Case 7
New Counsel for Andy Fastow
My God, this place is a shambles. What have I gotten myself into here?
NOTHING IN HIS PREVIOUS LIFE HAD PREPARED JORDAN MINTZ for what he found in his first week at Global Finance. Mintz had been at Enron for four years. He was a lawyer in the Tax Department. Then, in October 2000, Andy Fastow summoned him and asked him to become general counsel for Global Finance. The opportunity to move from tax to general corporate and securities law was enticing. Global Finance was controversial but was also known as a “creative shop.” In fact, Global Finance was now one of the “places to be” at Enron. Andy Fastow had become Enron’s chief financial officer in 1998. He immediately set about making Global Finance a major player within the organization. Fastow ran a secretive shop; it was known mostly for fiendishly complex financial transactions that seemed to coincide with Enron’s hitting its quarterly earnings guidance to Wall Street analysts. For this, Fastow and Global Finance had been rewarded with handsome compensation and powerful influence with Jeff Skilling, Enron’s COO.
Mintz accepted Fastow’s offer and reported for work late in 2000. One of the first things he found in his Global Finance files concerned a deal between Enron and a special-purpose company called LJM.
Mintz had known something about LJM before he transferred offices. He knew that it was a special-purpose vehicle set up to purchase assets from Enron. He had heard that LJM was one of the ways Enron pursued its asset-light business strategy and that Andy Fastow was the creative force behind the vehicle. There had also been more disturbing rumors. One hinted that Andy Fastow was part owner of LJM and was thus engaging in a blatant conflict of interest. However, Mintz had also heard that Fastow had reviewed LJM with the Enron board. In all likelihood, whatever relationship Fastow had with LJM had been vetted and approved.
As part of learning his new job, Mintz sought more information about LJM. He came across a Global Finance draft memo that contained considerable background on the origins, purpose, and structure of LJM1 (Attachment 1). The memo was also of interest because it was addressed to the board and sought to justify a Fastow exemption from the Enron Ethics Policy.
In reviewing the draft memo, Mintz noticed a number of disturbing points. First, the paper was crafted in such a way as to make Fastow’s exception request seem a sacrifice for the benefit of Enron. Yet Fastow would not only profit from the transaction but also make the most money if the option proved worthless to Enron. Moreover, the Enron shareholders seemed to be taking most of the risk. Should the option be “put” and LJM1 forced to absorb a loss, the partnership would have to sell off Enron shares to cover the deficit. Doing some quick sums in his head, Mintz estimated that at the current stock price, the 3.4 million shares Enron contributed were worth about $276 million. After deducting the $64 million in notes given back to Enron, LJM1’s net capital would consist of $212 million in Enron stock and $16 million in cash. Enron stock thus constituted about 93 percent of LJM1’s net worth and would fund essentially that percentage of any partnership loss. Enron’s stockholders would feel any partnership loss directly via dilution effects, i.e., an increase in the total number of shares outstanding and trading, if LJM1 ended up having to sell shares.
Mintz also noticed a scarcity of details in the memo regarding the LJM partners’ compensation. Clearly, Andy Fastow, in addition to receiving one-half million dollars in management fees, was to benefit along with the limited partners, but what was the “high return” that partners would earn if the option was never exercised? Were there any special partnership provisions that shifted even more of the risk to the Enron partner and away from Fastow and the private investors? Indeed, how substantive would the proposed transaction appear if all the facts were known?
So, Jordan Mintz had more than a few questions about LJM1. However, the file contained little in the way of further details. Normally, a transaction of this size and complexity would be evaluated by Rick Buy’s Risk Assessment and Control (RAC) department. However, no RAC assessment resided in the file. Mintz had heard that RAC had brought in Vince Kaminski to do an assessment of LJM1. However, Kaminski and his research group had shortly thereafter been transferred to Enron North America, where it reported to the VP of Trading, Greg Whalley. Whatever analysis Kaminski had provided was no longer available. There also was nothing in the way of analysis or opinion from Enron’s auditor, Arthur Andersen (AA). What the file did contain was a memo from Enron’s board secretary, documenting that on June 28, 1999, the directors reviewed and approved Fastow’s request for an exception to the corporate Ethics Policy. Additional papers confirmed that the Enron-LJM1 transaction closed on June 30. So, it was a done deal approved at the highest level. Mintz put the file in his drawer and turned to other matters.
Over the subsequent weeks, more disturbing questions surfaced for Mintz regarding Global Finance in general and LJM in particular. Other LJM-Enron deals had followed the swap transaction. Uniformly, they were poorly documented. Files were unorganized, and key documents were missing. Approval forms were lacking required signatures. Corporate separateness was not being respected; indeed, LJM people and Enron employees were working side by side without evidencing particular care or scruples about who was doing what. The cumulative effect added up to an extremely negative message. Either Global Finance was hugely disorganized as regards its many, highly complex, transactions and/or it had an interest in hiding matters pertaining to LJM.
Mintz decided to find out which was the case. He resolved to begin by testing Fastow directly. On January 16, 2001, Mintz met with Fastow and mentioned his concerns. Year-end Enron financials would soon be prepared. Mintz told Fastow that in his view, Enron should disclose more details about the LJM transactions and in particular report how much money Fastow was making from LJM. Fastow disputed the point. Instead, he asserted, Enron should use the same argument that had been applied to its 1999 financial filings, namely, that a sufficient number of transactions were still open that it wasn’t practical to estimate Fastow’s remuneration. After then commenting that he probably shouldn’t discuss his compensation before talking to his lawyer at Kirkland & Ellis, Fastow told Mintz:
“Let’s figure out a way not to disclose it. Hell, if Skilling knew how much I made, he’d have no choice but to shut LJM down.”1
Jordan Mintz had his answer. Global Finance was hiding things. Put together with the documentation and approval shambles, this amounted to a monumental set of risks for Enron. Should an investigation ever uncover these facts, SEC and shareholder suits were a likelihood, if not a certainty.
The damage might not stop there. Things could get personal in a hurry. If Mintz was convinced that Fastow’s compensation needed to be disclosed but then acquiesced when Enron published year-2000 accounts, was Mintz himself liable for abetting an accounting fraud? Where did Mintz’s responsibilities to his client, Enron, stop and his responsibilities to the law start? Even if Mintz convinced himself that he was making the correct decision about his responsibilities as an Enron attorney, would the SEC, in the cold light of day, see it the same way? Mintz became deeply concerned and a bit panicked.
Determining a Course of Action
What to do? It occurred to Mintz that his immediate problem was internal to Enron. Matters involving the SEC would come to a head only if he failed to persuade Enron to disclose Fastow’s compensation. Therefore, Mintz must remain focused on persuading Enron to discover Fastow’s compensation and make the appropriate disclosures.
Mintz closed the door of his office one evening at 6.00 pm, turned out the lights, and sat in the dying light, pad and pencil in hand. Sipping on a Diet Coke, he began to list the practical options available for action. The immediate objectives were twofold: (1) prevent Enron from incurring new legal violations while limiting the damage of those that might already have occurred, and (2) make sure that Jordan Mintz was himself not complicit in any legal violations. To pursue these objectives, Mintz would have to chart a course up the Enron management chain, escalating matters if initial reviews failed to produce results.
Mintz quickly determined that he first needed to decide what objection to raise to galvanize concern at high levels in Enron. Where should he start the discussion if the objective was to end up addressing the disclosure of Fastow’s compensation?
There were several candidates:
- Internal procedure and documentation. Necessary signatures and documents were not in condition to withstand audit or a serious investigation.
- Failure to disclose material facts to the Board. By failing to disclose the extent of his compensation relative to his capital at risk or to lay out clearly the economic consequences for shareholders if the option were exercised, Fastow failed to provide the board with a reasonable basis for deciding on the exemption request.
- Failure to conduct risk analysis and advise on the consequences of a downside case. By not being provided with a RAC analysis or audit report, management lacked the basis for assessing the consequences of adverse developments affecting LJM. Thus, management lacked a basis for deciding whether to continue doing business with LJM.
- The absence of controls and monitoring of Andy Fastow’s ethics exception. Global Finance had failed to propose means by which Fastow’s conflict of interest would be monitored and reported on to the Board.
- The failure to provide adequate disclosure about LJM in Enron’s public filings. A detailed outline of the parties to and the substance of the transactions should be provided to evidence that Enron’s management and board had carried out their fiduciary duties, that no “sweetheart deal” existed, that transactions were substantive, and that the compensation paid to LJM’s investors, including Andy Fastow, was appropriate.
Next, Mintz considered whom to approach with his chosen concern(s). There were several possibilities:
- Andy Fastow, his boss
- Rick Buy, chief risk officer
- Rich Causey, chief accounting officer
- Jeff Skilling, COO and Fastow’s boss
- Kenneth Lay, Enron chairman
- Greg Whalley, head of trading
- • Arthur Andersen (relationship manager David Duncan), Enron’s auditor
- Someone on the Enron board, perhaps the audit committee chairman, Janiche
- Jim Derrick, Enron’s chief legal counsel.
Mintz also had to consider the potential consequences for him personally. He could not know in advance the reaction of the person to whom he would first voice his misgivings. It was likely that he could expect resistance. How hard was he prepared to press his case? That would certainly be influenced by what consequences Mintz was prepared to accept. If he chose to go above his boss’s head, Mintz knew that Andy Fastow would react angrily. Fastow had gotten his previous counsel and an earlier treasurer reassigned for lesser offenses. Potentially, Mintz was risking transfer, demotion, and possible termination.
So, Jordan listed his potential personal end-game options. He could:
- Threaten to resign and be prepared to follow through.
- Ask for a transfer back to Tax.
- Back off and look for further opportunities to press the issue.
- Document fully that he had raised all matters with appropriate superiors, create secure files with backups, and be prepared to produce them if trouble arose down the road.
The tactical choices were obviously many and complicated. Mintz organized them into rough matrices and jotted down some pros/cons. Next, he converted the matrices to Word documents (Attachments 2 and 3), secured them into an encrypted file, shut down his computer, and went home for the weekend to mull over the options.
Attachment 1—Historical Recreation (HRC)
DRAFT MEMORANDUM
| To: | The Board of Directors |
| From: | Andrew Fastow |
| Subject: | Special Exemption from Ethics Policy |
This memo is intended to request a special exemption from the Enron Corporate Ethics Policy to allow the author, Andrew Fastow, to participate as general manager and minority owner of a private-equity fund, LJM. By granting this exemption, the Board will enable LJM to complete its organization, fund-raising, and the actions necessary for it to enter into a derivatives transaction with Enron that is decidedly in Enron’s interest. This transaction must be completed during the second quarter if it is to meet Enron’s objectives. Therefore, an immediate decision of the board is requested.
The transaction in question will allow Enron to hedge a large gain that has accrued on an investment made during the last year. In March 1998, Enron Broadband made a $10 million investment in a high-speed Internet start-up, Rhythms NetConnections (RNC). This investment was one element of the implementation of Broadband’s strategy: that of identifying and investing in emerging technologies in the broadband sector. RNC has since gone public and the stock has appreciated dramatically (last close at $69/share). Enron’s original $10 million investment is now worth upward of $300 million.
Management has reviewed RNC’s business plan and outlook. Although the future for the company remains bright, Enron has already captured all the technology and know-how that it is entitled to receive from RNC. In addition, Global Finance’s valuation indicates that RNC’s stock is now trading at a substantial premium to long-term fundamental valuation. Not only is there little further technology upside for Enron should it retain its RNC shares, but it is also more likely than not that the current investment valuation may erode, perhaps substantially. Therefore, Global Finance has recommended and management has endorsed a course of Enron’s divesting its position in RNC as soon as practicable.
When it made its pre-IPO investment in RNC, Enron agreed to a “lockup” provision. This lockup expires in November of this year. Enron therefore remains exposed to the erosion of its investment’s value until that time. Management believes that the prudent course would be to hedge the value of RNC shares with a derivative security for the period June to expiry of the lockup in November.
Normally this would be accomplished by Enron’s purchasing a “put” option on RNC’s shares. However, technical factors make this impossible. Enron owns approximately 50 percent of all RNC shares that trade. Trading volume in the stock is very thin. This condition is not atypical for start-up companies. Unfortunately, the combination of thin trading volume and the large size of Enron’s block of shares renders it virtually impossible to find counterparties willing to sell a RNC “put” option. Global Finance is thus of the view that no market hedge option is available to Enron.
RNC’s illiquid trading also implies that Enron is exposed to dramatic price declines at any time. Therefore, time is of the essence as regards development of an alternative hedging strategy. Accordingly, Global Finance has developed a near-term hedging alternative that involves the immediate raising of funds from outside investors.
Under this strategy, a private-equity fund, LJM1 will be formed. Third-party investors contacted personally by me are prepared to contribute $15 million to the fund. However, they will invest only if I am both general partner and an investor. Therefore, I have agreed in principle to serve and to invest $1 million of my personal funds. Enron must also invest in the fund to ensure that it is adequately capitalized to bear the risks of the hedge transaction. However, it may do so by contributing stock, a total of 3.4 million shares. LJM1 will then use a portion of the cash and stock to form a subsidiary (Swap Sub) for purposes of providing Enron with the RNC hedge it seeks.
Once LJM1 and Swap Sub are formed and capitalized, Enron will receive the following:
- A “put” option on its entire position in RNC stock at a strike price of $56 per share
- $64 million in LJM1 notes
Essentially, this transaction provides Enron with the hedge it seeks at no cost to the company. If RNC stock never falls below the $56 strike price, the option will expire, and Enron may sell its stock in the market at a higher price. Should RNC shares decline below $56 per share, Enron may “put” its entire block of shares to LJM1 Swap Sub and realize $56 per share. Should the “put” option be triggered, Swap Sub will use its cash and/or the sale of Enron stock to cover its losses when it disposes of any “put” RNC stock in the open market. Enron has no obligation to contribute cash to cover any LJM losses. Once the RNC shares are disposed of in the market, either by Enron directly or by Swap Sub, the fund will liquidate itself at an appropriate time and deliver all proceeds to the respective partners.
In this fashion, Enron is hedged on some 80 percent of its RNC gain. It also benefits from being able to recognize the receipt of LJM1 notes as operating cash flow in this reporting quarter.
As regards LJM1, the general partner (GP) will receive a $500,000 annual management fee. In addition, the GP and the limited partners will each earn fees and/or premium on their risked capital in the event the “put” option is never exercised. Should the option be exercised, the partners’ return will depend on the relationship between the strike price and the market price at which LJM1 disposes of the RNC shares. It is possible that the partners may lose a material portion or even all of their risked capital; it is to compensate for this risk that the partners’ return is high in the scenario in which the option is never exercised by Enron. The accounting firm of PricewaterhouseCoopers will be issuing a fairness opinion confirming that the transaction as described is fair to Enron.
For this transaction to be put in place promptly, it is necessary to work with the external investors who have indicated a willingness to commit sizable cash funds. Their participation is essential to establish LJM1 as a legitimate external counterparty for Enron and to secure hedge accounting treatment. These investors have made it clear that they desire that I be involved in the fund in the manner noted. This involvement will also be in Enron’s interest, as it will enable the transaction to be concluded in a timely manner and will provide Enron with more control over its subsequent operations.
Under normal circumstances, an Enron officer who was also a principal of another party transacting with Enron would be engaged in a conflict of interest prohibited by our Ethics policy. Under the special circumstances described, management has deemed it appropriate to disclose the facts and circumstances to the board and request that an exception to the Ethics Policy be granted. Such exceptions may be granted by the CEO when they do not adversely affect the best interests of the company. In this instance, both CEO Ken Lay and COO Jeff Skilling have reviewed and endorsed the granting of such an exception. However, the matter was felt to be of sufficient importance that it was deemed appropriate to inform the board and seek its endorsement as well.
Accordingly, an exception to the Enron Corporate Ethics Policy is requested to allow Andrew Fastow to engage in the aforementioned transaction in the manner as described.
Chief Financial Officer
Global Finance
Attachment 2—Historical Recreation (HRC)
| Potential objections to raise | Pros/Cons |
| Internal procedure and documentation | Pros: Proper concern for legal counsel; Low-key way to highlight bigger issues |
| Cons: Lacks impact; could be remedied w/o addressing bigger issue | |
| Risk analysis and sensitivities | Pros: Highlights legitimate issue; new information would come out; can be used to spotlight other issues; lower risk personally |
| Cons: Assumes that management wants to know; not analysis a legal counsel would do; management can say “thanks” and move on | |
| No controls/monitoring of Fastow ethics exception | Pros: Valid issue; appropriate for legal counsel; correction could, in turn, identify other issues that might lead to general reform; technical/procedural objection lowers personal risk |
| Cons: Impact issue? Board’s responsibility; puts Board in bad light; management may use “protecting” the Board as reason for no action; or could adopt control procedure w/o teeth | |
| Inadequate disclosure in Enron Public filings | Pros: Impact issue; appropriate for legal counsel; leaves “tracks” for external regulatory body; provides management with new facts to act against Fastow and “excuse” for prior approvals |
| Cons: Assumes management wants to know; Fastow will say it invites an investigation and law suits; high personal risk; be prepared to resign or be fired if push it | |
| Full disclosure to the Board | Pros: Way to reopen big issues at highest level; Gives Board new facts to prompt fuller review/basis for reversing earlier decision |
| Cons: How to get to the Board? If bypassed, management will object and work to block/discredit the move; high risk personally; expect to be fired |
Attachment 3—Historical Recreation (HRC)
| Potential objection to raise | Target contact | Approach |
| Internal procedure and documentation | Andy Fastow first, then Chief Legal Counsel Derrick | Cleanup needed or we’ll get into trouble; if no response, transfer back to Tax |
| Risk analysis & sensitivities | Andy Fastow and Trading VP Whalley then COO Skilling | First meeting is analytical, i.e., what if “this” happened? With Skilling, tie into housekeeping first, and personal disclosure risks for him; could become high risk if pushed, so consider job alternatives after first conversation |
| No controls/monitoring of Fastow ethics exception | COO Skilling, then Chairman Ken Lay; test Counsel Derrick’s appetite first | Management should do itself and board a favor and ensure that controls process exists; make it a “process” issue but hint that management will want a rigorous process and want to use it going forward to protect itself; if no appetite, document and request transfer back to Tax |
| Inadequate disclosure in Enron public filings | Andy Fastow first, then Causey/Buy, then Skilling, then Lay; worst case: consider leaking outside | Progressive escalation on grounds legal risks are too great; focus disclosure on Fastow’s compensation, which he is keen to hide; if Derrick and Skilling don’t support, prepare for resignation scenario |
| Full disclosure to the Board | CEO Skilling first, Audit Committee chair | Andy withheld key information; board then should request further data and reconsider; start looking for new job now and be prepared to resign |
Author’s Note
Jordan Mintz’s dilemma involves the challenges of going up the Enron management chain with a complaint. Enron’s legal and accounting gatekeepers have already signed off on the LJM transaction Mintz finds questionable. There is no internal financial-control organization to which he can appeal with much expectation of success. Thus, Mintz is left with the internal option of escalating to senior management.
At the end of the case, Mintz has not yet decided where to take his message. Mintz’s situation also differs from others in that Mintz is an attorney. This gives him certain knowledge about the public company legal framework surrounding Enron; it also makes him aware of the personal risks if he ends up complicit in a securities law violation. Finally, it affords him tactical options not available to non-attorneys. Students must consider his options and craft the best tactical plan for doing so.
Key facts in this case draw on the Conspiracy of Fools account of Mintz’s campaign to force Fastow’s LJM compensation out into the open. This account is consistent with that provided in The Smartest Guys in the Room but provides more details about Mintz’s reactions to LJM, his conversations with Fastow, and his subsequent efforts to force disclosure. The account of what Mintz originally discovered in the LJM files is consistent with the published reports of incomplete documentation but is not intended to be historically accurate about the specific documents missing or found. The account of Mintz’s January 16, 2001, conversation with Fastow is found in Conspiracy of Fools (pp. 412–413). The reference to Kirkland & Ellis appears in The Smartest Guys in the Room (p. 328). This case has also been read by Jordan Mintz for accuracy as regards the key historical events.
In fact, Mintz did not create planning lists like those outlined in Attachments 2 and 3. These are historical recreations designed to focus attention on Mintz’s tactical choices. Mintz advises that he did go through a process of considering many of these same points; however, it took place over time and in pieces as opposed to being focused into a single planning document.
Attachment 1 also is a historical recreation (HRC). It is designed to depict the type of restricted disclosure Fastow provided to the board in his PowerPoint presentation requesting the Conflict of Interest waiver. It is important to acknowledge and recognize that this Attachment is not a historical document from the Enron archives. For that reason, it is crafted as a DRAFT, i.e., something like a first attempt at a board communication that Mintz might have found in the files on moving into Global Finance. The real purposes of including this attachment are twofold. First, it provides a succinct summary of the LJM1 transaction. Second, it displays the type of care Fastow did take in communicating with the board. It is carefully economical with the truth. It serves up those facts that display the transaction to best advantage, avoiding or de-emphasizing others that might have been “red flags” to board members, such as any sort of numerical projection of compensation for the LJM partners if the “put” was never triggered.
Although this document is a creation, it does accurately reflect the public accounts of the LJM 1 transaction and the rationales Fastow provided to the board, including the assertion that the outside investors wanted him to be the general partner for the deal. Conspiracy of Fools contains a detailed account (p. 244–45) of the June 18, 1999, meeting at which Lay and Skilling gave Fastow their consent to take LJM1 to the Enron board. According to this account, Fastow told Lay that he would be LJM’s general partner in order to give Enron more control over it and that his investing in LJM would be the best way to get the deal done quickly and was the right thing for Enron. Fastow also asserted that Enron would continue to be a far more important source of income for him.
The Smartest Guys in the Room details Fastow’s presentation to the Enron Board on June 28. According to this account, Fastow “spun” his proposed activity as follows: “… his personal involvement in the new partnership was an act of altruism, an unfortunate but necessary ingredient to attract outside investors to LJM and essential to Enron’s goal of hedging the Rhythms investment.”2
In Conspiracy of Fools’ account of the Board review, Fastow is quoted as saying: “I do have serious concerns about me being general partner. But if the board and the company want me to do this, I’ll be happy to do it.”3
Attachment 1 thus attempts to capture Fastow’s “spin,” namely, that he didn’t really want to be LJM’s general partner but that it was necessary for various reasons—outside investor demands, time pressure, Enron control—in a document that also explains the workings of the Rhythms NetConnections hedge.
This case contains one other element touched on in other cases but never systematically developed. This element concerns the possible implications of resistance for Mintz’s career. These risks Mintz enumerates near the end of the case narrative. Students should incorporate plans to mitigate Mintz’s career risks into their final tactical plan.