Enron’s Crash Radiates in All Directions, Implications for Insurers

“Bankruptcy” and “Chapter 11” are inadequate terms to describe the carnage left in the wake of Enron’s collapse, which affected the lives of thousands of people, numerous banks and dozens of insurance companies. The tremors reverberate from the U.S. through Europe, Japan, Australia and on around the world. The allegations of insider trading, influence peddling, destroyed documents, coverups and fraud now go all the way to the White House.

No day seems to pass without some new revelation concerning the extent of the energy giant’s involvement in the world’s financial system. At least three agencies are conducting investigations—the SEC, the Labor Department and, most recently, the Justice Department, which announced it was seeking to determine if there had been any criminal violations. Five Congressional committees are also looking into the company’s affairs.

Enron rose from a medium-sized utility, formed in 1985 by the merger of Houston Natural Gas with Internorth, to become one of the biggest energy providers in the world. It compounded its position by capitalizing on the revolution in technology to pioneer trading energy products online. The system became fully operational in November 1999, and helped make Enron a household name, many shareholders very rich, and its officers and directors even richer. The site expanded its trading activity well beyond gas and electricity. At its height, daily transactions averaged $2.5 billion. In two years, it recorded $880 billion worth of trades.

Everyone now sees the flaws, but this wasn’t apparent less than six months ago, when shares of Enron traded in the $80 range. The company was winning all sorts of awards for its shrewd business innovations, and Wall Street analysts were touting its “growth potential.” Apparently, however, it went one step too far. Unlike e-bay, or the Commodities exchanges, Enron remained a party to the trades it conducted.

As energy prices dropped along with other commodities in a worldwide business slowdown, Enron’s participation virtually insured that it was losing money. But the company refused to publicly address the issue. It was finally forced to do so when its accountants, Arthur Andersen, rather belatedly raised questions about its earnings statements. In October, Enron finally revealed loss exposures of close to $1 billion for 2001, and restated its earnings for 1997 through the first half of 2001, lowering its reported results by $591 million.

A last minute merger with Dynegy Inc., another energy company controlled by Chevron, fell apart in November and a week later Enron filed for Chapter 11 protection listing outstanding debts of more than $13 billion —the biggest bankruptcy in U.S. history.

The creditors read like a “who’s who” of global finance led by J.P. Morgan Chase, Enron’s principal financial partner with $965 million in secured debt, and around $500 million unsecured. However, its exposures may go as high as $2.6 billion. It’s managed to be appointed as a “debtor in possession” on many of Enron’s energy contracts, which it backed, and has filed suits against the insurance companies seeking to recover on a number of Enron’s surety bonds, so it might end up losing a good deal less.

Many other banks also have significant exposures.

The insurance industry is involved on three fronts. Life insurers and asset management companies that held debt or equity positions in Enron securities have to face the fact that most of their investments are virtually worthless.

The second potential liability area is surety bonds and/or financial guarantees. Don Watson of Standard & Poor’s in New York explained that, “one of the main questions the insurance companies are asking is whether the policies they wrote were in reality financial guarantees, or were they insurance polices.” In the first case, Watson indicated that U.S. law generally requires that payment be made even if there has been fraud or misrepresentation. This protects investors, but allows the companies to try to recover the funds from those responsible.

“The problem with Enron,” Watson continued, “is that there are substantial questions as to whether the policies were really financial guarantees, and what they actually covered.” S&P hasn’t “gotten to the point that we can make a statement on this” due to the litigation and the claims by many insurers that there were misrepresentations made concerning the nature of the policies. S&P’s Fred Sklow confirmed that so far they had talked to nine of the 11 companies involved concerning these claims, and that, although they would continue to monitor the situation, it seemed unlikely that there would be any rating actions at this time.

Chubb Corp with an estimated $220 million and CNA Financial with around $50 million are the most severely impacted, but more than $1 billion in payments are currently the subject of the lawsuit with J.P. Morgan. Filed before the bankruptcy petition, it was the first official dispute to raise the question of fraud at Enron.

Other parties include Citigroup’s Travelers, Kemper’s Lumbermens Mutual Casualty, Allianz AG’s Firemen’s Fund, Hartford, Safeco, The St. Paul and Liberty Mutual. All refused to pay Morgan’s claims unless they can examine and verify the existence of the underlying contracts their various units insured, and all of them, except Travelers, have asked the bankruptcy court judge to void the obligations if they can’t be substantiated. Neither Morgan nor Enron has so far produced any contracts, calling the insurers’ claims a “fishing expedition,” but as the cloud of suspicion over Enron’s finances grows, it’s quite likely that more fishing boats will be casting their nets.

Finally there remains the potential impact of civil actions, which could trigger demands for coverage and defense under corporate indemnity and Directors and Officers liability policies.

The national law firm of Milberg Weiss Bershad Hynes & Lerach filed class action suits on behalf of both investors and employees the same week Enron filed for Chapter 11.

Their website explains the nature of the claims and seeks more participants, stating: “If you purchased shares of Enron Corp. publicly traded securities between October 19, 1998 and November 27, 2001 and would like to join the securities class action, please click here. If you are a current or former Enron employee and wish to inquire about the 401(k) and other benefits litigation, please click here.” One assumes that a chorus of crickets on a summer night wouldn’t be clicking any louder.

Bill Lerach stated, “This appears to be one of the worst instances of illegal insider trading we’ve ever encountered.” That opinion, coming from a partner in a firm that’s specialized in this type of litigation for over 30 years, gives an idea of the scope of the alleged violations of securities law.

Ironically the Justice Department investigation (from which Attorney General John Ashcroft, who received $50,000 from Enron related sources for a failed senatorial bid, has recused himself) might be a positive development for the insurance industry.

Gary Grasso, a Chicago-based attorney who specializes in Directors and Officers liability coverage, said that, “It [Enron] is clearly a situation with obvious defenses, if those indicted or peripherally involved operated outside of the scope of their employment.” He pointed out that an executive’s actions don’t necessarily have to be criminal to still be considered outside of his employment, but in situations where criminality is involved the classic defense is even more clear cut.

“If they’re convicted, or if they [Enron’s officers and/or directors] plead [guilty, even to a lesser charge], it’s admissible in civil cases; you’ve got good grounds for a summary judgment,” said Grasso. It’s an established fact that D&O coverage doesn’t require an insurer to step in and defend, or reimburse the losses of, an executive who’s committed a crime. It’s very much against public policy in the same sense that insurance can’t (or at least isn’t supposed to) cover punitive damage awards.

Grasso also pointed out that Enron could well pursue officers and directors who may have acted against the company’s interests, as well as its accountants Arthur Andersen. The firm’s certification of the company’s balance sheet without challenging numerous irregularities, particularly a number of “off balancesheet” items, was already being called into question even before it was revealed that some of its employees had apparently destroyed a number of Enron-related documents.

The investigations will certainly reveal more about Enron in the future, and the losses, even if the p/c insurers are able to avoid the worst of them, will be substantial. It’s clear that a number of persons connected with the company may have breached their trust, even if they’re never convicted of criminal offenses.