Lay's tale: 'The nail in the coffin...'
Enron's former CEO details his lost trust in CFO amid negative media barrage.
By Shaheen Pasha, CNNMoney.com staff writer

HOUSTON (CNNMoney.com) - A strong company ... a barrage of bad press ... and a traitor sent packing.

That's the picture Enron founder Kenneth Lay painted for jurors during his second day on the stand, defending himself against government charges of fraud and conspiracy in one of the most infamous bankruptcies in American business history.

Enron founder Kenneth Lay arrives at the federal courthouse for his second day of testimony in his fraud and conspiracy trial Tuesday, April 25, 2006 in Houston.
Enron founder Kenneth Lay arrives at the federal courthouse for his second day of testimony in his fraud and conspiracy trial Tuesday, April 25, 2006 in Houston.
Find out who you might have seen at the Enron trial, how they got involved, and what they're doing now.
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"I believed that the balance sheet was fundamentally strong," Lay said. "I believed that then, I believe that now."

Nevertheless that strength could not overcome the deceptions by the company's chief financial officer, plus bad coverage by the media and short seller activity, he claimed.

Specific charges refuted

Lay specifically denied that he deliberately misled employees about the true financial health of Enron in the third quarter of 2001 and refuted testimony from former financial chief Andrew Fastow that he was told the company was headed for trouble.

Earlier in the trial, government prosecutors alleged that Lay told employees in a Sept. 26 Internet chat that the company's third quarter was "looking great" and was poised for "strong growth in our business" even as he knew that Enron would post a $1.01 billion charge and $1.2 billion equity write-down in the quarter and was aware of $7 billion in embedded losses from its international portfolio.

Lay said the write-off was a non-cash item that had no impact on the balance sheet and the $1 billion charge was expected by the market as analysts had been recommending that Enron "clean up" its balance sheet to ensure future earnings growth. He added that the market the market initially responded positively to Enron's third quarter report until a barrage of negative newspaper articles about former financial chief Andrew Fastow and his role in some illicit partnerships sent the Enron's stock spiraling lower.

As for embedded losses, Lay scoffed at the term, saying that prior to the trial, he never heard of such a concept. He denied that he met with Fastow in August who told him that the company was "in dire financial straits."

Wall Street was initially positive about Enron's third quarter results, Lay claimed. But he said that positive sentiment was clouded by a series of articles in the Wall Street Journal, published starting the day after Enron's earnings release, raised questions about a possible conflict of interest with Fastow serving as both CFO and general partner of the LJM partnerships – special purpose entities that the government contends were used to hide millions of dollars in losses from Enron's balance sheet.

Lay added that the articles unfairly implied that the LJM deals, which proved profitable for Fastow, were inappropriate and prompted an informal investigation by the Securities and Exchange Commission.

"We thought the Wall Street Journal was on a witch hunt against Andrew Fastow," Lay said, adding that the articles were "absolutely destroying the confidence of the shareholders... and destroying the stock at a time we thought the company was doing extremely well."

Lay stood by the LJM partnerships, saying that the company had taken precautions to safeguard against any conflict of interest and had gotten approval from the board of directors.

He added that the board continued to support Fastow and one board member had even drafted a letter to the Wall Street Journal protesting the tone of the articles but never actually sent it.

But when defense attorney George "Mac" Secrest attempted to introduce the draft of the letter, presiding Judge Sim Lake - who has been increasingly concerned about the length of the trial - harshly stopped that line of questioning.

'We've got a lot of wasted time'

"What is the relevance?" Lake cut in sharply. "We've got a lot of wasted time so far in this direct examination... move along."

It was the second reproach from Judge Lake Tuesday after he originally admonished Secrest for continuing with a line of questioning after he sustained an objection from the prosecution.

Secrest took the lead in Lay's defense after his original lead attorney Michael Ramsey was hospitalized midway through the trial. While the defense camp last week said that Ramsey was planning to attend Lay's testimony to observe, he has yet to make an appearance.

But Lay and Secrest have yet to mesh as a team, with Lay often attempting to shape the direction of the questions and looking irritated at the manner in which Secrest conducts his direct examination. At one point, Lay responded to Secrest's line of questioning with "I'm not sure where you're going with this, Mr. Secrest."

Lay stood by the comments he made during an Oct. 23 meeting with Enron employees in which he said the company was in solid shape and reaffirmed his support of Fastow, despite the media barrage. Lay testified that, based on the information he had available at the time, he was "speaking from my heart."

'Andy, pack up your stuff'

But Lay said his original support of Fastow quickly waned once he was told the next day that banks wouldn't lend the company $1 billion as long as Fastow remained CFO. And he said he was shocked to learn at the board of directors meeting on Oct. 24 that Fastow had pocketed $45 million from his dealings with LJM – far above the board of directors' expectation for a mere $1 million gain from the transactions.

"Our trust in him had been unfounded," he said.

Lay testified that he told Fastow immediately after that meeting that he was being put on a leave of absence and had to resign from his position. But he said Fastow kept insisting that they negotiate a settlement package of about $5 million.

"I said: 'Hell no, Andy, pack up your stuff and leave the building,'" Lay recalled.

He pointed out negative media attention continued to increase at that time. He said one article in the Wall Street Journal in late October regarding the accounting of one of their financial instruments, called Chewco, raised concerns at the company. He said chief accounting officer Richard Causey conceded in a late night meeting that there was a possibility that the accounting may have been inappropriately approved by the company's accountants.

"When I left the building that evening, I thought this may be more serious problem than I had thought," Lay said, adding that it would have required an earnings restatement that could have had a real negative impact on the company in the midst of Fastow's departure.

He added that Enron conducted an investigation into the matter and found that Fastow and his partner at LJM, Michael Kopper, had deliberately set up the Chewco special-purpose entities in an inappropriate manner to control the entity and profit from it – making the financial vehicle's accounting invalid and causing Enron to restate $400 million in earnings from 1997 to 2001.

The nail in the coffin

Lay added that Fastow's willingness to compromise the company's integrity to make money for himself drove "the nail in the coffin of Enron's demise."

He said the company was forced to restate an additional $100 million over two years related to the first LJM transaction conducted in 1999 due to an "honest mistake" by Enron's auditors Arthur Andersen.

Ultimately, Lay said the company restated $600 million by November 2001 which "had a devastating impact on confidence in Enron and Enron's financials" and set the ball rolling for Enron to declare bankruptcy in December 2001.

At the heart of Lay and former chief executive Jeffrey Skilling's defense is that they relied on the advice and expertise of accountants and lawyers related to complex transactions at Enron.

Lay testified earlier that the LJM partnerships had been thoroughly reviewed by Arthur Andersen and internal and external lawyers. He added that Enron embarked on so many transactions that he, like Skilling who testified before him, didn't spend more than a couple of hours dealing with LJM.

The trial is now in its thirteenth week and jurors were visibly fatigued as Lay testified Tuesday. Lay's testimony is expected to go into early next week and will be followed by a series of character witnesses and accounting experts. At the end of the day, the defense team said it will likely wrap up its case in two weeks, rather than the end of next week as originally thought.

Combined Lay and Skilling face almost three dozen charges of fraud and conspiracy and could get 20 to 30 years behind bars if convicted. Lay will also face a trial for bank fraud once jurors begin deliberations in the current case.

Enron, once the seventh-largest corporation in the nation, declared bankruptcy in December 2001, resulting in billions in losses for investors and costing thousands of employees their jobs.

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Mr. Skilling's brave new world. For more, click here.

For complete coverage of the trial, click hereTop of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.