III. Derivatives "Inside" Enron
The derivatives problems at Enron went much deeper than the use of special purpose entities with outside investors. If Enron had been making money in what it represented as its core businesses, and had used derivatives simply to "dress up" its financial statements, this Committee would not be meeting here today. Even after Enron restated its financial statements on November 8, 2001, it could have clarified its accounting treatment, consolidated its debts, and assured the various analysts that it was a viable entity. But it could not. Why not?
This question leads me to the second explanation of Enron's collapse: most of what Enron represented as its core businesses were not making money. Recall that Enron began as an energy firm. Over time, Enron shifted its focus from the bricks-and-mortar energy business to the trading of derivatives. As this shift occurred, it appears that some of its employees began lying systematically about the profits and losses of Enron's derivatives trading operations. Simply put, Enron's reported earnings from derivatives seem to be more imagined than real. Enron's derivatives trading was profitable, but not in the way an investor might expect based on the firm's financial statements. Instead, some Enron employees seem to have misstated systematically their profits and losses in order to make their trading businesses appear less volatile than they were.
First, a caveat. During the past few weeks, I have been gathering information about Enron's derivatives operations, and I have learned many disturbing things. Obviously, I cannot testify first hand to any of these matters. I have never been on Enron's trading floor, and I have never been involved in Enron's business. I cannot offer fact testimony as to any of these matters.
Nonetheless, I strongly believe the information I have gathered is credible. It is from many sources, including written information, e-mail correspondence, and telephone interviews. Congressional investigators should be able to confirm all of these facts. In any event, even if only a fraction of the information in this section of my testimony proves to be correct, it will be very troubling indeed.
In a nutshell, it appears that some Enron employees used dummy accounts and rigged valuation methodologies to create false profit and loss entries for the derivatives Enron traded. These false entries were systematic and occurred over several years, beginning as early as 1997. They included not only the more esoteric financial instruments Enron began trading recently - such as fiber-optic bandwidth and weather derivatives - but also Enron's very profitable trading operations in natural gas derivatives.
Enron derivatives traders faced intense pressure to meet quarterly earnings targets imposed directly by management and indirectly by securities analysts who covered Enron. To ensure that Enron met these estimates, some traders apparently hid losses and understated profits. Traders apparently manipulated the reporting of their "real" economic profits and losses in an attempt to fit the "imagined" accounting profits and losses that drove Enron management.
A. Using "Prudency" Reserves
Enron's derivatives trading operations kept records of the traders' profits and losses. For each trade, a trader would report either a profit or a loss, typically in spreadsheet format. These profit and loss reports were designed to reflect economic reality. Frequently, they did not.
Instead of recording the entire profit for a trade in one column, some traders reportedly split the profit from a trade into two columns. The first column reflected the portion of the actual profits the trader intended to add to Enron's current financial statements. The second column, ironically labeled the "prudency" reserve, included the remainder.
To understand this concept of a "prudency" reserve, suppose a derivatives trader earned a profit of $10 million. Of that $10 million, the trader might record $9 million as profit today, and enter $1 million into "prudency." An average deal would have "prudency" of up to $1 million, and all of the "prudency" entries might add up to $10 to $15 million.
Enron's "prudency" reserves did not depict economic reality, nor could they have been intended to do so. Instead, "prudency" was a slush fund that could be used to smooth out profits and losses over time. The portion of profits recorded as "prudency" could be used to offset any future losses.
In essence, the traders were saving for a rainy day. "Prudency" reserves would have been especially effective for long-maturity derivatives contracts, because it was more difficult to determine a precise valuation as of a particular date for those contracts, and any "prudency" cushion would have protected the traders from future losses for several years going forward.
As luck would have it, some of the "prudency" reserves turned out to be quite prudent. In one quarter, some derivatives traders needed so much accounting profit to meet their targets that they wiped out all of their "prudency" accounts.
Saving for a rainy day is not necessarily a bad idea, and it seems possible that derivatives traders at Enron did not believe they were doing anything wrong. But "prudency" accounts are far from an accepted business practice. A trader who used a "prudency" account at a major Wall Street firm would be seriously disciplined, or perhaps fired. To the extent Enron was smoothing its income using "prudency" entries, it was misstating the volatility and current valuation of its trading businesses, and misleading its investors. Indeed, such fraudulent practices would have thwarted the very purpose of Enron's financial statements: to give investors an accurate picture of a firm's risks. |
