THE ANONYMOUS LETTER’S TEXT WAS FINISHED. Sherron Watkins stared at the words and debated her course of action yet again. In front of her sat an unsigned letter and an envelope. The letter was addressed to Ken Lay, Enron’s chairman now returning as CEO. Unless Sherron came up with a better idea, her letter was headed for the mailbox where Enron collected employee feedback.

Watkins reread the draft (see Attachment 1), trying to gauge its likely impact. If her letter made it to Ken Lay, it should get his attention. Sherron was telling him in no uncertain terms that ruin was stalking Enron. During the last few months, working again in Andy Fastow’s Global Finance, she had come across what she termed the worst accounting fraud she’d ever seen. Bits and pieces of this story were starting to leak to the press. Sherron was convinced that if the full story ever got out, it could quickly lead to Enron’s demise.

Until today, August 15, 2001, Watkins had regarded this outcome as a matter of time. So long as Jeff Skilling was Enron’s CEO, she felt there was little chance that Enron would take the radical steps necessary to reconstitute its finances. Skilling had been the senior enabler of Enron’s aggressive accounting and Special Purpose Entity (SPE) deals. Andy Fastow was Skilling’s protégé. Watkins doubted that Skilling would openly repudiate Fastow or his self-dealing structures. So, she had resolved to leave Enron. Her resume was out circulating. Once she had a job, the plan was to hand Skilling a letter of protest on her way out the door.

Only Skilling had beaten her to the punch. In a stunning development, Skilling had just resigned as CEO only six months after assuming the post he had coveted for years.

Skilling’s departure changed Watkins’s calculus. Ken Lay was stepping back in as CEO. Watkins regarded Lay with mixed feelings. His most dynamic years were behind him. Lay was not a detail man, and as his staff commented, he “gravitates toward good news.”¹ Lay had also been present during all the developments of the past several years. He had signed off on Fastow’s deals. Still, it was clear that Lay felt responsible for Enron. He had led the firm for more than fifteen years and had seen it rise from obscurity to global prominence. His decision to return as CEO conveyed commitment. Lay would be motivated to save Enron. He also had not been the actual architect of recent business strategies. Conceivably, he might be able to change course and save the ship.

So Watkins had revised her plan, deciding to approach Lay with both a warning and a recovery proposal. Because she was unsure what to expect from Lay, the warning would be delivered anonymously. If Lay responded, she was prepared to come forward with specific fix-it suggestions. Lay had scheduled an all-employee meeting for August 16. A mailbox had been set up to receive employee questions. Watkins had tapped out her draft with the intention of dropping it in the box before the meeting.

Now that the letter was written, something approaching panic had seized her. She hadn’t slept well in days. Some of the anxiety involved the risks she would be taking. Sherron was both primary breadwinner in her family and mother of a young child. If she came forward or was otherwise identified and then was fired, she might well enter an employment netherworld, being both unemployed and “damaged goods.”

The rest of the panic involved the correctness of her course of action. Watkins was now plagued with doubts. These did not involve her assessment that Enron was in trouble. She was convinced the SPE accounting was fraudulent, that sooner or later it would come out, and that when it did the news could crush Enron’s fragile financial structure. Rather, her doubts centered on two other questions: (1) was she taking the information to the right audience? (2) Would her suggestions improve Enron’s chances to survive, or was she merely hastening its demise?

Watkins ripped through her options one more time. In addition to Ken Lay, she had the option to take her concerns to the Enron board; the Finance Committee, chaired by Herbert S. Winoker, would be the proper entry point. Alternatively, Watkins could take her disclosures outside the company.

One external road led to the SEC. Enron was a publicly listed company. The SEC had jurisdiction over public-company financial disclosure. Presumably, the SEC would be interested in fraudulent reporting by a company as prominent as Enron. This path could ultimately lead to a formal SEC investigation. Another road led to the media, especially the financial press. Fortune, The Wall Street Journal, and others were already circling Enron, sensing hidden issues and hungry for inside information. Watkins could feed them such information, could calibrate the pace and extent of disclosure, and could insist on anonymity.

Somehow, Sherron had to choose a course of action, knowing that by doing so, she herself would be accepting no small responsibility for Enron’s fate. She also had to choose a course that gave her a reasonable chance to survive professionally. Whistleblowers did not always enjoy a long professional life expectancy.

Welcome Back; Now Meet the Raptors

Sherron Watkins was no Enron newcomer. After working for Arthur Andersen (AA) and Metallgesellschaft AG, she joined Enron in 1993. Sherron’s initial assignment involved working for Andy Fastow. She worked for him for three years, managing the JEDI joint venture with CalPERS; in the process, Watkins became wary of both his deals and his approach to internal politics. Then, a good opportunity opened up. Enron International (EI) was expanding from greenfield pipeline and power plant development into the finance and acquisition arena. Sherron jumped at the chance to join this group and leave Fastow’s world. After closing a significant acquisition in 1998, Watkins was promoted to vice president.

By the start of 2000, Skilling was shutting down the international focus. EI’s employees were strongly encouraged to join one of two shiny new business ventures: Enron Energy Services and Enron Broadband Services (EBS). Watkins chose EBS. By 2001, circumstances had changed again. For one thing, EBS was imploding. Watkins had been told to look for another job elsewhere within Enron. For another, Watkins now had a young child. Suddenly being on the road and putting in deal hours didn’t work so well. So, Sherron went looking for a less taxing position. She needed to find something quickly if she had any hope for a decent placement in the annual employee rankings. Actually finding another slot that fit her personal situation proved difficult; with some reluctance, she accepted an offer from Fastow to return to his shop.

Watkins reported to Global Finance M&A in late June 2001. Her immediate assignment was to review a list of potential asset sales, prioritizing them for cash flow and earnings impacts. She quickly discovered that several assets on the list had been hedged with certain SPEs called “Raptors.”

The Raptors turned out to be a family of SPEs owned by LJM2, the investor partnership run by Andy Fastow. The Raptors had been conceived for the express purpose of hedging the value of certain merchant assets, which Enron defined as assets or operations that could be sold; consequently, they were treated as marketable commodities suitable for mark-to-market accounting. In several cases, this meant that Enron had already booked profits derived from supposed appreciating asset values. These profits were vulnerable to being reversed should the asset values later decline. In such a case, Enron would have to record mark-to-market losses. The Raptors had been conceived as a means to insulate Enron’s financial reports from such occurrences.

Upon closer inspection, the Raptors turned out to be exotic creatures. For one thing, they were operated by an Enron insider. CFO Andy Fastow acted as their general partner, operating under an express conflict-of-interest waiver granted by Enron’s board. For another, although the structure of a Raptor deal was mind-numbingly complex, what Watkins saw when she peered through the boxes and lines was a phony hedge. At bottom, Enron had capitalized the Raptors with Enron shares or rights to shares; these formed the principal, if not sole, basis by which a Raptor could make good on any hedge payments owed to Enron. Fundamentally, this meant that Enron was hedging with itself.

The Raptor 1 deal illustrated this point. Attachment 2 provides a schematic depiction and a description of this LJM transaction.

It didn’t take long for Watkins to realize the essence of what was happening. Sherron remembered her reaction as follows:

In completing my work, it became obvious that certain hedged losses incurred by the Raptors were actually coming back to Enron. The general explanation was that the Enron stock that had been used to capitalize the Raptor entities had declined in value such that the Raptors would have a shortfall and would be unable to pay back what they owed to Enron. When I asked about third-party money or outside equity at risk, I never heard reassuring answers; basically the answer was that it just wasn’t there. I was highly alarmed by this fact. My understanding as an accountant is that a company could never use its own stock to directly generate a gain or, as in Enron’s case, avoid a loss on its income statement. [emphasis added]²

By this point, four Raptor entities existed. Collectively they had lost over $700 million on the hedges provided to Enron. Specific assets on Watkins’ list, Avici, New Power, and Hanover Compressor, were responsible for hundreds of millions in Raptor losses. Avici alone was down 90 percent versus the value at which it had been hedged.

With Enron’s stock in decline, the Raptors could not cover these losses out of their capitalization. With its stock and credit rating already under pressure, Enron was reluctant to fix the Raptors by infusing even more stock. The alternative was to accept the credit impairment of the Raptors and recognize a loss in Enron’s reported P/L. Since Enron had been less than clear when reporting the nature and condition of the related-party SPEs, recognizing losses would provoke a firestorm of questions and demands for further disclosure. Enron had boxed itself in.

Watkins recalled her assessment of Enron’s predicament: “… it didn’t take me long to discover the flaw in the Raptor transactions. The Raptor deals expired sometime in 2003 and 2004. It was like staring at a time bomb. When I discovered the problems with the Raptors, my first reaction was to leave Enron as fast as I could. This was some of the worst accounting fraud I had ever seen.”³

Skilling, however, had beaten Sherron Watkins out the door. Skilling left on August 14, 2001, citing “personal reasons.” Enron’s board asked Ken Lay to step back in as CEO, and he agreed.

Pondering an Approach to Ken Lay

Watkins recalled her first reaction to the news of Skilling’s departure: Enron’s condition must be even worse than she had thought. At first, she couldn’t make sense out of why Skilling would surrender the job he had fought for many years to obtain. Personal reasons didn’t cut it as a justification. No, Skilling must have decided that Enron was in deep trouble. As Watkins had written in her draft letter: “Skilling looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in two years.”⁴ (See Attachment 1.)

She had also concluded that Ken Lay didn’t fully appreciate what he was facing and that she had to warn him. Thus, she had almost decided to send Lay a warning letter now, rather than passing him a protest note later.

Watkins pondered for a moment what she hoped her letter might accomplish. Taking stock, she found that she hoped Lay would launch a thorough investigation of the related-party transactions. She also expected that Lay would establish a crisis management team to address the dangers Enron would face should its accounting liberties be exposed, which Watkins believed would happen sooner or later.

Watkins knew that the company was more vulnerable than was commonly understood. Enron’s core trading business was hugely dependent on having an investment-grade credit rating. Watkins saw the company’s Baa rating as endangered. Enron had many skeletons in its closet. The company owed far more in financial obligations than it reported, and many of its new businesses were failing miserably. (See Attachment 3 for a summary of business-line issues.) It wouldn’t take much to puncture the aura of invincibility that sustained the markets’ willingness to feed Enron’s appetite for capital. Once investors discovered that their cash was going down drains, financing would dry up, the company’s debt rating would be downgraded to junk, trading would be impacted, and Enron’s stock price would tank. This would trigger a need to recapitalize shaky SPEs with new Enron stock. Credit rating and stock price would decline further. The company could face a death spiral.

This was the deadly scenario that lay behind Watkins’ warning that the company could “implode in a wave of accounting scandals.”

Clearly, Enron needed time to get on top of problems and reverse questionable deals. That argued for working inside the company. Once warned, however, would Ken Lay take necessary corrective measures? Watkins had her doubts. What was Ken Lay capable of doing at this moment? Watkins determined that three questions held the answer to the CEO’s probable course of action:

1. How much did Ken Lay know about Enron’s perilous condition? Did he understand that much of the accounting was fraudulent and that the financial structure was fragile?
2. Was Lay coming back with a repair plan or just filling an unexpected opening? What first moves would he make, indicative of what new direction?
3. Who would Lay rely on for advice? In the past, he had relied upon strong number twos: Rich Kinder and then Skilling. Who would play that role now and to what effect?

Attachment 4 outlines Lay’s leading internal choices to replace Skilling.

As she pondered these questions, Watkins considered her other options. Foremost among these was going straight to Enron’s board. Watkins reflected that the possibilities there were intriguing:

1. The board likely had not been given full disclosure regarding the questionable related-party transactions. Giving the board new information would invite it to demand both full disclosure and corrective measures.
2. Second, the board had the power to force a change of course. By doing so, it could take the matter of defending the past out of management’s hands; this would remove a major barrier to needed reforms.
3. Perhaps most important, the board could, if necessary, change Enron’s management. At a minimum, the board could ensure that Ken Lay selected a team dedicated to confronting Enron’s problems; this would be critical given the complicity of various Enron executives in questionable deals.

But would Watkins’ letter ever reach the board and if so would it act? These same directors had approved Fastow’s conflict-of-interest waiver and every major related-party transaction from Whitewing and Chewco to the LJM deals. Was the board not just as complicit as Skilling and Fastow?

Bypassing management to go directly to the board would also turn Watkins into an internal whistleblower. By this, Watkins meant someone who regards the established management to be so compromised that warnings must be delivered outside of normal channels. Watkins knew what attaining whistleblower status meant: “What you hear about all the whistleblower stereotypes is true. You really get treated like a pariah … given no responsibilities, nothing to do … [until you’ve] seen the handwriting on the wall and found another job.”⁵

At this time, neither federal nor Texas law afforded protection to private-sector whistleblowers. Watkins could be fired by Enron and would have no cause for action for wrongful dismissal. However, the full legal context was somewhat more complicated. Attachment 5 provides a more detailed description of the legal framework surrounding whistleblowers in 2001.

Watkins certainly felt at risk of being fired for taking her disclosures outside the company. Going to the SEC would run precisely this risk. Enron would do everything in its power to discredit her. The company would point to the board’s review of each transaction, its approval of Fastow’s conflict-of-interest waiver, and the safeguards initiated to monitor these arrangements. Arthur Andersen’s signoff of every deal and Enron’s footnotes in its public filings would be cited as proof of the accounting’s probity. Enron would circle the wagons, declare that no accounting rules had been broken, and label Sherron Watkins as simply a disgruntled employee. None of this would make it easy for Watkins to find new employment. It would take outside investigators years to get to the bottom of any allegations, by which time Watkins’ career could be in shambles.

That did leave the option of disclosing information anonymously to the financial press. Several reporters were on the scent of Enron’s accounting problems. In March 2001, Bethany McLean had published an article, “Is Enron Overpriced” in Fortune magazine. McLean and her colleague Peter Elkind continued to follow the Enron accounting story, paying particular attention to the related-party transactions. The Wall Street Journal was also showing more interest in Enron’s story. WSJ’s recent articles were increasingly asserting that all was not what it seemed at Enron.

However, Watkins knew that leaking information posed serious risks. If Enron discovered or even guessed that she was doing the leaking, Watkins could be gone in a heartbeat; who then would hire an obviously untrustworthy employee? From a company-oriented perspective, what would leaking information accomplish? Possibly, it might force Enron’s management and board to get serious about corrective measures. Lenders and rating agencies might demand more information and then proper action. On the other hand, leaking involved partial disclosure and possible misinterpretation. The markets might overreact, dumping Enron’s stock and refusing to roll over its commercial paper. Watkins might precipitate the very death spiral she was seeking to avoid.

A Decision to Go Forward

The draft letter still lay on the desk. What should Watkins do with it?

Watkins reflected that the answer to this question might depend upon defining what she was trying to achieve. Was her priority to:

• End abusive practices;
• Save Enron from financial melt-down; or
• Ensure that the integrity of the broader financial markets was protected and Enron punished for wrongdoing?

Ideally, Watkins wanted to see all these goals achieved. Practically, she knew that her course of action might have to target one at some expense to the others.

There also was the question of tactically managing whatever path she chose. Could Watkins make her allegations stick when they were challenged? Which allegation and what support would she use to overcome the veil of propriety that Enron had draped over its finances? Who would stand with her when the corrupted elements within Enron closed ranks and fired back?

Within a couple of days, Ken Lay would start appointing new leadership and charting Enron’s path forward. Should she send her letter to Lay or choose another route? Now was the moment of choice if Sherron Watkins wanted to influence those decisions.

Attachment 2

Raptor 1 Transaction

The transaction schematic provided below shows a simplified version of the deal. The rest of the attachment describes the transaction in more detail.

Initial Capitalization

Fastow’s vehicle, LJM2, initially injected some cash into an SPE called Talon (the Raptor vehicle in this case). Enron formed its own entity, called Harrier. Enron capitalized Harrier with its common stock and contracts to deliver stock. Harrier then used these in an exchange transaction with Talon: An exchange of promissory notes between Talon and Harrier allowed Enron to report “operating cash generation” for accounting purposes (Talon’s was far bigger). Harrier also contributed the stock and stock contracts to Talon, balancing the exchange. These arrangements effectively completed Talon’s capitalization.

Hedge Instruments

Talon then wrote a “share settled put” in favor of Enron. This derivative gave Enron the right to “put” designated merchant assets to Talon at a specified value, one set to protect Enron’s accounting values for the assets. The structure worked in the sense that if the merchant assets’ value declined, the value of Enron’s put from Talon should increase by a similar amount. Thus, Enron’s accounting results would be hedged. Talon’s ability to pay Enron cash for the value of the put would in the final analysis depend upon its ability to liquidate Enron stock.

Cash Distributions/Investors’ Net Position

As a last piece of the puzzle, Enron paid Talon $41 million cash as the premium for the purchase of another “put” option, this one on Enron’s stock. This cash inflow allowed Talon to make a distribution to LJM of fees and profits; in reality, this distribution amounted to a complete return of LJM’s invested capital in Talon plus an $11 million profit. Fastow and his investor group thus had no net funds left at risk in the deal.

Raptor 1 Transaction–Schematic

Source: Powers Committee Report

Author’s Note

Like Jordan Mintz and Vince Kaminski, Sherron Watkins finds herself deliberating tactics for resisting activities she considers dangerous to Enron’s well-being. Like her two colleagues, Watkins must also decide among internal options within a management structure she now regards as corrupted; alternatively, she can take her concerns over the heads of management or to outside agents/authorities.

However, Watkins’ case also exhibits real differences. For one thing, Watkins has concluded that Enron’s accounting IS fraudulent. This raises the stakes in terms of her choice to work within the company, go to the Audit Committee or turn to the SEC. Second, Watkins is a CPA, not a lawyer. Expectations and even the law apply differently to accountants versus attorneys. Third, Watkins has ideas about an alternative business plan. If she gets a reasonable reception to her anonymous letter, she is prepared to weigh in with specific recommendations. Finally, Watkins has almost decided to put accusations of fraud in writing and communicate them at the highest level. This, she realizes, will invoke for her the unique status of whistleblower. Such status could have important career consequences for this family breadwinner and recent mother; in 2001, it also had a certain legal status.

This case thus serves as something of a capstone exercise. Students will need to deliberate whether they agree with Watkins’ severe judgment of Enron’s accounting. From there, a tactical course of action must be developed. Depending on one’s perception of the seriousness of Enron’s offense, this tactical plan must anticipate the potential to damage Enron. It must anticipate the possibility of intense, defensive reactions from individual executives and/or Enron as a whole. Finally, it should consider what alternative business plan to offer and when/how to offer it up: all in the hope that such recommendations may mitigate the various risks, including those to one’s personal career.

The facts of this case are drawn from Sherron Watkins’ account in Power Failure, the Inside Story of the Collapse of Enron, by Mimi Swartz with Sherron Watkins. These facts are confirmed and supplemented by the accounts in The Smartest Guys in the Room and Conspiracy of Fools. Insight into Sherron Watkins’ motives and state of mind is found in her article “Ethical Conflicts and Enron: Moral Responsibility in Corporate Capitalism,” published in the California Management Review (2003). This article documents Watkins’ initial reaction to the Raptor vehicles and includes her thinking on why she went to Ken Lay and what she’d do differently in retrospect. Watkins’ direct quotes are drawn from this article.

Attachment 1 reflects the text of Watkins’ final letter as provided in Appendix A of Power Failure. The schematic in Attachment 2 is as provided in the Powers Committee Report (p. 101). Attachment 3’s annual and quarterly financial results are as presented in Enron’s SEC reports as filed on April 2, May 15, and August 14, 2001, respectively. The discussion of distressed business-line results and Enron’s cash flow/indebtedness at the end of Attachment 3 reflects the account given in Conspiracy of Fools. According to this source, CFO Fastow provided the $34 billion debt figure to both COO Greg Whalley and to the Enron board during 3Q ‘01. The impairments indicated for EBS and Azurix reflect amounts incorporated into Enron’s 3Q net worth reduction, announced in October 2001.

There is no evidence from the extensive record on Sherron Watkins that she deliberated courses of action other than submitting her letter to Ken Lay. Her article in the California Management Review mentions that in retrospect, she wishes she had taken her issues directly to the Enron board. This case is written from the perspective of “what if” Watkins had systematically considered her options. Reports of Watkins feeling anxiety about going to Ken Lay, the reactions of colleagues, and about the consequences of her actions for Enron are historically grounded. In personal conversations with the author, Watkins reported that she felt a sense of urgency because of concern that Lay might appoint either Causey or Fastow to replace Skilling.

The discussion of Sherron Watkins’ legal situation as a whistleblower is based upon Leslie Griffin’s article “Whistleblowing in the Business World,” published in Enron, Corporate Fiascos and Their Implications, edited by Nancy B. Rapoport and Bala G. Dharan. Griffin discusses Texas statute and case law, as well as the various definitions of “whistleblower.” She also quotes from Vinson & Elkins attorney Carl Jordan’s e-mail discussing Enron’s legal situation regarding Sherron Watkins. The quote from a “legal analysis” prepared during the events of this case is drawn from this source.

There is no indication from the historical record that Watkins was aware of her legal situation when writing her anonymous letter. Material on whistleblowers’ legal status circa 2001 is included in recognition of the fact that legal protection for whistleblowers would be an important consideration for anyone debating whether to work an ethics issue internally or take concerns to external authorities.

Reportedly, Watkins was shocked to discover that Enron had explored the legalities of firing her. Watkins’ quote on whistleblowers’ status is drawn from her California Management Review article.

Subsequent to this episode, Congress passed the Sarbanes-Oxley Act of 2002. This law offers unprecedented protection for whistleblowers, described by Leslie Griffin as follows in her article:

“It expands both criminal sanctions and civil liability against retaliating employers, including any companies that file reports under the Securities and Exchange Act. The statute’s reach is broad. ‘Unlike most other federal statutes that protect employees … the Sarbanes-Oxley Act holds individual executives, agents and supervisors personally liable for unlawful retaliation, and it makes retaliation a felony offense under federal criminal law.”⁷

Griffin goes on to quote Houston labor and employment lawyers Laurence Stuart, who observed: “We call this the ‘Sherron Watkins provision’” (emphasis added).