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Analysis and Commentary
The Enron story is a living manifestation of the flight of Icarus from Greek mythology. According to legend, Icarus and his father Daedalus were imprisoned in the labyrinth of King Minos. The labyrinth was an elaborate maze with very high walls. As Daedalus was an inventor, he created a set of wings so they both could escape. Because the labyrinth was too complex to navigate, the walls were too high to scale and the land was well guarded, the wings would let them fly over the walls and away over the sea. But the wings were made of wax and feathers. So, Daedalus warned Icarus that flying too high in the air would place him too close to the sun, where the heat would melt the wax. Similarly, flying too low would place him too close to the water, where the moisture would cause the feathers to fall out. Icarus could not resist the temptation and flew all over the sky, high by the sun and low by the sea. His father tried in vain to get Icarus to stop but to no avail. Despite knowing that his behavior was dangerous, Icarus did it anyway. Sure enough, just as his father had warned, as Icarus flew by the sun, the wax melted and his wings came apart. Icarus fell to the sea and drowned. He could not resist the temptation, even knowing that the very thing he was tempted to do would kill him.
Like Icarus, Enron embarked on a precarious path. For a time, it flew high by the sun. The company grew revenues from $10 billion to $100 billion in 10 years. It was a Wall Street darling. The executives became fabulously rich and were widely admired in their industry, the media, and the public eye. But Enron was destined to fail.
Before examining the Enron crisis of 2001, it may be instructive to consider an underreported crisis the company experienced in 1987. On 23 January 1987, Enron managers learned that Louis Borget and Tom Mastroeni, two traders in its Enron oil trading unit in Valhalla, New York, were engaged in unethical activity. Enron discovered that the two had opened a business bank account at Eastern Savings Bank and failed to notify Enron headquarters in Houston. Moreover, the pair had transferred $2 million from the business account to a personal account in Mastroeni’s name at the same bank (Eastern Savings Bank). When confronted with the issue, Borget and Mastroeni told Enron CEO Kenneth Lay that they used the accounts to hide two derivatives transactions that would shift profits earned in one quarter to the next quarter, and they did not want to draw undue attention to the company. In examining the issue further, Lay discovered that the two had doctored the bank statements when presenting their side of the story. But the oil trading unit had posted profits of $10 million in 1985 and $28 million in 1986.
In contrast to the trading unit, the parent company had been struggling financially. Enron had reported a $79 million loss in 1985, and although it reported $556 million in net income in 1986, most of that money came from recoveries of past income taxes. EBIT in 1986 was only $230 million. The profits reported by the oil trading unit were thus the lone bright spot in Enron’s financials. So, despite learning of their serious transgressions, Lay kept Borget and Mastroeni in place.
Later in 1987, Borget and Mastroeni were again under scrutiny. This time, Enron was staring at a potential trading loss from Borget of $1 billion, which would force the company into bankruptcy. Enron executive Mike Muckleroy stepped in, however, to finesse the trades and ultimately worked the losses down from $1 billion to $140 million. According to later testimony by Muckleroy, “Despite having protested the trading practices going on in the Oil Trading Unit — even to the point of getting kicked out of his office, Kenneth Lay played the ‘I didn’t know anything about this’ routine when the scandal broke” (Moore 2005). Lay, despite knowing intimate details of what had been going on, professed shock at the scandal and fired Borget and Mastroeni.
Despite the problems, Lay remained attracted to the trading business. It was was lucrative and had much lower capital requirements than the energy production and pipeline business. As Enron struggled with the capital intensity and low returns of its traditional business, Lay remained focused on building Enron’s trading capabilities. It was just a matter of getting the right people.
Enter Jeffrey Skilling. In 1990, Lay hired Skilling to lead the company’s commodities trading unit. Later that year, Lay hired Andrew Fastow, who ultimately became chief financial officer (CFO). As a consultant at McKinsey, Skilling devised an “asset-lite” strategy to selling natural gas, whereby the company would promise delivery of the commodity but not necessarily produce it. And Enron traders would use their skills to bring natural gas to market from multiple suppliers at the best price (for Enron). Lay first brought Skilling in as a consultant and then brought him on full time to implement this approach at Enron. Over the next decade, Enron, leaving behind its old roots, fully embraced the energy-trading business. Lay and Skilling devised a plan to aggressively expand the business, and Fastow was to figure out how to finance it.
During the run-up to the technology bubble in the late 1990s, Enron rode the wave and promised to transform the energy business, and even the internet, with bandwidth trading. The market anointed Enron as a transformative leader. At its peak in 2001, Enron’s stock price reached more than $90 per share, and its market capitalization topped $66 billion (Tran, 2001). Its P/E reached 55× earnings at March 2001 (McLean, 2001). The company was part of the so-called New Economy, which was light on assets and fast moving. And Enron fulfilled this perception until the early part of 2001. Then, Enron lost its reputation in a wave of scandals, culminating in the company’s spectacular collapse. Seldom in corporate history has a company gone from dominant corporate titan to completely defunct in such a short time.
What Went Wrong?
Enron was deceitful in four main areas. First, Enron managers manipulated the intent and purpose of using Special Purpose Entities (SPE’s) by using them as vehicles to hide debt and manipulate the parent company’s reported revenues and earnings. Second, they used “mark-to-model” accounting which essentially let the company estimate – and book – large profits when contracts were initiated, regardless of how the contracts performed over time. Third, senior Enron executives, such as CFO Andy Fastow, were principals in many of the SPE’s, not only presenting a material conflict of interest, but also enriched themselves in the process. Fourth, Enron posted large amounts of its stock as collateral to back the financing of many of the SPE’s making the entire financial structure of the firm vulnerable to a material decline in Enron’s stock price (for any reason).
Enron’s Special Purpose Entities: JEDI and CHEWCO
In the first area of deceit, Enron used and misused off-balance-sheet financing vehicles known as special-purpose entities (SPEs). SPE’s were used in many aspects of its business from at least the early 1990’s until its demise in 2001. By the time Enron collapsed, it had created as many as 3,000 SPE’s. According to a piece in the New Yorker, the paperwork for SPEs comprised around 1,000 pages each (Gladwell, 2007). To understand all of Enron’s SPE’s would require analysis on 3,000,000 sheets of dense legal disclosure. Consequently, there was no attempt made to perform an exhaustive review of each and every deal as it would be far too unwieldy. Consequently, the analysis presented below details the inner workings of two different SPE’s which are useful as models in understanding the nature of Enron’s scheme.
The accounting rules regarding SPEs (SFAS 125, SFAS 140, and EITF 84-30, 90-15, and 96-21) were designed for companies engaged in the sale and lease back of physical assets. Accordingly, for Enron to avoid consolidating the financials of these SPEs, each SPE had to meet three criteria. First, outside investors have to have at least 3% ownership. Second, the general partner of the SPE has to have control of the SPE in such a way that it does not act on behalf of the sponsor (e.g., Enron). Lastly, the SPE must possess the lion’s share of the risks and rewards of ownership. As long as these criteria were met, Enron did not have to consolidate an SPE on its financial statements. Enron typically used the Equity Method of accounting for SPE’s meaning they simply added Enron’s proportional share in the earnings of each SPE in a single line item on its income statement without disclosing corresponding balance sheet, cash flow and other considerations. Many of Enron’s SPE’s failed on all three criteria.
Off-balance-sheet financing techniques are, in fact, common in the energy business (and others) and can certainly be used in ethical ways. However, as is clear with the progression of Enron’s use and misuse of SPE’s over time, they became increasingly bold in circumventing ethical practices. In 1993, Enron created an off-balance SPE named the Joint Energy Investment Limited Partnership, or “JEDI” for short. This was a joint venture with CalPERS where CalPERS invested $250 million in cash and Enron invested $250 million in stock. At the time the first JEDI contract was entered Enron’s stock was trading at roughly $16 (split adjusted), while at the time of the disposition of CalPERS stake in 1998, Enron’s stock was trading at about $30. In other words, the $250 million posted in Enron stock in JEDI1 in 1993 was worth about $460 million by 1998. Which brings us to an important point: just because a risky action worked out well once (or for a given period of time), does not mean it always works out well. In other words, had Enron stock fallen to $8 instead of rising to $30 during this time period, the SPE, and perhaps even Enron, might have experienced a crisis (in 1998). Moreover, volatility of individual securities is a given in finance. In fact, the only rational expectation is that a given stock will inevitably experience meaningful bouts of downside volatility no matter how successful the enterprise. That said, the JEDI 1 deal was not necessarily unethical, though it may not have been entirely prudent as discussed below.
When Enron wanted to engage in a second JEDI deal (JEDI2) with CalPERS in 1998, they discovered that CalPERS wanted out of the first JEDI deal before they would invest in the second. CalPERS $250 million stake in JEDI 1 was then valued at $383 million. So, Enron had to come up with $383 million to buy them out. Enter Chewco. It is best to think of the Chewco deal as two separate transactions, one for temporary financing of the purchase of CalPERS’ stake (which we will review first) and the other permanent financing (to replace the temporary financing, which we will review second).
In the temporary financing deal, Enron created an SPE called Chewco through which Enron would buyout CalPERS’ stake. Chewco borrowed $383 million from two banks and bought out CalPERS’ interest in Jedi for $383 million, closing out CalPERS’ stake in JEDI 1. So far, so good. However, in order for these two banks to underwrite the loans to Chewco, they first required Enron to guarantee the loans, which Enron did. (The Powers Report also intimates that Enron was required to keep half the loan proceeds on deposit at the lending banks as collateral, but this was not verified.) In essence, Enron bore all the risk of these loans while Chewco got the rewards (i.e., the financing). Because Chewco gained approval from Enron’s auditors, the debt was kept off Enron’s balance sheet as an SPE. For Enron, the debt was merely a guarantee. The temporary financing deal to buyout CalPERS share of Jedi is illustrated below:
With respect to the permanent financing of the CalPERS buyout deal, this is where you have to pay attention closely. Fastow engaged in an elaborate scheme to keep the SPE’s from being reported on Enron’s consolidated financial statements, partly by creating a daisy chain of SPE’s that could potentially comply with accounting criteria governing non-consolidation.
Since leaving prison in 2011, Fastow has been fairly open about his motives while CFO of Enron. In a Fortune article dated July 2013, Fastow states:
“Accounting rules and regulations and securities laws and regulation are vague. They’re complex … What I did at Enron and what we tended to do as a company [was] to view that complexity, that vagueness … not as a problem, but as an opportunity. The only question was ‘do the rules allow it — or do the rules allow an interpretation that will allow it?”
As each SPE was required to have a general and limited partner, Fastow simply created another layer of SPE’s to act as the general and limited partners. Rather than solving a business problem, Fastow was solving a disclosure “problem.” The General Partner and Limited Partner in Chewco were SPE’s also created by Enron called Big River and Little River, respectively. So, Big River and Little River each borrowed $11.5 million from Barclays (for a combined $23 million). The documents governing these loans to Big River and Little River closely resemble promissory notes and loan agreements. Nevertheless, they were labeled “certificates” and “funding agreements” rather than simply being called “loans.” In fact, instead of requiring Big River and Little River to pay interest to Barclays, the Big River and Little River SPE’s were required to pay “yield” at a specified percentage rate (Powers Report, 2002). If you think that sounds an awful lot like an interest rate, that’s because, for all intents and purposes, it was. In other words, the money capitalizing the general and limited partners of Chewco only met the 3% requirement for equity contribution by deceptive paperwork regarding the debt. The documentation was intentionally ambiguous allowing Barclays to characterize the transactions as loans (for its business and regulatory reasons), while allowing Enron and Chewco to simultaneously characterize them as equity contributions. Of course, a single capital transaction cannot be debt for one party and simultaneously be equity for the other. Regardless of how it was labeled, in effect it was debt for Chewco and should have moved the entire transaction onto Enron’s balance sheet. In essence, the Chewco deal was kind of like a consumer who takes out a mortgage to buy a house and fails to tell the bank that the downpayment was also borrowed (from someone else). Enron borrowed money to put down equity on these deals…and then hid it from view through deceitful accounting. (According to the Powers Report, this was not an unusual practice, though the practice is certainly unethical.)
Both Big River and Little River each invested the $11.5 million into Chewco. Then Barclays, the same bank that lent $23 million to Big River and Little River, also lent Chewco another $240 million (for a deal total of $263 million from Barclays). As if that weren’t enough, JEDI – the very same entity that just received financing from Chewco at the temporary stage – turns around and lends to Chewco $132 million in the permanent stage (presumably by selling some Enron stock that was now valued at about $460 million). Lastly, Michael Kopper (an accountant working for Fastow) invests a mere $125 thousand as a personal investor in the deal. So, for a total money raised of $395 million, the only real equity in this deal (Kopper’s) amounted to a mere 0.03% of the capitalization of Chewco – equal to a leverage ratio for Chewco of 3,161x. From the perspective of the accounting, the capital Chewco received from JEDI was considered equity in Chewco, no matter how convoluted it is for entity A to finance entity B so that entity B can finance entity A. It should be noted that such financing was ONLY possible because Enron stock price appreciated materially. While we can’t know for sure if JEDI received additional third party financing during this period, such large financing would only have been possible in one of three ways: a) by using the Enron stock that JEDI owned by selling some; b) using the Enron stock that JEDI owned as collateral on third party loans; or c) by having Enron guarantee this third party financing. Whatever the case, Enron needed a strong stock price.
The astute observer may suggest that individual SPE’s don’t need to have the same safety and soundness that the overall parent company does, particularly if there is a portfolio of them. While true, the leverage does illustrate quite clearly that any declines in asset values will push the SPE’s financial needs back onto the parent. The Chewco “Permanent” Financing deal is illustrated below:
In the Chewco transaction, it is not entirely clear what the participating banks knew about Enron at the time. Presuming that they were not directly colluding with Enron, it appears that they suffered from a micro-macro bias (i.e., missing the forest for the trees). By looking at the limited scope of an individual transaction, it’s conceivable that they may have neglected the overall picture of Enron’s desirability as a trading partner, ethics and financial health. In fact, if they had just achieved an understanding of the entirety of the very deal in which they were instrumental in financing (i.e., Chewco), then both ethics and prudence would demand refraining from doing business with Enron. Alternatively, these banks may well have been aiding and abetting Enron, but such inquiry was outside the scope of this investigation. Whatever the case, the Chewco deal, and others like it, enabled Enron to hide debt.
One of the ways they used SPE’s was to purchase assets from the parent company. By investing in projects first with the corporate balance sheet and then selling the assets to an SPE, Enron Corporation could book a gain on sale almost regardless of how the underlying assets performed. This process created the illusion of ongoing earnings from these gains, which were booked repeatedly on the parent company’s financial statements. The SPEs then carried the debt used to finance the deal, which would remain off balance sheet and undisclosed to Enron investors. Much like a Ponzi scheme, the aggressive accounting techniques combined with aggressive growth to maintain the illusion of success. In 2001, Enron reported a total debt of $10.2 billion. The post mortem analysis revealed that Enron owed a total of $22.1 billion (more than 2x the reported amount) (Fisher, 2006).
The Chewco deal was a landmark for Enron. In fact, it served as a model for a number of subsequent deals whereby Enron skirted disclosure and accounting conventions. As illustrated by the convoluted Chewco deal, Enron was clearly using off-balance sheet vehicles with the explicit intent of hiding assets and debt and thereby creating a picture of a company that was performing much better than it actually was.
Enron’s Special Purpose Entities: LJM1
Another reason Enron engaged in SPE’s was for so-called “hedging” transactions. In essence, this is how Enron manufactured gains and hid losses. In March of 1998, Enron invested $10 million in an Internet Service Provider named Rhythms Net Connections. A little over a year later, in April 1999, the Rhythms stock went public in an IPO. The stock immediately soared (like many during the tech bubble) and by May of 1999, Enron’s stake was valued at $300 million. However, due to a lock-up provision, Enron was prohibited from selling its shares until December of 1999. Because the Rhythms investment was part of Enron’s merchant portfolio, its gains and losses would flow through to Enron’s income statement. Given the windfall gain, Enron wanted to hedge the position. However, because Rhythms stock was illiquid, there were no over-the-counter options with which they could hedge the position.
So, in June of 1999, Enron created the LJM1 special purpose entity (SPE). As it happened, Enron was also obligated to fulfill a number of forward contracts on Enron stock with an investment bank in an unrelated transaction. However, the appreciation of Enron stock during this period beyond the fixed fulfillment price of the forward contracts encouraged Enron to exploit the difference. Though GAAP accounting does not allow a company to recognize gains or income from changes in the value of its own stock, Enron sought to take advantage of any increase in Enron’s stock price to unlock this “hidden value.” Yet again, Enron management chose a path that was technically legal, but clearly unethical.
Enter LJM1. In essence, Enron created this vehicle to hedge their position in Rhythms stock with Enron stock. As you will see, there is no economic basis for believing that this structure was a hedge at all. Upon creating the LJM1 SPE on 30 June 1999, Enron also created the Swap Sub SPE. Furthermore, both LJM1 and Swap Sub had their own general and limited partners, effectively creating three layers of affiliated companies (Enron, the SPE’s and their GP’s/LP’s). The LJM1 transaction is illustrated below:
Enron transferred 3.4 million shares of Enron stock (valued at $168 million) to LJM1. Based on Enron’s closing stock price on 30 June, the value of these shares was approximately $276 million. However, because there were restrictions in place that precluded their sale or transfer for four years, Enron discounted the value of the stock by 39% when recording the transaction, yielding a discounted value of $168 million. In exchange, Enron received a note (i.e., a promise) from LJM1 for $64 million (due 31 March 2000) and a put from the SwapSub SPE (another promise) valued at $108 million, for a combined total increase in assets of $168 million. As you can see, Enron recorded $168 million going out and $168 million coming in. So the transaction itself was neutral to Enron’s balance sheet assets at the initiation of the hedge…from an accounting standpoint.
Next, LJM1 capitalized Swap Sub by “investing” $3.75 million in cash and 1.6 million of the Enron shares (recorded at $80mm) into the Swap Sub SPE, for a combined total of $83.75 million. In exchange, Enron received a put option on 5.4 million shares of Rhythms stock from Swap Sub. Note that Swap Sub – Enron’s hedging partner – records a net equity position of around -$20mm. That’s right, its liabilities exceeded its assets, so it was negative.
In order for a transaction to truly act as a hedge, it must be entered into with an independent third party who has both the ability and willingness to assume the costs and risks of the hedge. There are so many things wrong with this set up its hard to know where to start. Swap Sub was far from independent having Fastow and other Enron employees involved in the SPE’s and as their general and limited partners. With Swap Sub showing negative equity, they were far from having the financial wherewithal to take on a large single security hedge. Moreover, using Enron stock to hedge Rhythms stock has no economic basis. If Enron’s stock had appreciated, then Swap Sub, and in turn LJM1, would have been capable of fulfilling their obligations under the swap. However, such an outcome would have been due to sheer luck. There was absolutely no basis to believe Enron stock might appreciate if and when Rhythms stock declined. So, there was no economic hedge. Nevertheless, the structure did assume economic risk which would be born when ENE stock price fell.
In the days after the LJM1 transaction closed, Enron accountants determined that the hedge was not working effectively – creating volatile income on Enron’s income statement. In order to tamp down this unwanted volatility from the hedge, Enron entered into four additional derivative transactions on 13 July 1999 on Rhythms stock with Swap Sub at no cost to either party. However it is not clear how these additional derivatives were structured. On 17 December 1999, LJM1 paid Enron the $64 million note plus accrued interest. As LJM1 was capitalized with only $16 million, it is not clear where they came up with the proceeds to pay off the note. Because the Enron shares held by LJM1 were restricted (due to their role in the futures contract with an investment bank), it is likely that LJM1 borrowed much of the money to pay off the note by using the Enron stock as collateral.
The Unwind of LJM1
In early 2000, Enron decided to close out the hedge on Rhythms. Just like the creation of Chewco had a temporary and a permanent phase, so did the unwind of LJM1. At some point in the duration of the hedge transaction, Fastow and a number of his Enron colleagues created an SPE named Southampton, LP which bought out LJM1’s interest in Swap Sub as the general partner. During the unwind phase, the principal investors in Southampton were meaningful beneficiaries of the unwinding of the LJM1 deal (more about Southampton in the Behavioral and Agency section below).
The temporary phase of the unwind began on 8 March 2000. At this time, Enron gave Swap Sub a put on 3.1 million shares of Enron stock priced at $71.31 per share for a notional value of $221 million. That same day, Enron stock closed at $67.19 (lower than the strike price on the put) meaning that the put Swap Sub received was “in the money” by $12.8 million. Enron’s Chief Accounting Officer Richard Causey testified to the Powers Committee that the put was given to Swap Sub to freeze the economics while the negotiating of the unwind could be finalized.
On 22 March 2000, Enron and Swap Sub entered into an agreement to unwind the hedge. The terms were as follows:
The impact of the hedge was as follows:
The Economics of the LJM1 Transaction
As illustrated in the below table, the three primary entities involved in the LJM1 hedging transaction were Enron(ENE) as the sponsor, LJM1 as the senior SPE and Swap Sub as the subordinate SPE. Because not all of the former employees cooperated with investigations subsequently, not all of the documentation of Enron’s off balance sheet entities were recovered either. So, there are gaps in our knowledge. Of course, each SPE had its own general and limited partners, but data on those was even harder to come by. Nevertheless, a fairly clear picture of what management was doing does indeed emerge. As illustrated by note 1 in the graphic below, the Rhythms hedge had no impact on Enron’s reported assets when it was entered into on 30 June 1999. As illustrated in note 2, Enron reported a gain of $319 million from the transaction at the date of unwind on 28 April 2000, just shy of 10 months later, but the net change in cash to Enron was only from the $64 million it received as a note from LJM1.
As far as LJM1 is concerned, it received 3.4mm shares (pre-split) of ENE stock at initiation valued at $168mm (including the 39% discount), but forwarded only 1.6mm shares to SWAP SUB (the subordinate SPE). LJM1 simply kept 53% of the ENE shares they received as a windfall gain worth an estimated $89mm at initiation. Moreover, upon the unwind of the deal on 28 April 2000, LJM1 also wrote-up the ENE stock to effectively remove the 39% discount (that had been debited against the shares at the initiation of the hedge) as illustrated in note 3. LJM1 was of course controlled by Fastow. So, in essence, Enron legally bilked 3.6mm Enron shares (post-split) from investors so that various employees of Enron might personally benefit. Take a breath while you absorb that. They used ENE stock as collateral in these deals so that they might personally enrich themselves in violation of accounting rules, but this very strategy of using ENE stock in deals made them vulnerable to collapse when the price of ENE stock fell.
Lastly, as illustrated in note 4, SWAP SUB was more or less a pass through entity. It received 1.6mm shares (or 3.2 mm shares post-split) of ENE stock at initiation and returned 3.1mm shares (post-split) of ENE stock at unwind. (It appears that SWAP SUB retained 100k shares for itself at the unwind – meaning we don’t know where those shares went, but they likely went to Fastow.) It appears the sole purpose of SWAP SUB’s existence was to help LJM1 achieve non-consolidation of its financials. The net effect of this “hedge” from Enron’s point of view was to record a gain of $319mm by posting ENE stock as collateral during a period when Enron’s stock price was down roughly 15%.
In turning to the ethics of these transactions, several Enron employees were secretly offered financial interests in LJM1 by Fastow through Southampton SPE. These employees accepted the opportunity in clear violation of the company’s Code of Conduct policy. Why do employees do such a thing? It’s not quite clear, but participation in these SPE’s suggest a combination of behavioral processes at work. First, it suggests a Milgram bias where employees may participate in an unethical activity by assigning blame to the senior executive(s) sponsoring the activity. It may also show incentive-caused bias as these employees might have been reluctant to disappoint a senior executive at the firm to maintain job security. It also shows greed, that they would enrich themselves despite the obvious conflict of interest. And it shows micro-macro bias insofar as these employees failed to understand the totality of what their involvement meant in what the senior executives were doing. In truth, employee participation in the Enron SPE’s is probably due to the intersection of all these human foibles.
Clearly, Fastow and other senior executives’ ownership in these SPEs shows something much different. These executives were in full purview of the nature and scope of these transactions. It is not plausible to accept the notion that they believed that Enron stock would never go down materially. This is a question of basic finance. All the principals involved here, from Andy Fastow to Jeff Skilling to Kenneth Lay were far too sophisticated and experienced in finance to gloss over such a basic concept of risk. Using Enron stock to back these financing deals suggests a degree of hubris that is almost unparalleled. It suggests that they thought they could scam investors and grow the company without ever having a consequence. It suggests that their financial sophistication had to be at odds with their corporate strategy. On some level, they had to know that it could not continue.
Whatever the case, they discovered that using SPE’s in this way could shift mark-to-market losses on specific investments from Enron to the SPE (or a group of SPE’s). While at first it may seem like a heads-I-win, tails-you-lose situation, in reality these tactics were merely delaying the economic consequences of their investments and enabling them to build up to unsustainable proportions. Also, because the hedge “worked” for Rhythms, it led Enron to believe they could amplify these efforts with SPE’s called Raptors. The Raptor SPE’s by and large mirrored the Rhythms-LJM1 hedge.
The Raptors 1 transaction transferred Enron stock to Raptor I (Talon LLC) to hedge a host of merchant investments, such as Avici Systems. The Raptor II transaction was created solely because Raptor 1 had exhausted its credit capacity with the combined declines in both Enron’s merchant investments as well as Enron stock. Raptor III was identical to the other Raptors except it was designed to hedge the value of stock warrants in a company called New Power Holdings with stock warrants in a company called New Power Holdings. That’s not a mis-print. That’s what they did with Raptor III. Raptor IV was created to provide financial support to the other three Raptors. But the tech stock bubble collapse throughout 2001, reduced the value of securities and assets in Enron’s merchant portfolio, and created a recession in the US economy. This combination meant that Enron’s stock went down (not up) as the value of these other assets went down. What transpired in the markets in 2001 simply fulfilled what a sensible observer could have expected all along.
By the third quarter of 2001, the Raptors had a combined deficiency of over $500 million. Enron was no longer able to keep the Raptors off the parent company’s books. Enron agreed to buy the Raptors from Fastow’s LJM2 partnership for $35 million. On 16 October 2001, Enron Corporation reported a $638 million loss for Q3 and declared a $1.01 billion charge to equity due to write-offs of failed water trading, broadband trading and the unwinding of the Raptor SPE’s run by CFO Andrew Fastow. The write-offs required historical charges as well. 1997 earnings declined by $27 million; 1998 earnings declined by $133 million; 1999 earnings declined by $248 million; and 2000 earnings by $99 million. The bulk of this write-off represented the consolidation of the Raptors. Not only did this announcement surprise the market, but it immediately began to destroy trust the market had placed in the firm.
The announcement caused not only the financial markets to reconsider their relationship with Enron, but also Enron’s auditors. Arthur Andersen, Enron’s chief auditor which had previously given its blessing to many of these deals, suddenly reversed course. As stated in the subsequent Congressional testimony dated 12 December, 2001 Andersen CEO Joe Berardino said:
“When we reviewed this [LJM1/Swap Sub] transaction again in October 2001, we determined that our team’s initial judgment that the 3 percent test was met was in error. We promptly told Enron to correct it.”
Days earlier, Arthur Andersen determined that Swap Sub failed to qualify for non-consolidation. Consequently, Enron was forced to consolidate Swap Sub and hence LJM1 onto its books in a public announcement. Little more than 3 weeks after announcing the major charge to earnings and write-down of equity on 16 October, Enron disclosed that Swap Sub was not properly capitalized on 8 November, 2001. Enron Corporation then fell into a fatal tailspin and officially declared bankruptcy on 2 December 2001. Inevitability had met reality. In the span of just two months, the foolish financing that Enron engaged in had come undone.
The LJM1 transactions reveal a lot about the mindset of Enron management. Using Enron’s stock as collateral made Enron’s ability to keep these deals off their books dependent upon the price of Enron’s stock. Using the [off-the-books] SPE’s to enrich themselves made this disclosure imminent if and when the SPE’s were consolidated. Using the SPE’s to take on large amounts of debt meant that the company was not only taking on large amounts of risk, they were also ensuring that the large amounts of risk would be dealt with harshly if and when the markets found out. And the risks from this hidden debt was not just financial. The favorable ratings of Enron’s public bonds by the ratings agencies (e.g., S&P) were critical to their ongoing ability to finance their operations. This combination of foolish tactics sealed Enron’s fate. The Enron approach was not just a different way of doing business, it was, in fact, a way of going out of business, albeit slowly. No matter how distorted a company’s accounting is, eventually, accounting and economics converge.
Enron’s executives violated the condition that the SPE was not supposed to act on behalf of the sponsor (i.e., Enron) because of the obvious conflict of interest. Moreover, these SPEs were not left alone to bear the success or failure of their investments. In fact, Enron’s finance team made numerous amendments to many of the agreements with their SPEs over time so as to shield Enron Corporation from losses accrued. Enron executives also violated the third criterion for non-consolidation regarding the risks and rewards of ownership. Clearly, the risks and rewards of ownership were not fully transferred to these SPE’s. Perhaps this is where Enron’s executives got tripped up – thinking they could keep changing the rules of the game and extend it indefinitely. But these tweaks on the margin paled in comparison to the central thrust of their approach – wagering that Enron stock would continue going up indefinitely.
Mark-to-Market & Mark-to-Model
Turning now to Enron’s accounting methods, Enron used mark-to-model (not just mark-to-market) in accounting for a wide range of commodity and derivatives contracts. For contracts that lack a readily available market price, Mark-to-market accounting allowed the company to estimate the present value of each contract by projecting both future costs and benefits, which of course are uncertain at the time the contract is entered. In essence, Enron booked profits at the date the contract began, regardless of how these contracts ultimately performed in the future. In short, it was a legal way to inflate earnings. Of course, for illiquid assets, marking to model is necessary, but in such cases, there needs to be an aggressive discount for the uncertainty of what market prices and costs will be realized over the life of the contract, not to mention the constraints from poor liquidity.
Perhaps the most aggressive usage of mark-to-market accounting was included in accounts Enron called “price risk management assets” (or PRMA’s). This was the bucket that Enron placed the estimated fair value of various trading and derivative contracts. Of course, where there were liquid markets, Enron was supposed to record a value consistent with quoted market prices. However, in many contracts, Enron was a holder of unique and/or illiquid contracts where it had to create models to estimate the “fair value.” In 1999, Enron’s PRMA’s were valued at $5 billion. By 31 December 2000, Enron’s PRMA’s were valued at $21 billion. Without being able to analyze each individual contract and the assumptions made, it is not possible to render a professional judgement here, but it is an area that gives management wide latitude to distort the economic value of contracts.
Mark-to-market accounting [on liquid marketable securities] presents enough difficulty grappling with the expected prices, costs, and hence estimated profits that must be booked at the time the contract is entered. Mark-to-model accounting is even more tenuous. Rather than live with the subsequent gains and losses of a typical mark-to-market contract, this technique clearly distorts the underlying economic reality of the business; the contract owner can simply make up a number and not be confronted with a different reality until the contract expires. In the case of an offsetting hedged position, one can make a case for such accounting treatment, particularly where liquidity can be a concern. For illiquid assets, such hedges have material basis risk. As noted in the SPE section, Enron got to cherry-pick which assets for which they wanted to “hedge” and consequently manufacture gains.
In an interview with short-seller Jim Chanos, he stated that he first gained interest in Enron after learning that energy merchant banks had successfully lobbied the US Congress in the 1990s to use mark-to-market accounting for certain derivatives contracts, and Enron chose this accounting method. In Chanos’s words, “Any time you have a company that can front-load profits, you’d really suspect the company of corporate abuse” (Chanos 2010). Moreover, the off-balance-sheet techniques it used also enabled Enron to sell underperforming assets to book gains rather than report losses. So, the company could pick the assets that performed well to keep on the balance sheet, divest those that were underperforming, and book a gain.
Third, senior Enron executives, including CFO Fastow, were part owners in some of these SPEs. Not only was their personal ownership inadequately disclosed, but the structures were also designed to enrich the executives at the expense of shareholders. During his tenure at Enron, Fastow “earned” $37 million just from these off-balance-sheet financing deals, separate and distinct from his compensation as CFO. Because these transactions were not arm’s length, such self-dealing was clearly unethical and also violated securities laws and numerous regulations. In footnotes to Enron’s fiscal year 2000 financial statements, one note refers to a related-party transaction with a senior executive, although the note does not cite Fastow by name. It suggested that “management believes that the terms of the transactions with the Related Party were reasonable compared to those which could have been negotiated with unrelated third parties.” Yet, the transaction in question involved the sale for $41 million of put options by Enron, where the put was almost certainly never going to be in the money, to one of its SPE subsidiaries controlled by Fastow.
Posting Stock as Collateral
Finally, Enron aggressively financed its SPEs by posting large amounts of Enron’s stock as collateral, which also remained undisclosed. Of course, stock prices of even the best companies can get hit hard for both good reasons and bad. In fact, any rational person with even limited experience in the markets would know that stock prices fluctuate— materially. If Enron’s stock price were to fall materially — whether from an occasional misstep, a bear market, or even on the back of a rumor — the unwinding of the entire financial structure of the firm would be assured. No public company can avoid volatility in its stock price forever. Therefore, Enron’s demise was inevitable.
In August 2001, Enron accountant Sherron Watkins warned CEO Kenneth Lay in a now-famous email about accounting irregularities discovered at the company (Watkins 2002). Specifically, she raised issues about two off-balance-sheet structures, Raptor and Condor, and described the intricacies of how Enron pledged stock to support these vehicles. Enron was flying by the sun, even though meltdown was inevitable.
Many Wall Street firms provided both strategic and financial advice to Enron during the lead-up to Enron’s demise. Merrill Lynch, JP Morgan, Credit Suisse First Boston, Citigroup, and others were intimately involved in the financing of Enron’s SPEs. Unlike Daedalus, these firms were all too happy to encourage Enron to fly near the sun. Analysts now believe that special financial deals these banks engineered for Enron moved about $11.9 billion off of Enron’s reported debt levels in 2000. The fees from the banks’ engagements were, of course, very lucrative. According to Chief Congressional Investigator Robert Roach, both JP Morgan and Citigroup then proposed the Enron scheme to other companies to help them hide debt. And Citigroup sold it to three others (Roberts 2002).
All of this analysis is of course possible in hindsight. But it also begs the questions “What was knowable and when?” How could an astute investor have identified something was awry? From a fundamental perspective, the company was reporting exceptionally high growth while also reporting very low returns on invested capital. While there is nothing inherently wrong with low returns in and of itself, it does suggest a couple points worthy of investigation. First, perhaps the low returns are temporary. As the company establishes a foothold in its markets, perhaps the harvesting of returns will soon begin to offset large capital outlays. In the case of Enron, they had begun investing in the trading business in the early 1990’s. By 2001, they should have been well into the harvesting phase. Established trading operations, such as the major investment banks (Goldman Sachs, Morgan Stanley, JP Morgan, etc.) didn’t endure years and years of investment without harvest. Nor did the major investment banks suffer limited harvests during the period that Enron had. Nor did that make sense given the nature of Enron’s trading operations.
The combination of low returns and high growth likely induce a reliance on capital markets, which on the margin creates more risk to future cash flows. Enron of course did exhibit a high reliance on capital markets. Perhaps the low returns demonstrated a company that is aggressively pushing growth at the expense of prudence. In the case of Enron, they were combining a portfolio of stable, low return energy businesses with high return trading businesses. Consequently, the combined business should have demonstrated high incremental returns. It didn’t. This is a red flag and was readily observable from public information over the 5 years preceding its collapse.
In terms of history, the Cendant fraud began to unravel in 1998. There are some similarities between the two cases insofar as management in both situations used transactions to distort reported results and disguise self-dealing. In the case of Enron, they used off balance sheet vehicles. In the case of Cendant, they used M&A. In both cases, they engaged in gross self-dealing and got scores of employees to facilitate the fraud. A High volume of legal transactions creates opportunities for management to revalue assets and liabilities for their own personal benefit. In fact, this is fairly common in cases of fraud and should be considered, not necessarily a red flag, but a cause for further investigation.
Agency & Behavioral Dimensions
In terms of agency costs, the magnitude of agency problems with Enron is truly staggering. Obviously, management was not acting in shareholder interests. However, many rank and file employees were in on the ruse. Enron’s auditors provided their blessing on deals that were clearly designed for Enron’s accounting benefits, not for their economic benefits. In some cases, Enron even garnered fairness opinions on specific transactions from supposedly independent third parties, like PWC. Lastly, investment bankers were intimately involved in many of these deals and in fact shopped the concept around to other companies to help them manufacture earnings. Enron even tried to “capture” Wall Street analysts. A number of sources suggest that Enron executives threatened to switch to competing investment banks if the banks did not fire analysts who took a negative view of the company. While analyst retribution is common in finance, its familiarity doesn’t make it any less problematic. Such capture is an example of one of many agency costs faced when investing.
With respect to the behavioral dimensions of the Enron scandal, there are many factors at work. Because there was a kernel of truth to Enron’s financial innovation — and because the complete financial profile of Enron was disguised from the public — the market became swept up in Enron euphoria. Enron was considered a so called “New Economy” company. Meme repetition and social proof were powerful allies in carrying Enron to stratospheric heights. In early 2001, ENE had reached a peak multiple of 63x earnings. And of course, this was based on inflated earnings.
In fact, Enron would have collapsed much sooner had its stock price collapsed sooner. Not only was the market swept up in Enron-mania, but sell-side analysts and financial media were as well. Consider the following quotes published just months before Enron’s demise:
“For Enron to say we can do bandwidth trading is like Babe Ruth saying I can hit that pitcher. You tell him to get up there and take 3 swings. The risk is staggeringly low and the reward is staggeringly high.” – Steven Parla, Energy Analyst at CSFB, Fortune, 24 January 2000).
“What’s new is that Enron is trying to make bandwidth a commodity. Absolutely, it will succeed. I think everyone wins.” Brownlee Thomas, senior telecom industry analyst for Giga Information Group. (Fortune, 24 January 2000).
“Enron has built unique and, in our view, extraordinary franchises in several business units in very large markets.” – Goldman Sachs analyst David Fleischer. (Fortune, 5 March 2001).
Of course, such lavish praise means absolutely nothing when it comes to due diligence. But it is just as clear that many market participants are fooled by such memes.
The financial media similarly promoted the innovation meme. Forbes magazine had ranked Enron as the most innovative company in the United States for six years running as of 2001. Other memes extolling the virtues of Enron were rife on Wall Street and Main Street alike creating belief by repetition. This strange combination of events enabled Enron to fool many investors, who then rewarded the company with higher and higher stock valuations. It all worked just fine — until it didn’t. And its collapse was all so predictable — had details of its financing structure all been transparent (or public).
The stock price history of Enron is noted in the graph below:
Many presume that large public companies have enough interested parties to prevent gross self-dealing like this. Alas, Enron stands as a testament to the limits of our knowledge (and actual financial disclosures). But it also requires a bit of suspended disbelief to come to accept that a large, “successful” company with well-credentialed management and a wide range of interested parties, would do something so utterly foolish. In the final analysis, executives at Enron were simply too tempted by the rewards and prestige of running a large successful company without showing an ounce of care or consideration for all the other interested stakeholders. They were willing to do just about anything to fly by the sun, but they were, quite simply, destined to fail.
The source for this paragraph is Arbogast (2008).
SFAS is statement of financial accounting standards; EITF is the Emerging Issues Task Force of the Financial Accounting Standards Board.
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