A month-long inquiry by Enron’s primary outside counsel in September 2001 into accounting issues raised by then-vice president Sherron Watkins determined that many of her charges were based on “footnotes to financial statements” and “office gossip,” a lawyer with Vinson & Elkins LLP (V&E) said Wednesday.
Testifying for the defense in the trial of Enron founder Kenneth Lay and ex-CEO Jeffrey Skilling, Max Hendrick, who is still a partner at Houston-based V&E, said Lay requested the inquiry after Watkins sent him a seven-page memo detailing her worries about the company “imploding in a wave of accounting scandals.” (Read Watkins’ memo here.)
In her memo, Watkins specifically said V&E should not conduct an inquiry because of its close relationship to the company. As its top law firm, Enron paid V&E $42.8 million in 2000 and $36.4 million in 2001, and the firm represented Enron in 66 special purpose entity (SPE) transactions beginning in 1997.
“What we did, we carried out and took our job seriously,” Hendrick told the jury. “We carried out our investigation in a professional way. I approached it just as I would an engagement for anyone else.”
“Were you prepared to throw away 30 years of professional integrity to conduct a whitewash?” asked Lay lawyer Bruce Collins. “I certainly was not,” Hendrick answered.
Hendrick said he discussed the investigation with James Derrick, Enron’s then-in house legal counsel. Derrick told him Enron wanted a quick investigation, and bringing in outside firms would slow the process.
“I think, as best as I recall, Mr. Derrick indicated he would like the company to move quickly and maintain the investigation on a confidential basis,” Hendrick said. “We understood some of [Watkins’] information came from office gossip.” He added, “It became clear she was relying on footnotes to financial statements to come up with numbers.”
Hendrick said V&E did not review accounting or financial records but instead talked with then-Enron executives that Watkins said should be questioned about whether there were irregularities, including Treasurer Jeffrey McMahon, Investor Relations Chief Mark Koenig, Chief Risk Officer Rick Buy and Vice Chairman Greg Whalley.
In mid-October 2001, as Enron was readying its dismal 3Q2001 results, Hendrick said he and a partner met with Watkins to discuss the unwinding of the SPEs that then-CFO Andrew Fastow ran.
“I think her concern was even if the accounting was appropriate, it looks bad,” Hendrick testified. “She did express on at least one or a couple of occasions [that] Enron was a risky place to work, and she needed to escalate her job search.”
Hendrick said his firm cautioned Lay about the SPEs after the investigation and told him, “There’s going to be questions about why was Enron using its stock to support these vehicles, why was Enron booking gains from transactions with a party that ultimately may not have been a true third party…that could pose a significant risk of litigation and adverse publicity.”
Under cross-examination by John Hueston, Hendrick admitted, “I think because of the relationship…Vinson & Elkins could not be seen as independent” in a more thorough investigation.
Hueston asked him if he had reviewed the financial analyst conference calls conducted by Lay and Skilling to see if they were misleading the public about Enron’s financial status. Hendrick said he did not review the calls; his only charge from Derrick was to look into Watkins’ allegations.
Hendrick also admitted under questioning that then-treasurer McMahon said he was concerned about the LJM partnerships run by Fastow. But McMahon’s concerns were never followed up, he said.
“Mr. Lay didn’t say to you, ‘Get to the bottom of this.’ He didn’t say any comment like that to you, did he?” asked Hueston.
“I don’t recall any comment like that, no,” Hendrick said.
Under questioning, Hendrick also named former Enron executives that V&E did not talk with during its investigation: Ben Glisan Jr., who created the Raptor transactions; Cliff Baxter, a former vice chairman who was mentioned in Watkins’ memo as complaining “mightily” about the LJM deals; and Skilling.
“We stated that no further investigation would be warranted to investigate the facts set forth in Ms. Watkins’ memo,” Hendrick told Hueston.
However, Hueston pointed out that just a few days later, the Securities and Exchange Commission (SEC) launched its own investigation into Enron’s accounting (see Daily GPI, Oct. 23, 2001).
Neal Batson, an examiner appointed by the U.S. Bankruptcy Court for the Southern District of New York, issued several scathing reports about Enron in 2003, and he concluded “there is sufficient evidence” to find V&E “committed malpractice based on Texas Rule 1.12, aided and abetted breaches of fiduciary duty by Enron officers, or committed malpractice based on negligence in connection with several transactions,” including the LJM1/Rhythms and LJM2/Raptors hedging transactions run by Fastow.
Batson also criticized V&E’s handling of the Watkins memo and subsequent investigation. He said V&E did not make full disclosure of its role in the transactions it was asked to investigate, “including the concerns Vinson & Elkins had about the transactions, some of which were similar to those raised by Watkins.”
Derrick, Enron’s in-house counsel and the second witness on Wednesday, also failed to pass scrutiny by Batson, who found “sufficient evidence from which a fact-finder could determine that Derrick committed malpractice based on negligence in connection with the performance of his duties as general counsel of Enron” concerning the SPEs and Watkins’ memo.
As Skilling prepares to testify, The New York Times on Wednesday released portions of a transcript of Skilling’s testimony to the SEC in December 2001, which had not been publicly released. Skilling’s testimony under oath to the SEC may serve “as a road map” to his defense, but it also “points up some potential pitfalls he faces,” the Times noted.
“Obviously, I couldn’t see the whole company,” Skilling reportedly said. “I mean, this was a gigantic company.” He denied there were ever any “last-minute dashes” to meet quarterly earnings projections from the time he took over the COO job in 1997 to his resignation in 2001. “I don’t think there was any time during that time period…that by the end of the quarter we were concerned about the numbers.”
Prosecution witnesses testified to Enron having a credit reserve account, referred to as “Schedule C,” which was used like a “cookie jar” to help the company improve a particular period’s earnings performance. However, Skilling apparently said Schedule C was a proper accounting reserve, used not to bolster earnings but rather put aside if some troubled California utilities that owned Enron money in 2000 and 2001 could not pay.
“The loss from PG&E alone was, I think, $560 million,” Skilling reportedly told the SEC. “These were significant numbers and so we started to reserve for those just to make sure that we could cover them if something did happen.”
Skilling apparently said he had no knowledge of any problems within the SPEs.
“I had absolutely no reason, given the process and the signoffs, to have any expectation that the accounting did not properly reflect what the transactions…the way the transactions were structured.” He also is reported to have professed little knowledge of the Raptors hedging devices, but he said Enron accountants had approved them.
“I cannot describe Project Raptor to you,” Skilling reportedly said. “Arthur Andersen was totally on board. They’d look at the structure and the governance and all the rest of the stuff. They thought it was fine, and it looked like it was a good way to hedge some of these high-technology investments that we had made. So it was approved by the board. But I don’t recall the mechanics of how it worked.”
Of Enron’s financial statements, the newspaper said Skilling told the SEC, “I can’t tell you I read them, you know, cover to cover. I felt by the time that process was completed that it was a fair and accurate presentation of what was going on in the company.”
In related news, Lay’s lead lawyer Mike Ramsey did not have surgery as planned on Wednesday. His spokeswoman said he was undergoing further tests, and surgery has not been rescheduled.
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