Enron Corp. created a series of intricate tax-reduction transactions that boosted its reported profits by nearly $1 billion between 1995 and last year, significantly exaggerating the size and strength of its operations, according to internal company documents obtained from the company's former top tax executive.
In 2000 alone, $296 million, or 30 percent of the profit that Enron recorded in its annual report to shareholders, came from these one-time tax-saving strategies -- rather than the company's energy supply and trading businesses, former Enron managing director and general tax counsel Robert J. Hermann told The Washington Post.
Hermann's disclosures reveal a second strategy that Enron's top executives employed to make the company appear more profitable and maintain its image as one of the nation's most successful firms. A previous investigation ordered by Enron's board of directors found that the company used accounting maneuvers involving off-balance-sheet partnerships created by former chief financial officer Andrew S. Fastow to overstate profits by nearly $1 billion since 1997.
To produce tax savings, Enron worked with prominent law firms and banks to transfer loans, securities and company assets between subsidiaries and specially created partnerships and entities, some of them offshore. Each dollar of tax savings was counted as a dollar of after-tax profit.
In interviews, Hermann defended his department's deals as legal and said they were carefully engineered to meet Internal Revenue Service regulations. But Enron's tax strategies are coming under scrutiny by congressional committees investigating whether Enron's top executives violated securities law by deceiving investors about the company's financial strength. Enron also is facing federal investigations into possible securities fraud.
The FBI searched Enron's tax offices in January and confiscated shredding machines after Enron notified the government that one of its tax executives had shredded documents and been fired, Hermann said. Hermann, who was discharged himself last week as part of Enron's corporate reorganization, has not been interviewed by the FBI but agreed to extensive interviews with The Post and provided documents after being contacted by a reporter.
Hermann said he grew increasingly uneasy in recent years as more and more of the company's reported profits came from one-time tax transactions rather than business operations. Enron's tax unit, like other departments within Enron, was under intense pressure to produce reportable earnings, in his case by reducing the company's tax costs, Hermann said. The gap between what he and fellow managers thought they could reasonably deliver and the profit targets top executives demanded was known inside Enron as "the stretch."
"It got to the point I was being asked to come up with a larger and larger number," Hermann said, adding that last year he finally protested to his boss, Chief Accounting Officer Richard A. Causey.
"When the number got up to $300 million [last year] I said, 'Rick, this is going to have to stop,' " Hermann said. " 'We have to come up with a way to get this through earnings -- through regular business.' "
Former Enron chief executive Jeffrey K. Skilling approved the tax transactions in small meetings he attended with Causey, Hermann and another company tax executive, Hermann said. Skilling wanted to know, "What are the risks? What can go wrong? What happens if it does?" Hermann recalled. "You had to get the sound bite right. He didn't care about the technical stuff."
Skilling testified before Congress that Enron was financially strong when he left the company in August. He said under oath that he was unaware of the details of Fastow's deals. He was not asked about tax transactions.
Attorneys for Causey and Skilling did not return phone calls seeking comment yesterday.
The tax deals are complicating the work of lawyers attempting to pin down how much value is left in Enron after its Dec. 2 bankruptcy filing, according to Hermann and documents he provided.
About 20 percent of Enron's assets, including its gleaming, 50-story Houston headquarters tower, were entangled in the tax deals as of late 2001, according to an analysis by Hermann's staff. Enron pledged pipelines and aircraft as loan collateral in some of the deals. Lawyers for the company and its creditors are now left trying to sort out which assets Enron still owns and which may be claimed by outside participants in the tax transactions.
"Enron is focusing on these tax issues and their impact at the present time," said the company's attorney, Robert Bennett. He added that "we are fully cooperating with congressional tax committees," which are reviewing tax information supplied by Enron.
Creative Tax Structures Hermann, 58, was a longtime Enron executive. In 1981, he became director of tax for Houston Natural Gas, one of the companies that combined to form Enron in 1985. Hermann has headed Enron's tax department since then.
At Enron, as at many other major corporations, the tax department was expected to contribute to the bottom line, Hermann said. "They knew if they needed it, I could give them $20 million or $30 million through the tax provisions to round things out," Hermann said.
In 1995, Hermann's tax group engineered its first structured transaction, called Tanya, which generated a $66 million profit gain. In this case, Enron created a new unit, run by several Enron officials, and gave it responsibility for managing Enron deferred compensation and post-retirement benefit programs. The new unit issued preferred stock and transferred the stock to Enron, which then sold the stock back to the officers at a loss, creating the tax deduction. The officers ultimately delivered the stock back to Enron, according to Enron's records. The IRS reviewed the deal and declined to challenge it, Enron tax department documents show.
Enron created a special "structured transactions group" within its tax department, which grew to about 20 employees, Hermann said. The group was headed by Vice President R. Davis Maxey, who is a lawyer and accountant, Hermann said. It was Maxey's job to prospect for new tax-saving strategies, and he constantly made the rounds of high-priced specialists in banks and law firms in search of ideas and possible partners, Hermann said.
The tax deals, 11 since 1995, carried code names such as Tomas, Teresa and Tammy -- named for hurricanes beginning with the letter "t," as in "tax." Others were named for Hermann's favorite golf courses, including Apache, Renegade and Cochise, near his Arizona vacation home.
The structures had varying effects: Some allowed Enron to book income upfront on tax savings that otherwise would have been realized over a number of years. Others provided low-tax dividend income through offshore entities.
Together, they provided nearly $1 billion in profits from 1995 through September 2001 and were ultimately intended to create $1.9 billion in earnings for Enron over 30 years, with most of the gains recorded by 2004.
Some of the most prominent law firms and banks in the nation -- including King & Spalding, Chase Manhattan Bank and Bankers Trust -- helped Hermann and a small cadre of subordinates create the transactions, documents show.
Hermann said Enron pursued only those deals in which its outside legal experts were willing to provide a written "should opinion," indicating that Enron could expect to ultimately prevail if the IRS challenged the transaction. The company's auditor, Arthur Andersen LLP, independently gave opinions that the deals should pass muster, Hermann said.
As it did with Andersen's audits, Enron paid handsomely for the legal and accounting assurances it received on these deals. One law firm, King & Spalding, received a $1 million fee for helping design and endorse the transaction involving Enron's headquarters tower, Hermann said.
King & Spalding did not respond to a request for comment yesterday.
In the "Teresa" transaction, Enron got a $225 million multiyear tax savings and a corresponding boost in after-tax earnings through a commonly used "synthetic lease" arrangement on its Houston office tower. Enron, which rented the building from J.P. Morgan Chase, created a series of inter-company and offshore transactions that generated nearly $1 billion in deductions and depreciation on the building -- benefits not available under traditional leases.
In defending the deals, Hermann said the company's massive tax savings were summarized in the footnotes to the annual financial statements given to shareholders, in compliance with Securities and Exchange Commission disclosure rules.
"We just did what the accounting rules allowed us to do and put it in the footnotes," Hermann said. "We took advantage of what the rules are. If you know the rules you don't have to break the rules, you just use them. That's what lawyers and accountants do."
Experts cautioned that it is difficult to determine from the footnotes precisely how much tax a company paid because companies are given wide latitude to include or exclude items. The footnotes in Enron's 2000 statement show that Enron had deferred payment on $2.6 billion in tax obligations due to U.S. and foreign governments -- payments it could avoid in 2000 but might have to make in future years. Enron also said it had amassed $800 million in tax deductions that it didn't immediately need but would be available for future years.
In Enron's published income statement for 2000, the company reported earning $1.4 billion in pretax profit, taxes due to U.S. and foreign governments of $434 million, and a net income of $979 million. But after taking advantage of refunds and deductions on employee stock options, Enron said its actual taxes paid totaled just $62 million in that year.
That appears to indicate that a great deal of Enron's reported income came from accounting and tax strategies and not business operations, said Bala Dharan, accounting professor at Rice University.
Hermann had worried for a long time that analysts would start asking tough questions about Enron's low tax rate, he said.
"I kept saying to my boss [Causey], the analysts have got to ask . . . sometime. 'What are we going to tell them?' To my knowledge, they never asked," Hermann said.
Some analysts did ask, according to Rebecca Followill, a securities analyst with the Howard Weil firm in Houston. "Their tax rate was inordinately low. I tried to get explanations [from Enron] as to why. I never got one. They said, 'We're just more efficient in tax planning,' " Followill said. It was not possible to conclude from the company's disclosures how much tax transactions were contributing to Enron's bottom line, she said.
Hermann said: "We are dancing on a pin. We did tell them, they just couldn't understand it."
Enron's collapse has triggered congressional demands for reforms of accounting procedures that would alert shareholders to a company's financial vulnerabilities. On a second front, tax policy critics say Enron's use of tax deals dramatizes the need for comprehensive tightening of loopholes that permit U.S. firms to avoid taxes on tens of billions of dollars. An inquiry into Enron's tax payments is underway by congressional tax committees.
Complex Deals Hermann said he refused to let Enron use the common tax structures that banks and accounting firms are widely peddling because of the risk that these commonly used deals could be attacked by the IRS as abusive tax shelters, which have no legitimate business purpose, he said.
"We wanted something under the radar screen that made sense to Enron from a business purpose," he said. "We didn't want to get involved in tax shelters. If you do the same thing enough times and the government doesn't like it, it's all going to hit the fan."
The transactions Enron's tax department did were so intentionally complicated it would take a year or more to construct a single deal.
"You could only think about one of these at a time," he said. "You couldn't understand why we did something a particular way unless you were in the room at the conference table. After a while you couldn't remember unless you wrote it down. They were that complex."
In the current climate, given the furor over Enron's financial dealings and collapse, Hermann expects the government to attack Enron's tax deals.
"The government is not going to like these," Hermann said. "The government is going to call these tax shelters."
The outside legal experts Enron hired to work on some of these tax deals consistently counseled Hermann and Maxey, head of the structured transaction group, to keep their work quiet, even inside Enron, and guard against leaving a detailed paper trail, Hermann said.
"I think it was being whispered in [Maxey's] ear by some of the advisers we were using that it would be a whole lot better if none of this came up. Do whatever you can to keep the circle tight," Hermann said.
"I wasn't afraid of any paper trail because I didn't think we had anything to hide. It wasn't anything I was going to stick under the nose of the IRS. But if they'd have asked me about them I would have told them everything."
Inside Enron, Hermann said, the pressure on his group to bring ever-larger sums to the bottom line "cranked up" after 1999 as Enron's stock price surged and the company's businesses struggled to achieve new heights of earnings that would keep Enron shares climbing.
In early 2001, Hermann was asked to come up with transactions that could contribute roughly $300 million to Enron's reported earnings, Hermann said. By September, Hermann's share of the "stretch" had doubled and Hermann was asked whether he could deliver $600 million, Hermann said.
As the tax transactions' importance to Enron's bottom line grew, so did the risks of disclosure. Inside Enron, Skilling and Causey understood the magnitude of the tax transactions and their contribution to Enron's reported profits, as did some of Hermann's employees in the tax department, Hermann said. "The fewer people who knew about these deals the less chance it had of hitting the front page of the Wall Street Journal and being an embarrassment," Hermann said.
A new group of top executives took over at Enron after the departures of Skilling and Fastow last summer and fall.
After the company declared bankruptcy, one of them, Enron's new chief financial officer, Ray Bowen, was astounded to discover that Enron's headquarters building was part of the 20-year Teresa tax deal, Hermann said.
Late last year, Hermann ordered his subordinate Maxey to write memos documenting details of all the tax transactions so that Enron executives could figure out how many of its assets were really owned or controlled by the outside partners in the tax transactions, he said.
Maxey stalled, then refused, Hermann said.
When Maxey failed to meet a Jan. 11 deadline to produce a memo on the Teresa transaction, in which the Enron headquarters was entangled, Hermann fired him that afternoon, a Friday, Hermann said.
The following Monday, two of Maxey's co-workers told Hermann that, immediately before being fired, Maxey had shredded documents from his office on the 15th floor of Enron's headquarters.
Hermann said he asked Maxey's replacement to try to determine what Maxey had destroyed and whether anyone had helped him.
That employee initially reported back that the files seemed to be complete: Nothing of significance appeared to be missing, Hermann said.
An Enron lawyer responsible for retaining company documents for use by government regulators was notified of the shredding in the tax department and alerted authorities, leading to an FBI investigation, Hermann said. Four months later Hermann still does not know whether his subordinate shredded innocuous personal papers or company records, he said.
Maxey's attorney, Philip H. Hilder, said his client did "absolutely nothing sinister." Maxey refused to write the requested memos because he didn't believe that they were necessary and didn't have adequate staff after Enron declared bankruptcy, his attorney said. Maxey shredded only personnel documents and duplicate files, none of which stemmed from the 11 structured tax deals, Hilder said. Maxey has been interviewed by the FBI, Hilder said.
"He's been completely cooperative with the investigators because he's done nothing illegal or unethical," Hilder said. "He will continue to be completely cooperative."
Jordan Mintz, now Enron's general counsel of corporate development, replaced Hermann as the top tax counsel in February while Hermann was on medical leave. Enron later terminated Hermann effective this month but has offered him a consulting contract, Hermann said. Enron offered to pay Hermann $500 an hour plus expenses if he agreed not to make any "unauthorized disclosure" of confidential Enron information and not to assist any government investigators or regulators without prior written permission from Enron lawyers, the contract shows. Hermann said he will refuse to sign.
Hermann is preparing to defend the tax department's transactions and planning to retire more modestly, now that Enron's collapse substantially diminished his personal nest egg. Hermann lost more than $10 million in deferred compensation and company stock when Enron failed, in part because he always believed top executives' assurances that Enron was sound, he said.
The pride he once felt in his ability to deliver a valuable service to Enron has been eroded, too, and replaced by doubts.
"Looking back, I thought I was very good," he said. "I always thought it was a talent I had to do these deals and get them through upper management. Now I wonder if that was a talent or whether they didn't give a damn about the details; they just wanted to book the earnings and they'd worry about the rest later." 11 Ways to Add to the Bottom Line Beginning in 1995, Enron's tax division used a series of structured transactions, designed primarily to take advantage of tax regulations, to increase the company's profits. The deals were intended to create $1.9 billion in earnings for Enron over 30 years. One of the biggest deals, Project Teresa, involved using Enron's interest in its headquarters in Houston and a $1 billion note from an Enron subsidiary to boost the building's tax value and take enhanced depreciation deductions, adding $120 million to the company's bottom line in 2000. Impact on net income, in millions: Total through Sept. 2001 = * Total through 2000 = ^ Tanya, 1995 $65.8* Teresa, 1997 $229.4*, $120^ Steele, 1997 $66.3*, $15.7^ Renegade, 1998 $.8* Tomas, 1998 $113*, $51.29^ Cochise, 1999 $109.6*, $53^ Apache, 1999 $50.7*, $20.6^ Condor, 1999 $88.8*, $37.1^ Valhalla, 2000 $20.2*, $7.38^ Tammy I, 2000 $189.6*, -$8.72^ Tammy II, 2001 $-.9* Total: $933.3*, $296.4^ SOURCE: Enron internal documents Deconstructing Enron's Earnings Until the company collapsed last year, many investors and others looking from the outside at Enron Corp. saw only tremendous revenue growth and mounting profits. What they couldn't see was that those profits had been significantly increased by two different types of transactions designed by Enron insiders and obscured in Enron's corporate reports. The first type of transaction has already received a great deal of public attention: special purpose entities (SPE) set up by Enron CFO Andrew Fastow. These SPEs sought to boost Enron's profits by buying company assets and protecting risky tech investments against losses. The details of the second type of transaction have not surfaced until now. These were structured transactions set up by Enron's tax division to boost profits by reducing the company's tax costs through accelerated depreciation, deductions on dividends paid by subsidiaries and losses on other transactions. The chart shows how much of Enron's reported net income came from SPEs and how much came from the structures created by Enron's tax division. Last November, Enron was forced to restate its earnings and remove the net income provided by several of the SPEs because they violated accounting rules. In addition, Enron improperly used SPEs known as 'Raptors' and operated by the Fastow-run LJM2 partnership to boost Enron's pretax income in the third and fourth quarters of 2000 by $531 million…accounting for 80 percent of the pretax income for those quarters, according to a special investigative report produced for Enron's board of directors. Total net income = * Total SPE contribution = ^ Total Tax deals contribution = Æ (in million) 1995: $47Æ, $520* 1996: $584* 1997: $56Æ, $28^, $105* 1998: $98Æ, $133^, $703* 1999: $132Æ, $248^, $893* 2000: $296Æ, $99^, $979* SOURCE: Enron internal documents and SEC documents.