Read Figure 5.4 Watkins' Whistle-Blower Letter to Enron Chairman in Chapter 5, pp. 149-152.

Explanatory notes:

AA=Arthur Andersen (auditing firm)

MTM=Mark to market

EES=Energy exchange schemes

ENE=Equity non-existing

IBIT=Income before Interest and Taxes

NI=Net Income

N/P=Notes payable

VIE=Variable interest entities

REQUIRED:

Identify as many financial and non-financial red flags from the letter as you can. According to my analysis, there are at least 20 red flags mentioned in Watkins' letter.

List your red flags in a numerical order (1, 2, 3...20).

Each red flag description should not exceed two lines. Red flags need be drawn from Watkins' letter directly, and not from any random source or other chapters in the textbook.

FIGURE 5.4 WATKINS' WHISTLE-BLOWER LETTER TO ENRON CHAIRMAN Has Enron become a risky place to work? For those of us who didn't get rich over the last few years, can we afford to stay? Skilling's abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting-most nota- bly the Raptor transactions and the Condor vehicle. We do have valuation issues with our international assets and possibly some of our EES MTM positions. The spotlight will be on us, the market just can't accept that Skilling is leaving his dream job. I think that the valuation issues can be fixed and reported with other goodwill write-downs to occur in 2002. How do we fix the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to pony up Enron stock and that won't go unnoticed. To the layman on the street, it will look like we recog. nized funds flow of $800 million from merchant asset sales in 1999 by selling to a vehicle (Condor) that we cap italized with a promise of Enron stock in later years. Is that really funds flow or is it cash from equity issuance? We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor. Much of that stock has declined significantly-Avici by 98 percent from $178 million, to $5 million; the New Power Company by (continued 150 Part: Fraud Detection positions. FIGURE 5.4 CONTINUED 80 percent from $40 a share, to $8 a share. The value in the swaps won't be there for Raptor, so once again Enron will issue stock to offset these losses. Raptor is an LJM entity. It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future. I am incredibly nervous that we will implode in wave of accounting scandals. My eight years of Enron work history will be worth nothing on my rsum, the business world will consider the past successes as noth- ing but an elaborate accounting hou. Skilling is resign- ing now for "personal reasons" but I would think he wasn't having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in two years. Is there a way our accounting gurus can unwind these deals now? I have thought and thought about a way to do this, but I keep bumping into one big problem-we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001, and it's a bit like robbing the bank in one year and trying to pay it back two years later. Nice try, but investors were hurt, they bought at $70 and $80 a share looking for $120 a share and now they're at $39 or worse. We are under too much scrutiny and there are probably one or two disgruntled "rede- ployed employees who know enough about the funny accounting to get us in trouble, What do we do? I know this question cannot be addressed in the all-employee meeting, but can you give some assurances that you and Causey will sit down and take a good hard objective look at what is going to hap- pen to Condor and Raptor in 2002 and 2003? Summary of Alleged Issues: underlying capitalization of the Raptor entities is de This year, with the value of our stock declining the ing and credit is pushing for reserves against MIN To avoid such a write-down or reserve in un 2001, we "enhanced the capital structure of the Raghr vehicles, committing more ENE shares. My understanding of the third-quarter premis that we must "enhance" the vehicles by $250 ullion I realize that we have had a lot of smart la look ing at this and a lot of accountants including & Co have blessed the accounting treatment. Not of the will protect Enron if these transactions are verdie closed in the bright light of day. (Please review the late 90's problems of Waste Management (newe/quote] where AA paid $130 million plus in litigation reques tionable accounting practices.) The overriding basic principle of accounting is that you explain the accounting treatment" to a man in the street, would you influence his investing decisions? Would he sell or buy the stock based on a thorough understanding of the facts? If so, you best present it cor rectly and/or change the accounting. My concern is that the footnotes don't adequately explain the transactions. If adequately explained, the investor would know that the entities" described in our related party footnote are thinly capitalized, the equity holders have no skin in the game, and all the value in the entities comes from the underlying value of the deri- vatives (unfortunately in this case, a big loss) AND Enron stock and NP. Looking at the stock we swapped, I also don't believe any other company would have entered into the equity derivative transactions with us at the same prices or without substantial premiums from Enron. In other words, the $500 million in revenue in 2000 would have been much lower. How much lower? Raptor looks to be a big bet if the underlying stocks did well, then no one would be the wiser. If Enron stock did well, the stock issuance to these entities would decline and the transactions would be less noticeable. All has gone against us. The stocks, most notably Hanover, the New Power Company and Avici are under water to great or lesser degrees. I firmly believe that executive management of the company must have a clear and precise knowledge of these transactions and they must have the transactions reviewed by objective experts in the fields of securities law and accounting. I believe Ken Lay deserves the right to judge for himself what he believes the probabilities RAPTOR Entity was capitalized with LJM equity. That equity is at risk; however, the investment was completely offset by a cash fee paid to LJM. If the Raptor entities go bankrupt LJM is not affected, there is no commitment to contribute more equity. The majority of the capitalization of the Raptor entities is some form of Enron NIP, restricted stock and stock rights Enron entered into several equity derivative transac- tions with the Raptor entities locking in our values for various equity investments we hold. As disclosed in 2000, we recognized $500 million of revenue from the equity derivatives offset by market value changes in the underlying securities of discovery to be and the estimated damages to the (continued Chapter 5 Records of raat FIGURE 5.4 CONTINUED spot at Enron Industrial Markets and see addressed the five steps with him b. Cliff Baxter complained mightily to Skilling and all who would listen about the inappropriateness of our transactions with LJM. c. I have heard one manager-level employee from the principal Investments group say, "I know it would be devastating to all of us, but I wish we would get caught. We're such a crooked company. The principal Investments group hedged a large number of their investments with Raptor. These people know and see a lot. Many similar comments are made when you ask about these deals. Employees quote our C.F.O. as saying that he has a handshake deal with Skilling that LJM will never lose money. 4. Can the general counsel of Enron audit the deal trail and the money trail between Enron and LJM/Raptor and its principals? Can he look at LJM? At Raptor? If the C.F.O. says no, isn't that a problem? company from those discoveries and decide one of two courses of action: 1. The probability of discovery is low enough and the estimated damage too great, therefore we find a way to quietly and quickly reverse, unwind, write down these positions/transactions 2 The probability of discovery is too great, the estimated damages to the company too great: therefore, we must quantity, develop damage con- tainment plans and disclose. I firmly believe that the probability of discovery sig nificantly increased with Skilling's shocking departure. Too many people are looking for a smoking gun. Summary of Raptor Oddities: 1. The accounting treatment looks questionable. a. Enron booked a $500 million gain from equity derivatives from a related party, b. That related party is thinly capitalized with no party at risk except Enron, c. It appears Enron has supported an income state ment gain by a contribution of its own shares One basic question: The related party entity has lost $500 million in its equity derivative transac tions with Enron. Who bears that loss? I can't find an equity or debt holder that bears that loss. Find out who will lose this money. Who will pay for this loss at the related party entity? If it's Enron, from our shares, then I think we do not have a fact pattern that would look good to the S.E.C. or investors. 2. The equity derivative transactions do not appear to be at arms length a. Enron hedged New Power, Hanover and Avici with the related party at what now appears to be the peak of the market. New Power and Avici have fallen away significantly since. The related party was unable to lay off this risk. This fact pat- tern is once again very negative for Enron. b. I don't think any other unrelated company would have entered into these transactions at these prices. What else is going on here? What was the compensation to the related party to induce it to enter into such transactions? 3. There is a veil of secrecy around LJM and Raptor. Employees question our accounting propriety consis- tently and constantly. This alone is cause for concern. a. Jeff McMahon was highly vexed over the inher- ent conflicts of LJM. He complained mightily to Jeff Skilling and laid out five steps he thought should be taken if he was to remain as treasurer. Three days later, Skilling offered him the C.E.O. Condor and Raptor Work: 1. Postpone decision on filling office of the chair, if the current decision includes C.F.O. and/or C.A.O. 2. Involve Jim Derrick and Rex Rogers to hire a law firm to investigate the Condor and Raptor transac tions to give Enron attorney-client privilege on the work product. (Can't use V & E due to conflict--they provided some true sale opinions on some of the deals.) 3. Law firm to hire one of the big 6, but not Arthur Andersen or PricewaterhouseCoopers due to their conflicts of interest: AA & Co. (Enronl: PWC (LJM). 4. Investigate the transactions, our accounting treat- ment and our future commitments to these vehicles in the form of stock, NP, etc., For instance: In the third quarter we have a $250 million problem with Raptor 3 (NPW) if we don't "enhance the capital structure of Raptor 3 to commit more ENE shares. By the way: in Q. 1 we enhanced the Raptor 3 deal, committing more ENE shares to avoid a write down. 5. Develop cleanup plan a. Best case: Clean up quietly if possible. b. Worst case: Quantity, develop P R. and I.R. cam- paigns, customer assurance plans (don't want to go the way of Salomon's trading shop), legal actions, severance actions, disclosure. 6. Personnel to quiz confidentially to determine if I'm all wet: a. Jeff McMahon b. Mark Koenig c. Rick Buy d. Greg Walley (continued) 352 Part 3 Fraud Detection FIGURE 5.4 CONTINUED To put the accounting treatment in perspective offer the following: 1. We've contributed contingent Enron equity to the Raptor entities. Since it's contingent, we have the consideration given and received at zero. We do, as Causey points out, include the shares in our fully diluted computations of shares outstanding if the current economics of the deal imply that Enron will have to issue the shares in the future. This impacts 2002-2004 earnings-per-share projections only 2. We lost value in several equity investments in 2000, $500 million of lost value. These were fair-value investments, we wrote them down. However, we also booked gains from our price risk management transactions with Raptor, recording a correspond ing PRM account receivable from the Raptor anti- ties. That's a $500 million related party transaction- it's 20 percent of 2000 IBIT, 51 percent of Nl pretex, 33 percent of Ni after tax. 3. Credit reviews the underlying capitalization of Raptor, reviews the contingent shares and deter- mines whether the Raptor entities will have enough capital to pay Enron its $500 million when the equity derivatives expire. 4. The Raptor entities are technically bankrupt; the value of the contingent Enron shares equals or is just below the PRM account payable that Raptor owes Enron. Raptor's inception-to-date income statement is a $500 million loss. 5. Where are the equity and debt investors that lost out? LJM is whole on a cash-on-cash basis. Where did the $500 million in value come from? It can from Enron shares. Why haven't we booked the transaction as $500 million in a promise of shares to the Raptor entity and $500 million of value in our "economic interests in these entities? Then we would have a write-down of our value in the Raptor entities. We have not booked the latter because we do not have to yet. Technically we can wait and face the music in 2002-2004 6. The related party footnote tries to explain these transactions. Don't you think that several interested companies, be they stock analysts, journalists, hedge fund managers, etc., are busy trying to dis. cover the reason Skilling left? Don't you think their smartest people are poring over that footnote disclo- sure right now? I can just hear the discussions- looks like they booked a $500 million gain from this related party company and I think, from all the unde- cipherable half-page on Enron's contingent contribu- tions to this related party entity, I think the related party entity is capitalized with Enron stock." ... "No, no, no, you must have it all wrong. it can't be that, that's just too bad, too fraudulent, surely AA & Co. wouldn't let them get away with that?" "Go back to the drawing board, it's got to be something else. But find it!" ... "Hey, just in case you might be right, try and find some insiders or 'redeployed former employees to validate your theory." SOURCE: https://www.justice gov/archive/enron/exhibit03-15 BBC-0001/Images/9811.001.PDF, accessed June 1, 2004. This letter, together with whistle-blowing acts by Review of the Learning lleen Rowley of the FBI and Cynthia Cooper of Zrld Com, resulted in the three of them being Objectives med Time magazine's 2002 "Persons of the Year." Understand how symptoms help in the detection Time magazine stated, "These three did the right of fraud. When unusual symptoms of fraud ng by just doing their jobs rightly." become apparent, a more focused, directed search of where the fraud is originating from sho Remember this ... conducted. Employees other than auditors (such as co-workers or Identify and understand acco managers are thithe . FIGURE 5.4 WATKINS' WHISTLE-BLOWER LETTER TO ENRON CHAIRMAN Has Enron become a risky place to work? For those of us who didn't get rich over the last few years, can we afford to stay? Skilling's abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting-most nota- bly the Raptor transactions and the Condor vehicle. We do have valuation issues with our international assets and possibly some of our EES MTM positions. The spotlight will be on us, the market just can't accept that Skilling is leaving his dream job. I think that the valuation issues can be fixed and reported with other goodwill write-downs to occur in 2002. How do we fix the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to pony up Enron stock and that won't go unnoticed. To the layman on the street, it will look like we recog. nized funds flow of $800 million from merchant asset sales in 1999 by selling to a vehicle (Condor) that we cap italized with a promise of Enron stock in later years. Is that really funds flow or is it cash from equity issuance? We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor. Much of that stock has declined significantly-Avici by 98 percent from $178 million, to $5 million; the New Power Company by (continued 150 Part: Fraud Detection positions. FIGURE 5.4 CONTINUED 80 percent from $40 a share, to $8 a share. The value in the swaps won't be there for Raptor, so once again Enron will issue stock to offset these losses. Raptor is an LJM entity. It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future. I am incredibly nervous that we will implode in wave of accounting scandals. My eight years of Enron work history will be worth nothing on my rsum, the business world will consider the past successes as noth- ing but an elaborate accounting hou. Skilling is resign- ing now for "personal reasons" but I would think he wasn't having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in two years. Is there a way our accounting gurus can unwind these deals now? I have thought and thought about a way to do this, but I keep bumping into one big problem-we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001, and it's a bit like robbing the bank in one year and trying to pay it back two years later. Nice try, but investors were hurt, they bought at $70 and $80 a share looking for $120 a share and now they're at $39 or worse. We are under too much scrutiny and there are probably one or two disgruntled "rede- ployed employees who know enough about the funny accounting to get us in trouble, What do we do? I know this question cannot be addressed in the all-employee meeting, but can you give some assurances that you and Causey will sit down and take a good hard objective look at what is going to hap- pen to Condor and Raptor in 2002 and 2003? Summary of Alleged Issues: underlying capitalization of the Raptor entities is de This year, with the value of our stock declining the ing and credit is pushing for reserves against MIN To avoid such a write-down or reserve in un 2001, we "enhanced the capital structure of the Raghr vehicles, committing more ENE shares. My understanding of the third-quarter premis that we must "enhance" the vehicles by $250 ullion I realize that we have had a lot of smart la look ing at this and a lot of accountants including & Co have blessed the accounting treatment. Not of the will protect Enron if these transactions are verdie closed in the bright light of day. (Please review the late 90's problems of Waste Management (newe/quote] where AA paid $130 million plus in litigation reques tionable accounting practices.) The overriding basic principle of accounting is that you explain the accounting treatment" to a man in the street, would you influence his investing decisions? Would he sell or buy the stock based on a thorough understanding of the facts? If so, you best present it cor rectly and/or change the accounting. My concern is that the footnotes don't adequately explain the transactions. If adequately explained, the investor would know that the entities" described in our related party footnote are thinly capitalized, the equity holders have no skin in the game, and all the value in the entities comes from the underlying value of the deri- vatives (unfortunately in this case, a big loss) AND Enron stock and NP. Looking at the stock we swapped, I also don't believe any other company would have entered into the equity derivative transactions with us at the same prices or without substantial premiums from Enron. In other words, the $500 million in revenue in 2000 would have been much lower. How much lower? Raptor looks to be a big bet if the underlying stocks did well, then no one would be the wiser. If Enron stock did well, the stock issuance to these entities would decline and the transactions would be less noticeable. All has gone against us. The stocks, most notably Hanover, the New Power Company and Avici are under water to great or lesser degrees. I firmly believe that executive management of the company must have a clear and precise knowledge of these transactions and they must have the transactions reviewed by objective experts in the fields of securities law and accounting. I believe Ken Lay deserves the right to judge for himself what he believes the probabilities RAPTOR Entity was capitalized with LJM equity. That equity is at risk; however, the investment was completely offset by a cash fee paid to LJM. If the Raptor entities go bankrupt LJM is not affected, there is no commitment to contribute more equity. The majority of the capitalization of the Raptor entities is some form of Enron NIP, restricted stock and stock rights Enron entered into several equity derivative transac- tions with the Raptor entities locking in our values for various equity investments we hold. As disclosed in 2000, we recognized $500 million of revenue from the equity derivatives offset by market value changes in the underlying securities of discovery to be and the estimated damages to the (continued Chapter 5 Records of raat FIGURE 5.4 CONTINUED spot at Enron Industrial Markets and see addressed the five steps with him b. Cliff Baxter complained mightily to Skilling and all who would listen about the inappropriateness of our transactions with LJM. c. I have heard one manager-level employee from the principal Investments group say, "I know it would be devastating to all of us, but I wish we would get caught. We're such a crooked company. The principal Investments group hedged a large number of their investments with Raptor. These people know and see a lot. Many similar comments are made when you ask about these deals. Employees quote our C.F.O. as saying that he has a handshake deal with Skilling that LJM will never lose money. 4. Can the general counsel of Enron audit the deal trail and the money trail between Enron and LJM/Raptor and its principals? Can he look at LJM? At Raptor? If the C.F.O. says no, isn't that a problem? company from those discoveries and decide one of two courses of action: 1. The probability of discovery is low enough and the estimated damage too great, therefore we find a way to quietly and quickly reverse, unwind, write down these positions/transactions 2 The probability of discovery is too great, the estimated damages to the company too great: therefore, we must quantity, develop damage con- tainment plans and disclose. I firmly believe that the probability of discovery sig nificantly increased with Skilling's shocking departure. Too many people are looking for a smoking gun. Summary of Raptor Oddities: 1. The accounting treatment looks questionable. a. Enron booked a $500 million gain from equity derivatives from a related party, b. That related party is thinly capitalized with no party at risk except Enron, c. It appears Enron has supported an income state ment gain by a contribution of its own shares One basic question: The related party entity has lost $500 million in its equity derivative transac tions with Enron. Who bears that loss? I can't find an equity or debt holder that bears that loss. Find out who will lose this money. Who will pay for this loss at the related party entity? If it's Enron, from our shares, then I think we do not have a fact pattern that would look good to the S.E.C. or investors. 2. The equity derivative transactions do not appear to be at arms length a. Enron hedged New Power, Hanover and Avici with the related party at what now appears to be the peak of the market. New Power and Avici have fallen away significantly since. The related party was unable to lay off this risk. This fact pat- tern is once again very negative for Enron. b. I don't think any other unrelated company would have entered into these transactions at these prices. What else is going on here? What was the compensation to the related party to induce it to enter into such transactions? 3. There is a veil of secrecy around LJM and Raptor. Employees question our accounting propriety consis- tently and constantly. This alone is cause for concern. a. Jeff McMahon was highly vexed over the inher- ent conflicts of LJM. He complained mightily to Jeff Skilling and laid out five steps he thought should be taken if he was to remain as treasurer. Three days later, Skilling offered him the C.E.O. Condor and Raptor Work: 1. Postpone decision on filling office of the chair, if the current decision includes C.F.O. and/or C.A.O. 2. Involve Jim Derrick and Rex Rogers to hire a law firm to investigate the Condor and Raptor transac tions to give Enron attorney-client privilege on the work product. (Can't use V & E due to conflict--they provided some true sale opinions on some of the deals.) 3. Law firm to hire one of the big 6, but not Arthur Andersen or PricewaterhouseCoopers due to their conflicts of interest: AA & Co. (Enronl: PWC (LJM). 4. Investigate the transactions, our accounting treat- ment and our future commitments to these vehicles in the form of stock, NP, etc., For instance: In the third quarter we have a $250 million problem with Raptor 3 (NPW) if we don't "enhance the capital structure of Raptor 3 to commit more ENE shares. By the way: in Q. 1 we enhanced the Raptor 3 deal, committing more ENE shares to avoid a write down. 5. Develop cleanup plan a. Best case: Clean up quietly if possible. b. Worst case: Quantity, develop P R. and I.R. cam- paigns, customer assurance plans (don't want to go the way of Salomon's trading shop), legal actions, severance actions, disclosure. 6. Personnel to quiz confidentially to determine if I'm all wet: a. Jeff McMahon b. Mark Koenig c. Rick Buy d. Greg Walley (continued) 352 Part 3 Fraud Detection FIGURE 5.4 CONTINUED To put the accounting treatment in perspective offer the following: 1. We've contributed contingent Enron equity to the Raptor entities. Since it's contingent, we have the consideration given and received at zero. We do, as Causey points out, include the shares in our fully diluted computations of shares outstanding if the current economics of the deal imply that Enron will have to issue the shares in the future. This impacts 2002-2004 earnings-per-share projections only 2. We lost value in several equity investments in 2000, $500 million of lost value. These were fair-value investments, we wrote them down. However, we also booked gains from our price risk management transactions with Raptor, recording a correspond ing PRM account receivable from the Raptor anti- ties. That's a $500 million related party transaction- it's 20 percent of 2000 IBIT, 51 percent of Nl pretex, 33 percent of Ni after tax. 3. Credit reviews the underlying capitalization of Raptor, reviews the contingent shares and deter- mines whether the Raptor entities will have enough capital to pay Enron its $500 million when the equity derivatives expire. 4. The Raptor entities are technically bankrupt; the value of the contingent Enron shares equals or is just below the PRM account payable that Raptor owes Enron. Raptor's inception-to-date income statement is a $500 million loss. 5. Where are the equity and debt investors that lost out? LJM is whole on a cash-on-cash basis. Where did the $500 million in value come from? It can from Enron shares. Why haven't we booked the transaction as $500 million in a promise of shares to the Raptor entity and $500 million of value in our "economic interests in these entities? Then we would have a write-down of our value in the Raptor entities. We have not booked the latter because we do not have to yet. Technically we can wait and face the music in 2002-2004 6. The related party footnote tries to explain these transactions. Don't you think that several interested companies, be they stock analysts, journalists, hedge fund managers, etc., are busy trying to dis. cover the reason Skilling left? Don't you think their smartest people are poring over that footnote disclo- sure right now? I can just hear the discussions- looks like they booked a $500 million gain from this related party company and I think, from all the unde- cipherable half-page on Enron's contingent contribu- tions to this related party entity, I think the related party entity is capitalized with Enron stock." ... "No, no, no, you must have it all wrong. it can't be that, that's just too bad, too fraudulent, surely AA & Co. wouldn't let them get away with that?" "Go back to the drawing board, it's got to be something else. But find it!" ... "Hey, just in case you might be right, try and find some insiders or 'redeployed former employees to validate your theory." SOURCE: https://www.justice gov/archive/enron/exhibit03-15 BBC-0001/Images/9811.001.PDF, accessed June 1, 2004. This letter, together with whistle-blowing acts by Review of the Learning lleen Rowley of the FBI and Cynthia Cooper of Zrld Com, resulted in the three of them being Objectives med Time magazine's 2002 "Persons of the Year." Understand how symptoms help in the detection Time magazine stated, "These three did the right of fraud. When unusual symptoms of fraud ng by just doing their jobs rightly." become apparent, a more focused, directed search of where the fraud is originating from sho Remember this ... conducted. Employees other than auditors (such as co-workers or Identify and understand acco managers are thithe