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. |
