By Jason Leopold
Aug. 29, 2002 - Three months before he was nominated as secretary of the Army by President Bush, Thomas White faced what surely was the most difficult task in his 10-year career as an Enron executive: Helping hide the hundreds of millions of dollars in losses from Enron Energy Services, the retail division he had headed since 1998.
It was February 2001 and for White and others in charge of EES, it was imperative that the division find ways to inflate its first-quarter earnings and hide what was becoming a black hole of losses.
But after White had left to pursue his Army post, the company was boasting a record quarter for EES, with a remarkable 18-percent increase in earnings over the previous year and new contracts with Eli Lilly, Owens-Corning, Quaker Oats, J.C. Penney and Saks. EES reported a 59-percent increase in new retail energy services contracts totaling $5.9 billion. But those figures were based on highly questionable accounting practices. According to documents obtained by Salon, EES helped Enron keep its illusion of profitability by grossly inflating the value of contracts it signed in February and April 2001, showing EES turning a profit when it was not.
Presiding over and even encouraging EES's accounting was Tom White.
When White testified July 18 before the Senate Commerce Committee about his role at Enron, questions focused primarily on his relationship to the various Enron schemes already familiar to the public, such as the alleged price-fixing schemes that contributed to the energy crises of many Western states in 2001. They also explored, to a limited degree, how Enron managed to hide some of EES's problems by transferring more than $500 million in losses into the company's wholesale services division.
White explained how, unlike Enron's wholesale division, the energy crisis caused grave cash-flow problems for EES. "I can say categorically that it was not ever in the interest of Enron Energy Services to have wholesale energy prices escalate," White testified.
But when asked about the troubled accounting of his own division, he offered an adamant -- but curiously qualified -- statement: "The deals that we put together within the accounting structure that was accepted and was the standard in the industry -- I stand behind that -- were signed and the right deals to do and were properly accounted for at the point that we signed those up."
What he did not explain was how these multibillion-dollar deals were able to create such a false picture of prosperity. Two off-the-books partnerships set up by White and Pai in February 2001 shed some light on EES's illusory profits and how the division was willing to go to great lengths to fool Wall Street.
On Feb. 20, 2001, Enron announced that EES had entered into a $1.3 billion, 15-year contract with Eli Lilly, the Indianapolis-based pharmaceutical company. Following in the Enron tradition of nicknames (like the price-setting "Fat Boy" scheme, or the famous off-budget shell companies named "Jedi" after "Star Wars") EES coined the deal "Heston" after the actor Charlton Heston, according to a former EES sales manager. According to a news release at the time, Enron was to "manage the supply of electricity and natural gas for Lilly facilities in Indiana, as well as perform operations and maintenance on energy assets and related energy infrastructure upgrades that will increase energy efficiency at Lilly facilities."
It helped EES that Kenneth Lay, former chairman and chief executive of Enron, was a member of Eli Lilly's board of directors and used his influence in getting the drug manufacturer to agree to the deal, according to one of the sales executives who worked on the contract. This former employee also said Lay discussed the contract at a meeting of Eli Lilly's board of directors, saying Enron would offer the pharmaceutical company cash if it signed the contract.
The problem with the deal, however, was that Indiana had not yet deregulated its wholesale electricity market. EES, therefore, could not yet provide Lilly with electricity. So, according to the source, White and Pai instructed the salesmen to predict when Indiana would deregulate and then predict how much Enron would earn during the projected 10 years of the contract. Ultimately, the deal was valued at around $600 million, even though it was based on two unreliable factors: When Indiana would deregulate, and the wholesale prices in the wildly erratic energy market.
This accounting method -- forecasting a future profit and counting it as revenue -- is called "mark-to-market" accounting, and is required under rules adopted in recent years by the Financial Accounting Standards Board. Mark-to-market involves recording the value of deals based on forward prices, allowing a company that agreed to supply gas or power at a fixed price to optimistically project future energy prices below the contract price. A company can then record the difference as profit as soon as a deal is signed, even though fluctuating prices change the value of the deal over time. The Securities and Exchange Commission has urged trading firms and other corporations to begin immediately, in 2001 financial reports, to boost disclosure in several areas, including valuation of energy trading contracts and the impacts of mark-to-market practices on earnings.
But back then, mark-to-market accounting was a loophole to exploit. Every quarter, prior to Enron's earnings release, an elite EES group that included White and that referred to itself as "G5," and then later (just like the United States and its economic allies) "G7," would meet to discuss, among other things, how EES would use mark-to-market accounting to boost Enron's earnings and standing on Wall Street. One former EES employee who attended the meetings said it was White and Pai who were responsible for implementing the mark-to-market approach to EES's earnings.
The employee explained how, under their guidance, energy contracts EES would sign over a 10-year period were booked as immediate gains for the company and helped inflate Enron's earnings when, in fact, the contract would cause EES to hemorrhage cash. According to the documents, White and Pai signed off on all of the long-term energy contracts EES entered into.
"Mark-to-market accounting allowed Enron to show a false profit and delay taking the loss," the former EES employee said. "It is not mark-to-market accounting that caused that, but instead the misuse of the method."
As a result, the method has its critics. "Because mark-to-market accounting allows for a considerable degree of discretion on how companies value their energy trading portfolios, there always is the potential that some companies may succumb to the temptation to use more favorable methods or techniques to increase the value or earnings associated with their portfolio when no independent market exists to verify that," said Paul Patterson, an independent energy consultant based in New York, who has been a leading critic of mark-to-market murkiness. "If this method is misused it's very possible that a company's earnings growth may prove illusory.
"Giving companies such wide latitude in reporting their results can become a prescription for disaster," Patterson said.
Said one former EES executive who worked on one of three off-the-books energy contracts: "Where Enron pushed the envelope is that many of these contracts are ones that usually would have been signed for one to three years, whereas EES would sign deals lasting 10 years and immediately book the projected revenue as profit. But there isn't a market that exists that far out that could accurately predict the revenue stream EES said it would be getting."
White has been portrayed as an EES "cheerleader" who was in the dark about Enron's financial machinations and questionable accounting practices. "White was the guy who shook hands with people and motivated the sales staff," said Lance Dohman, a former sales manager for the division. "He would just try and get everyone all fired up to go out and sign contracts." When sought for comment for this story, White's spokesman, Maj. Mike Halbig, said White had answered all questions about his tenure at Enron and has put the issue behind him to focus on his job running the Army.
But White, the only Enron executive who seemed liked by almost everyone who knew him, played a much more crucial role in the day-to-day operations at Enron, according to the documents, which include EES memos and interoffice e-mails.
In one February 2001 e-mail, as panic about EES's mounting losses began to spread among White's employees, an EES employee reported to ESS chairman Lou Pai and to White that the division was losing more than $3 million a month on other contracts signed because of rising wholesale energy costs.
"Close a bigger deal to hide the loss," White responded in the e-mail.
White's word choice is illuminating, because at that point, EES's primary concern became how to "hide" growing losses behind new contracts that, through a questionable use of an accounting loophole, allowed it to claim profits that were wildly speculative in order to give the appearance that the company was actually making money. That false image, of course, would be shattered in the fall, when Enron became the country's biggest bankruptcy ever and 4,500 employees lost their jobs.
But White's employees saw ominous signs long before that.
In February 2001, it was widely known among the EES staff on the seventh floor of Enron's Houston towers that some of the contracts the division had signed in 1999 and 2000 were causing EES to hemorrhage money, according to former EES sales manager Margaret Ceconi, and rumors were spreading that White and Pai might be forced out as a result. The growing energy crisis was causing the wholesale costs of electricity and natural gas to skyrocket, and EES, Enron's retail division, was paying a steep price.
Intensifying the pressure, Pai and White had set the bar dizzyingly high for their division just weeks earlier. At a conference for Wall Street analysts on Jan. 25, 2001, in Houston, Pai and White made the bold prediction that Enron Energy Services' revenues would jump to $10 billion that year, up from $4.6 billion the year before. Earnings, White and Pai said, would reach $225 million in 2001, up from $103 million in 2000. Those were the numbers Jeff Skilling, appointed that month as Enron's chairman, and Andrew Fastow, the company's former chief financial officer, told White and Pai they would have to meet in order for Enron to keep its standing on Wall Street, according to a former EES sales manager who worked on six of EES's large contracts and attended the analysts meeting in Houston.
But within weeks, White and Pai tried to cancel an electricity contract with two University of California campuses. EES was spending as much as $300 a megawatt-hour for the power it delivered to the colleges, but was only charging the universities around $32 a megawatt-hour, based on its 1998 contract. EES executives said the unit could lose as much as $1 billion annually on the U.C. contract alone. But the U.C. system sued Enron, and a judge later ruled in April 2001 that EES must continue to supply the college campuses with power.
Pressure began to grow to land new deals, and make them look as big, and as profitable, as possible. Even if it wasn't entirely true.
The Lilly contract, however, also included a perk to Lilly hidden from the public, Enron shareholders and the budget sheets. According to a copy of the Eli Lilly contract (which, according to an EES source, was ultimately signed by White, Pai, Skilling and Fastow) Enron and Lilly established a limited liability company, made up of Enron and Lilly executives, in order to facilitate the contract. Being a part of the LLC gave Eli Lilly and Enron huge tax incentives. Enron also, through the LLC, would pay Lilly $50 million in cash upfront to win the partnership; Lilly would have to pay back the money over time.
According to John Couch, a Houston tax attorney with Bracewell and Patterson who looked at the contract for Salon, the shares appeared to be the primary attraction for Lilly to sign. "The reason Eli Lilly signed this is because they got $50 million in cash from Enron that the company was able to use to accelerate income and to absorb other losses the company incurred," Couch said. "It says it would provide a legitimate service to Eli Lilly, which an LLC needs to do. But what makes this deal a better deal is it was structured through an LLC and it gave a Eli Lilly a tax advantage."
Once EES formed a limited liability corporation to handle the partnership, the company would then sell its stake at a profit to a third party, such as a bank, which is exactly what EES did in the case of Quaker Oats and Owens Corning, two other deals that were set up in the form of LLCs, according to the former EES sales executive.
And, perhaps most startlingly, the contract stipulated that any earnings Enron made off the contract would be split between Enron and Lilly 30 percent to 70 percent. That means the $600 million that Enron projected as revenue would have been, at best, only $180 million.
So the Lilly deal, listed in the company quarterly reports as worth $600 million, would only mean, optimistically, profits of $130 million. And that was based on a rosy, best-case scenario market report.
Nonetheless, White and Pai were a step closer to reaching their earnings goal.
The Lilly contract says Enron will "develop, design, construct and implement demand-side energy management projects" but all that entailed was removing and replacing a chiller, projecting the revenues over 20 years, and booking the revenues as a mark-to-market profit.
The Eli Lilly deal, which was handled by EES executives Jeff Forbis, Michael Mann and Richard Zdunkewicz, earned White, Pai and others a sizable bonus, according to sources within EES.
But according to Joan Todd, a spokeswoman for Eli Lilly, the deal never actually commenced. "The contract was structured in a manner that allowed the partnership to enter into routine leases for assets," Todd said. "We barely got into the contract with Enron before the company got into its problems."
Todd said the contract was unwound last month and Lilly resumed control over its own energy management. Todd also said that Lilly never accounted for the $50 million payment from Enron on its balance sheet and that the money was not booked as income. Todd did not know whether Lilly received tax incentives from the partnership but she said the company is negotiating with Enron's creditors on whether to pay the $50 million back to the company.
The deal, though, allowed Lilly to keep the transaction off its balance sheet. If Lilly did receive tax incentives from the deal, it's likely the company would have to restate its earnings after the deal was unwound, Couch said.
To fully understand the Enron/Eli Lilly deal, said one of the three sales executives who worked on the contract, "you have to understand why we needed to sign the contract in the first place."
"We were scrambling," the EES sales executive said. "We needed to sign as many large deals as we could between February and April to keep EES from collapsing. If we didn't sign these contracts it's likely that Enron would have imploded right then."
Ceconi, the former EES sales manager, said the Lilly contract allowed EES to claim revenue and margins in the current quarter that were not coming in. "That's what created the cash-flow crisis," she said. "It gave the appearance that EES was a cash machine. In that kind of environment the only way to continue -- and this gets to the issue of the house of cards -- was to continue and generate more business.
"Pai and White told us we had to keep feeding the fire," she said. "That's where the nervousness started to set in."
Also, some of the profits EES booked from the Eli Lilly deal don't appear to make sense. EES projected earnings on equipment it would install for Eli Lilly and maintenance, but no forward market exists for that. EES would do the same thing on Feb. 21, 2001, a day after it announced the Eli Lilly deal. On that day, EES announced in a press release another multibillion-dollar contract, this time with Quaker Oats, the second off-the-books partnership set up under White and Pai that brought them closer to reaching earnings. This deal was set up as a "special purpose entity" in order to provide both companies with tax incentives, according to the contract.
Tom White played key role in covering up Enron losses | 1, 2, 3, 4
EES agreed to supply 15 Quaker plants with energy management, from supplying natural gas and electricity to a staff of EES employees who would maintain boilers and pipes and procure spare parts. Enron, according to a copy of the contract obtained by Salon, guaranteed Quaker it could save $4.4 million from its 1999 energy bill. Enron forecast a $36.8 million profit over the 10-year deal and used mark-to-market accounting to book $23.4 million of that -- before it had even consummated the Quaker deal.
Under accounting rules, such treatment is permitted for commodities, such as natural gas and electricity. But the rules are more restrictive when it comes to services, such as boiler maintenance and parts procurement, for which no forward markets exist. Profits from these activities are supposed to be, according to the FASB, booked on a more conservative "accrual" basis, whereby a fraction of the profit is realized each year as it comes in.
According to a report earlier this year in the Financial Times, Enron's problem was that almost all the profits projected for the Quaker deal were derived from services, not commodities. How did it manage to book them upfront? The company used a questionable method called "revenue allocation." The net effect of this highly complex treatment was to redefine as commodities some of the money Quaker was paying for services and thereby create more profits that Enron could book upfront.
Under the system, Enron's internal accountants created a new category called "allocated revenues." These were based not on what Quaker had historically paid for energy commodities and its service contracts, but on figures that Enron claimed reflected the open market value of the commodities and services.
This revaluation made a significant difference to the reported worth of the contract. Enron would have earned only a small margin supplying gas and power to Quaker based on the original revenue figures it used to calculate the deal. Instead, revenue allocation allowed the company to claim an immediate hefty profit on the deal. Asked if such a move is illegal, a former Enron accountant told the Financial Times: "It's certainly skirting the edge. It's very, very aggressive."
The former EES sales executives claim the division, under White and Pai, managed to list as mark-to-market $85 million in energy services profits from 12 deals, including the Quaker contract, that should have been listed as accrued. In some instances, the sales executives said, the profits came from changing light bulbs and air-conditioning filters, the Financial Times reported.
Former employees say it was easy for White and Pai to get their sales staff to inflate services margins, because no one could accurately predict them. Perhaps Enron's boldest assumptions had to do with something called "efficiency projects." No one will ever know how accurate EES's projections were for the Quaker deal. Enron collapsed just months into the deal. Quaker says it has since made "other arrangements."
During White's contentious hearing before the Senate, one issue that came up repeatedly was how White weighed the importance of his division against the competing divisions, particularly Enron's wholesale division, which profited heavily from the energy price spikes in 2001, and also Enron, the company. White continually tried to paint his role as that of a captain of his own ship, autonomous with respect to the rest of the company.
"Well, when the difference was between the interests of the company, the Enron Corporation, or your divisions, which interest wins?" Democratic Sen. Byron Dorgan of North Dakota asked during the testimony.
"The division," responded White.
But according to key documents and sales reports obtained by Salon, known within Enron as "The Lou and Tom Report" (after Pai and White), their loyalties are clearly to the company -- and the company's bottom line. They detail, for example, how EES shifted more than $500 million in losses to Enron North America and listed the losses as debt. This made EES look like it was turning a profit -- because the division wiped out the losses and only showed profits -- and made Enron's wholesale division look like it was entering into lucrative electricity deals.
They also, in plotting the division's course, were heavily influenced in their actions by a keen concern for the company's overall health. "We need to push Tyco to take this deal or ENA [Enron North America, the parent company] isn't going to make the quarter," White and Pai said in their report, referring to a pending outsourcing energy management deal with Tyco Healthcare Group LP, a unit of Tyco International Ltd., in 1999. "You guys need to close the books a month before earnings."
On many occasions, the documents show, EES would be forced to renegotiate long-term energy contracts it signed with large corporations as many as three or four times, often resulting in the contract losing its original value (which itself was based on a bogus curve) by hundreds of millions of dollars. One example of this is a contract EES signed with Tyco in 1999 that was renegotiated four times.
Analysts said Enron should have disclosed this information or restated its quarterly earnings. "If the contract was amended or changed, that would lower your earnings for the period in which the value of the contract fell," Patterson said. "If the contract has fallen because of price changes or because it was renegotiated, then theoretically the value of the contract has fallen; then one would expect that the earnings from that contract would go down in the period in which the value fell."
But such disclosures, including in the Tyco case, were never made. And as EES's fortunes were slowly dwindling away, officials, including White, remained silent.
- - Jason Leopold is finishing a book on the California energy crisis.