California's Prescient Brush With Enron

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Long before the power crisis, California and Enron got along just fine. The California Public Employees' Retirement System (CalPERS), the nation's largest pension fund investor, had invested $250 million in one of the first of Enron's now-infamous off-balance-sheet partnerships — called JEDI — and got a 73 percent return over just three years. Small wonder then that when Enron execs came back in 1997 with JEDI II, a similar vehicle to invest in energy projects, including Enron's own Energy Services, CalPERS listened.

But according to minutes of a closed-door 1997 CalPERS Investment Committee meeting obtained by TIME, members saw in JEDI II the same red flags flying at the Enron crime scene now. The committee was clearly mystified by Enron's murky corporate structure and by the company's proposal to put up stock, not cash, for part of their investment in JEDI II. The potential for conflicts of interest between Enron and JEDI — already flagged by CalPERS' investment advisers — was also raised.

Yet the members voted 10-1 to invest $500 million of pensioners' retirements in JEDI II, with one lone dissenter: California's state controller, Kathleen Connell. "I didn't feel comfortable about the deal," she told TIME. "It didn't pass the smell test."

If you lived in California, you'd know that Connell can be a pain in the butt — especially to the rears of spendthrift public servants wasting taxpayer money. As the fiscal watchdog for the state, she uncovered more than $1 billion worth of Medi-Cal fraud in 1999 and more recently, refused to pick up $2,600 in expenses for takeout sushi and pizza ordered by state employees working late during the energy crisis. At the time CalPERS was considering JEDI II, Connell was the only one on the board with an investment banking background. An investment banker for a decade, she had run her own investment banking firm and served as a vice president and director at the Chemical Bank of New York. And she had a lot of questions that the Enron execs pitching the deal didn't seem to want to answer.

"It was so confusing a deal, they couldn't explain it. Or maybe they didn't want to explain it," she says. "I was very concerned about the hybrid structure. It was awkward, seemed intentionally complex. I said why do we have to structure it this way? What is relationship between the entities? Nobody could answer. I asked about the upside and downside protection. And who would monitor it? I asked about the cash vs. stock investment proposed. All structure questions. I was really confused from the very limited information we got. We didn't get any documents at the board level — only the consultant's description. I couldn't understand why it had to be so complex. Yet everybody was trying to convince me it was okay."

In a closed door session with investment advisers before the arrival of Enron's go-go salesman that day — Jeff Skilling himself — committee members were similarly confused about the structure of Enron and puzzled over the lack of transparency in the JEDI setups. Only after repeated questioning did the outside advisers who brought CalPERS the deal — Pacific Corporate Group of LaJolla, Calif. — admit that Enron was offering stock, instead of cash, as a maneuver to improve their debt-to-equity ratio and keep their credit rating up. Connell was offended. "We were going to put cash in, they were going to put in stock. They were playing a game with us," she says with disgust.

Worse, she thought, was the blow to CalPERS' long-held national reputation as an advocate for responsible corporate governance. When Connell brought up the issue — repeatedly and forcefully — she was dismissed by other board members, the minutes show. "Enron had a question mark by their name and yet we were willing to go in the back door and make money off of the deal. I thought that was unseemly."

In the end, California's pensioners got out unhurt. In what Connell says was a normal rotation of funds, CalPERS eventually liquidated its eventual $175.5 million investment in Jedi II in 2000 and received $171 million as of Oct. 31, 2001 — "a wash," according to spokeswoman Pat Macht. (The deal was actually tougher on Enron — CalPERS' exit forced the company to cover the funds by setting up the flawed Chewco partnership that would eventually start Enron's financial dominoes falling.) By then, says Connell, "We were just happy to get our money out."

And now Connell, who is not running for office again, is pushing for the nation's largest pension funds — those in California, New York and Texas — to lead reform in on 401(k) and accounting practices by themselves. "I have no confidence in Congress seeing any significant reform through," she says. "But we represent about 10 percent of all stock ownership in the country, and we can hammer through changes regardless of Congress — if we are emphatic about not investing in companies that don't change certain practices."

As for CalPERS' Enron experience, Connell hopes the right lesson has been learned. "Obviously I was wrong on the profit side. We clearly made money," she says. "But on the smell test, I was right."