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Testimony of Frank Partnoy
Professor of Law, University of San Diego School of Law
Hearings before the United States Senate
Committee on Governmental Affairs, January 24, 2002
[posted January 29, 2002]
Introduction and Overview
Derivatives "Outside" Enron
Derivatives "Inside" Enron
Conclusion
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I am submitting testimony in response to this Committee's request that I address potential problems associated with the unregulated status of derivatives used by Enron Corporation.
I. Introduction and Overview
I am a law professor at the University of San Diego School of Law. I teach and research in the areas of financial market regulation, derivatives, and structured finance. During the mid-1990s, I worked on Wall Street structuring and selling financial instruments and investment vehicles similar to those used by Enron. As a lawyer, I have represented clients with problems similar to Enron's, but on a much smaller scale. I have never received any payment from Enron or from any Enron officer or employee.
Enron has been compared to Long-Term Capital Management, the Greenwich, Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of derivatives and was rescued in September 1998 in a private bailout engineered by the New York Federal Reserve. For the past several weeks, I have conducted my own investigation into Enron, and I believe the comparison is inapt. Yes, there are similarities in both firms' use and abuse of financial derivatives. But the scope of Enron's problems and their effects on its investors and employees are far more sweeping.
According to Enron's most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history. Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out $70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts. Long-Term Capital Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the bailout, while Enron employed 20,000 people, more than 4,000 of whom have been fired, and many more of whom lost their life savings as Enron's stock plummeted last fall.
In short, Enron makes Long-Term Capital Management look like a lemonade stand. It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm. Nothing made this more clear than the layout of Enron's extravagant new building - still not completed today, but mostly occupied - where the top executives' offices on the seventh floor were designed to overlook the crown jewel of Enron's empire: a cavernous derivatives trading pit on the sixth floor.
I believe there are two answers to the question of why Enron collapsed, and both involve derivatives. One relates to the use of derivatives "outside" Enron, in transactions with some now-infamous special purpose entities. The other - which has not been publicized at all - relates to the use of derivatives "inside" Enron. Derivatives are complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas. Derivatives can be traded in two ways: on regulated exchanges or in unregulated over-the-counter (OTC) markets. My testimony - and Enron's activities - involve the OTC derivatives markets.
Sometimes OTC derivatives can seem too esoteric to be relevant to average investors. Even the well-publicized OTC derivatives fiascos of a few years ago - Procter & Gamble or Orange County, for example - seem ages away. But the OTC derivatives markets are too important to ignore, and are critical to understanding Enron. The size of derivatives markets typically is measured in terms of the notional values of contracts. Recent estimates of the size of the exchange-traded derivatives market, which includes all contracts traded on the major options and futures exchanges, are in the range of $13 to $14 trillion in notional amount. By contrast, the estimated notional amount of outstanding OTC derivatives as of year-end 2000 was $95.2 trillion. And that estimate most likely is an understatement.
In other words, OTC derivatives markets, which for the most part did not exist twenty (or, in some cases, even ten) years ago, now comprise about 90 percent of the aggregate derivatives market, with trillions of dollars at risk every day. By those measures, OTC derivatives markets are bigger than the markets for U.S. stocks. Enron may have been just an energy company when it was created in 1985, but by the end it had become a full-blown OTC derivatives trading firm. Its OTC derivatives-related assets and liabilities increased more than five-fold during 2000 alone.
And, let me repeat, the OTC derivatives markets are largely unregulated. Enron's trading operations were not regulated, or even recently audited, by U.S. securities regulators, and the OTC derivatives it traded are not deemed securities. OTC derivatives trading is beyond the purview of organized, regulated exchanges. Thus, Enron - like many firms that trade OTC derivatives - fell into a regulatory black hole.
After 360 customers lost $11.4 billion on derivatives during the decade ending in March 1997, the Commodity Futures Trading Commission began considering whether to regulate OTC derivatives. But its proposals were rejected, and in December 2000 Congress made the deregulated status of derivatives clear when it passed the Commodity Futures Modernization Act. As a result, the OTC derivatives markets have become a ticking time bomb, which Congress thus far has chosen not to defuse.
Many parties are to blame for Enron's collapse. But as this Committee and others take a hard look at Enron and its officers, directors, accountants, lawyers, bankers, and analysts, Congress also should take a hard look at the current state of OTC derivatives regulation. (In the remainder of this testimony, when I refer generally to "derivatives," I am referring to these OTC derivatives markets.)
II. Derivatives "Outside" Enron
The first answer to the question of why Enron collapsed relates to derivatives deals between Enron and several of its 3,000-plus off-balance sheet subsidiaries and partnerships. The names of these byzantine financial entities - such as JEDI, Raptor, and LJM - have been widely reported.
Such special purpose entities might seem odd to someone who has not seen them used before, but they actually are very common in modern financial markets. Structured finance is a significant part of the U.S. economy, and special purpose entities are involved in most investors' lives, even if they do not realize it. For example, most credit card and mortgage payments flow through special purpose entities, and financial services firms typically use such entities as well. Some special purpose entities generate great economic benefits; others - as I will describe below - are used to manipulate company's financial reports to inflate assets, to understate liabilities, to create false profits, and to hide losses. In this way, special purpose entities are a lot like fire: they can be used for good or ill. Special purpose entities, like derivatives, are unregulated.
The key problem at Enron involved the confluence of derivatives and special purpose entities. Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets. These derivatives included price swap derivatives (described below), as well as call and put options.
Specifically, Enron used derivatives and special purpose vehicles to manipulate its financial statements in three ways. First, it hid speculator losses it suffered on technology stocks. Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers. Third, it inflated the value of other troubled businesses, including its new ventures in fiber-optic bandwidth. Although Enron was founded as an energy company, many of these derivatives transactions did not involve energy at all.
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.
B. Using Derivatives to Hide Debts Incurred by Unprofitable Businesses
A second example involved Enron using derivatives with two special purpose entities to hide huge debts incurred to finance unprofitable new businesses. Essentially, some very complicated and unclear accounting rules allowed Enron to avoid disclosing certain assets and liabilities.
These two special purpose entities were Joint Energy Development Investments Limited Partnership (JEDI) and Chewco Investments, L.P. (Chewco). Enron owned only 50 percent of JEDI, and therefore - under applicable accounting rules - could (and did) report JEDI as an unconsolidated equity affiliate. If Enron had owned 51 percent of JEDI, accounting rules would have required Enron to include all of JEDI's financial results in its financial statements. But at 50 percent, Enron did not.
JEDI, in turn, was subject to the same rules. JEDI could issue equity and debt securities, and as long as there was an outside investor with at least 50 percent of the equity - in other words, with real economic exposure to the risks of Chewco - JEDI would not need to consolidate Chewco.
One way to minimize the applicability of this "50 percent rule" would be for a company to create a special purpose entity with mostly debt and only a tiny sliver of equity, say $1 worth, for which the company easily could find an outside investor. Such a transaction would be an obvious sham, and one might expect to find a pronouncement by the accounting regulators that it would not conform to Generally Acceptable Accounting Principles. Unfortunately, there are no such accounting regulators, and there was no such pronouncement. The Financial Accounting Standards Board, a private entity that sets most accounting rules and advises the Securities and Exchange Commission, had not - and still has not - answered the key accounting question: what constitutes sufficient capital from an independent source, so that a special purpose entity need not be consolidated?
Since 1982, Financial Accounting Standard No. 57, Related Party Disclosures, has contained a general requirement that companies disclose the nature of relationships they have with related parties, and describe transactions with them. Accountants might debate whether Enron's impenetrable footnote disclosure satisfies FAS No. 57, but clearly the disclosures currently made are not optimal. Members of the SEC staff have been urging the FASB to revise No. 57, but it has not responded. In 1998, FASB adopted FAS No. 133, which includes new accounting rules for derivatives. Now at 800-plus pages, FAS No. 133's instructions are an incredibly detailed - but ultimately unhelpful - attempt to rationalize other accounting rules for derivatives.
As a result, even after two decades, there is no clear answer to the question about related parties. Instead, some early guidance (developed in the context of leases) has been grafted onto modern special purpose entities. This guidance is a 1991 letter from the Acting Chief Accountant of the SEC in 1991, stating: "The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar [leasing] transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe that 3 percent is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated with the lessee and the market risk factors associated with the leased property."
Based on this letter, and on opinions from auditors and lawyers, companies have been pushing debt off their balance sheets into unconsolidated special purpose entities so long as (1) the company does not have more than 50 percent of the equity of the special purpose entity, and (2) the equity of the special purpose entity is at least 3 percent of its the total capital. As more companies have done such deals, more debt has moved off balance-sheet, to the point that, today, it is difficult for investors to know if they have an accurate picture of a company's debts. Even if Enron had not tripped up and violated the letter of these rules, it still would have been able to borrow 97 percent of the capital of its special purpose entities without recognizing those debts on its balance sheet.
Transactions designed to exploit these accounting rules have polluted the financial statements of many U.S. companies. Enron is not alone. For example, Kmart Corporation - which was on the verge of bankruptcy as of January 21, 2002, and clearly was affected by Enron's collapse - held 49 percent interests in several unconsolidated equity affiliates. I believe this Committee should take a hard look at these widespread practices.
In short, derivatives enabled Enron to avoid consolidating these special purpose entities. Enron entered into a derivatives transaction with Chewco similar to the one it entered into with Raptor, effectively guaranteeing repayment to Chewco's outside investor. (The investor's sliver of equity ownership in Chewco was not really equity from an economic perspective, because the investor had nothing - other than Enron's credit - at risk.) In its financial statements, Enron takes the position that although it provides guarantees to unconsolidated subsidiaries, those guarantees do not have a readily determinable fair value, and management does not consider it likely that Enron would be required to perform or otherwise incur losses associated with guarantees. That position enabled Enron to avoid recording its guarantees. Even the guarantees listed in the footnotes are recorded at only 10 percent of their nominal value. (At least this amount is closer to the truth than the amount listed as debt for unconsolidated subsidiaries: zero).
Apparently, Arthur Andersen either did not discover this derivatives transaction or decided that the transaction did not require a finding that Enron controlled Chewco. In any event, the Enron derivatives transaction meant that Enron - not the 50 percent "investor" in Chewco - had the real exposure to Chewco's assets. The ownership daisy chain unraveled once Enron was deemed to own Chewco. JEDI was forced to consolidate Chewco, and Enron was forced to consolidate both limited partnerships - and all of their losses - in its financial statements.
All of this complicated analysis will seem absurd to the average investor. If the assets and liabilities are Enron's in economic terms, shouldn't they be reported that way in accounting terms? The answer, of course, is yes. Unfortunately, current rules allow companies to employ derivatives and special purpose entities to make accounting standards diverge from economic reality. Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was. Many other companies do the same.
Of course, it is possible to detect the flaws in plastic surgery, or financial engineering, if you look hard enough and in the right places. In 2000, Enron disclosed about $2.1 billion of such derivatives transactions with related entities, and recognized gains of about $500 million related to those transactions. The disclosure related to these staggering numbers is less than conspicuous, buried at page 48, footnote 16 of Enron's annual report, deep in the related party disclosures for which Enron was notorious. Still, the disclosure is there. A few sophisticated analysts understood Enron's finances based on that disclosure; they bet against Enron's stock. Other securities analysts likely understood the disclosures, but chose not to speak, for fear of losing Enron's banking business. An argument even can be made - although not a good one, in my view - that Enron satisfied its disclosure obligations with its opaque language. In any event, the result of Enron's method of disclosure was that investors did not get a clear picture of the firm's finances.
Enron is not the only example of such abuse; accounting subterfuge using derivatives is widespread. I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a company's transactions. Such a broad standard - backed by rigorous enforcement - would go a long way towards eradicating the schemes companies currently use to dress up their financial statements.
Enron's risk management manual stated the following: "Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management's performance is generally measured by accounting income, not underlying economics. Risk management strategies are therefore directed at accounting rather than economic performance." This alarming statement is representative of the accounting-driven focus of U.S. managers generally, who all too frequently have little interest in maintaining controls to monitor their firm's economic realities.
C. Using Derivatives to Inflate the Value of Troubled Businesses
A third example is even more troubling. It appears that Enron inflated the value of certain assets it held by selling a small portion of those assets to a special purpose entity at an inflated price, and then revaluing the lion's share of those assets it still held at that higher price.
Consider the following sentence disclosed from the infamous footnote 16 of Enron's 2000 annual report, on page 49: "In 2000, Enron sold a portion of its dark fiber inventory to the Related Party in exchange for $30 million cash and a $70 million note receivable that was subsequently repaid. Enron recognized gross margin of $67 million on the sale." What does this sentence mean?
It is possible to understand the sentence today, but only after reading a January 7, 2002, article about the sale by Daniel Fisher of Forbes magazine, together with an August 2001 memorandum describing the transaction (and others) from one Enron employee, Sherron Watkins, to Enron Chairman Kenneth Lay. Here is my best understanding of what this sentence means:
First, the "Related Party" is LJM2, an Enron partnership run by Enron's Chief Financial Officer, Andrew Fastow. (Fastow reportedly received $30 million from the LJM1 and LJM2 partnerships pursuant to compensation arrangements Enron's board of directors approved.)
Second, "dark fiber" refers to a type of bandwidth Enron traded as part of its broadband business. In this business, Enron traded the right to transmit data through various fiber-optic cables, more than 40 million miles of which various Internet-related companies had installed in the United States. Only a small percentage of these cables were "lit" - meaning they could transmit the light waves required to carry Internet data; the vast majority of cables were still awaiting upgrades and were "dark." The rights associated with those "dark" cables were called "dark fiber." As one might expect, the rights to transmit over "dark fiber" are very difficult to value.
Third, Enron sold "dark fiber" it apparently valued at only $33 million for triple that value: $100 million in all - $30 million in cash plus $70 million in a note receivable. It appears that this sale was at an inflated price, thereby enabling Enron to record a $67 million profit on that trade. LJM2 apparently obtained cash from investors by issuing securities and used some of these proceeds to repay the note receivable issued to Enron.
What the sentence in footnote 16 does not make plain is that the investor in LJM2 was persuaded to pay what appears to be an inflated price, because Enron entered into a "make whole" derivatives contract with LJM2 (of the same type it used with Raptor). Essentially, the investor was buying Enron's debt. The investor was willing to buy securities in LJM2, because if the "dark fiber" declined in price - as it almost certainly would, from its inflated value - Enron would make the investor whole. In these transactions, Enron retained the economic risk associated with the "dark fiber." Yet as the value of "dark fiber" plunged during 2000, Enron nevertheless was able to record a gain on its sale, and avoid recognizing any losses on assets held by LJM2, which was an unconsolidated affiliate of Enron, just like JEDI.
As if all of this were not complicated enough, Enron's sale of "dark fiber" to LJM2 also magically generated an inflated price, which Enron then could use in valuing any remaining "dark fiber" it held. The third-party investor in LJM2 had, in a sense, "validated" the value of the "dark fiber" at the higher price, and Enron then arguably could use that inflated price in valuing other "dark fiber" assets it held. I do not have any direct knowledge of this, although public reports and Sherron Watkins's letter indicate that this is precisely what happened.
For example, suppose Enron started with ten units of "dark fiber," worth $100, and sold one to a special purpose entity for $20 - double its actual value - using the above scheme. Now, Enron had an argument that each of its remaining nine units of "dark fiber" also were worth $20 each, for a total of $180.
Enron then could revalue its remaining nine units of "dark fiber" at a total of $180. If the assets used in the transaction were difficult to value - as "dark fiber" clearly was - Enron's inflated valuation might not generate much suspicion, at least initially. But ultimately the valuations would be indefensible, and Enron would need to recognize the associated losses.
It is an open question for this Committee and others whether this transaction was unique, or whether Enron engaged in other, similar deals. It seems likely that the "dark fiber" deal was not the only one of its kind. There are many sentences in footnote 16. |
