Oh, the Games Enron Played: Knowledge@Wharton (http://knowledge.wharton.upenn.edu/article.cfm?

articleid=469)

Oh, the Games Enron Played

Published : November 21, 2001 in Knowledge@Wharton

In the 1990s, Houston’s Enron Corp. was Wall Street’s darling. It had thrown out the This is a
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energy-industry playbook, remaking itself from a staid gas pipeline company to a copy of
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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?

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Oh, the Games Enron Played: Knowledge@Wharton (http://knowledge.wharton.upenn.edu/article.cfm?articleid=469)

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

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Oh, the Games Enron Played: Knowledge@Wharton (http://knowledge.wharton.upenn.edu/article.cfm?articleid=469)

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

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Oh, the Games Enron Played: Knowledge@Wharton (http://knowledge.wharton.upenn.edu/article.cfm?articleid=469)

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.

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