A friend did much of the legwork on this article. Investors lured by Enron's promises --------------------
Documents show partners enticed by insider profits By Robert Manor, Tribune staff reporter. Tribune staff reporters Laurie Cohen and Flynn McRoberts contributed to this report March 3, 2002 A select group of blue-chip investors was offered big profits based on insider dealing at one of the Enron Corp. partnerships that later brought down the Houston energy company, internal documents show. The investors, the records show, were told that their investments would benefit from a top Enron executive's dual role working for the partnership. The investors, according to partnership-offering documents, would have exclusive opportunities to profit from Enron-oriented investments not available to the public. Among the billion-dollar institutions that bought the sales pitch were Chicago's John D. and Catherine T. MacArthur Foundation, the New York investment bank Merrill Lynch and financial giant J.P. Morgan Chase & Co. When Enron chief financial officer Andrew Fastow set up the partnership in late 1999, he talked of profits as high as 5,048 percent. Fastow promised investors that he could use his position at Enron to deliver a stream of moneymaking deals. Fastow disclosed far more financial information about Enron to would-be partners than he did to Enron's shareholders. And for institutional investors he could not entice with astronomical returns, Fastow talked tough, documents and former Enron insiders say, sometimes warning that Wall Street securities firms would lose the chance to do business with Enron unless they joined his partnership. The partnership raises serious questions about conflicts of interest by corporate executives and their legal responsibility to keep all investors equally informed about business matters, experts say. The partnership, named LJM2 after the initials of Fastow's wife and two young children, offered a peculiar asset. Fastow made clear that as the manager of the partnership, and with the help of another Enron executive, he would use his position at Enron to deliver business deals developed by Enron. "Investors in the partnership should benefit from Mr. Fastow's and the other principal's dual roles, which will facilitate the partnership's access to Enron deal flow," the LJM2 sales pitch reads. The partnership warned investors that if Fastow lost his job at Enron, the deals would stop. Enron used dubious investments in its dealings with LJM2 to conceal debt and falsely book earnings. When the scheme was disclosed late last year, Enron admitted it had earned almost nothing over the previous two years. That set off a cascade of events culminating in Enron's bankruptcy. The plan to profit on Fastow's conflict of interest is a bizarre business proposal, according to lawyers and industry observers. "You think `Oh, my God, how are they going to make this work?'" said Randal Picker, a professor at the University of Chicago Law School. "It makes your eyes bug out." Picker said it is almost impossible to fairly serve two employers, as Fastow and another Enron executive in the partnership, Michael Kopper, proposed to do. And he said it is truly rare for an employer to permit such an arrangement. No red flags raised But the deal was put together by some of the best known names in finance and law. Enron approved of Fastow's conflict of interest. Chicago-based Kirkland & Ellis provided legal counsel to the partnership. Merrill Lynch recruited investors. KPMG handled the auditing. And the chance to do business with Enron lured $386 million from some of the world's most sophisticated investors--J.P. Morgan, GE Capital, Credit Suisse First Boston, Aon and others. Among the investors was the MacArthur Foundation. Ray Boyer, spokesman for the foundation, said it had committed up to $15 million in March 2000 and has invested about $9.4 million. "At the time, Enron was one of the most innovative companies in the world, with a ton of experience in energy investments. It appeared to be a very good investment," Boyer said. Enron's excellent credit rating, seemingly substantial risk-management business and extensive pipeline operations all made LJM2 appealing, he said. Fastow's promise to funnel insider deals to his partners caused no concern. "Certainly we knew the relationship of Enron with the partnership, and at the time we were comfortable it was an acceptable way of setting up the arrangement for that partnership," Boyer said. Boyer said that while it seemed appropriate to invest in LJM2 in the past, it doesn't now. "Given what we know today about the manner in which Enron conducted business, we wouldn't have made the investment," he said. The foundation was unaware that Enron allegedly would use LJM2 to artificially inflate profits and conceal debt, Boyer said. He declined to comment on how the investment has fared, citing partnership confidentiality agreements. He did say that "we haven't got back as much money as we put into it." It is unclear whether, on balance, the partners have lost or made money on LJM2. At times LJM2's assets included large holdings of Enron stock, which are nearly worthless. The MacArthur foundation at least had a choice in its decision to invest in LJM2. Some other investors say they did not. Pressure tactics A source familiar with J.P. Morgan Chase said Fastow demanded the firm invest in the partnership, baldly saying Enron would take its financial business elsewhere if the investment house refused. "Certainly, Fastow was heavy-handed," the source said. "Some of the people who worked closely with him felt that he was being obnoxious about it." Through a spokesman, Fastow declined to comment for this article. When called to testify before a congressional committee, Fastow invoked his 5th Amendment right to remain silent. J.P. Morgan and Chase separately invested a total of $10 million in the partnership shortly before they merged, a spokesperson said. That is a tiny sum for a huge investment firm, and a signal the companies were not enthusiastic about the partnership, some observers suggest. Merrill Lynch recruited partners for LJM2, invested $5 million of its own funds and allowed about 100 of its employees to invest a total of $16 million. Merrill Lynch denies doing anything wrong. "Coinvestment by Merrill Lynch and some of our qualified employees is common in these kinds of placements and does not represent a conflict of interest," said spokesman Bill Halldin. Not everyone thought Fastow's proposal made good business sense, however. The California Public Employees' Retirement System, the huge California pension plan, was offered the chance to invest. "We declined it because of the conflict of interest," said Pat Macht, spokeswoman for Calpers. "In a meeting, Andy Fastow disclosed he was going to be a general partner" in LJM2, Macht said. "He explained it was approved by Enron management. "We didn't like the fact that the general partner, Andy Fastow, would remain as CFO at Enron. We thought he should have picked one or the other." The partnership's law firm, Kirkland & Ellis, declined to discuss specifics of LJM2, saying the partnership had instructed it to say nothing. "We are confident that as additional facts are made public, it will become clear that Kirkland & Ellis acted properly," said Laurence A. Urgenson, a lawyer speaking on behalf of the firm. KPMG, the partnership's auditor, also denied involvement in any wrongdoing. Withholding information But something was seriously wrong with the partnership, experts say, because its members knew more about Enron's financial status than the company's shareholders did. For example, the partners were told that in 1999, Enron had $34 billion in assets on its balance sheet and $17 billion more in off-balance sheet assets, mostly in partnerships and joint ventures. "That's enormously valuable information to investors," said Robert McCullough, head of McCullough Research. He said that while the partners knew of the off-balance assets, the shareholders did not because Enron's financial statements were incomplete. McCullough said the off-balance assets raise the possibility of off-balance debt, but shareholders would not know of it. "Any analyst looking at this would conclude that we have a set of liabilities heavily skewed towards debt," McCullough said. "As we now know, they are almost 100 percent debt." Joel Seligman, a securities law historian and dean of the Washington University Law School in St. Louis, said he's "deeply troubled" by the fact that LJM2 investors were told more about Enron's finances than the company's shareholders. "If it's the case that documents were circulated to 50 or so potential investors which had materially different numbers than those being disclosed to the public, then that is extraordinarily serious," Seligman said. "It suggests they created a dual-book system, the likes of which I can't recall having seen in any honest securities offering in my lifetime." Under federal securities laws, shareholders and the general public are entitled to full disclosure, Seligman said. Companies must give the same information to all investors. Seligman said failure to disclose material information--information that meaningfully affects a company--would violate antifraud provisions of the nation's securities law. Then there were the deals LJM2 did with Enron. From an economic standpoint, they appeared to make no sense whatsoever, observers say. In December 1999, for example, LJM2 paid Enron $30 million to buy the Nowa Sarzyna power plant under construction in Poland, according to a report to the Enron board of directors. Enron recorded a gain of $16 million on the sale. But the plant malfunctioned during testing, and when LJM2 tried to sell it, no buyer could be found. Still, in March 2000, Enron bought Nowa Sarzyna back from LJM2 for $31.6 million. While the transaction enriched LJM2 and allowed Enron to report a fictitious gain of $16 million, in reality it cost Enron at least $1.6 million to carry out. In a series of other transactions, Enron used several partnerships called Raptors, set up with LJM2 to protect the value of its many stock holdings. Enron gave shares of its stock to the Raptors, which were to use the stock to compensate Enron if the value of its investments declined. What Enron was attempting to do is called a hedge. But a hedge is possible only between two independent parties. In this case, Enron was trying to hedge using its own stock, which is impossible, observers say. When both the Enron stock and the company's stock investments fell in value, the mock hedge collapsed, creating a $710 million loss for the company. But LJM2 appears to have escaped harm when Raptors deals disintegrated. It typically took at least $11 million from each of several Raptors partnerships soon after they were set up. "These terms were remarkably favorable to LJM2 and served no apparent business purpose for Enron," a report to the Enron board says. Can't-lose deals It is possible LJM2 simply could not lose money in any deal it did with Enron. The report to the board noted "the LJM partnerships made a profit on every transaction, even when the asset it had purchased appears to have declined in market value." "We have identified some evidence that, in three of these transactions where Enron ultimately bought back LJM's interest, Enron had agreed in advance to protect the LJM partnerships against loss," the report says. It is unclear how much Fastow earned through the partnership deals or how much Kopper paid him to become general partner last year. Documents indicate that as recently as Jan. 2, Kopper withdrew $3.8 million from LJM2 as part of his management fee, paid twice yearly. The Enron board's report says Kopper earned $10 million and Fastow earned $30 million from partnerships, including income from earlier partnerships. McCullough, the energy analyst, said the conflict of interest surrounding LJM2, especially Enron's willingness to disclose vital information only to big investors and the huge profits it seemingly guaranteed them, created a unique situation. "After many years of experience in the electricity business, I have never seen anything like it," he said. -- Michael Perelman Economics Department California State University [EMAIL PROTECTED] Chico, CA 95929 530-898-5321 fax 530-898-5901
