Former Enron Corp. CEO Jeffrey Skilling told top executives, including founder Kenneth Lay, “they’re on to us,” after reviewing an investment boutique’s research note that was critical of Enron’s special purpose entities (SPEs) run by then-CFO Andrew Fastow, a witness testified Thursday. Fastow, potentially the star witness in the trial of Skilling and Lay, is expected to take the stand this week in Houston.

Kevin Hannon, ex-COO of Enron Broadband Services (EBS) between January 2000 and June 2001, was the final witness to testify for the week. Hannon pleaded guilty in 2004 to one count of conspiracy to commit wire and securities fraud, and he agreed to forfeit $2.2 million and pay $1 million in civil fines (see NGI, Sept. 6, 2004).

In questioning by the prosecution, Hannon recalled a May 2001 meeting attended by several top Enron executives, including Lay, Skilling, COO Greg Whalley, CFO Andrew Fastow and Chief Accounting Officer Richard Causey. The meeting was called to discuss some of the SPEs run by Fastow, including LJM1 and LJM2. The team also reviewed a report issued two weeks earlier by Off Wall Street Consulting Inc., which suggested Enron’s stock price was overpriced and should have been about $27/share, less than half its value at the time.

Hannon told jurors the report “questioned the quality of Enron’s earnings, whether it was a trading company…and questioned the valuation” of the different business units, including EBS.

“It seemed to indicate the market was starting to understand how Enron was making its money,” Hannon testified.

What was Skilling’s reaction to the report?, asked prosecutor Cliff Stricklin.

“They’re on to us,” Hannon recalled Skilling saying.

Hannon recalled Whalley stating, “I don’t know if you’ve all seen this, but other than the criticism of us being a trading company, it’s pretty much on target.” (Whalley was never indicted for wrongdoing at Enron.)

After discussing the report, Hannon said Skilling turned the meeting over to Fastow.

“Did Fastow address LJM at that meeting?,” Stricklin asked.

According to Hannon, “He said, ‘LJM is a good deal for me,’…As I remember, [Fastow’s comment] was met by stunned silence.”

Hannon’s statements, which are expected to be challenged by the defense, appeared to directly challenge Lay’s and Skilling’s insistence that the SPEs were proper and had been approved. Lay and Skilling are not alleged to know how much Fastow made from the partnerships. However, the prosecution contends the men knew the SPEs were used to manipulate earnings.

Fastow is scheduled to take the stand following Hannon’s testimony. Fastow has made no public statements since he pleaded guilty in January 2004 to one charge of conspiracy to commit wire fraud and one charge of conspiracy to commit wire and securities fraud and agreed to be sentenced to up to 10 years in prison (see NGI, Jan. 19, 2004). He cooperated in a plea agreement for both himself and his wife Lea, who served one year in federal prison on an Enron-related tax charge (see NGI, May 10, 2004).

The prosecution’s case has been subtle at times, eschewing most of the technical financial footnotes to instead slowly draw testimony from ex-executives and former employees about what happened inside Enron to build the case against Lay and Skilling.

In other testimony, Hannon also recalled a brainstorming session of Enron executives, including Skilling, on March 7, 2001 in Houston. Hannon said EBS was in poor financial shape at that point, and executives wanted to find ways to meet earnings targets.

“We talked about doing acquisitions of another company…We looked at the potential of buying WorldCom,” Hannon said, referring to a company that ironically collapsed in financial ruin following misdeeds by top officials and ended up eclipsing Enron as the biggest U.S. bankruptcy.

However, Skilling thought buying the then-powerful telecommunications behemoth was a “nonstarter.” Instead, Hannon said Skilling suggested folding EBS into the profitable wholesale trading unit, Enron North America. The tactic has been described in earlier testimony as a way Enron’s top brass wanted to disguise losses within Enron Energy Services (EES).

“It would hide the problem,” Hannon said.

Asked by Stricklin if folding EBS into Enron North America would have solved its financial problems, Hannon responded, “No, I think it would have made it worse.”

Wesley H. Colwell, 46, the former chief accounting officer of Enron North America, was first to take the stand last Monday. Colwell became chief accounting officer of Enron Wholesale Services, which encompassed Enron North America, in September 1999, and he held the post until February 2002. In 2003, Colwell agreed to pay $500,000 in penalties to the Securities and Exchange Commission (SEC) and to cooperate with civil and criminal investigations (see Daily GPI, Oct. 13, 2003). He testified under an immunity agreement.

“If I tell the truth and don’t withhold any information, I will not be prosecuted for my crimes while at Enron,” Colwell told jurors as he explained the reason for his testimony. Colwell, who had worked at Arthur Andersen for 17 years before joining Enron, lost his certified public accountant license, and he is barred from serving an officer in a publicly traded company. However, he is not considered a felon.

With its wholesale energy trading unit going strong, Colwell testified Enron set aside $70 million in the unit’s profits in a reserve fund in 2000. Within a five-day period in July 2000, between the close of 2Q2000 and Enron’s official earnings announcement, Colwell testified he raided the reserves, moving $7 million twice into the corporation. Each $7 million increase created about $5.25 million in net earnings after taxes, which in turn pushed Enron’s quarterly earnings to $289 million after taxes, when they should have been about $278.5 million, he said. Earnings per share increased to 34 cents from 32 cents (see NGI, July 31, 2000).

“Did you use reserve accounts at Enron North America to fraudulently manipulate Enron’s reported earnings?” prosecutor Sean Berkowitz asked Colwell.

“Yes,” Colwell said.

Did Enron’s reported 2Q2000 earnings accurately reflect the company’s performance?, Berkowitz asked.

“No,” Colwell said. “The releases had no economic substance to them.” He said the monetary releases were based on a “desire to increase earnings.”

“Who gave the orders to release the $14 million?,” Berkowitz asked.

“I understood that to be Jeff Skilling,” Colwell said quickly.

Colwell testified he told his boss, former Enron North America CEO David Delainey, in an e-mail days before Enron released its 2Q2000 earnings that he understood Skilling’s “preference” was to beat financial analyst expectations for the quarter.

When Enron collapsed, it also pulled Arthur Andersen into bankruptcy, and the accounting firm was the first Enron defendant to go to trial, convicted in 2002 of obstructing a government investigation (see NGI, Oct. 21, 2002). (The U.S. Supreme Court has since overturned the verdict.) In its trial, Andersen was fingered as being instrumental in helping Enron in its cover up, but Colwell offered another perspective.

Enron hid its actual 4Q2000 earnings from Andersen, “backward engineering” its earnings for that period to meet targets set by Skilling, Colwell said. And, as it had done in 2Q2000, Enron drained the reserves fund set aside by Enron North America to boost corporate earnings, Colwell said.

“What do you believe Arthur Andersen would have done if they’d known the actual way earnings were derived for the fourth quarter?” Berkowitz asked.

“They would have had to report that to the [Enron board of director’s] audit committee, the fact that this was backward engineered,” Colwell said. Andersen’s required annual financial opinion of Enron’s financial statements likely would not have stated a “clean opinion, without qualifications” if Andersen had known Enron purposely shaped its results to meet internal earnings estimates.

On cross examination, Skilling lawyer Randy Oppenheimer tried to get Colwell to admit that transferring reserves from one ledger to another ledger was legal because of Enron’s use of mark-to-market accounting for energy trading. Oppenheimer showed the jury a document indicating Enron North America had $42.3 million in reserves overages in 2000.

What was wrong with taking out $14 million from reserves to add to Enron’s quarterly ledger?, Oppenheimer asked.

“If I flipped the switch and used these reserves, there is a set of policies and a set of practices associated with credit reserves,” Colwell said. “If I had somebody come to me and ask me, because they wanted another penny or two pennies of earnings and to take this $42.3 million in reserves and make it $14 million lower, that would be illegal. The fact that this reserve exists is part of the normal practice of the company.”

Colwell also testified the amount of money held in reserve after 4Q2000 by Enron North America was shaped from the beginning by what was needed for the company to hit an internal earnings target. Unlike 2Q2000’s earnings, which would have been $278.5 million before the $14 million change, Colwell said there was no baseline number for 4Q2000.

“We were engineering from the earnings-per-share number,” Colwell said of 4Q2000 earnings figures. “We were not walking this through the quarter. My reserve [for Enron North America] ended up at $369 million at the end of that quarter [4Q2000]. I didn’t make an independent determination of what the reserves should actually be.” The reserves earnings “demand” was 41 cents/share, which he said was achieved through back engineering. Colwell testified he did not know whether the earnings actually should have been higher or lower than 41 cents because the proper calculations were never made (see NGI, Jan. 29, 2001).

In redirect questioning Berkowitz asked, “What relationship should the earnings process have on the reserves process?”

“None,” Colwell said.

“Why is that?”

“Because your reserves should be independently determined,” said Colwell.

Wanda Curry, a 20-year Enron employee, who has never been accused of wrongdoing at Enron, testified after Colwell. She served as chief accounting officer of Enron North America for four months prior to Colwell’s appointment. Prosecutor Kathryn Ruemmler took over the questioning, asking Curry why she was the chief accountant for only four months before being transferred in February 2000.

“I was told I was being replaced as chief accounting officer of Enron North America because I was not capable of making aggressive accounting decisions,” Curry answered. She said she was told of the move by J. Clifford Baxter, then CEO of Enron North America. Baxter committed suicide less than two months after Enron declared bankruptcy (see NGI, Jan. 28, 2002). Curry said Baxter’s decision to replace her stemmed from her scrutiny of a 1999 transaction with Merrill Lynch, which helped Enron disguise a $7 million loan as a sale of three Nigerian energy barges (see NGI, April 25, 2005).

Curry was transferred to the retail division, EES, where she began reviewing those operations. She said she found “internal controls were nonexistent,” and said the accounting books had to be rebuilt.

“It was a complete do-over because we couldn’t trust what was in the risk books,” Curry testified.

Ex-Enron North America’s Delainey, following Curry to the stand, testified Tuesday the company played “fast and loose” with accounting rules, and financial tricks were “standard operating procedure.

Delainey, who also served as CEO of EES, told the jury he met almost daily with Skilling during his tenure. He struck a deal in 2003 to plead guilty to insider trading and manipulating earnings. Along with cooperating with the prosecution, Delainey forfeited nearly $4.26 million from money he made at Enron, and he also paid a $3.74 million fine to the Securities and Exchange Commission (see NGI, Nov. 3, 2003).

Ruemmler asked him whether it was a surprise when cash reserves from Enron North America were tapped in 2000.

“No, it was standard operating procedure at Enron,” said Delainey, 40. “My history with Enron in Houston was that we tended to be pretty fast and loose with the rules, generally.”

Delainey, a Canadian citizen, worked first for Enron in Calgary, then moved to Houston. At 34, he was awarded Enron’s plum position of CEO of Enron North America. He described meeting almost daily with Skilling.

“He was very detail-oriented, very complete, very thoughtful, very smart,” said Delainey. “He was always encouraging us to go one step further, to find transactions in the market that made sense and to build the business we were all working toward.”

Delainey recounted a time in the fall of 2000 when he told Skilling that Enron North America would be incredibly profitable that year.

“I said we had a couple of quarters in our pockets that would give us flexibility in the future,” Delainey testified. “I wanted to make sure he was aware we were doing really well.” Skilling, said Delainey, was ecstatic.

“He gave me a hug,” Delainey said of his former boss. “We were making so much money, it was a good thing.”

However, Delainey also testified there was a darker side to the company. He said he often felt “pressure” from Skilling and Causey to raid Enron North America’s reserves to boost corporate earnings. Causey originally was going to trial with Lay and Skilling, but he pleaded guilty in December and is cooperating with the prosecution (see NGI, Jan. 9, 2006).

Using reserves to boost earnings was wrong, Delainey said, because the reserves had to be applied to specific risks and were not supposed to cover potential trading losses “or just kind of at management’s discretion…Anything else is cheating and misrepresenting the company. You can’t just pull money to create earnings from the reserves. It’s backwards.”

He testified that Skilling lied during a financial analyst meeting in January 2001 to attempt to show Enron had more stable businesses than only the highly profitable — but highly risky — wholesale gas trading unit. Enron North America’s trading risks were so volatile when the power and gas markets were shaken up in late 2000 that the company routinely recorded losses and gains on hundreds of millions of dollars on a daily basis, he said.

On one single day in 2000 for instance, Enron’s traders lost between $500-600 million — equivalent to the company’s entire profit in 1999, he said. However, Enron North America’s usual huge gains more than offset losses, and the trading unit managed to post strong earnings in 1999, Delainey testified.

Recalling a meeting with financial analysts in January 2001, Delainey said Skilling told him before the meeting he wanted him to frame Enron North America in a certain way and to avoid calling it a “trading” unit.

“If we represented ourselves completely as a market maker, intermediary, originator and a services company — and also a speculative trader, there would be a lot of questions from the analyst community,” Delainey told the jury. “If [we were] asked those questions, we would have to admit we were a very large trader and a very good trader.”

Delainey added, “the investment community does not pay significant multiples for significant trading revenues, especially speculative trading revenues.”

To change the culture at the company, Delainey testified executives wanted employees on the trading desk to be referred to as “risk managers” instead of traders. However, he said, “employees like to be proud of what they do, and if they’re good at it, they get insulted if they’re told they’re not that. The next step, they thought, was that, ‘if you’re not going to call me a trader, you’re not going to pay me for trading.”

Being an Enron energy trader was especially prestigious because many of them made seven-figure bonuses in 2000. One trader, or “risk manager” made an $8 million bonus on top of salary, he said.

“They were encouraged to take large and well-thought out trades based on their view of where supply and demand was and where they could profit the most based on those bets,” Delainey told the jury.

Delainey also offered an explanation of Raptor, the complicated special purpose entity put together by Fastow. He said Raptor was presented by Fastow and former Enron treasurer Ben Glisan Jr. as a way to hedge trading losses. Glisan pleaded guilty to one count of criminal conspiracy and is serving a maximum five-year prison sentence (see NGI, Sept. 15, 2003).

“The analogy made by Ben Glisan and my team was that it was analogous to an insurance policy,” Delainey said. “This vehicle had a certain amount of value that could cushion losses for Enron during which time those assets could be sold and cash be brought into the company. It was never represented to me as a true hedge or a third-party sale or anything like that.”

In April 2001, he assumed the CEO position at EES. He mirrored Curry’s statements that the retail energy unit’s bookkeeping was a mess.

“It was one of the two or three growth areas that had been touted by the management team,” he said, and the company was boasting that the “nature of the customers we were dealing with in that segment would create consistent, repeatable and growing earnings in the future…and thus deserved a higher multiple [in stock price] than even our Enron North America business,” Delainey testified.

But in early 2001, as the company was touting EES, “it was a basket case, is the only way I can put it,” he said.

In mid-January 2001, as the California energy crisis continued, Delainey said EES had an exposure of nearly $1 billion because of poorly written contracts. During a meeting of top executives on Jan. 22, 2001, Delainey suggested the “uncollectible” $500 million in receivables for EES could be moved to Enron North America. He said the transaction basically was moving the problem from a “little bucket” to the “big bucket.”

“‘Dave, that sounds like a good idea,” Delainey said Skilling told him. “Why don’t you follow up with Mr. Causey.”

At the same meeting, Delainey said management decided it wanted to get out of several of the “screwed up” electricity service contracts by dumping them back on California utilities.

Presiding U.S. District Judge Sim Lake asked why the California utilities would take on the additional contracts. Delainey said Enron threatened to sue the utilities if they didn’t take them back.

A few weeks later, Delainey said Skilling rewarded him with a $3 million cash bonus.

Under cross examination, Delainey said not telling the truth at Enron was not uncommon.

“As a management team, we did lie,” said Delainey. “We had a very compelling story that we were telling and we weren’t telling the complete truth.

“What was this Enron story?,” demanded Skilling lawyer Daniel Petrocelli. “Is it a story about a criminal conspiracy?”

“Yes,” Delainey shot back.

“Is it a story about fraud?” the lawyer asked.

“Yes,” Delainey replied.

Petrocelli asked Delainey to recount the times he lied to coworkers, investors, the FBI and others. Delainey said he had lied to the FBI before finally turning state’s evidence, and Petrocelli used those statements to portray the witness as someone willing to do anything to save himself. Calling him “opportunistic,” Petrocelli reminded Delainey that he had once hoped to rise to Skilling’s level at Enron.

“I think I said I was in denial and that I just wasn’t taking full responsibility for what I’d been part of and I was trying to protect myself,” Delainey said of his earlier statements to the FBI.

“By the way, are you still trying to protect yourself?” Petrocelli asked.

“No, I’m telling the truth.”

Petrocelli shot back, “we’ll talk about that.”

“Are you nervous if you don’t keep saying that you’ll get in trouble with the [Enron] task force?” Petrocelli later asked.

Delainey answered, “I just want to make sure the truth comes out.”

Lay’s lawyer Michael Ramsey questioned Delainey about statements he first made to the FBI. At first, Delainey said, he lied, but he eventually pleaded guilty in October 2003 to insider trading.

Asked about the turnabout in his statements, Delainey was at a loss for words. “I’m very, very… It was a terrible… I wish it… There were a lot of things I think I did well, and a lot of things I’m not proud of, and I wish I could take them back. And I wish they hadn’t gone bankrupt, and people didn’t get hurt. It’s a big tragedy.”

Timothy Belden, who once headed Enron Power Marketing in Portland, OR, followed Delainey to the witness chair. Belden pleaded guilty in October 2002 to conspiracy to commit wire fraud relating to power trading schemes (see NGI, Oct. 21, 2002). Belden claimed to know a lot about the inner workings of the company, but Belden admitted he had never met Lay and only met Skilling once at a dinner with colleagues.

He recalled the winter of 2000-2001, when Enron purchased inexpensive power in the Northwest and resold it back to energy-stricken California at exorbitant rates. Belden told jurors California’s “dysfunctional” market following electricity deregulation made it easier to game prices.

“The chaos drove high prices and the high prices drove our profits,” Belden said.

On cross examination by Skilling lawyer Randy Oppenheimer, Belden said he “may” have said the troubled electricity retail unit EES would do better if it was folded inside Enron North America, the company’s massive — and profitable — trading operation. The prosecution has argued EES was moved into Enron North America in mid 2001 to mask its earnings losses from investors and analysts. Under questioning, Belden refused to acknowledge an assertion by Oppenheimer that merging EES into Enron North America enhanced Enron Corp.’s efficiency.

Ramsey also laboriously reviewed Belden’s plea agreement with the government almost line by line, in a confusing set of questions that even the witness sometimes could not answer. Ramsey attempted to show the jury that witnesses with plea agreements might testify in a way to reduce their sentence.

“You’ve made a settlement where you hope, if you perform correctly and render ‘substantial assistance’…your hope and belief is a judge will accept that settlement,” Ramsey said.

“My understanding is [the prosecution] won’t make a recommendation until before sentencing,” Belden said.

On redirect by prosecutor Sean Berkowitz, Belden was asked if he had been told by prosecutors to lie to the jury.

“My primary obligation is to be truthful,” Belden said.

A 22-year Enron veteran, who lost all of his retirement savings when the company collapsed, testified Thursday he and other employees were told in the fall of 2001 to ignore negative press reports about the company’s failing condition and to listen instead to corporate leadership. John Sides first worked in Midland, TX, for a subsidiary of Enron predecessor Houston Natural Gas. Sides now works for the Houston Independent School District.

Until October 2001, Sides testified he had about 75% of his 401(k) retirement account in Enron stock, and then rumors began circulating about the poor financial condition of the company. At that time, Sides recalled how he changed his investment mix.

“I moved all my mutual funds into Enron stock in October 2001,” said Sides. Two months later, the company declared bankruptcy.

What happened to the 401(k)?

“Basically it had evaporated,” Sides said. He was not allowed to discuss exact amounts he lost.

Sides was asked why he had not been worried about his retirement account when the rumors began circulating about Enron.

“At Enron, we’d basically been told by management that articles in newspapers were rumors and we should look to the company to get facts about the true condition of the company,” Sides said.

Sides said his decision to keep and then increase his stake in Enron came from Lay’s statements about the company’s health in August 2001. Lay sent an e-mail to employees on Aug. 14, 2001 and then delivered an upbeat message in person on Aug. 16, 2001, following Skilling’s resignation at CEO. Lay assured employees Enron was stable, and he offered a positive outlook on Enron Energy Services (EES), the company’s retail energy arm, which Sides said was important to him.

“It was very important to me that [EES] be successful because here it becomes a core business; it wasn’t a start-up company anymore, and we were using that same business model to go into things like broadband and possibly other items as well,” Sides said.

Was he aware EES had been losing money in 2001, as previous witnesses have testified? Sides said no, he did not know the business had been losing money.

“To me that would have meant the value of the stock was going to drop…, so I would probably want to diversify my funds,” Sides said.

Under cross examination by Lay lawyer Mac Secrest, Sides said Lay, in addition to promoting EES, talked about some of the negative issues facing the company, including losses related to an Indian plant investment and problems within the company’s broadband business.

“He gave us both the good stories and the bad,” Sides said.

The trial resumes on Monday. Because of requests, the Enron Task Force is now posting copies of documents put into evidence on the Department of Justice website. The documents include e-mail postings, Enron board of director meetings, earnings releases and press releases. It is available at www.usdoj.gov/enron/index.html.

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