Enron did almost all (I say that "almost" because, hell, I didn't look at any of the thousands of entities...relying on authoritative research by others) of their accounting according to GAAP. The problem is with the percent of ownership. Fifty percent ownership of an outside entity leaves a legal knife-edge where many problems arose.
Here is the Senate testimony to that fact, by Professor Partnoy, Law Professor at University of San Diego:
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.
D. The "Gatekeepers"
These are but three examples of how Enron's derivatives dealings with outside parties resulted in material information not being reflected in market prices. There are others, many within JEDI alone. I have attempted to summarize this information for the Committee. Clearly it is important that investigators question the Enron employees who were directly involved in these transactions to get a sense of whether my summaries are complete.
Moreover, a thorough inquiry into these dealings also should include the major financial market "gatekeepers" involved with Enron: accounting firms, banks, law firms, and credit rating agencies. Employees of these firms are likely to have knowledge of these transactions. Moreover, these firms have a responsibility to come forward with information relevant to these transactions. They benefit directly and indirectly from the existence of U.S. securities regulation, which in many instances both forces companies to use the services of gatekeepers and protects gatekeepers from liability.
Recent cases against accounting firms - including Arthur Andersen - are eroding that protection, but the other gatekeepers remain well insulated. Gatekeepers are kept honest - at least in theory - by the threat of legal liability, which is virtually non-existent for some gatekeepers. The capital markets would be more efficient if companies were not required by law to use particular gatekeepers (which only gives those firms market power), and if gatekeepers were subject to a credible threat of liability for their involvement in fraudulent transactions. Congress should consider expanding the scope of securities fraud liability by making it clear that these gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements.
With respect to Enron, all of these gatekeepers have questions to answer about the money they received, the quality of their work, and the extent of their conflicts of interest. It has been reported widely that Enron paid $52 million in 2000 to its audit firm, Arthur Andersen, the majority of which was for non-audit related consulting services, yet Arthur Andersen failed to spot many of Enron's losses. It also seems likely that at least one of the other "Big 5" accounting firms was involved at least one of Enron's special purpose entities.
Enron also paid several hundred million dollars in fees to investment and commercial banks for work on various financial aspects of its business, including fees for derivatives transactions, and yet none of those firms pointed out to investors any of the derivatives problems at Enron. Instead, as late as October 2001 sixteen of seventeen the securities analysts covering Enron rated it a "strong buy" or "buy." Enron paid substantial fees to its outside law firm, which previously had employed Enron's general counsel, yet that firm failed to correct or disclose the problems related to derivatives and special purpose entities. Other law firms also may have been involved in these transactions; if so, they should be questioned, too.
Finally, and perhaps most importantly, the three major credit rating agencies - Moody's, Standard & Poor's, and Fitch/IBCA - received substantial, but as yet undisclosed, fees from Enron. Yet just weeks prior to Enron's bankruptcy filing - after most of the negative news was out and Enron's stock was trading at just $3 per share - all three agencies still gave investment grade ratings to Enron's debt. The credit rating agencies in particular have benefited greatly from a web of legal rules that essentially require securities issuers to obtain ratings from them (and them only), and at the same time protect those agencies from outside competition and liability under the securities laws. They are at least partially to blame for the Enron mess.
An investment-grade credit rating was necessary to make Enron's special purpose entities work, and Enron lived on the cusp of investment grade. During 2001, it was rated just above the lowest investment-grade rating by all three agencies: BBB+ by Standard & Poor's and Fitch IBCA, and Baa1 by Moody's. Just before Enron's bankruptcy, all three rating agencies lowered Enron's rating two notches, to the lowest investment grade rating. Enron noted in its most recent annual report that its "continued investment grade status is critical to the success of its wholesale business as well as its ability to maintain adequate liquidity." Many of Enron's debt obligations were triggered by a credit ratings downgrade; some of those obligations had been scheduled to mature December 2001. The importance of credit ratings at Enron and the timing of Enron's bankruptcy filing are not coincidences; the credit rating agencies have some explaining to do.
Derivatives based on credit ratings - called "credit derivatives" - are a booming business and they raise serious systemic concerns. The rating agencies seem to know this. Even Moody's appears worried, and recently asked several securities firms for more detail about their dealings in these instruments. It is particularly chilling that not even Moody's - the most sophisticated of the three credit rating agencies - knows much about these derivatives deals.
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.
B. Mismarking Forward Curves
Not all of the misreporting of derivatives positions at Enron was as brazen as "prudency." Another way derivatives frequently are used to misstate profits and losses is by mismarking "forward curves." It appears that Enron traders did this, too.
A forward curve is a list of "forward rates" for a range of maturities. In simple terms, a forward rate is the rate at which a person can buy something in the future.
For example, natural gas forward contracts trade on the New York Mercantile Exchange (NYMEX). A trader can commit to buy a particular type of natural gas to be delivered in a few weeks, months, or even years. The rate at which a trader can buy natural gas in one year is the one-year forward rate. The rate at which a trader can buy natural gas in ten years is the ten-year forward rate. The forward curve for a particular natural gas contract is simply the list of forward rates for all maturities.
Forward curves are crucial to any derivatives trading operation because they determine the value of a derivatives contract today. Like any firm involved in trading derivatives, Enron had risk management and valuation systems that used forward curves to generate profit and loss statements.
It appears that Enron traders selectively mismarked their forward curves, typically in order to hide losses. Traders are compensated based on their profits, so if a trader can hide losses by mismarking forward curves, he or she is likely to receive a larger bonus.
These losses apparently ranged in the tens of millions of dollars for certain markets. At times, a trader would manually input a forward curve that was different from the market. For more complex deals, a trader would use a spreadsheet model of the trade for valuation purposes, and tweak the assumptions in the model to make a transaction appear more or less valuable. Spreadsheet models are especially susceptible to mismarking.
Certain derivatives contracts were more susceptible to mismarking than others. A trader would be unlikely to mismark contracts that were publicly traded - such as the natural gas contracts traded on NYMEX - because quotations of the values of those contracts are publicly available. However, the NYMEX forward curve has a maturity of only six years; accordingly, a trader would be more likely to mismark a ten-year natural gas forward rate.
At Enron, forward curves apparently remained mismarked for as long as three years. In more esoteric areas, where markets were not as liquid, traders apparently were even more aggressive. One trader who already had recorded a substantial profit for the year, and believed any additional profit would not increase his bonus much, reportedly reduced his recorded profits for one year, so he could push them forward into the next year, which he wasn't yet certain would be as profitable. This strategy would have resembled the "prudency" accounts described earlier.
C. Warning Signs
Why didn't any of the "gatekeepers" tell investors that Enron was so risky? There were numerous warning signs related to Enron's derivatives trading. Yet the gatekeepers either failed utterly to spot those signs, or spotted those signs and decided not to warn investors about them. Either way, the gatekeepers failed to do their job. This was so even though there have been several recent and high-profile cases involving internal misreporting of derivatives.
Enron disclosed that it used "value at risk" (VAR) methodologies that captured a 95 percent confidence interval for a one-day holding period, and therefore did not disclose worst-case scenarios for Enron's trading operations. Enron said it relied on "the professional judgment of experienced business and risk managers" to assess these worst-case scenarios (which, apparently, Enron ultimately encountered). Enron reported only high and low month-end values for its trading, and therefore had incentives to smooth its profits and losses at month-end. Because Enron did not report its maximum VAR during the year, investors had no way of knowing just how much risk Enron was taking.
Even the reported VAR figures are remarkable. Enron reported VAR for what it called its "commodity price" risk - including natural gas derivatives trading - of $66 million, more than triple the 1999 value. Enron reported VAR for its equity trading of $59 million, more than double the 1999 value. A VAR of $66 million meant that Enron could expect based on historical averages that on five perce |
