Oh, the Games Enron PlayedPublished: November 21, 2001 in Knowledge@Wharton
In the 1990s, Houston’s Enron Corp. was Wall Street’s darling. It had thrown out the energy-industry playbook, remaking itself from a staid gas pipeline company to a high-tech trading firm that created exotic securities for betting on everything from gas prices to the number of hot days in summer.
Share prices soared from $30 to $90 between 1998 and 2000, as sales increased from $31 billion to more than $100 billion. Enron executives gained reputations as the energy industry’s visionaries.
This fall it all came apart. Share prices have fallen by 90% this year, including a plunge from just below $40 to less than $10 this fall. In October, Enron reported a third-quarter loss of $618 million. The company’s massive debt was downgraded to near junk-bond status, and the CEO and CFO were expelled. Shareholders sued and the Securities and Exchange Commission launched an investigation.
Finally, the humiliated company, which employs more than 20,000, agreed Nov. 9 to be taken over by smaller cross-town rival Dynegy Inc. for about $9 billion in stock and $13 billion in assumed debt. It is not certain the merger will take place since it is subject to regulatory approval and could be blocked on antitrust grounds. And some news accounts suggest that major Dynegy shareholders could derail the merger over concerns about inheriting liabilities from current or future lawsuits by Enron shareholders.
The Enron story is not simply a case of a lone company that played with fire and got burned. Enron was able to take enormous risks while keeping shareholders in the dark because it could exploit accounting loopholes for subsidiaries that are available to most publicly traded companies. Companies like Enron can legally conceal massive debts because rules require a full accounting of a subsidiary’s balance sheet only when the parent company owns more than half of it.
"If I’m a shareholder of Enron and I want full and fair disclosure, I would want information about the entities Enron controls," says Wharton accounting professor Robert E. Verrecchia. Yet Enron shareholders have never received such a report.
Enron’s fate is crucial to the energy industry and other markets it serves, points out Paul R. Kleindorfer, a professor of public policy and an expert on deregulation at Wharton. Producers and users of gas, oil, electricity and other forms of energy rely on Enron’s system for trading futures, forwards, options, swaps and other contracts to get the best prices and control costs far into the future. Without such a system, deregulation simply cannot work.
"If Enron’s trading platform were to go down it would not be a minor loss," Kleindorfer says. "It would be a huge loss for the industry….In the early 1990s the company single-handedly produced the backbone infrastructure that has led to a whole industry of broker intermediation."
To some extent, Enron appears to have been a victim of sagging securities prices and volatile energy costs in 2000 and 2001, and it has lost hundreds of millions by laying fiber-optic cable for which there is no demand. But although those factors may have determined the timing of the company’s troubles, they were not the chief cause. Enron appears to have lost enormous amounts of shareholder money by gambling at its own roulette wheels.
"In hindsight, we made some very bad investments in non-core businesses that performed worse than we ever could have conceived," Chairman Kenneth Lay told analysts last week.
How did Enron get into this mess?
Becoming a Market Maker
When it was created in 1985 by the merger of Houston Natural Gas and InterNorth, parent company of Northern Natural Gas, Enron’s chief business was the operation of thousands of miles of natural gas pipeline. Lay became chairman in Feb. 1986. Then early in the 1990s, the federal government took key steps to deregulate the energy industry.
Previously, large regulated utilities were vertically integrated, giving them control from wellhead to consumer, Kleindorfer says. Deregulation effectively broke apart the production, long-range transmission and local distribution functions, leaving each to a different set of players. A factory owner, for example, can now buy gas or electricity from number of producers.
To function, a free market such as this needs brokers, or intermediaries, to create, buy and sell contracts for production and delivery, and it requires a market maker to facilitate trading, just as the big Wall Street firms and exchanges facilitate trading in stocks. Enron created that marketplace. "This intermediation activity, or brokerage activity, just revolutionized the marketplace," Kleindorfer says.
Since utilities and other energy users must line up dependable supplies for many months in the future, they rely on various forms of contracts specifying quantities, prices and delivery dates. But before the commodity is delivered, prevailing prices may go up or down, and a supplier may find it has promised to sell at a price that’s now too low, while a purchaser may find that it could have bought for less than it had agreed to pay.
Suppliers and purchasers therefore use a variety of derivative contracts to benefit from prices that move in their favor and hedge in case prices move against them. A company that has contracted to buy a shipload of liquefied natural gas at a specific price in three months, could, for a much smaller sum, buy an options contract giving it the right, but not the obligation, to buy a shipload at a lower price. And it could buy an option giving it the right to sell at a higher price. Thus it is protected regardless of whether prices move up or down.
This was the business Enron invented. By permitting competition and price discovery far into the future, it brought to the marketplace the most efficient pricing and allowed energy users to predict and stabilize costs far into the future, Kleindorfer says. "Having that information historically, as well as projected into the future, could revolutionize how you plan your business," he said.
At the heart of Enron’s business strategy was the belief that it could be a big energy player without owning all the power plants, ships, pipelines and other facilities involved. Instead, it could use contracts to control the facilities in which other companies had invested, says Ehud Ronn, director of the Center for Energy Finance Education and Research at the Red McCombs School of Business at the University of Texas at Austin. The Center trains masters candidates in the use of energy securities. (Enron is one of the center’s eight corporate sponsors.)
Enron, he says, evolved into something akin to a Wall Street firm. "Enron thought of itself in very similar terms as an investment banker that wanted to tie up as little capital as possible."
By 2001, Enron had evolved into a market maker for some 1,800 different products, many of them energy- or Internet-related contracts or derivatives the company had created itself. They included products allowing customers to buy, sell, hedge or speculate in markets ranging from traditional commodities like coal, oil, gas and electricity to cutting edge markets for Internet bandwidth, pollution emissions, semiconductors, wind energy and many others. Prices for many of these products were available on the company’s free website, giving the energy markets unprecedented price transparency.
Betting on the Weather
To see how these products could be used, consider one of Enron’s "weather risk management" products meant for utilities, energy distributors, agricultural companies and financial institutions. A gas utility, for example, might use a "floor" to protect its revenue in the event of a mild winter. In exchange for a premium similar to that paid on an insurance policy, Enron will compensate the utility for every day between November and March on which the temperature rises above a set level. The payments would make up for reduced gas sales.
In another form of contract called a swap, or collar, Enron will pay the gas company a given amount if the number of warm days exceeds a set level. But if the number of cold days exceeds a threshold, the gas company will make a payment to Enron. The utility would not have to pay a premium as it would with the floor, and if it had to pay Enron, the money would come from the extra revenue received by selling more gas in a colder-than normal winter.
To a layman this might look like betting. "We never use that word," says Ronn. "The worst we say is to ‘have a view.’"
In practice, other parties are often involved in such transactions, taking over the contractual obligation created by Enron. So, in addition to placing its own bets, Enron serves as a middleman, the way a stockbroker stands in the middle of a securities trade.
Like many middlemen, Enron has to be in a position to make good on any transaction should either party default. Otherwise, it would be hard to make a market in these products. In addition, says Ronn, Enron often has to pay out money before receiving payment from another party. Finally, Enron needed large amounts of capital to trade products in its own account, just as a Wall Street firm invests in stocks on its own in addition to executing customers’ trades. To accomplish all this, Enron needed vast amounts of capital. "You do need to have liquidity in huge numbers," Ronn says.
This created a dilemma. A public company can raise capital by selling additional shares, but current shareholders don’t like that because the new shares dilute the value of their holdings. The alternative is to borrow, but large debts hurt a company’s credit rating, forcing it to pay higher interest rates on its loans.
Andrew S. Fastow, who became the company’s senior vice president of finance in 1990, found innovative ways to issue new shares without dilution and to raise capital by selling old-fashioned assets like power plants and pipelines.
"He has invented a groundbreaking strategy," Ted. A. Izatt, senior vice president at Lehman Brother’s Inc., told CFO Magazine in the fall of 1999. Or, as Enron president and CEO Jeffrey K. Skilling told the magazine: "We needed someone to rethink the entire financing structure at Enron from soup to nuts. We didn’t want someone stuck in the past, since the industry of yesterday is no longer. Andy has the intelligence and the youthful exuberance to think in new ways. He deserves every accolade tossed his way."
Fastow, named chief financial officer in March 1998, told the magazine: "We transformed finance into a merchant organization….Essentially, we would buy and sell risk positions." A key to the strategy: Move many of Enron’s transactions "off the balance sheet." In part, this involved exploiting a loophole in the securities and accounting regulations. As noted earlier, debts accumulated by subsidiaries, partnerships or other "entities" can be kept off the parent company’s books so long as the parent does not own more than 50% of the entity incurring the debt.
By using so-called unconsolidated subsidiaries, "you do not make transparent either the nature of the investment or the relationship between the parent and the subsidiary," said Verrecchia. Heavy hitters such as Wall Street analysts and major shareholders may have the clout to get a company to provide additional information on subsidiaries. "But if you’re just an investor picking up Enron’s annual report, you are stuck," Verrecchia added.
A Pattern of Sketchy Details
It has long been clear from company statements and SEC filings that Enron’s off-balance-sheet transactions were enormous, but details were sketchy because Enron did not have to report them, and chose not to. By this fall, however, it became obvious these transactions involved huge risks when Enron acknowledged it had improperly kept some activity off its books. Putting those debts and losses into Enron’s financial statements last month meant reducing shareholder equity by $1.2 billion. Corrected statements reduced net income by $96 million for 1997, $113 million for 1998, $250 million for 1999 and $132 million for 2000.
At issue were so-called "special purpose entities," or SPEs, set up for a variety of transactions for Enron’s benefit. Enron conceded some of these entities did not meet the accounting standards to be kept off of Enron’s books. In one case, for instance, the entity had "inadequate capitalization" for such treatment.
In 2000, Enron had created four entities known as Raptor I, II, III and IV to "hedge market risk in certain of its investments," according to an Enron filing with the SEC. Enron acquired notes receivable from the Raptors in exchange for an obligation to issue Enron shares to the entities. But Enron had improperly included the value of the notes receivable on its books without accounting for the cost of the shares it would have to issue. In correcting this violation of accounting rules, Enron said it had overstated its shareholders equity by $1 billion in March and June 2001.
Enron was particularly embarrassed in acknowledging that two special purpose entities, limited partnerships LJM Cayman and LJM Co-Investment, had Fastow as the managing partner. Fastow, who according to Enron made in excess of $30 million in this role, was forced out of the company in October. An internal committee and the SEC are investigating the use of the partnerships.
Obviously, Fastow’s role was a problem. If the partnerships were truly independent entities, he was in a conflict of interest. If he was running them on Enron’s behalf, they were not independent.
Despite the write-downs and disclosures this fall, many analysts complain they still do not have a full picture of Enron’s activities. Enron, for instance, has not fully described other partnerships it believes it can properly keep off the balance sheet. Nor is it clear to what extent Enron’s losses are due to bad bets it had made through highly-leveraged derivatives. While a stock market investor can simply hang on to shares to wait out a downturn, options and other derivatives typically have expiration dates. If the bet has not turned out as hoped, the entire investment can be lost.
"New disclosure was modest and management did not resolve concerns," Goldman Sachs analysts David Maccarrone and David Fleischer wrote in an Oct. 24 report to clients. Though Enron had long faced such criticisms, investors had tended to give the company the benefit of the doubt "because of its strong growth in earnings and acknowledged industry leading capabilities…," the two analysts said.
In other words, when stock was soaring, investors didn’t require details on how it was done. Now they are crying foul, and a number of shareholder suits have been filed. Essentially, they claim the company inflated its stock price by filing false financial statements. Investors who bought shares at those high prices have suffered huge losses.
For years, the Financial Accounting Standards Board, which sets accounting rules, has had a draft proposal for improving disclosure of subsidiaries’ activities and numbers. Essentially, it would move toward a more qualitative evaluation of whether the parent controlled the subsidiary even if it owned less than 50% of the stock. Control could be exerted by holding board seats or through contracts that effectively make the subsidiary a unit of the parent.
"What the FASB has promulgated seems to me to be sensible," Verrecchia said, noting that the whole purpose of accounting is to give an accurate view of a company’s inner workings and true earnings. To conceal obligations, risk and debt, as Enron and others do, undermines that goal, he said.
But, facing heavy opposition from accountants and corporations, the FASB has not acted on the draft proposal, citing insufficient support on its board. So for the time being, off-balance-sheet transactions will continue to be a common practice among American corporations.