<DOC> [107 Senate Hearings] [From the U.S. Government Printing Office via GPO Access] [DOCID: f:80300.wais] S. Hrg. 107-511 THE ROLE OF THE BOARD OF DIRECTORS IN ENRON'S COLLAPSE ======================================================================= HEARING before the PERMANENT SUBCOMMITTEE OF INVESTIGATIONS of the COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS SECOND SESSION __________ MAY 7, 2002 __________ Printed for the use of the Committee on Governmental Affairs U.S. GOVERNMENT PRINTING OFFICE 80-300 WASHINGTON : 2002 _____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512ÿ091800 Fax: (202) 512ÿ092250 Mail: Stop SSOP, Washington, DC 20402ÿ090001 COMMITTEE ON GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan FRED THOMPSON, Tennessee DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Joyce A. Rechtschaffen, Staff Director and Counsel Richard A. Hertling, Minority Staff Director Darla D. Cassell, Chief Clerk ------ PERMANENT SUBCOMMITTEE ON INVESTIGATIONS CARL LEVIN, Michigan, Chairman DANIEL K. AKAKA, Hawaii, SUSAN M. COLLINS, Maine RICHARD J. DURBIN, Illinois TED STEVENS, Alaska ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Elise J. Bean, Acting Staff Director and Staff Director Robert L. Roach, Counsel and Chief Investigator Kim Corthell, Minority Staff Director Mary D. Robertson, Chief Clerk C O N T E N T S ------ Opening statements: Page Senator Levin................................................ 1 Senator Collins.............................................. 6 Senator Lieberman............................................ 9 Senator Durbin............................................... 11 Senator Bunning.............................................. 12 Senator Fitzgerald........................................... 42 Senator Carper............................................... 46 WITNESSES Tuesday, May 7, 2002 John H. Duncan, former Executive Committee Chair, Board of Directors, Enron Corporation, Houston, Texas................... 13 Herbert S. Winokur, Jr., Finance Committee Chairman, Board of Directors, Enron Corporation, Greenwich, Connecticut........... 16 Robert K. Jaedicke, former Audit and Compliance Committee Chair, Board of Directors, Enron Corporation, Bozeman, Montana........ 19 Charles A. LeMaistre, M.D., former Compensation and Management Development Committee Chair, Board of Directors, Enron Corporation, San Antonio, Texas................................ 21 Norman P. Blake, Interim Chair, Board of Directors, Enron Corporation, Rosemont, Illinois................................ 25 Charles M. Elson, Director, Center for Corporate Governance, University of Delaware, Newark, Delaware....................... 93 Michael H. Sutton, former Chief Accountant, Securities and Exchange Commission, Williamsburg, Virginia.................... 96 Robert H. Campbell, former Chairman and Chief Executive Officer, Sunoco, Inc., and Current Board Member of Hershey Foods, CIGNA, and Pew Charitable Trusts, Coronado, California................ 99 Alphabetical List of Witnesses Blake, Norman P.: Testimony.................................................... 25 Prepared statement........................................... 181 Campbell, Robert H.: Testimony.................................................... 99 Prepared statement with an attachment........................ 195 Duncan, John H.: Testimony.................................................... 13 Prepared statement........................................... 113 Elson, Charles M.: Testimony.................................................... 93 Article submitted for the Record............................. 185 Jaedicke, Robert K.: Testimony.................................................... 19 Prepared statement with attachments.......................... 155 LeMaistre, Charles A., M.D.: Testimony.................................................... 21 Prepared statement with an attachment........................ 176 Sutton, Michael H.: Testimony.................................................... 96 Prepared statement........................................... 191 Winokur, Herbert S., Jr.: Testimony.................................................... 16 Prepared statement with attachments.......................... 116 Exhibits May 7, 2002 1. GRed Flags Known to Enron's Board, chart prepared by the Permanent Subcommittee on Investigations....................... 203 2. a. GSelected Observations, 1998 Financial Reporting (Source: February 7, 1999, Andersen Presentation to Audit Committee.)... 204 b. GDraft Minutes, Meeting of the Audit and Compliance Committee of the Board of Director, Enron Corporation, February 7, 1999........................................................ 205 3. GSelected Observations, 1998 Financial Reporting (Source: February 7, 1999, Andersen internal document related to presentation to Enron Audit Committee.)........................ 208 4. GTranscription of handwritten note of David Duncan on Exhibit #3 (above.).................................................... 209 5. GLetter from Arnold and Porter to Permanent Subcommittee on Investigations, dated May 2, 2002, regarding Tom Bauer and handwritten notes on Exhibit #3 (above.)....................... 210 6. GHigh Priority Financial Reporting Risk Areas, Ongoing--1999 Specific (Source: May 3, 1999, Andersen Presentation to Enron Audit Committee.).............................................. 211 7. a. GHigh Priority Financial Reporting Risk Areas, Ongoing-- 2000 Specific (Source: May 1, 2000, Andersen Presentation to Enron Audit Committee.)........................................ 212 b. GSummary of Fees--Activity Overview (Source: May 1, 2000, Andersen Presentation to Enron Audit Committee.)............... 213 c. GDraft Minutes, Meeting of Audit and Compliance Committee of the Board of Directors, Enron Corporation, May 1, 2000...... 214 8. a. G2000 Audit Update, Selected Observations--Financial Reporting (Source: February 12, 2001, Andersen Presentation to Enron Audit Committee.)........................................ 218 b. G2000 Audit Update, Status and Required Communications (Source: February 12, 2001, Andersen Presentation to Enron Audit Committee.).............................................. 220 9. GHigh Priority Financial Reporting Rish Areas, Ongoing--2001 Specific (Source: April 20, 2001, Andersen Presentation to Enron Audit Committee.)........................................ 221 10. a. GApproval Report, May 18, 2000, Andersen Internal Assessment of Enron............................................ 222 b. GFS Misstatement Risk, November 22, 1999, Andersen Internal Assessment of Enron................................... 226 11. GSpecific References to Whitewing/Nighthawk/Osprey in Enron's Board/Committee Presentations, table prepared by the Permanent Subcommittee on Investigations................................. 228 12. GMinutes, Meeting of the Board of Directors, Enron Corporation, December 9, 1997.................................. 231 13. GMinutes, Special Meeting of the Board of Directors, Enron Corporation, February 1, 1999.................................. 240 14. GMinutes, Meeting of the Board of Directors, Enron Corporation, September 17, 1999................................ 244 15. GSeptember 17, 1999, Facsimile to Members of the Board of Directors regarding Condor flowcharts: Condor Transaction, Step 1--December 1997 and Condor Transaction, Step 2--September 1999 (Source: September 1999, Presentation to the Board of Directors.).................................................... 253 16. GWhitewing, 1997-2001, chart prepared by the Permanent Subcommittee on Investigations................................. 256 17. GEGF Execution Schedule, 2000 Balance Sheet Management (Source: August 2000, Finance Committee Presentation.)......... 257 18. GReferences to LJM Controls and Waivers in Board/Committee Presentations, table prepared by the Permanent Subcommittee on Investigations................................................. 258 19. GProject LJM Board Presentation, June 28, 1999: Economics of ENE Stock Positions; Current ENE Stock Positions of Little Value to Enron; Transaction Summary; Direct Value to Enron; Benefits to Enron; A. Fastow Involvement; Key Elements of Transaction to be Approved; Transaction Structure; Steps to Complete the Transaction....................................... 261 20. GLJM2 Summary (Source: October 11-12, 1999, Finance Committee Presentation.)................................................. 271 21. GLJM2 Co-Investment, L.P., Private Placement Memorandum, Merrill Lynch & Co. (Source: October 1999, LJM2 Co-Investment, LP Private Placement Memo.).................................... 272 22. GLJM Investment Activity, 1999 (Source: February 7, 2000, Audit Committee Presentation.)................................. 277 23. GLJM2 Update (Source: May 1, 2000, Finance Committee Presentation.)................................................. 278 24. a. GEnron Corp, Review of LJM procedures and transactions completed in 2000, February 12, 2001; LJM Investment 2000 Activity With Enron; Related Party Transactions--LJM 2000, Internal Policies and Procedures, (February 2001) (Source: February 12, 2001, Audit and Finance Committee Presentation.).. 279 b. GNotes of Dr. LeMaistre regarding call to Andrew Fastow on LJM-related compensation....................................... 283 25. GLJM Investments, Annual Partnership Meeting, October 26, 2000 (Source: October 26, 2000, LJM Investments Partnership Meeting Presentation.)......................................... 284 26. GEnron, Code of Ethics, July, 2000........................... 291 27. GThe Raptors, 2000-2001, chart prepared by the Permanent Subcommittee on Investigations................................. 300 28. a. GMinutes, Meeting of the Finance Committee of the Board of Director, Enron Corporation, May 1, 2000....................... 301 b. GProject Raptor, Hedging Program for Enron Assets; Purpose; Vehicle Structure; Project Raptor--Risks, Mitigants; (Source: May 1, 2000, Project Raptor Finance Committee Presentation.)................................................. 306 29. GMinutes, Meeting of the Board of Directors, Enron Corporation, May 2, 2000....................................... 311 30. a. GMinutes, Meeting of the Board of Directors, Enron Corporation, August 7-8, 2000.................................. 319 b. GProject Raptor II (Source: June 22, 2000, Executive Committee Meeting, Project Presentation.)...................... 327 31. GEnron Deal Summary (Raptor). (Source: April 18, 2000, Enron and LJM2 Deal Approval Sheets: Raptor.)........................ 328 32. GStock Price Risk in Financings, Potential Required Future Equity Issuance. (Source: April 2001, Finance Committee Presentation.)................................................. 334 33. a. GOctober 2-5, 2001, E-Mails regarding Enron Stock transactions (REDACTED by the Permanent Subcommittee on Investigations)................................................ 335 b. GSEALED EXHIBIT: October 2-5, 2001, E-Mails regarding Enron Stock transactions (UNREDACTED).......................... * 34. GThe Luntz Research Companies, October 19, 2001, Memorandum to Ken Lay, Grey Whalley, and Mark Frevert, regarding Initial Focus Group Observations & Recommendations..................... 339 35. a. GEnron Board Member, Total Compensation--Fiscal Year 2000, chart prepared by the Permanent Subcommittee on Investigations. 348 b. GEnron Board of Directors, Estimated Equity Compensation, 1991-2000, chart prepared by the Permanent Subcommittee on Investigations................................................. 349 36. a. GKen Lay's Repayment of Cash Loans By Transferring Enron Stock Back to Enron, chart prepared by the Permanent Subcommittee on Investigations................................. 350 b. GInteroffice Memorandum from Kenneth L. Lay, dated November 20, 2000, regarding $4 Million Enron Line of Credit... 351 c. GLetter from Kenneth Lay to Paine Webber, Inc., dated November 20, 2000, regarding sale of 49,950 Enron shares for repayment of $4 million line of credit......................... 352 37. GEnron's Many Strands: Executive Compensation; Enron Paid Huge Bonuses in '01; Experts See a Motive for Cheating, March 1, 2002, New York Times........................................ 353 38. a. GDecember 31, 1999, Excerpts from SEC Form 10-K, Enron Footnotes, Related Party Transactions.......................... 359 b. GDecember 31, 2000, Excerpts from SEC Form 10-K, Enron Footnotes, Related Party Transactions......................... 360 c. GSeptember 30, 2001, Excerpts from SEC Form 10-Q, Enron, Description of Restatement Items............................... 362 39. GPrivate Equity Strategy (Source: October 2000, Finance Committee Presentation.)....................................... 370 40. GSummary of Investment Portfolio as of March 31, 2001 (Source: April 2001, Finance Committee Presentation.).......... 371 41. a. GPortfolio Summary as of March 31, 2001 (Source: April 2001, Finance Committee Presentation.)......................... 372 b. GPortfolio Summary as of June 30, 2001 (Source: August 13, 2001, Finance Committee Presentation.)......................... 373 42. GFinance Related Asset Sales, Prepays and 125 Sales (Source: August 2001, Finance Committee Presentation.).................. 374 43. GEnron Board of Directors--Financial Ties to Enron, chart prepared by the Permanent Subcommittee on Investigations....... 375 44. a. GPartnership Spurs Enron Equity Cut, October 18, 2001, The Wall Street Journal............................................ 376 b. GEnron CFO's Partnership Had Millions in Profit, October 19, 2001, The Wall Street Journal.............................. 378 45. GMinutes, Meeting of the Board of Directors, Enron Corporation, October 7, 2000................................... 380 46. G2001 Proxy Statement for Enron Corp. with list of Directors. 383 47. a. GCorporate Governance Guidelines of The Board of Directors of Enron Corp.................................................. 385 b. GEnron Corp. Audit and Compliance Committee Charter (As Amended February 12, 2001)..................................... 393 c. GEnron Corp. Finance Committee Charter.................... 396 d. GEnron Corp. Compensation Committee Charter............... 398 e. GEnron Corp. Nominating Committee Charter................. 401 48. GEnron Corp. Business Risk Management Process Overview, chart prepared by Arthur Andersen.................................... 403 49. GAudit and Compliance Committee Calendar of 2001 Activities.. 404 50. GArthur Andersen Report to the Audit Committee of the Board of Directors, Enron Corp., August 2000......................... 405 51. GApplication of Mark-to-Market and Fair Value Accounting, October 11, 1999, Arthur Andersen Presentation to Enron Corp... 407 52. GLetter to Enron Corp. Compensation & Management Development Committee Members, dated April 13, 2001, regarding Potential Proxy Q & As, attaching table entitled Confidential For Enron Board of Directors, Public Relations, Investor Relations & HR Use Only, Potential Questions--Enron Proxy 2001................ 416 53. GEnron Interoffice Memorandum to Enron Corp. Board of Directors, dated November 2, 2001, regarding Management Committee Compensation Summary and attaching copy of November 2, 2001 letter to Enron Compensation Committee from Towers Perrin regarding observations regarding the Ken Lay insurance swap approved by Enron's Compensation Committee................ 422 54. GEnron Corp. Compensation Committee 12/20/01 meeting, Agenda Item No. 6, Other Business--6(a) Employment Agreement Summaries; 6(b) Kenneth L. Lay, changes To Current Employment Agreement Provisions........................................... 425 55. GDefendant Andersen Exhibit 763 and 764 (Arthur Andersen email, May and June 1999, re: Enron), U.S. v. Arthur Andersen (USDC SD Texas, Criminal Action No. H-02-0121)................. 428 56. a. GExcerpts from Minutes, Special Meeting of the Board of Directors, Enron Corp., June 28, 1999.......................... 432 b. GMinutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., October 11, 1999....................... 436 c. GMinutes, Meeting of the Board of Directors, Enron Corp., October 11-12, 1999............................................ 444 d. GMinutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., December 13, 1999...................... 448 e. GMinutes, Meeting of the Board of Directors, Enron Corp., December 14, 1999.............................................. 452 f. GDraft Minutes, Meeting of the Audit and Compliance Committee of the Board of Directors, Enron Corp., February 7, 2000........................................................... 458 g. GDraft Minutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., August 7, 2000................ 462 h. GMinutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., October 6, 2000........................ 468 i . GMinutes, Meeting of the Board of Directors, Enron Corp., October 7, 2000................................................ 481 j . GDraft Minutes, Meeting of the Audit and Compliance Committee of the Board of Directors, Enron Corp., February 12, 2001........................................................... 500 k. GMinutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., February 12, 2001...................... 506 l. GMinutes, Meeting of the Finance Committee of the Board of Directors, Enron Corp., October 8, 2001..................... 511 m. GDraft Minutes, Meeting of the Audit and Compliance Committee of the Board of Directors, Enron Corp., November 2, 2001........................................................... 517 57. GLetter from PriceWaterhouseCoopers LLP, dated August 17, 1999, to Enron Capital Management, regarding fairness opinion between Enron Corp. and LJM Cayman, L.P., for put option on Rhythms NetConnections Inc. stock.............................. 520 58. GLJM2 Co-Investment, L.P., Supplement Number One To Private Placement Memorandum, December 15, 1999........................ 525 59. a. GArthur Andersen Memorandum, December 31, 1999, regarding LJMII Partnership Structure.................................... 526 b. GArthur Andersen Memorandum, December 31, 1999, as amended October 12, 2001, regarding LJMII Partnership Structure........ 529 60. GMajor Transactions, Largest 10 Transactions (June 30- December 31) (Source: August 2000, Finance Committee Presentation.)................................................. 532 61. GEnron Interoffice Memorandum, March 8, 2001, regarding LJM Approval Process--Transaction Substantiation................... 533 62. GEnron Interoffice Memorandum, March 28, 2001, regarding Related-Party Proxy Disclosures................................ 538 63. GArthur Andersen Memorandum, February 9, 2001, regarding LJM Related Party Transactions..................................... 540 64. GDraft Enron Corp. Memorandum, September 2001, regarding Project Raptor--Addendum....................................... 542 65. GEnron Corp. Interoffice Memorandum, August 16, 2000, regarding EITF Issue Update.................................... 544 66. GEnron Corp. email, December 12, 2000, regarding EITF 00-19 Year End Implications.......................................... 546 67. GArthur Andersen email, August 23, 2001, regarding Documentation of Client Call................................... 550 68. GEnron Corp. draft responses to the Securities and Exchange Commission's questions on the LJM transactions, November 2, 2001........................................................... 553 69. GRaptor Hedging Strategy Analysis, Enron Corp. Risk Assessment and Control Presentation, 2001...................... 556 70. GEnron Global Markets, Enron's Funds Flow Targets, March 2001 562 71. GEnron Global Assets and Services, Equity Value Schedule, As of June 2001................................................... 564 72. GSummary Notes from Enron Corp. Board of Directors Meetings, November through December 2001................................. 565 73. GArthur Andersen documents related to Joseph Berardino's visit to Enron Corp. in February 2001, decision to retain Enron Corp. as a client, and removal of Carl Bass from Enron Corp. engagement team in March 2001.................................. 566 74. GAdditional materials from Arthur Andersen, some with David Duncan's handwriting, related to Enron Corp. accounting practices...................................................... 589 75. GStoel Rives LLP Memorandum, December 8, 2000, regarding Traders' Strategies in the California Wholesale Power Markets/ ISO Sanctions, provided by Enron Corp.......................... 592 76. GSeth Vance, Schroder Salomon Smith Barney, email, October 2001, to Andrew Fastow......................................... 600 77. a. GMemorandum of the Special Committee of Enron's Board of Directors, January 8, 2002, Interview of Herbert S. Winokur, Jr............................................................. 601 b. GMemorandum of the Special Committee of Enron's Board of Directors, January 11, 2002, Interview of Dr. Robert Jaedicke.. 612 c. GMemorandum of the Special Committee of Enron's Board of Directors, January 14, 2002, Interview of John Mendelsohn...... 621 d. GMemorandum of the Special Committee of Enron's Board of Directors, January 30, 2002, Interview of Norman Blake......... 623 e. GMemorandum of the Special Committee of Enron's Board of Directors, January 21, 2002, Interview of Ronnie Chan.......... 629 f. GMemorandum of the Special Committee of Enron's Board of Directors, January 10, 2002, Interview of Paulo Ferraz Pereira. 634 g. GMemorandum of the Special Committee of Enron's Board of Directors, January 14, 2002, Interview of Wendy Gramm.......... 638 h. GMemorandum of the Special Committee of Enron's Board of Directors, January 10, 2002, Interview of Lord John Wakeham.... 644 78. GRemarks by Securities and Exchange Commission Chairman Arthur Levitt, ``The Numbers Game,'' September 28, 1998........ 645 79. a. GReport and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees... * b. GReport and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, Overview and Recommendations section........................... 652 80. GClarifications and supplemental questions and answers for the record of Messrs. John Duncan, Herbert Winokur, Norman Blake, Dr. Charles LeMaistre and Dr. Robert Jaedicke........... 665 81. GSupplemental questions and answers for the record of Michael H. Sutton...................................................... 684 82. GSupplemental questions and answers for the record of Robert H. Campbell.................................................... 690 83. GStatement for the Record of Ira M. Millstein, Co-Chairman of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees..................................... 696 84. GReport of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp., William C. Powers, Jr., Chair, Raymond S. Troubh, Herbert S. Winokur, Jr., February 1, 2002, (``Powers Report'').......................... * 85. GThe Outside Directors' Response to the Permanent Subcommittee on Investigations' Report: The Role of the Board of Directors In Enron's Collapse............................... 715 86. GInstitutionalizing Good Governance: Keys to Success, article by Rosemarie B. Greco in Director's Monthly, the official newsletter of the National Association of Corporate Directors, January 2002................................................... 751 * May be found in the files of the Subcommittee THE ROLE OF THE BOARD OF DIRECTORS IN ENRON'S COLLAPSE ---------- TUESDAY, MAY 7, 2002 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Governmental Affairs, Washington, DC. The Subcommittee met, pursuant to notice, at 9:37 a.m., in room SH-216, Hart Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin, Lieberman, Durbin, Carper, Collins, Bunning, and Fitzgerald. Staff Present: Elise J. Bean, Acting Staff Director and Chief Counsel; Linda J. Gustitus, Chief of Staff for Senator Levin; Mary D. Robertson, Chief Clerk; Stephanie E. Segal, Professional Staff Member; Ross Kirschner, Deputy Investigator; Jamie Duckman, Majority Accountant; Kim Corthell, Republican Staff Director; Alec Roger, Counsel to the Minority; Claire Barnard, Investigator to the Minority; Jim Pittrizzi, Detailee/ General Accounting Office; Joyce Rechtschaffen, Staff Director and Counsel, Governmental Affairs Committee; Marianne Upton (Senator Durbin); Joe Bryan (Senator Levin); Bill Weber (Senator Durbin); Cindy Lesser (Senator Lieberman); Kathleen Long (Senator Levin); Holly Schmitt (Senator Bunning); Anne Fisher (Senator Cochran); Bob Klepp and Trent Kittleman (Senator Thompson). OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. The Subcommittee will come to order. On December 2, 2001, the seventh largest corporation in America collapsed. Its stock, having plummeted from $80 a share to practically nothing in less than 10 months, the reins of what was once a high-flying company of $100 billion in gross revenues and 20,000 employees were handed over to a Federal bankruptcy judge. That collapse has rolled like a tidal wave across the corporate boardrooms of America, across Wall Street, and across the entire investing community, which now includes over half of U.S. households. With this tidal wave, we are all asking two questions: What happened at Enron, and could it happen again? Today, we hope to help answer the first question in order to ensure that the answer to the second question will become ``no.'' One of the key players responsible for overseeing the operations of our publicly held corporations is the Board of Directors. Directors are charged by law to be the fiduciaries, the trustees who protect the interests of the corporate shareholders. In that capacity, they are supposed to exercise their best business judgment on behalf of those shareholders. They are supposed to be independent. And while they are not expected to be detectives, they are expected to ask tough questions of management, to probe opaque answers, and to display sufficient skill and fortitude to say no to transactions that do not look right. Along with management and the auditors, the Board shares the responsibility to provide to the company's shareholders a financial statement that is a fair representation of the financial position of the company. As the Second Circuit Court of Appeals held in a widely quoted opinion, technical compliance with Generally Accepted Accounting Principles may be evidence of acting in good faith, but it is not necessarily conclusive: The ``critical test,'' the court said, is ``whether the financial statements as a whole fairly present the financial position'' of a company. Enron's financial statements did not, and the Board's role in that failure is before us. Today, we have five key members from the Enron Board of Directors to tell us what they knew about the financial condition of Enron, when they knew it, and what they did about it. In other words, what role did the Board play in these events? The Subcommittee issued over 50 subpoenas for documents to Enron, Arthur Andersen, members of the Enron Board, and officers of Enron. Staff has reviewed about 300 boxes of documents to date, and conducted interviews with 13 current and past Board members. Each Board member complied with the document subpoenas and willingly appeared for interviews. We appreciate their cooperation and their voluntary appearance today. We have found that when you pare down the hundreds of incredibly complex financial transactions that were the hallmark of Enron, you realize that many were nothing more than smoke-and-mirrors bookkeeping tricks, designed to artificially inflate earnings rather than achieve economic objectives, to hide losses rather than disclose business failures to the public, to deceive more than inform. The decisions to engage in these accounting gimmicks and deceptive transactions were fueled by the very human but unadmirable emotions of greed and arrogance. Putting a growth gloss on the balance sheet pumped up the stock price, and the rise in stock price, regardless of the underlying true value of the company, was, for many, the measure in the 1990's for judging corporate success. The Board that was supposed to be the check on the greed and the arrogance, in fact, was not. Here is how it happened. Enron was in transition from an old-line energy company, with pipelines and power plants, to a high-tech global enterprise engaged in energy trading and international investment. It experienced large fluctuations from quarter to quarter in its earnings. Those large fluctuations affected the credit rating Enron received, and the credit rating affected Enron's ability to obtain low-cost financing, attract investment, and increase its stock price. In order to smooth out its earnings and avoid the natural dips, Enron engaged in a variety of complicated transactions that relied on structured finance, derivatives, and other arrangements that, while legal if done right, are nonetheless designed to massage a company's financial statement to make its financial condition look better than it really is. While it is not uncommon for a company to use these devices, they are also used somewhat sparingly. Enron, however, made them a high art form and used them aggressively, and in some cases, improperly. When used extensively and when they become dominant, when they involve billions of dollars, $27 billion in assets at Enron's peak, the real impact of these complex transactions on a financial statement is to cover up reality with a glitzy coat of paint. The financial statement becomes a fiction, and that is what happened at Enron. Step by step, Enron shifted a larger percentage of its assets into these structured finance arrangements, not for any real business purpose, but in order to make Enron look more profitable than it really was. Funds flow and the appearance of funds flow became the Enron mantra in order to keep Enron's credit rating up and its stock price climbing, and the Board of Directors went along with it. In many actions starting in 1997, when the Board first approved Whitewing, through the summer of 2001, just before things fell apart publicly, the Board of Directors went along with management's wishes. The Board relinquished its role of questioner and adopted the role of facilitator. It succumbed to the Enron ether of invincibility, superiority, and gamesmanship in manipulating Enron's financial statement to keep the Enron stock price soaring. This is a company, we are told, that had televisions in its elevators in order for employees to monitor Enron's stock price at all times. The financial transactions that the Board approved were used to make debt look like equity, to make loans look like sales, to make poorly performing assets look like money makers, and to make Enron-controlled entities look like legitimate third parties. By the time of the collapse, Enron held almost 50 percent of its assets off its books, and what started as a useful tool to address specific business problems had become a way of life. As long as Enron's stock was rising, these elaborate financial structures did what they were designed to do, make Enron's financial condition look better than it was. But once Enron stock started falling, these financial structures collapsed on themselves like a house of cards, revealing at the end that there was no ``there'' there. These transactions involved a number of deceptions that pushed the limit of accepted accounting practices and, at times, exceeded them. And parenthetically, if it turns out that Generally Accepted Accounting Principles allow such deceptions, then those accounting principles need to be changed. One type of deception that Enron used was to report on the company's financial statements the sale of an asset despite an understanding that Enron would buy it back after the financial statement was filed, or despite a hidden guarantee that the entity buying the asset would receive a certain rate of return. Five of the seven assets sold this way to the LJM partnership at the end of the last two quarters of 1999 were bought back by Enron, sometimes within 6 months' time. But those guarantees did not show on Enron's books as a liability. Only the sales showed as funds flow. Another type of deception made what was essentially a loan look like a sale, so the company's financial statement reflected the transaction as income or cash flow instead of debt. A third type of deception inflated the value of the assets that Enron held for sale. For example, Enron would buy a power plant on day one for $30 million, and within a month or so would begin carrying it on Enron's books as an asset worth $45 million. Two weeks ago, Enron filed a statement with the SEC declaring that it is going to write down its assets by another $14 to $24 billion, a staggering sum, due to overvaluations on the books and ``accounting errors or irregularities.'' Another type of deception, the Raptors, used Enron stock to backstop a risk that the LJM partnership and its investors were supposed to be assuming for Enron, and the risk retained by Enron was not disclosed on the company's financial statements in a meaningful way. As these structured financial transactions grew in number, size, and frequency, and as 50 percent of Enron's assets were moved off Enron's books, no one on the Enron Board said that their fiduciary duty required them to blow the whistle and prevent a deceptive picture of Enron's financial situation from being presented to the public. During the 13 interviews, the Board members told us that they had not been aware of the depth of Enron's problems or the extent of these structured transactions and accounting gimmicks, and most said they had no inkling that Enron was in troubled waters until mid-October 2001. But look at this chart that the Subcommittee staff has put together,\1\ identifying numerous red flags presented to the Board of Directors from February 1999 on, that signaled the risks Enron was taking, and that should have alerted the Board to probe and then to change course. --------------------------------------------------------------------------- \1\ See Exhibit No. 1 which appears in the Appendix on page 203. --------------------------------------------------------------------------- The staff has identified well over a dozen of these red flags, but I am just going to highlight a few. In February 1999, the Board's Audit Committee was told by Arthur Andersen directly that Enron's accounting practices were high risk and pushed limits. In June 1999, the Board approved at a special meeting and without prior Finance Committee consideration the creation of the LJM partnership, and waived the conflict of interest provision of the Enron code of conduct. The Enron Chief Financial Officer, Andy Fastow, served as the managing partner of LJM, something no Board member had ever approved or heard of prior to this. The Board was to approve a code of conduct waiver for Fastow three times over the next 16 months. In September 1999, the Board approved moving off the Enron balance sheet a $1.5 billion joint venture called Whitewing, which was established by the Board in December 1997 to get a loan that looked like equity, and then used from 1999 on to purchase assets that Enron wanted to move off its books. In May 2000, the Board approved the first Raptor transaction, a vehicle designed to hedge Enron investments by using Enron stock to backstop the hedge, which amounted to Enron hedging with itself. By October 2000, the Board knew that Enron had $27 billion in assets, almost half of its assets, off its balance sheet. In April 2001, the Enron Board knew that 64 percent of Enron's assets were troubled or not performing and that 45 million shares of Enron stock were at risk in Raptors and Whitewing. Starting with the creation of Whitewing in 1997 and with its deconsolidation in 1999, the Board started to wade into dangerous waters. With the establishment of the LJM partnership and the waiver of the code of conduct, they were up to their necks, and with the Board's approval of the Raptors, the Board was swimming way over their heads. In the end, Enron drowned in its own debt. As the chart shows, the Board had ample knowledge of the dangerous waters in which Enron was swimming and it did not do anything about it. The Board told the Subcommittee staff that because each of Enron's transactions was approved by Enron management, whom they saw as some of the most creative and talented people in the business, and because the transactions had been approved by Arthur Andersen, a top auditing firm, and by Enron's lawyers and private law firms like Vinson and Elkins, by the credit rating agencies, or by investment bankers who had a significant stake in a lot of these transactions, the Board assumed that the transactions were OK. Now, I can see why you might rely on a company auditor or an outside attorney, but the Board must exercise independent judgment. The Board is not supposed to be a rubber stamp for auditors or attorneys. Also, the people that the Board relied on were conflicted in their roles involving Enron, and the Board knew it. First, the Board knew that Enron's management handed out bonuses like candy at Halloween. Employees were given huge bonuses for closing deals, and many of these deals proved damaging to Enron. For instance, two executives closed a deal on a power project in India, which is now a financial disaster, and got bonuses in the range of $50 million. The head of one Enron division who was moved out of the company walked away with more than $250 million in the year that he was shown the door. The temptation to self-enrichment at Enron was overwhelming. Arthur Andersen was conflicted, because it served Enron as both an auditor and a consultant, and, for 2 years, it also served as Enron's internal auditor, essentially auditing its own work. Enron was Andersen's largest client, and in 2000, Andersen earned over $50 million in fees from the company. Employees of Andersen routinely crossed over to work for Enron, and an Andersen employee who actually questioned Enron practices while serving on the audit team was promptly reassigned to another client at Enron's urging. Relying on outsiders, conflicted or not, does not relieve the Board from the ultimate responsibility to make sure that at the end of the day, Enron was operating properly and Enron's financial statement was a fair representation of Enron's financial condition. The Board failed in that responsibility. The structured debt and guarantees overwhelmed Enron's ability to pay, and that meant bankruptcy for the corporation, huge pension losses for employees, investment losses for stockholders, and business losses for hundreds of small companies that did business with Enron, while the officers of the corporation walked away with fortunes. Today, we are going to go over the decisions that the Board made on a number of these transactions, as well as the decisions that they made with respect to compensation. We will also look at the interlocking financial relationships that some members of the Board had with Enron. Following the Board, we will hear in a second panel from several experts in the field of corporate governance, and I expect that we will be taking a break for lunch sometime around 12 or 12:30. Senator Collins. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Mr. Chairman. Today is the first in a series of hearings to be held by the Permanent Subcommittee on Investigations into the events that led to the bankruptcy of the Enron Corporation. As a result of the company's downward spiral and ultimate bankruptcy, shareholders, both large and small, individual and institutional, lost an estimated $60 billion. This includes more than 15,000 Enron employees and retirees who had a significant proportion of their pension funds invested in the company's stock. They lost an astounding $1.3 billion. The collapse of Enron caused thousands of Americans to lose their jobs, to lose savings, and to lose confidence in corporate America. Unraveling the complexities of what happened, determining who is responsible, and prosecuting those individuals will take the Department of Justice, the Labor Department, and the Securities and Exchange Commission many months and possibly years. The Subcommittee's job is not to duplicate those efforts, but rather to examine the actions taken by all of the players who contributed to Enron's demise in order to illuminate the public policy issues. By doing so, the Subcommittee can help focus the debate in Congress, in State legislatures, and in corporate board rooms across the Nation on what measures should be taken and by whom to minimize the chances of another Enron-like debacle. In this first hearing, the Subcommittee will examine the role played by Enron's Board of Directors in the company's bankruptcy. I want to acknowledge the Board's full cooperation with this investigation. I also want to take a moment to praise Senator Levin and the dedicated both Majority and Minority Subcommittee staff who have been tireless in their efforts to unravel a very tangled web of conflicts of interest, unusual transactions, and lax oversight. Corporate boards play an essential role in the American economy. They are the single most important guardians of a company's shareholders, and as such, they have a fiduciary duty to promote the interests of the corporation, to act in good faith, and to exercise their best judgment. When Korn/Ferry, a major corporate recruiter, polled corporate directors in 2001 to determine the outstanding capabilities of board members, it identified one single trait that stood significantly above all the others. That trait is a willingness to challenge management decisions when necessary. There is no question that directors generally should be able to rely on the representation of management and independent experts. But directors have an obligation to do more than simply accept what they are told, occasionally ask whether there are any problems, and inquire whether the accountants agree on the propriety of actions presented for their approval. Prudent directors retain their objectivity and to some degree, a healthy skepticism. They must be willing to ask the tough questions of management, recognize those situations where independent expert advice should be sought, and exercise heightened diligence when a company is pursuing unfamiliar or new territory. Enron was a company that prided itself on its innovation. CEO Jeffrey Skilling often boasted of Enron's pioneering efforts as it transformed itself from a traditional energy company to a global enterprise creating new markets and businesses. In contrast, it appears that the Board of Directors continued to perform its duties as if Enron were still an old- line, conservative energy company, at a time when it appears they should have been far more probing, given Enron's metamorphosis into an energy trading company. Serving as a director for a corporation as complicated as Enron obviously is not an easy task. Enron was one of America's largest corporations. It had thousands of partnerships, joint ventures, and other special purpose entities, many of which were engaging in transactions that can only, and barely even then, be followed with the aid of complex diagrams. In fact, the Board members interviewed by the staff appear to have been unaware that Enron has some 3,000 related entities, including 600 using the same post office box in the Cayman Islands. I would argue that should have been another red flag. The complexity of the responsibility is precisely why Enron's Directors were paid hundreds of thousands of dollars per year in cash, stock, and options. While the exact amount of compensation can be difficult to determine, depending on how one calculates the value of stock options, there is no question that Enron's Board members were among the most highly compensated in the world. Today, we will ask five Enron Directors what they did to protect shareholders and why they believe that they failed in doing so. We will also hear an evaluation of their efforts from some of the leading experts on corporate governance. I am particularly interested to learn more about the Board's response to the large stock sales engaged in by Enron's management, its reaction to the departure of a CEO who left after only 6 months on the job, and its decision to approve a waiver of Enron's code of conduct to allow the Chief Financial Officer to engage in business deals with the company. This latter decision is the Board action that I find among the most inexplicable. During the investigation, the Subcommittee spoke with many experts on corporate governance, and not a single one had ever heard of a public company ratifying a similar proposal. I want to understand also the Board's view of what now appears to be the obvious conflicts of interest that contributed to Enron's collapse and to explore whether the Board, and its Audit Committee in particular, believed that they acted prudently in monitoring the outside auditor, Andersen. Actually, Andersen, as we know, was more than the outside auditor, which is another issue in and of itself. The Board, with Andersen's endorsement, approved many of the transactions described by Senator Levin that enabled the company to paint a false picture of its financial health and Enron employees to enrich themselves at the expense of the corporation, its shareholders, and ultimately its creditors. We are still working to unravel the complexities of these transactions, which has proven to be a monumental task. It is troubling to me that in staff interviews, Board members have provided little insight into major transactions. For example, not one Board member could explain or recall a $2.2 billion Board resolution that approved the issuance of preferred Enron stock to an outside investor. Now, I certainly do not expect the Board members to have perfect recall of every deal that they approved, but I would hope that transactions that rise to the threshold of multiple billions of dollars would be memorable to at least someone on the Board. In addition, we will discuss some of the alleged conflicts of interest created by some of the Board members' other relationships with Enron. Was the Board's vigilance dulled by large consulting fees, corporate contributions to their favorite charities, and other business relationships? Every corporate governance expert with whom we spoke was critical, for example, of any Board member having a consultant contract with Enron. At a minimum, such relationships do not foster the appearance of propriety and financial independence of Board members. Mr. Chairman, the Enron case is uncannily similar to another business failure that occurred some 70 years ago. In the early 1930's, an electric holding company called Middle West Utilities collapsed under the weight of stock fraud and cooked books. Middle West was comprised of so many interlocking boards that it took the Federal Trade Commission 7 years to fully comprehend its structure, which involved 284 affiliates. Underneath its incredibly complex structure lay an immense amount of debt taken on as it expanded in the 1920's. Ironically, Middle West's auditor was a relatively new firm named Arthur Andersen. There is, however, one significant difference between Middle West's and Enron's executives. The Middle West CEO's considerable fortune of around $150 million was tied up in Middle West holdings and disappeared with the company. In contrast, many of Enron's managers were making tens and, at least in one case, hundreds of millions of dollars by dumping their Enron stock before the corporation's collapse. Although imperfect, it is important to remember that today, our systems of accounting and financial regulation are the best in the world. That makes the Enron case all the more troubling, because it simply should not have happened. It represents a colossal failure of virtually every mechanism that is supposed to provide the checks and balances on which the integrity of our capital markets depend. And in that system, the Board of Directors is supposed to provide the first line of defense by overseeing the conduct of management. There are already encouraging signs that many directors in the wake of Enron's collapse are taking their roles much more seriously. As we seek answers in the Enron case, we should be careful not to act precipitously without understanding the true nature and extent of the problems underlying the corporation's bankruptcy. The testimony we will hear this morning about the role of the Board of Directors should provide some answers. It should also yield valuable lessons for strengthening our free enterprise system, restoring public confidence in our capital markets, and ensuring that small investors, in particular, have access to complete and accurate information to guide their investment decisions. Senator Levin. Thank you very much, Senator Collins. The Chairman of our full Committee, Senator Lieberman. OPENING STATEMENT OF SENATOR LIEBERMAN Senator Lieberman. Thank you, Senator Levin. Thanks to you and Senator Collins and your staff of the Permanent Subcommittee on Investigations for holding this important hearing, which really does initiate the next phase of the Senate Governmental Affairs Committee's investigation of the scandalous collapse of the Enron corporation. Over the past 6 months, we have all heard many reports about who failed Enron's shareholders and employees leading up to the company's fall. Obviously, the company's management has been cited, Arthur Andersen, government watchdogs, stock analysts, and even rating agencies. There were bad decisions, breakdowns, and some betrayals at several points and links in the oversight chain. Today, we focus on another group that must accept some of the blame for failing to uncover the crookedness in the company's behavior and books, and that is the Board of Directors. Textbooks tell students that the board of directors is a group of people elected by the shareholders to watch over the management of a corporation on behalf of the shareholders. Board members are, in that sense, like trustees or guardians for the shareholders and, in a larger sense, for the integrity and reliability of our economic system. In fact, because of their essential role, directors by law owe special duties to the corporation and particularly to its shareholders, duties of loyalty and care. Loyalty, meaning freedom from conflicts of interest--in other words, serving shareholders and only shareholders with independence and undivided attention. Care, meaning doing their work responsibly, thoroughly, and in good faith. By all appearances, unfortunately, Enron's Board of Directors failed their shareholders on both counts. First, about the Directors' loyalty to their shareholders, even though a majority of Enron's Board was made up of outside directors, meaning directors not in Enron's management, a stunning 10 of the 15 most recent outside Directors had conflicts of interest, including contracts with Enron, common ties or contributions to charities, and memberships on the board of other companies doing business with Enron. For example, charities close to some of the Directors were supported heavily by Enron and its officers. Two Directors earned more than $6.5 million in consulting fees from Enron since 1991. One Director served on the board of a company that in 1999 signed a $1 billion energy management agreement with an Enron affiliate. Arrangements like these can divide or even redirect a director's loyalties to the hand that feeds them, management, and away from their single-minded responsibility to the shareholders. Consulting contracts or large donations to favored charities, just as a matter of human nature, can whittle away the objectivity directors must bring to every decision they make and leave shareholders without the protectors that they need. Second, regarding the Directors' duty to take care and be diligent in overseeing the management of the company, my colleagues have spoken to this, and the fact is, unfortunately, that the more we look, the more evidence we find of inadequate oversight. In 1999, as has been said, the Board went so far as to suspend Enron's Code of Ethics on two separate occasions to allow the company's Chief Financial Officer, Andrew Fastow, to run partnerships that would enter into deals with Enron. That, to me, was extraordinary, and extraordinarily irresponsible. Rather than raising a red flag, the Board gave a green light to Mr. Fastow to, as Sherron Watkins put it in her testimony before the Senate Commerce Committee, ``put his hands in the Enron candy jar.'' As the shareholders' elected representatives, it seems to me that the board of directors has an affirmative obligation to ask questions and get answers, and these Directors were and are qualified individuals, very qualified, with a professional understanding of industry. They had impressive credentials-- former Chairman of the Executive Committee of Gulf and Western Industries, former Chairman of the U.S. Commodity Futures Trading Commission, former Secretary of State for Energy of the United Kingdom, professor of accounting and former Dean of the Stanford Business School. The question is, why all that experience and so much more accomplished so little for the shareholders of Enron in the end. To me, the Directors' lack of due diligence is even more troubling in light of the fact that some of them profited so much from their positions as Board members. In stock sales alone over the years studied by our staff, some made hundreds of thousands of dollars and a few made more than $1 million. In that sense, I am sad to say that the Board of Directors did not just fiddle while Enron burned, some of them toasted marshmallows over the flames, even as those flames shook our economy and engulfed the dreams of thousands of dedicated Enron employees who lost not only their jobs, but their retirement security. The failures of Enron's Board of Directors are a warning that we must heed, particularly because of the more than 100 million Americans who are now, in one way or another, stock investors, owners of stock, particularly those millions of middle-class Americans who entered the market over the last 20 years. They are shaken and they are asking, if the distinguished Board of Enron failed in this case, as they did, to represent the shareholders adequately, how many other boards of how many other American corporations might be similarly negligent? After all, investment capital is the lifeblood of our free market economy. So the belief that directors are failing their shareholders is a threat to the health of our economic system. We cannot let it grow or go untreated. We all must work together now to restore investors' confidence, and quickly. There are many proposals of potential reforms that have been made to strengthen directors' accountability. I believe we should give the SEC new powers to remove negligent directors from their boards and prohibit them from future service on the boards of any other public companies. I am also very interested in proposals that have been made to ban or limit company stock sales by directors for the duration of their terms on the boards and to impose mandatory term limits on directors. I strongly support the call to the stock exchanges to adopt listing requirements that would obligate companies to limit the number of insiders who can serve on boards, to restrict directors from serving on more than a given number of boards, and to prohibit behavior such as that we have all described this morning by Enron's Directors, some Enron Directors, that amounts to conflicts of interest. As usual, self-regulation by the companies and by the stock exchanges would, in my opinion, be the most direct and effective path to reform. But if there is inadequate self- regulation, there is no question that some government action will be necessary to prevent the most egregious abuses of responsibility by boards of directors. Mr. Chairman, about 100 years ago, the famous satirist Ambrose Bierce defined a corporation as, ``an ingenious device for obtaining individual profit without individual responsibility.'' Let us work together now to make sure that cynical joke does not become a prophecy. Let us make sure that directors are accountable and vigilant, that they act as the shareholders' first line of defense against corporate negligence, mismanagement, or corruption, and that they give investors the confidence our economy needs to grow as robustly as we all want it to. Thank you very much. Senator Levin. Thank you very much, Senator Lieberman. Senator Durbin. OPENING STATEMENT OF SENATOR DURBIN Senator Durbin. Thank you, Mr. Chairman. I will be very brief and I thank you for this hearing. I think it is fair to say that the Enron experience has shaken corporate America to the core. I think it has shaken America to the core because of the victims. Those victims are scarcely represented at these Congressional hearings, not only employees that have lost their jobs at Enron and related companies, but the investors, the pensioners, all of those victims will only have the comfort of reading these transcripts or watching C-SPAN. That is as close as it gets. The theory behind corporate governance is that the board of directors is supposed to be defending them, too. But as we look at the report from the Powers Committee and others, it is not very encouraging in terms of the role of the Board of Directors at Enron. In fact, the Powers Report says point-blank, ``The Board of Directors failed, in our judgment, in its oversight duties.'' That is a stunning condemnation. Enron has called into question corporate governance and corporate honesty. It appears now when you look at the salaries being paid to some of the people who were clearly deceiving everyone in sight, they were being treated like corporate royalty in a Nation which long ago decided that royalty was not going to be part of our future. I am going to be asking these Board members, some of whom I know and have worked with and respect very much, whether they were misled, whether or not as directors of a corporation of this size and importance they had the tools or gave the time that was necessary to do their job right. I am always fascinated by how many people express an interest in how many boards of directors they serve on, and I just wonder if that is a real service, a real dedication, and a real commitment, or just another notch on your gun, another line on your resume, whether or not members of boards of directors of important companies really take that job as seriously as they should if this system is to work. I think that as we look at the challenge we have before us, that this hearing of this Subcommittee will lead us to ask some hard questions, lead us to, I hope, pass some important legislation, because if all of these hearings on Capitol Hill are just about face time on the nightly news, we have failed those employees and those pensioners and the people that count on this government to enact laws to protect them. Thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator Durbin. Senator Bunning. OPENING STATEMENT OF SENATOR BUNNING Senator Bunning. Thank you, Mr. Chairman. Enron's collapse has not only affected its shareholders and employees, but it will continue to have tremendous ramifications on the markets, specific sectors of the economy, and in the way stock analysis, credit rating agencies, and accounting firms do business. The status quo in many of these industries is no longer acceptable, and I suspect Congress and Federal agencies will be making several reforms over the next couple of months and years to prevent another company from slipping through the cracks. Congress will never be able to prevent another Enron from happening, but we can make it more difficult. Today, we will be looking at the role Enron's Board of Directors played in the company's collapse. As has been said before, the Powers Report that was published in February is fairly critical about some actions taken by Enron's Board of Directors, while also acknowledging that critical information was withheld. I hope this Subcommittee can get answers today to some important questions about decisions the Directors made and their relationships with the company's management and outside contractors. What is striking about the Enron collapse is that so many people, both inside and outside the company, failed to ask the questions that needed to be asked. Enron's failure did not occur because one person dropped the ball. Instead, it was an across-the-board failure of many individuals. In hindsight, I am sure that many of them wish that they had done more. Thank you for coming today. I appreciate the time you have taken, and I am looking forward to hearing from you today on the Enron collapse. Thank you. Senator Levin. Thank you, Senator Bunning. We will now introduce our first panel of witnesses this morning who are either current or former members of the Board of Directors of Enron Corporation. These are the five men that we have at our witness table. John Duncan, the former Executive Committee Chair for Enron Corporation; Dr. Herbert Winokur, Enron Corporation's Finance Committee Chair; Robert Jaedicke, former Audit and Compliance Committee Chair for Enron; Dr. Charles LeMaistre, former Compensation Committee Chair; and finally, Norman Blake, who is the Interim Chairman of the current Board of Directors and a former member of the Compensation and Finance Committees. Pursuant to Rule VI of this Subcommittee, all witnesses who testify before the Subcommittee are required to be sworn. I now would ask our witnesses to please stand and raise your right hand. Do you solemnly swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Duncan. I do. Mr. Winokur. I do. Mr. Jaedicke. I do. Dr. LeMaistre. I do. Mr. Blake. I do. Senator Levin. We are going to use a timing system today. About a minute before the red light comes on, you will see the light change from green to yellow, which will give you an opportunity to conclude your remarks. We have your written testimony, which will be printed in the record in its entirety, and so we would ask that you limit your oral testimony to no more than 10 minutes. Mr. Duncan, let us start with you. TESTIMONY OF JOHN H. DUNCAN,\1\ FORMER EXECUTIVE COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, HOUSTON, TEXAS Mr. Duncan. Chairman Levin, Senator Collins, and Members of the Subcommittee, good morning and thank you for the opportunity to address this Subcommittee. My name is John Duncan. From 1967 to 1985, I was a Director of Enron's predecessor company, Houston Natural Gas, and I was there when Enron began in 1985. I have served as the Chairman of the Executive Committee since 1986. Thus, I am the Enron Director who has served the longest period of time. Until the Fall of 2001, I considered Enron one of the great companies of this country, and I was proud to be one of its directors. I resigned from the Board in March 2002. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Duncan appears in the Appendix on page 113. --------------------------------------------------------------------------- After receiving my bachelor's degree in business administration at the University of Texas, I set out to become a businessman, to start and run my own company. With the exception of the first job, in a family business, and a stint in the U.S. Air Force during the Korean War, I have not drawn a paycheck from a company of which I was not either the founder or the co-founder. As co-founder and President of Gulf and Western and founder of Gulf Consolidated Services, both companies had small beginnings and wonderful success stories. During the course of my career, I have served on the board of seven New York Stock Exchange Companies, and, Senator Durbin, not all at one time. I have also served and chaired the boards of several important Texas institutions, including the Chancellor's Council of the University of Texas System, Southwestern University in Georgetown, Texas, the Board of Visitors at M.D. Andersen Cancer Center, and all the metropolitan Houston YMCAs. I provide that background to the Subcommittee to respectfully suggest that I have had substantial experience and exposure to the workings and to the role and to the duties of a board of directors. I also know a board's limitations. That is what I want to talk about today. In particular, I want to focus on what I believe are the elements of an effective board and why I believe the tragic events of Enron occurred. First, I believe the directors must be individuals who possess integrity and intelligence. They also should collectively bring a broad spectrum of knowledge and experience in the areas of business and finance and in the particular fields that the company is in. People usually acquire this experience by having operated a company with a significant budget or by having obtained unique experience from other professions that are relevant to the company's mission. The Directors of the Enron Board certainly possess, in my opinion, these qualities. My colleagues are highly ethical and of good character. As far as intelligence goes, I can simply say that if education is any measure, I believe I was one of only two directors who did not have a master's degree or a doctorate degree. Our directors are experienced, successful businessmen and women, experts in areas of finance and accounting, and have had experience in leading large institutions. Others, like our overseas directors, brought experience in certain areas of the world in which Enron saw great business potential. Second, I believe the board must be dedicated and diligent in addressing the matters that are presented to it. The directors need to do their homework, analyze the issues, ask penetrating questions, and make decisions that are always in the best interest of the shareholders. In my opinion, the Enron directors met this criteria. We worked hard. We prepared for meetings. We asked probing questions and imposed specific controls and procedures that management and outside advisors were required to follow. I know that my colleagues here today will address those items in more detail. We were also willing to say ``no'' to management when we did not agree with its recommendations. A good example of exercising a board's responsibility and to act independently in the company's best interest occurred only last September, when all the indicators that we had were still positive and before any of the outside directors was aware that Enron was in trouble. We were presented two transactions at the Executive Committee and the Board; management requested to authorize the purchase of two pulp paper mills at a price in excess of $300 million cash. We did not approve these acquisitions because we were concerned about a prior acquisition in the same field; we did not like the purchase price; and we wanted to preserve our financial flexibility in the light of the September 11 tragedies. We postponed our decision, but we now know that subsequent events soon overtook us and the company. I did not sit on the Audit Committee or the Finance Committee, but I did sit in as a guest at a number of their meetings. I witnessed my colleagues asking probing questions of management and independent accountants. In my opinion, these committees and these members thoroughly executed their duties. Third, I think that a board cannot be successful unless it feels comfortable relying on the intelligence and integrity of the management, as well as other advisors who present matters to the board. With over 20,000 employees working at the company, with over 200 lawyers writing contracts every day, and with over 400 accountants posting the daily books, we, the directors, had to rely on the reports given to us by the officers of the company. Frankly, there is no other way that we could direct effectively a company of that size. We felt confident relying on the senior management of the company, as we truly believed we had hired some of the best and the brightest in the industry. National, independent publications lauded the Enron officers for their intelligence, leadership, and creativity. Finally, I believe the management and other advisors reporting to the board must tell the truth. They must tell the complete truth, good or bad, in order for the board to make informed decisions. We now know this did not happen at Enron. The Board had implemented mechanisms and controls to ensure, at the very least, it obtained early warning signals of any impending problem. Among other procedures, we created a risk management officer position, and we staffed that department with nearly 100 employees. That officer and that department was responsible for reporting to the Board the most significant concerns and credit issues that faced the company. That did not happen. It is now quite clear that significant information about related party transactions was withheld from us. We were not aware, for example, of the problems of Chewco. They were withheld from us for years. We were not informed about Raptor III. We were not told about the $800 million recapitalization of the Raptors in late 2000 and 2001. We were not told that employees, in addition to Andy Fastow, were participants in a number of partnerships, and we were unaware of their substantial windfall profits. As late as the August 14, 2001 Board meeting, the Board was briefed on the financial condition of the company. Your staff has that briefing. The report was--earnings were up, balance sheet was stable, except maybe a credit rating improvement in the year 2002. Various Power Point slides given at that same meeting indicated to the Board that the company's good business was still improving as usual. The Powers Report and the reports we now have read in the press indicate that for many months, if not years, certain members of management and our outside auditors were well aware of the problems facing the company, and they did not tell us. In sum, I do not believe that Enron's fall would have been avoided had the Board asked more questions, implemented more controls, or avoided certain financing projects, because they were too complicated or risky. Rather, I believe if management had implemented the Board's controls, as they assured us they had, if just one of the Board's officers or employees had fulfilled his or her corporate duty to reveal these problems or to any one director, or if the outside auditors had executed their obligation to convey to us concerns they privately expressed and documented amongst themselves, that I and we would not be here today. I thank you for allowing me to make this statement. Senator Levin. Thank you very much. Dr. Winokur. TESTIMONY OF HERBERT S. WINOKUR, JR.,\1\ FINANCE COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, GREENWICH, CONNECTICUT Mr. Winokur. Chairman Levin, Senator Collins, Members of the Subcommittee, good morning and thank you for the opportunity to address you. My name is Herbert S. Winokur, Jr. I currently am a member of the Board of Directors of Enron Corporation. I have served as Chairman of the Finance Committee of the Board of Directors and have been a member of the Board since the mid-1980's. I volunteered for and served as a member of the Board's special investigative committee, the Powers Committee, to understand what happened at Enron. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Winokur appears in the Appendix on page 116. --------------------------------------------------------------------------- I appreciate the opportunity today to talk with the Members of this Subcommittee about the involvement of Enron's Directors in the related party transactions that have received so much attention and about our oversight of Enron more generally. In my opinion, and it is only my opinion, one of the principal causes of Enron's failure was the loss of lender and investor confidence that resulted from the three significant restatements to Enron's financial statements presented in October and November 2001. Two related to earnings restatements for 4 and 2 years, respectively, and the third, a significant reduction in shareholder equity. While a related party was involved in each transaction, the related party aspect does not appear to have been a factor in any of the accounting errors. In none of these three restatements did the Board or its Audit Committee have prior knowledge of the errors that were required to be corrected. In each case, Enron's management had approved the original financial statement presentations, and as appropriate, Arthur Andersen had certified or reviewed them. With that in mind, I would like to discuss three areas. First, how Enron's Board of Directors and Finance Committee discharged its obligations; second, the specific circumstances in which we approved the LJM structures and the controls we put in place; and finally and very briefly, certain of the hedging transactions that the Board approved. Enron's Finance Committee reviewed regularly the company's financial ratios and liquidity. At our meetings, Enron management routinely presented Enron's actual and projected financial ratios and near-term liquidity, a report on relationships and meetings with the credit rating agencies, and an analysis of Enron's borrowing costs relative to those of its competitors, which informed us of the market's contemporaneous view of Enron. Between meetings, we also received and read reports on Enron from Wall Street equity and debt analysts, including the analysts' detailed financial projections. Let me turn to the Finance Committee's involvement in the approval and oversight of the LJM partnerships. The press and others have reported repeatedly that Enron's Board waived the code of conduct when it permitted Enron's Chief Financial Officer, Andy Fastow, to serve as general partner of LJM1 and LJM2. The Board did not. For many years, Enron has maintained a code of conduct with which every employee must comply. It also permits the Chief Executive Officer to make a determination that an officer's investment ``presents no probability of any conflict of interest.'' When the Board approved LJM1 in June 1999, the Board adopted and ratified the determination by the Office of the Chairman that Andy Fastow's participation as managing partner ``will not adversely affect the interests of the company.'' The Board was told that PricewaterhouseCoopers would be rendering a fairness opinion on the transaction between LJM and Enron with which we were presented and that Mr. Fastow would have no direct pecuniary interest in the Enron stock, which was used as part of that transaction as credit support. Enron publicly disclosed this transaction, including the related party aspect, and Arthur Andersen reviewed it as part of its 10-Q review in June. At the October 1999 Finance Committee and Board meetings, Mr. Fastow recommended to obtain quick, flexible equity to Enron with reduced transaction costs, that he be permitted to organize and serve as managing partner of LJM2, a newly formed fund with outside investors that would be an alternative and optional source of private equity. There would be no requirement that Enron trade with LJM2. He proposed that the Chief Accounting Officer review and approve all transactions between Enron and LJM2. The Finance Committee, after questioning, learned that Arthur Andersen was fine with the partnership structure and that LJM2's limited partners were expected to be institutional investors who would be able to remove Mr. Fastow without cause. The Finance Committee augmented these controls by requiring that the Chief Risk Officer also review and approve all transactions and that the Board's Audit Committee review all transactions annually and make any recommendations it deemed appropriate. The Board ratified the Office of the Chairman's determination that Mr. Fastow's participation would not adversely affect the interest of the company. Enron publicly disclosed LJM2 as a related party transaction. Updates given to the Finance Committee about the LJM transactions were positive. At the May 2000 Finance Committee meeting, Mr. Fastow reported that he was personally devoting approximately 3 hours a week to the investment vehicles. We were also told that LJM2's investments had a projected rate of return of 17.95 percent. Mr. Causey, the Chief Accounting Officer, told us that Arthur Andersen was comfortable with the governance structure of LJM. We, of course, now know that the LJM2 investors received much higher returns. The minutes of the October 2000 Finance Committee also show that the Committee continued to focus on Mr. Fastow's dual role. Mr. Fastow described to the Committee six of the mechanisms that had been put in place to mitigate any potential conflicts, one of which was that Messrs. Buy, Causey, and Skilling approve all transactions between the company and LJM funds. A second was that Mr. Fastow maintain his fiduciary duty to Enron. In addition to these controls that Mr. Fastow described, the Committee instructed management that the Board's Compensation Committee review Mr. Fastow's compensation and that the Finance Committee, in addition to the annual review by the Audit Committee, conduct a quarterly review of the transactions between the company and the LJM funds. The Finance Committee received its first quarterly and the Audit Committee its second annual report on the related party transactions with LJM on February 12, 2001, from Mr. Causey. Mr. Causey discussed the Board-established guidelines for transacting with LJM. He then told the Board that the company had adopted certain procedures and controls in response to the Board's direction and reviewed the checklist review complemented by the adoption of additional controls. Mr. Causey informed the Finance Committee that the controls ``had been discussed with the Audit and Compliance Committee and commented that the process was working effectively.'' The preceding, I submit, illustrates that the Board applied Enron's code of conduct when it ratified management's recommendation regarding LJM1 and LJM2 and added substantial additional controls to ensure that all of the Enron LJM transactions would be in the best interest of the company. The record also indicates that the directors regularly monitored the LJM transactions and management's involvement. We asked for and repeatedly received reports informing us that the controls were working and that there were no concerns raised either by management or our outside auditors. Let me turn to the financing. Enron has been criticized for its use of off-balance-sheet financing or special purpose vehicles to raise debt and equity. This practice is common and permitted by the accounting rules, if structured correctly. For example, leasing companies and reinsurance companies exist to provide off-balance-sheet financing to their customers. The Board also has been criticized for authorizing hedge transactions involving these vehicles that made use of Enron stock for credit support. Let me respond. Enron owned certain highly volatile high-technology investments. That combination of volatile investments and required mark-to-market accounting had the potential to create instability and unpredictability in Enron's income statement. Putting in place hedges to mitigate these risks made good business sense. In fact, companies have been sued by their shareholders because they failed to put in place hedges on significant and volatile investments. Management wanted, appropriately, to use the significant unrealized value and forward contracts on Enron stock most effectively for the benefit of Enron's stockholders. It informed the Board that the proposed hedge transactions did so. Outside auditors concurred, or in one case, provided fairness opinions. In conclusion, what happened at Enron has been described as a systemic failure. I see it instead as a cautionary reminder of the limits of a director's role. A director's role, by its nature, is a part-time job. By force of necessity, we could not know personally all of Enron's employees. As we now know, key managers and employees whom we thought we knew proved to disappoint us significantly, and outside advisors whom we believed to be critical components of an effective oversight role failed in their duty. Arthur Andersen's failure to disclose its concerns to the Board, as well as management's marked disregard for the required internal controls and lack of candor with respect to information owed to us deprived the Board and deprived me of the ability to deal proactively with these problems. We cannot, I submit, be criticized for failing to address or remedy problems that had been concealed from us. Three months ago, days after the release of the Powers Committee report, I appeared before a House subcommittee. At that time, I was deeply disturbed and disappointed with what I had learned. I also squarely disagreed with certain conclusions, particularly about the directors' judgment and oversight, presented in the report, which disagreement I expressed during my testimony. Even with the benefits of a few more months to review these issues, I remain resolute in my belief that we were diligent and dedicated to our charge. Based on the recommendations, advice, and information we received from management and our advisors, we, the directors, acted in good faith and attempted to pursue the best interests of Enron and its shareholders. However, I deeply wish that at least one person in management, an employee, or an outside advisor, someone had come forward to the Board with his or her concerns when we could have addressed them. I am prepared to respond to any questions from the Subcommittee. Thank you. Senator Levin. Thank you very much. Dr. Jaedicke. TESTIMONY OF ROBERT K. JAEDICKE,\1\ FORMER AUDIT AND COMPLIANCE COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, BOZEMAN, MONTANA Mr. Jaedicke. Chairman Levin, Senator Collins, and Members of the Subcommittee, good morning and I also thank you for the opportunity to address the Subcommittee. My name is Robert Jaedicke. I served as the Chairman of the Audit Committee of the Board of Directors of Enron Corporation. As part of an overall restructuring of the Board, I recently resigned as a director, having served since the mid-1980's. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Jaedicke with attachments appears in the Appendix on page 155. --------------------------------------------------------------------------- Let me tell you very briefly about my background. I joined the faculty of the Stanford Graduate School of Business in 1961. I served as Dean of the school from 1983 to 1990. At that time, I returned to the faculty of the Business School, and I retired from the university in 1992. Throughout my tenure as Chairman of the Enron Board's Audit Committee, I was committed to ensuring that it was an effective and actively functioning body. Over the last few years, we undertook to review and strengthen our already vigorous control systems. In 1999, we began a number of initiatives to ensure that we remained a ``best practices'' audit committee. Throughout 2000 and into 2001, our committee worked with Arthur Andersen to make sure that we complied with the recommendations of the Securities and Exchange Commission, the New York Stock Exchange, and the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. That effort culminated in February 2001, when the Audit Committee drafted a new charter that was approved by the full Board. The lifeblood of the work of any audit committee is the development and implementation of adequate controls, many of which cross-check each other. The committee's responsibility is to review reports from management and the outside auditors, to review the adequacy of internal controls, and to oversee the filing of financial statements. The committee's effective oversight also depends on the full and complete reporting of information to it. Without full and accurate information, an audit committee cannot be effective. The audit committee does not manage the company and does not do the auditing. It is my understanding that audit committees of most corporations, like Enron, typically meet for a few hours several times a year. Warren Buffet wrote to the New York Stock Exchange Chairman and CEO Richard Grasso in 1999, and I quote, ``An audit committee that meets for a few hours several times a year is simply not going to pick up anything that is missed by the outside auditors. Therefore, the task of the audit committee should be to hold the feet of the outside auditors to the fire.'' In that same letter, Mr. Buffet also stated, and I quote, ``Simply put, audit committees cannot act as auditors. Their true job, and I would argue the only important function that they can adequately discharge, is to make sure that the auditors do their job instead of becoming subservient to management.'' I agree. We held regular meetings at least four or five times a year; always four, usually five. At meetings, we received reports from a broad range of senior management and Arthur Andersen personnel. Audit Committee meetings regularly included three Arthur Andersen partners, Enron's Chief Accounting Officer, Chief Risk Officer, General Counsel, Chief Internal Auditors, Mr. Lay, Mr. Skilling, and other senior officers and outside advisors, as appropriate. We were entitled to rely on these reports. We asked questions. We provided oversight. We received several special reports on accounting policies. And we continually discussed the adequacy of our internal controls. I respectfully submit that we did our job. At each Audit Committee, it was my invariable practice to hold--or at least offer to hold--an executive session with the Arthur Andersen representatives where they could meet with us without management present. There, Arthur Andersen could freely report to the committee any matters of concern that made the auditors uncomfortable, including whether they had any significant disagreements with management, whether they had full cooperation of management, whether reasonably effective accounting systems and controls were in place, whether there were any material systems and controls that needed strengthening, and whether they had detected instances where company policies had not been fully addressed. Arthur Andersen did not raised concerns about the partnerships in these executive sessions. In fact, they normally reported to us that the structures and transactions were complex, they required judgment, but that they were in at an early stage to understand and review the transactions and that they were comfortable with the accounting treatment. Last February, Alan Greenspan testified before the Congress, ``I have served on too many audit committees to know that even though I would consider myself independent, I would consider myself knowledgeable, I did not know what questions to ask the Chief Financial Officer during meetings to find out what it is that conceivably is wrong in the corporation, and he was not about to tell me.'' I agree with Mr. Greenspan. We did everything possible to ensure that our controls and procedures were being followed. To my knowledge, we were one of the few major corporations that required Arthur Andersen or their outside auditor to give an attest opinion on the management's assertions that our controls were adequate. What happened at Enron, as my colleague has indicated, has been described as a systemic failure. I agree with him as it pertains to the Board. I see it as a cautionary reminder, also, of the limits of the director's role. We served as directors of what was then the seventh-largest corporation, which required us to confine our attention to the broad policy decisions. At meetings of the Board and its committee, in which all of us participated, these issues were considered and decided on the basis of summary reports, corporate records, upon which we were entitled to rely. We also relied on the honesty and integrity of management, their subordinates and advisors, and on the integrity of the information we were receiving. At the time, we had no doubt--we had no reason to doubt the integrity of either the management or the advisors. We did all this and more. Sadly, despite all that we tried to do in the face of all the assurances that we received, we had no cause for suspicion until it was too late. Thank you very much, and I am prepared to respond to questions from the Subcommittee. Senator Levin. Thank you very much, Dr. Jaedicke. Dr. LeMaistre. TESTIMONY OF CHARLES A. LeMAISTRE,\1\ M.D., FORMER COMPENSATION AND MANAGEMENT DEVELOPMENT COMMITTEE CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, SAN ANTONIO, TEXAS Dr. LeMaistre. Chairman Levin, Senator Collins, Members of the Subcommittee, we are delighted to be here to participate in your investigation. Senator Durbin, I want to assure you that we were shaken to the core, also. It is a very good description of what happened by the events that we first learned about on October 17, that our controls were not being followed. The Board thereafter took immediate action on several fronts, one of which was very valuable to you in your investigation, the no-holds-barred Powers Report, which enlightened all of us as to where the problems were. --------------------------------------------------------------------------- \1\ The prepared statement of Dr. LeMaistre with an attachment appears in the Appendix on page 176. --------------------------------------------------------------------------- My name is Charles LeMaistre. I am a physician by profession. I am also President Emeritus of the University of Texas M.D. Anderson Cancer Center and former Chancellor of the University of Texas System. For 17 years, I have served on the Enron Board. For most of those years, I have held a position as Chairman of the Compensation and Management Development Committee. I resigned in March 2002 as a part of the restructuring of that Board. I would like to directly address some of the questions that have been raised regarding compensation and the bonus process for executives. The Compensation Committee's basic responsibility is to assure that the senior executives of the company are compensated effectively in a manner consistent with the compensation strategy stated to the shareholders. The Committee considered internal equity, competitive compensation practices, and the requirements of appropriate regulatory bodies. The philosophy behind the executive compensation is to reward executive performance that creates long-term shareholder value, in essence, a pay-for-performance philosophy that benefits the shareholder. Executives had the opportunity to earn up to the 75th percentile or higher of the compensation rates at comparable competitive companies, subject to obtaining a performance at 75th percentile or higher. As a first step in this process, we received the recommendations from management and discussed their justifications fully. We also relied almost always on the outside executive firm, Towers Perrin, to independently review the recommendations and give us advice and a recommendation regarding the various compensation issues brought to the committee. Based on that advice, the committee arrived at proposals for presentation to the Board, and they deliberated on these very carefully and for long hours in order to arrive at a common position. In recent years, the Compensation Committee was dealing with Enron's evolution from a pipeline company to an energy trading company that engaged in sophisticated and complex financing structures. Enron sought out different talent for its management in the energy trading business. To hire and successfully retain these highly-sought individuals, Enron needed to offer compensation packages equivalent to, and sometimes better than, those offered by the competition. Enron believed that the talented individuals leading the company were one of the most valuable assets the company had and critical to its success. Towers Perrin was often asked to craft compensation packages, stress test the executive compensation plan, and conduct surveys of competitive practices to be sure Enron was well positioned in the marketplace. Let us go into some compensation-related issues. First, with regard to Ken Lay, the media and others have raised many questions about Mr. Lay's compensation. In particular, I would like to address the $141 million he received in total compensation for the year 2000. It has been suggested that this level of compensation was unreasonably high and over 10 times the average received by the CEOs of the top 200 companies. First, I believe that comparing Mr. Lay's total compensation against the average salary of the CEO in a top 200 company does not necessarily yield an accurate picture. Because Mr. Lay's compensation placed him in the top 10 highest-paid CEOs, I believe that comparing his compensation to those in that category is more accurate. Within the top ten, Mr. Lay was ranked seventh that year. Enron, coincidentally, was ranked as the seventh largest company. The average compensation for the top 10 CEOs was about $169 million. The top compensation was $293 million. I have attached a chart to my statement that presents this information. Second, I think it is important to break out what comprises Mr. Lay's total compensation package to determine the actual cost to the company for that year. A very large portion of the total compensation is at risk under the pay-for-performance philosophy. The portion at risk depends upon meeting competitive criteria for the future value from stock options exercised to be realized and from restricted stock payouts to be realized. For this portion at risk, the executive is rewarded only if the shareholder is rewarded. If the ``at risk'' portion is subtracted from the total, you arrive at about $10 million, which I believe is a more accurate representation of what Mr. Lay's 2000 compensation cost the company that year. I also note that 2000 was an extraordinary year for Enron and its shareholders, which accounts for the large increase in bonus for that year. That is roughly $10 million, including his base salary of $1.3 million and a bonus of $7 million. Mr. Lay's compensation was disclosed and footnoted and detailed in the proxy statement each year. Next, Andy Fastow's salary from the LJM partnerships. On October 19, 2001, the Wall Street Journal reported that Mr. Fastow and possibly some of his partnership associates received more than $7 million in compensation from the LJM partnerships. Let me comment on what I know about his LJM compensation. On October 19, a special meeting of the full Board was called to discuss Mr. Fastow's compensation from the LJM and other related matters. We went into it in some detail, and on October 22, 2001, the Board authorized Mr. Duncan, Chairman of the Executive Committee, and myself, as Chairman of the Compensation Committee, to inquire directly of Mr. Fastow as to his compensation from the partnerships. Enron's General Counsel drafted the questions we would ask. I called Mr. Fastow on October 22 and arranged for a conference call the very next day. On that call, Mr. Duncan and I asked Mr. Fastow about the amount of his investment in LJM1 and LJM2 and his return on those investments. Mr. Fastow responded that his commitment in LJM1 and LJM2 was $1 million and $3.9 million, respectively. He stated that his income from LJM1 was $23 million, and approximately $22 million from the LJM2. On October 24, the very next day, the Board met. Mr. Fastow was relieved of his responsibility as Chief Financial Officer. I do not believe that the Board of Directors would ever have approved Mr. Fastow's participation in the partnerships if we had known he would be generating such compensation. Indeed, we were told just the opposite. Very conservative yields should come from the formulas that were presented to the Board. If management had instituted the controls that the Board authorized, Mr. Fastow's compensation would have been reported to Mr. Skilling, the Audit Committee, the Finance Committee, and the Compensation Committee. On October 6, 2000, the Finance Committee meeting minutes clearly show from his own presentation that Mr. Fastow was aware of the six controls imposed by the Board on his participation in LJM, including his responsibility to review with Mr. Skilling ``his economic interest in the company and the LJM funds.'' Following Mr. Fastow's presentation, the Finance Committee then added to the existing controls a quarterly review of the LJM transactions and a review by the Compensation Committee of Mr. Fastow's LJM compensation. That meant there would be two full reviews by the Finance Committee and the Audit Committee, one on a quarterly basis and the other on an annual basis, through which that information should have come in addition to the newly authorized review by the Compensation Committee. Enron's Performance Unit Plan has been confusing to many. I would like to comment briefly on it. Prior to 1999, Enron granted performance units to corporate and certain operating company executives who were not in an Enron long-term incentive plan at that time. These operating company executives were, for the most part, in commercial support and in the pipeline business. Enron was a highly decentralized company at that time. The first performance units were awarded in 1987 and the last in 1998. The units have a life of 4 years, so the payouts could still be continuing as of last year. Awards were based on Enron's total shareholder return over the 4 years. The participants were nominated by the Office of the Chairman and approved by the Compensation Committee. There was a limit of three million performance units per individual. Performance was measured against that of a performance of peer group of companies with a payout scale of one to seven. Each unit was assigned a valuation of $1. A ranking of one had a payout of $2, twice the value, and a ranking of seven did not pay out anything. In the event that the total shareholder return did not exceed the cumulative percentage for the 90-day Treasury Bill, a performance unit would have no value. In conclusion, I believe that our Committee and the Enron Board endeavored to manage carefully and effectively Enron's executive compensation while the company was rapidly evolving, growing, and undertaking new business opportunities. The Committee sought and relied on the advice of outside executive compensation experts to ensure our recommendations and decisions were consistent with the marketplace. Although the Board was willing to award compensation that was competitive and deserved, it certainly did not approve and was not made aware by management that some individuals reaped huge profits at the company's expense or that others abused certain benefits in ways for which they were not designated. Thank you very much for your attention. I will be pleased to answer your questions. Senator Levin. Thank you very much, Dr. LeMaistre. Mr. Blake. TESTIMONY OF NORMAN P. BLAKE,\1\ INTERIM CHAIR, BOARD OF DIRECTORS, ENRON CORPORATION, ROSEMONT, ILLINOIS Mr. Blake. Thank you, Mr. Chairman. It is good to be here, Senator Collins and Members of the Subcommittee. It is certainly a privilege to be here and I thank you for the opportunity. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Blake appears in the Appendix on page 181. --------------------------------------------------------------------------- My name is Norm Blake. I am Interim Chairman of the Board of the Enron Corporation. I have been a Director of Enron since 1993. Since the onset of bankruptcy, five members of the Board and I have been actively engaged in the development of a newly constituted Board of Directors in cooperation with Enron's Creditors Committee. It is the intention of these Board members and me to resign from the Board once an orderly and effective transition of authority has taken place. We are now serving on a pro bono basis in recognition of our responsibility to serve the interests of Enron's stakeholders and employees. My background can essentially be characterized as having extensive management and leadership experience in a variety of industries, with significant involvement in financial services. Over the last 12 years, I have been Chairman and CEO of three different Fortune 500 companies and held board membership positions in others. Much of my earlier business career was with the General Electric Company, with my latest position in 1984 being Executive Vice President of Financing Operations for the General Electric Credit Corporation. My colleagues in their statements today will discuss the Board's and its committees' respective roles and involvement in the related party transactions. I would like to focus on certain issues that have been raised with respect to the Board and the outside Directors as a collective unit. I will begin by saying unequivocally that I am proud to have served as a member of the Board with such capable, hard working, intelligent, and ethical individuals. Personally, I believe while we may have initially just been a collection of individuals, we have now evolved into a very cohesive and collegial group. Moreover, in my view, this Board has remained diligent and dedicated to its responsibilities throughout the process. Although we, at the time, had much confidence and respect in the abilities of the management of the company, we did, in fact, operate independently and did, in fact, exert our influence, and at times, contrary to the wishes of management. For example, the decision made by the majority of the Board to acquire Wessex and form Azurix was made over the dissention of two Directors and abstention of another. More recently, management's intention to acquire a pulp mill in October of last year was resisted by the Board to the extent that the decision was not made to make the acquisition. Allow me to put Enron into perspective over the last couple of years, and as cited by many of you this morning. By 2000, Enron was one of the 10 largest companies in the United States. Enron had begun a transformation from a traditional pipeline and energy company with substantial fixed assets to an innovative energy trading company that showed tremendous potential but required liquidity and creditworthiness. My personal focus as a member of the Board and its Finance Committee had been Enron's liquidity and financial leverage in furtherance of this strategy. As a Board, we were attentive to and working with management and outside experts to realize this mission. We believed that the company was successful in moving in that direction. In late 2000 or early 2001, no one had predicted by the end of 2001, Enron would file for bankruptcy. In fact, as late as October 2001, we were informed by management that we were ahead of plan in terms of earnings and that creditworthiness and liquidity issues were manageable. A central issue at hand involves Enron's intentions in establishing SPEs. I would like to provide an opposing point of view to that held by many that the intention of Enron in establishing these partnerships was to manufacture earnings. To the contrary, it is my opinion that the primary purpose of these partnerships was to improve liquidity and get debt off our balance sheet. The LJM partnerships were specifically constituted for that purpose, and by the way, I would contend that many companies establish SPEs for exactly such a purpose. Of course, now, with the benefit of hindsight, committees of Congress, the media, government officials, financial experts, and others have tried to dissect and examine what went wrong at Enron. Over the past several months, several questions have been raised with respect to the Directors as a group. In particular, people ask if the Board failed in its oversight duty, whether Enron was moving so quickly that independent directors could not keep up. I think not. We worked hard. We worked very hard. We came prepared and we asked questions. We were sent materials in advance of meetings and it seemed that each Director reviewed them and came to the meetings prepared. Sometimes before a Board meeting, after spending many hours in preparation for these meetings, I would speak with Mr. Skilling about the balance sheet issues or with the Chief Risk Officer, Rick Buy, about liquidity, leverage, and credit issues. I know that my fellow Director Pug Winokur, who is here today, spent time with Enron's Chief Financial Officer, Andy Fastow, before meetings, asking him a variety of questions. And Dr. LeMaistre, who is also appearing with us today, spent much of his time in advance of upcoming Compensation Committee meetings with Enron's human resource and compensation staff, as well as external consultants, to ensure himself that he understood all the technical aspects of Enron's compensation plans and to be in a position to evaluate recommendations made by management. He took his job very seriously, as we all did. In short, I believe, judged by any standard, that this Board executed its duties to the company and its shareholders. During Board and committee meetings, we did, in fact, question management. For example, during October 1999 Finance Committee, in which we discussed the LJM2 partnership, the Board material discloses that I specifically asked whether Arthur Andersen had reviewed the partnership. We were told by the Chief Accounting Officer that Arthur Andersen was, ``fine with it.'' If we had been told that Arthur Andersen had not reviewed the structure or that Arthur Andersen had reservations, this Board would never have approved it. The first Raptor transaction was brought to the Finance Committee, in May 1, 2000. The minutes reflect the Chief Accounting Officer told us that, ``Arthur Andersen LLP had spent considerable time analyzing the Talon structure and the governance structure of LJM2 and was comfortable with the proposed transaction.'' This advice was critical to our decision to authorize this transaction. Some commentators have since suggested that the structure of this transaction was inappropriate on its face. This is not the advice that we received. My fellow directors asked questions pertaining to propriety and the oversight of these transactions. We did not rubber stamp management's recommendations and requests. Even with the benefit of hindsight, I cannot speculate as to what else we could have done to ensure that our controls and procedures were followed. We put the right controls in place and we asked the right questions. These directors were a smart and talented group of people who brought a diversity of experience and expertise to the Board. Unfortunately, I believe that we were uninformed because management and outside experts who reported to us failed in their jobs and did not give us full and complete information. Again, I thank you for being here today. I welcome the opportunity to answer your questions. Thank you, sir. Senator Levin. Thank you very much, Mr. Blake. Let me start with you, Dr. Jaedicke. You were Chairman of the Audit Committee. The Audit Committee got an annual briefing from Andersen about its accounting policies and its practices, as you have testified. We have a number of excerpts from those briefings in the exhibit book, and I wish you would turn to Exhibit 2.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 2 which appears in the Appendix on page 204. --------------------------------------------------------------------------- Mr. Jaedicke. Yes, sir. Senator Levin. Exhibit 2 is part of the Andersen briefing on February 7, 1999. It relates to the Enron financial reporting in 1998, which was the previous year that had just finished. Now, this was an unusual Audit Committee meeting, because instead of taking place in Houston, it took place in London. Do you remember this meeting in London? Mr. Jaedicke. Yes, I do. Senator Levin. Thank you. The Board's minutes reflect that David Duncan, the Andersen partner who headed the Enron audit team, and that Tom Bauer, who was also on the audit team, and that Steve Goddard, who was head of the Andersen office in Houston, were in attendance. Those were the three Andersen partners who typically dealt with your Audit Committee and the Board, and the minutes show that all of the Audit Committee members were there, as well as another Andersen employee and several members of Enron management, including Mr. Lay and Mr. Skilling. Now, this chart, or this document that you're looking at says at the top ``Risk Profile,'' which means the risk to Enron that its accounting practices may not be found to be in compliance with sound accounting practices. And you will see there the letters ``H'', ``M'', and ``L'', and those letters stand for high, medium, and low risk. So ``H'' stands for high, ``M'' for medium, and ``L'' for low risk. Andersen was telling your Audit Committee about the risks, and the first item you will see on the list is highly structured transactions. These are the elaborate transactions which I talked about in my opening statement. And the chart here shows high risk, ``H'', circled for emphasis, in all three categories, including accounting judgments. So the document indicates--and this is a document from your files, so we know you were shown this document--that Enron was engaging in high- risk accounting practices when it came to those structured transactions. Do you remember that presentation? Mr. Jaedicke. Yes, I do. Would you like me to comment on it, sir? Senator Levin. Feel free to do that. Mr. Jaedicke. I think the way--the interpretation--this was a template given to the Audit Committee to try to help us--to help us understand the kinds of accounting policies that were important to the company. Now, maybe ``risk'' is a poor term, but if you look, for example, at highly structured transactions, I think the way to read this, and I think the comments generally support this, is to say energy asset securitizations--now, this is in 1998--that the accounting judgments--read ``H'' as important. They are important because there is a risk that---- Senator Levin. I am going to read ``H'' for what it stands for, which is high. Mr. Jaedicke. The risk, the judgments, they are complex. They need to be made very carefully. Senator Levin. Are you denying that ``H''---- Mr. Jaedicke. Now just let me---- Senator Levin. Excuse me. Are you denying that ``H'' means high? Mr. Jaedicke. OK, high. Disclosure judgment, the importance is high. The risk is high. It needs to be done carefully. The rule change--risk in the sense of rule change, I think simply means there is a high probability that the rules in this area will develop and can change, and they did. Now, if you just allow me to contrast that with something like purchase accounting down in the middle of the page, to judge whether the purchase accounting can be used instead of, say, a pooling of interest, that is an important, in your terms, high-risk area. You need to make a very careful judgment. But then if you move over, the disclosure is ``M''. I would assume that is medium. And it is because that issue has been around for a long time and there is a fair amount of guidance on it. It was already in existence in 1998. And if you go to the rule change, under ``L'', some rule change coming along, the odds were fairly low. About the only one at that time that was under consideration was to do away with pooling. And so I think what this is and what we used it for was a way of saying, well, where are the sensitive areas, what are their disclosure characteristics, and what are the odds that rule changes will come along and somehow change what either we have to do or the way we have to disclose or the way in which the accounting has to be done. That is my interpretation, sir. Senator Levin. Well, these are not my terms. These are Arthur Andersen's terms and they are circled. The ``H'' is not my term. It stands for high. You can say that the ``H'' under rule changes means there is a high risk that the rule may change, and I fully agree with you, but by that same logic, the ``H'' under accounting judgments means there is a high risk involved in that judgment. So, Dr. Jaedicke, these are not my terms. These are the documents presented to you with ``H'', high risk, circled by Arthur Andersen in 1999. Next, Exhibit 3.\1\ The handwriting on this document belongs to David Duncan. --------------------------------------------------------------------------- \1\ See Exhibit No. 3 which appears in the Appendix on page 208. --------------------------------------------------------------------------- Mr. Jaedicke. Yes. Senator Levin. It is his handwriting on it, and this is basically Andersen's version of the previous exhibit, with the same matrix, but now it is a document with their talking points for the presentation that was made to you at that London Audit Committee meeting. I would like to direct your attention to the handwritten note in the lower right-hand corner. It is hard to read, so we put it up on the board here and made that Exhibit 4.\2\ This is what that note says at the bottom. ``Obviously, we are on board with all of these, but many push limits and have a high `others could have a different view' risk profile.'' High-risk profile. This is Duncan's note on this document. Then it lists those various accounting practices which you also see on Exhibit 4. --------------------------------------------------------------------------- \2\ See Exhibit No. 4 which appears in the Appendix on page 209. --------------------------------------------------------------------------- So not only was the Audit Committee told by Andersen that although Andersen was on board, that many of Enron's accounting practices, in the words used there, his note, ``push limits,'' and that others could view them as outside of compliance with Generally Accepted Accounting Principles. Now, do you remember David Duncan telling that to the Audit Committee on February 7, 1999? Mr. Jaedicke. I do not remember David Duncan telling us this particular note. David Duncan did tell us on several occasions that these were complex transactions, that they were complex structures, that Enron was a complex company. They were moving very fast, and very careful accounting judgments were required. He also would, on occasion, try to indicate to us how much guidance was available on those. But in terms of--and I do not recall him saying, well, others could have a different view. But I think all of us understood that these were highly structured, new kinds of transactions, but please, sir, keep in mind, that was one reason that Enron paid Arthur Andersen some pretty hefty fees, to try to be in on the beginning of these transactions so that those accounting judgments, they understood the transaction and that the accounting judgments would be properly made. Senator Levin. You do not remember David Duncan notifying your Committee that these were high-risk accounting approaches? Mr. Jaedicke. I remember these--this chart, sir. I cannot say that I remember this quote that is in the bottom of his-- the lower right-hand corner of the---- Senator Levin. If he had told you that they were high-risk accounting approaches, would you remember it? Mr. Jaedicke. I think I would. I do not quite--we knew these were important transactions. Senator Levin. I am using the words ``high risk.'' You can try to change that from a ``H'' to an ``I''. I am saying that the ``H'' was circled. It was Andersen's word. It was presented to you in the document in Exhibit 2. We have Duncan's note saying specifically that these push limits. Those are his words on his copy of the document, and you are saying you do not remember him using the words ``push limits,'' is that correct? Mr. Jaedicke. I do not remember the words ``push limits.'' Senator Levin. OK. Let me just keep going, then. Now, Andersen also rated the accounting risks that Enron was taking. They did their own rating, which is reflected in the documents which you have just seen. This analysis is done at accounting firms for a number of reasons, and the Andersen analysis upon which those first two documents were based are Exhibits 10a and 10b. If you could look now at Exhibits 10a and 10b---- Mr. Jaedicke. Exhibits 10a and 10b---- Senator Levin. Let me go back. I missed a document that I wanted to show you, Exhibit 5,\1\ so if I could just interrupt the flow here for a moment---- --------------------------------------------------------------------------- \1\ See Exhibit No. 5 which appears in the Appendix on page 210. --------------------------------------------------------------------------- This is a letter that we received last week from legal counsel representing Arthur Andersen's partner, Tom Bauer, who was at that London meeting and participated in the discussion. Here is what this letter says, and this, again, is Exhibit 5 in the book. ``Certain risk areas were described as pushing the limits, as reflected in Dr. Duncan's note, or as being at the edge.'' So now we have Exhibit 2, which you acknowledge was before you, with that circled ``H'' for high-risk accounting approaches. We have Exhibit 3, which has Duncan's note as to what he was telling you. And now we have an exhibit which supports those two earlier exhibits. This is a letter which says that Mr. Bauer remembers that, ``Certain risk areas were described as `pushing the limits,' as reflected in Mr. Duncan's notes, or as being `at the edge'.'' So now we have got that memory of Bauer, which is added to Exhibits 2 and 3. So now your memory differs also with Bauer as well as with the exhibit itself. Now I want to move you over to Exhibit 10.\2\ This is a document which was Arthur Andersen's internal document, but upon which Exhibits 2 and 3 had either been based, or it is similar to a document in which those conclusions were reached. --------------------------------------------------------------------------- \2\ See Exhibit No. 10 which appears in the Appendix on page 222. --------------------------------------------------------------------------- First, if you would turn to Exhibit 10a.\3\ This is for the year 2000. This is for a later year, and I am going to give you this and then go back to 1999. Take a look, if you would, at the line which is marked on the first page there in which it says, ``Accounting and Financial Reporting Risk--Very Significant.'' ``Management Pressures''--do you see that, on driver number five? Do you see that on the front page? ``Management Pressures--Very Significant.'' --------------------------------------------------------------------------- \3\ See Exhibit No. 10a which appears in the Appendix on page 222. --------------------------------------------------------------------------- This document, signed by David Duncan, this risk classification offers several comments which justify their conclusion. On the front page, under ``Management Pressures,'' ``Enron has aggressive earnings targets and enters into numerous complex transactions to achieve those targets.'' Also on the front page, ``The Company's personnel are very sophisticated and enter into numerous complex transactions and are often aggressive in structuring transactions to achieve derived financial reporting objectives.'' The 1999 risk analysis is Exhibit 10b and it uses similar-- let me get you to the third page of Exhibit 10a before we turn to Exhibit 10b. It's under ``Risk Classification and Rationale.'' It says, ``Risk Classification: Maximum.'' Do you see that there? Mr. Jaedicke. I see it. Senator Levin. Do you see where it says ``Prior Year Risk Classification,'' and it says ``Maximum'' ? Now, these are risk classifications. Mr. Jaedicke. I see it. Senator Levin. Now we will go back to 1999 and Exhibit 10b.\1\ And again, these are further evidence not only that Andersen considered Enron to be engaged in high-risk accounting and had management pressure, but they also substantiate the Duncan note, the Bauer letter, and Exhibit 2 which was directly presented to you and which talked about high-risk accounting transactions. --------------------------------------------------------------------------- \1\ See Exhibit No. 10b which appears in the Appendix on page 226. --------------------------------------------------------------------------- But if you will look now on Exhibit 10b, you will see under ``Complex/risky transactions,'' where it says, ``Form over substance transactions.'' ``Form over substance transactions''--this is 1999, now, we are talking about. The box that they check is ``Very Significant.'' So your auditor viewed Enron accounting practices as being high risk. They said that the use of form over substance transactions was very significant and that very strongly supports the Duncan note as to what he told you in London in 1999 and Exhibit 2, which was directly handed to you and which said that your accounting practices were high-risk practices. And despite all of that, what you are saying is you do not remember or you deny that your auditor told you in 1999 and 2000 that you were engaged in high-risk accounting practices, is that correct? Mr. Jaedicke. We knew that the company was engaged in high- risk and innovative transactions. But if you contrast this, if David Duncan had given this to the Audit Committee, my guess is the discussion would have been a lot different than it was. If you go back and you look at the Audit Committee, the various meetings, Senator, you would find that on almost every agenda, there were listed--you would look at what were the audit emphases of the past quarter and what were the audit emphases of the quarter coming up, and they would almost always list related party transactions, structured transactions, securitizations, and mark-to-market and fair value. Those were almost always areas of emphasis. Now, when we would ask them, even in executive session, about, OK, how do you feel about these, the usual expression was one of comfort. It was not, these are the highest risk transactions on our scale of one to 10 or whatever this is. If the information in this kind of a document had been conveyed to us in the terms that it showed here, the template that you showed me, the ``H''s were almost always interpreted, at least by me, as saying if you want a template of those accounting areas that are important to Enron and deserve our emphasis, that is where you would look, and the ``H''s were no surprise. Those were almost always on the agenda of the Committee. Now, this kind of information, where you say pushing the limits or whatever--form over substance, I never, ever heard that term used. Senator Levin. The reason that---- Mr. Jaedicke. That I recall. Senator Levin. The reason that is so important is because what was presented to you were the ``H''s, not ``I''s, not ``M''s, not ``L''s, ``H''s, high-risk accounting judgments. You acknowledge that. Now the question is, well, wait a minute. Did that mean what it said? Then you have got a note contemporaneously from Duncan, as well as from the other witness who was there, saying you, in fact, were informed that these were pushing the limits at that meeting. You deny hearing that, but there is very strong evidence that, in fact, that occurred--the evidence: Contemporaneous notes, statement of another witness, and the internal documents of Arthur Andersen--show that was, indeed, their conclusion. You put all that together, and the evidence is pretty strong that you were informed these were high-risk accounting practices but that you did not act on those notes and that information. That is what jumps out from these exhibits and from this testimony. So weigh that against ``you do not remember''--it seems to leave me with one conclusion. You may not remember---- Mr. Jaedicke. All I said was I do not remember the particular wording of the comment that you showed me on that particular--on that slide. Senator Levin. Thank you. Senator Collins. Senator Collins. Thank you, Mr. Chairman. Dr. Jaedicke, in an interview with the Subcommittee staff, Lord Wakeham indicated that he had been concerned that Andersen's high level of involvement with the company meant that Anderson might be too close to Enron's management. As Chairman of the Audit Committee, did you ever have a similar concern? Mr. Jaedicke. Well, Senator, we--on the independence issue, for the last couple of years, we had a very sort of set pattern of trying to assure ourselves that, in fact, Arthur Andersen was independent. It worked like this. There is a series of criteria and guidelines that are set forth by, for example, the Independent Standards Board. We would discuss those usually in the August meeting and we would also hear from Arthur Andersen how their internal processes on affecting the independence issue worked, and those stemmed all the way from saying, well, how do you monitor and handle the relationships of family members, all the way over to saying, what do your internal dispute resolutions look like for partner disputes? How do they work at the local level? How do they work at the Chicago level? How do they work worldwide? And they would go over in August with us all of the--sort of their internal processes for assuring independence. And then in the February meeting, when we reviewed the financials and we had to make a recommendation to the auditors, we heard a representation from the Arthur Andersen engagement team that the firm had assessed its independence using these procedures and criteria and that they believed they were independent. So in February, we would receive their independence--or, excuse me, their representation. Senator Collins. I understand that the Audit Committee accepted the representation of Andersen that it was independent, but I do not understand why the Audit Committee would accept that assertion given that Andersen had consulting, and internal and external auditing roles for Enron. Essentially, was not Andersen passing judgment on its own work? We have talked with numerous experts who are very critical of having the outside auditor also do some internal auditing as well as consulting work. Does that not set up a situation that is just ripe for conflicts of interest? Mr. Jaedicke. Let me speak to the so-called integrated audit, which is commonly phrased as doing the internal auditing. You have to keep in mind that Enron probably had about on the order of twice as much internal auditing as Arthur Andersen did. We had a Risk Control Group that consisted of, I do not know, 100 people or more. We had the Enron Assurances Group, which were a group of internal auditors that had internal auditors in each business unit, and we had an Information Technology Auditing Group. Now, that alone would be a sizeable amount of internal auditing. What the integrated audit tried to do, two things. One is to say, Arthur Andersen, you have to review the adequacy of internal controls in order to make a judgment on the fairness of the financial statements. What we would like you to do is to go farther than that and do enough internal auditing on the adequacy of the internal controls, where you control the scope, not management, such that you can give us an attest opinion on management's assertion that the controls are adequate. Now, I was in favor of that because otherwise, you get the assertion that says, we do not know of any material weaknesses. It is a very positive opinion. But the other thing I wish to emphasize is they were not auditing their own work. For example, my colleague Dr. Winokur, and I, worked for a couple of years responding to drafts from the management who was working on a risk management policy, not only for the trading, but for liquidity and many other things. When the Board adopted that policy, it was our policy, but what we wanted Arthur Andersen to tell us is, we have done enough auditing to assure you that it is the management's contention that it is adequate and we also will be able to tell you it is being followed. That is what we were after. Senator Collins. Were you aware that the fees paid to Andersen had increased dramatically, from $29.6 million in 1998 to $46.4 million in 1999? Mr. Jaedicke. That is total. Senator Collins. That is total. Mr. Jaedicke. Yes. Well, we were reported the fees, but I think about half of that, Senator, would be the baseline and the integrated audit--the baseline integrated audit and the fees that they charged us to express an accounting opinion on the transactions. Senator Collins. My point is that this work was pretty lucrative for Andersen and Andersen was playing more and more of a role and passing judgment on transactions that were risky, to say the least. Should it not have been a red flag to the Audit Committee, given how lucrative this business was, that Andersen might not be as forthcoming as it should have been? You have been very critical of Andersen for not sharing information. Should these not have been red flags that Andersen was playing more and more of a role, such that Lord Wakeham raised a concern about it? Mr. Jaedicke. Are you asking for my opinion? Senator Collins. I am. Mr. Jaedicke. In my opinion, I did not see it as a red flag. I saw it actually as some comfort that said the management is willing to pay fees large enough to get Arthur Andersen to tell us in a positive way whether our internal controls are adequate and functioning, rather than to have an internal auditor working for the company do it, which was always, to me, a problem. Senator Collins. Let me ask you this question. The SEC had a blue ribbon commission in 1999 and 2000 that made several suggestions to ensure the independence of auditors. Are you familiar with those? Mr. Jaedicke. Well, I am familiar with some of their rules. Senator Collins. Let me ask you about a specific one, if I may. One of the recommendations that the SEC made was that the Audit Committee obtain a written statement from the auditor listing all of the relationships between the auditor and the company, and that the Audit Committee should then discuss each of those relationships and pass judgment--the Audit Committee should pass judgment, not the auditor passing judgment on itself--on whether or not any of those relationships compromised the independence of the auditor. Was that done? Mr. Jaedicke. The review of independence in August, I think, would have included that, because I think one of the criteria or one of the issues that you had to look at had to do with those relationships, and they reported to us on, well, what are the firm's policies when you have people go to work for Enron? They also reported to us at one point, and I would have to look at the details because I have forgotten it, that there was a small joint venture, I believe on some software, and I really have to go back and look at it and see what the details were. It was considered to be immaterial, but it was disclosed to the Audit Committee. Senator Collins. Dr. Jaedicke, you have a lot of experience. Have you ever known an auditor to come in and say, ``we are not independent,'' or ``we are too close to management'' ? Mr. Jaedicke. No, I guess---- Senator Collins. Is it not the job to be---- Mr. Jaedicke. They would not last very long if they did that. Senator Collins. Exactly my point. Mr. Jaedicke. I agree. Senator Collins. When the auditor is making over $40 million a year, the auditor is not likely to come to the Audit Committee and say anything other than that it is independent. Is it not the job of the Audit Committee to make sure that the auditor truly is giving full, accurate, and independent advice to the Board? Mr. Jaedicke. I think the way we tried to do that, Senator--I agree, we should try to do it--was to say OK and once a year, at least, lead us through all of the controls that the firm has in place to help assure their independence. Again, an Audit Committee's work is on the adequacy not only of the company's controls but also of the controls of their outside advisors, and we did that. Senator Collins. As the Chairman of the Audit Committee, you were the Board member most responsible for ensuring that there was full and complete and accurate communication between Andersen and the Board. In your tenure as Chairman, how often did Andersen tell you of problems that concerned Andersen with the management of Enron? Mr. Jaedicke. Well, they would usually--let me define problems. They would usually--these would usually come out in the form of saying, for example, we are engaged in a review of the internal controls of the new businesses, and then we would--and so they would--there was reason to believe you needed to concentrate on the controls. There was need for, for example, some pre-measurement type of controls in Enron Energy Systems at one point. We were concerned about were there access issues in Enron On-Line. Now, things of that nature would come out in talking to the Audit Committee and then we would follow that. And if you looked, for example, at the minutes, you would find that the next meeting, they would say, significant progress has been made in these areas. And so they did--the types of problems that they talked to us about were usually in connection with their auditing emphases or the controls that were inherent in a particular business unit or things like that, and they brought those to our attention. Senator Collins. Mr. Duncan, in February 2001, Fortune magazine ran an article about Enron and questioned whether its stock was overpriced. According to the story, the company was described by one analyst as impenetrable, a black box to outsiders. Another said the lack of clarity was a red flag. You told the Subcommittee staff that you remembered the article, that it was not flattering, that you were concerned about it. Did you ask Andersen to take a look at the allegations in the article? Mr. Duncan. I did not. You must remember, I was not on the Audit Committee. But to answer your question, I did not ask Andersen to take a look. Senator Collins. Did you bring it up in your role as Chair of the Executive Committee to any of the executives of Enron? Mr. Duncan. I do not remember doing so. Senator Collins. Dr. Jaedicke, did you bring it up to the other members of the Audit Committee or to Andersen and ask them to look into it? Fortune magazine is a well-regarded publication and these were pretty serious criticisms of the business for which you were on the Board. Did you take any action in response to it? Mr. Jaedicke. Not in response to that particular article, ma'am, no. Senator Collins. Mr. Duncan, in October 2001, and I actually want all of the panel to answer this question, the Board became aware that an Enron employee had written an anonymous letter to Ken Lay. We now know this as Ms. Watkins' memo. Mr. Lay advised you that he had met with the employee and turned the matter over to Vinson and Elkins for further review. He obviously thought the charges were serious enough to warrant a review, but then he reported to you that there was no substance to the charges. I would like to ask each of you, and since my time is fast running out, if I could just get a quick answer, did you ask to see the Watkins memos? Mr. Duncan. Mr. Duncan. I did not. Senator Collins. Dr. Winokur. Mr. Winokur. I did not. Senator Collins. Dr. Jaedicke. Mr. Jaedicke. We asked for a written report after they gave us an oral report and they had characterized the essence of Ms. Watkins' comments in that oral report, and we asked for a written report afterwards, which we got, but not until fairly late. Senator Collins. Did you see her memo which warned that the company could implode in a wave of accounting scandals? Mr. Jaedicke. The first time we asked for the report, at least the Audit Committee did not get the memo. Now, I am talking about December. Senator Collins. Right. But did you ask---- Mr. Jaedicke. Then we asked for the memo. Senator Collins. When did you ask for the memo? Mr. Jaedicke. When we got the written report from Vinson and Elkins, which turned out to be--you have got to remember, a lot of things happened--which turned out to be at the December Board meeting in 2001. That is when I got the memo. Senator Collins. Dr. LeMaistre. Dr. LeMaistre. My recollection is exactly like Dr. Jaedicke's. We got the memo after we heard the report. We only had an oral report saying that there was going to be an investigation. When the investigation was reported, we asked to see the memo. Senator Collins. Mr. Blake. Mr. Blake. Mine is very similar, and I do specifically remember asking for a written--we did not have a copy of the letter at the time that the report was given to the Board and we specifically asked also for a copy of the letter as well as a report from Vinson and Elkins. Senator Collins. Dr. Jaedicke, former SEC Chairman Rod Hills has said very strongly that he feels the Audit Committee should have engaged an outside firm to review the allegations in the memo rather than leaving it up to the CEO. Could you comment on that? Mr. Jaedicke. Yes, I could comment on that, Senator. The memo was--actually, memos. There were, I think, two of them, a letter and a memo that were given to Mr. Lay, in August at some point. Mr. Lay handled those as they would have been handled under the code of conduct. They would have required an investigation. And we did not hear about the results of that investigation. We did not hear there was an investigation underway until about the time of the October Audit Committee meeting. By that time, the investigation had been completed. The investigation turned up no new information. I can come back to that if you like. But it also--some of the issues that she had brought up were not even verified by the people whom she had named, or at least who were thought to know something about them. The investigation was completed and it did not say, I do not think, that there was nothing, there were no problems. I think what it said is that no further investigation seems warranted. Senator Collins. That really is not my point. My point is that the CEO chose the firm to do the investigation of the allegations against the firm, and Rod Hills says, as a former SEC Chair, and I agree with him, that it would have been better and would have allowed for a more thorough review of the allegations for the Audit Committee to control that. But let me move just quickly to another point, if I may. Senator Levin. I wonder if I could just intervene for one second---- Senator Collins. Please go ahead. Senator Levin [continuing]. Because I want to just pursue one aspect of the point which Senator Collins just raised to make sure I understand your answer. No one on the Board saw a copy of the Watkins memo until after the Powers Committee report was completed, is that correct? Mr. Jaedicke. No. I do not think---- Senator Levin. In that case, I will let your answers stand the way they were. Senator Collins. Thank you. Dr. LeMaistre, you attended the October 6, 2000, Finance Committee meeting in which Mr. Winokur suggested that Andrew Fastow's compensation should be reviewed by the Compensation Committee, is that correct? Dr. LeMaistre. That is correct. Senator Collins. And I believe Dr. Winokur proposed that review as a control to mitigate Mr. Fastow's conflict of interest. Yet, it is my understanding that the Compensation Committee did not at that time follow through on that recommendation. Can you explain why? Dr. LeMaistre. Yes. The Compensation Committee was aware that there had been controls put in place for Mr. Fastow to report his compensation. They were aware of the fact that his approved compensation on both LJM1 and LJM2 was to be modest. Second, we knew there were reports coming on an annual basis and on a quarterly basis and we expected information to come through these reports and that management, as they should have done, bring that to the Compensation Committee. I inquired on two occasions of our staff, after the first quarterly report subsequent to that, whether we received any information on a 16(b) officer outside compensation. The answer was no. The second time I inquired was a few months later, in August or September, I believe, and we still had not received the information. With all of the events that transpired, the next trigger became, of course, the October 17 or 19 revelation that he was alleged to have made $7 million. Senator Collins. That was the story in the Wall Street Journal. Dr. LeMaistre. Yes Ma'am, that is correct. Senator Collins. So it took a story in the Wall Street Journal to prompt your going back. You had asked twice, had not gotten the information. But it was only when the Wall Street Journal learned that there was an important issue here and actually gravely understated the amount of money that Mr. Fastow was making that you pursued this? Dr. LeMaistre. That is correct. Senator Collins. Thank you, Mr. Chairman. Senator Levin. Senator Lieberman. Senator Lieberman. Thanks, Mr. Chairman. Thank you, gentlemen. Yesterday, attorneys for Enron provided several documents to the Federal Energy Regulatory Commission which related to what I would consider to be highly questionable trading strategies used by Enron in the California and Western electricity markets in the year 2000 energy crisis, and apparently continuing into 2001. These documents, which, as I am sure you know, have now been made public by FERC and which I had a chance to look over this morning were prepared for Richard Sanders, a senior official of Enron, by attorneys from both inside and outside the company, apparently in anticipation of possible regulatory sanctions, investigations, and litigation arising out of the crisis, or perhaps, I suppose, just as notification to the traders. They are very interesting documents because they describe a range of different strategies with very colorful names, such as Death Star, Get Shorty, Wheel Out, Fat Boy, Ricochet, and others by which Enron's traders maximized profits while gaming the system and taking advantage of the energy crisis in California. One memo which I have looked at, dated December 8, 2000, specifically discusses the California market regulations against gaming and other predatory market behavior after it describes the strategies that the Enron traders were following, and in my opinion, may have been violating, although the memo is, in that sense, as I read it, you might say value neutral. It does not make a recommendation. It describes the strategies and then the sanctions that can be applied by the California-- against Enron should the activities be discovered, and that is a direct quote, ``should it discover such activities, a California system operator could take these actions against Enron.'' So I want to ask a series of questions about that. First, was the Enron Board of Directors aware of the trading practices and strategies used by Enron's traders in the California and Western markets? Mr. Duncan or Mr. Blake? Mr. Blake. No, sir. We were not aware of those specific strategies, and if I may add, the first time I was aware of those strategies was when Pug Winokur and I, who are on the Restructuring Committee of the Board, were given those documents 2 weeks ago to this day and I subsequently, as Acting Interim Chairman, set up a Board meeting for that following Thursday, at which time we discussed it with the Board. I think, in fairness, the predisposition was to make this disclosure as responsibly and as quickly as possible. We instructed our counsel to investigate further because Rob Walls, who Mr. Walls is the now-current General Counsel, but was not there before, just came upon these memos. Subsequently, the following week, last week, there was further discussion of this report by counsel, actually last Sunday morning, by counsel and the management and we, as a Board, moved to direct specifically the release of that information yesterday. Senator Lieberman. I appreciate the speed with which you did move. What was your reaction when you saw the documents 2 weeks ago? Mr. Blake. I was extremely upset and disappointed. Senator Lieberman. Did you read them as I did, that they seemed to be both descriptions of strategies that were questionable and then an indication of what the penalties were, but almost a directive about how to avoid the law instead of how to comply with it? Am I overreaching, or was that part of your reaction? Mr. Blake. Well, in candor, my reaction was very much similar to yours. It certainly appeared on its face, although it was sort of a description of the practices, but from what I could discern, certainly questionable practices, seemingly gaming the system--I think those are the exact words I used at the Board meeting--very offensive to me personally and members of the Board. Senator Lieberman. I appreciate that answer. Dr. Winokur, perhaps as Chairman of the Finance Committee it is appropriate to ask you that question, also. Mr. Winokur. Sir, in terms of the recent 2 weeks, I was exactly where Mr. Blake was. There were five meetings from October 2000 to August 2001 in which there were reports to the Board of Directors by management about California, and we asked questions, including are we doing anything wrong? There is a lot of bad press. Are we doing everything that we are supposed to do to comply? We had reports from our General Counsel on litigation. We had reports from our Chief Regulatory Executive. We had reports from the senior people. And at no time ever were we given any information or hint of information that we might be out of compliance with the trading rules. Senator Lieberman. So that, again, as far as any of you know, and particularly the two of you, the Enron Board was not aware of these memos until 2 weeks ago, and, therefore, aware of any of the legal and financial liabilities that might be incurred by the trading strategies, is that correct? Mr. Winokur. Yes, sir, we were not aware. Senator Lieberman. Right. Let me ask this question about this matter, and this is as we try to work our way through what is the appropriate and required role for boards of directors. I mean, ideally--well, I suppose the first question has an answer to itself, which you have already given. You actually asked questions. I mean, there was a lot of public commentary when this was going on, particularly from people in California and our colleagues who represent California here in the Senate or the House that Enron was profiteering, whatever the word was. So you asked questions, then, of the employees and really got what you now know are inadequate answers? Mr. Winokur. Yes, sir. I lived in Los Angeles for 7 years and was on the board of UCLA Hospital, so I have a lot of friends there. I responded to the press statements and said, are we asked questions, are we doing anything wrong? Is there anything we should be talking about here? We had reports in these five meetings from our General Counsel, our Chief Regulatory Officer, and the senior executives, not everybody at every meeting, but in those series of meetings, all those people reported, and not once did we hear anything that suggested any impropriety in California. Senator Lieberman. Let me ask it in a different way, a different kind of question, which is, both stepping back and looking back--and here it sounds to me like you had public notice--you asked the question, you dispatched your responsibility. More generally speaking, what can we expect of directors in terms of their oversight of activities such as trading practices of a corporation? Let us say it would not have fit the public interest because there was not that much interest in the California price spikes during that time period, so how would you set a standard for what directors should expect to know? Mr. Winokur. Sir, I am not sure I was qualified, but it seems to me that if we ask the senior people responsible for that line of business and we ask separately the General Counsel to give us reports on what is going on, and we, third, set up a risk system to measure quantitatively how the trading system has worked, I am not sure I have any other suggestions. I am sorry. Senator Lieberman. Anyone else? Mr. Jaedicke. Mr. Jaedicke. It is a very thoughtful question. As far as the trading is concerned, we, of course, paid an awful lot of attention to the financial measures to say, do not take too much risk. Do not have too many open positions. We had an elaborate policy on that. Now, one part of that policy was that we were in the process of developing even more, was something called operational risk, and operational risk, we did not have it fully developed in terms of what all it meant, but surely, whatever it meant, it meant that you would try to put in control systems that would assure you that you were complying with the law. Our other compliance systems involving the internal and external legal people, you would expect that to be part of the systems and to be reported if they were not followed. Senator Lieberman. Let me move on to one additional area of questioning. I thank you for that answer. As I am sure you know, there has been a lot of concern among the employees, former employees, particularly, of Enron, and, of course, that concern has been expressed over the months since early December by members of Congress about the inequity, perceived inequity of the bonuses given to various higher-level employees of Enron at the same time the 4,000 or 5,000 employees who were laid off were given severance payments that were greatly below what they expected. In the case of some of the bonuses, I gather that to get and keep the money, they had to agree to stay for 90 days. Some of the bonuses exceeded $1 million. One was even $5 million. That is contrasted with the employees, who, by my recollection, received an average of about $4,500 each, which, as I said, was a fraction of what they had expected in the way of severance. According to Mary Joyce, who I know you know is a VP of Compensation at Enron, the issue of severance was discussed at a meeting of the Compensation Committee of the Board just before bankruptcy, but she has said to us that she did not remember the substance of the discussion. Dr. LeMaistre, you are the Chairman of the Compensation Committee. I believe, if my records are right, that Mr. Duncan, Mr. Jaedicke, and Mr. Blake are members of the Committee. So my question, obviously, is can you remember and describe for us what was discussed at that meeting about the severance payments, and particularly, did anyone ask if it was possible to compensate these people more fairly for the employees, that is, the lower-level employees, for their service to the company? Dr. LeMaistre. Senator Lieberman, I recall that very clearly and I would ask my colleagues to comment on it, to add additional things. It is a very important question. The severance plan presented by management to us required several different areas of interrogation by us of management, and the plan actually was moot because we went into bankruptcy before it was acted upon, if we are talking about the same severance plan, and I assume we are. The W.A.R.N. (Workers' Adjustment and Retraining Notification Act) provisions can be exempted in bankruptcy and all that is allowed to be paid, if the bankruptcy court agrees, is the $4,500 per employee. So I think that explains the problem. Yes, we did discuss this. The Board of Directors met on December 2, which I think is the day we went into bankruptcy. The Directors agreed to work without compensation and expressed the desire that our fees go to the employees or to an employees' fund. Later, we were told it was too complicated to work that out. We discussed this because we were very much concerned about what was happening to the employees. I would remind you, one of the prime reasons everyone should be concerned about that is as far as I know now, a very small number of employees created a major part of the internal problems at Enron and there were more than 20,000 very honest people there---- Senator Lieberman. Correct. Dr. LeMaistre [continuing]. And those are the ones that suffered. Senator Lieberman. Who suffered? So am I hearing you correctly, that you would have wanted to give the 4,000 or 5,000 employees something closer to the severance payments they thought they were entitled to under their agreements, but you could not do it according to bankruptcy law? Dr. LeMaistre. Well, we were--if I recall correctly, and I would ask the members of the committee to comment, the first discussion was on a Saturday, December 1, and I think the next day, Sunday, December 2, we were ready to propose this. Unfortunately, Enron had filed for bankruptcy at 2 a.m. in the morning on Sunday, and so we were governed by bankruptcy law. But to answer the other part of your question, the high bonuses that you---- Senator Lieberman. Right. Dr. LeMaistre [continuing]. Alleged to be high. Those were for traders. We felt that the traders were the group that was essential to hold the company together. In the weeks approaching bankruptcy, we were trying desperately to hold on to them. We were trying to merge with Dynegy, and the traders were of primary interest to Dynegy. That was really the group they wanted. Second, we knew that they were being sought by many other companies because of Enron's public problems, and, therefore, we were trying to give them a 90-day stay bonus---- Senator Lieberman. I see. Dr. LeMaistre [continuing]. Which had a draw-back on it. They had to repay if they did not. Senator Lieberman. If they---- Dr. LeMaistre. If they did not stay. Senator Lieberman. For the 90 days? Dr. LeMaistre. Yes, that is correct. Senator Lieberman. So that explains my other concern, which was why you would give such large bonuses for people who are only staying 90 days, and you are saying you were doing it because they were traders and you wanted them for that period of time. The light is up, so I am going to close in a minute on my time. Do I take it that bankruptcy law did not similarly prohibit the company from paying the large bonuses---- Dr. LeMaistre. That occurred before we were under bankruptcy. Senator Lieberman. You made the decision before? Dr. LeMaistre. Timing, yes. Senator Lieberman. OK. My time is up. Thank you. Senator Levin. Senator Fitzgerald. Senator Fitzgerald. Thank you, Mr. Chairman. This is my first meeting at the Governmental Affairs Committee and this Subcommittee. I just joined the Committee, and I appreciate you having me on. I think I get assigned to all the committees investigating Enron. Senator Levin. The Chairman, I think, wants the honor of welcoming you---- Senator Lieberman. Yes. Senator Levin [continuing]. But we welcome you to the Subcommittee today, and the Chairman can do that appropriately. Senator Lieberman. Thank you, Senator. Senator Fitzgerald, we welcome you here. This is a very interesting Subcommittee with very significant oversight responsibility and we are delighted to have you and I am sure you will contribute substantially to our work. OPENING STATEMENT OF SENATOR FITZGERALD Senator Fitzgerald. I am pleased to be aboard, and all of you, thank you. Some of you, I have met you in the Commerce Committee, which has also had several hearings on Enron. Some of you may know my theory on Enron. I was the one who described Enron as a gigantic pyramid scheme or Ponzi operation, and if I could just explain why I say that. Mr. Blake made mention earlier of the SPEs being used to improve liquidity and get debt off the balance sheet. After going through several of those SPE transactions and all the 41 boxes that were delivered to the Commerce Committee, I concluded that what Enron was doing was creating off-the-books partnerships, instructing those off-the-books partnerships to borrow money, in essence, and then Enron would transfer assets to the off- the-books partnerships. The partnerships would borrow money, while Enron had typically guaranteed their borrowings, and then the SPEs or the partnerships would pay Enron for some asset that Enron had transferred to the SPE. But Enron had always provided a credit support in all the cases I looked at for the borrowings of the SPE, and if you really reduce this to simple terms, Enron was simply borrowing money, filtering the borrowings through the off-the-books partnerships, and then booking that borrowed money as income, and that is how you built up some $20 billion worth of off-the- books indebtedness. But Enron was contingently liable for that indebtedness, and when you filed for bankruptcy in December, it was because you had a very familiar problem. You had too much debt. You had several billion dollars worth of indebtedness coming due and Enron could not pay it. Now, I think these specific transactions were very well disguised. I think that the management obfuscated enough, used high-falluting sounding language to describe all these transactions to make them sound legitimate. I think it would be very difficult, you would really have to be on your guard to figure out what they were up to. But I have also felt that in the hands of management was plenty incentive to engage in this kind of pyramid scheme, to keep booking fictitious earnings, and that incentive was to keep the stock price up, and they wanted to do that because many of them had millions or tens of millions, and in some cases hundreds of millions of dollars worth of stock options in their hands. Now, many of the senior managers cashed in their stock options and got out of the company before it all spun out of control. There are many people who got out of the company, having successfully cashed in millions of dollars worth of stock options. I think Mr. Baxter, who committed suicide, got out a long time ago. Others, the Army Secretary, got out quite some time ago. Mr. Skilling tried to get out last summer. He succeeded in cashing in, I think, $78 million worth of his options, of 1.7 million options in 2000 and 2001. He got out. I have heard reports that Mr. Lay had lined up a job at another company and was planning to get out. He cashed in in the last 2 years $82 million worth of options. In all, the top 29 executives at Enron cashed in some $1 billion worth of options in the last 3 years, according to reports that I have read. I have several questions for you. I notice that the compensation of the Board, total compensation in fiscal year 2000 for each Board member was roughly an average compensation of $329,000 per Board member. Some got less, some got more, depending on what committees they chaired, what committee meetings they attended. Only a small portion of that compensation was cash compensation. The average Board member got $78,000 in cash compensation, but the average Board member got $250,000 in stock options. The question I have to ask to you is, your interests were to see that the stock price kept going up, given that your compensation was so heavily weighted towards options. Did you all not have a financial interest in seeing those options go up and always be in the money? I understand you could exercise them--they did not expire for 10 years, and so you did not have pressure to cash them in right away. But do you care to comment on that issue? I mean, were your interests really aligned with the interests of the long-term shareholders? How many shares did each of you own outright in Enron, excluding options? How many shares? Mr. Blake. Mr. Blake. I cannot quite remember, sir. I bought some initial shares of both Enron and Enron Oil and Gas and EOTT and Northern Border Partners when I first joined in 1993 as a statement of interest in the company, and---- Senator Fitzgerald. How much do you think you had---- Mr. Blake. I might guess---- Senator Fitzgerald. What was your cost basis? Mr. Blake. Maybe about 3,000 shares, something of that nature. Senator Fitzgerald. And would that be, like, $30,000, or-- -- Mr. Blake. Yes. Well, I also made a purchase in October 2001 that was $80,000, so I would say probably something in excess of $100,000.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 80 which appears in the Appendix on page 665. --------------------------------------------------------------------------- Senator Fitzgerald. Dr. LeMaistre. Dr. LeMaistre. I had--I lost approximately $3.5 million in shares of the restricted stock, which is a gift, of course, and in the stock options, I cannot give you the exact total, but I would say something in the order of maybe 40,000, 50,000 of beneficially owned stock---- Senator Fitzgerald. Forty or 50,000 shares? Dr. LeMaistre. Yes, something like that. Senator Fitzgerald. That you had bought outright, or had-- -- Dr. LeMaistre. Had bought outright, maybe more than that. I cannot remember the exact figure---- Senator Fitzgerald. And that you owned in your own account? Dr. LeMaistre. That is right, and---- Senator Fitzgerald. What would your cost basis have been in that, roughly? Dr. LeMaistre. Well, they were bought all the way back to 1991, so I would have to recalculate that to tell you that. I would assume--I really could not answer it accurately without looking at notes. I would be happy to do that. Senator Fitzgerald. A hundred-thousand dollars, maybe? Dr. LeMaistre. Probably.\1\ Senator Fitzgerald. About $100,000. Dr. LeMaistre. A little more than that, I think, but---- Senator Fitzgerald. A little more than that? Dr. LeMaistre. Yes. Senator Fitzgerald. Mr. Jaedicke. Mr. Jaedicke. I could give you the information. I would be glad to send the exact information. My recollection is it would be slightly over 20,000 shares, many of which were taken as part of Board compensation. Senator Fitzgerald. But what would your cost basis for what you had---- Mr. Jaedicke. Well, the cost basis of the shares taken for Board compensation would be that I was paid ordinary income at the time I got them. So, I do not know, I suppose it would be between $20 and $30 or $40 a share. I do not know what the average would be. Again, I can supply that to you.\1\ Senator Fitzgerald. I would be very interested in that. Dr. Winokur. Mr. Winokur. Yes, sir. I own approximately 80,000 shares. I have a cost base of about $1.8 million or $1.9 million. Some of those were shares I bought. Some of those were shares from options that I exercised and did not sell. I have never sold a share of stock.\1\ Senator Fitzgerald. So you had some skin in the game, as SherronWatkins would say? Mr. Winokur. Yes, sir. Senator Fitzgerald. Mr. Duncan. Mr. Duncan. I now own 167,000 shares. I have owned those shares from the beginning. I cannot now recall my cost basis. I do recall that the options that I exercised only last year, and held, I did pay ordinary income tax on them, so that changes the arithmetic a little. But broad general statement, I lost over $10 million. Senator Fitzgerald. How much money do you think you had invested, though, your total cost basis---- Mr. Duncan. Well, if you go back---- Senator Fitzgerald. Now, did you acquire those shares from prior companies that Enron merged with? Mr. Duncan. No. When Enron sold for cash--excuse me. When Houston Natural Gas sold for cash to InterNorth, then I took my proceeds and invested the proceeds in Enron. Senator Fitzgerald. OK. Mr. Duncan. At that particular time, if my memory serves me, it was about $1.5 million.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 80 which appears in the Appendix on page 665. --------------------------------------------------------------------------- Senator Fitzgerald. So some of you did have substantial investments in the company, and I would think your personal financial interests were, for some of you, very closely aligned with those of ordinary shareholders. Did any of you think about what kind of temptations, though, could be in the hands of senior managers when they stood to make the kind of sums Mr. Skilling and Mr. Lay did by cashing in their options, because cannot any company fictitiously goose-up its earnings per share to keep its stock price high, for a while, at least, until other people catch on? When there is so much in options outstanding in the hands of senior management, does that not begin to worry some of you as Directors that, ultimately, their interests could no longer be allied with the interests of the long-term shareholders? They could just try to goose the stock price, cash in their shares, and get out of the company? Would any of you care to comment? Dr. LeMaistre. Let me make a comment, Senator Fitzgerald, that first, the policy of awarding stock was to ensure that they kept their eye on the ball and saw that the stock price increased for the shareholders' benefit, because that is really what the shareholder does, he invests in a company and wants that stock to increase. So that over the period of time, to have the stock increase, the employees win, but also the shareholders win. So I think that it is a two-edged sword. If one gets the incentive so high that is all that people are really working for in order to cash out---- Senator Fitzgerald. As Chairman of the Compensation Committee, did you ever worry that maybe the incentives were so high, there were so many options outstanding, that, boy, maybe we have a problem here, because some people play a game here? Dr. LeMaistre. I did not worry about it, primarily because I talked to our Towers Perrin consultant every year about whether our scale of pay, our programs, including the incentive pay that we had, especially the incentive pay, was commensurate with exactly what was being done by companies our size. We had our last report as of the spring of 2001 that said we were right on target with where we were supposed to be. Senator Fitzgerald. Can you think of any other motivation that management would have had to engage in such aggressive accounting and gimmicks to keep the earnings up, other than to keep the share price up to keep their options in the money, because they were getting very rich very quickly on this scheme while everybody else was--all your other rank-and-file employees were wiped out, pension funds were wiped out, and $60 or $70 billion in market capitalization was lost, but a lot of your inside management got very rich and came out very well on the whole thing. Can any of you think of any other motive that management would have had for deceiving the Board and deceiving the public? Dr. LeMaistre. Senator, I do not want to monopolize the time, the other Subcommittee Members may want to speak to this, but I will say that we thought the integrity and honesty of our employees, especially those in key positions, was intact, and that was the most important thing. We had quarterly reviews of all of the higher-level echelon officers by Mr. Lay directly to the Compensation Committee and then a very large review annually in our management development responsibility. So we thought we knew these individuals well. I have no answer for your question except that the problem was, in my opinion, dishonesty and lack of integrity. Senator Fitzgerald. Mr. Chairman, I appreciate the Subcommittee's time, and all of you, thank you for being here today. Senator Levin. Thank you, Senator Fitzgerald, and again, it is great having you with us. Senator Carper. OPENING STATEMENT OF SENATOR CARPER Senator Carper. Thanks, Mr. Chairman, and to each of you, welcome and we appreciate your time and your testimony today and your responses to our questions. Before I was elected as Senator about 2 years ago, I served as Governor of Delaware for 8 years. One of the things I learned as Governor was that when things went well, I was wise to share the credit. When things went badly, I was wise to assume the blame. One of my frustrations in listening to the testimony here this morning, and frankly, listening to the comments of those who served in very senior positions at Enron, relatively few people seem willing to accept the blame. I, for much of my life, served in the Navy as a Naval flight officer, about 23 years, in fact, on active and reserve duty. In the Navy, we have a tradition, and a proud tradition, that the captain of the ship assumes the responsibility when things go badly, or the commanding officer of the squadron that I served in assumed responsibility, was held accountable and responsible when things went badly. Obviously, from your testimony today, you believe that you were deceived and misled. Who bears the responsibility? If not the Board, if not the Audit Committee, if not those with whom you served, if not the Chairman, who does deserve the blame? Who should step forward and say, this is my fault? Mr. Jaedicke. Are you directing that at me? Senator Carper. From any of you, please. Mr. Blake. Well, I will speak for all the Board and say that we feel terrible, what has happened here, and we have scrutinized our own behavior and we have asked the question numerous times, what could we have done differently? I am absolutely convinced, sincerely, honestly convinced that the controls, had they worked, this would not have happened, and I feel absolutely misled in light, too, with that question. I do not know where the fault lies. I mean, I accept the same philosophy as you do, and as the CEO of many companies, it is my ship and I am totally responsible for its conduct and the companies that I run. I absolutely philosophically totally agree with you, without exception. I do not know where the fault lies here. I do not know enough of the information. I do not want to get into personalities today, but---- Senator Carper. If you do not, and those of you with whom you serve--excuse me for interrupting, but if you do not know where the fault lies, how are we going to figure that out? Mr. Blake. We do not know the facts, sir. I do not know what Ken Lay knew or did not know. I would love to know. I would like to know what Jeff Skilling knew and what he did not know, because I look to them as leaders of the company, responsible to the Board in the exercise of their particular responsibility as the chief executives of the company and responsible for the ship. I want the answer, too. I do not have an answer. If I had the facts, I would give it to you, honest. Mr. Winokur. Senator, I served on the Powers Committee, the special investigative committee, and as that report indicates, there is considerable ambiguity in exactly who knew what, when, and how, because our committee was not able, as government agencies can, to subpoena people, to force them to talk, and so on. So I think all of the interviews have been provided to you and there are numerous investigations underway by people who have the ability and the authority to find out answers to those questions. But I concur with what Norm said. I think we reacted as best we could to the information we had. We relied on the candor of management. We relied on our advisors to do their job, which was to confirm what we were being told, and there is a lot left to be learned, unfortunately, as the Powers Committee report indicates. Senator Carper. Anyone else? Mr. Jaedicke. I agree with the two statements that have been made. I guess all I would say to elaborate on that, or to maybe bring up another point, is to say--and I guess I am speaking from the viewpoint of an Audit Committee, although I think it would be the same for a Board, as well, is that there is this classic problem that the information that the Board needs to do the oversight, not entirely, but largely comes from management. And so the people you are supposed to be overseeing do control a great deal of the information. Now, how do you deal with that? Well, you try to put controls in place. You also hire an external auditor. We had within Enron an organization that I thought supported that, those kinds of checks and balances, because, for example, we had a separate financial officer, a separate accounting officer, and a separate risk control officer, a separate legal officer. None of those were combined and all of them reported in at the same level. Dr. LeMaistre makes a very good point, also, with this whole thing, you hire one of the best accounting firms in the business, or at least that was their reputation. The same with legal. You try to assess management, and we had no reason to distrust management or our outside advisors. Where you feel let down is when you do not get the information that you need to act, and I do not know how you can act if you do not have that information. Senator Carper. What punishment is appropriate for those who have led to this debacle? And again, this is for any of you. Mr. Winokur. Senator, I will just speak for myself. I am not a lawyer, and I am certainly not a criminal lawyer, I am not a civil lawyer. I do not have any idea what is appropriate. I hope the investigation pursues everything it can to find out everything it can because I think all of us, you, the Directors, the employees, deserve to know who knew what, when, how, and why. But I could not comment on the---- Senator Carper. Anyone else? Mr. Duncan. Only that we share your frustration. Senator Carper. I serve on three committees that have conducted parts of the hearings into Enron and we will presumably be developing a legislative package to address a number of the suggestions that we have heard throughout the course of the last several months. They include the roles of the auditing firms, the independent audit, whether they should rotate firms, whether we should rotate lead auditors, issues involving independence of the board, how many independent directors should there be, what constitutes a breach of independence, issues involving 401(k)'s, how long people should have to hold their company stock in order to vest. Some of the people who have testified to us have said, you should legislate little. You should let the market force the corrections and punish those who make the reforms, adopt the reforms, and that is the better approach. We have heard from people who say the SEC should do certain things, that the board exchange, the New York Stock Exchange and others, should push various reforms. In the end, what should the Congress do? What should we do in some of the areas that I have mentioned or others that I have not touched on? What should we do as legislators? Dr. LeMaistre. Senator, I would like just to agree with you. I think there is much the Congress can do once the facts are known. I think the only thing the Congress can do now, though, is to await the final understanding of exactly how this happened, how Enron was brought down and by whom, and where controls need to be placed, not by the Board but by either law or by the voluntary organizations, and businesses that do this, such as the auditors. But there is going to be a role for legislation. It may be a mid-point between those that said, leave it alone and let it happen, and those of us who are a little bit emotional about getting everything done right now. I think the best thing to do is to let the process of justice go through here where we will find out everything, and I am looking forward to that understanding, because I could answer your question better then. I will say this to you. A Board like this one that has been through what we have been through would be willing to help you in any way we can and tell you where we think, in some more detail than we can do today, what really happened and why we were let down. I think we do not know enough today to tell you more about what is the real problem. Mr. Blake. Senator, if I could add one thing, I want to go back to the point you made. It gets down to the leadership. You cannot legislate leadership. It gets down to what the role of a leader of an organization is, the culture of the organization he is responsible for, the discipline and the incentives put in place to encourage character, honesty and integrity as an offset to greed or whatever may be the other compelling factor in someone's mind. I have been associated with some very successful companies as an employee and as a leader of that company, and stressing values above performance, values above compensation, a sense of integrity and sense of purpose about the company, is what it is all about. There has to be a higher purpose for that company ultimately to be successful. It should not be motivated by short-term windfalls of stock prices. It should be motivated by the vision of the company. It should become sort of imbibed in the person. You know what I am talking about. That is what real leadership is about. So I have to say my honest answer to your question, it starts with leadership. Forget about anything else. It starts with leadership, and if it is not there, then the company will fail. Senator Carper. Well, there are certain things we can do. We are not very good at legislating integrity or character, but that is obviously what is needed to best ensure that these kinds of things do not happen again. Anybody else in terms of--I know my time is expiring. Mr. Duncan. Senator, I would agree that it would be very difficult to legislate integrity. It would be very difficult to write the law on leadership and character. But there are some issues, in my opinion, that your Subcommittee and this Congress and this Senate should consider, and one of them is that stock option problem of how it is accounted for. And one of the problems that really is a catch-22, if the Dow had not moved from 3,000 to 10,000 while these employees had their options, their 7- and 10-year options, then they would not be so rewarded. But when the whole market moves up and they want to go to work for options and the overhang of the stock is one of the things that we kept worrying about. We worried that we wanted to compare ourselves with other companies on the overhang, i.e., the amount of options that were out in relation to the total number of shares of stock, and was that in the ballpark, and if it was in the ballpark and if we thought we were hiring and were hiring the youngest, the brightest leaders, then they wanted options and we would issue options. But once issued, if they were 10-year options and the whole market triples, then you have a catch-22 there, which is an incentive to get out, and I do not know the answer to that. If we would have issued these options in 1970, at the end of the 10-year period, they would not have any profit because the market did not move. And so I do not know how you put that into legislation. I will say that one of the reasons, in my opinion, that the American system has worked so well for the majority of the leaders is because they had options and they led the company with leadership and integrity and they made themselves and their families some money. So if that had to have been removed from the system entirely, I do not think the American economy would be doing as well as it is today. Senator Carper. Thank you for those comments, and Mr. Chairman, thank you for allowing me the time. Senator Levin. Thank you, Senator Carper. Senator Durbin. Senator Durbin. Thank you, Mr. Chairman. Let me say at the outset that I am personally familiar with one of the members of the panel. Dr. LeMaistre and I became acquainted almost 20 years ago. Dr. LeMaistre, you are one of my heroes---- Dr. LeMaistre. Thank you, sir. Senator Durbin [continuing]. What you have done in the field of public health has saved countless lives, not just in Texas, but in our Nation and around the world---- Dr. LeMaistre. Thank you, Senator. Senator Durbin [continuing]. And I am truly sorry that you are in this predicament now and wearing a different hat, but I wanted to start off by saying my admiration for you has not been diminished in any way whatsoever by this. But I want to raise this question. Let me concede at the outset I am a liberal arts lawyer. I am not a business major, so I struggle to understand a lot of the things that you talk about, which are common parlance for people who are involved in business. But occasionally, I rely on folks that I think really get to the core of the issue for me, and the person that I turn to once a year and make sure I never miss his views on life is a fellow by the name of Warren Buffet, who puts out the Berkshire Hathaway Annual Report. It should be ``must'' reading for everyone in Congress, if not everyone in business, because I think Warren Buffet has proven that you can do things differently and still be very successful. Here is what he said in his most recent report to the shareholders of Berkshire Hathaway. He said, ``Though our corporate performance last year was satisfactory, my performance was anything but. I manage most of Berkshire's equity portfolio and my results were poor, just as they have been for several years.'' He goes on to say, ``One of my ground rules is applicable. I cannot promise results to partners. But Charlie Munger,'' who is his vice chairman, ``and I can promise that your economic result from Berkshire will parallel ours during the period of your ownership. We will not take cash compensation, restricted stock, or option grants that would make our results superior to yours. Additionally, I will keep well over 99 percent of my net worth in Berkshire. My wife and I have never sold a share, nor do we intend to.'' ``Charlie and I are disgusted by the situation so common in the last few years in which shareholders have suffered billions in losses while the CEOs, promoters, and other highers-up who fathered these disasters have walked away with extraordinary wealth. Indeed, many of these people were urging investors to buy shares while concurrently dumping their own, sometimes using methods that hid their actions. To their shame, these business leaders view shareholders as patsies, not partners. Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America.'' My question to you, because some of you--Mr. Duncan, you talked about your business experience and your success--and others, as well, have dedicated your lives to American business. You have taken risks. Some have succeeded and some have failed. For your successes, you have been rewarded, and that is the nature of capitalism and free enterprise, as it should be. But reflect for a moment on what it says to America that we can step back and look at this viper's tangle of Enron and judge that Mr. Lay was worth over $140 million a year to create this fraud on the American public, or that Mr. Fastow was discovered to be making an additional $15 million which had not quite come to light. Think about what this says to the rest of America that wants to believe this is on the square. I do not think it meets the standard and test which Warren Buffet is talking about here. I think Enron, as I said at the outset, has shaken us to the core. I do not think any Americans are opposed to success. That is what America is all about. That is the American dream. But this is not success, this is fraudulent conduct that has resulted in unjust rewards. I would like to ask you, Dr. LeMaistre, you deal in your hospital situations with some of the most gifted men and women in the world, skilled people who give more of their lives than any of us even in Congress and receive a tiny fraction of what some of these corporate officers were receiving. Help me put this in perspective. Help me understand why we should use as a standard who is making the most in business to decide who is worth an extra dollar. Dr. LeMaistre. Senator, your quote and your question come right to the point. I think that it is difficult for someone who has come from a purely academic background to speak to this because M.D. Anderson is an academic institution and we do not use the same pay methods that we are talking about. The real problem, it seems to me, is that we need more disclosure from the leadership of business as to what the principles are on which they are operating their companies. We had an inquiry earlier about what went on in California, for example. This Board was never told of any illicit practices that were going on in California. I think that the leadership should be required to tell a board and the shareholders what their practices are going to be. We know in medicine exactly what they are going to be and we have a high standard, and if it is not met, then there is a remedial action taken. As a consequence, I would like to see the same stringent approach to the responsibility for leadership, including boards, and all of business, because I think we can find ways. I think it is going to require, though, as I said before you came back in, that we really understand thoroughly what happened at Enron. I think the Powers Report is a first, and a very quick look at that, and until we get testimony under oath, I do not think we are going to fully know exactly why charges like gaming are being made in this thing. Senator Durbin. Let me use another illustration and then ask the other panelists to comment, as well. About a month ago, the New York Times in the business section published the salaries of the top 100 executives in the United States and they compared what they were making to the performance of their corporations. Now, you have heard this story repeatedly, how boards of directors have repeatedly given bonuses and extra payment while the company is going into the dirt. If you are standing on the outside looking in from the viewpoint of an average citizen or a worker or an investor or someone whose pension is on the line, you have got to say this is an upside down world. There must be such a closed culture within American corporations that they believe they are royalty, that they can treat one another with royal conduct even if they have not performed accordingly. When I look at some of these salaries that are being paid here, this goes way beyond incentive compensation. Mr. Duncan, you started long ago. Your opening testimony talked about your distinguished career in business. You have seen some dramatic changes in executive compensation, have you not? Mr. Duncan. I certainly have. Senator Durbin. Are they fair? Mr. Duncan. What a comp committee has to do in today's world is try to determine whether that executive is the best and then determine what he can get if he walks across the street. When I was President of Gulf and Western, there were two guys working there, Michael Eisner and Barry Diller. They made a lot more than I did. Why? Because they could walk across the street and get more money, and representing the shareholders, we did not want them to walk across the street. So one of the catch-22s that you face is that you have to pay the going rate. Now, the second part of your question, is the going rate ludicrous? Yes. But when you have a large corporation and you have 20,000 employees and you want the corporation to succeed, then you cannot ignore what the going rate is, whether you think it is right or wrong. And incidentally, I like Warren Buffet's approach. He is my hero, too. But he can talk with luxury because he is the second richest man in the United States. So he can enjoy saying, ``I am not taking a dollar.'' But the young guy who is fresh out of MBA school, who has kids that are growing up and knows what he can get if he walks down the street, you cannot ignore that, either, and it is a tough problem, and it is helped by the fact that the Dow keeps moving and stock options are in the mix. It is really helped by that fact, because everybody starts reading what the other guy is making. Senator Durbin. I could defer to our Chairman on the stock option question. We are both cosponsors of legislation which he has introduced on this issue. But Dr. Winokur, would you comment on this executive compensation? What is, I think, brewing in this land is a feeling of disgust about how much people are being paid and how the chasm between the average person who gives his life to Enron, puts his entire pension and future in that Enron 401(k) and sees it disappear while others are skating away with second and third multi-million-dollar homes, there is a basic injustice here. There is a feeling of privilege which is not part of the American experience. Could you comment on that, as well? Mr. Winokur. Yes, sir. I manage a private investment partnership with a number of financial institutions involved and the way our partners get paid is after our limited partners have been paid all their money, and a return on their money, and all that cash has been sent out, then we split what is left if any is left. So I am the last guy in the food chain, so I am very sympathetic to both you and Warren Buffet and Charlie Munger's point. I would just make one suggestion of an item to consider as the Chair and you consider the stock option matter. It has seemed odd to me in the companies in which we invest that if we issue stock, restricted stock, to the employees, there is a charge to earnings. If we issue stock options, there is not a charge to earnings, a point you obviously know well. But if we issue options but the options vest only on achievement of performance criteria, there is a charge. Now, it would seem to me it would go the other way around, that is, that you would want to give people incentives not to receive compensation unless they have actually performed, as opposed to, as my colleague, Mr. Duncan, said, have a ride on the market. I do not know if that is helpful, but it is something that has occurred to me. Senator Durbin. Well, I stopped short of reading the next sentence in Warren Buffet's report, but I am going to read it now since it is an open invitation. He says in his annual report, ``One story I have heard illustrates the all-too-common attitude of managers toward owners. A gorgeous woman slinks up to a CEO at a party and purrs, `I will do anything, anything you want. Just tell me what you would like.' With no hesitation, he replies, `Reprice my options.' '' [Laughter.] A lot of us believe that this option business has gotten completely out of hand, not just for tax purposes but as incentives for compensation. I thank you for your testimony today, and Mr. Chairman, thank you for this hearing. Senator Levin. Thank you, Senator Durbin. We are going to proceed for perhaps 45 minutes to an hour here and then break, perhaps completing this panel, but perhaps not. I am absolutely amazed at your denial of any responsibility for what happened at Enron. From the outside, Enron appears as a case where insiders made fortunes, much of it based on stock options, jacking up share prices, while the shareholders were left holding an empty bag. That is from the outside. From the inside, I think there is responsibility just from what we are going to go into right now and what we have gone into. What the Board knew should have triggered on the part of the Board a heck of a lot greater vigilance than it did. In the words of the Powers Report, which we are going to try to demonstrate here factually with documents, ``The financial reporting abuses of management could and should have been prevented or detected at an earlier time had the Board been more aggressive and vigilant.'' That is the Powers Report. You deny even that, that you could have been more aggressive and vigilant. You just point your fingers at management, and let me tell you, they bear a lot of the responsibility, plenty of it, and their time will come. But now, you should step up to the plate. You are the Board. You are the captain of this ship that went down, and you are denying any responsibility. All of those red flags which we are going to go into, you say you did not see them, they were not there, you were not told. There were plenty of things you were told and that you knew which should have triggered much stronger action on your part. I want to go into some of those right now because I do not think the facts support your denial of any responsibility, and I just don't buy it. There is responsibility in this Board and it should be accepted. Otherwise, directors are going to duck responsibility in all corporations, blame it on people who did not tell them things, even though there were warning signals and even though there were facts, much more than warning signals, facts which we are going to go into which were brought to the attention of the Board and which should have triggered action on the part of the Board. First, I want to talk about Whitewing, one of these complex transactions. This was an early step which you took as a Board which waded into dangerous waters. The strategy of Enron was to become asset-light. That means selling assets to or syndicating, sharing the liability or risk of assets, with a third party. The money raised from the sale of these assets was then to be used for new instruments that would offer a higher return, and the sales would improve your balance sheet. Enron called these assets that were held for sale merchant assets. I want to talk to you about how Enron set about selling these assets and finding outside investors to invest in them, and I will be asking most of these questions of Mr. Winokur, as Chairman, and Mr. Blake. Both of you were on the Finance Committee. First, back in 1997, according to the CFO magazine, Enron is having a challenging year. The debt is the result of enormous growth. It was higher than was consistent with your credit rating, and retaining a high credit rating was critical to the success of your trading business. So with that background, Mr. Blake first, what can you tell me about Whitewing and Nighthawk? Mr. Blake. Well, as the chart indicates,\1\ this is a means by which to substitute equity for debt, and that is the $1 billion that comes in from Whitewing is proceeds that can be used to pay down debt, and when you are transferring convertible preferred stock to Whitewing. --------------------------------------------------------------------------- \1\ See Exhibit No. 15, chart entitled ``Condor Transaction,'' which appears in the Appendix on page 253. --------------------------------------------------------------------------- Senator Levin. Now, when you talked to our staff, did you tell them that you did not have much recollection of this? Mr. Blake. That is correct. I did, Senator. Senator Levin. So you have refreshed your recollection since then? Mr. Blake. Yes, I have. Senator Levin. Fine. Mr. Winokur, what can you tell me about Whitewing and Nighthawk? Mr. Winokur. Nighthawk, which is really an entity owned by Citibank, put up $500 million. Enron put up $500 million into Whitewing, which was an LLC, and that company took the $1 billion and paid it back to Enron, so Enron had net $500 million with which it could pay down its debt or make further investments. Senator Levin. All right. Now, when you met with my staff, did you also tell my staff you did not have much recollection of that transaction? Mr. Winokur. Yes, sir. Senator Levin. Now that you have refreshed your recollections, Enron was borrowing a half-a-billion dollars from Citibank, but it did not show up on the balance sheet of Enron as debt but rather as preferred shares, which looked more like equity than debt. It was a loan disguised as equity in order to avoid showing debt on the books. Now, look at page 2 of Exhibit 15.\1\ Mr. Winokur. Sir, I believe it was accounted for as a consolidated subsidiary with a---- Senator Levin. Was it shown as a loan? Mr. Winokur. It was shown as--the entity was consolidated and the $500 million of Citibank was a minority interest. Senator Levin. But was it shown as a loan? Mr. Winokur. No, sir. Senator Levin. That is, in effect, what it was. Let us go now to 1999. The Board is now getting into deeper and deeper water. This time, Jeff Skilling tells the Board about his asset-light strategy, and Andrew Fastow is talking openly about the determination to sell assets. The market goes for it. Enron's stock price continues to go up. This Nighthawk-Whitewing deal had worked like a charm. Enron borrowed a half-a-billion dollars in funds without appearing to burden the company with more debt. Now, it needed more money to invest in broadband and other new ventures, but it did not want to directly borrow the money and put the debt on the balance sheet, so now you have to figure out a new way to bring funds into Enron. So the second stage of Whitewing comes along. It is a trust called Osprey. Now, first, Mr. Winokur, did you tell my staff you basically did not remember much about the Osprey transaction? Mr. Winokur. Yes, sir. Senator Levin. And, Mr. Blake, did you also tell my staff you did not remember much about that transaction? Mr. Blake. Yes, sir. Senator Levin. OK. Now, this was a transaction where Osprey raised $1.5 billion by selling bonds to outside investors and used it to buy a stake in Whitewing. Enron deconsolidated Whitewing, so it took Whitewing off the Enron books. This chart is the second page of that Exhibit 15.\1\ It lays out this structure of Whitewing with Osprey. Basically, what the Board did here was use Enron stock as collateral for Osprey's $1.5 billion borrowing. --------------------------------------------------------------------------- \1\ See Exhibit No. 15 which appears in the Appendix on page 253. --------------------------------------------------------------------------- Mr. Duncan, I believe that you were there when you moved to approve that transaction, is that correct? Mr. Duncan. That is correct. Senator Levin. And, Mr. Blake, you seconded that? Mr. Blake. That is correct. Senator Levin. A billion-and-a-half dollars. At least when my staff talked to you, no memory of that. Osprey had come up 15 times in presentations to the Finance Committee and to the entire Board. Now, Mr. Winokur, do you know what Whitewing did with the $1.5 billion that it got from Osprey? Mr. Winokur. Well, it repaid Citibank the $500--actually, $570 million, because that was--there was an accrual, and part of the reason was that the convertible preferred stock that had been in Whitewing had appreciated significantly and that was not part of the consideration to Citibank. Senator Levin. Did it also buy Enron's assets? Mr. Winokur. It bought merchant assets at no gain or loss. Those were merchant assets. Senator Levin. All right. Mr. Winokur. And the debt---- Senator Levin. Did Enron have to sell these in order to go through its asset-light strategy? Was that part of the strategy, to sell these assets? Mr. Winokur. Well, it was part of the strategy to sell the assets when it was time to sell them. I do not know specifically what the motivation was behind each individual sale. Senator Levin. But you do remember the meeting where Mr. Fastow, the Chief Financial Officer, talked openly about the need to sell assets back in 1999, and Skilling talking about the asset-light strategy? Do you remember that? Mr. Winokur. I understand that strategy, yes, sir. Senator Levin. Do you remember that? Mr. Winokur. Yes, sir. Senator Levin. Was this part of that strategy? Mr. Winokur. Yes, sir. I would also like to say that the bonds were rated and the equity in affiliates, which is where Whitewing was then carried, showed the consolidated balance sheet for all of the equity and affiliate transactions. Senator Levin. Now, were the bondholders--did they have a guarantee that if the assets did not generate cash to pay them back on their bonds, that Enron shares would be used to pay them back? Mr. Winokur. Yes, sir, and that was fully disclosed, as well. Senator Levin. These were promises that were made to the bondholders that Enron shares would be used if they did not get---- Mr. Winokur. They were made to the bondholders and disclosed in Enron's financials, yes. Senator Levin. So they could not lose. The bondholders could not lose. Enron stock was there to guarantee the return, is that the bottom line? Mr. Winokur. Well, they could lose if Enron went bankrupt and could not make good on its---- Senator Levin. Right. Other than that, though, Enron stock, no matter how much was needed, was used to back up that bond return, is that correct? Mr. Winokur. It was not an infinite quantity of stock, as I recall. It was either convertible preferred stock in a fixed amount or common shares. Senator Levin. You think that there was a limit on how much stock could be converted or used to pay for those bonds? Mr. Winokur. I think it was convertible preferred stock was available, as well. Senator Levin. So was there, then, in effect, either through convertible preferred stock or otherwise, a guarantee as long as Enron was in business that whatever amount of stock of Enron was needed to pay those bond holders, it would be used? Mr. Winokur. It was contingent support, sir. Senator Levin. Contingent? Mr. Jaedicke. That would have been disclosed in the footnote. Senator Levin. I am asking you, what was there? Was there any limit on how much Enron stock, preferred or otherwise, could be used to back up the payment of those bonds to the bondholders? That is a simple question. Mr. Jaedicke. Was there any limit? Senator Levin. Yes. As long as Enron was in business, was there any limit to the amount of stock? Mr. Jaedicke. I think the only limit that would come into play would be that there is a transaction approval process on the sale and purchase of assets and the issuance of stock. It would have had to come to the Board. Senator Levin. My question is, to repay those bondholders what they were guaranteed, was there any limit on the number of shares of Enron stock that had to be or would be sold, if necessary, to pay them back? That is my question. Mr. Jaedicke. The market would have imposed the limit, just like they would have imposed a limit on how much you can borrow.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 80 for clarification which appears in the Appendix on page 665. --------------------------------------------------------------------------- Senator Levin. I am talking about the number of shares sold, not the value of---- Mr. Jaedicke. I do not think--no---- Mr. Winokur. Sir, the minutes say that there were reserved 20 million additional shares of common stock and 100,000 preferred shares of the company for issuance under the share settlement agreement. Senator Levin. Take a look at Exhibit 32,\1\ if you would, the ``Stock Price Risk and Financing.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 32 which appears in the Appendix on page 334. --------------------------------------------------------------------------- Mr. Winokur. Yes, sir. Senator Levin. Do you see that risk on Osprey? Mr. Winokur. Yes, sir. Senator Levin. Ten thousand shares if it went down to $40? Mr. Winokur. Ten million shares, yes. Senator Levin. Ten million shares if it went down to $40? Mr. Winokur. Yes, sir. Senator Levin. If it went down to $20, what would be the risk? Mr. Winokur. I cannot do that calculation. Senator Levin. But whatever was necessary? Mr. Winokur. No. The share settlement agreement that I just read--now, again, I do not have the detailed document--said that a certain amount of common stock or preferred stock was reserved for issuance, and that is why I said to you that I believe that there was a contingent limited guarantee. Senator Levin. You believe it was limited as to how many shares would be sold to pay back those bondholders, is that what you are saying? Mr. Winokur. In 1999, when this was done, to the best of my knowledge. Senator Levin. Let me just make sure here that we are on the same wavelength. We are talking about the number of shares, not the amount of the dollars to be repaid. But what I am asking you again is, was there any limit on the number of shares of Enron that would be sold to pay back the bondholders? That is my question. You are saying the answer is yes. Is that your answer? Mr. Winokur. To the best of my recollection--this was a transaction that happened 3 years ago--I am referring to the minutes which says there will be reserved 20 million additional shares of common stock and 100,000 preferred shares of the company for issuance under the share settlement agreement. That is my only recollection, is what is here. Senator Levin. You do not know, then, whether or not there was any limit? Mr. Winokur. I do not know---- Senator Levin. You know how many were reserved, but you do not know whether there was a limit? Mr. Winokur. Well---- Senator Levin. Under the agreement--I am just trying to get an answer. Mr. Winokur. I only know what is in the minutes, sir. Senator Levin. All right. You do not know, then, whether there was a limit or not. Next, LJM. Now getting more and more dangerous and deeper, here is another off-the-books entity that Enron helped to create which bought Enron assets. With the Board's approval of the partnership, here is what happened. On June 28, 1999, the Board held a special meeting in which all five of you participated either by phone or in person. You approved the creation of LJM1, and for the first time, you waived Enron's conflict of interest provision in your code of conduct to allow the Chief Financial Officer, Andrew Fastow, to take an ownership interest and act as the general partner of the LJM partnership. Now, Mr. Winokur, under the normal order of business, this matter was not first presented to the Finance Committee, is that correct? Mr. Winokur. Yes, sir. That is correct. It was not presented. Senator Levin. It was not presented to the Finance Committee. The Finance Committee was skipped. Why was that? Mr. Winokur. Well, this was not a regularly scheduled meeting of the Board. Senator Levin. You had a lot of special meetings of the Board. Mr. Winokur. Special meeting. I cannot tell you why there was not a special Finance Committee meeting. Senator Levin. Did you ask? Mr. Winokur. I do not recall asking why there was not a special Finance Committee meeting, no. Senator Levin. Now, you testified this morning that the Board did not waive the code of conduct. Mr. Winokur. Yes, sir. Senator Levin. That was your testimony this morning. Take a look at Exhibit 19, if you would.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 19, entitled ``Key Elements of Transaction to be Approved,'' which appears in the Appendix on page 261. --------------------------------------------------------------------------- Mr. Winokur. Sir, I know that the chart uses the term---- Senator Levin. That is your chart, is it not? Mr. Winokur. No, this is management's chart. Senator Levin. Was it presented to you? Mr. Winokur. It was presented to us, and in the resolution that the Board approved, we ratified management of the Office of the Chairman's decision that permitting Mr. Fastow to participate in this would not be adverse to Enron. Senator Levin. Well, that is a different issue. The question is whether or not it was considered inside Enron, as well as by the rest of us, as a waiver of your code of conduct. Your own document says, ``waiver of code of conduct,'' yet you testified this morning that there was no waiver of a code of conduct. I am just presenting you with your own document. Mr. Winokur. Sir this is---- Senator Levin. It says it was. Mr. Winokur. This was management's presentation to the Board. We applied the code of conduct. The Chief Executive has the ability to make a determination, as I said in my statement this morning, that permitting Mr. Fastow to make this investment would not have any probability of conflict of interest, and we ratified that decision, which is applying the code of conduct. Senator Levin. Applying the code of conduct. Let us take a look at Exhibit 20.\2\ Now, the second time it is presented to you as a waiver. It has got the Enron logo on there. Look at the bottom, Finance Committee, Board of Directors action requested. ``Ratify decision of Office of the Chairman to waive--not apply--waive code of conduct in order to allow A. Fastow participation.'' --------------------------------------------------------------------------- \2\ See Exhibit No. 20 which appears in the Appendix on page 271. --------------------------------------------------------------------------- Now, did you tell them, hey, wait a minute, do not present that to us as a waiver. Present that to us as an application. You did not tell them that, did you? Mr. Winokur. When we approved it at the Board meeting, that is what we approved, the application. Senator Levin. I understand that. That was the first time. Mr. Winokur. The resolution following this meeting, which was in October 1999, has the same language. Senator Levin. Right. I understand. But it is presented on Enron documents the second time now as a waiver. That is the way it was viewed inside Enron by the management. That is the way it is viewed by me. But you are saying, no, we did not waive it, we applied it. I am just asking you this question. When this was presented to the Board as a waiver in the Enron document Exhibit No. 20,\1\ did you object to the presentation of it to you as a waiver? Mr. Winokur. I did not treat it as a waiver. I did not object to the words in this document. Senator Levin. You did not tell management, hey, wait a minute. You are asking us to waive---- Mr. Winokur. Yes, sir. Senator Levin [continuing]. For the second time. We are telling you, we are not waiving. We are applying. Did you do that? Mr. Winokur. We did that in the Board approval. Senator Levin. You told them, this is not a waiver? Did you ever use the words, ``This is not a waiver'' in the Board approval? Mr. Winokur. No, sir. Senator Levin. No. Mr. Jaedicke. Mr. Chairman, can I---- Senator Levin. Sure. Mr. Jaedicke [continuing]. Just inject that I think if you--I am not absolutely sure of this, but I think if you look at the minutes of that meeting, you will find that Fastow himself says in presentation--this slide does not say it, but that it requires the Board to ratify the decision of the Office of the Chairman---- Senator Levin. Right. Mr. Jaedicke [continuing]. That his--it requires a finding and a recommendation that it will not--that there appears to be a zero probability that it will be adverse to Enron. Now, he did not use zero probability, but---- Senator Levin. That is his opinion. Mr. Jaedicke. But he presented it, I think, properly, is what the minutes indicate. Senator Levin. He presented it in this document as a waiver. Was that proper? Mr. Jaedicke. The document---- Senator Levin. Is that proper? Mr. Jaedicke. No. Senator Levin. Thank you. Now, LJM1 is an extremely unusual arrangement. You set up a private equity fund. You waive the code of conduct, or in your words, you approve a deviation from it, and install Enron's CFO as the managing partner of the fund. Each of you said during your interview that you had never approved a similar arrangement before and you were unaware of any company that had its CFO running a private equity fund on the side. So far, are you with me? Mr. Winokur. Yes, sir. Senator Levin. None of the experts we have contacted have ever heard of such an arrangement, either. But LJM1 was made after 3 days notice of the proposal, no prior Board discussion with either Enron management or Andersen, no written legal opinion, no prior Finance Committee review. Now, some of you told us that the Board was told that speed is of the essence. Is that your understanding? Was speed of the essence? Mr. Winokur. I do not recall saying that. Senator Levin. You do not remember---- Mr. Jaedicke. I think I can speak to that. Senator Levin. Is that what you were told, that speed is of---- Mr. Jaedicke. Well, the meeting took place in the middle of June. The end of June was the end of the quarter, second quarter. Shortly after that, you had to issue financial statements. They had the Rhythms stock. The Rhythms stock had gone up greatly and they wanted to get it hedged. We thought this was a valid hedge. We did not--I think the reason they wanted it done by the end of June is because they did not want to be in the position of having a fair value investment, a stock on their books, a mark-to-market, without a hedge. So there was--the hedge should have been put on by the end of June. There were other items on the agenda of that June Committee, sir. I do not know, we had a stock split. There were two or three other items on the agenda, and I think it was not--I think we can probably find other decisions were made that necessarily did not go through a particular committee. Senator Levin. This was an unusual transaction, was it not? Mr. Jaedicke. Well, you mean---- Senator Levin. No one had ever heard of an equity fund like this before. Mr. Jaedicke. What is the unusual transaction? Senator Levin. To create an equity fund to buy your own assets. Mr. Jaedicke. Sir, I am sorry. We approved a specific transaction, which was a Rhythms hedge, and the company--we did it with Fastow. That was different. But the use of hedges and the use of at least what I would call less-than-perfect correlation hedges, was explained in detail in the annual report. I mean, that was part of the strategy. Senator Levin. But you have said that now the only purpose of this was to acquire a hedge. Mr. Winokur. Sir, LJM2, which was set up in October, was, in fact, an alternative optional source of capital. Mr. Jaedicke. That was different. I am sorry. I thought you were talking about LJM1. Senator Levin. I am talking about LJM1. Is it not true that LJM1, in addition to the hedge, which you said was its only purpose, could negotiate with the company regarding the purchase of additional assets? Is that not true? Mr. Jaedicke. That is true. Senator Levin. So it was not just for the hedge. It had an additional purpose, which was to buy assets. Mr. Jaedicke. And in the meantime, you would put in the controls that were necessary. Senator Levin. I understand, but you just said a minute ago the sole purpose---- Mr. Jaedicke. Sir, I would just like to point out to you-- -- Senator Levin. But you just said a minute ago the sole purpose was for the hedge. I am just pointing out to you that it had an additional purpose, which was to buy assets. Mr. Jaedicke. I told your staff this, that the ironic part of this is--I have been in a situation recently where I would have been prepared to have an inside transaction, in this case, with an equity fund that was run by a very senior--not the CFO, but a very senior person in the company. It turned out the transaction did not--because I thought in that case, as this case, that you could do it better inside than you could outside. It was cheaper. It was quicker. It was more efficient. That was the thought on LJM1. And on the related party, I just happened to be in a similar position with a very similar fund. It did not take place, but I would have supported it. Senator Levin. In October 1999, more than 3 months after you approved LJM1, the Finance Committee was asked to approve LJM2. Mr. Fastow now was proposing another vehicle that would complete a large number of deals with Enron and push further the Enron strategy to move assets off the books. Mr. Winokur, I believe you told the staff that before the Finance Committee meets, you typically meet with Enron management to set the agenda and to discuss the issues, but that did not happen with LJM2, did it? Mr. Winokur. Well, we had a telephonic meeting in advance to go over the agenda. I have no reason to believe it did not happen. Senator Levin. Did you not tell us the first time you heard about this was at the Finance Committee meeting on October 11? Mr. Winokur. I do not recall whether there was a telephone meeting or not. Senator Levin. When was the first time you heard about LJM2? Mr. Winokur. At the meeting, unless we had a telephonic meeting to describe the agenda. Sir, I do not remember which. Senator Levin. Is not the creation of LJM2 something that you, as Chairman of the Finance Committee, should have been consulted on before the day that you were expected to make a decision? Mr. Winokur. Well, to make a recommendation, yes, sir. Senator Levin. To make a recommendation. Well, it is a decision to make a recommendation. But my question is, should you not have been consulted before the day that you were expected to make a decision or a recommendation? Mr. Winokur. Sir, I do not recall when I learned of the LJM2 matter, whether it would have been with the material that was provided in advance of the meeting or in a telephonic conversation or at the meeting itself. Senator Levin. But my question is a little different. Should you not have been consulted about this transaction, this proposal, prior to the meeting, as Chairman of that Committee? Mr. Winokur. The principal purpose of a pre-meeting was to make sure that we had the agenda laid out, not so much necessarily to go through individual items in detail. Senator Levin. Was LJM2 on the agenda? Mr. Winokur. I do not have the agenda here. Senator Levin. Do you remember whether it was on the agenda? Mr. Winokur. Well, I believe it was, yes, sir. Senator Levin. This is a major transaction. We are talking billions of dollars. You are now telling us that you would not normally have discussed a transaction of that magnitude prior to it appearing on the agenda at the Finance Committee? Mr. Winokur. Sir, we were talking about organizing a fund that might raise $200 million that would be alternative and optional as a source of funds for Enron. It did not require-- there was no specific transaction being proposed except the organization of the fund and the ratification of the decision to permit Mr. Fastow to participate in it. There was no sale being discussed. Senator Levin. It was a fund, however, which would openly now have a member of the Enron management participate in an outside company whose purpose was to purchase assets, is that correct? Mr. Winokur. Yes, sir. We had a vigorous discussion at the meeting. Senator Levin. And you decided to let him do it? Mr. Winokur. We decided to ratify the decision of the Office of the Chairman. Senator Levin. Another off-balance-sheet vehicle, buying assets. But this time and the time before, this is really interesting, this time, when we talk about LJM, now you have got a guy who is management who is on the other side of the table. He is buying assets from you, and he is wearing both hats. He is now playing a key role in the sale, setting the sale price, and he is also buying at the same time. You put certain what you call protective devices in place, but they sure did not work very well. Mr. Winokur. Sir, the concept of LJM was to provide bridge financing for the business unit heads who wanted to sell assets. They were not required to sell them to LJM2. They had their own financial incentives. They had their own operational capabilities. So LJM2 was an alternative and optional source of capital for them. If they did not like the price LJM2 was offering, they did not have to use it. Senator Levin. Why did you create LJM2? What was wrong with Whitewing? Mr. Winokur. Whitewing was a very large vehicle. It was expensive and time consuming and complicated to create. To have an independent, smaller, private vehicle which would provide bridge financing for smaller transactions seemed like a perfectly reasonable thing to do. Senator Levin. Let me show you Exhibit 21,\1\ if you would. This is the way LJM was being marketed. The first page of the text, in the middle, says, ``Under Mr. Fastow's management, the Partnership expects to have the opportunity to co-invest with Enron'' and then ``acquire existing Enron assets on a highly selective basis. This access to deal flow should provide the Partnership with unusually attractive investment opportunities.'' The memo goes on to say it is going to be managed by a ``team of three investment professionals who all currently have senior level finance positions with Enron.'' Then if you look at the end of this document, the last line, ``The Partnership should also benefit indirectly from time spent by the Principals in evaluating and structuring investments for Enron, as many of these investments may become candidates for investment by the Partnership.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 21 which appears in the Appendix on page 272. --------------------------------------------------------------------------- They are touting their inside information in Enron as they are selling the interest in that LJM partnership. That conflict of interest is being sold as a plus to people who are investing. Now, did you ever inquire as to how they were marketing this? Did you ever ask for any marketing documents like this? Mr. Winokur. We asked and were told that Enron's counsel, Vinson and Elkins, had reviewed drafts of the document. I did not actually see this document until my work on the Powers Committee, and we, of course, were never told that Mr. Kopper was a participant. Mr. Glison said in his Powers interview that his name was erroneously included here. Senator Levin. Mr. Glison was not erroneously included, though. Mr. Winokur. Well, as it turned out. Senator Levin. Right. But what I am saying is, you never asked to see documents? Mr. Winokur. This was an independent, separately organized entity. We asked our counsel to review the drafts to make sure the disclosures were proper. Senator Levin. And did your counsel tell you that it is OK to tout a conflict of interest as a way to sell something? Mr. Winokur. They did not. Senator Levin. Have you asked them about why they did not? Mr. Winokur. Well, I did not ask Vinson and Elkins, no, sir, but the Powers Committee report makes it clear that Vinson and Elkins reviewed these drafts. They would have done that and reported through the Enron legal chain and no one came forward---- Senator Levin. And after you heard that they approved this kind of marketing, using a conflict situation to sell an interest, saying that: Hey, I have got an inside position. We are in Enron, three of us. We are in a great position to help this partnership that is buying things from Enron get a good deal. That is being used, touted. And you are saying your lawyer saw that and approved it. Then my question to you is, after you heard that he had approved it and after you now have read this, have you ever asked your lawyer, how in heaven's name could you have approved that? That is my question. Mr. Winokur. Sir, first of all, we knew that a possibility is that Enron would be selling assets to LJM2. One of the reasons for establishing LJM2 was to provide an optional alternative source of capital to buy assets from Enron, and the benefit of having Fastow, who is the only person we knew about, involved in this is that he would know the assets, and the benefit of having the other people inside Enron who ran divisions to go to Fastow, if they did not like Fastow's bid, they did not have to take it. We also had the Chief Risk Officer and the Chief Accounting Officer reviewing each transaction. So the fact of the conflict was known from the beginning. Senator Levin. Exhibit 16,\1\ if you will take a look at it, will show you how you could have sold these assets without that kind of a conflict. This is the result, though, of what happened. When LJM bought these Enron assets--now we are talking LJM again--Enron tacitly agreed to buy some of them back if LJM could not sell them. Are you aware of that? --------------------------------------------------------------------------- \1\ See Exhibit No. 16 which appears in the Appendix on page 256. --------------------------------------------------------------------------- Mr. Winokur. No, sir. Senator Levin. When that happened, Enron paid more to LJM than Enron had paid to buy the asset in the first place. Are you aware of that? Mr. Winokur. No, sir. Senator Levin. In negotiating the sale of assets to LJM, Fastow clearly had a superior bargaining position over Enron personnel because both sides reported to him. Are you aware of that? Mr. Winokur. Well, the operating divisions did not report to Mr. Fastow. Senator Levin. Were there people involved on the Enron side making a decision who did report to Fastow? Mr. Winokur. We later found that was the case. That was not consistent with the controls that we had put in place. Senator Levin. Those controls were not working very well, were they? Mr. Winokur. We were told they were and they obviously turned out not to be. Senator Levin. So that, at a minimum, the controls you put in place did not function to protect Enron. Mr. Winokur. Well, Mr. Fastow told us in October with Mr. Buy, Mr. Causey, and Mr. Skilling sitting right there, that the three of them were reviewing every transaction with LJM. Senator Levin. My question, though, is a little different. My question is the controls that you put in place did not work very well. Mr. Winokur. Well, we did not know that. Senator Levin. I am just saying---- Mr. Winokur. We were told that they---- Senator Levin. They did not work very well. Mr. Winokur. Well, they should have worked, but people did not do them. Senator Levin. Did LJM investors get a 69 percent return on their investment? Mr. Winokur. I saw a presentation through my Powers work to the LJM investors that showed a very high rate of return. I think that was the number you are quoting. Senator Levin. And would you agree that when LJM was benefitted to that extent, that would be at the expense of Enron? Mr. Winokur. Yes, sir. Senator Levin. And Fastow would profit from that? Mr. Winokur. Sir, in May 2000, Mr. Fastow told us he was spending approximately 3 hours a week on these vehicles and the vehicles were earning approximately an 18 percent return. Senator Levin. But my question is a little different. Do you agree that Fastow, when a 69 percent return was obtained by LJM, personally benefitted from that huge return? Mr. Winokur. Absolutely. Senator Levin. OK. That is the outcome of that conflict of interest--one of the outcomes, because you have got a guy on the other side of the table now who is doing the negotiating who, when he is putting on the LJM hat, gets a 69 percent return at the expense of Enron. That is the outcome of the conflict of interest. Mr. Winokur. But his supervisor, Mr. Skilling, and his peers, Mr. Buy and Mr. Causey, we were told that they were reviewing each and every transaction. Mr. Causey, Mr. Buy, and Mr. Skilling had no economic interest in LJM. Their interest was in Enron stock. If they had known, presumably, they would have taken steps to make sure that LJM was not making a 69 percent return. We were told they were on top of each and every transaction. Senator Levin. And when you found out to the contrary, you asked them about it? Mr. Winokur. I found out the contrary in the Powers investigation. Senator Levin. That is the first time you knew? Mr. Winokur. Yes, sir. Senator Levin. On the LJM transaction reviews, let us go on to that, Mr. Jaedicke. The Audit Committee had the primary responsibility for reviewing these transactions. It conducted two annual reviews of LJM transactions, one on February 7, 2000, and the other a year later in February 2001. First of all, is it true that the Audit Committee spent no more than 30 minutes at each meeting going through the LJM transactions? Mr. Jaedicke. I am sorry, who said that? Senator Levin. I am asking you, is it true? Mr. Jaedicke. Is it true that we spent no more than 30 minutes? Senator Levin. On the LJM transactions during those Audit Committee meetings. Mr. Jaedicke. Well, we did not necessarily review each individual transaction. We reviewed the type of transactions. We asked pointed questions about are these done at arm's length or fair to Enron. We were assured that they were. Arthur Andersen was sitting there. That footnote is in the annual report and it is an auditable footnote, and neither management nor Andersen--management cannot make that representation to us unless they have some reason, and Andersen has to audit it. Senator Levin. I understand, but my---- Mr. Jaedicke. So a half-hour? Yes, I would imagine that was probably 25 percent of the time in a typical Audit Committee, but we had the information before, and I do not know how many-- I do not know how much time people spent on the exhibits and so on when they were given to us. Senator Levin. OK. Mr. Jaedicke. All I can say is I think the--even though we did not have the information we needed, we were not told the truth, in fact, I think we spent a sufficient amount of time-- -- Senator Levin. That was not my question. Mr. Jaedicke [continuing]. To carry that out. Senator Levin. My question was, is it true you spent no more than 30 minutes? It is just a simple, direct question. Mr. Jaedicke. I would suppose that would be true. Senator Levin. Thank you. Now, on LJM3, on October 6, 2000, Fastow proposed LJM3 to the Finance Committee and asked for a third waiver. The Committee approved that waiver. At the same time, Dr. Winokur, I believe you proposed that the Compensation Committee review Fastow's LJM compensation. Mr. Blake, you proposed that the Finance Committee review Enron's transactions with LJM every quarter. Mr. Blake. Yes, sir. Senator Levin. So now I want to focus on the October 6, 2000, meeting, where Fastow proposes LJM3 to the Finance Committee, asks for the waiver, and gets it. But now, Dr. Winokur, you are proposing that there be a review of his compensation, and Mr. Blake, you are proposing that the Finance Committee review the transactions every quarter. These proposals were unanimously agreed to at the meeting. So the Committee now imposes some reviews. Now, let us talk about the follow-through on those decisions. First, I think I asked Dr. LeMaistre about this one. You attended the Finance Committee meeting on October 6 when that proposal was adopted for the Compensation Committee to review Mr. Fastow's compensation. But that review was not completed in 2000. In fact, it was not done that year at all, was it? Dr. LeMaistre. As far as I know, it was not. Senator Levin. Now, why didn't you promptly do the review since you had that vote? Dr. LeMaistre. Primarily because we did not have the information, and it was our understanding at the time that Fastow's compensation was to be under the control of formulas. It was to come through with the other reports on the quarterly base and the annual base and it did not. Senator Levin. In other words, you are saying it was not intended that you review that compensation immediately? You were supposed to wait? Dr. LeMaistre. Mr. Winokur's direct words in that meeting were, ``Perhaps it would be a good idea to have the Compensation Committee take a look at information regarding his compensation.'' It was a remark that would indicate to me that they already had the compensation there, and that turned out not to be the case at the end of the first quarter when I checked, and, therefore, that is basically the reason I did the checking. Senator Levin. When did you do the checking? Dr. LeMaistre. After the first quarter of 2001. Senator Levin. It was reported in the Wall Street Journal-- we have gone into this today--that Mr. Fastow had made millions of dollars more from LJM. When was that? Dr. LeMaistre. That was on October, 19, 2001. Senator Levin. It was only then? Dr. LeMaistre. That was the first time that any of us knew that there was something wrong going on. Senator Levin. Right, but you had made inquiry about his compensation. Didn't you ask the Compensation Officer at Enron, Mary Joyce, about it? Dr. LeMaistre. I asked Mary Joyce about it. Senator Levin. And what did she tell you? Dr. LeMaistre. She said she did not have the information. Senator Levin. Did you say, well, I want it? Dr. LeMaistre. She knew that I wanted it and I asked---- Senator Levin. Did you get it? Dr. LeMaistre. I did not. Senator Levin. This is the heart of the problem. You have got a Board that says, I want it. You have got a request for it. It does not come, and you do nothing. That is an approach which is unacceptable for a Board. Those folks are supposed to be reporting to you. You are the captains. You make a decision. We want to find out about this compensation. You make an inquiry of an employee and she says she does not have the information, she will get back to you. She does not, and nothing happens. There is a Wall Street Journal article a year later. That is not the way a Board can operate and carry out its fiduciary duties, folks. Dr. LeMaistre. I did have a subsequent conversation to see if the information had been obtained. It had not, and that is immediately prior to all of the things that unfolded very rapidly in the fall. But let me make it clear---- Senator Levin. Should you have gotten that information? Dr. LeMaistre. Yes, I should have gotten it and I should have gotten it through channels. It was Mr. Skilling's responsibility to have put that through and he did not. It did not come through any of the transactions. Mr. Fastow, in his declaration of the controls on him, said he reported that information to Mr. Skilling. Senator Levin. But you had a conversation now with this employee, Mary---- Dr. LeMaistre. Mrs. Joyce, yes. Senator Levin. Mary Joyce, and you asked her for information---- Dr. LeMaistre. Yes. Senator Levin [continuing]. And she did not get it to you. Dr. LeMaistre. She had not received it, that is correct. Senator Levin. And did you ask her to get it? Dr. LeMaistre. I asked--I told her I wanted all of the information on any 16(b) officer that had outside income---- Senator Levin. And would that include Fastow? Dr. LeMaistre. Of course, yes. Senator Levin. Sure. That was the reason you called, was it not? Dr. LeMaistre. That is right. Senator Levin. You did not mention his name? Dr. LeMaistre. No, I did not mention his name. Senator Levin. Even though that is why you called? Dr. LeMaistre. That is exactly right, but I wanted it on all 16(b) officers. Senator Levin. And you did not get it. Dr. LeMaistre. I did not get it, but if I had gotten it, I would have had some other people involved in there, as you now know. Senator Levin. Good. The point is, you did not get it and you did not act to get it and that is---- Dr. LeMaistre. I did not act to get it primarily because it was supposed to come through with the other reports and it did not. Senator Levin. But did she not tell you she would get it to you? Dr. LeMaistre. No, she did not. Senator Levin. You did not say you wanted that information? You are doing this report for the Board. You are told, hey we would like to know more about it, and you just call up and say---- Dr. LeMaistre. She said she did not have the information. I said, well, let me know when it gets there. Senator Levin. And did she? Dr. LeMaistre. She did not let me know, so I asked again a few months later and she did not have it, and that was in August or September. Senator Levin. Did you just throw your hands up? I mean, she does not have it. Dr. LeMaistre. Well---- Senator Levin. Why does she not have it? You are a Board member. You are paid a lot of money. You are carrying out a Board direction. You want information. You do not get it. She will call you when she gets it. She does not call you. Two months later, she still does not have it. To me, that is an approach which is totally unacceptable, I have got to tell you. I think that is what characterized the Board--is that it was deferential to management. I want to go into another document on that. When you were told, finally, after you found out how much money--if you would take a look at Exhibit No. 24b.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 24b which appears in the Appendix on page 283. --------------------------------------------------------------------------- Dr. LeMaistre. All right. Senator Levin. So now it appears in the Wall Street Journal, and the Board asks, I think, both Mr. Duncan and Dr. LeMaistre to call Fastow. I think, Dr. LeMaistre, you said in your interview that you asked the Enron General Counsel to write the questions that you would ask Mr. Fastow on the phone, and Exhibit 24b is the document that the General Counsel faxed to you with your notes from that phone conversation, is that correct? We are looking at Exhibit 24b now. Dr. LeMaistre. That is correct, Mr. Chairman. Senator Levin. OK. And here is the note that he typed for you. ``Andy, because of the current controversy surrounding LJM1 and LJM2, we believe it would be helpful for the Board to have a general understanding of the amount of your investment and of your return on investment in the LJM entities. We understand that a detailed accounting of these matters will soon be done in connection with the response to the SEC inquiry. We very much appreciate your willingness to visit with us.'' This is a guy who is supposed to be working at your direction, and you cannot get much more deferential and obsequious than that. And not only that, you then want to make sure that he understands right up at the front how much you appreciate his willingness to visit with you, and I presume you take a line, circle that, ``We very much appreciate your willingness to visit with us,'' and make sure that goes at the top. Why do you not call up and say, ``What in God's name is going on? We just read something in the Wall Street Journal here that just shakes the heck out of us. Is it true? How much money did you make? What is your return?'' That is not what comes out here. You apparently, when he told you how much money he made, found it to be--I think this is your handwriting? Dr. LeMaistre. That is correct, sir. Senator Levin. ``Incredible'' is your word. Dr. LeMaistre. Mr. Chairman---- Senator Levin. Yes, please. Dr. LeMaistre. This is drafted by legal counsel and I followed it directly. Senator Levin. Right. But is not that arrow that puts the, ``We very much appreciate your willingness to visit with us--'' Dr. LeMaistre. Yes, that is right, because---- Senator Levin. That is your writing, is it not? Dr. LeMaistre. Yes, and may I explain it? Senator Levin. Sure. Dr. LeMaistre. The day before when I talked to Mr. Fastow, he was very cautious at first about this, and finally, he said he would be glad to talk with us. But it was a decision that he could have made not to talk to us, and we would have had to go through channels to get it, but we wanted it immediately, that is the reason that we did it that way. Senator Levin. Why do you have to go through channels? Why can you not just call up Fastow and say, I want to know right now? Dr. LeMaistre. I could have, but I would have not used language in here had I done that. I would have used---- Senator Levin. Why did you not use language that was not in here? Dr. LeMaistre. Primarily because---- Senator Levin. I guess that is what it comes right down to. Dr. LeMaistre. Well, the point is that this is what our General Counsel told us to use in talking about income to a third party investment, an SPE. Senator Levin. Were you mad? Dr. LeMaistre. I was mad after the answer to the first question. Senator Levin. Did you let him know? Dr. LeMaistre. Yes. Senator Levin. Right there on the phone? Dr. LeMaistre. Yes. Senator Levin. Good. That is a year late, but good. Now, there were supposed to be quarterly reviews by the Finance Committee, I believe, because the Finance Committee was supposed to begin quarterly reviews of the LJM transactions, according to the decision of the Committee, and the Finance Committee agreed. But there is only one quarterly review that was ever conducted by the Finance Committee, which was in February 2001. So if my recollection is correct, the decision of the Board was October 2000 that these quarterly reviews of these LJM transactions would be conducted, but there was only one, and that was February 12, 2001. Now, why is that? Mr. Winokur. The first meeting after the October meeting was December, which was about 6 or 7 weeks later, so I think we assumed that a quarterly review would have meant after the year end, since the October meeting would have been around the end of the third quarter. After the February quarter, there was not activity, new investments being made, and by June, Mr. Fastow had sold his interest, so there was no more related party aspect. Senator Levin. We will get to that in a moment, but there were supposed to be what are called deal approval sheets, or DASHs, for each of the LJM transactions, I believe, since they were transactions with a related party. Did you ever see those DASHs, those LJM DASHs? Mr. Winokur. No, sir. There is an LJM approval sheet and a DASH which is for every transaction. They are separate. Senator Levin. And did you ever see the DASH? Mr. Winokur. The regular DASHs, we saw all the time---- Senator Levin. For LJM? Mr. Winokur. No. Senator Levin. Should you have? Mr. Winokur. Those were internal and those, we were told, were being reviewed by Mr. Skilling, Mr. Causey, and Mr. Buy. There would have been no reason, unless the size of the investment was such that it would have normally come through our---- Senator Levin. So that was not normally supposed to come to you? Mr. Winokur. No, sir. Senator Levin. But I believe that, Mr. Jaedicke, those DASHs should have come to you, is that not correct? Mr. Jaedicke. No, sir. We did not--we reviewed the transactions and the type of transactions and the fairness, but we did not go--we are not auditors and so we did not go to the level of the deal approval sheets. Senator Levin. So those deal approval sheets were not supposed to go to any of the committees, is that correct? Mr. Winokur. Sir, transactions involving Enron's expending more than $75 million came to the Board for approval. Transactions more than $25 million but less than $75 were within the purview of Mr. Lay and Mr. Skilling. So our practice was that the transactions between $25 and $75, those DASHs were packaged up and we were sent them after the fact to look at, so we could comment on them. The deals would have been approved, but if any member of the Committee had any questions, he could bring those up. So the only expenditure of cash that we would have seen would have been above that level of $25 million, and for divestitures, the level was much higher. So to the extent that Enron was selling assets, the transaction approval process would not have required us to see those. Senator Levin. Even though there was this conflict of interest problem? Mr. Winokur. The conflict of interest was being dealt with because Mr. Skilling, Mr. Buy, and Mr. Causey were reviewing, according to what Mr. Fastow told us, every transaction. Senator Levin. All right, so that there was no need for a DASH? Mr. Winokur. The only need we had was what we got, and that was to make sure we were told regularly that the controls we put in place were working. Senator Levin. You did not need the DASH in order to achieve that? Mr. Winokur. No, sir. Senator Levin. That is just what I was asking. There was no need, then, for you, in your judgment, to get one of those DASHs for these transactions because you had another mechanism that you thought was doing the control? Mr. Winokur. We were told the people who did review the DASHs had done so. Senator Levin. Right, which is another mechanism. Mr. Winokur. Yes, sir. Senator Levin. Now, I believe you just testified that when you learned that Fastow was selling his LJM interest, that there was no need for a second quarterly review. But the first quarterly review, I believe, was February 12, is that correct? Mr. Winokur. Yes, sir. Senator Levin. When did he sell his interest? Mr. Winokur. I said two things. I said there were no transactions that we knew about that occurred with LJM after the February meeting. He sold his interest, I later learned, in June. That was disclosed to us in August, I think. Senator Levin. But should there not have been a quarterly review in June? You had one in February---- Mr. Winokur. We have a May meeting and an August meeting, and so we---- Senator Levin. A quarterly---- Mr. Winokur [continuing]. We did not have one in the May meeting. At the August meeting, we were told that he had sold his interest in June. Senator Levin. Right, but since it was supposed to be a quarterly review, and there was one that occurred in May--there is one that occurred in February, should there not have been one in June, is my question. Mr. Winokur. If there were transactions to review, yes, sir. Senator Levin. In other words, when you did not get a quarterly report, you assumed there were no transactions? Mr. Winokur. Yes, sir. Senator Levin. And did you check? Mr. Winokur. No, sir. Senator Levin. Now, did you know to whom he sold it, by the way? Mr. Winokur. I did not know then. I learned later. Senator Levin. And who was that? Mr. Winokur. Michael Kopper. Senator Levin. And had you known that, would you have wanted those quarterly reviews to continue? Mr. Winokur. Well, I did not know---- Senator Levin. Mr. Kopper was so close? Mr. Winokur. I did not know Mr. Kopper was involved in Chewco. I did not know he was involved in all the things he was involved in, and had he complied with the code of conduct, we would have gotten into that much earlier. Senator Levin. But did you know that he was very close to Fastow? Mr. Winokur. Well, I knew Andy had a bunch of bright people working for him. I did not know that Kopper was any closer to him than anybody else. Senator Levin. But if you had known, if Fastow had told you that he had sold his interest to Kopper, would you have said, ``whoops, wait a minute; even though Fastow left, given our relationship with Kopper, we better continue----'' Mr. Winokur. Absolutely. Senator Levin [continuing]. Those quarterly reviews? Mr. Winokur. If I had known that the related party relationship continued informally as well as formally, I would have wanted to continue the reviews, yes, sir. Senator Levin. Now, when you did find that out, then what happened? Mr. Winokur. Well, I did not find it out until---- Senator Levin. August. Mr. Winokur. No, I found out that he sold. I do not believe that I found out--I do not remember exactly when I found that Kopper bought it. I thought it was actually during the Powers work that I found out who bought it. Senator Levin. That was the first time you learned that Kopper bought it? Mr. Winokur. That is my recollection. Senator Levin. Was it relevant as to who bought his interest? When you found that he had sold his interest, did it become relevant as to whom he sold it, since if he sold it to another related party, directly or indirectly, you would want the controls to continue? Should you have asked who he sold it to? Given that history, should you not have asked who he sold it to is my question. Mr. Winokur. I would have to look back at the August minutes to see what was said by Mr. Koenig about how it was sold. If it was said it was sold to an unaffiliated party, then I would not have thought more about it. Senator Levin. I asked you about whether or not there was an unwritten guarantee that LJM would not lose money in a deal with Enron. Were any of you aware of such a guarantee? Dr. LeMaistre. I was not. Mr. Duncan. I was not. Mr. Winokur. No, sir. Senator Levin. Mr. Duncan. Mr. Duncan. I was not. Senator Levin. I think what we are going to do here is take about a half-hour break. I just want to summarize this one LJM issue, though, before we leave to sort of tidy this thing up. The things that really trouble me are the lack of real energy and effort by the Board in a situation where you are using accounting methods which are clearly at the margin, high risk. You were so informed early. You know that you are using a lot of off-the-balance-sheet entities, special purpose entities. You are into this whole area. You decide on a compensation review, and despite a decision in October 2000 to do it, you do not do it. No one ever saw this LJM initial placement memo. I take that back. Your lawyer did, apparently, but your lawyer, when he saw that the conflict of interest is being touted as a reason for investors to buy LJM apparently was not troubled by that. If I understood you correctly, Dr. Winokur, you never asked your lawyer as to why. Mr. Winokur. I did not learn that until my work on the Powers Committee, sir. Senator Levin. Right, but after that, you did not ask your lawyer---- Mr. Winokur. Well, I did not have direct contact with Vinson and Elkins at that point. Senator Levin. It is not the kind of active control and responsibility that I think we have to expect of Boards; that's what it comes down to. That is just on LJM, and we will go into Raptors when we come back, but let us take a half-hour break now until 2:30. Thank you. [Recess.] Senator Levin. The Subcommittee will come back to order. We now come to the time when the Board dives into perhaps the most dangerous waters of all, and these are the Raptors, the very complex set of transactions that the Board knew about and approved, despite questionable accounting and significant financial risk to Enron. The Raptor transactions consisted of a series of four complex transactions, each of which involved Enron, LJM2, and various special purpose entities. In each of the four complex Raptor transactions, Enron placed highly volatile shares of stock from companies in which Enron had invested. Enron did this because it had already booked as income the increase in the companies' share prices, and it wanted to protect itself from any loss if these shares dropped in price. And so Enron's goal was to hedge these stocks. The problem was that no third party would agree to enter into a hedge to protect Enron from a loss on those shares, so Enron used LJM2, set up these special purpose entities, and secured each of the hedges by pledging its own stock as collateral. Through a series of deceptive transactions and improper accounting entries, Enron recorded earnings on its books of about $1 billion, and another $1.2 billion in increased shareholder equity. If we could take a look at Exhibit 28b.\1\ This is the ``Hedging Program for Enron Assets,'' as it is described, that was presented to the Board on May 1, 2000. And if you will look at the last page, where it says ``Project Raptor.'' When you look at the risks cited here, this lists the risks involved here, maybe, Mr. Winokur, you can explain this. --------------------------------------------------------------------------- \1\ See Exhibit No. 28b which appears in the Appendix on page 306. --------------------------------------------------------------------------- Mr. Winokur. Senator---- Senator Levin. First of all, did you remember this before-- -- Mr. Winokur. Yes, sir. Senator Levin [continuing]. When you were talking to our staff, did you remember this? Mr. Winokur. Yes, sir. Senator Levin. Details of this? OK. Do you want to explain---- Mr. Winokur. To the best of my recollection, I did. Senator Levin [continuing]. What you were told back on May 1 about the risks of Project Raptor, looking at those bullets? Mr. Winokur. Sir, it was Enron's staff practice when they presented an item for recommendation and approval always to describe the risks of the transaction. Every transaction obviously has risks and they would set them forward, and for each risk, they would have a mitigant. In other words, the idea was, this was a risk, they had already thought about it, and here is how they dealt with the risk. And in this case, one of the risks of a complicated structured finance transaction like this was that it would not be properly able to be accounted for, and the mitigant was, and the minutes suggest or support this, as well, that Rick Causey, the Chief Accounting Officer, and Andersen had been involved-- in fact, Enron paid Arthur Andersen a fair amount of money for helping to structure this transaction so that it would conform to the accounting requirements, and so that mitigant meant that the accounting scrutiny had been dealt with. Obviously, any time there is a hedge, there is a risk that the hedge does not work, and the mitigant there, if the hedge did not work, was to terminate the program. And, in fact, as I believe I have said here in the House, in the Powers Committee report, it says had the Raptor transactions been terminated in the first quarter of 2001 when it was clear they did not work, as opposed to their having been restructured without Board approval, I do not think, personally, Enron would be in the position it is in today. ``Counterparty credit'' just means that you have to have enough credit in the structured transaction to be able to execute the hedges you propose. Senator Levin. Now, first of all, what was your understanding of the words ``accounting scrutiny''? Does that mean that it might not have complied with Generally Accepted Accounting Principles? Mr. Winokur. No. That meant to me that it was important to make sure that the transaction was structured in a form that would pass accounting muster, and because Arthur Andersen had been paid to help work on the structuring and Rick Causey said they were comfortable and he was comfortable with it, that meant that risk was mitigated. Senator Levin. Did the Board understand that this was a true hedge? Mr. Winokur. Well, I did, and I believe everybody did. Senator Levin. If you believed it was a true hedge, why would there be any risk to Enron? Mr. Winokur. Well, Senator, we contributed unrealized gains on forward positions in the stock. In other words, we had an asset that had not previously been in Enron's income statement and we used that in contributing it in this structure as credit support for the hedge. So any time--if we contributed Exxon stock and the Exxon stock had gone down, that would have been the same issue. We would have terminated the hedge. Senator Levin. But my question, I think, is a little different, which is that if it were a true hedge, if you had gotten a third party to take that risk, your own stock would not have been at risk, would it? Mr. Winokur. It depends on the structure of the hedge. Senator Levin. If it is a true hedge. Mr. Winokur. Well, as I said, in my example---- Senator Levin. Do you not transfer the risk to someone else in a true hedge? Mr. Winokur. Well, you transfer risk, but if for some reason the hedge does not work, then it terminates, and that is what I said in my example. If Enron had contributed Exxon stock and Exxon stock had gone down, the credit capacity of that vehicle would have not permitted it to be viable, and so in this case, instead of Exxon stock, we used unrealized gains in forward positions on Enron stock. Senator Levin. Did the Board understand that Enron stock would be at risk under some circumstances here? Mr. Winokur. Yes. In fact, we---- Senator Levin. At the time of this deal, you realized that there was still a risk to Enron? Mr. Winokur. Well, we had a large unrealized gain in these forward contracts, so we understood that realized gain would be at risk. That was part of the structure. Senator Levin. If, in fact, the stock price went down and the unrealized gain disappeared, did the Board understand that then Enron would have to--that Enron stock itself would be at risk--not just the gain, but that Enron stock would be at risk, that you were not transferring the entire risk to a third party? Did the Enron Board understand that, or did the Enron Board believe that you were transferring that risk to a third party? Mr. Winokur. If the assets that were being hedged went up in value, then if the forward position was in decline, it would not have mattered, or vice-versa. Senator Levin. Yes. Now we are talking going down. Mr. Winokur. The bad outcome was that both the assets and the forward position went down, that is, Enron stock went down and Avici or whatever stock was hedged, and in that case, which is exactly what it says here, program terminates early in negotiation of an early termination agreement. So this was contemplated as a possibility. Senator Levin. The Board understood, then---- Mr. Winokur. That this possibility could occur. Senator Levin [continuing]. That Enron stock was being pledged as collateral? Mr. Winokur. No, forward positions on Enron stock. It is a derivative instrument. Senator Levin. My question is, did they understand that Enron stock itself was being pledged as the collateral? Mr. Winokur. Well, my recollection is, and I could look back at the previous page, was that forward positions were being pledged. That is my recollection. Senator Levin. Then the answer to my question about Enron stock being pledged as collateral? Mr. Winokur. We put seven million--from the previous page, we put stock in and we wrote--well, here, I think this was forward positions, even though it says that--Senator, I am looking at the diagram here. I do not have from 2 years ago the specific terms. Senator Levin. Let me---- Mr. Winokur. I believe that it was forward positions on the stock as opposed to the actual shares. Senator Levin. Forward positions on stock that Enron held in other companies? Mr. Winokur. No, that Enron was contributing unrealized gains in its own stock as credit support to get this structure organized. This structure could then purchase stock in some other company---- Senator Levin. Let me try to ask the question, because it is an important question. Did the Board realize that Enron stock was being pledged as collateral for the hedge? Mr. Winokur. I can only answer for myself. Senator Levin. You cannot give me a ``yes'' or ``no'' on that? Mr. Winokur. My recollection is that we were using forward--unrealized gains in forward contracts. That is my recollection. Senator Levin. Therefore, the answer is you did not realize that Enron stock was being pledged as collateral for the hedge? If that is not your answer---- Mr. Winokur. My recollection is just as I said, which is I believed that we were using forward contracts, unrealized gains in the forward contracts. That is my recollection. Senator Levin. Why is that not then a simple, ``no,'' that you did not realize that Enron stock itself was being pledged as collateral to obtain that hedge? Mr. Winokur. I do not recall that Enron stock specifically was being pledged----\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 80 for clarification which appears in the Appendix on page 665. --------------------------------------------------------------------------- Senator Levin. OK. Mr. Winokur [continuing]. Over and above the forward positions. Senator Levin. That is good. Now, let me try to put this in a slightly different way. What did the Board understand to be the risk to Enron at the time it approved these transactions? Mr. Winokur. The risks that were presented to us were, first, that the structured finance vehicle might not be structured in a way to meet the accounting rules, and that was mitigated, we were told, because Arthur Andersen was involved and Rick Causey approved it. And second, we understood because of the forward positions in Enron stock that credit capacity could go away if, in fact, Enron stock went down, in which case the Raptors would have to be terminated. Senator Levin. Did you understand, then, that if Enron stock fell in value, that you would have to put up large amounts of Enron stock in order to pay off the guarantee to others who were willing to---- Mr. Winokur. No, sir. I understood that we would have to terminate the arrangement because the credit capacity would fall. Senator Levin. OK. Now, when you were shown Exhibit 32,\1\ you asked for this, as I understand it, Mr. Winokur, the ``Stock Price Risk in Financings''--you asked for a chart showing what would happen if Enron's stock kept falling in price. You asked the management for this. --------------------------------------------------------------------------- \1\ See Exhibit No. 32 which appears in the Appendix on page 334. --------------------------------------------------------------------------- Mr. Winokur. Yes, sir. Senator Levin. And by April, Enron stock had fallen from $80 to $60, and this shows what would happen if it fell to $40. It lists four deals, Osprey and three of the Raptor transactions, and shows that Enron would have had to come up with another 45 million shares of Enron stock to pay these entities. Now, were you surprised by what you saw? Mr. Winokur. Well, I appreciated being provided the information I had requested. Senator Levin. But were you surprised when you saw that your stock was on the hook to this extent? Did that surprise you? Mr. Winokur. Actually, sir, what I read into this was Enron had about 800 million shares outstanding at this point. So what this chart said to me is if the stock price falls by another third from where it is, and at that time, I think that was not considered a probable event, Enron would have to issue approximately less than 6 percent additional shares. So the dilution to the existing shareholders to top-up these vehicles would have been around 6 percent if the stock fell by a third. Senator Levin. And you were not surprised that your risk was that great in the Raptor transactions? That did not surprise you when you got that chart? Mr. Winokur. Actually, I thought that a 6 percent dilution matching against a one-third decline in the stock when the stock was not considered to be overvalued at that point, or not particularly--I do not recall the specifics--was not maximal dilution. Senator Levin. OK. You recognized that impact on Enron, the dilution of its stock which would result from the Raptor transactions if Enron's stock value went down, and that did not surprise you? You realized there was that great a risk in the Raptor transactions to Enron? That is all I am asking. Mr. Winokur. Senator, in addition, I would like to make the point that the fully diluted shares in the EPS calculation, Enron used a model to include these kinds of results in the fully diluted share calculation, so that the additional shares already were disclosed in Enron's disclosure documents and already were included. Senator Levin. When the risk was supposedly transferred, which was the purpose of those transactions, Enron maintained some significant risk, and you are telling me the Board was not surprised by that retained risk in Enron. Even though it was informed that this was a hedge transaction to transfer that risk to others, you are saying that the Board understood the extent of the risk to Enron that was left following the Raptor transactions, is that what you are telling me? They understood this? Mr. Winokur. Sir, the handwritten note, which is a little hard to read, says, ``Assumption: The value of the other assets,'' it looks like it says, ``were zero,'' so I viewed this as a worst case scenario. In other words, the assets that were supposed to be hedged went to zero, and I did say earlier that the one bad outcome is the assets that were being hedged and the Enron forwards both went down. So worst case, the other assets are not worth anything--I think that says zero, the best I can read it--and even in that extreme case, Enron stock goes down a third and all the assets we put in these vehicles are worthless, there is only 6 percent dilution and it has been fully disclosed. I do not think that was a good outcome. I also did not think it was a very probable outcome. Senator Levin. My question is neither whether it was good or probable. My question is, did the Enron Board understand when it was hedging a risk that it was maintaining a risk to that extent, whatever the extent is? Did it understand that? Mr. Winokur. Well, we assume, because in the previous exhibit---- Senator Levin. Can that not be yes or no? Did it understand that it was maintaining a risk to this extent under the circumstances that you just outlined? Mr. Winokur. We understood that if the credit support we provided for the vehicle was inadequate, the vehicle would have to be terminated early. That was part of the presentation when we approved Raptor. Senator Levin. All right. And is not the shorthand for that, the Board understood that Enron was retaining a risk under the circumstances that you just outlined? Mr. Winokur. A risk, yes, sir. Senator Levin. And this shows the extent of the risk under various circumstances. Mr. Winokur. Under extreme circumstances. Senator Levin. It turned out not to be so extreme. Mr. Winokur. Yes, sir--what were thought to be extreme circumstances at the time. Senator Levin. And I just want to ask the other Board members, did they understand that this was not a hedge where the risk was transferred, but that a risk was retained to the extent that Dr. Winokur just outlined? Did you understand that, Dr. Jaedicke? Mr. Jaedicke. Yes, I did, sir, because that hedging strategy is explained in the annual report and had been used in Enron on many transactions. They are typically referred to as something like low-correlation hedges. Senator Levin. On this chart, I think it is Exhibit 27 in your books,\1\ when you look at that chart, we see that the payments by Enron to LJM2 for the Raptors were $197 million. That is up at the top. Do you see that number? --------------------------------------------------------------------------- \1\ See Exhibit No. 27 which appears in the Appendix on page 300. --------------------------------------------------------------------------- Mr. Winokur. Yes, sir. Senator Levin. And the loss to Enron is at the bottom, $710 million. That is the outcome of this. LJM got $197 million. Enron lost $710 million on that transaction. Would you agree with that summary, Dr. Winokur? Mr. Winokur. Well, I would like to ask Dr. Jaedicke to talk about the reduction in shareholders' equity, but as far as the losses, I do not know where these--I have not seen these numbers before, obviously. The Powers Committee had some numbers in them that were prepared by the Deloitte people. Those were not other than very rough estimates and the Powers Report specifically said that would assume that Enron had taken no other action and there is nothing else going on. In other words, it was a number that is just pro forma, add this and subtract that. It is not a number that has any, at least in the Powers Report, had any backup that was provided. Senator Levin. Now, this is a number from the Powers Report. Mr. Winokur. As a member of the Powers Committee, I specifically said in my testimony in front of the House that the accounting consulting help that we got was not reviewed by Deloitte and Touche and did not have any independent verification of it and did not assume that Enron would have taken any other action in the interim. Senator Levin. All right. Going back to the $710 million, this is what Enron put in its SEC filing. Mr. Winokur. Yes, sir. Senator Levin. So can you accept that? Mr. Winokur. Yes, sir. Senator Levin. OK. So Enron showed a reduction in earnings due to Raptor termination of $710 million. The $197 million was made by LJM2. That is the outcome, and I am just saying, do you differ with those numbers? Mr. Winokur. I do not have any disagreement with that. Senator Levin. Would you acknowledge today that the Raptors were, in hindsight, a disaster for Enron? Mr. Winokur. Sir, what I would say, and I said, I believe, in my statement this morning, if management had come to us in the first quarter and said the Raptors did not work, it was a great idea, but it did not work and we want to cancel them, Enron would have taken then something like a 50-cent a share charge. Mr. Skilling told the Powers Committee he did not think at that time, in the first quarter of 2001, that Enron stock would have been affected materially because lots of companies were writing off high-tech, broadband, and other kinds of investments. So had the Raptors been terminated early, which is what we thought would have happened in May 2000 when we approved them if both the assets and Enron's forwards went down, we would have had a loss. It would have been a large loss, $400 or $500 million, but it would have been manageable by Enron. And the fact that the $800 million of additional stock was contributed and the Raptors were restructured without Board approval also gave rise to the accounting error that led to the equity write- off, and as I said this morning, I think that combination turned out to be a very bad thing. Senator Levin. If a real third party had participated in the hedge, would the outcome have been different? Mr. Winokur. Well, I do not know the answer to that except for one thing, and that is a real third party would not have been able, presumably, to restructure itself without Board approval in the way that this happened. We were not told of the restructure. Senator Levin. OK. Mr. Winokur. And LJM2 had many outside investors. It was a real third party. It had a related party as an investor, but it was a creditworthy third party when we dealt with it. Senator Levin. You have seen a number of red flags now along the way, starting as early as 1999, February 1999, where it was stated that Enron's accounting was pushing limits. We have seen the various ways in which fund flows were generated to move assets off the balance sheet with Whitewing, with LJM, with Raptor, and the losses that were caused here. Then we see a steady decline, we saw in that earlier chart, of Enron's stock from which it is not going to recover. During this time, the Board saw no red flags at all, no sense of trouble that lies ahead until mid-October 2001, and that is when you learned that Enron would take an equity write- down of $1.2 billion. That was the first time you testified that you saw any sign of trouble. We have demonstrated, I think, plenty of signs, but nonetheless, the Board did not see those signs. But a number of people associated with Enron did see the writing on the wall well in advance of the announced write- down, even if the Board did not. One example is a senior Enron executive who left Enron in September 2001, and despite an effective separation date of November 2001, this individual sent a series of E-mails to his stockbroker about selling Enron stock. So this is September 2001. Here is what he said on October 2, a few weeks before Enron's problems became public, and this is Exhibit 33a,\1\ if you wish to follow along. This is a senior Enron executive now. ``I think we may want to sell some Enron calls in the next few days before earnings are released. I don't know anything, but I know how Enron works and I am sure they will be able to show strong recurring earnings, . . . and do some housecleaning on some non-productive assets.'' So he says he knows how Enron works and will show some strong recurring earnings, and again, this is additional evidence suggesting that Enron management was deliberately engaged in earnings management. --------------------------------------------------------------------------- \1\ See Exhibit No. 33a which appears in the Appendix on page 335. --------------------------------------------------------------------------- Then on October 4, the same person writes, ``I think we should begin thinking about shorting January calls on, say, 100,000 shares at or near the money. . . . There are a number of analyst reports out that are really trying to push up the stock and with a little help from the market, they may get a few more points out of it over the next few days.'' Then later the same day, he writes, ``I believe [Enron] stock has limited upside in the near term and, in fact, has some downside exposure.'' Now, this is a pretty strong statement given the fact that the stock had already fallen from $90 to about $30 a share at the time that he wrote these E-mails. His comments are deeply troubling. This is a senior officer at Enron, not yet separated when he begins selling calls, and a few weeks later, Enron took a $800 million earnings hit and a $1.2 billion reduction in shareholder equity. We cannot release the person's name at this time. We are still looking into the matter. But if the facts bear it out, we will be recommending to the SEC that they open an insider trading investigation with regard to this individual. But in terms of what he knew, what he saw from the inside, which you did not see until later, I am wondering whether you have any comments that you want to add. Does anybody want to add any comment to that? [No response.] Let me ask you about Ken Lay's loans. Let me ask Senator Carper before I get to that. Senator Carper. Thank you, Mr. Chairman. We appreciate your patience and your sticking with us into this afternoon. Dr. Jaedicke. Mr. Jaedicke. I am sorry, sir. I was not paying attention. Senator Carper. That is all right. I understand from the introduction today that you ran the business school at Stanford? Did you? Mr. Jaedicke. I was Dean of the business school. Senator Carper. You were the Dean of the business school. When I was in the Navy, we were stationed at Moffett Field, California, not far from where you used to hang your hat, and I lived in Palo Alto and Menlo Park. In fact, I lived on Santa Cruz Avenue, right up against the Stanford golf course, and I remember as a younger man going to--I am not Catholic, but I remember going to a lot of folk masses on Stanford at the campus on Sundays and very much enjoyed those. I have good memories. One of my best friends, my roommate for part of the time I was in the Navy out there, ended up going to the Stanford business school, I think at the time that you were running it, and from time to time, we talked about case studies in different businesses, some that did well, some that did not do so well. I think we have got a classic here that the business schools, I do not know about Stanford, but certainly a lot of them will come back to this one time and again to figure out how they got into trouble and how a company thought to be as successful and as mighty as Enron could tumble so quickly. How would you describe it to the next generation of business school students at Stanford who say, this is what happened and this is how they got into this mess and why they could not get out of it? How would you describe it? Mr. Jaedicke. I think, first of all, you would have to say--you would have to indicate that there was a lot of incomplete information floating around--well, I would not even say floating around, reported, that a lot of the reports were not accurate, that some of them were misleading in terms of how good things were or how much things had been looked at. I think you would have to say this is a classic case of having lots of overlapping controls, which I said in my statement, involving lots of different people, trying to get very good advisors, trying to cope with the problem--the classic problem that all boards have if you are supposed to monitor management and management provides you the information. What do you do? You put in place the best controls you can think of, and these did not work. Then I suppose you could back off and say, well, why do you think they do not work? We will describe to you the situation and then you, as students, tell us why you think they did not work. That is kind of the classic case, I guess, to get them to confront that problem. I am not sure that I would have any answers for them other than the integrity of the people and so on that were supposed to furnish information to us. It was not always what I would want it to be. Senator Carper. We talked earlier about whether or not we can legislate character or legislate integrity and I think we pretty much agreed that is a hard thing to do. I did not, but I might have gone on to say some folks who looked at the situation have suggested that while the Congress cannot legislate integrity or character, one of the things we can do is to pass laws that call for punishment for people who break our laws. The Congress, it is not our responsibility to prosecute and to convict those who have done so, but as you know, with our system of government, we pass the laws and then we leave it to the Executive Branch and the Judiciary to ensure that the laws we passed are enforced. One of my hopes of what is going to come out of these hearings, and we thank you again for joining us, is that the anger, the frustration that so many Americans feel--and you have heard it and you have felt it, certainly we have--will be transformed into ensuring that justice is done in these instances. If I could sort of segue from there, Mr. Chairman, for just a moment, we are going to have, I think, a second panel, I hope later today, with some very knowledgeable people who know a thing or two about corporate governance who are going to, I do not know that they are going to second-guess you, but they are going to come in and certainly give us their perspective. I just want to ask you a couple of questions, and I hope to be able to ask that panel. One of those deals with the independence of board members and what we can do, given your experience on this Board and other boards that you have served on, what can we do? This is for anybody on the panel. What can we do? What ought we do to better ensure, not just we in the Congress, but we collectively, to ensure that members of boards of directors have the kind of independence that will better ensure that they make decisions that represent the interest of the shareholders? Anyone? Mr. Blake. Senator, I think that I would like to respond to some of the comments that were made this morning, I, frankly, agree with. I think there has to be scrutiny relative to what extent of involvement a member or director has on a board with a company and to assess whether that could, in fact, present a conflict of interest situation, in other words, too much vested interest in the relationship with the company such that it cannot be--that person cannot be independent or dispassionate about decisions that need to be made. I think, also, that in this case, this Board actually percentage-wise has a relatively high level of independent directors on its Board and I think that is a good thing. There is probably a rationale to have some inside directors, particularly as it relates to continuity and succession of management. It is very common, for example, when one CEO was leaving and there may be a COO or something of that nature, where you want to give exposure of that potential successor to the board and to have that individual participate in the board. There is real ample justification, perhaps, of having, say, two, particularly in light of the succession situation. Otherwise, I would be more inclined to suggest that just the CEO should be a member, except for the isolated situation. Senator Carper. OK. Other thoughts on board independence? Other comments from any of you with respect to board independence, steps that need to be taken to better ensure board independence? Mr. Jaedicke. Senator, I suppose you could give the simplistic answer and say, well, you could pass legislation or come up with regulations that would say you cannot have a consulting arrangement. There is a trade-off here. It is disclosed, it is controlled, but Mr. Urquhart, for example, was an expert in the--ran the power division of GE. I am sure he gave us a lot of help overseas. It is like--I suppose you could say, well, maybe that individual should not serve on the Board. Well, the question is, can you get him? I do not know how to--I realize that this is my personal answer, and it is just an opinion. Free enterprise is great because it is free. Now, if you want to impose constraints on it, there is always a trade-off. I am not going to tell you that you should not impose some constraints because maybe your assessment of those trade-offs is different than mine. That is what makes a system work, I guess. Senator Carper. Let me just interrupt. I do not mean to be rude---- Mr. Jaedicke. I do not know how to answer this. Senator Carper. This is not a trick question. We have got a lot of wisdom represented at this witness table and this is an issue we are going to deal with, and we can make wise decisions or unwise decisions, and if you have some thoughts, just share them with us from your heart. Mr. Jaedicke. I guess I do not understand what you are asking me, sir. Senator Carper. Anyone else? If not, I could restate the question. Mr. Duncan. Well, I will try that. I agree that every board member should be independent. Those that are not 16(b) officers should be totally independent, period. That, I agree to. I would think that a board could do something like we did, and that is have an annual board appraisal, and in that board appraisal have items that would lead one to conclude that member is independent. Now, how you write the textbook on that would take some time. Senator Carper. Anyone else? Dr. LeMaistre. I have wondered a great deal about the rotation of directors. It seems to me that during service on a board, it takes a good while to get acquainted with the business, especially for a physician. I can tell you that after a period of time, it would seem to me that a rotation would serve to give an indoctrination period to others coming on so that they could learn to be fully effective while over two- thirds of the board would be experienced. But it is just a thought. I do not know whether boards do that or not. We did not do it at Enron. I did discuss that with some of the 16(b) officers as a possibility. I also feel that in the board's self-evaluation, there has to be action taken and there has been action taken in the Enron Board. Senator Carper. You say there has? Dr. LeMaistre. There has been when a Director was not found to be effective in representing the shareholders. Senator Carper. Dr. Winokur. Mr. Winokur. Sir, my colleagues are knowledgeable and, I think, articulate about this subject. I would just say that Enron's Board was voted one of the five best in the country 2 years ago--because I still have the plaque somewhere in my office. Senator Carper. Hold on to that. [Laughter.] Dr. LeMaistre. But more importantly than that, we did go through a self-evaluation process and we attempted to conform with the best practices that the General Motors Pension Fund and all of the other governance entities did. So I think that independence is important, and I think a board that tries to improve itself all the time is important. Senator Carper. Thank you. Mr. Chairman, I do not want to go on too long. Do I have time for one more? Senator Levin. Sure. Senator Carper. What kind of future, if any, is there for Enron coming out of bankruptcy? What do the folks who are involved in still holding shares or the people who are the employees or were the employees who have the shares in their 401(k)'s, what do they have to look forward to? Mr. Blake. Senator, not very much, unfortunately. I think the jury is still out, but as represented by the recent 8(k) filing for the write-down that I believe Senator Levin mentioned in his comments this morning, there is an imbalance, obviously, in terms of claims against the estate and assets. We have already stated earlier that there is no specific value and current equity of Enron. As it relates to employment as contrasts with perhaps an investment in Enron stock, the Board, Pug and I and the Board approved an organizational plan which we presented to the Bankruptcy Court last week called OPCO, which basically takes the traditional assets of the company, pipeline investments, power generating investments, and things of that nature, within which there is some level of synergy and relationship to the component makeup of that entity. It is hopeful that we can, essentially, try to sell these various business interests into and through a trust with something they call a 363 sale. The sale out of bankruptcy of these assets in a trust would take place whereby all the claims against the estate would be set aside, until such time that this OPCO company could then go operate as a stand alone ongoing business. And the view, with which I personally agree, is that the ongoing value of the company is better than break up or liquidating value of assets. Enron is one of the more efficient gasline, pipeline suppliers and operators in the country. It is one of the lowest cost producers. Its reliability is one of the best in the industry. So there is real value and there are great people in that business. So the hope is that we will be able to take this collection of assets called OPCO, have it purchased out of bankruptcy into a trust, and as such there would be employment for those employees and a livelihood to go forward, as contrasts with perhaps liquidating those assets. Otherwise, I think there are many assets that will be liquidated, and I do not want to get too far into discussion on that, but there are a lot of claims still out there and a diminishing level of assets, unfortunately. Senator Carper. All right. Thank you. Mr. Blake. You are welcome, sir. Senator Carper. Mr. Chairman, do I have time for one more? Senator Levin. Sure. Senator Carper. Just imagine for a moment that you were not sitting there and meeting the responsibilities that you now hold in your lives but you sat up here and you wore our hats for a while. Let me just ask each of you, if you were in the role of a member of the U.S. Senate, can you think of one thing that you would do, whether it is with respect to corporate governance or the role or responsibilities of the accounting firms and the way they are managed or governed, or 401(k)'s, one thing that you think needs some legislative action, needs to be addressed legislatively, not just the marketplace forcing the changes, compelling the reforms, not just the SEC, not just the Federal Accounting Standards Board, but something that we need to do, could you give me an example, each of you, just one example of something that the Congress needs to do to better ensure that this sort of thing does not happen again? Mr. Blake. First of all, I think the comment was made earlier by some of my colleagues this afternoon, this morning, disclosure. Truth does not hurt, and the more disclosure the better, as far as I am concerned. That, frankly, is the governing mechanism of off-balance-sheet transactions, is the requirement of disclosure, the adequacy and completeness of disclosure. I think that is a practice that probably could be extended beyond where it is today, personally. I do think there is an accountability that CEOs like myself have in terms of being honorable to my position and should be accepting of the consequences if I were to misbehave or I have proven to have been involved in a wrongdoing. Frankly, I think, personally, having such an act that would suggest criminal liability, if that was--it is a gray area in terms of negligence and whether there was really intent to deceive, but if, in fact, there was an intent to deceive and, in fact, it was a fraud and that the leader of that company was responsible for perpetrating that fraud, I would hope that there would be a criminal action against that individual. Senator Carper. All right. Thank you. Mr. Blake. That has no application to Enron. It is just a philosophical statement. Senator Carper. I understand. Thank you. Dr. LeMaistre. The company's most valuable asset is its employees. I think the 401(k) should be managed by the employees, but there should be some oversight to correlate with the top management, the CEO, and the board so that you can be sure that those employees who are managing the fund know fully what the condition of the company is, especially with regard to stock. But that does not happen. At Enron, there is no fiduciary responsibility of the Compensation Committee nor any management responsibility. Our only responsibility is to amend the original plan when amendments are required. Senator Carper. Thank you, sir. Mr. Jaedicke. Sir, I do not know that I could answer your question. I have been so busy that I do not really think I know enough about the public policy to say what you should focus on. I have no disagreement with what my colleagues have said here, but I am just really not well enough informed on this whole process to suggest to you anything other than something off the top of my head. Senator Carper. If something comes to mind and you would like to share it with us later---- Mr. Jaedicke. I certainly will. Senator Carper [continuing]. We would be delighted to have it. Mr. Jaedicke. I certainly will, and I promise you I will think about it, and if I think I can pass along anything that would be of any help to you, you will hear from me. Senator Carper. Thanks so much. Mr. Winokur. Senator, this is not meant to relate to Enron, because I do not think it would have--I do not think it is particularly applicable, but I think, going forward, I would find it very helpful--we talked about it a little bit earlier-- if the whole issue of stock versus performance options versus stock options could be simplified and clarified and made people as agents, because employees are agents for the shareholders, made their incentives more closely tied. There are many people, including the chairman, who have thought a great deal about that. I do not have the specific proposals. But the more there is disclosure and the more the incentives are aligned with the owners, the better things will be. Senator Carper. Thank you. Mr. Duncan. Mr. Duncan. Senator, I agree with what my colleagues have said. The only thing that I would add is that the world goes on at a faster and faster speed. As the Internet comes into play in bigger and bigger portions--most of the SEC Act was, what, 1933 or something like that--as that comes into play and derivatives come bigger and bigger into the world, and a cashless society becomes a totally cashless society, the rules might have to be a little different as you move into that. I do not think that they are overdue, but I think they will be due. Senator Carper. All right, thanks. Mr. Jaedicke. Senator, can I make one comment that may sound a little facetious, but he reminds me. I do not really believe it is facetious. It seems to me that one of the things--I do not think management would like this very well because it may disclose things that really are not vital to the investment decision but would give away trade secrets or financing secrets or something like that--I have this vision in the back of my head as an accountant that the way to deal with the disclosure problem is do away, eventually, in this information age, with the annual report and just send everybody a compact disk. And on that compact disk would be all kinds of information, and then you could maybe imbed in that--now, this sounds hare- brained, but I do not think we are too far away from some of these things--the software that would say, off-balance-sheet does not mean out of the statements. What it means is you have disclosures in different places than the balance sheet and the footnotes. One of those footnotes would be--you were worrying earlier about the assets that are off the balance sheet and in the non-consolidated subsidiaries. I am sure even I could give you a piece of software so that you could say, well, here is a statement that is according to GAAP now, but those subsidiaries are not consolidated. I would like to see them consolidated. That would be like falling off a log. And then you can see all of the assets that are in that footnote. That would be the idea. Now, I realize that is kind of hare-brained, but my colleague has reminded me---- Senator Carper. That is a great idea. Mr. Jaedicke [continuing]. That we are in a new age. Mr. Duncan. And it would also save the company money. Senator Carper. Mr. Chairman, years from now when it is time to send out those annual reports and we open up our mailboxes and out of them fall these CDs, we will know where the idea came from, right here on this day. Mr. Jaedicke. Thank you. Senator Carper. Thank you all. Mr. Chairman, thanks. Senator Levin. Let me get back to Ken Lay's loans. In May 1999, the Enron Compensation Committee told Ken Lay that--and by the way, Senator Carper, because you were inquiring, I think, in a very gentle way, I should be done in about 10 minutes, in case anyone else is trying to plan a schedule, too. [Laughter.] I want to take just a moment, though, on Ken Lay's loans. The Compensation Committee told Mr. Lay that he could repay his company loans with stock in May 1999. At that time, he had a line of credit with Enron of about $4 million, and that was raised to $7.5 million in August 2001. But in a 1-year period, from October 2000 to October 2001, Mr. Lay began using an ``ATM approach'' to his Enron credit line, as one Board member put it in his interview. If you look at Exhibit 36,\1\ Mr. Lay repeatedly withdrew the entire amount available, and then repaid the loan with Enron stock. First he did this about once per month, and then about every 2 weeks, and then on some occasions several days in a row. By the end, he had obtained $77 million in cash in exchange for his Enron stock. --------------------------------------------------------------------------- \1\ See Exhibit No. 36 which appears in the Appendix on page 350. --------------------------------------------------------------------------- Now, every Board member acknowledged to us that these transactions could fairly be described as stock sales. By characterizing them as loan repayments, though, Lay was able to bypass the rules for quarterly disclosure of insider stock sales and was able to delay reporting his stock transfers until the end of the 2001 calendar year plus 45 days. All the Board members told us that they did not know that this was going on at the time, and they were shocked to learn of it later. The facts suggest, and your reactions suggested, that Ken Lay was abusing his line of credit. First of all, do you agree that he was abusing his line of credit? Dr. LeMaistre. Dr. LeMaistre. May I comment on that in two ways. First, just from what I have seen of the records, this is very unusual behavior. This is very clearly a different pattern from what occurred in the previous years. Second, the loans were characterized as a line of credit and that interpretation needs always in the future to be clarified. I think it is a very important point. The third thing is that we found out about this only this year. I believe it was February when we finally learned of this, primarily because of the point you made, Mr. Chairman, and that is the disclosure does not come periodically forward to the Board or to any other Federal agency or the SEC. So the surprise that occurred here was one that really concerned all of us greatly without any understanding of why it was necessary. The only comment ever made to me personally by Mr. Lay was that he had found the previous loan useful and that he would like to have the loan increased to $7 million. Checking with Towers Perrin, I found that was a mid-line range, that there were loans much higher than that to executives. We had a lot of experience at Enron over many years with loans to executives. We have never seen this before. Therefore, we were very deeply concerned about this. Senator Levin. In your judgment, did this constitute an abuse of his line of credit? Dr. LeMaistre. I think it is subject to another concern. With the confusion over the definition of the terms, you hear terms like ``revolver'' and all of the other terms that would more characterize this used interchangeably. It is not a term I care to use, but I have heard that term--I think the real problem comes in what is the code of business conduct. One of the lines in the Enron code says you will do nothing to hurt the interest of Enron, and taking this much money out and repaying it with stock when the stock is declining certainly is very devious. It is very difficult for me to understand why that did not hurt Enron. Senator Levin. You are stopping a little short of saying that it was an abuse. Is that intentional? Dr. LeMaistre. It was intentional, yes, because I do not know the circumstances. Senator Levin. Does anyone else have a comment on that? [No response.] OK. Dr. LeMaistre, let me just ask you this. Whose job is it to monitor and stop that from happening? Whether you call it an abuse or short of that--I think it is an obvious abuse, but you say that you were concerned, dismayed--but in any event, whose job was it, if not yours and your Committee, to monitor that particular activity of Ken Lay? Dr. LeMaistre. There are three points in this. The Treasurer receives the request and disburses the money. A lawyer in the General Counsel's office receives the stock back and it is registered with the person who then must make the filing, unfortunately, 45 days after the yearend. To correct that, some kind of quarterly reports will be needed. If the CEO has the loan, the report should come directly to the board by the people who handle the transations. Senator Levin. But looking back at this now, you do not feel that you had any responsibility to monitor this? Dr. LeMaistre. We had never had any responsibility to monitor this. Senator Levin. Does anyone else want to add anything to that? Mr. Blake. Senator, I would. I do not want to go close to the word ``abuse,'' but I would say that as a CEO, it is not what you say, it is what you do. Sale of a stock in the nature that took place was inappropriate. And, I also personally feel as a member of the Compensation Committee that I agree with everything that Mickey said, that we did not know about this until February of this year. I was absolutely shocked by this. And I would suggest that if we had a chance to have known that occurred, we would have taken immediate and corrective action to ensure that behavior would not happen again. Senator Levin. See, what I would hope for would be outrage. Mr. Blake. Well, I can use that, too. Senator Levin. Good. That is what we would hope for. I have not felt it. Mr. Winokur. Senator, it would be impossible to feel anything other than outrage, given the amount of money that was lost by the employees, the amount of jobs that were lost---- Senator Levin. I did not hear that. I gave you all a chance to comment. I said, is it an abuse? Dr. LeMaistre would not go that far. I am glad to know that once I used the term ``outrage,'' that at least that resonates, because I have got to tell you, I did not sense outrage here. Mr. Blake. You have got it. Senator Levin. I have got it, OK. Good. Mr. Winokur. This made me very angry when I heard it. Senator Levin. Good. I am glad, and I wish that was transmitted. What stands out here, this is perhaps a harsh thing to say, but I must tell you that we have learned a lot today in terms of information, but what really stands out to me is the denial of any responsibility on your part--for what happened to Enron. A highly-paid Board not taking any responsibility for the events at Enron, with a management that was just management gone wild. That last question was just one of about 20 examples of where we had this swashbuckling management, this arrogant, greedy management that was stuffing their own pockets with the money of shareholders. What we need in boards are people who are willing to stand up to management. You have got the backgrounds to do it. You have got the experience and knowledge. But what comes out is that you all say you did not do anything wrong, and what I am afraid of is, too often, you did not do anything, period. I mean, there were a lot of warning signs along the way. You did not hear Andersen say that Enron used high-risk accounting. You did not remember the details of Whitewing as of 3 weeks ago. There was a $2 billion off-the-books vehicle, but no interest in reviewing LJM's private placement memo. When you learned about that memo--this is the memo that was touting a conflict of interest that cost your company that you have the fiduciary duty to protect. It cost your company, that LJM enterprise. It made a lot of money at your expense. There was a conflict of interest that was inherent right in it, because the guy who was selling, or that you were selling assets to, was on both sides of the negotiating table. He did very well at LJM, while Enron and its stockholders were getting socked. But even after the lawyers told you about it or you read about it in the Powers Report and the lawyers were asked to look at this document, it touts conflict of interest. That is about the only thing you can say. It holds out this insider information that these folks had in Enron while selling partnership interests in LJM. You have not asked those lawyers, my God, how could you not have brought that to the attention of the Board? You did not press to learn Fastow's LJM compensation for 1 year after you were supposed to look into it. The Board directed that you would look into this compensation. A year goes by. An employee of Enron says she does not have the information, she will get back to you. She does not get back to you. Nothing happens. You read about it in the newspaper. You did not ask who bought Fastow's interest in LJM, even though LJM meant $2 billion in funds flow for Enron--no inquiry as to who bought that interest. You knew there was something wrong there by then, but still, no inquiry, no questions. No questions about the Fortune article. I do not see any concern about the $27 billion that were represented when half of Enron's assets were off the books. Sixty-four percent of Enron's international investments were underperforming. Forty-five million shares or more of Enron's stock were at risk in the Raptor transactions. It does not set off any alarm bells. This is stuff that you knew. You did not ask to see Watkins' letter when it was presented to the Board. You got the memo summarizing it, but you did not ask to see that letter itself. Mr. Blake. Sir, I beg to differ. We did ask for the letter. Senator Levin. OK. Did you get it? Mr. Blake. Subsequently, but not right away, yes. Senator Levin. I will stand corrected, then. You got it subsequently. You really did not know of anything wrong, despite all of that, until the Wall Street Journal told everybody something was wrong on October 18 when the world found out. I think that is unacceptable, for a Board to be that out of touch with the reality of their own company. I think you were taken advantage of, too. I think your passivity was taken advantage of--I do not have any doubt of it--by the management. That placement memo that I made reference to, which has this touting of this insider information at your expense, was issued on October 13, 1999, which was just 1 day after the Board approved LJM2. This is a pretty complicated document here that Fastow put out. It was obvious he assumed that you would approve this 1 day before he put it out. He counted on that approval. It looks like Enron's Chief Financial Officer saw you as a rubber stamp. It is just deeply troubling to me, because I know you are good people. I have no doubt about the fact that you are individually good people. I do not know you personally, but I know your biographies and I can see that. But this responsibility is placed on the shoulders of good people, and sometimes good people do not carry out that responsibility well. The shareholders elected you to use independent, tough judgment, to probe for facts, not to accept whatever management gives you. I do not believe you looked hard. I do not believe you asked tough questions. I do not think you considered the personal motivations that prompted related party transactions that ultimately did contribute to your downfall. We have gone through the warning signs that you knew of. There were many of them. We have tried to go through some of them this morning and this afternoon. As I said, directors are not expected to be detectives. They are not expected to assume that misconduct pervades the highest reaches of management. But they are expected to be more than a rubber stamp for management. They are expected to dig for facts and understand complexities and to say no to transactions that do not look right. I think the shareholders deserved better than what they got. Too often, I believe you were followers and not leaders, not the captains but followers. The management there had created this corporate culture where anything goes as long as it could produce apparent profits, and those profits that appeared on the financial statement then increased the share price. That was the culture. That was the environment. That rise in stock price, while I am sure gave great pride to members of the Board, failed to stimulate even one Director to consider that age-old truism that if something looks too good to be true, it probably is. I hope we all learn from the Enron debacle. I hope Congress can pick up some of the points that are learned, whether here or in other committees or in the media or through just investigation, to take appropriate actions to tighten up the accounting standards, to increase independence of auditors, to give the SEC responsibility to require the directors and the auditors to be more responsible to the shareholders. We have our responsibility. The SEC has responsibility. But the first line of defense against corporate abuse lies with the Board of Directors. There is just no substitute for it. We can pass all the laws in the world and all the regulations can be adopted by the SEC, but the corporate governance responsibility must rest with the Board of Directors. I would just hope that in all areas, whether it is the regulatory area, whether it is the legislative area, or whether it is that area of corporate culture that so badly needs to be changed into a fiduciary culture, from a culture of the share price is a god, to a fiduciary duty is a true obligation, that is the change that has to be made. You folks have been participants in an experience which I am sure has been painful to you. It is painful to the shareholders of the company that you ran as Directors, and it took a toll on the economic system. But we are hoping that this hearing and this investigation will contribute to some corrections, that they will be common-sensical, that they will be thoughtful, that they will try to avoid unintended consequences. We will keep our focus on what we can properly do and what the SEC can properly do, and just leave to our people of integrity that will be on these corporate Boards the understanding as to that responsibility and that obligation to represent the shareholders and to stand up to management when management gives any indication that they are going in the wrong direction. We thank you. It has been a long hearing. We thank you for coming forth. As I said, you have done so voluntarily. You have cooperated with us. You have presented what we have asked for with documents. We would greatly appreciate your continuing cooperation, and we will now move to the second panel. Thank you all. The second panel of witnesses are experts in corporate governance and accounting. First, Charles Elson, Director of the Center for Corporate Governance at the University of Delaware, a leading expert in corporate governance issues; Michael Sutton, the former Chief Accountant at the Securities and Exchange Commission from 1995 to 1998; and Robert Campbell, former CEO, Chairman of the Board of Sunoco, and current Board member of Hershey Foods, CIGNA, and Pew Charitable Trusts. It is a distinguished panel. We first of all must tell you how grateful we are for your staying with us. I do not know whether we warned you that it might be this long of a wait. If not, I apologize for not alerting you to it, but in any event, we are very grateful that you stayed with us. As I indicated this morning, pursuant to Rule VI, all of the witnesses who testify before us are required to be sworn, so I would ask you to please stand and raise your right hand. Do you swear that the testimony you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Sutton. I do. Mr. Elson. I do. Mr. Campbell. I do. Senator Levin. We will try that timing system again. If you can see these lights, 1 minute before 10 minutes is up, the green will change to yellow. It will let you then conclude your remarks. The written testimony will be part of the record in its entirety, and we will start with Mr. Elson. TESTIMONY OF CHARLES M. ELSON,\1\ DIRECTOR, CENTER FOR CORPORATE GOVERNANCE, UNIVERSITY OF DELAWARE, NEWARK, DELAWARE Mr. Elson. Thank you. My name is Charles Elson and I am the Director of the Center for Corporate Governance at the University of Delaware in Newark, Delaware, and the Edgar S. Woolard Professor of Corporate Governance at the University of Delaware. I serve on several commissions of the National Association of Corporate Directors, on director professionalism, director compensation, and various other commissions relating to corporate governance. Additionally, I am Vice Chair of the American Bar Association's Committee on Corporate Governance and a Director of the Investor Responsibility Research Center here in Washington, DC. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Elson appears in the Appendix on page 185. --------------------------------------------------------------------------- I am going to talk just a little bit about the red flags, I think, that were raised for the Enron Board, some of which were talked about today, a little bit about what corporate governance types look for in corporate Boards, what factors should be present, we believe, and finally, the problems vis-a- vis the Enron Board in meeting those requirements. I do not have any knowledge specifically of what occurred within the Enron Boardroom other than what I have read in the press and my comments really will be more structural in nature as to the internal workings. That is something that obviously will have to be developed later on. There were several flags that came before this Board and one wonders why they were not responded to. First and really most important was the waiver of the conflict of interest policy. That is a pretty extraordinary thing for a Board to do. A conflict of interest policy is laid out for very specific reasons. It lays out what is in the company's interest, what is not in the company's interest, and waivers from a code of ethics is not a very usual occurrence, and that is something that, in my view, at least, should have triggered lots of questions--who, why, when, and where, particularly when the policy was waived vis-a-vis the company's Chief Financial Officer. That is your chief control officer, financial control officer, and it is very unusual to have that officer on both sides of a transaction. Additionally as a flag, there was a lot of stock selling by executives of the company, again, a flag that apparently was not responded to. You had, additionally, a number of Directors on the Board who had financial relationships to the company itself, again, not a major flag, but something that should have raised some questions, at least amongst those who did not have those connections. Finally, vis-a-vis the audit, an auditor, Audit Committee, you had the independent auditor of the company acting as both the internal and the external auditor. That, from a governance standpoint, is questionable. The independent auditor also was taking substantial fees from the company from both audit and consulting work, something, again, governance types should say is not such a good idea. And finally, there apparently was a bit of a revolving door between the external auditor and the company's financial department, again, a flag, something that should have raised questions, not practices that in and of themselves were problematic, but practices that an independent Board should have been asking questions about and trying to get to the bottom, and had questions been asked, perhaps something might have been avoided. Now, the next issue is, well, OK, these flags were there. Why were they not responded to? What kind of Board would have responded to it and was this Board somehow deficient structurally in its composition and its procedures such that these flags were not responded to? Corporate governance types will tell you that the most important aspect of any Board, really two aspects, are that of independence and equity, independence meaning directors serving on the Board with no financial connection to the company whatsoever other than long-term equity ownership in the company, that is, no consulting arrangements, no business connections to the enterprise, no service provision to the enterprise, the only relationship being that of a director who owns equity in the company. The second important factor is that of equity, that each director should have a personally meaningful equity position in the company itself, that a director should be compensated in stock and that the director should personally invest a meaningful amount, meaningful such that the director is aligned with the shareholder interests rather than managerial interests, the key being substantial equity ownership provides that alignment. Independence is important for a director because it gives the director objectivity. The director's job is to monitor management for the sake of the shareholders, and independence gives you the effective objectivity to do that monitoring. Equity gives you the incentive to exercise that objectivity, very important. The two work together. They work in tandem. An independent board without equity is not very good to the shareholders. It may be objective, but there is no incentive to exercise the objectivity. An equity holding board without independence is no good. They may have incentive, but no objectivity. And independence is actually sort of an interesting concept. It is a two-way concept. Not only is it important vis- a-vis its monitoring aspects or its creation of objectivity, but it is also important within the organization itself, because if the board is viewed as independent of management, an employee who believes there is a problem within the organization is much more likely to contact the board if there are problems. The difficulty with a non-independent board, a board that is seen as just an arm of management, is that complaints rarely reach the level of the board. That is why independence, as I said, is important for two reasons. Independence and equity are really the hallmarks of a good board, and that is something that corporate governance types have been calling for for a long time. The two, as I say, reinforce one another. Additionally, vis-a-vis qualifications of directors, there is concern about directors serving on too many boards. An over- Board director is not a good director because, obviously, he o she is like a jack of all trades, a master of none. Someone who is on too many boards does not have the time or energy to focus appropriate attention on the boards on which he or she serves. Second, there is concern about the length of directors' terms. Directors who are on a board for too long, are viewed as becoming effectively tired, not as sharp as they once were in reviewing the company and much more willing to accept management representations than not. That is why a number of folks have called for term limits for directors, either through retirement policies or through actual 10- to 15-year terms, such that, at some point, someone rotates off. How does this apply to the Enron Board? The Enron Board was problematic, I think, in the independence issue. There were a number of directors of the company who did not meet that definition that I described to you, who were service providers or recipients of corporate largess in some way, shape, or form, and that, I think, was problematic. Additionally, you saw a conflict, I guess, vis-a-vis this Board in the sense that they held lots of options. There was equity on this Board, but there were also substantial numbers of company options, and a number of governance folks have suggested, too, that the way to incentivize a director is not necessarily through an option, which is an expectancy, but through straight equity ownership. An option is terrific on the upside, but on the downside, you do not lose very much. As an owner of a share of stock, on the downside, you lose quite a bit. You lose your investment and, obviously, the potential for upside. I think that was the really primary thing we saw vis-a-vis the Enron Board, the presence of a number of non-independent Directors or what folks would view as non-independents. Did that mean they did not exercise independent judgment? Not necessarily. All it means is that if one is not independent, it is a lot tougher to make that difficult call with management. You are probably more trusting of management, because, in fact, you have relations to management. Additionally, the Board of Enron served for a long time. A number of Directors had been there for at least 10 years, and again, the problem of length of service vis-a-vis being more accepting of management representations than not, I think, came into play. In short, there were warning signals that were present. The warning signals were apparently missed until it was, in fact, too late. Why did it occur? That will obviously be the subject of your hearings and review. But what I can say is from a structural standpoint, there were reasons, at least in my view, that the flags may, in fact, have been missed or not responded to early enough, and I think that this is something that this Subcommittee, and, frankly, the investing public, should demand of our companies, that a substantial majority of corporate Board members should be: A) independent of management, and B) own personally meaningful equity, long-term equity stakes in the company, equity stakes that cannot be sold on the short term but must be retained for the length of the director's service on the Board. Thank you. Senator Levin. Thank you very much, Mr. Elson. Mr. Sutton. TESTIMONY OF MICHAEL H. SUTTON,\1\ FORMER CHIEF ACCOUNTANT, SECURITIES AND EXCHANGE COMMISSION, WILLIAMSBURG, VIRGINIA Mr. Sutton. Chairman Levin, Senator Collins, Members of the Subcommittee, thank you for inviting me to share my thoughts with you today. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Sutton appears in the Appendix on page 191. --------------------------------------------------------------------------- First, let me comment briefly on my background and experience. I was Chief Accountant of the Securities and Exchange Commission from June 1995 to January 1998. Prior to holding that office, I was a senior partner in the firm of Deloitte and Touche, responsible for developing and implementing firm policy relating to accounting and auditing and practice before the SEC. My career with Deloitte and Touche spanned from 1963 to 1995. As a retired partner, I receive a fixed retirement benefit from that firm. Presently, I undertake from time to time independent consulting and other assignments in the field of accounting and auditing regulation and related professional issues. Effective oversight by Boards of Directors is at the heart of the financial reporting processes that serve and protect the interest of investors and the public. Without effective oversight, important checks on the integrity, judgment, and performance of management are compromised. Without effective oversight, critical safeguards of the rigor and objectivity of the independent audit are weakened. As we have seen in the case of Enron, failures of the corporate governance processes can be devastating and the investing public, rightly so, is asking, ``Can we rely on corporate governance, oversight by Boards of Directors and audit committees, to ride herd on management and see to it that auditors do their jobs? '' We would like to believe that Enron is an anomaly, that the governance issues raised are isolated to this case, but they are not. While Enron has become a poster child for a system out of control, the underlying concerns about the diligence of Boards of Directors and audit committees reach far more broadly into our corporate and capital market culture. As we look at the issues today, it should be abundantly clear that there is no higher goal for financial reporting than providing useful and reliable information that promotes informed investment decisions and confidence in the system. It also should be abundantly clear that without diligent, probing directors and audit committees and dispassionate, independent auditors, the quality of financial reporting can be and will be systematically undermined. Without adequate checks that must come from effective governance, conflicts of interest can, and will, go unchallenged. One of the most practical and effective steps in reforming the financial reporting system, in my view, would be to immediately revisit and rewrite our corporate governance policies and guidelines to clearly break the bonds between management and the independent auditor and to unmistakably spell out the responsibilities of boards of directors and audit committees to shareholders and the investing public. Management should be the subject of, and not the manager of, the independent audit relationship and process. The ultimate responsibility for full and fair disclosure to shareholders, and the direct responsibility for the independent audit relationship and the quality of the audit process, should be clearly fixed with the board of directors and its audit committee. The audit committee should be made up entirely of independent directors. For independent auditors, I believe that a brighter future begins with full acknowledgement of the reality that seems so clear today. Failures in our financial reporting system are more than aberrations. They seriously undermine investor confidence in the institutions that are supposed to protect them. They ``poison the well.'' To restore and maintain confidence in the independent audit, I believe that profession will have to do three things. First, it will have to embrace a role that is fully consistent with high public expectations. In public capital markets, insiders have an advantage over public investors, and in that arena, independent auditors are expected to balance the scales by assuring investors that the financial reporting gives them a fair presentation of the economic realities of the business. Second, the auditing profession will have to tackle fraudulent financial reporting as a distinct issue with a distinct goal, zero tolerance. We understand that in life zero defects are almost never realized. Nevertheless, the public expects that the profession will pursue that objective. Third, it will have to accept and support necessary regulatory processes that give comfort to the public that the profession is doing all that it can do to prevent future episodes of failed financial reporting. With respect to accounting standards, we simply cannot tolerate financial reporting that ``hides the ball'' and we cannot tolerate processes that are not responsive to critical financial reporting needs. Current rules for accounting for SPEs, for example, are nonsensical. They can only be explained by accountants to accountants. More broadly, outdated rules governing consolidation and off-balance-sheet financing have become recipes for masking a company's true economic risks and obligations. We have a right to insist that accounting standards clearly reflect the underlying economics of transactions and events, and it is not acceptable to sit by while market innovations outstrip the development of needed guidance. Criticisms of U.S. standards is beginning to focus on the fact that they have become increasingly detailed, and arguments have been made that they should be broader statements of principle, applied with good judgment and respect for economic substance. I have sympathy for the desire to break the cycle of the mind-numbingly complex accounting rules that have become the norm, but to do that, I think we have to confront realistically the reasons why our standards have evolved the way they have. Here are some of the underlying pressures that are at work. Business managers want standards that provide the greatest flexibility and room for judgment. They want to be able to manage reported results, but yet be able to point to a standard that assures the public that they are following the rules. Deal makers and financial intermediaries want standards that permit structuring transactions to achieve desired accounting results, results that could obscure the underlying economics. In that world, creative transaction structures are valuable commodities. Auditors are pressured to support standards that their clients will not take issue with, and they often are restrained in their expected support for reporting that is in the best interests of investors and the public. Others, including legislators, some legislators, too often lose sight of the fundamental importance of an independent and neutral standard- setting process. Without independence and neutrality, standard setters cannot effectively withstand the myriad of constituent pressures that they inevitably will face and make the tough decisions that inevitably are required. And then standard setters too often seem to pull their punches, perhaps because of the perceived threat to the viability of private sector standards setting, perhaps because of the sometimes withering strain of managing controversial change, and perhaps because of a loss of focus on mission and concepts that should guide their actions. As we reexamine the processes, the issue and debate should not be about whether accounting standards should be detailed or broad, but rather about what formulation of standards and standard-setting processes best accomplish the goal of providing capital markets with reliable and decision-useful information. We need to reenergize our standard-setting processes and the commitment of capital market participants to support a fully effective, independent standard setter. We should provide independent funding for the FASB, funding that does not depend on contributions from constituents that have a stake in the outcome of the process. We also need a more independent governance process to replace the current foundation board. The leadership for these changes should come from visionaries of unquestioned objectivity and demonstrated commitment to the goals of financial reporting and the public interest. At the outset, I suggested that the common interest in preserving and maintaining healthy capital markets far outweighs the concerns or goals of any particular group or special interest. We have to keep focusing on that fundamental tenet. Only a continuing commitment to that goal will guarantee that we continue to enjoy the best capital markets in the world. Thank you again for inviting me. I would be pleased to respond to your questions. Senator Levin. Thank you very much, Mr. Sutton. Mr. Campbell. TESTIMONY OF ROBERT H. CAMPBELL,\1\ FORMER CHAIRMAN AND CHIEF EXECUTIVE OFFICER, SUNOCO, INC., AND CURRENT BOARD MEMBER OF HERSHEY FOODS, CIGNA, AND PEW CHARITABLE TRUSTS, CORONADO, CALIFORNIA Mr. Campbell. Mr. Chairman, ladies and gentlemen, I, too, appreciate the opportunity to testify before this Subcommittee today. This Subcommittee's deliberations are extremely important, in my opinion, because it is a national imperative that we begin the process of restoring the confidence of investors in publicly-held companies. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Campbell with an attachment appears in the Appendix on page 195. --------------------------------------------------------------------------- For your information, my active business career has spanned a 40-year time period, from mid-1960 until June 2000. The entire career was spent with one company, the Sun Oil Company, or Sunoco, as it is known today, or its subsidiaries. In 1991, I was named President and CEO, and in 1992, Chairman of the Board, and I held the Chairman and CEO positions until I retired in June 2000. Before I begin, I need to make two points clear. First of all, any remarks that I make are my own personal belief and they do not necessarily reflect the beliefs of the corporations on whose boards I have served or am currently serving. And second, you need to understand that my knowledge of Enron and its Directors or Arthur Andersen and its partners is limited to what I have read in the print media or seen on television or heard today. I have no direct knowledge of what has taken place in those organizations. Now, in your letter of invitation to me, you asked that I comment on whether I thought the governance problems exposed in the Enron matter are unique or representative of most U.S. publicly-traded companies. My answer is that I certainly do not believe that the alleged behavior is representative of boards of directors in the United States today. In addition to Sunoco, I have been or am currently a Director of CoreStates Bank, before its acquisition, Hershey Foods, CIGNA, Pew Charitable Trusts, Rocky Mountain Institute, plus numerous civic and nonprofit boards. I have chaired audit committees. I have chaired the compensation committees. I have been on governance committees, finance committees, and executive committees, and during those 15 years, I have come to know probably more than 100 directors and can state from personal experience that the allegations that I have read in the print media and seen on television are not even remotely similar to the director experiences that I have had. Unfortunately, the general public seems to believe that Enron is typical, and I think that is terrible and it is part of the reason that I am here today. I believe the best way to explain the type of board governance that I am accustomed to is to cite some of the practices we instituted at Sunoco. The list of governance practices of that corporation spans four single-line typed pages, and you will be happy to know that I have absolutely no intention of reading them here this afternoon, but have instead submitted them as an attachment to my proposed remarks for your information.\1\ --------------------------------------------------------------------------- \1\ The list of corporate governance standards appears at the end of Mr. Campbell's prepared statement in the Appendix on page 199. --------------------------------------------------------------------------- Senator Levin. Thank you. Mr. Campbell. In those remarks that I prepared and submitted for today's performance, I briefly outlined the company's practices in director independence, director compensation, and director election. I spoke of the company's approach to the code of ethics and to conflict of interest policies, the company's approach to CEO evaluation, director evaluation, and ``board-as-a-whole evaluation. And finally, I wrote of our experience in changing the independent auditors. Now, I am not going to take the time to read through those now, but I will be glad to answer any questions that you may have on my experience with those practices. You might be interested to know that Sunoco's approach to governance resulted in several instances of external recognition and culminated in that board of directors receiving the 1999 National Board Excellence Award from Spencer Stuart, the executive search firm, and from the Wharton School of Business at the University of Pennsylvania. Now, also in your letter of invitation to me, you asked if I might have any recommendations for new legislation or regulatory reforms. I will confess to you up front that my business career has conditioned me to seldom seek more legislation or regulation from government. However, I do believe that the current situation calls for strong action on the part of someone, and I would suggest four areas of focus. First, I believe there needs to be a more complete and understandable annual disclosure of the relationship between a director and the corporation. The typical corporate proxy today issued prior to an annual meeting and the election of the directors gives a very brief description of the director standing for election. I would like to see a much more complete description, on one page, of each director's relationship with that corporation, including not only the total compensation received in whatever form it takes, cash, stock, benefits, or perks, but also any consulting or employment contracts for them or their relatives, any business relationship between their company and the subject company. Are they a significant supplier or a customer? What are their financial holdings in the company they serve as director, stock, stock equivalents, options, bonds, other forms of debts, loans, etc.? I realize that some of this information is disclosed in other documents. However, bringing it all together annually in one place in an easily-read format and publishing it will help ensure complete disclosure of how independent your so-called independent directors really are. My second suggestion is that an annual meeting of outside directors, and with that I mean no CEO or other members of management present, be made mandatory, not just a voluntary good practice, and it be followed with an extensive feedback session to the CEO/chairman. I have instituted that on boards that I have been on and have found it to be of tremendous value to both the CEO and the outside or independent directors in surfacing issues early while they still can be dealt with constructively. Mr. Chairman, my experience is that you do not get in big trouble in one step. You get there in a series of small steps that progressively take you further and further away from acceptible behavior. It is the so-called slippery slope. That is why there has to be an extensive, no-holds-barred meeting of independent directors, regularly scheduled, at least annually, with no management present, because I believe in that discussion the best way to surface the issues that somehow just do not feel right in your gut as a director is to have that kind of discussion with your colleagues. Third, I believe that consideration should be given to limiting the years an outside auditor can serve a corporation. The need for a different set of eyes is currently recognized by the existing requirement that the partner in charge be rotated every 7 years. However, bringing in a new lead partner from the same firm to work with the existing team from that firm is inadequate, in my opinion. I am certain that this requirement would be seen as unnecessarily disruptive and expensive by most corporations today, but if an outside auditing firm knew that 10 years from now, a competing auditing firm would be looking over and possibly commenting on their prior work, a whole new dynamic would be introduced in the current process. Fourth and finally, since good corporate governance is a constantly evolving process, it would be unwise to legislate or regulate with too much specificity. What is viewed as good practice this year may not be viewed as adequate in future years. Boards instead need to institute a continuous governance review process, and I believe it would be helpful if the following were required by regulators. One, corporations should be required to put their governance practices in writing and publish them annually in their proxy statements. In that manner, it would be clear to all shareholders how their corporation is being governed. And two, a board committee should be identified and held responsible for reviewing and updating a corporation's governance practices, similar to the way the audit and compensation committees currently have certain regulatory duties. One of Sunoco's current directors, Rosemarie Greco, recently published in the January 2002 edition of National Corporate Directors Monthly an excellent description of a process which a corporation can use to institutionalize the best governance practices.\1\ I strongly recommend you review her offering because it is only when the governance process is institutionalized that it will continue to be effective over time. --------------------------------------------------------------------------- \1\ See Exhibit No. 86 which appears in the Appendix on page 751. --------------------------------------------------------------------------- Again, I thank you for the invitation to be here today and I will be happy to try to answer any of your questions. Senator Levin. Thank you all for your testimony and again for your patience. Enron kept about 50 percent of its assets off its balance sheet, about $27 billion out of $60 billion. It also had off- the-books guarantees that were not reported, major business ventures that were not disclosed to investors. Now, we have been told there is no way to know whether the extent of Enron's off-the-balance sheet activities is typical or unusual for U.S. companies since the activities are, by definition, off the books and not reported. How can investors rely on financial statements if a large percentage of a company's business activities, assets, and liabilities are off the balance sheet, and what accounting rules need to be changed, with as much specificity as you are willing to give us, to acquire that disclosure which you referred to of material off-the-balance sheet activities, assets, and liabilities? Maybe, Mr. Sutton, we could start with you. Mr. Sutton. Let me offer several--make a few points about that. Senator Levin. If I could interrupt for one second, I think you said that the current rules on these SPEs are nonsense, so that is the reason I am starting with you. You have made a very pungent point about it. Mr. Sutton. Let me offer a few comments to help explain why I said that and what the state of the art is. Off-balance-sheet financing is one of the most valuable commodities on Wall Street because markets tend--or companies perceive that markets tend--to value companies that have less debt on their balance sheet. Rating agencies also will do it. The markets, some segments of the markets--tend to view asset-light companies as being more attractive investment opportunities. That creates an incentive of companies to get debt off the balance sheet, to get asset-light, so that they will be looked at and perceived favorably by the market. What has happened in the standard-setting process, and when I said we need to understand what the drivers are to understand the problem, instead of trying to develop standards that say, ``what is the economic substance,'' ``who has the risks and the benefits of these assets and liabilities,'' ``who really owns them,'' the standard setting has lapsed into a process of ``what rule do I have to comply with in order to get an asset or a liability off the balance sheet? '' So that is the state of the art, and it creates a situation, as in Enron, where you can have substantial obligations, that you or I might recognize as liabilities, off the balance sheet, substantial assets that you or I might say, ``well, Enron really has the risks and benefits of that asset off the balance sheet,'' and it is accomplished through accounting standards that, in part, were not complied with, and in part that were complied with but that were poorly designed. Senator Levin. Before I turn to either of the other two witnesses, would you have specific changes that you would propose? Because you are moving from a legalistic to an equitable or to a judgmental or, not intuitive, but something which is a little less legalistic in its description to something which is more, hey, who really has these risks and benefits. How do you put that in a rule? Mr. Sutton. You have to first articulate conceptually what you are trying to accomplish, and then you develop rules to the extent that you need to develop rules to accomplish that. Senator Levin. Has somebody done that? Mr. Sutton. Well, the FASB's charge is to do that, and I mentioned their mission. That is what they are charged to do. In my personal opinion, they have not done a very good job of that, particularly in recent years. Senator Levin. Has anybody outside of the FASB made an effort to design rules which would achieve that objective? Mr. Sutton. Well, there is a new body in place now, relatively new, and that is the International Accounting Standards Board, that has pledged, in a sense, to take a more principled approach. I would not suggest in any way that whatever approach you take is going to be easy because it is like any set of rules that you try to develop. There are always going to be those who want to game the rules. But my view is that you ought to develop your rules following the concepts that you believe are best--that give the best and fairest presentation, the most transparency, and develop those rules as best you can. Senator Levin. For instance, has any academic tried to design rules which would correct for the inadequacy of the current rules relative to these transactions? Is there anyone who has done some writing in this area in academia? Mr. Sutton. There is lots of writing, but there is no magic bullet. The magic bullet in this is having an independent process of highly qualified people who are clearly focused on a mission that is in support of what you expect financial reporting to be in the marketplace. Senator Levin. You have said you would give FASB an independent source of financing. You testified to that today. Would you also have them appointed by a different body than is currently the case? Would you, for instance, have the SEC appoint any members of that board? Mr. Sutton. Chairman Levin, I have not thought in detail about how the structure--my view is, we needed to get some really capable visionary thinkers who have thought about this issue a lot and try to develop a consensus view. It may be worthwhile that some part of the board would be appointed by the SEC. It may be--it would seem logical to me--that you would want a certain segment of those members who would clearly be, and clearly be recognized as, advocates of or sensitive to the needs of the investing community. Senator Levin. Would you give that board additional powers, including subpoena powers? Would you give them also powers to enforce rules, in other words, separate that enforcement function? Mr. Sutton. What I had in mind that we were just talking about would be a body that would set accounting standards. There is a need for--the other accounting leg of this stool is the accounting profession, and I would see clearly a need to have another body, an independent body, oversee the auditing profession, and that body should have appropriate investigative powers, in my mind. Senator Levin. Mr. Elson, do you have any comments on the subject that I have been talking to Mr. Sutton about? Mr. Elson. I am a transparency person. I have always been a big fan of transparency, and I think the more that is disclosed about those sorts of things, the better. But vis-a-vis the technical aspects of on or off-balance-sheet financing, I am a little out of my field. Senator Levin. OK. Mr. Campbell, did you have any comment on that? Mr. Campbell. No. I would agree with Mr. Sutton and Mr. Elson. Prior to the Enron disclosures, I had never seen that amount, or proportion of a company's assets off-balance-sheet. Sometimes it is appropriate to have some items off-balance- sheet, where you have an investment and no control, but never to that extent. As to how you would correct that situation, I cannot offer expertise in that, sir. Senator Levin. Mr. Elson, have you ever seen or know of a company that had that many off-balance-sheet entries? Mr. Elson. Not that I am aware of. On the other hand, again, my expertise really is not in that area. It was quite a bit to obviously have it off the balance sheet, and obviously not disclosed. Senator Levin. Mr. Sutton. Mr. Sutton. Well, many companies have off-balance-sheet assets and liabilities, but my experience is that Enron is at the top of the scale in terms of the extent of it. Airlines, for example, would frequently have much or most of their aircraft off-balance-sheet through leasing arrangements and that would not be regarded as unusual. Senator Levin. Thank you. The Enron Board approved Andersen serving not only as the outside auditor for the company, but also for a couple of years as the company's internal auditor at the same time and paid Andersen also tens of millions of dollars for consulting work. The end result was that Andersen was essentially auditing its own work. Now, the Board members defended this practice by saying that it gave them great comfort to know that Andersen was involved in all of Enron's transactions from the very beginning. They called it an integrated audit. What is your reaction to this idea of an integrated audit, in which the same auditor is the company's consultant, internal auditor, and external auditor? Mr. Sutton. Mr. Sutton. Well, in my experience, the term or label ``integrated audit'' generally referred to a proposal to combine the internal and external auditing, and so a couple of things I would say about that. One is that it became quite fashionable in the late 1990's. The second is, I think it is a terrible idea because it does create the situation where, on the one hand, the auditor is performing a management function, i.e., internal auditing, and on the other hand is called upon to examine the financial statements. The other aspect of it that you mentioned is consulting in the area of transaction structures. That clearly, in my mind, raises questions about auditing your own work, and it depends really on what was done and to what extent it was done. If the auditors were the creative thinkers, if you will, in terms of how do we accomplish a transaction to accomplish a certain accounting result, to me, that is over the line. On the other hand, you would expect a company that is getting ready to enter into a transaction to ask its auditor, do you have any concerns about this? So there is a line there that, in my mind, once you cross that, you have a problem. Senator Levin. OK. Mr. Elson. Mr. Elson. I guess my answer would be in two parts. First, vis-a-vis the internal/external audit role, I have always believed that they should be separated for a very important reason. Those are--they are watchdogs, effectively. An external audit, internal audit are watchdogs of the company's financial processes in some way, shape, or form, and anytime you concentrate two watchdogs in the same watchdog, you have effectively reduced the effectiveness by half, if you have one less person there. Second, the fashion typically today has been to outsource internal audit. Traditionally, it was always internal. That is why they called it internal audit. But there is some merit, a great deal of merit, to outsourcing the internal audit function. And when you do so, I have always felt that there is some benefit to separating the internal auditor from the external auditor because you have two different large firms in the company effectively, even if informally, checking each other's work. The presence of a different internal auditor or the presence of a different external auditor, I think acts as a bit of a check on the work of either party and that is a pretty--I think it is healthy competition. That is the first point. I have never, frankly, felt that the two should be combined, and when it was, I think 2 or 3 years ago, the SEC effectively allowed that, I was rather critical of that at the time and I still am. Second, vis-a-vis the consulting, the auditor consulting, when auditors do consulting, a lot of consulting, the question is, does it compromise the effectiveness of the audit itself? Can you trace the presence of heavy consulting work with a busted audit? I have not been made aware of any empirical data to date that demonstrates emphatically the correlation between consulting, heavy consulting, and a busted audit. On the other hand, from an optical standpoint, a shareholder trust standpoint, putting it in the same party is problematic. It looks problematic. It looks as though, even though one can argue there is a Chinese wall, if you will, between the two functions, there is certainly the public perception of potential corruption of the audit process by the desire to seek consulting fees, and because of that public concern, I think it is something that I would limit. Unless you have a really good reason to do it, I do not think I would have the external auditor doing consulting work, or if they did consulting work, it ought to be very limited in nature and in scope and only used when, frankly, you can demonstrate that there is nobody else out there who can deliver an effective service. In other words, you do not want the consulting to affect the audit function and you do not want those, certainly the members of the public who are relying on the financial statements, to be concerned that those financial statements are not reliable because someone was doing both. Senator Levin. I think it is more than optics. Enron paid Andersen $5 million in the year 2000 to help structure LJM, and so it would seem to me it would be pretty hard for Andersen's auditors to say that the Andersen consultants got it wrong. I think that is the problem. I think it is a real problem, but let me ask Mr. Campbell, do you have any comment on that issue? Mr. Campbell. I think what was described today as the integrated audit is a horrible practice and I do not think it should be permitted. As far as consulting is concerned, I think when you end up with an auditing firm which, first of all, bids a proposal on the basis of conducting the external audit and then finds over a period of time that the non-audit fees continue to grow, in my mind, that does nothing but continue to reduce, not only optically but in reality, the independence of those so-called independent auditors. There is no question, at least recently, there have been pressures to begin to bring that down because people are focusing on that issue, but it sure can reduce independence, in my opinion. Senator Levin. Thank you. This is for you, Mr. Elson. You have written extensively on the importance of independence and you have testified to that this afternoon. Exhibit 43,\1\ if you have a book near there, identifies some of the economic ties between Enron and some of the outside Directors. The Board members told us that none of these dollar commitments was large enough to have impaired anyone's judgment or to sway any Director from being honest and skeptical with Enron management. You can perhaps scan the amount of dollars that are involved in those items. I am just wondering what your response is to that. --------------------------------------------------------------------------- \1\ See Exhibit No. 43 which appears in the Appendix on page 375. --------------------------------------------------------------------------- Mr. Elson. I think that if amounts for consulting services were not meaningful, then the individuals would not have taken them to begin with. Obviously, they had some meaning or they would not have accepted compensation for services rendered. The problem with taking separate fees, other than one's directors' fees, is I think it creates a linkage between you and management. By taking those fees, you are effectively becoming part of the management team, and I think there is a real problem with exercising independent judgment vis-a-vis what the management has done if you feel part of that team, either through participating in the development of management plans and strategies or the fear that if one objects too strenuously, those consulting fees may disappear. That, at least, has been the generic critique of those. I think, too, the problem with them is that by taking them and becoming, again, part of management, in a sense, you are much more reticent to be critical of management, not because you are no longer ``independent,'' but because of the relationship you have with management, that financial management. You may take what they are telling you at face value without being more probative because of the relationship that this thing creates. That is why the National Association of Corporate Directors in their commission report on director compensation said that if a director's role is as a consultant, hire the director as a consultant. If the director's role is to be a director, hire them as a director. You cannot blend the two. The argument that we could not retain someone's consulting services unless we made them a director, I have never felt was a very good argument. Again, the problem here is either these fees may have affected their view of what was being presented to them--again, you have to get each of them here to testify as to whether they did or they did not, but certainly in the part of those within the organization, the presence of those relationships might have made the perception of those directors within the organization viewed as less than independent. If that were the case, it would be tougher for someone within the organization, if they objected to what was going on in management, to approach any of these directors because they were of the view that, gee, they are just part of management anyway, and that, I think, is the real issue here. In other words, independence, as I said, is a two-way street, and I think the presence of these relationships is not a good idea, and that is why the National Association of Corporate Directors has strenuously recommended against these sorts of relationships. Senator Levin. This is for Mr. Sutton. You were Chief Accountant at the SEC, and by the way, did either of you have any comment on that last answer before I go on? Mr. Campbell. Well, I would just like to point out, I think the consulting arrangements with directors is absolutely incorrect, absolutely wrong. When you accept the directorship of a corporation and join the board, you are paid a fee, obviously in the case of Enron, substantial. In my mind, your thoughts, your processes, and what have you, your support and you are there available to the management at any time they want to contact you. And if, in fact, they need you on an ongoing consulting basis, then you should not be a director of that corporation. Senator Levin. Thank you. Mr. Sutton, now a question about the Raptor transactions. You were Chief Accountant, as I indicated, for the SEC and I would like you, if you would, to turn to Exhibit 28b,\1\ which is the initial Raptor presentation to the Board. --------------------------------------------------------------------------- \1\ See Exhibit No. 28b which appears in the Appendix on page 306. --------------------------------------------------------------------------- Mr. Sutton. Exhibit 28---- Senator Levin. Exhibit 28b. The first page states that the purpose of the Raptors is to establish a risk management program in order to hedge the profit and loss volatility of Enron investments. The last page of this Exhibit 28b lists the risks that are associated with the Raptors. The first one is ``accounting scrutiny.'' The second one is ``substantial decline in the price of Enron stock,'' what would happen. I am just wondering, what is your reaction to the presentation, in particular, the focus on hedging profit and loss volatility as opposed to hedging real economic risk? Mr. Sutton. Let me couch my response in these terms. Obviously, we do not know what was said at the meeting, and so I am going--what I give you is more of a reaction based upon my experience and insights. The first thing that comes to mind is when I see the slide labeled ``Purpose,'' it says establish a risk management program in order to hedge the profit and loss volatility of Enron investments. The first thing that comes to my mind is, ``what does that mean,'' quite honestly. What does it mean to say, ``hedge profit and loss volatility? '' I had a similar question in listening to the testimony this morning. The term ``hedge,'' in my mind and experience, refers to transactions that are used to transfer or alter the risk of the company, so that there is another party out there that you exchange risks with, or you transfer risk to, that has an economic impact. And this says ``hedge profit and loss volatility,'' and I do not know what that means. That is my first reaction. What was the other page? Senator Levin. On the last page, you have got a risk list. One is accounting scrutiny. The other one is a substantial decline in the price of Enron stock. In other words, in addition to trying to protect itself against paper losses here, not as you testified, in effect, against real economic risks, but against paper losses, Enron used the Raptors to hedge against the decline in value of certain assets, but that was backed by Enron shares rather than independent third-party equity. It was Enron shares which were put up for that hedge, so they are hedging against themselves, are they not, or am I missing something here? Mr. Sutton. Well, all I can interpret from the comment is that the risk is from a substantial decline in Enron stock, and then the consequences of that are identified ``as the program terminates early.'' I assume that would be at a loss of some kind, and it increases the credit risk, so I assume that is Enron's credit risk, but---- Senator Levin. The risk here, as I understood it, is since they put up their stock as the collateral, that if, in fact, that stock declined in price and was called upon, then they would have to put up a huge amount of their own stock. So they were not transferring risk, they were using their own stock to cushion against the risk of their own assets, their own stock holdings going down in value. Is that a true hedge? Mr. Sutton. That is not what I would understand a hedge to be, and that would also explain, perhaps, the first slide, by what they meant by ``hedge profit and loss volatility.'' Senator Levin. OK. So it is just not clear to you as to what---- Mr. Sutton. It is not clear to me. Senator Levin. Does anyone else have a thought on this? [No response.] All right. What does a board do if they are told that high- risk accounting practices are being used? What is their fiduciary duty? We will start with you, Mr. Campbell. Mr. Campbell. Well, first of all, I cannot imagine going into an audit committee room and sitting down with the auditors and being told that we are using high-risk auditing practices and just agreeing with that. I mean, my experience has been people would want to know, why are they high risk? How did we get there? Why are we using them? And what are you going to do to get us out of it? Going forward with that kind of an environment, it is what I said before. It is a little bit like this whole thing turns into one step after another. You are going down a slippery slope on this thing, and at what point in time do you yell, enough is enough? But having an audit committee confronted with the fact that you have high-risk auditing practices and then having the chairman take that to the board and report it to the board and have that board agree that is OK, it is unlike any board that I have ever seen or heard of. Senator Levin. Mr. Elson. Mr. Elson. My first reaction to that would have been an extremely queasy stomach. That is a giant red flag, being told that you are--for a large publicly traded company, the seventh largest public traded company in the country--taking serious accounting risks is a pretty scary thing, just to say the very least. As a director, under the duty of care, you are being compared to what would the reasonable director say under similar circumstances, and the reasonable person would certainly say, why are we doing this? Why is this risky? Is this very smart to be doing this? What is considered conservative treatment? Why are we not in conservative treatment? And how do we get ourselves out of risky treatment, because, obviously, risky treatment has risks. That is why they call it risky treatment. What are the risks before us and how do we restore conservative treatment? At that point, you want to ask an awful lot of questions, and if you do not get the right answers, then you need to bring in a third party. Senator Levin. OK, thank you. Mr. Sutton. Mr. Sutton. I would just support those comments and say that from the accountant's perspective, you would also expect some kind of dialogue to arise between the audit committee and the independent auditors. Senator Levin. One of the issues which came up had to do with the compensation of the Board of Directors. Exhibit 35a\1\ is the total compensation of Enron Board members for fiscal year 2000. As you can see, including stock option value which probably represented three-quarters of it, roughly, it was in the range of $320,000 to $340,000, with the cash compensation being roughly from $70,000 to $90,000 and the balance in stock option value. This is a chart from their own sources. --------------------------------------------------------------------------- \1\ See Exhibit No. 35a which appears in the Appendix on page 348. --------------------------------------------------------------------------- Mr. Elson, you particularly made reference to stock options as being an expectancy where you do not lose as much on the downside, as you put it. Even though it turned out these options were not worth much in many cases when they held those options, when they were granted those options, there was a hope and an expectation that they would be worth a tremendous amount of money. This is what the estimated compensation was, a quarter-million dollars in the value of those options just in that 1 year. Doesn't that create pressure on the Board, basically, to go along with management or with these far-out, pushing the envelope accounting practices which make the financial statement look good and then push up stock prices, because their options go up in value? Now, their answer today, frankly, was not particularly satisfactory to me because what they said is, well, they turned out not to have any value or they lost money. That is not the issue I am talking about, whether they ended up losing the value of those options. What I am talking about is when they were granted those options, those options had real value and great potential value if the financial statement continued to look good, and one way to make that financial statement look good was with all these transactions that we have heard about. So does that fact not create some subtle, maybe not-so- subtle, pressure on Board members to go along with the idea that it is the stock price which is the end-all and be-all, and that is so affected by the bottom line on a financial statement, then to go along with accounting standards which are pushing the envelope? That is my question, Mr. Elson. Mr. Elson. Sure. Let me answer in two parts. Part one, share amount. This is pretty good work here. This is a lot of compensation for being a director. You know the old joke, good work if you can get it. Three or four hundred thousand dollars a year is quite a bit for directors. That is quite a bit over the norm in companies of this size and scale. These compensation amounts would put the Directors of Enron certainly in the top quartile, or probably higher, vis-a-vis similar compensated U.S. directors. The problem with paying a director too much is an obvious one. If management, as in many companies--I am going to speak generically--controls the proxy process and the compensation scheme for the directors becomes too high, the fear is the director, because of the income stream the director is receiving from serving as director becomes so great, that to object to a management proposal and potentially court non- renomination would not be in the director's best financial interest, and that is where compensation that is too out-of- the-ballpark, if you will, for a director is problematic. These numbers undoubtedly placed this Board pretty far up there in the grand compensation scheme. Again, most of the value was in stock options, but their cash compensation was not small. It was pretty high, too. But clearly, the real value was in the options. So the second part of your question, does giving director options make a director more likely to take risks, if you will, financial risks, again, that is a two-part answer. I have never been a big fan of options. I think they are useful in certain circumstances. I think they are problematic because, traditionally, you cannot charge--you do not charge them against earnings. I think there is a bill floating around that, Senator Levin, you have been involved in that would require that there be some charge for granting options. I think when you cannot charge them against earnings, people are a lot freer with them than they would ordinarily be if they had to give restricted stock and they give more of them. The problem with an option is it has a geometric upside to it, if you work out the math, even based on mediocre performance of a company, and that, to me, is problematic. There is no real downside. The worst you can lose is the expectancy of great riches. There is no real sting on the down. They simply become worthless. Stock is a different incentive. If a stock falls, you actually have a wealth decline on the part of the holder of the stock. In this case, they got a lot of options, and again, the weakness of options, I think, of potential on the upside rather than on the down, certainly comes out here. But your question on does it make you more risky, only if-- -- Senator Levin. Not quite. Mr. Elson. Yes? Senator Levin. Does it make it more likely that you would go along with pushing the envelope on accounting standards which have the effect of raising that stock price and then raising your option amount? Does that make it more likely or not? Mr. Elson. Only if you can sell the stock underlying the option relatively quickly. I mean, I have always believed that directors should not sell their stock while they serve on the board unless there is a very unusual circumstance. In other words, as long as you are a director, you have got to hold company stock. You cannot be in the business of selling stock. I think the ability to sell your stock or exercise an option short-term and sell it is problematic because there is the risk of the informational disadvantage, if you will. I know that bad things are going to happen. I push the stock price up. I sell, and then when the bad things happen, I am long gone and I have taken my profit. That is the risk. That really does not have to do with the option, the grant of the option. It really has to do with the ability to sell the option or exercise the option and sell the stock quickly, or if you give a director restricted stock, the ability for the director to sell that restricted stock while that director serves on the board. I think that is the real issue. It has got to be, and my remarks earlier had to do with long-term equity holdings. If you give someone stock and give them the ability to sell it quickly, then you have got a real problem. One, you have got that insider trading potential. And two, it is not very good to the public for a director to say, gee, I think I have found a better place for my money and it is not on the company on whose board I sit. It does not look very good. For that reason, I think the stock holdings have to be long-term. So in the short, I do not think the fact that they gave options was problematic here vis-a-vis the question you asked, if, in fact, you required that the stock underlying the options be held long-term. Senator Levin. So that would cure whatever problem there is that I have described---- Mr. Elson. Yes. I just do not like options. Senator Levin [continuing]. That prohibition. But there is no such prohibition, is there? Mr. Elson. No, sir. Senator Levin. OK. Now, Mr. Campbell, do you have any comment on that? Mr. Campbell. I agree that these numbers are high, and, in fact, if you look at it, this is for year 2000, so if you have multiple years of compensation and multiple stock options, then they could be multiples of this. I have never felt that options for directors are appropriate for the exact reasons that Mr. Elson said. And I would just point out to the Subcommittee that as you are thinking about where to go from here, part of problem, I am going to lay at the feet of compensation consults, which invariably come in and tell board compensation committees, if you want to compensate either your directors or your senior executives and your CEO at the 75th percentile range or level, then this is what you need to do. And then they go on to the next company and give the same talk. That becomes a one-way ratchet and it has occurred here over the past decade that is off the top of the scale, and I think we really need to get back to thinking about how do we determine what is really competitive out there. Senator Levin. It is a very important issue and it is essential that dialogue occur, one way or another. Mr. Sutton, do you have any comment on this question? Mr. Sutton. I do not disagree with anything that either of them has said. I would just add a thought that while I am not an expert in ethics, I have done considerable study in connection with the work at the Commission on Auditor Independence Issues. I would observe that whether it is selling, the pressures to sell non-auditing services, whether it is incentives by directors to enter into consulting arrangements, or whether it is what is perceived to be excessive compensation, those arrangements can create incentives that can interfere with otherwise expected independent behavior. Ethicists sometimes call that ``gray blindness,'' meaning that once you get so co-opted, you cannot tell the difference between black and white anymore, and there is that risk. Other incentives can give rise to it, but certainly financial incentives can. Senator Levin. You all have added a very important dimension to this hearing and to our investigation. The Congress really has a very heavy responsibility that we are addressing, but we are playing just a partial role in implementing and taking care of the problems. But your participation--your staying power is very much appreciated, and your very thoughtful written testimony, which will be made part of the record, and your comments in response to questions are very much appreciated. Mr. Elson, regards from Senator Carper. He had to go and preside this afternoon or else he would have been here to ask questions. Mr. Elson. Thank you. Senator Levin. I want to thank my staff for the enormous effort they put into going through all of these documents. We will stand adjourned. Thank you all. 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