DECEMBER 23, 2002


What About Enron's Lawyers?
Its auditors and bankers have been under the spotlight. Now, BusinessWeek reveals the attorneys' role

These are not happy days for Enron Corp.'s hired hands. The company's auditor, Arthur Andersen LLP, has been driven out of business. Its bankers, including Citigroup (C ) and J.P. Morgan Chase & Co. (JPM ), have been pilloried repeatedly, most recently in the Senate on Dec. 11.

But one group of professionals has so far escaped the inquisition: the energy giant's lawyers. They have been accused of no crimes, have paid no big fines, and are taking a hard line against critics. "There's nothing that I'm aware of that we would change," Joseph C. Dilg, managing partner of the Houston-based law firm Vinson & Elkins, told the House Energy & Commerce Committee in March. "We never saw anything at Enron that we considered illegal."

Are the lawyers as innocent as they claim? V&E and Enron's other outside law firms have taken far less heat than the company's accountants and bankers, but they played an equally important role in concocting the controversial transactions that allegedly concealed the company's true performance. Indeed, there's no way Enron's left hand could have sold so many assets to its right hand without creative input from both inside and outside counsel.

So far, this piece of the Enron drama has gone largely untold. But using recently released documents, as well as interviews with corporate insiders, BusinessWeek has assembled the most detailed picture yet of how attorneys assisted Enron's financial engineers. The lawyers not only drafted the documents that brought the company's deals to life but also wrote opinion letters that vouched for the legality of the company's acrobatic maneuvers--a little-understood piece of the puzzle that had to be completed before some of the deals could go ahead. By writing those opinion letters, attorneys blessed several transactions now being attacked as deceptive. "It takes a lot of little pieces of paper for an Enron to happen--and lawyers wrote a lot of those little pieces of paper," says Susan Koniak, a professor of legal ethics at Boston University School of Law, who is writing an analysis of the company's lawyers.

Enron is far from the only case in which lawyers helped executives accused of ripping off shareholders. But while accountants will be answering to a new independent oversight board and investment banks are facing the involuntary restructuring of their research units, lawyers are looking at only some modest new regulations that the Securities & Exchange Commission is scheduled to implement in January. Many experts question whether the proposed reforms go far enough. "It is still part of the mythology of the profession that lawyers serve as brakes on bad conduct," says New York University School of Law legal ethics expert Stephen Gillers. "What we've seen in the past 20 years is that client pressures have turned them into more of a gas pedal."

Enron's attorneys insist that they violated none of their legal, ethical, or moral obligations. Whether they worked inside or outside the company, they all mount the same defenses: that the deals they worked on were legal, they had nothing to do with the company's accounting, and they didn't have enough facts to grasp the big picture at Enron. "If you are working on a deal, you don't always see the rest of the elephant," says V&E partner Harry M. Reasoner.

Ignorance may yet prove to be a legitimate excuse for many of Enron's lawyers, if only because, in its heyday, the company handed work to more than 100 firms and employed 250 in-house attorneys. The vast majority got nowhere near the deals Enron allegedly used to conceal its bad investments.

In fact BusinessWeek has learned that a fairly small group of lawyers handled the most controversial transactions at Enron. In-house, the key players were a few attorneys assigned to Enron Global Finance (EGF)--a legal team created to assist former Chief Financial Officer Andrew S. Fastow. The aggressive CFO seemed to think of EGF's top lawyer as "[his] attorney, rather than Enron's attorney," according to a summary of an interview with associate general counsel Rex R. Rogers conducted by the special investigative committee of Enron's board of directors. Fastow declined comment through his attorney, and Rogers did not return BusinessWeek's phone calls.

Fastow rewarded favorite lawyers with juicy carrots. Former EGF general counsel Kristina Mordaunt invested $5,800 in Fastow's LJM1 partnership and saw a return of more than $1 million within months. Mordaunt's attorney did not respond to BusinessWeek's calls. Lawyers Fastow disliked were clubbed with big sticks. According to several sources, he fired Mordaunt's successor, Scott M. Sefton, and attempted to sack EGF staff lawyer Joel N. Ephross because both resisted his direction. "Andy clearly surrounded himself with people he thought would be loyal to him and whom he could influence or pressure," says a high-ranking exec who participated in many of the deals. Sefton and Ephross declined to comment.

The outside firms that handled "the vast majority" of Enron's controversial off-balance-sheet transactions were V&E and Houston-based Andrews & Kurth (A&K), says a former Enron staff lawyer. They were frequently seated across the table from Kirkland & Ellis (K&E), a Chicago-based outfit that often represented the "independent" special-purpose entities (SPEs) that bought Enron's assets. "Most of the heavy lifting was done by outside firms," says an Enron insider.

Andrews & Kurth declined to comment in detail on its work for Enron because of attorney-client privilege. "We know all our work for Enron was of the highest caliber and consistent with all of our professional obligations," said managing partner Howard Ayers. "We have just concluded this is something we cannot talk about." K&E says it billed less than $1 million on Enron transactions. "It is important to look at our firm's role," says K&E partner Laurence A. Urgenson. "We were not responsible for any of Enron's accounting judgments or any of its disclosure judgments."

The main tools Enron allegedly used to manipulate its balance sheet were structured-finance deals--Rube Goldberg-like transactions cooked up by cross-disciplinary teams of lawyers, accountants, and investment bankers. The goal of these schemes, which are legitimately used by hundreds of companies, is usually to lower borrowing costs. This is done, in simple terms, by transferring a reliable income-producing asset, such as rents, movie receipts or franchise fees, into a separate special-purpose entity (SPE). Because the SPE is liberated from the parent's credit risks, which might include everything from high debt to litigation exposure, it can borrow money at lower rates.

At Enron, these transactions were twisted to serve a novel goal, according to many public and private investigators who have scrutinized the company. The energy giant was less interested in borrowing money at low rates than it was in transferring underperforming investments to SPEs--and thereby reaping the rewards of accounting rules that allowed these assets to be turned into cash and income without adding debt to Enron's balance sheet.

That, in turn, changed everything else about the deals. For one thing, the banks that put money into the SPE, thereby giving the entities their legal independence from Enron, did not look to the income stream generated from the SPEs' assets for repayment. Instead, they allegedly counted on guarantees known as "total-return swaps," which were backed by Enron or one of its subsidiaries. The swaps generally provided that the energy giant would make all of the loan payments owed by the SPE to the banks--meaning that Enron was essentially buying assets from itself.

For corporate lawyers, structured finance is big-game hunting. Fees for handling the deals typically run up to $175,000--more than triple what the accountants earn. Attorneys first construct the SPE--an independent company, partnership, or trust with its own managers and complex operating rules. Then they'll often build layers of corporate shells around it and execute a series of complex transactions among the various entities.

By definition, the attorneys have to know the terms of the deal inside out. Structured finance experts and Enron insiders say that it might be possible for a law firm to be called in to handle one transaction and still be in the dark about its broader business rationale but that this becomes less plausible the more deals a firm handles. "V&E saw a lot of these structured deals and they had to be smart enough to connect the dots," says one top executive at Enron. "V&E got nervous over time and started to push back. At the end of the game, V&E's role and share [of Enron legal work] was diminishing."

By far, the most sensitive task assigned to the attorneys was the writing of legal opinion letters. These are official memorandums expressing their view that a deal complies with particular facets of the law. Because opinion letters can be a source of liability, partners take them seriously. Before one gets issued, the firm completes a due diligence investigation, and a special partner committee generally has to approve the letter. Much like audited financial statements, they are signed by the firm rather than an individual partner--and are written to make all parties comfortable with the deal.

For instance, accountants rely on opinion letters when they are reviewing structured-finance deals involving common stock or other types of financial assets--which were quite popular at Enron. Under Financial Accounting Standard 140 (and its predecessor FAS 125), auditors can approve off-balance-sheet treatment for these transactions only if they get two opinion letters. Both are intended to assure SPE investors that the assets they are counting on to provide income will not be snatched away in the event that the sponsor of the deal--in this case, Enron--goes bankrupt. The first is known as a "true-sale" opinion, and the second is called a "nonconsolidation" opinion.

In November, 2001, Enron disclosed that FAS 140/125 transactions accounted for about $2.087 billion in previously hidden debt. About 98% of these deals were handled by V&E and A&K, according to an interview in-house attorney Ephross conducted with the board's special investigative committee. These firms have attempted to minimize their role in the Enron debacle, but the fact is that many of Enron's twenty-odd FAS 140/125 transactions wouldn't have happened if lawyers had withheld true-sale and nonconsolidation opinions.

For the outside lawyers and Arthur Andersen, the opinion letters appear to have been a source of anxiety. The problem was the total-return swaps. They ran the risk of making the deals seem less like legitimate sales to an SPE and more like loans channeled from a bank through an SPE back to Enron (diagram). So the lawyers met with Arthur Andersen to discuss what the opinion letters should say. "V&E attorneys met withAndersen auditors to ensure that V&E opinions would satisfy changing accounting standards involved in FAS 125 and 140," said a summary of the Ephross interview with the special committee.

When law firms have doubts about the legality of a particular transaction, they typically deal with it by writing hedged opinions. But that angers the accountants, who are required under FAS to obtain letters that meet certain minimum standards. As a result, there was frequently a tug of war about what the FAS 140/125 letters would say.

"The law firm might say to the deal team, `Listen, under these circumstances, we cannot deliver a true-sale opinion. In order for us to deliver one, we need X, Y, and Z to happen,"' recalls an in-house attorney at Enron. "The accountants then look at what results from the legal changes and they say, `Under those circumstances, we can't reach the accounting result we would like to reach."' The source says the two sides would go back and forth in a collaborative process driven by "what the commercial team wanted at the end of the day--for example, to take an asset off the balance sheet."

Both sides occasionally drew lines in the sand. "Andersen read some of the early letters Enron obtained in the Hawaii monetizations [a series of FAS 140 deals conducted in 2000 and 2001], was not comfortable with them, and asked Enron to obtain new ones," says the summary of an interview that the special committee conducted with Clint Walden, a high-ranking member of Enron's accounting team. Walden declined to comment.

Despite V&E's close relationship with Enron, it chose not to write opinions for some of the FAS 140/125 deals, according to both V&E partner Reasoner and Enron attorneys. In those instances, sources say, the company was able to get the letters from A&K instead. According to the summary of the special committee's interview with Ephross, Enron lawyers believed that "it would be easier to get an opinion from A&K than V&E because A&K would raise less issues than V&E." He also said V&E was concerned that its opinion letters "were being improperly relied upon by Andersen." A&K's Ayers says it is "not aware of receiving any assignment from Enron that another law firm had declined."

Oddly enough, the players who seemed least interested in the opinion letters were those they were meant to benefit: the banks funding the SPEs. According to a report issued by Neal Batson, the examiner appointed by federal bankruptcy court to review Enron's dealings, "Enron employees indicated that typically, these legal isolation opinions were more a matter of importance to Enron and to Andersen but were generally not a condition to closing the financing" with the banks. Because they had the reassurance of the total return swaps, the banks felt secure. To Boston University legal ethics expert Koniak, that should have raised a big red flag. V&E and A&K "had to have a bag over their head not to see that there was something fishy going on here," says Koniak. "The fact the buyer did not want a true-sale opinion is not some subtlety. It is a blatant sign of possible fraud."

So just how vulnerable are the lawyers to liability? It's not clear. Like all professionals, lawyers face multiple layers of regulation--by their state bar associations, private lawsuits, and the federal government. So far, there's no hint of action on the self-regulatory front, though it's possible unannounced investigations may be underway.

Some attorneys have been named in private securities-fraud suits, however. Class-action lawyers have named both V&E and Kirkland & Ellis as defendants in the Enron case and are considering adding A&K and perhaps other firms to the list. But to squeeze any money out of corporate attorneys, tort lawyers are going to have to clear unusually high hurdles. In 1994, the U.S. Supreme Court held that outside professionals cannot be held accountable for "aiding and abetting" executives who commit fraud. Instead, they can be attacked only if they're deemed to be primary wrongdoers--a tough standard.

A bigger threat to Enron's attorneys is likely to be malpractice suits. The bankruptcy trustee, acting on behalf of the corporation, has the power to sue V&E and A&K for failing to steer the energy giant away from its disastrous deals. Bankruptcy Examiner Batson may have laid the groundwork in his interim report in October when he wrote that several of the SPE transactions "appear to be, from both an economic and risk-allocation standpoint, a loan rather than a sale of an asset." But a malpractice suit, given all the complexities, wouldn't be a slam dunk. The Enron bankruptcy "far exceeds any other case in history in professional fees," says a lawyer involved with the matter. "Someone is going to have to analyze whether it will be worth it to sue [the attorneys]."

All of this leaves a bit of a regulatory vacuum. That's one reason Congress gave lawyers new whistleblower responsibilities in the Sarbanes-Oxley law--which is now being fleshed out and implemented by the SEC. The act requires attorneys who come across evidence of misconduct by a public company to report it "up the ladder" to top management, such as the general counsel or CEO. If there's no response, the lawyer must alert the board.

Sounds good in theory. But the Enron tale shows how unworkable it might prove in practice. Some Enron attorneys did speak up, but their worries were almost always dismissed. In September, 2000, in-houser Stuart R. Zisman wrote a memo in which he warned that one of the SPE deals ran a high risk of being seen as balance-sheet manipulation. Close review of the transaction, Zisman wrote, "might lead one to believe that the financial books at Enron are being manipulated in order to eliminate the drag on earnings that would otherwise occur."

When he showed it to his supervisor, Mark E. Haedicke, he was told that "he had used unnecessary inflammatory language and editorialized too much in the memo," according to a summary of the interview Zisman gave the special investigative committee. Haedicke declined to respond to BusinessWeek's request for comment. At this point, the new law would have compelled Zisman to take the matter to general counsel James Derrick or CEO Kenneth L. Lay. But it is difficult to imagine that many attorneys, after being shut down by their boss, would then bring their complaints to the top brass. And even if Zisman had done so, would anything have been different? Probably not, considering all of the other warning signs Enron's executive suite overlooked.

The SEC is considering dealing with this problem by requiring lawyers who can't get the board to take them seriously to contact the agency itself. But the American Bar Assn. and other professional organizations are fighting this provision tooth and nail. They argue that it will make clients less likely to trust their lawyers. Perhaps so. But given what happened at Enron, that may be a fair price to pay for restoring the public's faith in the profession.

By Mike France