Earlier [Enron] scandal pointed to need for controls

Financial times ^ | 1/16/02

[NativeNewYorker]

As more details of the Enron debacle emerge, industry insiders see similarities with a trading scandal that Enron faced in the late 1980s - in Kenneth Lay's early years as chairman and chief executive.

The affair led the company to incur a loss of $142m, a substantial amount as it made just $6m in revenues in 1987.

Untangling the collapse of Enron, the seventh-biggest company in the US, has been hindered by its secretive culture. But while rivals ascribe Enron's downfall to arrogance in the face of investors' concerns, those who have known the company from its inception also cite lack of internal control.

"Ken Lay says he never knew anything then or now. He was the head guy, but nothing ever happened on his shift," says Richard Perkins, ex-head of Chevron International trading group.

The trading case, which was settled in 1990 when two former senior Enron executives pleaded guilty to fraud charges, received scant attention at the time because Enron was a much smaller company. But it revealed loose controls that allowed Louis Borget, head of its oil contracts trading subsidiary, and Thomas Mastroeni, the unit's vice-president and treasurer, to operate a trading scheme that eventually cost Enron $142m in petroleum trade losses between October 1985 and October 1987.

Perhaps more troubling, in the light of recent events, is that no explanation to shareholders appeared in subsequent annual reports.

According to court documents of the time, the two men defrauded Enron by setting up four phoney offshore shell corporations to "arrange sham oil trading contracts" with Enron. They masked the unauthorised trading activity by keeping false financial records.

The two pleaded guilty to conspiracy to defraud Enron and to filing false tax returns, after the US Attorney charged that the 1985 consolidated tax return for Enron (then known as Internorth) "failed to report as 1985 income approximately $7.38m in gains". Mr Borget was sentenced to a year in prison while Mr Mastroeni was sentenced to two years' probation and 400 hours of community service. Enron also launched a civil lawsuit against them, which is understood to have been settled out of court.

"The oil traders scandal showed they didn't have the checks and balances system in place," says Thornton House, an Enron shareholder and ex-employee. But Mr Lay, who became chairman and chief executive in February 1986, told the Houston Chronicle last year in reference to the 1980s trading incident: "We learned a lot. . . . We put in place probably the best risk management and control system, not just in our business, but in any industry."

Many energy experts would disagree. According to Walter Zimmermann, vice-president of the energy brokerage United Energy: "Enron's actual track record over the years with regard to both trading incidents and new business development suggests a consistent difficulty managing their own risks."

Last month Enron filed the largest bankruptcy in US history and is now subject to several investigations surrounding its accounting and disclosure policies.

The debacle revolves around a number of off-balance-sheet partnerships - some based offshore - which were used to obscure debt exposure and allegedly cover losses at Enron's broadband entity. They had been set up by and headed by Andrew Fastow, the former chief financial officer.

Companies can use off-balance-sheet financing legitimately. However, Enron's aggressive use of partnerships was questionable because it failed to disclose the extent of its contingent liabilities.

Following Enron's acknowledgment of an inquiry by the Securities and Exchange Commission in October, Mr Lay sought to reassure investors, which included many employees. "There was a 'Chinese wall' between [partnership] LJM and Enron," he said.

By November 8, however, Mr Lay was forced to admit that several of these special purpose vehicles, which helped to shift debt from the balance sheet, should have been consolidated there.

Many industry peers see a pattern of delegation and poor subsequent monitoring of management emerging.

Jeff Reardon, former vice-president of trading operations at Phibro, a rival commodities trader, said: "The situation with Lou Borget should have made everybody nervous that something bad could happen.

"Ken Lay should know everything as chairman."