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The debacle at Enron Corp. could well be a turning point for the pension fund famed for its shareholder activism, the California Public Employees’ Retirement System. The nation’s largest pension fund is seeking damages in a class action against former executives of Enron and Arthur Andersen. Yet the fund’s own activist history came into question when it failed to take more vigorous action against the Houston energy company — even when it had knowledge of the Enron partnerships’ conflict-of-interest issues. Responding to criticisms both inside and outside the institution, CalPERS last week unveiled steps intended to “prevent future Enrons.” It urged the federal government and stock exchanges to adopt a package of financial market reforms and said it is improving communication structures within CalPERS to correct “faulty” corporate governance. Among other things, the pension fund plans to organize a program with other investors to identify and expose the “myriad of potential conflicts of interest” that can contribute to a company’s collapse. Michael Flaherman, chair of CalPERS’ investment committee, said these agencies and corporations “can expect to hear from CalPERS over the coming months as we press for change.” The moves come amid criticism that CalPERS didn’t sound the alarm early on when it first became aware of Enron’s conflict-of-interest problems. In the late ’90s, Enron had tried to raise money for an independent partnership known as LJM2, which was headed by then-Enron chief financial officer Andrew Fastow. CalPERS turned down the offer to invest in LJM2 and subsequently raised the conflict of interest with Enron’s board and its lawyers. The pension fund also passed on LJM3 in 2000, according to company spokeswoman Pat Macht. Yet CalPERS did not publicize those concerns and continued to co-invest with Enron in a 50:50 limited partnership called Joint Energy Development Investments, or JEDI, to invest in energy projects. It invested $250 million in JEDI I in 1993, but in 1997, CalPERS sold its holdings back to Enron, netting $132.5 million in profit. Flaherman said CalPERS wasn’t aware of the financial irregularities that happened to JEDI I after it exited. In 1998, CalPERS then committed $500 million in JEDI II. Of that, $175 million was drawn down and $171 million was returned, which means a possible $4 million loss for CalPERS from JEDI II after liquidation proceedings. Moreover, CalPERS co-invested with LJM2 in an Enron spinoff, NewPower Holdings Inc. of Purchase, N.Y., which is expected to result in a $36.8 million loss. CalPERS’ total Enron-related losses, from stocks and bonds, now stand at $105.2 million. Flaherman spoke with The Daily Deal to discuss the recent moves and some details on its Enron-related investments. The Daily Deal: To what extent were these moves related to CalPERS’ decision to refurbish its image as a shareholder activist? Michael Flaherman: They have to do with the fact that our economy and our financial markets are moving very, very fast. And we need to match the pace of evolution in our corporate governance program. If we’re not running as fast as we can, the problems that crop up will continue to surprise us. DD: CalPERS was advised at least as far back as December 2000 not to invest in the LJM3 partnership. What steps were taken, if any, with regards to Enron holdings? Flaherman: The advice was taken in the sense that we didn’t invest. It would have been great if it had happened, but nobody had the foresight to recognize how that structure, which we thought were deficient at the private equity vehicle, represented a whole structure of the corporate parent and represented the moorings of the people running the parent company. DD: So it wasn’t clear to you what those relationships actually meant in the broader context of the parent? Flaherman: Yes, but the other point I’d like to make is that LJM2 and LJM3 partnerships were widely marketed to the entire institutional investor community. The reality is that I don’t think you could point to any major Wall Street firm or any major pension fund that did not have in their files the document offerings. But unfortunately, nobody had the vision to recognize how the structures described threatened the corporation. DD: Is it because the investment mechanisms within your institution are just not geared towards scrutinizing investments to the required level of detail? Flaherman: I think the level of detail in which that investment was reviewed was actually excellent. That’s why we didn’t invest. What we were not well geared up to do and which I think nobody was well geared up to do was to have the managers overseeing the private equity decision-making process step back and say, “You know, this is a deal that not only do we not want to do, but we want to go running across the hallway to the people who manage the public equity division and those who manage the corporate governance program for the institution and raise serious red flags.” That’s what I don’t think anybody did, despite widespread dissemination and awareness of the structure of those partnerships. DD: Is CalPERS typical in that respect, with regards to the limitations of the investment process as it related to corporate governance? Flaherman: It was a limitation that we’ve now discovered and that we’re now trying to take very strong steps to try to cure. DD: What exactly are you planning? Flaherman: We’re going to put in place procedures so that the private equity review process includes a step where people who see troubled deals that they want to pass on would raise flags and be sure to pass on the information to the public equities and corporate governance sides. DD: Is there a sense that CalPERS’ activist role had diminished or slowed in recent years? Flaherman: I think we just need to evolve it to the current circumstances of corporate America, in terms of how the financial press and electronic media have changed very significantly over the last decade. You have the gigantic cable financial networks where the Wall Street perspective is constantly present in the form of talking heads, and we’ve not really thought of having a presence there as an investor. The perspective of the sell side and our perspective on the buy side really are not the same. And yet we have lagged in our presence there. We have to be very vocal. DD: When CalPERS invested in JEDI, what was its understanding of that partnership? Flaherman: Our understanding then, as today, was that the partnership was a 50:50 investment in a separate entity from Enron. It was created by us and Enron together. It wasn’t part of Enron and it had a separate and transparent governance structure. DD: Did you know who the managing partner was at the time? Flaherman: Enron was. Let me be clear about one thing. An entity called JEDI was a significant source of Enron’s downfall, but that was not the JEDI we invested in. What I mean is that we originally invested in an entity called JEDI with Enron in 1993. It was a very clean, transparent and appropriate structure. In 1997, we sold our interest back to Enron. That was when Enron started playing games with accounting. That entity called JEDI was no longer the same entity that we were involved in, but they kept the name. So there was a taint on JEDI, but that didn’t happen until after we left. What happened was after we sold our JEDI I holdings back to Enron, Enron set about financing the acquisition through another entity called Chewco. My understanding is that Chewco was represented in financial statements as a separate independent entity. In fact, that was a sham. Just this past fall, Arthur Andersen reconsidered that [relationship] and had Chewco consolidated on Enron’s books, which caused a significant restatement of Enron’s earnings. This happened subsequent to our sale, and we had no involvement in that. DD: But you subsequently committed $500 million in JEDI II? Flaherman: Well, I don’t know if it was subsequent to that. I don’t think it was, but it was something we didn’t know about. We didn’t know how they had churned that entity through their financial structure. As far as we knew, they had simply taken the assets and sold it back to the parent corporation. There was no reasonable way that we could have realized it. As a common stockholder, we certainly had a financial interest in what they did but we didn’t have any special reason to view our dealings with them with suspicion. DD: Did CalPERS know it was co-investing with LJM2 in NewPower, even when there was some concern about LJM2′s conflict of interest problems with Enron? Flaherman: I don’t know for a fact that we actually knew that LJM2 was a co-investor in NewPower. We weren’t really aware of all the sources of capital in the sense that we certainly knew they were coming from Enron, but we weren’t aware they were coming from these different pockets. Copyright (c)2002 TDD, LLC. All rights reserved.

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