Some Background
In 1984, Ken Lay's first major action as CEO was to fight off a takeover. In response to this threat, he positioned his Houston National Gas predecessor to Enron like "pure-play" Texas gas-gathering and processing companies. This specialization extended into the national natural gas market and, subsequently, the regional electricity markets. Whether or not Enron was as good as its public perception was in these markets is not the topic of this work. Though we provide some background information to set context, our focus is on Enron's post-1997 activity. Unfortunately, this activity saw Enron lose its energy focus and disappear. [2]
Particularly from 1999 on, it appears that Enron was a house
of cards, or, more correctly, a shell game.
Of course, our analysis is retrospective.
Enron’s asset shell continued to grow in value into 2000. Had one
bought one share of Enron predecessor, Northern Natural Gas, stock in January
of 1979, then the maximum value of this postion was attained on August 23,
2000. A $34.75 investment had grown to $3,683.60.
The primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income up, asset values inflated and liabilities off the books. These actions were probably a broad conspiracy, the work of a rogue Treasury department, or hubris and bad luck. Nevertheless, most paths to Enron's gutted corpse are touched by Enron's CFO, Andrew Fastow. Given the continued and pervasive pattern of action and deception, it is hard to see how those who supervised him could not have known something was amiss. Events around March 2001 are particularly troubling. Incredibly, a major source for our analysis, the Enron Board Report of the Special Investigative Committee (pdf), does not provide a thorough analysis of the Board's role in March 2001 and subsequent transactions.
So, what happened to Enron? Based on a reading of public documents, this thesis runs through the following fateful chain of events:
- Growth/Market Integration - Interstate natural gas market deregulation presented an integration and innovation opportunity. In taking advantage of this opportunity, Enron like many energy companies was not cash rich.
- Own Equity Transactions and Derivatives - The
structure of a successful partnership revealed two techniques for Enron
Treasury departments' financial "Eureka."
a. "Available for Grant" shares from Enron's stock grant and stock option plans.
b. Monetizing gains on derivative hedges of the stock plan in a partnership structure. - Risk Restructure and Shifting - Through another partnership structure, market price risks were shifted into credit risks. For a while, earnings volatility and declines were limited.
- Credit Failure and Default - Deteriorating credit capacity (or simply decreased collateral) in various partnerships was augmented by Enron's own equity-related transactions to prevent write downs of the credit. Ultimately, nothing was left for shareholders and employees of Enron (or much left for creditors.)
Up until it's downfall, Enron's credit ratings had been remarkably stable. Nevertheless, as their leverage grew through outright lending, lending guarantees and the implicit lending associated with many derivative transactions, Enron failed to upgrade their credit capacity. [3] Unfortunately for Enron, they failed to set up such reserve credit capacity. Effectively and contrary to their public pronouncements, Enron held on to its assets and was short of cash.
More importantly, Enron failed to write down poorly performing partnership investments. Subsequently, these losses added up to the level of annual earnings. We believe that this situation could have been remedied with significant "one-time" pain in March 2001. Up until that time, Enron's support of the partnership structures might have been defended. Instead by continuing to exchange restricted stock-related claims with their partnerships, Enron pushed even further. Since Enron's partnership values were falling, they propped up the values artificially by mis-pricing Enron restricted stock-related derivatives in favor of the partnerships and to the detriment of Enron shareholders and employees.
Since auditing for Enron and the partnerships was done by different accounting firms and the limited partners in the partnerships were said to demand confidentiality for the partnerships, such valuation inconsistencies were difficult, if not impossible, to uncover. Only if Arthur Andersen had demanded to see detailed partnership accounting documents and matched the entries against the associated Enron entries would they have been able to uncover these structures. If those documents were not forthcoming, then their only choice would have been to withhold their audit fairness opinion. In retrospect, it seems clear to all Arthur Andersen should have aggressively sought more information, and without it they would have had to resign. [4]
Financial analysts, the financial press, the famous internal Watkins memo and other negative reviews of the situation focus on declining partnership values, and not on how these values could be supported without showing losses. During this time, Enron's internal risk management and valuation teams were evaluating the certain partnerships and penalizing them for poor performance. [5] The reason that these controls did not hold is that own equity transactions are not accounted for as other equity, currency, debt and commodity investments are. Enron accounted for the fair value of it's restricted shares at the current spot market value. On the contrary, these shares were restricted promises to issue the shares, and the partnerships accounted for them on a future or forward market value basis.
For a stock that pays a low dividend such as Enron, the future-based assessment of value will be greater than the current spot value. This difference grows with a greater difference between interest rates and dividend yield and longer maturity. Since the partners in Enron's partnerships owned about 3% of the partnership equity, any transfer of restricted stock to the partnerships ended up being a direct transfer of 3% of any value difference to the general and limited members of the partnerships. The additional 97% of the value difference was simply a transfer of value from Enron shareholders to themselves. Nevertheless, adding this second component of value to the partnerships allowed them to have sufficient creditworthiness in their assets not to be formally questioned.
With every such transfer, more under-performing Enron assets could be moved into the partnerships. Every dollar transferred also generated value and fees for the general and limited partners of these related entities. [6] In his Senate testimony, Enron Finance Committee Chairman indicated that he continued his lack of understanding of this situation: During the hearing, Mr. Winokur was asked about Enron's ongoing liability for the Raptors. “He admitted knowing that Enron had retained a risk despite setting up the Raptor ‘hedges,’ but declined to admit that Enron shares had been pledged as collateral. He stated that the Board had pledged "forward positions on Enron stock," and not Enron stock itself.” [7]
We focus on March 2001 as the prime period for identifying fraud at Enron. In March 2001, Enron's Board authorized 21 million additional restricted shares of stock under a new amendment to their 2001 stock plan. [8] Additionally, the Board authorized a share split. Though we evaluated these actions only from the value transfer perspective, it is important to note that increases in shares available for option grants and a share split are usually indicative of improving firm prospects. [9] In retrospect, the positive signaling aspect of these Board actions was clearly off.
The availability of stock plan shares provided another opportunity to add more mis-valued Enron restricted share contributions to its partnerships. By rudimentary calculation, at least 12 million restricted shares were added to the Enron partnerships in March 2001. At the then NYSE closing share price of $47, this investment totaled $564 million. In return, Enron received a $568 million dollar note. However, restricted share holder could use these shares as a perfect hedge in a term stock loan. As such, the loan would earn interest on the cash share value over the life of the restricted stock grant. Unlike many restricted share grants, the Enron grants had a fixed maturity date and could explicitly be used as share loan collateral.
With a ten year maturity, $55 stock price; and assuming a 5.6% cash investment return and 2.5% dividend yield, 12 million restricted Enron shares would be worth about $75 on a forward basis. Under the mark to market accounting used in the partnerships, the discrepancy between the $75 owned and the $47 owed to Enron for the shares is $28 per share. To ascertain the value of $28 per share in ten years, we discount this value down to $16.50 per share. The total value of this 12 million restricted share transfer is almost $200 million. [10] At the same time, an additional 18 million shares were transferred to partnerships in a particular derivatives structure. Subsequently, our calculation of the net value of this structure is $568 million. Therefore, our estimate of Enron's March 2001 net value additions to the partnerships is $768 million. [11]
In our assessment, the Enron Treasury transactions of March 2001 benefited special purpose entity (SPE) general and limited partners immediately by about $23 million (3% of $768 million). By providing $768 million in extra assets to them, it allowed the partnerships to remain operating and decline further in value for an additional six months. Following information of Skilling's retirement in August, decreased earnings in September, restatement of income and balance sheet information in October, and the fall below an investment grade credit rating in November, Enron for all intents and purposes ceased to exist.
The predominance of academic work on managers' hedging firm risk is favorable toward the activity. Among academic literature, our interpretation of Enron's actions and fall is from the managers' hedging perspective. Another relevant literature deals with compensation, and particularly manager's hedging of their restricted stock and option-based compensation. As we discuss in our sequel, Enron consistently attempted to signal good corporate hedging practice, while at the same time undoing these actions with offsetting derivative transactions on Enron's own underlying shares.
The managerial hedging literature begins with the risk reduction perspective of Stulz (1984). Hedging risk should lower costs related to financial distress and expected tax costs under progressive tax structures, Mayers-Smith (1982), Smith-Stulz (1985), and Nance-Smith-Smithson (1993). By reducing the risk of debt, hedging also can alleviate conflicts between managers, equity holders and creditors. The cited works point to the benefit of hedging undiversifiable risks by reducing managers and equity holders potential for under investment in positive net present value (NPV) projects. By hedging against the risks that will benefit only bond holders, managers equity holders should better allocate their capital to projects with the best growth options. Hedging also may limit the delegated management problems faced by equity holders.
Another branch of the hedging literature emphasizes the signaling aspect of managers' hedging actions. These works are differentiated primarily by their information set partitions. Breeden-Viswanathan (1998) is indicative of work in which managers know how good they are. In their case, the best managers hedge to distinguish themselves from less effective managers. The other strand of this literature is specified in DeMarzo-Duffie (1995). In their model, managers and the market both are uncertain about managers' abilities and project characteristics. Managers only have better information about firm risks. With additional treatment of different disclosure rule sets, DeMarzo and Duffie show that full disclosure of manager's hedging activity can result in over hedging (risk increasing) activity by the best managers. They also motivate decentralized hedging at a divisional level.
Empirical tests of these hedging hypotheses find, generally, that both better firms and highly risk sensitive firms tend to hedge more. Nance-Smith-Smithson (1993) first documented this phenomenon across forwards, futures, swaps and options and all market risks. Subsequent studies of the gold market by Tufano (1996), foreign exchange by Geczy-Minton-Schrand (1997), as well as oil and gas by Haushalter (2000) all find that more risky firms hedge more. Tufano documents different behavior for managers whose stock holdings are in the form of stock or options. He finds that option holders hedge less, while shareholders hedge more. In examining the efficacy of oil and gas market hedging instruments, Haushalter finds that firms with significant idiosyncratic or basis risk tend to use market risk hedging tools less. Finally, Geczy-Minton-Schrand and Haushalter identify more hedging by firms with scale economies in hedging.
In the corporate finance context, Enron seems to have learned well the way to manage investors' expectations. They appeared to hedge their macro-business risks extensively. As we have noted, these actions are consistent with signaling high-quality projects, performance-oriented management, limiting risk, continuing opportunity for growth investments, tax minimization, and economies of scale in hedging. [12]
In reality, the DeMarzo-Duffie signaling story seems to fit three interesting dimensions in Enron's post-mortem: First, separate divisions were mostly under performing and, therefore, obfuscated the picture of their units by not making relevant disclosures. Secondly, these units drastically increased the risks in their enterprise. Third, increased hedging activity disclosure (particularly FAS 133) could motivate managers to hedge less because hedged profits are more informative about ability and expose the manager to greater risk from the firm's random performance. In this manner, "good" units like energy trading and service could have behaved like "bad" performers by taking on additional risk. Therefore, once things turned down no transparent, low risk and marketable divisions remained to support whatever growth options still existed for Enron. [13]
On the point of growth options, there is some rationale for judging a part of Enron's fall as a bad draw. Particularly, the September 11 events placed energy deregulation on a back policy burner. Enron was always aggressively pushing to open new markets, and had been successful in these endeavors. Subsequent Supreme Court and Federal Energy Regulatory Commission decisions (FERC) could have raised Enron's growth potential had they come sooner.
In the end, Enron provides a clear example of an Agency problem explosion. Despite public pronouncements of their "asset light" strategy and almost growth-annuity income prospects, Enron simply shifted its under performing investments into non-reporting entities. We have not been able to identify ANY asset that Enron sold to the market. Furthermore, Enron's decline in asset quality was not offset by any significant increase in loss reserves. Instead, all asset sales were made to related parties. Additionally, these transactions were cloaked as low-cost transactions with economies of scale derived from the Enron Treasury-related "external" investment bank, LJM.
The agency value transfer for senior Enron executives will be clearly brought out in their stock transfers. Nevertheless, Enron entered a whole new level of corporate hedging by actively hedging their Enron shares. As noted in Ofek-Yermack (2000), executives undo the agency resolving aspects of their own stock positions by selling off their holdings when new grants are made. Enron took this process even further by conducting such transactions at the corporate level.
The pervasiveness of agency transfers is illustrated with three new personal hedging transactions. The three parties to these transactions were Jeff Skilling, Michael Koppers, and Andrew Fastow. Mr. Skilling introduced the drastically overpaid related party on the payroll transfer by having his fiancé and Enron board secretary receive a $600,000 annual salary. Mr. Kopper signed over an approximate $12.5 million partnership interest to his domestic partner. Mr. Fastow's investment banking income from LJM surpassed $40 million. All of these actions were either approved, known or unquestioned by the small, well compensated and highly related Enron Board of Directors. [14] As a final lesson in running an asset shell game, Mr. Skilling, Mr. Koppers and Mr. Fastow are building palatial residences in Texas, where primary residences are not subject to bankruptcy foreclosure.
The Transactions
Among Enron's many transactions, we focus on four particular developments and related structures. The chain of these structures both follows and matches the chain of events that we noted above. Particular names apply to each of the events and structures, respectively:
- Enron/HNG - Growth/Market Integration
- JEDI and Chewco - Own Equity Transactions and Derivatives
- LJM and Rhythm - Risk Restructure and Shifting
- Raptor [15] - Credit Failure and Default
Enron's core natural gas transmission business supported a circle of poorly chosen and managed investments that devoured the central value. Enron's Treasury staff performed end of quarter and fiscal year contortions to push accounting and financial numbers in particular directions. The likely rationales for these actions are two: maintain the illusion of Enron's growth, and meet bonus, stock and option grant performance levels. [16]
1. Natural Gas Deregulation and Initial Strategy - Enron/HNG
In 1974, Deputy UnderSecretary Kenneth Lay left the Department of the Interior and joined Florida Gas (subsequently renamed Continental Resources Company.) He rose to the Presidency of Continental Resources and was Executive Vice President of its parent, Continental Group. In 1981, he became President and COO of Transco, a Texas oil and gas company with a pipeline in New York. [17] Though he may have followed a far too prevalent practice of write the rules and then get paid to bend the rules, there is no question that his integration of natural gas pipelines across state jurisdictions was effective and profitable. [18] His success came after leaving Transco for Houston Natural Gas (HNG) in 1984. He focused HNG on natural gas production and transmission, and merged into Internorth. In 1986, Internorth was renamed Enron. [19]
In 1992 and 1994, Public Utility Holding Company Act of 1935 (PUHCA) amendments exempted holding companies investing abroad and power marketing-trading operations, respectively. These amendments set the stage for Enron's international and domestic initiatives. A critical fault in Enron's expansion strategy was their assumption that their past success in breaking down or leading the charge through falling natural gas market barriers would translate directly to other markets. In particular, Rebecca Mark led Enron's international and interregional power, water and other investments into businesses that did not return natural gas deregulation-era levels of returns. These investments were capital/asset intensive. Simultaneously, Jeff Skilling led a competitive domestic energy focused set of initiatives. He called his effort the "asset light" strategy.
By 1999, disruptions in foreign markets led to stagnation of or retreat from emerging market countries' international market integration. Any linked potential for growth in the Rebecca Mark portfolio stalled. The international assets underlying this initiative added drag to standard measures of Enron's financial performance.
Domestically, energy markets and the ability to move gas across state lines grew exponentially in value. Additionally, the volatility of electricity prices provided unique trading opportunities. Rebecca Mark lost and Jeff Skilling won. [20] However, the under-performing international investments were not sold off. It seems that the losses just couldn't be recognized.
Continuing to carry these assets, Skilling drastically increased Enron's electricity bet. He also made another wager on broadband market expansion. The success of these bets required an accelerated market integration and deregulation timetable relative to Enron's natural gas market experience. For broadband, the initiative also required a huge market expansion. A combination of factors held back electricity and broadband market deregulation: public utilities and their regulatory commissions, local phone companies and their regulators, as well as the Asian and dot.com financial meltdowns. However, and in the few states that sufficiently deregulated electricity, Enron made money. Their problems arose in five areas:
- Making
large acquisitions in a state ahead of deregulation .
Portland General is a prime example. [21] - Structuring a national
business prior to national regulation.
(This issue was resolved with the March 5, 2002 U.S. Supreme Court ruling. Under the ruling, Enron lost its claim that state regulators had moved too slowly. [22] ) - Not receiving full payment in California. [23]
- Not being as big or as good traders as initially indicated. [24]
- Running a credit-intensive business model without cash and marketable asset reserves. [25]
Throughout gas deregulation, Ken Lay grew with his business. Clearly, Skilling and his colleagues weren't as successful in electricity and communication. Neither Rebecca Mark nor Jeff. Skilling had navigated a severe stock market and economic downturn. Furthermore, they had not dealt with significant delays in markets opening up for them. Basically, Enron got behind internationally and too far ahead domestically. With regard to the domestic situation, Enron most closely resembles a dot.com. It did all it could to accelerate receivables, translate debt into equity, keep assets off the books and use its own stock as cash. [26]
2. "Available for Grant Shares" and Income from Own Share Capital Gains - JEDI and Chewco
CalPERS, the California Public Employees Retirement System, is a premier investor. They have lots of money to invest, are socially responsible, and have been leaders in demanding attention for shareholder value. For a corporation in search of capital, having CalPERS' investments should lead others to follow. [27]
On July 1, 1993 and as part of a new program to invest 3% of their funds in private placements, CalPERS and Enron each announced $250 million private placement investments. These investments were the CalPERS/Enron Joint Energy Development Investment (JEDI) Limited Partnership. The partnership was funded with a deposit of 12 million Enron issued and Treasury shares ($250 million worth at $20.83 per share) and a $250 million cash investment by CalPERS to be made in three annual installments. The project was scheduled to have a nine-year life. While this information was broken out in the 1995 10-K, Enron had contributed 1,934,055 common shares and 455,300 Treasury shares. Enron had bought back the Treasury shares from shareholders. Enron's contribution through 1995 was $85 million, an average of $35.58 per share on 2,389,355 total shares. [28]
Since the exact terms of this deal were not publicly disclosed, determination of the value of Enron's contributed shares is an estimate. [29] The implied value of a share under the deal terms is $20.83. Based on rudimentary analysis of Enron's equity value throughout 1993, a minimum fair value estimate for the shares is $27.74 per share. [30] Therefore, CalPERS received a subsidy of roughly $6.90 per share for accepting Enron's stock in partnership. Overall, Enron and CalPERS agreed that their relative contributions to the JEDI venture were each to be valued at $250 million, and that they were equal and joint owners.
By November 1997, CalPERS had fully paid in its $250 million investment and the stated value of their investment had grown to $382 million. Backward engineering based on the salient features of this structure may be straight-forward. Enron's deposit of 12 million shares in the partnership must also be worth $382 million. [31] Therefore, the total value of CalPERS' other JEDI assets was roughly $152 million. From July 1, 1993 until November 1, 1997, the total capital gain on JEDI was 53.2% (10.3% annually compounded over the 4.34 year investment period.). The total capital gain on non-Enron share investments in JEDI was 4.6% on an annualized basis. Total income generated over the period from the partnership should be between $59 and $93 million. [32]
In November of 1997, the success of the JEDI partnership led CalPERS to consider doubling its investment to $500 million. However, there was a condition, CalPERS had to cash out of the first JEDI partnership. If our interpretation is correct, Enron was looking to pick up another $117 million in cash from CalPERS, ($500-$383 owed). Importantly, potential JEDI returns were not sufficient to entice an external party to pick up CalPERS investment share. Enron needed to come up with $383 million to pay off CalPERS before the newly promised $500 million started coming in. [33] With cash dangling, Enron got creative and took its first doubling bet on its own investments and its own share price.
Apparently without the cash reserves or other partners to supply the capital, Enron had to borrow to fund the CalPERS buyout. They did so in their Chewco Partnership. The Chewco partnership was the focus of Enron's November 2001 earnings restatement, which consolidated this partnership with Enron's other businesses. The restatement was clearly made under duress, and may actually be in technical error. The reason for this orthogonal conjecture to most other reviews is simple. Whether Enron was a swindle or not depends on whether or not Enron executives, their auditors and related parties acted in their own interest to the detriment of Enron's shareholders and employees, and not in complicated financial structures.
In November 2001, we conjecture that Enron and Andersen took a write-down bath to clear out all the bad news: first as an extraordinary item and secondly as a one-time restatement of the income statement and balance sheet over past years. Obviously, this tactic did not work and both Enron and Arthur Andersen went down the drain.
Basically, one of two structures supplied Chewco's funding. Both of these financial structures sought to meet the 3% external equity investment requirement to permit a non-consolidated investment. Though such an investment may seem ridiculously small to indicate control of the funded entity, this structure has been used regularly in the highly levered energy project development area. In the energy industry, this structure makes sense because the capital intensity and related collateral in plant and equipment of a project are so high that a large portion of these assets was funded by debt. Funded in this way, equity investors may expect a reasonable return. The Public Utilities Holding Company Act (PUHCA) of 1935 governed much investment under this structure, and required firms not to engage in unconsolidated projects, partnerships or trusts.
The PUHCA was passed in response to utility-related trust investments in all sorts of enterprises unrelated to their core business prior to the 1929 depression. Most of those investments did not pay off, and a fair number turned out to be, effectively, frauds. In 1992 and 1994 the Act was amended, and many types of previously restricted investments were no longer restricted. Enron was very active in lobbying to amend the Act in this manner.
To supply needed equity for the Chewco Partnership, Andrew Fastow, the Enron CFO, suggested that his (wife's) family be the outside investors, and that he serve as manager. [34] Mr. Skilling declined to take this road, and may well have left Mr. Fastow to his own devices to find an "investor." Fastow's subordinate Michael Kopper surfaced as a potential manager with $125,000 to invest ($115,000 directly in Chewco and another $10,000 in a Chewco partnership.). Additionally, Barclays was ready to make a $11.4 million "equity loan." Thus, the outside investment amounted to $11.515 million. Since $11.515 million is 3.0065% of $383 million, Chewco was in the running as a non-consolidated investment. [35]
All in Chewco was not as presented. Instead of making a full $11.4 million equity loan, Barclays demanded a $6.6 million cash reserve as collateral for the loan. Clearly, if Enron, JEDI or any other party related to Enron provided this reserve, then the Chewco structure was not an arm's length structure. Furthermore, none of Barclay's equity loan could be counted as equity. Only $125,000 of equity existed and the structure was the following:
|
Non-complying structure |
|
$240 million Barclay loan guaranteed by Enron |
|
$132 JEDI revolving credit (the JEDI capital gain owed to Enron) |
|
$125,000 investment by Michael Kopper as general partner and of Enron Treasury |
|
$4.8 million Barclay's bank "equity loan" |
|
$6.6 million Barclay's bank "equity loan" backed by cash reserve for loan from Enron's profit on JEDI |
|
Equity is 0.03% of investment |
In this structure, the Chewco investment had far less than 3% equity. Chewco's balance sheet and income would have to be consolidated in Enron.
However, there is another possible structure that could meet the letter of the consolidation rules. In one report, it has been stated that this $6.6 million cash reserve was gleaned from gains on the sale of a JEDI asset after Chewco had become its owner in November 1997 and prior to year-end. [36] If this gain was used to fund the loan cash reserve, then the whole structure might comply with non-consolidation rules at year-end. In this case Enron and JEDI, effectively, would have provided bridge financing to Chewco over the one month prior to 1997 year-end.
Such a transaction may well have brought the Chewco partnership structure within the letter, if not the spirit, of the consolidation rules. Importantly, the bridge financing provided the chance or option for Chewco not to be consolidated. The structure did, however, leave the potential to require consolidation if JEDI assets underlying Chewco did not appreciate enough to generate the cash reserve for the Barclays loan internally. This two-stage structure is depicted below:
|
November
1997 non-complying interim structure
=> |
December
31, 1997 Complying structure |
|
$240
million Barclay loan guaranteed by Enron
|
$240
million Barclay loan guaranteed by Enron |
|
$132
JEDI revolving credit (the
JEDI capital gain owed to Enron) |
$132
JEDI revolving credit (the JEDI capital gain owed to Enron) |
|
$125,000
investment by Michael Kopper as general partner and of Enron Treasury |
$125,000
investment by Michael Kopper as general partner and of Enron Treasury |
|
$4.8
million Barclay's bank "equity loan" |
$4.8
million Barclay's bank "equity loan" |
|
$6.6
million Barclay's bank "equity loan" backed by
cash reserve for loan from Enron's profit on JEDI
|
$6.6
million Chewco share of profit on sale of JEDI Coda Energy investment
supplies cash reserve for Barclay's loan |
|
|
Equity
is 3.0065% of investment |
Whether or not the Chewco partnership satisfied consolidation rules criminally and civilly will be determined in hearings and court. Chewco was, by itself, too small a transaction to bring down Enron. Nevertheless, key aspects of the structure were subsequently engineered in at least five other partnerships. First, restricted Enron stock or derivatives on the stock were exchanged for non-market partnership assets (notes and/or options.) Second, assets were managed in the partnership to generate accrual (accounting) gains for Enron, and generate mark to market (financial) gains for the partnership. Third, the net value of the partnership was maintained or augmented so that any credit sensitive investments did not require credit reserves that reduce earnings. [37]
The key requirement for these tactics to work is for partnership asset values not to fall so much that the credit supplied in the highly levered transactions must be written down. As Enron added more and more partnerships of this type to its finance mix, it may have hoped that some natural diversification would reduce the chance of a credit call. However, we believe that Enron failed to fully recognize the chained nature of the debt across all of their partnerships.
3. LJM and Rhythm
There was an important side benefit of Enron's success in lining up CalPERS as a private placement investor, Enron Treasury stumbled on their capacity to increase current earnings by investing their own restricted shares in related partnerships:
Enron also was looking for a way to take advantage of an increase in value of Enron stock reflected in forward contracts (to purchase a specified number of Enron shares at a fixed price) that Enron had with an investment bank. Under generally accepted accounting principles, a company is generally precluded from recognizing an increase in value of its own stock (including forward contracts) as income. Enron sought to use what it viewed as this 'trapped' or 'embedded' value. Andrew Fastow and his Treasurer Ben Gilson developed a plan to hedge the Rhythms investment by taking advantage of the value in the Enron shares covered by the forward contracts. They proposed to create a limited partnership SPE, capitalized primarily with the appreciated Enron stock from the forward contracts. This SPE would then engage in a 'hedging' transaction with Enron involving the Rhythms stock, allowing Enron to offset losses on Rhythms if the price of Rhythms declined. Fastow would form the partnership and serve as the general partner. [38]
It is most likely that any Enron restricted stock used for these transactions was made available from their employee stock plans. When employees buy their own stock or exercise their stock options, they pay cash to the firm and receive shares that exceed their cash payment in value. The number of shares outstanding is increased, and the relative share of equity accruing to each share is lessened or diluted. Therefore, the employees benefit relative to any party who was a shareholder prior to the employees' stock purchase or option exercise.
Many firms buy back their shares or enter into derivative transactions to mitigate this dilution loss to existing shareholders. Any time that Enron exchanged these dilution-reducing shares with a partnership at an unfair value, they were both giving 3% of that value to the associated partnership, and artificially inflating the creditworthiness of the partnership.
In the Rhythym structure, we estimate that $91 million was shifted to the LJM partnership by the forward restricted share sale. We emphasize that this value was meant to prevent dilution of shareholder and employee option stakes in Enron. Instead, it was used to move an under-performing asset from Enron's books, Rhythm NetConnections, and shift value into the LJM partnership. [39] In the accounting view of this transaction, we will see below that this transfer initially generated $168 million in estimated value.
The key rationale for the Rhythm partnership was to remove Enron's $300 million position in Rhythm Netconnections stock from its balance sheet. This transaction limited all Rhythm stock price change effects on Enron's earnings. Because the Rhythm shares could not be sold until January 2000, Enron was particularly interested in ensuring that Rhythm's value did not fall prior to 2000.
Among Enron's and particularly Jeff Skilling's concerns about Rhythm stock, the potential for a value decline was probably the dominant one. To engineer a solution to Skilling's problem, Fastow and Glisan decided to have a partnership (like Chewco) sell Enron insurance against a Rhythm share price fall. Among derivative structures, a put option provides this protection. Enron acquired the right to sell its 5.4 million Rhythm shares to LJM-SwapCo for $56 per share. Enron accountants estimated a $104 million fair value fpr this option. [40] In addition to this put, Enron received a $64 million note from LJM. [41]
As noted above, Enron only had $91 million in economic value to contribute from their employee option hedge. Additionally, LJM was capitalized with $16 million. On its balance sheet, LJM was capitalized for $168 million with Enron restricted stock. Therefore, we find an economic and accounting disconnect equal to $61 million ($168-107). This issue raises the question on the fairness and legality of the share-note exchange. For such a transaction, the Enron shares must be validly issued, fully paid and non-assessable. Should LJM's note to Enron not have represented a bona fide $168 million obligation, the share issue was not fully paid.
In receipt of Enron shares and cash, LJM, then, funded another partnership, SwapCo, with 3.2 million restricted shares and $3.75 million. By March 2000, the LJM-SwapCo partnership was heading underwater. With Rhythm's share price falling to an estimated $9.4 per share, the value of Enron's Rhythm stock put had grown to $207 million. LJM-SwapCo's only good asset was Enron stock, and this stock had fallen from $81 per share to $67.19. LJM-Swapco had 3.2 million restricted Enron shares and $3.75 million in cash. Therefore, it's nominal accounting value was about $219 million; which left a surplus of only $12 million over the $207 million put liability. With both Enron and Rhythm stocks under pressure and the first quarter coming to a close, drastic action was required.
To fix the immediate problem with the one currency that Enron Treasury had at their disposal, 3.1 million Enron restricted share puts with a $71.31 exercise price were GIVEN to LJM-SwapCo. Since Enron's share price was $67.19 at the time, each put option was worth at least $4.12 (71.31-67.19) in intrinsic value. Whether or not these options were cancelled on April 28, 2000 when SwapCo was closed is important. If not, then the minimum direct transfer to LJM-Swapco was $13.4 million. If the transaction was made with the understanding that these options would be cancelled, then this gift value is only the time value of the options on March 8th or $590,000.
To close out LJM-SwapCo's risk to further declines in Rhythm's share price, the Rhythm stock put was cancelled against a payment to Enron of Swapco's 3.2 million restricted shares and $27 million. SwapCo was out of business, but LJM remained holding a significant number of Enron restricted shares. Since Enron's shares had split two-for-one in August 1999, the effective post-split acquisition share price of the restricted shares was $40.5 ($81/2). The worst case for the partnership is that it paid down its $64 million note (790,123 shares at $81 per share) to Enron at partnership inception. Under this assumption, LJM was left with title to over 2 million post-split restricted shares that were nominally worth $135 million for its $16 million investment.
On its Rhythm investment, Enron had nominally made $64 million from the note, and had missed having to report losses of $252 million. All Enron really received was 4.8 million restricted shares back from it's original 6.8 million issue to LJM. Enron's employees and shareholders faced future dilution of about 2 million shares. The forward protection that had originally been purchased for Enron's shareholders from an investment bank was also gone.
Three entities were involved in the transactions: Enron, LJM and an LJM subsidiary partnership SwapCo. Though the Enron Board investigation of the Rhythm stock-related structures goes into great detail to examine ownership issues, we believe that the question is one of rule compliance only. Andrew Fastow invested $1 million as LJM general partner, and bank investment vehicles related to CSFB and Natwest each contributed $7.5 million as limited partners. With value-based calculations, the partnership equity ratio was 17.6% ($16 million/$91 million.), and on Enron's own accounting basis the ratio was 3.4% ($16 million/$168 million). [42] LJM was reasonably well capitalized.
The LJM-Rhythm transaction includes three underlying: Rhythm stock and related derivatives, Enron stock and related derivatives, and cash. These underlying were heold by three legal entities: Enron, LJM and LJM-SwapCo.
The following table shows the transactions, their magnitudes and relative values.
|
Date |
Underlying |
Enron |
LJM |
LJM-SwapCo |
|
6/99 |
Rhythm shares |
+5.4 Rhythm
Puts @ $56 |
|
-5.4 Rhythm
Puts @ $56 |
|
|
Enron
(post-split)
shares |
-6.8 |
+6.8 |
|
|
|
|
|
-3.2 |
+3.2 |
|
|
Cash
and Notes |
+64 |
-64 |
|
|
|
|
|
-3.75 |
+3.75 |
|
Interim |
Note
repaid |
-64 |
+64 |
|
|
|
Cash
|
+64 (or +1.58
Enron shares) |
+64 (or -1.58
Enron shares) |
|
|
3/8/00 |
Hold Enron |
-3.1 Enron
Puts @ $71.31 |
|
+3.1 Enron
Puts @ $71.31 |
|
4/28/00 |
Rhythm stock |
-5.4 Rhythm
Puts @ $56 |
|
-5.4 Rhythm
Puts @ $56 |
|
|
Enron
shares |
|
+3.2 |
-3.2 |
|
|
|
+3.2 |
-3.2 |
|
|
|
|
+3.1 Enron
Puts @ $71.31 |
|
-3.1 Enron
Puts @ $71.31 |
|
|
Cash
and Notes |
+27 |
-27+3.75 |
-3.75 |
|
|
|
|
|
|
|
|
Net Enron
shares |
-2.02 |
+2.02 |
|
|
|
|
-3.1
3/8/00-4/28/00 Time Value of Enron Puts @ $71.31 |
|
+3.1
3/8/00-4/28/00 Time Value of Enron Puts @ $71.31 |
|
|
Net Cash |
+27 |
-27 |
|
All quantities are in millions except for those with a $-prefix which are stock prices per share. Enron restricted share amounts are post-August 1999 stock split quantities.
Though this analysis doesn't account for discounting and investment returns on cash, the short-term aspect of the transaction makes the omission reasonable. The table reveals a very clear picture of the net transaction. Enron received $27 million in cash against LJM's claim on about 2 million Enron restricted shares and the interim Enron stock put protection provided to SwapCo from 3/8/2000 until 4/28/2000. Furthermore, Enron was still holding the Rhythm NetConnection shares. The following graph plots Rhythm NetConnection ("the bad asset") and Enron ("the good asset") stock prices over this period.
The critical condition for this and similar structures to work is for "good" assets that are deposited in the partnerships to generate enough value to support the bad assets that are placed in the partnerships. In the LJM-Rhythm structure, the good assets were Enron restricted shares. These shares increased in value, while Rhythm NetConnections went away.
The LJM-Rhythm partnership structure had three important features that were manifest in Enron's and LJM's subsequent partnerships:
- Exchange restricted Enron stock or derivatives based on this stock and other investments for a partnership note.
- Manage partnership assets to generate accrual (accounting) gains for Enron, and generate mark to market (financial) gains for the partnership.
- Maintain the partnership's credit capacity by ensuring that Enron restricted shares in the partnership generate sufficient gains.
Wiithin the LJM-Rhythm structure, the following transactions are assigned to their respective categories:
- 6.8 million restricted shares and the Enron 71.31 exercise price puts
- The $64 million note and the 5.4 million Rhythm stock puts
- The SwapCo partnership was closed as its asset value fell and approached the rising value of the put option liability.
Had Enron bought put protection for this position in an arm's length transaction, they would have been able to sell their Rhythm stock at $56 in April 2000. They would have been out of the position fully. Instead, the position required the allocated Enron stock to support its non-existent credit capacity. [43]
4. Raptor
Evaluated in April 2000, the Rhythm investment and its associated partnership transaction was a minor disaster for Enron. Enron's implicit loss was largely limited to its transfer of 2.0 million restricted shares to LJM. Nevertheless, the Rhythm investment was still well ahead relative to its inception in March 1998. Enron's initial Rhythm investment was only $10 million at $1.85 per share. With a bit of spinning, the transaction could be viewed positively. For those concerned with earnings management, keeping a $250 million Rhythm stock loss off Enron's balance sheet and income statement was a victory.
For LJM, the transaction was a resounding success. Though its increased value was held in restricted Enron shares, Andrew Fastow had shown that he could redeem these shares with Enron for cash and could also structure derivative transactions with the shares to generate money. In less than a year, the CSFB and Natwest limited partners saw a combined $16 million investment grow to $135 million. [44]
Another large and important Enron partnership was known as Whitewing. When this structure was established at the end of 1997, it was was similar to the JEDI partnership. Enron and an investor group owned the $1 billion Whitewing partnership in equal parts. Therefore, Whitewing was consolidated with Enron. For their contribution, the investor group borrowed $500 million from Citibank loan. Enron’s contribution was $500 million in cash and equity.
It appears that a major portion of Enron’s investment was a transfer of Enron stock contingent value rights. These contracts were long-term options on Enron stock that were purchased in 1997 as a hedge of Enron’s stock option plan and its potential shareholder dilution. [45]
In December 1999, the scale of Whitewing was increased by $1.4 billion with establishment of its Osprey Trust. With this capital infusion Enron’s ownership stake was determined to have fallen below 50 percent, and Whitewing was unconsolidated. This investment was funded with an 8% coupon debt issue that was secured by a new series of Enron preferred shares.
Given an objective to keep Enron’s shell game running, two key features existed for Enron in the Whitewing/Osprey structure: 1) no consolidation, and 2) preferred share backing. No consolidation required that the investment be carried at cost, and as long as Enron’s credit rating did not fall. Without an Enron credit downgrade, the preferred share fair values were largely constant and implied that no impairment charges needed to be taken no matter what happened to the values of the $2 billion of Enron assets that were sold to the Trusts. The earliest date of reckoning for the Whitewing/Osprey Trusts began with initial debt refunding requirements in September 2002. Problems in the Enron Raptor partnerships, that are our focus, placed Whitewing in position that it stopped paying interest in July 2001. Through July 2002, Whitewing had still not been declared in default. Clearly, any problems in the Whitewing were subordinate in those of the Raptors. [46]
As Mr. Fastow was the brain behind both the Rhythm structure, the JEDI/Chewco partnership that had been successful for CalPERS, and Whitewing, his partnerships had a strong record. To continue to carry and fund Enron's weakening merchant investments, he would attract more investors.
Enron "merchant investments" arose through Enron's expansion into international markets and Enron's interest in growing domestic businesses similar to their natural gas business in other industries. Enron, as it had done with the Public Utilities Act, had been able to obtain a waiver of some consolidation rules for many of its foreign-based investments. In foreign markets, Enron major investments were in energy and water industries. Domestically, the major new areas into which Enron was expanding were technology and transmission. Broadband, electricity, steel, pulp and paper were just a few of the industries in which Enron was trying to expand. Enron made equity investments in these areas and, then, through its partnership structures shifted these market-sensitive investments into credit-sensitive notes that were backed by the same assets.
As with Rhythym NetConnections, these investments performed poorly. The following graph depicts Enron's market-traded merchant investment performance. The stocks and their associated tickers are Transportadora de Gas del Sur SA (TGS), Catalytica Energy Systems Inc. (CES), Azurix (AZX), Hanover Combustion (HC), Avici Systems Inc. (AVC), and The New Power Company (NPW). As 2001 progressed, these related party investments required more support from Enron's stock. Otherwise, the notes for which these shares served as collateral would have to be written down.
None of these investments were consolidated in Enron.
In setting up most of its partnerships, Enron used the services of LJM to provide needed equity capital. Generally, LJM made cash investments of $30 million and these investments supported up to $1 billion in assets under the partnership non-consolidation constraint. However, LJM structured short-term option transactions that would generate enough profits to pay off their investment. Then, with capital returned, LJM retained its limited partnership stake and moved on to seed other partnerships.
Among Enron's partnerships, considering one example will be sufficient to both illustrate what was and did go wrong. Though there were four Raptor partnerships owned by a second LJM partnership, we will generically refer to one LJM partnership and a single Raptor subsidiary partnership. Though the primary reason for this simplification is expositional, all four Raptor partnerships were, in the end, aggregated. Like most, if not all, Fastow activities, this aggregation was meant to keep Enron playing its shell game.
In the Raptor transactions, LJM served only as an investor. The $30 million LJM investment was to be paid off within six months. In fact, a Raptor partnership was not permitted to accept any external assets (like Rhythm stock previously) until LJM was returned its capital from partnership profits. With regard to Enron restricted stock related transactions, portraying Enron's asset and liability position also depicts Raptor's respective liability and asset position. The Raptor partnerships were distinguished by the quality of the Enron assets that were exchanged for Raptor notes.
The following table provides a greatly simplified representation of the Raptor structure(s) from Enron's perspective:
|
|
|
|
Estimated Enron value gain (loss) |
|
4/18/2000
Raptor 1 |
Raptor 1 $400 million note |
Notes and actual stock
and options
[47]
($443 million) |
$43 million Raptor 1 |
|
|
Put on Enron Stock estimated |
$41 million in cash for
put on Enron stock |
($38 million) Raptor 1 |
|
6/22/2000
Raptor 2 |
Put on Enron Stock estimated |
$41 million in cash for
put on Enron stock |
($38 million) Raptor 2 |
|
8/7/2000
Raptor 4 |
Put on Enron Stock estimated |
$41 million in cash for
put on Enron stock |
($38 million) Raptor 3
|
|
9/27/2000
Raptor 3 |
Note for roughly $259 million |
24 million New Power
Company (NPW) shares for Raptor 3 issued at $10.75
[49]
|
[NPW shares rose to $27, fell to $20 in five days, and $10 in within
40 days.] |
|
|
Put on Enron Stock estimated to be worth $3 million |
$41 million in cash for
put on Enron stock |
($38 million) Raptor 3 |
|
8/3/2000
Raptor 1 |
Cancel Put on Enron Stock for $4 million |
|
$3.97 million Raptor 1 |
|
10/31/2000
Raptor 1 |
Call on Enron stock at 116 strike price
[50]
|
Put on Enron stock at 81 strike price |
($26 million) |
|
11/27/2000
Raptor 2 |
Call on Enron stock at 112 strike price |
Put on Enron stock at 79 strike price |
($27 million) |
|
12/21/2000
Raptors |
45-day Raptor cross-guarantee + in Raptor 2&4 offset - in Raptor
1&3 |
45-day Raptor cross-guarantee |
($?? million, dependent on the portfolios) |
|
1/24/2001
Raptor 4 |
Call on Enron stock at 112 strike price |
Put on Enron stock at 83 strike price |
($29 million) |
|
3/22/2001
Raptors |
Notes payable - $260 million |
18 million restricted shares less call strip on
50, 53 and 63 strike prices
[51]
|
($599 million) |
|
3/22/2001
Raptors |
Notes payable - $568 million |
12 million restricted share grant from new stock option plan
|
($197 million) |
|
Total to 12/31/2000 |
|
|
($188 + ?? million) |
|
Total to 3/22/2001 |
|
|
($985 + ?? million) |
In these transactions LJM was at risk for its investment. If Enron's stock fell markedly, then LJM would be left holding the bag. However, it appears to us that the first such transaction was priced very much in LJM's favor. Specifically, Raptor 1 (or Talon) sold a 57.5 strike price put to Enron while Enron's stock traded at 68. A standard valuation of this put yields about $3 million in value. Between Enron and Raptor, this put was valued at $41 million. The option term was six months, and as long as Enron's stock was greater than 57.5 at the end of that period, then the option would expire worthless. In this case, Raptor would make $41 million in profit. However, LJM and Enron redeemed the option prior to maturity as Raptor 4 was being structured. Though a standard calculation shows that the put option was only worth $4,000, Raptor paid Enron $4 million to extinguish the claim. With $37 million in profit, Raptor paid off LJM's $30 million in seed capital and began to accept merchant investments from Enron in return for Raptor Notes. [52]
It is stated in the Enron Board's special investigative report that Enron's derivative transactions with the Raptors generated gains of $500 million by the end of 2000. This value means that Enron's $1.5 billion notes in Raptor merchant investments fell by about $500 million over the last half of 2000. By our analysis, the first Raptor was funded either at fair value or at a benefit to Enron. The only clear offset to our favorable interpretation of Enron’s investmentis an accounting allocation made in favor of Raptor 1. The value of the Enron equity that was acquired for the Raptor $400 million note was booked in the Raptor at its unrestricted and undiscounted value of $587 million. Therefore, Raptor 1 was ahead on an accounting basis by $187 million at its inception. Additionally, it had two true sources of value: a rolling $30 million investment by LJM, and, by our calculation of the fair value of Enron's mis-valued transfers to the Raptors through December 2000, another $188 million. With $405 million total value to allocate, the Raptors appear to have been short $95 million in value at year-end 2001.
The pressure to report problems in Raptor came in evaluating their assets as collateral for the $1.5 billion in notes that had been issued to Enron for Raptor merchant investments. The notes were roughly under collateralized in Raptors 1 and 3, and Enron's risk control and accounting groups were requiring that reserves be set aside in case the notes could not be repaid in full. Raptors 2 and 4 had gains, and these gains must have been at least $95 million to cover the Raptor 1 shortfall.
Though the Raptors were each separate investments for Enron, and each should have been treated on an arm's length basis, Enron instituted a swap to tie their values together. This transaction pasted things together for one more accounting quarter and the 2000 fiscal year. Quarter and fiscal year end financial structuring activity followed a consistent pattern at Enron. [53] A significant motivation for these transactions would be to push accounting and financial numbers over hurdles set for bonuses, as well as additional stock and option grants. [54]
The NASDAQ market and general technology market meltdown continued into 2001, the merchant investments that Enron had exchanged with the Raptors performed even worse. For the first quarter of 2001, the Raptors had lost another $500 million. The Enron Board special report (pg. 121) notes that the Raptors were under capitalized by $500 million at the quarter end, and a $36 million credit reserve was established. [55] At and over quarter end, a flurry of Enron activity occurred. First and foremost in its proxy statement, the Board approved a new stock plan.
This March 27, 2001 proxy stock option plan permitted issue of 21 million shares. (The initial March 3, 2001 proxy sought 24 million shares.) It is noted in the proxy that only 3 million shares remained available under the old plan. It seems to us that at least half of these 24 million shares shares were immediately pledged to mis-valued derivative transactions. Additionally, we are unsure how the completion of the Whitewing contingent value rights would be allocated. It is quite possible that the completion of the external calls led to effective grant of full shares that should have gone against the remaining 12 million shares available for grants. If this is the case, then Enron carried a negative six million available for grant share balance after the March 2001 Raptor transactions. In any case, their direct transfer of 12 million restricted shares and 18 million partially restricted shares pushed almost $800 million into the Raptor partnerships. This $800 million is in addition to the $828 million in notes that Enron received from the Raptors for its new capital infusions. After deducting the $500 million loss from the $800 million in over capitalization the Raptors had less than $300 million in excess value to support $1.5 billion in notes.
At a very gross level of approximation, the net effect of all of the restricted and actual stock and related derivatives that Enron had passed through to the Raptor partnerships was the following: 3.6 million shares at 81, 7.8 million shares at $79, 6.3 million shares at $83, 18 million shares at $55 and 12 million shares at $47. Since the losses related to strike prices above $55 had already occurred, Enron had $300 million in the clutches of its Raptors to weather price declines from $55 to $47. There were 18 million shares of obligations in the price range between $47 and $55. An $8 price fall from $55 reaches $47, and results in a $144 million loss on 18 million shares. With this loss, $156 million in reserve credit capacity remained. At stock prices below $47 per share, another 12 million shares were underwater. Therefore every dollar decline in Enron's share price below $47 per share generated at least $30 million in Raptor losses. On 30 million shares, this $156 million reserve could only support another $5.20 share price drop to $41.80.
By the end of the second quarter of 2001, Enron's share price stabilized, rose slightly, and settled near $49. In the third quarter, Enron's shares began to sink. On August 15, 2001, Enron's price dropped below our $41.80 price cut-off for the first time (to $40.25.) The company began its sustained fall into bankruptcy. Coincidentally, Jeff Skilling had resigned on August 14th.
By the end of the third quarter, Enron's share price had dropped to $27.23. The roughly $20 price drop from $47 to $27.23 generated a $593 million loss estimate on the Raptors' Enron stock. Adding back $300 million of reserve credit capacity that existed at the end of the first quarter, Enron had, at best, $293 million in losses and nowhere to turn. As the following Figure illustrates, Enron was, literally, trapped by the Raptors. At the same time, we have seen that many other endeavors were also going bad. [56]
On October 16, 2001, Enron fell apart. A $618 million third-quarter loss was reported, and $1.01 billion was charged against equity. Our calculations roughly match these write-downs. Our third quarter loss estimate is low because we have not calculated any further losses on the Raptor merchant investments and other Enron investments. However, unlike previous quarters, there remained no reserve to draw on to cover any of these losses. Enron's third quarter $1 billion charge to equity is consistent with our assessment of value destroyed in supporting the partnerships. Since the earnings on these Enron share trading positions had already been recorded over the previous three or four years, they were simply being undone with the accounting adjustments. As in the end of Jurassic Park, the Raptors were dead. Scarred and dazed survivors struggled out of Enron Park. [57] In the vernacular of a current media offering, the markets voted Enron off the Island.
Conclusion
Our main point is that Enron's fall could not have occurred without significant misvaluation and asset shifting. Enron's bankruptcy occurred on November 29, 2001 and was triggered by S&P's downgrade of its debt below investment grade. This downgrade activated a call provision in some loan indentures with principal amounts totaling $4 billion. [58] Clearly, Enron did not have $4 billion in cash. Furthermore, the most marketable assets that it did have claim on were related- party notes that were under collateralized by their past merchant investments and their own stock. At that time, Enron was possibly itself worth less than $4 billion in total.
In retrospect, the fall of some corporation, like Enron, and its related transgressions should not be surprising. Once any market peaks, some businesses will have over expanded, over committed and been over estimated. As these companies cut back and are cut back, some will fail. During the time of Enron's fall, dominant firms such as Cisco and GE suffered value losses greater than Enron's maximum stock market value. Simply put, in a market economy some companies fail. Furthermore, in any economy, some companies cheat and lie. Substitutes and competitors for Enron's economic activities existed and exist. Despite Enron's representations of dire consequences from its failure, regulators and politicians instead recognized the actual situation and did not step in to save Enron. Basically, the market as currently structured worked. [59]
Against the possible response of re-regulating the energy and other market sectors, we advocate leaving investors at risk to evaluate investment opportunity and allocate their capital. In line with this broad point, we suggest four changes:
- All claims including
derivatives and insurance referenced to own equity value need to be
reported. These reports could
be footnotes to proxy and/or 10-Q/10-K statements. In effect, these notes should show the worst, expected
and best dilution cases envisioned.
In a way, this requirement already exists under SEC FR- 48.
This rule requires broad disclosure of market risk impacts on the
firm. Certainly, a registered
and traded equity share is subject to market risk. All S.E.C. equity
security filings (in forms 3, 4 and 5) by directors, officers, or owners
of more than ten percent of a class of equity securities should be
available on Edgar and in the annual Proxy filing summaries of such
activities.
Enron's 10-k clearly disclosed it's credit rating sensitivity. However, it failed to disclose the direct link its credit-worthiness to its own share value and the values of its merchant investments. The listed equity risk in Enron's 2001 10-K Risk Management disclosure is miniscule compared with their actual risk. The amount of Enron stock and merchant investments that they had moved into their related partnerships was incredible. To fully understand the motives of all parties to the related party transactions, the net ownership positions across corporate entities and individuals will have to be untangled. Looking ahead, having such information more readily available (though not necessarily disclosed publicly) seems beneficial. - When specific material transactions are not accounted for on the same basis for both trade counter-parties, these discrepancies should be disclosed. Enron accounted for its partnership note investments on an accrual basis while the partnerships accounted for the associated investments on a mark-to-market basis. In the same manner, Enron's transactions with many counter-parties were booked as revenue or capital gains, while counter-parties accrued income or classified the investment as held to maturity. The proposal for an auditor of auditors could embody some validation of the appropriateness of any differing accounting treatment. As noted above, netting positions after all transactions also requires review capacity across multiple corporate entities.
- Auditors may be required to randomly select assets and liabilities for liquidation through arms length sale. Just as in standard audit procedures for inventory, a sample liquidation set that failed to sufficiently match booked values would have to be resampled with more liquidations.
- Auditor risk should be broader than literal GAAP-compliance. GAAP and FASB developments lag market and business practice. An auditor's opinion should be a valuation fairness opinion and not simply bookkeeping judgment. Though such a change would certainly, in the short-term, raise the cost of audits, the change would draw more knowledgeable and risk-sensitive parties into the audit and value verification function.
All of our suggestions may be summarized simply: any party or person purporting to represent a valuation fairness opinion that is based on privileged information from the entity that is being evaluated can't stand behind a set of rules as a defense against incompetence or worse. Such opinions should conclude in a clear and active voice:
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and its subsidiaries as of year-end. Also, these statements are in conformity with accounting principles generally accepted in the jurisdiction of this Company.
The following is an example from the Dow Chemical Company 2000 10-K which leaves open an auditor's defense of being in compliance with a bad set of rules:
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Dow Chemical Company and its subsidiaries at December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
The dangling and highlighted preposition "in conformity with accounting principles generally accepted in the United States of America," and the limited three year look back period are examples of audit legal language liability hedges that failed both Enron and Arthur Andersen. From an information and valuation perspective, such hedging significantly lowers the value of an audit, and can leave an audit process virtually worthless.
As a first step in this direction, the S.E.C. has instituted such language by requiring the C.E.O. and Principal Financial Officer to affirm their corporation's 10-k. [60]
I, [Name of principal executive officer or principal financial officer], state and attest that:
(1) To the best of my knowledge, based upon a review of the covered reports of [company name], and, except as corrected or supplemented in a subsequent covered report:
·
no covered report contained an untrue statement of a material fact as of the
end of the period covered by such report (or in the case of a report on Form
8-K or definitive proxy materials, as of the date on which it was filed); and
· no covered report omitted to state a material fact necessary to make the statements in the covered report, in light of the circumstances under which they were made, not misleading as of the end of the period covered by such report (or in the case of a report on Form 8-K or definitive proxy materials, as of the date on which it was filed).
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