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Non-Tech : The ENRON Scandal -- Ignore unavailable to you. Want to Upgrade?

To: Baldur Fjvlnisson who wrote (3791)	4/2/2002 5:54:43 AM
From: Baldur Fjvlnisson	Read Replies (1) \| Respond to of 5185

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.