A. Using Derivatives to Hide Losses on Technology Stocks
First, Enron hid hundreds of millions of dollars of losses on its speculative investments in various technology-oriented firms, such as Rhythms Net Connections, Inc., a start-up telecommunications company. A subsidiary of Enron (along with other investors such as Microsoft and Stanford University) invested a relatively small amount of venture capital, on the order of $10 million, in Rhythms Net Connections. Enron also invested in other technology companies.
Rhythms Net Connections issued stock to the public in an initial public offering on April 6, 1999, during the heyday of the Internet boom, at a price of about $70 per share. Enron's stake was suddenly worth hundreds of millions of dollars. Enron's other venture capital investments in technology companies also rocketed at first, alongside the widespread run-up in the value of dot.com stocks. As is typical in IPOs, Enron was prohibited from selling its stock for six months.
Next, Enron entered into a series of transactions with a special purpose entity - apparently a limited partnership called Raptor (actually there were several Raptor entities of which the Rhythms New Connections Raptor was just one), which was owned by a another Enron special purpose entity, called LJM1 - in which Enron essentially exchanged its shares in these technology companies for a loan, ultimately, from Raptor. Raptor then issued its own securities to investors and held the cash proceeds from those investors.
The critical piece of this puzzle, the element that made it all work, was a derivatives transaction - called a "price swap derivative" - between Enron and Raptor. In this price swap, Enron committed to give stock to Raptor if Raptor's assets declined in value. The more Raptor's assets declined, the more of its own stock Enron was required to post. Because Enron had committed to maintain Raptor's value at $1.2 billion, if Enron's stock declined in value, Enron would need to give Raptor even more stock. This derivatives transaction carried the risk of diluting the ownership of Enron's shareholders if either Enron's stock or the technology stocks Raptor held declined in price. Enron also apparently entered into options transactions with Raptor and/or LJM1.
Because the securities Raptor issued were backed by Enron's promise to deliver more shares, investors in Raptor essentially were buying Enron's debt, not the stock of a start-up telecommunications company. In fact, the performance of Rhythms Net Connections was irrelevant to these investors in Raptor. Enron got the best of both worlds in accounting terms: it recognized its gain on the technology stocks by recognizing the value of the Raptor loan right away, and it avoided recognizing on an interim basis any future losses on the technology stocks, were such losses to occur.
It is painfully obvious how this story ends: the dot.com bubble burst and by 2001 shares of Rhythms Net Communications were worthless. Enron had to deliver more shares to "make whole" the investors in Raptor and other similar deals. In all, Enron had derivative instruments on 54.8 million shares of Enron common stock at an average price of $67.92 per share, or $3.7 billion in all. In other words, at the start of these deals, Enron's obligation amounted to seven percent of all of its outstanding shares. As Enron's share price declined, that obligation increased and Enron's shareholders were substantially diluted. And here is the key point: even as Raptor's assets and Enron's shares declined in value, Enron did not reflect those declines in its quarterly financial statements. |
