Business Week Online:A Hero--and a Smoking-Gun Letter

JANUARY 28, 2002

SPECIAL REPORT -- THE ENRON SCANDAL

A Hero--and a Smoking-Gun Letter

Watkins' memo spoke volumes about Enron's behavior. So did higher-ups' tepid response

At last, someone in the sordid Enron Corp. (ENE ) scandal seems to have done the right thing. Thanks to whistle-blower Sherron S. Watkins, a no-nonsense Enron vice-president, the scope and audacity of the accounting mess is becoming all too clear. Her blunt Aug. 15 letter to Enron CEO Kenneth L. Lay warns that the company might "implode in a wave of accounting scandals." And now that her worst fears have been realized, it is also clear that Watkins' letter went far beyond highlighting a few accounting problems in a handful of off-balance-sheet partnerships. Watkins' letter lays bare for all to see the underbelly of Enron's get-rich-quick culture.

Watkins, 42, a former Arthur Andersen accountant who remains Enron's vice-president for corporate development, put her finger on the rot: top execs who, at best, appeared to close their eyes to questionable accounting maneuvers; a leadership that had lost sight of ordinary investors and the basic principles of accounting; and watchdogs--the outside auditors and lawyers whose own involvement may have left them too conflicted to query the nature of the deals. Perhaps the question shouldn't be how Enron collapsed so quickly--but why it didn't implode sooner.

Lay's response to Watkins' complaints is nearly as damning as her letter itself. Yes, he talked to her for an hour. And, yes, he ordered an outside investigation. But contrary to Watkins' advice, he appointed the company's longtime Houston law firm, Vinson & Elkins, despite the obvious conflict: V&E had worked on some of the partnerships. And Enron and V&E agreed there would be no "second-guessing" of Andersen's accounting and no "detailed analysis" of each and every transaction, according to V&E's Oct. 15 report. The inquiry was to consider only if there was new factual information that warranted a broader investigation. V&E declined comment.

Surprise: V&E concluded that a widespread investigation wasn't warranted. It simply warned that there was a "serious risk of adverse publicity and litigation." And Watkins' letter reveals the inadequacy of Lay's response in the months following CEO Jeffrey K. Skilling's sudden Aug. 14 resignation for "personal reasons." His departure triggered the letter. Lay never fully disclosed the partnerships or explained their impact to investors, even as he vowed there were no accounting issues and "no other shoe to fall." Even after Enron revealed on Oct. 16 a $1.2 billion hit to shareholder equity related to the partnerships, Lay continued to express ignorance about details of these deals and support for Chief Financial Officer Andrew S. Fastow, who managed and had stakes in certain partnerships. But on Oct. 24, Fastow was removed from his job and promptly left the company.

Watkins, an eight-year Enron veteran, is not some disgruntled naysayer who is easy to dismiss. Her lawyer, Philip H. Hilder, says she became familiar with some of the partnership dealings when she worked in June and July in Fastow's finance group. Her position allowed her to review the valuation of certain assets being sold into the partnerships, and that's when she saw "computations that just didn't jibe," says Hilder.

Former executives say the Tomball (Tex.) native was tenacious and competent. "She wasn't really an alarmist," says one former Enron employee. Her mother, Shirley Klein Harrington, a former high school accounting teacher, calls her daughter "a very independent, outspoken, good Christian girl, who's going to stand up for principle whenever she can." Watkins had previously worked at Andersen in Houston and New York and then for Germany's Metallgesellschaft AG.

At those companies, she befriended Jeffrey McMahon, whom she helped recruit. Now the CFO at Enron, McMahon "complained mightily" about the Fastow partnerships to Skilling, Watkins told Lay in the letter. "Employees question our accounting propriety consistently and constantly," she claimed. McMahon didn't return calls. Skilling has denied getting any warnings about accounting.

Watkins didn't stop there. Five days after she wrote to Lay, Watkins took her concerns directly to an Andersen audit partner, according to congressional investigators. He in turn relayed her questions to senior Andersen management on the Enron account. It's not known what, if any, action they took.

Of course, Skilling and Andersen execs shouldn't have needed a letter and a phone call from Watkins to figure out something was seriously amiss. Red flags abounded. And Watkins, for one, had no trouble putting her finger on questionable accounting practices. She wondered if Enron was hiding losses in off-balance-sheet entities while booking large profits from the deals. At the same time, the outside partnerships were backed with Enron stock--a tactic sure to backfire when it was falling--and no outsiders seemed to have any capital at risk. Was Enron creating income essentially by doing deals with itself? "It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future," she wrote.

In the end, Watkins grasped one thing that Enron's too-clever-by-half dealmakers didn't: Enron's maneuvering didn't pass the smell test. Even if Enron and its high-priced auditors and lawyers can ultimately show that they followed the letter of the law, it matters little. As Watkins herself wrote, if Enron collapses, "the business world will consider the past successes as nothing but an elaborate accounting hoax." And that seems destined to become Enron's epitaph.

By Wendy Zellner, with Stephanie Forest Anderson, in Dallas and with Laura Cohn in Washington