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Near the end of Sherron Watkins’ extraordinary August memo to her boss, Kenneth Lay, outlining concerns about Enron’s accounting practices, she cautions against having the company’s regular outside counsel, Vinson & Elkins, investigate the issues she raised. “Can’t use V&E due to conflict,” she wrote, “they provided some ‘true sale’ opinions on some of the deals.” But Enron did tap Houston-based Vinson & Elkins to handle the investigation. The result was a nine-page letter to Enron’s general counsel (and former Vinson & Elkins partner) James Derrick Jr. on Oct. 15 from partner Max Hendrick that, in effect, brushed Watkins’ concerns aside. Six weeks later, Enron became the largest bankruptcy in history. How Vinson & Elkins handled its investigation of Watkins’ allegations, what it did, and perhaps more importantly, what it didn’t do, will no doubt be examined and reexamined in the months to come. But for aficionados of the gray and cautious verbiage lawyers use while peering into the abyss, the report makes fascinating reading. The letter is striking for the narrowness of the investigation, the key people who were not interviewed, and for the way in which it fails to fully probe bombshell allegations such as that: Enron’s CEO had “a handshake agreement” with its CFO, who headed controversial partnerships used to shift debt off the company’s books, to reimburse the partnerships for any losses. The employees who negotiated with the partnerships reported to the CFO who headed them. Outside investors in the partnerships reportedly felt their arms had been twisted to invest so they could do other business with Enron. Vinson & Elkins and Enron agreed at the outset that the lawyers’ review “would not involve second-guessing of the accounting advice and treatment” by Arthur Andersen and that “there would be no detailed analysis of each and every transaction, and that there would be no full scale discovery-style inquiry.” The object was not to reach conclusions about Watkins’ charges but only to “determine whether [they] … warrant further independent … review.” Vinson & Elkins reviewed documents from Enron and its own files; interviewed 10 Enron executives (including then-CFO Andrew Fastow) and two Andersen partners (including David Duncan, then head of Andersen’s Houston office) and Vinson & Elkins partner Ronald Astin. But Vinson & Elkins apparently did not interview Jeffrey Skilling, the wunderkind CEO whose abrupt resignation in August helped prompt Watkins to air her concerns to Lay. Nor is Lay’s name mentioned outside the introduction. The key figure in the Enron debacle is CFO Fastow, who headed the two key investment partnerships set up by Enron in 1999, known as LJM1 and LJM2, that were at the center of the earnings restatement the company announced in October. Fastow’s dual role was “fully discussed” and approved by the Enron board — an approval that required a waiver of Enron’s code of ethics, the Vinson & Elkins letter recounts. It says the partnerships were set up to help Enron hedge risks and gain favorable accounting treatment. For example, the LJM1 partnership bought an equity stake in Enron’s Cuiaba power plant in Brazil. That allowed Enron to “deconsolidate” the money-losing venture — i.e., get it off its books. The LJM2 partnership, established in October 1999, would ultimately raise $349 million from investment banks, insurance companies, pension funds and high-net-worth individuals, and participate in 21 deals with Enron. In approving the formation of LJM2, Enron’s board set guidelines for dealings with the partnership, including an annual review of transactions by the board. But, the Vinson & Elkins investigators acknowledged, “concerns were expressed about the awkwardness in LJM’s operating within Enron.” Vinson & Elkins identified two clear conflicts of interest in the arrangement. First, the Enron employees who negotiated with LJM worked under Fastow, so, in effect, they were negotiating against their boss. Despite guidelines meant to address that, several Enron executives told Vinson & Elkins that they feared the Enron executives were under undue pressure because they “would ultimately have their performance evaluated for compensation purposes by Mr. Fastow in his capacity as Chief Financial Officer.” One of those executives, Treasurer Jeffrey McMahon, complained about the conflict to Fastow and Skilling, but nothing was done. Soon after, he was asked to head another Enron division. Vinson & Elkins’ investigation also turned up that some outside investors in the LJM ventures “may have perceived that their investment was required to establish or maintain other business relationships with Enron.” But V&E interviewed none of those outside investors. Vinson & Elkins reported that Fastow and other Enron executives “stated unequivocally” to Vinson & Elkins that there was no tie-in between investing with the partnerships and doing business with Enron. Who complained? The report doesn’t say, but it does note that pension funds and individuals had no business with Enron. That leaves the banks and insurance companies. Enron, of course, was a famously lucrative client for Wall Street’s money men. Summarizing the conflicts issues posed by the partnerships, Vinson & Elkins concludes that the LJM vehicles provided Enron with “a convenient equity partner with flexibility” and that this “permitted Enron to close transactions that otherwise could not have been accomplished.” Sherron Watkins’ memo to Lay focused primarily on accounting issues. The report states conclusively that “all material facts of the Condor/Whitewing and Raptor vehicles, as well as other transactions involving LJM appear to have been disclosed to and reviewed by AA.” Specifically, Vinson & Elkins found that Andersen assured Enron that LJM vehicles had sufficient equity to qualify as third parties in transactions with Enron. Vinson & Elkins further concluded that the Andersen-Enron relationship was “open” and that Andersenconsulted with Enron “early and often” on accounting issues. The report indicates that Andersen generally agreed with that assessment, but said that Andersen relied on Enron’s statements as to the purposes of transactions and Enron’s valuations of assets placed in the LJM partnerships. The report doesn’t tackle howAndersen could find a partnership sufficiently capitalized if it couldn’t value the assets of partnership. Andersen brought in senior technical experts from its Chicago office to advise on transactions with the partnerships. The report also concludes that Andersen’s approval of Enron’s financial statements amounted to tacit approval of the transactions involving the LJM partnerships. Trouble arose, however, when V&E lawyers showed Andersen the Watkins memo. Andersen found two significant allegations that, if true, would cause them to revise their audits of Enron’s books. The first was that Fastow and Skilling had a “handshake” deal that LJM would never lose money on deals with Enron. According to the report, when Vinson & Elkins asked Fastow about this he adamantly denied it and recognized that “such an agreement would defeat the accounting treatment that was the very objective for the formation of LJM.” Skilling, of course, was not interviewed. Enron’s chief accounting officer, Richard Causey, told Vinson & Elkins he wasn’t aware of such an agreement and had seen no evidence of it. The second issue in Watkins’ memo that concerned Andersen was her statement that she had heard LJM had received a cash fee from Enron that completely reimbursed it for its investment in Enron deals. Fastow confirmed LJM had received $1,000,000 fee for managing the four Raptor partnerships, but denied that these fees covered LJM’s investment. However, according to the report, LJM’s costs were more than covered by puts on Enron stock which “settled favorably to LJM prior to maturity” in an amount equal or greater than its investment. The report states that Andersen was aware of these gains and found that they did not undermine LJM’s equity position. Vinson & Elkins attempts to undercut Watkins, saying she had no firsthand knowledge of the LJM transactions and that her accusations were based on rumors she heard while working for Enron Global Finance. To a large extent, Vinson & Elkins concluded, the allegations stated in the Watkins memo reflected “only her opinion.” If true, Watkins now ranks as one of the great prognosticators in the history of capitalism. The letter also reveals Vinson & Elkins’ own part in Enron’s financial disclosures. Vinson & Elkins said it relied on Andersen’s conclusion that there had been sufficient disclosure about the partnerships “in aggregate terms” in footnotes to Enron’s financials. But it seems that Vinson & Elkins, in fact, reviewed the disclosure language and the footnotes: “It is our understanding that Enron’s practice is to provide its financial statements and disclosure materials to Vinson & Elkins with a relatively short time frame within which to respond with comments,” the letter says. If Vinson & Elkins downplayed the substance of Watkins’ allegations, it clearly realized that Enron’s accounting might not stand up well to public scrutiny and could be portrayed very poorly in the press or in shareholder actions. Vinson & Elkins precisely identified the areas in which the company’s accounting was most suspect, including the use of Enron stock to capitalize the partnerships, and the recognition of earnings through transactions involving no true third party. These factors, and others, led Vinson & Elkins to conclude that Enron was at “serious risk for adverse publicity and litigation.” Despite that, Vinson & Elkins found that none of Watkins’ allegations warranted further investigation by independent counsel and auditors. Why? On that final point the report is moot, but the answer seems to be if Andersen was OK with it, then so was Vinson & Elkins. Of course, Andersen is now engulfed in the Enron inferno � leaving Vinson & Elkins uncomfortably close to the flames. Douglas McCollam is a reporter withThe American Lawyer magazine. Related Documents (pdf format): Read the Watkins-Lay memo. Read the Vinson & Elkins’ Oct. 15, 2001 letterreporting on its investigation into Watkins’ allegations.

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