Former Enron Corp. CFO Andrew Fastow testified Tuesday that the company, under then-President Jeffrey Skilling's direction, used off-the-book partnerships to illegally revise earnings beginning in 1999.
Fastow, 44, has remained publicly silent since he pleaded guilty in January 2004 (see Daily GPI, Jan. 15, 2004). He originally was charged in 2002 with fraud and money laundering in a 78-count indictment. Initially pleading not guilty, Fastow changed his mind when his wife Lea was charged with tax fraud in an Enron-related case. In an intricate plea deal that arranged for his wife to plead guilty to one count of tax fraud -- for which she spent one year in federal prison -- Fastow pleaded guilty to two counts of fraud, agreed to a 10-year prison term and forfeited about $24 million, including homes in Galveston, TX, and Vermont.
Although he continues to live in Houston with his family, Fastow has remained out of the spotlight, never speaking to reporters. On Tuesday, however, he captivated U.S. District Judge Sim Lake's Houston courtroom, offering clear and concise answers in his first day of testimony in the trial of Skilling, the ex-CEO, and Enron founder Kenneth Lay. Dressed in a gray suit and colorful tie, his hair now completely gray, Fastow calmly described his role as CFO for Enron, a post he reached at age 38.
"I had fiduciary responsibility to the shareholders," Fastow told prosecutor John Hueston in describing his job duties. "That means I'm supposed to take actions that are in the best interest of the shareholders."
In some of the most revealing testimony, Fastow told the jury that Enron's fortunes were as an energy trading company -- even though company executives did not want to admit it to Wall Street. The distinction is considered important to the case: Lay's and Skilling's defense teams have portrayed Enron as a "logistics" company, but prosecutors have maintained that Enron was an energy trading company.
Fastow testified there was no question within the executive suite as to what Enron's main purpose was -- Enron was a trading company, and it lied about its business to Wall Street.
"The investor community to my knowledge was being told the opposite...that Enron was a logistics company," Fastow testified. But he said within the company, energy trading was well known as Enron's "primary driver."
"Did you hear Mr. Skilling make comments like that?," asked Hueston.
"Yes," said Fastow.
"Did you hear Mr. Lay make comments like that?"
"Yes. And I made comments like that," Fastow replied.
At a meeting of Enron executives in The Woodlands, a suburb near Houston, Fastow said he suggested the company drop the charade that it was a logistics company.
"I said, 'why don't we just become the best trading company?," Fastow told Hueston.
How did Enron executives react?
"I pretty much got stunned silence," Fastow answered.
When Fastow began testifying early Tuesday, Hueston wasted no time in getting him to describe the partnerships, or special purpose entities (SPE), that Fastow ran and partly owned, known as LJM 1 and LJM2 -- named for the initials of Fastow's wife and two sons. The initial $15 million LJM1 SPE was approved by Enron's board of directors, including Lay and Skilling, to help Enron meet financial targets, according to Fastow.
Enron's expectation for LJM was "to engage in deals primarily with Enron to make Enron meet their numbers," Fastow told the jury. The SPE, he said, was a "rather unusual arrangement," designed to "mask potential losses of hundreds of millions of dollars."
Under the SPE arrangement, Fastow was allowed to personally profit from LJM1, making money from the transactions LJM did with Enron, as well as from any rise in Enron's share price. The SPE, structured by Fastow, was designed to allow the CFO to make money from fees regardless of whether the partnership made money or not. He also invested $1 million of his own money into the first LJM partnership, which Skilling used as a selling point to the board.
Hueston asked if there was any personal risk to investing in LJM?
"I considered there to be almost no risk to me," Fastow told jurors. "Not in my mind. I thought it was pretty much pure upside."
Skilling, he said, was unsure how LJM should be disclosed to Enron's investors. Skilling was concerned, he said, that as a top executive with Enron, Fastow's role in running LJM would be scrutinized.
"If dissected, people would see what the purpose of the partnership was, which was to mask, potentially, hundreds of millions of dollars in losses," Fastow testified.
But Fastow said Skilling lent his support, telling the board Fastow "has skin in the game," referring to his $1 million investment. According to Fastow, Skilling told the board the biggest risk "was the Wall Street Journal risk," referring to scrutiny that might come if the actual nature of the deal was investigated.
The LJM1 partnership worked well, he said, and Enron was able to boost its earnings in 2Q1999 by selling off an investment called Rhythms Net to the SPE. Fastow then approached Skilling and suggested forming a second, larger partnership.
"Get me as much of that juice as you can," Fastow recalled Skilling telling him about forming a second partnership, implying that the equity raised was used as "juice" for Enron's earnings. "The juice was the equity, but we were using the equity to juice the earnings, to increase the earnings of Enron Corporation so we could report the numbers we wanted to report."
How much "juice" was there? Hueston asked. Fastow answered that by May 2000, LJM2 had raised $386 million in capital commitments.
Why Enron didn't sell off its unprofitable assets through other legitimate financial institutions? Hueston asked.
"We were using this to inflate our earnings, and I don't think we wanted to show people what we were doing."
LJM2 was formed in 1999, and Fastow ultimately raised more than $386 million of capital commitments for it.
What was the plan for LJM2?
"It was to engage in transactions primarily with Enron," Fastow said. "The nature of the transactions would be for Enron to make its numbers, meaning to make the financial statements look the way they wanted them to look."
By the end of 1999, Fastow testified that six new deals were completed by LJM2, which propped up the company's year-end 1999 earnings. Just for managing LJM2, Fastow received $8 million in fees the first year. Fastow also had about 10 Enron employees working on the deals. However, Fastow did not consider every transaction worthwhile. One particularly bad deal, he said, was pushed by Skilling.
Cuiaba was a poorly performing power plant in Brazil that Enron wanted to sell. When it could find no buyer, Skilling told Fastow to have LJM buy it.
When asked by Hueston why he didn't want LJM to buy the plant, Fastow replied, "I don't know how graphic my language is allowed to be." Pushed by Hueston, Fastow said, "I told him it was a piece of s--t, and no one would buy it."
Hueston asked Fastow why it was such a bad deal. Fastow laughed and said, "First of all, it was in my opinion." But Skilling told Fastow not to worry about taking it over, he recalled. "He told me don't worry, you'll be all right on the project..., you won't lose any money...and that eventually LJM would get its money back," Fastow told jurors.
LJM bought a 13% stake in Cuiaba for $11 million. After the transaction was completed, Enron took Cuiaba off its books and recorded a natural gas supply agreement related to the plant as $65 million in earnings for year-end 1999.
Fastow said he knew he would make money by buying the plant, but he wanted Skilling to realize what he was doing.
"I was going to solve this problem, and I wanted Mr. Skilling to recognize just how big a favor I was doing so it would help me out later on," Fastow testified. "I thought I was being a hero for Enron. It would help Enron make its numbers, and if Enron made its numbers, its stock would go up. I was a big stockholder. If I helped Enron make its numbers, I get a bigger bonus. At the time, it looked like I was helping myself and helping Enron."
Fastow also talked about Southampton, another SPE set up with other Enron employees, including then-Treasurer Ben Glisan Jr. (Southampton was named after the subdivision in Houston where Fastow lives.)
Fastow testified he needed to unwind a transaction that required Enron to pay a fee to the banks that were LJM's limited partners. One of the banks was willing to accept a $1 million fee, but Fastow said he told former Chief Accounting Officer Richard Causey the smallest fee a bank would accept was $20 million.
Fastow was given the $20 million for the fee, and he testified he transferred the extra $19 million into Southampton. Fastow said he then set up a charitable foundation to hold the $4.5 million he personally earned in the illegal transaction. The foundation, he said, was set up to boost his family's stature in Houston. He also asked his father to run the foundation for $50,000 a year.
"I lied to Enron," Fastow said of the $19 million. "Those should have been funds that Enron was able to keep."
Describing another partnership, RADR, Fastow said Enron wanted to sell some wind turbines to a third party, but it still wanted to control the assets. So, he asked the domestic partner of Enron associate Michael Kopper to act as the third party. If Kopper and William Dodson, his partner, had been married, Dodson would not have been allowed to be a legal "third party." However, Texas law does not recognize same-sex unions.
"Under Texas law, Mr. Dodson wasn't recognized as his [Kopper's] spouse," Fastow said. "Technically, it worked under the law."
Fastow testified Skilling thought the third-party arrangement "was great. He had a little laugh that there was this hole in the law."
Fastow then described how he ensured his financial fortunes by using his wife and his sons as financial conduits in the RADR deal.
"I directed my wife to make a loan to Mr. Kopper to invest in the RADR transaction," Fastow testified. The loan was repaid at a high interest rate, returned to the Fastows through a series of checks Kopper wrote to Fastow's wife and children, which were characterized as gifts. Shown copies of the checks by Hueston, Fastow forced back tears, nodding and replying that they were the checks his family was given illegally. Fastow also nearly broke down when Hueston questioned him about his guilty plea.
"I thought it was in the best interest of my family not to go to trial, to take responsibility for my actions and go forward with my life," Fastow testified. He still has 10 civil lawsuits pending against him, which could amount to "millions, maybe billions of dollars."
After lunch, Hueston continued questioning Fastow about his wife Lea's involvement in illegal Enron deals. Although she pleaded guilty, Fastow said his wife was innocent.
Choking back tears, Fastow said he lied to his wife, which led to her spending one year in federal prison.
"You involved her in one of your deals?" asked Hueston.
"Yes," Fastow answered.
"And because of your efforts, you caused her to go to jail, right?" Hueston asked.
"Yes," Fastow said, nearly crying.
Fastow testified he wanted to provide evidence that his wife was innocent at her trial, but he could not convince presiding U.S. District Judge David Hittner to change the trial date to enable him to do so (see Daily GPI, May 7, 2004).
"I had exculpatory information that would help to prove her innocence," Fastow told jurors, as he visibly struggled to remain calm. "But if her trial started before mine it would make it impossible to do...without incriminating myself."
Fastow told jurors he told Lea that money the family received from RADR was a gift from Kopper and Dodson.
Lea Fastow, who is a member of the prominent Weingarten family, pleaded guilty to one misdemeanor count of filing a false joint tax return in 2000. She served one year in federal prison in Houston, was sent to a halfway house in June 2005 and was finally released in July 2005.
Fastow testified he worried that he and his wife would be in prison at the same time and would be unable to take care of their young sons.
"In short, I misled my wife," he told jurors. "I led her to believe that these checks were gifts from Mr. Kopper and Mr. Dodson...I told her accountants and her attorneys that these checks could be treated as gifts, and that's the reason they were prepared that way." He said his wife "did not conspire. I conspired with Michael Kopper to do this."
If the illegal activity within the SPEs had not been uncovered, Fastow said he, Skilling and Causey were planning to expand their ventures.
Fastow testified they talked about forming LJM3. The three men also talked about removing Fastow from his CFO role at Enron, still paying his salary, to allow him to keep running the LJM deals as independent companies. Removing Fastow from Enron would have freed the company from disclosing what was going on, Fastow said.
Fastow mostly referred to Skilling and Causey as being in on his illegal transactions. But in the late afternoon, Fastow also described the Raptors, a set of transactions that Lay approved, he said. Enron owned stock in several smaller companies, and when the value of those companies' shares changed, Enron was required to reflect the gains and losses in quarterly reports.
Like many companies, Enron entered into hedge transactions to limit potential losses in its investments. Under Securities and Exchange Commission accounting rules, the other party to the hedge has to be independent. However, Fastow described how he engineered a series of transactions known as the "Raptors," that made the hedging party appear independent -- when it fact it was not.
Fastow testified he described the Raptors to Skilling as "perpetual motion machines." With Skilling's approval, the Raptors then were presented to Enron's management committee, which included Lay and Skilling. Everyone, including Lay, thought the Raptors were a good idea, Fastow testified.
Enron provided $537 million in stock and options to create the Raptor subsidiary Talon LLC, while LJM2 contributed $30 million in cash. The investment from LJM2 was key because it met the threshold for Enron's treatment of Talon as an independent third party. However, because LJM2 was controlled by Fastow, Enron promised Fastow he would recoup his investment with substantial profit.
As its hedge, Enron paid Talon $41 million for the option of making Talon buy 7.2 million shares of Enron stock at a future date. Talon then paid LJM2 $41 million in August 2000, which covered its initial investment and another $11 million. The prosecution argues that LJM2 never had any money at risk, and Enron was the sole investor.
"At Enron, the culture was, and the business practice seemed to be, to do transactions that maximized the financial reporting as opposed to doing transactions that actually maximized value," Fastow testified. "They were paying money to be able to report higher earnings."
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