Copyright 2002 Federal News Service, Inc. Federal News Service
January 24, 2002, Thursday
SECTION: PREPARED TESTIMONY
LENGTH: 9378 words
HEADLINE:
PREPARED TESTIMONY OF FRANK PARTNOY PROFESSOR OF LAW, UNIVERSITY OF SAN DIEGO
SCHOOL OF LAW
BEFORE THE SENATE COMMITTEE
ON GOVERNMENTAL AFFAIRS
BODY: 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 finns' 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 finn.
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 derivativesrelated 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 modem 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 Not 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 nra-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 entityapparently 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/EDI, and therefore -
under applicable accounting rules - could (and did) report/EDI as an
unconsolidated equity affiliate. If Enron had owned 51 percent of /EDI,
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 modem
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 l0 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,
ShelTon 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 finn, 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 Baal 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 finns 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 or $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
worstcase 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 percent of all trading
days (on average, twelve business days during the year) its "commodity"
derivatives trading operations alone would gain or lose $66 million, a not
trivial sum.
Moreover, because Enron's derivatives
frequently had long maturities - maximum terms ranged from 6 to 29 years - there
often were not prices from liquid markets to use as benchmarks. For those
long-dated derivatives, professional judgment was especially important. For a
simple instrument, Enron might calculate the discounted present value of cash
flows using Enron's borrowing rates. But more complex instruments required more
complex methodologies. For example, Enron completed over 5,000 weather
derivatives deals, with a notional value of more than $4.5 billion, and many of
those deals could not be valued without a healthy dose of professional judgment.
The same was true of Enron's trading of fiber-optic bandwidth.
And finally there was the following flashing red light in Enron's most
recent annual report: "In 2000, the value at risk model utilized for equity
trading market risk was refined to more closely correlate with the valuation
methodologies used for merchant activities." Enron's financial statements do not
describe these refinements, and their effects, but given the failure of the risk
and valuation models even at a sophisticated hedge fund such as Long-Term
Capital Management - which employed "rocket scientists" and Nobel laureates to
design various sophisticated computer models - there should have been reason for
concern when Enron spoke of "refining" its own models.
It was Arthur Andersen' s responsibility not only to audit Enron's
financial statements, but also to assess Enron management's internal controls on
derivatives trading. When Arthur Andersen signed Enron's 2000 annual report, it
expressed approval in general terms of Enron's system of internal controls
during 1998 through 2000.
Yet it does not appear that
Arthur Andersen systematically and independently verified Enron's valuations of
certain complex trades, or even of its forward curves.
Arthur Andersen apparently examined day-to-day changes in these values,
as reported by traders, and checked to see if each daily change was recorded
accurately. But this Committee - and others investigating Enron - should inquire
about whether Arthur Andersen did anything more than sporadically check Enron's
forward curves.
To Arthur Andersen's credit as an
auditor, much of the relevant risk information is contained in Enron's financial
statements. What is unclear is whether Arthur Andersen adequately considered
this information in opining that Enron management's internal controls were
adequate. To the extent Arthur Andersen alleges - as I understand many
accounting firms do - that their control opinion does not cover all types of
control failures and necessarily is based on management's "assertions," it is
worth noting that the very information Arthur Andersen audited raised
substantial questions about potential control problems at Enron. In other words,
Arthur Andersen has been hoisted by its own petard.
But
Arthur Andersen was not alone in failing to heed these warning sins. Securities
analysts and credit rating agencies arguably should have spotted them, too. Why
were so many of these firms giving Enron favorable ratings, when publicly
available information indicated that there were reasons for worry? Did these
firms look the other way because they were subject to conflicts of interest?
Individual investors rely on these institutions to interpret the detailed
footnote disclosures in Enron's reports, and those institutions have failed
utterly. The investigation into Arthur Andersen so far has generated a great
deal of detail about that firm's approach to auditing Enron, but the same
questions should be asked of the other gatekeepers, too. Specifically, this
Committee should ask for and closely examine all of the analyst reports on Enron
from the relevant financial services firms and credit rating agencies.
Finally, to clarify this point, consider how much Enron's
businesses had changed during its last years. Consider the change in Enron's
assets. Arthur Andersen's most recent audit took place during 2000, when Enron's
derivatives-related assets increased from $2.2 billion to $12 billion, and
Enron's derivatives-related liabilities increased from $1.8 billion to $10.5
billion. These numbers are staggering.
Most of this
growth was due to increased trading through EnronOnline. But Enron Online's
assets and revenues were qualitatively different from Enron's other derivatives
trading. Whereas Enron's derivatives operations included speculative positions
in various contracts, EnronOnline's operations simply matched buyers and
sellers. The "revenues" associated with EnronOnline arguably do not belong in
Enron's financial statements. In any event, the exponential increase in the
volume of trading through EnronOnline did not generate substantial profits for
Enron.
Enron's aggressive additions to revenues meant
that it was the "seventh-largest U.S. company" in title only. In reality, Enron
was a much smaller operation, whose primary money-making business - a
substantial and speculative derivatives trading operation - covered up poor
performance in Enron's other, smaller businesses, including EnronOnline. Enron's
public disclosures show that during the past three years the firm was not making
money on its non-derivatives businesses. Gross margins from these businesses
were essentially zero from 1998 through 2000.
To see
this, consider the table below, which sets forth Enron's income statement
separated into its non-derivatives and derivatives businesses. I put together
this table based on the numbers in Enron's 2000 income statement, after learning
from the footnote 1, page 36, that the meaning of the "Other revenues" entry on
Enron's income statement is - as far as I can tell - essentially "Gain (loss)
from derivatives":
Enron Corp. and Subsidiaries 2000
Consolidated Income Statement (in millions) 2000 1999 1998 Non-derivatives
revenues 93,557 34,774 27,215 Non-derivatives expenses 94,517 34,761 26,381
Non-derivatives gross margin (960) 13 834
Gain (loss)
from derivatives 7,232 5,338 4,045 Other expenses (4,319) (4,549) (3,501)
Operating income 1,953 802 1,378
This chart
demonstrates four key facts. First, the recent and dramatic increase in Enron's
overall non-derivatives revenues - the statistic that supposedly made Enron the
seventh-largest U.S. company- was offset by an increase in non-derivatives
expenses. The increase in revenues reflected in the first line of the chart was
substantially from EnronOnline, and did not help Enron's bottom line, because it
included an increase in expenses reflected in the second line of the chart.
Although Enron itself apparently was the counterparty to all of the trades,
EnronOnline simply matched buyers ("revenue") with sellers ("expenses"). Indeed,
as non-derivatives revenues more than tripled, nonderivatives expenses increased
even more. Second, a related point: Enron's non-derivatives businesses were not
performing well in 1998 and were deteriorating through 2000. The third row,
"Non-derivatives gross margin," is the difference between non- derivatives
revenues and non-derivatives expenses. The downward trajectory of Enron's
non-derivatives gross margin shows, in a general sense, that Enron's
non-derivatives businesses made some money in 1998, broke even in 1999, and
actually lost money in 2000.
Third, Enron's positive
reported operating income (the last row) was due primarily to gains from
derivatives (the fourth row). Enron - like many firms - shied from using the
word "derivatives" and substituted the euphemism "Price Risk Management," but as
Enron makes plain in its public filings, the two are the same. Excluding the
gains from derivatives, Enron would have reported substantially negative
operating income for all three years.
Fourth, Enron's
gains from derivatives were very substantial. Enron gained more than $16 billion
from these activities in three years. To place the numbers in perspective, these
gains were roughly comparable to the annual net revenue for all trading
activities (including stocks, bonds, and derivatives) at the premier investment
firm, Goldman Sachs & Co., during the same periods, a time in which Goldman
Sachs first issued shares to the public.
The key
difference between Enron and Goldman Sachs is that Goldman Sachs seems to have
been upfront with investors about the volatility of its trading operations. In
contrast, Enron officials represented that it was not a trading firm, and that
derivatives were used for hedging purposes. As a result, Enron's stock traded at
much higher multiples of earnings than more candid trading-oriented firms.
The size and scope of Enron's derivatives trading
operations remain unclear. Enron reported gains from derivatives of $7.2 billion
in 2000, and reported notional mounts of derivatives contracts as of December
31, 2000, of only $21.6 billion. Either Enron was generating 33 percent annual
returns from derivatives (indicating that the underlying contracts were very
risky), or Enron actually had large positions and reduced the notional values of
its outstanding derivatives contracts at year-end for cosmetic purposes. Neither
conclusion appears in Enron's financial statements.
IV.
Conclusion
How did Enron lose so much money? That
question has dumbfounded investors and experts in recent months. But the basic
answer is now apparent: Enron was a derivatives trading finn; it made billions
trading derivatives, but it lost billions on virtually everything else it did,
including projects in fiber-optic bandwidth, retail gas and power, water
systems, and even technology stocks. Enron used its expertise in derivatives to
hide these losses. For most people, the fact that Enron had transformed itself
from an energy company into a derivatives trading firm is a surprise. Enron is
to blame for much of this, of course. The temptations associated with
derivatives have proved too great for many companies, and Enron is no exception.
The conflicts of interest among Enron's officers have been widely reported.
Nevertheless, it remains unclear how much top officials knew about the various
misdeeds at Enron. They should and will be asked. At least some officers must
have been aware of how deeply derivatives penetrated Enron's businesses; Enron
even distributed thick multi-volume Derivatives Training Manuals to new
employees. (The Committee should ask to see these manuals.)
Enron's directors likely have some regrets. Enron's Audit Committee in
particular failed to uncover a range of external and internal financial
gimmickry. However, it remains unclear how much of the inner workings at Enron
were hidden from the outside directors; some directors may very well have
learned a great deal from recent media accounts, or even perhaps from this
testimony. Enron's general counsel, on the other hand, will have some questions
to answer.
But too much focus on Enron misses the mark.
As long as ownership of companies is separated from their control - and in the
U.S. securities market it almost always will be - managers of companies will
have incentives to be aggressive in reporting financial data. The securities
laws recognize this fact of life, and create and subsidize "gatekeeper"
institutions to monitor this conflict between managers and shareholders.
The collapse of Enron makes it plain that the key
gatekeeper institutions that support our system of market capitalism have
failed. The institutions sharing the blame include auditors, law firms, banks,
securities analysts, independent directors, and credit rating agencies.
All of the facts I have described in my testimony were
available to the gatekeepers. I obtained this information in a matter of weeks
by sitting at a computer in my office in San Diego, and by picking up a
telephone. The gatekeepers' failure to discover this information, and to
communicate it effectively to investors, is simply inexcusable.
The difficult question is what to do about the gatekeepers. They occupy
a special place in securities regulation, and receive great benefits as a
result. Employees at gatekeeper firms are among the most highly-paid people in
the world. They have access to superior information and supposedly have greater
expertise than average investors at deciphering that information. Yet, with
respect to Enron, the gatekeepers clearly did not do their job.
One potential answer is to eliminate the legal requirements that
companies use particular gatekeepers (especially credit rating agencies), while
expanding the scope of securities fraud liability and enforcement to make it
clear that all gatekeepers will be liable for assisting companies in
transactions designed to distort the economic reality of financial statements. A
good starting point before considering such legislation would be to call the key
gatekeeper employees to testify.
Congress also must
decide whether, after ten years of steady deregulation, the post-Enron
derivatives markets should remain exempt from the regulation that covers all
other investment contracts. In my view, the answer is no. A headline in Enron's
2000 annual report states, "In Volatile Markets, Everything Changes But Us."
Sadly, Enron got it wrong. In volatile markets, everything changes, and the laws
should change, too. It is time for Congress to act to ensure that this motto
does not apply to U.S. financial market regulation.
Biography of Frank Partnoy- January 22, 2002
Frank Partnoy is a Professor of Law at the University of San Diego
School of Law, where he teaches courses in Corporations, Corporate Finance,
Deals, Emerging Financial Markets, and White-Collar Crime, and specializes in
financial market regulation. He holds degrees in mathematics and economics from
the University of Kansas. After graduating from Yale Law School, Professor
Partnoy structured and sold fixed income derivatives for CS First Boston and
Morgan Stanley in New York. He left Wall Street in 1995 and moved to Washington,
D.C., where he practiced law in the white-collar criminal area for two years at
the law firm of Covington & Burling. He has been a law professor at the
University of San Diego School of Law since 1997.
Professor Partnoy's publications include F.I.A.S.C.O.: Blood in the
Water on Wall Street, a book about the derivatives industry that was a finalist
for the Financial Times/Booz-Allen Global Business Book Award, and more than a
dozen articles about financial market regulation and derivatives. He has given
numerous presentations on various aspects of the derivatives markets to academic
and regulatory organizations throughout the world, including keynote addresses
at conferences held by the U.S. Office of Thrift Supervision and the North
American Securities Administrators Association. Professor Partnoy currently is
writing a book about the collapse of Enron.