Power Players

Did executives at the energy company TXU commit securities fraud in 2002?


Dave Mann

In early 2002, Erle Nye was the toast of the business world. As chief executive of TXU, he had managed to keep the Dallas-based, multibillion-dollar energy firm healthy and profitable at a time when many other energy companies stewed in disarray. All around Nye, the giants—Dynegy, AES Corp., Reliant, and, most spectacularly, Enron—were imploding from reports of inflated profits, sham trades, off-the-books partnerships, and undisclosed debt. In a six-month span beginning in late 2001, four of the nation’s leading energy CEOs had resigned in disgrace. In contrast, analysts credited TXU’s unsullied reputation to the common-sense business approach of its straight-talking chief executive. Then 65, Nye had worked for the company since Dwight Eisenhower was president. In 43 years, he scaled the ranks the old-fashioned way, eventually ascending to chief financial officer and in 1995, to CEO. He oversaw TXU’s steady growth from a provincial power company into a sprawling multinational energy services corporation with operations on three continents and more than $41 billion in assets. Numerous business magazines nominated him as executive-of-the year. Southern Methodist University presented him with its business achievement award. Media outlets from CNBC to The New York Times turned to Nye as a grandfatherly voice of reason. In an industry mired in scandal, Nye had swiftly become known as a rare honest man.

So when TXU released a glowing second-quarter earnings report on July 25, 2002, under the headline, “TXU Reports Strong Second Quarter Results,” most analysts and shareholders believed every word of it. The company had not only met quarterly earnings estimates, but declared that it would do the same in the third and fourth quarters. The report contained little hint of looming financial trouble. “TXU took further action to strengthen the balance sheet, maintain ample liquidity, and position the company for future growth,” read a press release accompanying the report. Although TXU’s share price had recently declined from a high of nearly $50 to around $35, Nye insisted that the market was punishing the entire energy sector for the sins of a few companies. “There should be no doubt that we have sound accounting practices and do not trade to artificially increase revenues,” he said during a conference call with analysts after the release of the second-quarter earnings report. “[Yet] our stock price has fallen significantly as bad news runs rampant through the sector.” It was a pitch designed to assuage analysts, and, for the most part, it did. “The utility stocks had been hit hard by worst-case scenarios connected with energy trading, but they still have strength,” Argus Research analyst Jeff Gildersleeve told the Fort Worth Star-Telegram, echoing Nye’s analysis. Meanwhile, the CEO boasted that TXU’s stock, at $35 a share, was quite a buy.

But despite all the happy talk, TXU was actually careening toward bankruptcy. Just three months after that upbeat July earnings report, TXU abruptly disclosed that its European subsidiary had glaring financial problems. Executives were forced to sell off the European outfit at a $4 billion loss. The price of TXU stock plummeted 75 percent, and many elderly shareholders saw their life savings vanish in a matter of days. Nye and other TXU executives claimed ignorance, saying that the company’s “near death experience,” as Nye put it, surprised them as much as everyone else.

Now two federal lawsuits charge that TXU executives committed securities fraud in 2002. The complaints allege that TXU executives knew all along that the company was risking bankruptcy and never disclosed the dangers to shareholders. In public, Nye had relentlessly pitched TXU stock; in company meetings, he had referred to TXU’s economic condition as “whistling by the graveyard,” according to court documents (Nye later claimed he was talking about other companies, not TXU). The plaintiffs allege that TXU executives offered misleading financial statements, embellished their earnings reports, inflated the stock price for their own gain, and, in some cases, told outright lies to stock market analysts and the public.

TXU officials have said that both suits lack merit. “TXU provided proper disclosure then and now,” said a company spokeswoman in an e-mailed response to written questions from the Observer. Nye initially declined an interview request. But in a brief conversation with the Observer at the Republican National Convention in New York, Nye said, “[The lawsuits] result from the fact that the stock price went down substantially from the failure in Europe. There were probably 12 to 15 companies that had a similar pattern of losses in Europe. The causation is clear. I think our case is clear. We feel very comfortable about our position.”

One of the lawsuits is a class-action suit filed in federal court by TXU shareholders, who lost billions during the company’s 2002 crisis. The second, more unusual case, is a whistleblower claim filed by a former TXU senior vice president. It is believed to be the first case to test the whistleblower protections of the 2002 Sarbanes-Oxley Act passed by Congress in response to the Enron fiasco. If the accusations are correct, then TXU violated the very laws designed to prevent another Enron.

Much of the behind-the-scenes information about TXU comes from court documents filed by Jim Murray, the former TXU vice president and the plaintiff in the whistleblower case. (Citing a confidentiality agreement with TXU, he refused to be interviewed.) Murray was hired in December 2000 as a senior vice president for capital management in TXU’s energy trading company. He spent most of his time working on business development and putting together deals, but because of his background as a securities lawyer, he was also asked to comment on drafts of financial disclosures before they were released to the public.

According to his complaint, Murray, not long after joining the company, began pointing out to his superiors that TXU’s statements were overly positive and failed to disclose important financial weaknesses. On April 23, 2001, for instance, he e-mailed his boss, President of Energy Trading V.J. Horgan, criticizing Nye’s recent comments that, “Once again our quarterly results are outstanding.” In fact, revenues were down 7 percent from the previous year.

When Enron collapsed in late 2001, Murray fretted that TXU could be descending into a similar morass. According to his complaint, then-CFO Mike McNally talked openly in executive meetings about “earnings management”—inflating profits. McNally’s notion of earnings management included, on at least one occasion in early 2002, directing Horgan to shift some of her division’s cash reserves into McNally’s totals so he that could “make his numbers,” according to Murray’s complaint. (McNally has since left TXU and couldn’t be reached for comment.) Murray e-mailed Horgan: “We are bending over backwards to avoid having our book accounting reflect economic reality.”

By early 2002, it had become clear to Murray that TXU faced some serious problems. He foresaw three ways in which the company could easily go bankrupt by the end of 2002, if not sooner. One danger was an over-reliance on natural gas. Although primarily considered an electricity provider, TXU derived a remarkable amount of its profits, according to Murray’s complaint, from natural gas. If, as some analysts predicted, the price of gas fell, TXU could plummet into bankruptcy. Investors had little way of knowing that they were betting their money on a company that was so reliant on a single commodity.

That wasn’t TXU’s only vulnerability. The company’s finances were in such poor shape that Murray was concerned about TXU’s credit rating. It was only a matter of time, he argued, before Wall Street’s independent credit rating agencies caught on and significantly lowered their evaluation of TXU to below investment grade. “I find it unpardonable that we got down to $100 million of untapped liquidity in July, that we had $5.6 billion more current liabilities than current assets at year end,” he e-mailed Horgan in late 2001. “The markets and ratings agencies are going to focus on us with increasingly [sic] scrutiny and figure out our risks.”

A lower credit rating would have been disastrous because it would have triggered payment clauses in various contracts and energy deals; an internal TXU study concluded that $4.3 billion in payments would have immediately come due. That would have been problematic, to say the least, given that TXU had only $850 million in the bank at the time. Again, investors had no clue.

To make matters worse, TXU’s British subsidiary, TXU Europe, was suffering in a weak electric market in England and was hemorrhaging cash. Nye and TXU had purchased the British outfit in 1995. By 2002, it was threatening to sink the whole company. In June of that year, TXU treasurer Kirk Oliver (who now serves as TXU’s chief financial officer) sent an internal memo about the subsidiary’s many troubles to TXU executives, including Murray. According to court documents, Oliver wrote that TXU Europe was no longer financially fit enough to maintain an “investment grade” credit rating. The only reason that the rating agencies hadn’t downgraded it was the parent company’s collateral. In essence, TXU’s own shaky credit was temporarily buttressing that of its crumbling subsidiary. Both lawsuits allege that TXU executives, including Nye and McNally, were well aware of the dangers.

Nye told the Observer that the magnitude of TXU’s problems in Europe weren’t clear at the time. “It took everyone by surprise,” he said. “If you look at the disclosures, they are very clear that risks were there. But nobody in the industry, including the analysts, had any idea that there was that sort of exposure. And I think it was a unique thing for this country.”

On June 7, 2002, Murray attended a management meeting with about 15 other TXU executives at the company’s Dallas headquarters. The group discussed the serious risks confronting the corporation, including TXU Europe’s cash drain and the threat of bankruptcy. Treasurer Kirk Oliver said he had just returned from New York, where he had learned that at least one rating agency had TXU “in its cross-hairs” to reduce the company’s rating to below investment grade. Brian Dickie, then TXU’s executive vice president, predicted that the company would have trouble meeting its earnings estimate in the near future. (The very same day, Dickie sold more than 14,000 shares of his TXU stock at $50 a share for a profit of $717,100, according to public records. Five months later, the stock would be trading near $12 a share. Dickie has since left the company and returned to London. He couldn’t be reached for comment.)

At this and subsequent meetings, Murray argued strenuously that TXU had an obligation to shareholders to disclose the risks that the company faced. He thought the situation could still be salvaged, but TXU had to reveal its problems to the public, lower its earnings estimates, and begin to pay down its short-term debt and marshal cash reserves in order to convince rating agencies that the company deserved to maintain its credit rating.

Instead, the corporate leadership simply plunged ahead, undeterred. A few weeks later, on July 25, 2002, TXU released its unrepentant sunny earnings report. In the conference call with analysts that day, Nye described the second quarter as “excellent.” One analyst asked McNally about reported problems in Britain. Not to worry, he responded. TXU Europe was struggling with a weak market that would soon pick up; the numbers had been crunched, and McNally said he was confident that the temporary European problem would drain TXU of no more than 20 cents per share (or roughly $60 million).

That was quite an understatement given that TXU Europe’s demise eventually cost the parent company $4 billion. In their lawsuits, Murray and the shareholders both contend that McNally knowingly lied to the analysts. Murray claims that the day after the conference call, he asked McNally about that 20-cents-per-share prediction. McNally replied that he knew TXU Europe’s problems could cost more, “but that he told the analysts that it would not be worse…so they would not worry about the issue,” according to Murray’s complaint.

In fact, TXU executives had a significant incentive for hiding the company’s financial decay. Releasing such information would no doubt hurt the stock price—and their own bonuses. Because TXU’s stock had remained pricey for a three-year period ending on March 31, 2002, TXU’s bonus structure handsomely rewarded top executives. Nye received a stock bonus of $4.3 million in 2002 (out of $7.8 million in total compensation), McNally took home $1.393 million, and Dickie $1.07 million, according to TXU’s filings with the Securities and Exchange Commission (SEC).

In addition to the bonus, Nye also saved himself hundreds of thousands of dollars by selling more than 47,000 of his TXU shares on September 10, 2002. At $44 per share, the sale earned him $2.179 million. Three weeks later, on October 9, the stock was priced at $16.90 a share. At the time, Nye defended his sale, saying that he had long planned to sell the shares to finance a real estate purchase. Still, the shareholder lawsuit raises the possibility that the stock dump may have been insider trading. (In the e-mailed response to Observer questions, a company spokeswoman said, “The executives of the company have put the interests of the shareholders above their own, and the interests of the shareholders was to grow the company.”)

Eventually, TXU’s risk-taking caught up with it. On October 4, the company announced that it would miss its third-quarter earnings forecast. Nye claimed publicly that he didn’t discover the magnitude of TXU Europe’s problems until late September, when McNally visited London. TXU Europe filed for the British equivalent of bankruptcy, and was soon sold off at a $4 billion loss. A spooked stock market hammered TXU’s stock, and investors lost billions.

Jack Pruitt remembers exactly why he purchased TXU stock: because he trusted Erle Nye. Now a 69-year-old retired pastor living in Dallas, Pruitt says he became interested in TXU stock during its October 2002 crisis. When TXU’s troubles slowly became apparent and the price of stock dipped about 25 percent to $25 a share, he thought he might have found a bargain. Energy company stocks are popular with retirees like Pruitt because they often pay a dividend. TXU had dispensed a healthy dividend every quarter for years, and Pruitt needed the money to augment his retirement income.

With TXU in fiscal disarray, some analysts were predicting that the company would slash its dividend, but the TXU leadership insisted that the dividend would remain intact. On October 6, Nye told a national CNBC audience, including Jack Pruitt, “I think you can say that the dividend is very secure…I think, frankly, [TXU stock] is quite a buy.” Pruitt was convinced. He bought several thousand shares of TXU stock the next day, October 7. Just three business days later, TXU reduced its dividend by 80 percent.

Pruitt couldn’t believe it. “I couldn’t understand how a CEO, who has all the information, could assure people one day and then cut it a few days later,” he says. “I still don’t understand that.” Without the dividend income, Pruitt had to sell the stock right away. After TXU’s dividend reversal, its share price tumbled again to $12. Pruitt lost $50,000—most of his life’s savings. “I always trusted people,” he says. “You know, when you get that big disappointment, it’s like a big punch in the midsection, when you realize you’ve lost a good part of your life’s savings. And, of course, at my age, you don’t recoup those kinds of losses.” Pruitt later joined with dozens of angry shareholders in the class-action suit now pending before a federal judge.

“Conditions at that time w
re changing on an
ourly, if not minute-by-minute, basis,” TXU said in a statement to the Observer. “TXU provided investors with the best information we could, and when the company said the dividend was secure, it believed that it was. It was only when an unexpected threat to the company’s credit rating appeared that required the dividend reduction was the dividend reduced by the [TXU] board.” In October 2002, TXU revealed that the SEC requested documents from the company relating to the dividend cut; no findings were ever announced (an SEC official in Fort Worth, citing agency policy, would not confirm current or previous investigations of TXU).

At a kiss-and-makeup meeting with TXU shareholders on February 14, 2003, Nye said that shareholder lawsuits are to be expected after a company suffers a down year. “When you have a large decline in stock price, there is an inclination for some to believe it is because of something that was not done properly,” he said. “I’ve looked for any indication that there was not proper handling of our situation in the UK, and to my knowledge, I believe we handled the UK situation entirely properly.”

Murray had departed TXU before the October 2002 crisis; he had been fired in August of that year. Murray’s suit against TXU claims that the company sacked him for raising objections about accounting and public disclosures, or lack thereof. He filed the suit under a central provision of the Sarbanes-Oxley bill that Congress passed almost unanimously in the summer of 2002 in response to Enron’s collapse. The law was intended to encourage executives to speak out about improper accounting practices without fear of losing their jobs. TXU, in its court documents, argues that Murray was fired as part of a routine downsizing because his job was expendable. The case is set for trial in a Dallas federal district court next spring. “The big picture of this case,” contends Murray’s attorney Hal Gillespie, “is it’s going to be a test of whether Sarbanes-Oxley is going to be enforced or if it’s just window dressing.”

Though McNally and Dickie have both left the company, Nye remains. He stepped down as CEO in February 2004, and now serves solely as chairman of the TXU board. Remarkably, he not only escaped fallout from his actions in 2002, but he’s still making money from the episode. When TXU’s stock price tanked in 2002, it had nowhere to go but up. As it did, so did Nye’s stock-related bonuses. In 2003, he earned stock bonuses worth $16 million, according to TXU records. Sometimes nearly bankrupting your company really can pay off.

Jake Bernstein contributed to this story from the Republican National Convention.