April 9, 2002

Enron's McMahon Is in Spotlight For Involvement in Merrill Deal

In recent congressional hearings, Enron Corp. President Jeffrey McMahon was touted as an executive-suite hero who early on questioned the propriety of the firm's controversial partnership arrangements. In one exchange on Capitol Hill in February, Sen. Olympia Snowe (R., Maine) said she wished there had been more Sherron Watkinses and Jeffrey McMahons at Enron "because it might have well prevented this catastrophic demise of one of the largest companies in America."

But there are a few things lawmakers didn't ask Mr. McMahon about -- and he didn't offer up.

Two years before Enron imploded, Mr. McMahon was involved in a sale of several Nigerian barges to brokerage firm Merrill Lynch & Co. that helped Enron artificially boost its profits and contributed to the company's misleading financial picture. And in the summer of 2000, Mr. McMahon attempted, unsuccessfully, to set up a separate partnership to package some slow-growing businesses off Enron's books.

No one is suggesting that Mr. McMahon enriched himself through these activities, the way some Enron executives did. Yet other Enron executives involved in controversial activities have left the energy firm. Mr. McMahon, 41 years old, not only remains at Enron; in January, he was named president and has been commended for questioning the conflicts of interest raised by the partnerships set up by former Enron Chief Financial Officer Andrew Fastow, in which Mr. Fastow had an ownership interest.

But, like other senior executives at Enron, Mr. McMahon, who was Enron's treasurer between 1998 and late March 2000, painted a much-rosier picture of the company's finances than turned out to be true. Last month, an official at a major Wall Street credit-rating concern testified that Mr. McMahon was among the Enron officials who purposely misled the firm. During a January 2000 presentation to Standard & Poor's, Mr. McMahon offered the "kitchen sink" -- but failed to mention controversial partnerships that hid millions of dollars of off-balance-sheet assets from investors, Ronald Barone, an S&P managing director, told Congress. Included in Mr. McMahon's David Letterman-style list of "top 10 reasons" to upgrade Enron's credit rating was: "Communication with analysts, investors and credit officers is direct and candid -- No Secrets Policy," according to documents submitted as part of S&P's testimony.

Mr. McMahon also attempted to refute "common misperceptions" about Enron. Among them, the documents show, was this: "Myth: There are massive amounts of debt that is not included in Enron's credit profile. Fact: The inclusion of all obligations (without adjustment for non-recourse) does not materially change the financial profile of Enron."

Mr. McMahon declined to comment for this article. Mark Palmer, an Enron spokesman, says "it is fantastic to believe that S&P's understanding of the company hinged on one presentation." He says Mr. McMahon's description of the company's debt load was an accurate representation of its obligations at the time and he notes that the "kitchen sink" analysis referred to an explanation, which S&P requested, of a footnote in the company's annual report: "They asked for this information and we put it together in a presentation and 2 1/2 years later they are claiming we didn't answer a question they didn't ask."

What could put the spotlight on Mr. McMahon even more is the Merrill transaction, and Mr. McMahon's role in it. The deal wasn't just another example of Enron hiding assets off the books. It also involved a verbal pledge by Enron, and Mr. McMahon, to arrange for the investment to be bought back, say people familiar with the situation. That raises the question of whether the deal was, in effect, a "sham" transaction simply to allow Enron to book an earnings gain.

"This looks like manufactured earnings,'' says John Coffee, a Columbia University law school professor. He says that the principal violation of securities laws, if any, would be by Enron, which is "fabricating a structure where they can call it a sale" and thereby book an earnings gain.

It all began in mid-December 1999, when Mr. McMahon approached Merrill with a curious request, say people familiar with the situation. Would Merrill invest in the three electricity-producing barges, to be anchored off the coast of Nigeria? Mr. McMahon asked.

It was Enron's plan, these people say Mr. McMahon said, to arrange for Merrill's $7 million investment to be bought back in the coming months. But Mr. McMahon said Merrill had to move quickly: Enron wanted to close the deal by year end so it could book an anticipated $12 million earnings gain from the deal, the people say. In December 1999, Enron created a special-purpose vehicle for the barges, contributing $21 million of debt to it and $7 million of equity from Merrill. The exact gain Enron booked from the deal is not known.

Merrill says it made the investment to please a major client. And, sure enough, an Enron partnership bought back the investment seven months later. Now the Securities and Exchange Commission and congressional investigators probing the Enron matter are examining the Nigerian barge deal to see if it was done simply to temporarily, and artificially, bulk up Enron's earnings, ultimately helping to conceal the Houston energy company's changing financial picture from investors.

Mr. McMahon's call to Merrill came after the Enron executive had pitched bankers at other securities firms without success. In one conversation with a Wall Street investment banker, Mr. McMahon stressed the urgency and assured the banker that "we'll make sure you'll get taken out" in the first half of 2000, suggesting Enron would buy back the investment, if necessary, according to a person who heard the pitch.

Mr. Palmer says Mr. McMahon's "involvement in the transaction was entirely legitimate. Jeff didn't promise nor does the documentation support that anybody would be guaranteed a rate of return." Mr. McMahon wouldn't comment.

The Nigerian deal, albeit small, came at a time when Enron appeared to be padding its profits with sales of assets to LJM1 and LJM2, two partnerships central to the company's downfall. "Near the end of the third and fourth quarters of 1999, Enron sold interests in seven assets to LJM1 and LJM2," according to a report by a special committee of Enron's board. The asset sales to LJM1 and LJM2 "were done quickly and permitted Enron to remove assets from its balance sheet and record a gain in some cases." The report quoted Mr. Fastow as saying in a presentation to the board's finance committee that the LJM transactions generated, directly, or indirectly, "earnings" to Enron of $229 million in the second half of 1999.

Mr. McMahon indicated to Merrill that Enron had been negotiating to sell the revenue streams thrown off by the barges to a third party. But a sale had been delayed because the buyer wouldn't sign on until Enron had reached a power-purchase accord with the Nigerian government, with which it was simultaneously negotiating, say people close to the matter.

Merrill now says it believed the deal was "appropriate" given what it knew about Enron at the time. It says it viewed the deal as providing bridge financing to accommodate a client with which it wanted to cultivate a relationship. The transaction was "carefully reviewed" and, in the end, a Merrill spokesman says: "We concluded that it was appropriate given what we knew about Enron at the time. We felt it was a real transaction with real risk consistent with Enron's core business." The Merrill spokesman says the deal was fully vetted by the firm's banking, credit and legal departments and was a small transaction immaterial to Merrill and Enron. Merrill also confirms that Mr. McMahon "made the formal request on this and was involved in it."

Mr. McMahon's overture to Merrill is documented in transaction notes Merrill recently handed over to the SEC. The notes say that "Jeff McMahon, EVP [executive vice president] and treasurer, has asked Merrill Lynch to purchase $7 million of equity in a special-purpose vehicle that will allow Enron to book $12 million of earnings." The notes also indicate that the proposed transaction has a maturity date of six months. By selling the barges to a special-purpose vehicle, Enron could book a gain on the asset, reflecting the difference between the value at which it was carried on its own books and the price at which it was sold to the special purpose vehicle, accountants explain. For arranging the deal, Merrill earned $250,000; when the investment was sold seven months later, Merrill received an additional $525,000.

In June 2000, after Mr. McMahon had left the treasurer's job, Enron executive Dan Boyle told Merrill it had found a buyer for its equity stake in the Nigerian barges -- Enron's own LJM2 partnership, say people familiar with the situation. On June 29, 2000, LJM2 bought the investment for $7.5 million, and, in September, LJM2 sold the investment for $8.2 million to power company AES Corp. and pocketed a $700,000 profit, LJM partnership documents show. Mr. Boyle declined to comment.

To be sure, other Enron officials were involved in the Nigerian deal. In another conversation with Merrill -- cited in interview transcripts done for an internal investigation conducted by a special committee of Enron's board -- a senior director of transaction support at Enron said he was told by Mr. Boyle that during the 1999 talks with Merrill, Mr. Boyle "participated in a phone call in which Andy Fastow gave Merrill Lynch a verbal assurance that he would make sure Merrill Lynch was relieved of its interest in Nigeria Barge by June 2000." Mr. Fastow, through a spokesman, declined to comment.

The Nigerian transaction also underscores the degree to which Wall Street firms helped Enron create its complex and misleading financial structure -- a topic that is likely to draw congressional scrutiny in months ahead. The House Energy and Commerce Committee sent letters last month to more than a dozen securities and credit-rating firms seeking records about Enron and its partnerships, and a Senate panel grilled Wall Street analysts who recommended Enron's stock last fall as the company headed toward a bankruptcy-court filing.

Since Enron's troubles have surfaced, Mr. McMahon has tried to distance himself from its problems, even though he was publicly bullish on the stock just months before the firm's collapse. For instance, Mr. McMahon painted a glowing picture of Enron on Sept. 20 and Oct. 18, 2001, during two visits to his alma mater, the University of Richmond. So bullish was Mr. McMahon that managers of a university student fund say they sank nearly $13,000 in Enron.

"He was going on and on about how undervalued the stock was that you would have never thought there was something wrong at the company," says Devin Weisleder, one of the 11 student managers of the $90,000 Student Managed Investment Fund, or Spiderfund, "value" portfolio. The fund lost nearly all its investment when Enron filed for bankruptcy-court protection in December. The fund sold the stock at 83 cents after buying 1100 shares at about $11.61 a share.

When Mr. McMahon was asked about his rosy portrait of Enron by the student newspaper, the Collegian, he said in an interview on Jan. 30, 2002, that he was "running an operating division at the time [of his first visit], responsible for paper and steel." Enron's Mr. Palmer said Mr. McMahon was responding to a question that assumed he was the finance chief at the time of the presentations. Mr. McMahon delivered a company-prepared and approved presentation, the accuracy of which he had no reason to doubt, Mr. Palmer said.

Still, Joe Ben Hoyle, Mr. McMahon's former accounting professor at the university, remains puzzled by his pupil's comments. "You'd think with a guy who is that high up in the company, if he tells you to buy the stock, the company won't go bankrupt," he says, adding that Mr. McMahon's bullish comments came "very late in the game."

Meantime, Mr. McMahon also had a hand in other Enron practices that now are being questioned. In the summer of 2000, he attempted to set up a partnership to move Enron's slow-growing pulp and paper business, among other things, off the books and develop them without reflecting the costs on Enron's consolidated income statement. The planned $1 billion partnership, Enron Net Works Partners, would pursue acquisitions in base metals, pulp and paper, lumber and steel industries, according to a confidential private-placement document from underwriter Chase H&Q, now a unit of J.P. Morgan Chase & Co. Mr. McMahon was slated to be president and chief operating officer of Net Works. (Net Works never got off the ground because Chase H&Q couldn't raise the money from investors for the partnership.)

Mr. Palmer says the company's strategy was to develop these businesses with outside capital. "You can question that corporate strategy but I don't see how you can question Jeff McMahon for carrying it out," says Mr. Palmer.

Still, "there is no legitimate reason" that the assets in Enron Net Works should be housed off balance sheet, says Edward Ketz, an accounting professor at Pennsylvania State University.

Responds Enron's Mr. Palmer: "If there is third party equity involved, and there is a true transfer of risk, it's entirely legitimate."

-- Robert Block and Michael Schroeder contributed to this article.

Write to Anita Raghavan at anita.raghavan@wsj.com³

Updated April 9, 2002 12:04 a.m. EDT