enron, as a company,
took a number of business and financial risks.
These risks were disclosed by Enron.
They were also recognized by the analysts and rating agencies who
followed the company. To suggest
otherwise is to ignore the disclosed and well-publicized facts about Enron and
its business strategy.
One of the responsibilities
of Enron’s Finance Committee was to review regularly the Company’s financial
ratios and liquidity. At the Finance
Committee meetings, Enron management routinely presented us with Enron’s actual
and projected financial ratios and near-term liquidity, a report on meetings
and discussions with the credit rating agencies, and an analysis of Enron’s
borrowing costs relative to those of its competitors, which informed us of the
market’s contemporaneous view of Enron.
Between meetings, we also received reports on Enron from Wall Street
equity and debt analysts, including their detailed financial projections.
For example, during the
February 12, 2001 Finance Committee meeting, we were told that “the Company’s
total liquidity was over $8.3 billion.”
We were also told that “there had not been any change in the Company’s
ratings by the rating agencies but noted that the Company was working on being
upgraded to ‘positive outlook’ by Standard & Poors.” We regarded this as a good report on the
financial health of the Company. Based
on the Powers Report, we have since learned, however, that during this time
period, management (without Board knowledge or approval) was working to restructure
the Raptor vehicles by inserting $800 million in additional equity
capital. Neither the Finance Committee
nor the Board was told of those efforts.
The Raptor structures, in fact, never appeared on a list of the top 25
credit exposures that was presented regularly to the Finance Committee. I do not know why we were not told of the
credit concerns about the Raptors. The
procedures we had put in place to receive reports on significant credit
exposures should have revealed this issue to us, but the required report was
never made. The improper accounting
related to the Raptor restructuring was one of the matters that were addressed
in the October/November 2001 restatement.
The picture presented by
management at the August 13, 2001 Board meeting was no different. Recurring net income for the second quarter
and the six-month period was reported to be higher than plan and the prior
year’s levels. Debt to equity capital
ratio was 46% at the end of June, about the same as the prior year, and was
expected to be 42.7% by year-end.
I will now focus on the
Finance Committee’s involvement in the approval and oversight of the LJM
partnerships.
The press and others have
reported repeatedly that Enron’s Board “waived the Code of Conduct” when it
permitted Enron’s Chief Financial Officer, Andrew Fastow, to serve as general
partner of LJM1 and LJM2. The Board did
not.
For many years before the
LJM matters were brought to the Board, Enron maintained a Code of Conduct for
its employees, which required each employee to certify in writing annually as
to his or her compliance.
Enron’s Code of Conduct
permits the Chief Executive Officer to make a determination that an officer’s
investment does not present a conflict of interest. The Code of Conduct provides as follows:
“The Chairman of the Board
and Chief Executive Officer of Enron Corp. shall consider carefully the summary
of relevant facts, and if he concludes that there appears to be no probability of any conflict of interest
arising out of the proposed investment the officer or employee shall be so
notified and may then make the proposed investment in full reliance upon the
findings of the Chairman of the Board and Chief Executive Officer of Enron
Corp.” (emphasis added)
As the Board minutes of June
28, 1999 state, when LJM1 was approved, the Board adopted and ratified the
determination by the Office of the Chairman “that participation of Andrew S.
Fastow as managing partner/manager of the [LJM] partnership will not adversely
affect the interests of the Company.”
This Board action followed a presentation describing the business
purpose of LJM1 and the significant financial benefits therefrom to Enron. The Board was told that
PricewaterhouseCoopers “would be rendering a fairness opinion” and that Mr.
Fastow would have “no direct pecuniary interest in the Company’s stock” which
provided credit support to the partnership.
This transaction was disclosed in Enron’s June 30, 1999 and in
succeeding Form 10-Qs and 10-Ks, including the related party aspect. Arthur Andersen reviewed the transaction as
part of its review of the June 30, 1999 10-Q.
At the October 10, 1999
Finance Committee meeting and the Board meeting on October 11, Mr. Fastow
presented an update on the financial benefits from LJM1, and recommended, to
obtain quick, flexible equity to Enron with reduced transaction costs, that he
be permitted to organize LJM2, a new fund with outside investors (and him as
managing partner) to be an “additional, optional source of private
equity.” He proposed that the Chief
Accounting Officer review and approve all transactions with LJM2. The Committee, upon questioning, learned
that Arthur Andersen was “fine with” the partnership structure, and that LJM2’s
limited partners -- expected to be institutional investors -- would be able to
remove Mr. Fastow without cause. The
Finance Committee augmented these controls by requiring that the Chief Risk
Officer also review and approve all transactions and that the Board’s Audit and
Compliance Committee review all transactions annually and make any
recommendations it deemed appropriate. Thereafter, upon management’s
recommendation, and after mandating additional controls, the Board ratified the
Office of the Chairman’s determination that Mr. Fastow’s participation “will
not adversely affect the interest of the Company.” LJM2 was disclosed as a related party transaction in Enron’s 1999
and 2000 Forms 10-K and the 2000 Proxy Statement.
Updates given to the Finance
Committee about the LJM transactions were positive. At the May 1, 2000 Finance Committee meeting, prior to a
discussion of the proposed “Raptor” hedging transaction, Mr. Fastow reported
that “he had hired individuals to manage the investment vehicles [LJM1 and
LJM2] and that he personally was devoting approximately three hours a week to
the investment vehicles.” We were also
told that LJM2’s investments had a “projected rate of return of 17.95%.” Mr. Causey, the Chief Accounting Officer,
told the Finance Committee that “Arthur Andersen, LLP had spent considerable
time analyzing . . . the governance structure of LJM2 and was comfortable . . .
.” We now know from the Powers
Committee report that the LJM2 investors were receiving much higher
returns.
The minutes of the October 6, 2000 Finance Committee
show that the Finance Committee continued to focus on Mr. Fastow’s dual
role. Mr. Fastow described to the
Committee six of the mechanisms that “had
been put in place to mitigate any potential conflicts,” (emphasis added)
one of which was that “Messrs. Buy, Causey and Skilling approve all
transactions between the Company and the LJM funds.” A second was that Mr. Fastow maintained his fiduciary duty to
Enron. In addition to the controls that
Mr. Fastow described, the Committee instructed management that Mr. Fastow’s
compensation be reviewed by the Board’s Compensation and Management Development
Committee and that transactions between the Company and the LJM funds be
reviewed quarterly by the Finance Committee in addition to the annual review by
the Audit Committee.
The Finance Committee
received its first quarterly, and the Audit and Compliance Committee received
its second annual, report on the related party transactions with LJM on
February 12, 2001 from the Chief Accounting Officer. Arthur Andersen was present at the Audit Committee meeting when
these matters were discussed. Mr.
Causey discussed the “Board-established guidelines for transacting with
LJM.” He then reviewed compliance with
the Board guidelines, informing them that “The Company has adopted the
following procedures and controls in response to the Board’s direction,” and
listed them. Finally, he reviewed with
the Committees the “Checklist review complemented by the adoption of additional
controls.” Mr. Causey informed the
Finance Committee that the controls “had been discussed with the Audit and
Compliance Committee, and commented that the process was working
effectively.”
The preceding, I submit,
illustrates that the Board applied Enron’s Code of Conduct when it ratified
management’s recommendation regarding LJM1 and LJM2, and added substantial
additional controls to ensure that all of the Enron/LJM transactions would be
in the best interests of the company.
The record also indicates that the directors regularly monitored the LJM
transactions and management’s involvement.
We asked for and repeatedly received reports which informed us that the
controls were working and that there were no concerns raised either by management
or our outside auditors.
Enron has been criticized
for its use of what are widely accepted and well-established off balance sheet
financing or special purpose vehicles to raise debt and equity. This practice is common and permitted by the
accounting rules (if structured correctly).
Many large and well-known companies use off-balance sheet financing
routinely. Leasing companies and reinsurance
companies exist to provide off balance sheet financing to their customers. Enron’s extensive use of off-balance sheet
financing was widely known and well publicized.
The Board has also been
criticized for authorizing hedge transactions that made use of Enron stock for
credit support. Let me address that
criticism.
Enron had within its
portfolio certain highly volatile investments, such as restricted stock of
Rhythms NetConnection, a high technology company. Enron was required to use mark to market accounting on its
“merchant” investments. That
combination of volatile investments and mark to market accounting had the
potential to create instability and unpredictability in the Company’s income
statement. Putting in place hedges to
mitigate and stabilize those risks made good business sense. In fact, companies have been sued by their
shareholders because they failed to put in place hedges on significant and
volatile investments.
The Board was presented by
management with a plan to hedge these investments with an under-utilized
asset. We were told that Enron had
significant unrealized value in forward contracts previously issued on its own
stock. These forward contracts were
written by Enron in order to hedge the expense of Enron’s stock-based incentive
compensation plan. In simple terms,
Enron wrote forward contracts to purchase its stock in the future at present
prices to protect itself against the risk that its stock would appreciate in
value and thus make its incentive compensation plan more expensive. I understand this to be a common business
practice.
Management wanted,
appropriately, to use that unrealized value most effectively for the benefit of
the shareholders. It informed the Board
that the proposed transaction was the best way to do so. We were informed at
the same time that the transaction would be the subject of a fairness opinion
by PriceWaterhouse Coopers. We were
also aware that Arthur Andersen would be reviewing the transaction in
connection with its review of the June 30, 1999 10Q and had no reason to believe,
either at the time we approved the transaction or at any subsequent time, that
Arthur Andersen was troubled by the transaction or its accounting treatment.
We believed that the Raptor
I transaction, which was presented to the Finance Committee on May 1, 2000, was
quite similar structurally to the original LJM hedge transaction. By that time, Arthur Andersen had certified
the 1999 10K, and our inside and outside attorneys had, we believed, approved
the disclosure. The minutes disclose
that during that meeting, Mr. Causey “stated that Arthur Andersen LLP; had
spent considerable time analyzing the [Raptor] structure and the governance
structure of LJM2 and was comfortable with the proposed transaction.”
The use of forwards on Enron
stock in Rhythms Net and the Raptor transactions was disclosed in Enron’s
public filings, in disclosures that we believed had been reviewed and approved
by both Arthur Andersen and Vinson & Elkins, our regular outside securities
counsel.
The transactions that were
presented to us—and many were not—were presented as valid economic hedges of
Enron’s risks, using the gains in the Enron stock forward positions. I want to make clear that I never
understood, and was not told, that the business purpose of entering into the
LJM transactions was to create fictitious earnings. Quite the contrary, I was told that the LJM transactions were
being undertaken to hedge the risks and volatility of our assets, and to assist
Enron in obtaining additional third-party debt and equity capital on favorable
terms to Enron shareholders to support the company’s growth.
III. CONCLUSION
What happened at Enron has
been described as a systemic failure. I
see it instead as a cautionary reminder of the limits of a director’s role. We
served as directors of what was a large and complex corporation. A director’s
role, by its nature, is a part-time job.
It also was necessarily defined by the nature of Enron’s
enterprise—which was worldwide in scope, employed more than 20,000 people, and
engaged in a vast array of trading and global development activities.
By force of necessity, we
could not know personally all of the employees. As we now know, key managers and employees whom we thought we
knew proved to disappoint us significantly.
And outside advisors, whom we believed to be critical components of an
effective oversight role, failed in their duties.
Take, for example, the
Raptor restructure. As has been disclosed in the press, on February 5,
2001, Arthur Andersen held an internal meeting in which it expressed
significant concern about the credit capacity of the Raptor vehicles and the
quality of the earnings being attributed to them. Just one week later, however, with full knowledge of the Raptor
credit problems, Arthur Andersen assured the Audit Committee that Enron would
receive a clean audit opinion on its financials. Andersen also told the Audit Committee that there were no
material weaknesses in Enron’s internal controls—even though one week earlier
its auditors had discussed, but not shared with the Board, the fact that the
controls imposed by the Board for these related party transactions were not
being followed.
Had
the Raptor restructure been presented to the Board, I believe the Board might
well have chosen the alternative - to shut down the Raptors - which also would
have by definition avoided the accounting error related to issuance of new
equity which accounted for the bulk of the $1.2 billion reduction in
shareholders’ equity we took in October.
I find the failure of management to come forward in this mater to be
particularly tragic.
Arthur Andersen’s failure to
disclose its concerns to the Board, as well as management’s marked disregard
for the required internal controls and lack of candor with respect to
information owed to us, deprived the Board—and deprived me—of the ability to
deal proactively with this problem. We
cannot, I submit, be criticized for failing to address or remedy problems that
were concealed from us.
Three months ago, days after
release of the Powers’ Report, I appeared before a House Subcommittee. At that time, I was deeply disturbed and
disappointed with what I had read. I
also squarely disagreed with certain conclusions in the Report, especially
about the directors’ judgment and oversight, which disagreement I expressed
during my testimony. Even with the
benefit of a few more months to review these issues, I remain resolute in my
belief that we directors were diligent and dedicated to our charge. Based upon the recommendations, advice, and
information we received from management and our advisors, we acted in good
faith and attempted to pursue the best interests of Enron and its
shareholders. I deeply wish, however,
that at least one person—management, employee, or outside advisory - had come
forward to the Board with his or her concerns when we could have addressed
them.
I am prepared to respond to
any questions from the Subcommittee.
Thank you.