The Enron Companywide Risk Management Report

Kaminski’s team leaders, Kevin Kindall and Li Sun, handed around their report. It laid out in cold, hard facts that Enron was flirting with disaster. Enron’s year-2000 financial statements were telling investors and rating agencies that the company’s non-trade debts totaled some $10 billion. (Attachment 1 summarizes Enron’s 2000 balance sheet and provides a sample of Enron’s disclosure about its related-party transactions.) Kaminski’s team did not yet have all the information to compute the real figure, but what it had discovered suggested that Enron owed a much higher amount.

Getting to a comprehensive measure of Enron’s risk required both detective work and financial know-how. For example, Enron Global Finance made profligate use of corporate guarantees. Kaminski’s team had tracked down 2,700 such guarantees and had no confidence that they all had been found. Global Finance kept no central record of guarantees. Arriving at a companywide risk assessment required that such guarantees not only be tabulated but also quantified as “debt equivalents.”

A similar situation existed regarding Enron’s huge, ever-changing derivatives positions. Trading was the beating heart of Enron; the firm constantly bought and sold gas, electricity, and other commodities on a forward basis and then bought and sold futures and options to hedge these positions or profit from spreads. All these positions might then be traded, using other derivative products and creating new ones. At any given point, the result for Enron might be a huge net obligation to deliver physical goods or their financial equivalent to third parties. These liabilities were volatile and could add massively to the trading obligations that the company did acknowledge on its year-end balance sheet.

Most disturbing of all was Enron’s connections to the off-balance sheet Special Purpose Entities (SPEs) concocted by Enron Global Finance. These entities warehoused huge amounts of suspect merchant assets and associated debts. Global Finance deliberately designed the SPEs to avoid their inclusion in Enron’s consolidated financial reports. Yet many deals contained provisions that required Enron to support the SPEs should adverse events materialize. Kaminski thought these “contingent obligations” to be especially dangerous, as they would likely be activated only when Enron’s financial condition was already deteriorating.

One exceptional example of Enron’s connections with the SPEs was the “Total Return Swap” (TRS). Global Finance used this arrangement to provide guaranteed returns to independent SPE investors while drawing the economic risks of “sold assets” back into Enron. The company had encountered resistance from investors to whom Enron wanted to divest troubled assets; this was especially so when Enron, up against a financial reporting deadline, sought to sell assets for a certain price to book needed profits or to avoid losses. So, Enron had turned to the related-party SPEs put together by Enron CFO Andy Fastow. These vehicles provided the appearance of independent equity willing to pay asset prices consistent with Enron’s accounting targets. The quid pro quo for the SPE’s owners, however, was a high and almost riskless financial return. Enron would use the TRS tool to provide that return without disturbing the accounting result it sought to achieve.

Total Return Swaps worked as follows. Enron might sell merchant assets and associated liabilities to an SPE. Normally, such an asset sale would transfer full upside and downside economic risk to the SPE buyer. Under the TRS, however, Enron and the SPE would swap returns. Enron would contract with the SPE to receive the more risky and volatile return on the merchant assets. In return, Enron would agree to pay the SPE a specified formula return, such as London Interbank Offer Rate (LIBOR) + 3%. This return would be calibrated at a sufficient spread over the SPE’s own debt costs such that it generated a high return on the vehicle’s small equity capital.

The result of the TRS was to reverse the normal effects of an asset sale. Enron effectively took back all economic upside potential and downside risk associated with the underlying assets. It simultaneously paid the SPEs investors a high return on their small capital at risk. This effectively amounted to paying a service fee to the SPE for its helping to produce needed accounting results. Enron’s own board minutes acknowledged this relationship by noting that these SPEs “did not transfer economic risk” but served to hedge “accounting volatility.”¹ Attachment 2 illustrates the structure of a TRS.

Even more frightening to Kaminski and his team was the embedding of trigger events into these SPE deals. Triggers had come into widespread use during the 1990s as a financial engineering tool. Typically, they were used by lenders when a financially stronger parent wanted lenders to fund a weaker subsidiary without receiving a parent guarantee. In such circumstances, lenders might demand the comfort of a covenant specifying that the parent must inject certain funds into the subsidiary if some trigger event occurred. Usually, the trigger events occurred when: (1) the parent’s debt rating was downgraded or (2) the parent’s stock price fell below a threshold price. The intended effect of the trigger was to assure lenders that their SPE borrower would immediately be strengthened before other calls on the now weaker parent came into play. In agreeing to deals with triggers, Enron remained obligated to support supposedly “independent” parties if/when specified adverse circumstances materialized.

Enron Global Finance used this technique to persuade independent investors to enter into transactions that otherwise involved unacceptable prices or risks. One example of how Enron used triggers was the Whitewing transaction. There Enron induced Citibank to lend $500 million on a non-guaranteed basis to the Whitewing SPE. Whitewing used this money to purchase an Enron preferred stock that was also convertible into Enron common stock. Whitewing’s source of cash flow to pay loan interest would be the preferred stock dividends from Enron.

Citibank, however, had a reasonable concern: How was Whitewing to repay loan principal? Ultimately, the vehicle’s ability to do so would depend upon converting the preferred stock itself into cash. However, no ready market existed for what was, in effect, a privately placed preferred. Hence, the preferred stock had been made convertible to Enron common stock, for which there was a ready market. So far, so good, but Citibank had one more question: What if Enron’s common stock fell below the price level needed to generate the cash to repay the Citibank loan? Citibank refused to accept the argument that such a scenario was too improbable to consider. So, Enron agreed that if such an event occurred, it would trigger a change in the preferred’s conversion ratio. Said differently, if Enron common stock fell below $28/share, Enron stood ready to issue to Whitewing whatever additional common stock was needed to ensure loan repayment.

What seemed a brilliant technical solution to the Whitewing financial architects was positively frightening to Vince Kaminski. He understood that within a broader scenario of troubles for Enron, Whitewing’s financial architecture could produce a cascade of additional repayment obligations. Focusing for the moment on Whitewing, Kaminski and his team pondered this hypothetical train of events: (1) suppose something really bad happened, such that Enron’s stock is under severe pressure, and falls below $28/share; (2) Whitewing’s trigger is pulled, and Enron must issue more convertible preferred; (3) Citibank gets nervous and forces Whitewing to convert to common and sell stock into the open market; (4) Enron’s stock is blindsided by a surge of selling from a new source and falls further; (5) other triggers in other deals come into play, feeding the spiral.

And there were other triggers embedded in Enron’s other deals with LJM. The effect of seeing one trigger after another pulled was almost beyond imagining. Kaminski and his team knew that they had to get Enron’s senior management to look at a full picture of what they would face if worse came to worst. There might still be time to undo the worst of the deals and perhaps store up financial reserves to handle others. But Kaminski knew that the task would not be easy. He would not simply be bringing bad news to management; he would be presenting a possible disaster scenario that was the product of management’s own proud creation. Kaminski also knew that he had a reputation of being somewhat of a Cassandra; in fact, he had already paid a price for this. As he pondered how best to bring his findings to management’s attention, Kaminski found himself thinking back over a previous experience when he had questioned some dubious Enron practices.

Kaminski and LJM

The case in point occurred in June 2000. At that time, Jeff Skilling was seeking to hedge a large capital gain Enron had accrued on its investment in a small Internet company: Rhythms NetConnections (Rhythms). Using mark-to-market accounting, Enron had already booked several hundred million dollars of this paper gain into net income. Skilling was concerned that a reverse in the Rhythms’ stock price would force Enron to realize large losses and was therefore interested in hedging this exposure. The Rhythms’ stock was thinly traded. This made it difficult, if not impossible, to hedge over the six-month time period of concern to Enron. So, CFO Andy Fastow had proposed that Enron capitalize a new partnership, called LJM, with Enron stock. Fastow, two banks, and some other individuals would provide a small sum of independent equity. Fastow would run the partnership. LJM would then provide Enron with a “put” option on Rhythms’ stock, thereby hedging the exposure that worried Skilling.

At the time, Vince Kaminski was working in Enron’s Risk Assessment and Control (RAC) Department. His boss, Rick Buy, had asked Kaminski to price the LJM put option on Rhythms’ stock. Kaminski’s initial reaction was that the hedge could not be priced; any put option price would depend upon the put writer’s ability to hedge by shorting Rhythms’ stock; that hedge, Kaminski argued, would be almost impossible to accomplish, because Rhythms’ stock was so thinly traded. Upon learning further details, Kaminski quickly concluded that the LJM transaction itself was a sham. It amounted to Enron’s hedging with itself. LJM’s only means to cover major losses resided in the stock Enron had contributed. Economically, Enron would be covering losses from a Rhythms’ stock price decline by issuing new common shares and diluting its shareholders.

When he learned that CFO Fastow had conceived of the idea and was going to run LJM, Kaminski was outraged. He told Buy:

“I am very uncomfortable with this whole thing. This is a cockamamine idea. This idea is so stupid, only Andy Fastow could have come up with it … Enron should never go forward with such a thing. It’s a terrible conflict of interest.”²

Buy asked Kaminski not to jump to conclusions. However, three days and detailed analysis by his top experts did not alter Kaminski’s view. When they met again on June 21, Kaminski told Buy that the conflict of interest involved in Fastow’s running the partnership was a disaster in the making. He showed Buy how this conflict of interest had already influenced Fastow’s structuring of LJM: “You can already see why, the way the partnership is structured. The payout of the structure is completely skewed against Enron shareholders. It’s heads, the partnership wins, tails Enron loses … the structure is simply unstable. It’s a partnership funded with Enron stock, and if Enron stock drops at the same time Rhythms’ stock drops, the partnership will be unable to meet its obligations.”³

“Buy professed to see the light and told Kaminski that he would stop the deal. Four days later, however, Buy admitted that he had been unable to do so: “I couldn’t stop it. The momentum was too strong … It will be fine. It’s just temporary.””⁴

Kaminski had walked away enraged but also thinking that this was the end of it as far as he was concerned. He was wrong. Late on a Friday afternoon shortly thereafter, Kaminski received a phone call from Jeff Skilling. Kaminski’s group was to be transferred out of RAC and into Wholesale Trading. No longer would Kaminski and his team evaluate firmwide transactions. Kaminski asked the reason for the change; Skilling replied: “There have been some complaints, Vince, that you’re not helping people to do transactions. Instead you’re spending all your time acting like cops. We don’t need cops, Vince.”⁵

This history weighed on Kaminski. Obviously, taking the risk study to Andy Fastow would be a waste of time, and given his previous reaction, Jeff Skilling did not look like a good bet, either. Still, he had to start somewhere in financial management. After all, they were the architects of the deals responsible for these frightening risks.

It occurred to Kaminski that Ben Glisan, the new treasurer, might be a good place to start. Clearly Glisan was one of Fastow’s protégés. On the other hand, he had been around for only a couple of years and had taken the treasurer’s role only a year ago. Kaminski decided to start with Glisan and see where that led.

Meeting with Ben Glisan

Kaminski and his team met Glisan in his office on March 9, 2001. Kaminski introduced the companywide risk assessment and its rationale and then asked Kevin Kindall to cover it in detail.

Kindall went through a series of findings that amounted to a powerful indictment of how Global Finance was conducting business. Kindall started with the structured deals that used total return swaps with triggers. These, he argued, involved unleashing massive potential liabilities under certain downside scenarios. The danger was that Global Finance was neither tracking these liabilities and their triggers nor weighing the probabilities of multiple trigger thresholds being crossed.

Next, Kindall noted that Global Finance was not keeping track of Enron’s swap book. Neither the amounts nor the specific deal terms were being monitored. Kindall mentioned that his team had also identified 2,700 corporate guarantees. Again, Global Finance was not aware of their implied liability amounts because it possessed no database for tracking these obligations.

Perhaps most damning, Kindall noted the absence of any system for determining Enron’s daily cash position. Data came in from different business units in an uncoordinated and untimely fashion; as a result, Enron needed to borrow extra money to make sure that it didn’t run out of cash.

Kindall saved certain off-balance sheet transactions for last. Specific vehicles, such as the Raptors, were known for combining large debts and stock price triggers with poorly performing assets. Kindall’s team could not, however, quantify the implied risks for Enron, because transaction details had not been made available.

“We weren’t able to gain access to a lot of information. But what we could review pointed to the existence of huge risk exposures that Enron simply hasn’t fully analyzed and does not understand. We’ve assessed the likelihood of hitting one of those triggers. For example, we have a five-percent chance of a credit downgrade in the next twelve months. But you have to understand, these are just the triggers we have located. There appear to be other triggers embedded in other vehicles as well. It’s likely the occurrence of one trigger will push down the share price so far that we hit another one embedded in some other vehicle.

In truth, it’s conceivable we could hit a cascading series of triggers, setting off a domino effect, where each trigger pushes down our stock price even more. That would result in a massive decrease in the share price and lower our bonds to a junk rating.”⁶

Kaminski followed up Kindall’s remarks by emphasizing the need for more budget funds and more information to finish the project. A complete list of off-balance sheet SPEs was needed, so that all their assets and obligations could be examined. Only then could the potential for interrelated negative trigger events be assessed. Adding that piece of the puzzle to the information already compiled would allow Kindall and his team to estimate Enron’s “probability of ruin.”

So far, Ben Glisan had listened without comment. Casually, he perused the written report while Kindall and Kaminski spoke. It was dense with data and analysis. Near the end, however, the report referenced a recent Fortune article that had shed unflattering light on Enron’s financial results. Clearly, bringing to light the type of information Kindall and Kaminski were compiling would result in a further journalistic feeding frenzy. That could not be good for Enron.

Glisan then closed the report and spoke: “Well, I appreciate all the work that went into this. But there really isn’t anything to worry about. Vince, I’ve been involved in designing almost all of these vehicles. We know what the risks are. It’s not an issue.”⁷

Kaminski pressed Glisan to consider authorizing more study. Glisan responded by saying that he’d take another look at the report and get back to Kaminski.

Weeks passed. Kaminski never heard another word on the matter.

What now? Without Glisan’s say-so, Kaminski and his team could not get details on the transactions that constituted the holes in their report. Global Finance held all the files on the off-balance sheet vehicles. Above treasurer Glisan there was only CFO Fastow. Kaminski was not optimistic that Fastow’s reaction would be more favorable; potentially, it could be a lot worse, such as seizing and destroying all work done to date.

Was there an audience outside of Global Finance? Remembering his “cops” conversation with Jeff Skilling, Kaminski quickly discarded him as a possibility. Ken Lay was too detached from the business details and anyway tended to take Skilling’s word on structured transactions.

There was one other possibility, however. Greg Whalley, head of Wholesale Trading, was a rising star within Enron. Whalley was also Kaminski’s ultimate boss. If Enron’s credit rating was to slip because of disguised debts and poorly structured vehicles, it was Whalley’s trading franchise that would be most severely impacted. Perhaps Kaminski could interest Whalley in his companywide risk assessment.

How then, should Kaminski present this material to Enron’s head trader?

Elsewhere in Enron

In July 2001, Margaret Ceconi, a sales executive in Enron Electricity Services (EES) was disturbed about how her division was faring. EES had reported a $40 million profit for the first quarter. Yet the business was widely known to have suffered serious business reverses and trading losses. Informal estimates within the group put the losses at a minimum of $500 million. Enron had responded by merging EES into the larger Wholesale Trading business and calling the merger an overdue efficiency move. Still, Ceconi could not understand how EES was reporting profits or how its losses could be submerged into Wholesale Trading and not reported separately.

Ceconi decided to contact the SEC anonymously. Filling out a form on the agency website, Ceconi posed a hypothetical question about merging a loss-making unit into a profitable larger unit. Did the losses still have to be broken out and reported?

Ceconi had given the SEC her phone number and got a call back. An SEC officer advised that both the size of the losses and their separate origin had to be disclosed to avoid a distortion of reporting for both segments. No follow-up discussion occurred, however.

Ceconi soon found herself laid off as part of the EES/Wholesale Trading merger. Before departing, Ceconi addressed a signed, ten-page letter to the Enron board, alleging SEC violations regarding the non-reporting of EES’s $500 million in losses. The letter, which went to board secretary Rebecca Carter, was never shown to Ken Lay or the board. Ceconi also began e-mailing information to Prudential Securities analyst Carol Coale; these e-mails included tough questions for her to use on analyst conference calls.

Elsewhere, a former Enron executive noted how the press had begun to circle around Enron’s off-balance sheet transactions. This executive still possessed copies of the offering documents for LJM2. Fastow had used these documents when trying to raise capital for his fund from Wall Street investment bankers. Among other revelations, the documents made statements that the Powers Committee Report later described as follows:

“… LJM2 solicited prospective investors … using a confidential Private Placement Memorandum (PPM) detailing … the ‘unusually attractive investment opportunity’ resulting from the partnership’s connection to Enron. The PPM emphasized Fastow’s position as Enron’s CFO, and that LJM2’s day-to-day activities would be managed by Fastow, Kopper, and Glisan … It explained that ‘[t]he Partnership expects that Enron will be the Partnership’s primary source of investment opportunities’ and that it ‘expects to benefit from having the opportunity to invest in Enrongenerated investment opportunities that would not be available otherwise to outside investors.” The PPM specifically noted that Fastow’s ‘access to Enron’s information pertaining to potential investments will contribute to superior returns.”⁸

The former executive decided to send the documents to John Emshwiller and Rebecca Smith at The Wall Street Journal.⁹

Attachment 2—Total Return Swap: Illustrative Example

Author’s Note

Vince Kaminski’s dilemmas are symptomatic of those that resisters face inside a company whose ethical decomposition is well advanced. The internal financial control system and its gatekeepers are compromised, and some senior managers are by now complicit in unethical dealings. Potentially, Kaminski has nowhere to go with his well-researched warnings.

At this stage, being the bearer of potentially bad news is a lonely, unwelcome business. This Kaminski had already discovered via his encounter with Jeff Skilling on LJM. Now, he may have one remaining inside option in Greg Whalley. How must he approach Whalley? What message will engage Whalley’s interest at a time when senior executives are beginning to sense the ground moving under their feet? Or, does Kaminski really have no viable internal options? If so, is this the time to take matters to outside parties, as other former Enron employees had begun to do?

Details of Vince Kaminski’s thinking on the need for an Enron companywide risk management study and the content of that study are as recounted in Conspiracy of Fools (pp. 309–310). The account of the meeting with Ben Glisan, which includes the study’s initial findings and Glisan’s unresponsiveness, is found in the same text (pp. 429–432). Kaminski’s decision to approach Greg Whalley is found on pp. 471–472.

The accuracy of this account has been affirmed by multiple interviews with Vince Kaminski. These discussions have also provided additional insights into the tactical choices Kaminski felt he had, the risks associated with each course of action, and Enron’s usage of the Total Return Swap.

The account of Margaret Ceconi’s actions is found in The Smartest Guys in the Room (pp. 303–304, 358–359). The action of an ex-Enron executive to disclose LJM’s offering circular to The Wall Street Journal is as reported in Conspiracy of Fools (p. 503).

Summarized financial statements and excerpts from footnotes are drawn from Enron’s SEC filing dated April 2, 2001. Their inclusion is intended to give a sense of the picture Enron was presenting of its financial condition and the nature of its disclosure on such matters as related-party transactions.