Infectious Greed
Page 40
The great paradox of Enron was that, notwithstanding these awful decisions, Enron’s core business—natural-gas and electricity derivatives trading—generated enough money to offset its other failed efforts, including billions of dollars in profits during Enron’s last years. By August 1999, Enron had withdrawn entirely from oil and natural-gas production. Instead, Enron made money by exchanging billions of dollars of long-term natural-gas and electricity derivatives, in which it committed to buy or sell energy products of various types for up to ten or more years. Enron’s traders routinely took speculative positions that were much riskier than those Louis Borget and Thomas Mastroeni had taken at Enron Oil more than a decade earlier. In the developing energy markets, Enron’s traders were in basically the same position Andy Krieger had been in years earlier: there were no organized exchanges for trading long-term energy contracts, and Enron traders could make huge sums trading with relatively less sophisticated market participants and taking advantage of market inefficiencies. Enron shareholders supposedly didn’t need to worry too much about the risks of these trading operations, because Ken Lay had learned his lesson about trading risks with Enron Oil, and had committed to improved controls.
From the managers’ perspective, the problem with Enron’s derivatives trading was that even successful trading firms were not highly valued in the market. Investors generally believed that markets were efficient, and that trading made big money only when traders took on substantial risks. Simply put, investors didn’t value firms that took on substantial trading risks. Whereas a trading firm might have a price/earnings ratio of 10 or perhaps 15, a typical technology firm had a P/E ratio of 60 or more. To maximize its stock price, Enron executives needed to make it appear to investors that earnings were increasing because of the firm’s successes in a range of technology businesses, not because of profits from its core business of derivatives trading. To the extent Enron appeared to be a technology firm, not a trading firm, its stock price would rise, and the executives’ options would be worth more money.
As Enron shifted to new technology businesses, while hiding its derivatives trading, the perception of the firm’s technology investments and the reality of its trading business were in intractable conflict. As a technology firm, Enron needed to borrow billions of dollars to pay for new investments and infrastructure. But as a trading firm, it needed to keep debt low, to maintain a high credit rating. This conflict eventually would tear Enron apart.
In the late 1990s, Enron Capital, the company’s venture-capital fund, began investing in start-up technology companies, just as Frank Quattrone’s fund at CS First Boston had bought shares of his clients’ start-up companies before they did IPOs. For example, in March 1998, Enron invested $10 million in Rhythms NetConnections, an Internet service provider and a potential competitor of Netscape, the company whose IPO had marked the beginning of the Internet boom.
Enron’s point man for Rhythms NetConnections was Ken L. Harrison, the former CEO of Portland General, an energy company Enron had just acquired. Harrison had just joined Enron’s board and, after Enron invested in Rhythms NetConnections, he joined that board, too. Harrison was an ideal overseer, given that he had been named as a defendant several years earlier in a major financial-fraud case related to Bonneville Pacific, an energy company in which Portland General owned a substantial stake. Bonneville Pacific had raised several hundred million dollars, allegedly manipulated its earnings by using off-balance-sheet vehicles, and then declared bankruptcy—the same things Enron later would do. Portland General had settled the litigation while Ken Harrison was CEO. Given that both Ken Lay and Ken Harrison had been through painful financial scandals, it seemed likely that Enron would be safe from any similar scheme related to Rhythms NetConnections.
Enron originally had purchased shares of Rhythms NetConnections for less than $2. On April 6, 1999, Rhythms NetConnections did its IPO with Salomon Brothers, offering shares to the public for $21. At the end of the first day of trading, the stock was at $69, a big jump even for a late-1990s IPO. Enron had made 35 times its money on a $10 million investment—the same payoff as betting on a single number on a roulette wheel—and suddenly it had a $300 million gain, which represented almost half of its earnings from the previous year. (WorldCom and its CEO, Bernard J. Ebbers, made even more money from the IPO26—more on that in the next chapter.)
The huge paper gain put Enron in an awkward situation. Enron couldn’t realize the gain right away, because as an insider of Rhythms NetConnections, it was prohibited from selling the shares during a lockup period of 180 days. But even if Enron could have sold the shares, it wouldn’t have wanted to do so. Why? A $300 million gain on a speculative Internet stock was not the kind of steady growth from technology investments Enron wanted to show investors. Securities analysts and credit-rating agencies wanted to see increases in income from operations, not one-time speculative gains. Solid earnings would help Enron’s share price, but a several-hundred-million-dollar roulette win would not.
Andy Fastow, having sharpened his creative skills in structured finance with JEDI and other deals, had the solution. The road map came from a deal he had just done in 1997 to buy out CalPERS, the original investor in JEDI (CalPERS insisted that Enron buy its share of JEDI before it would do JEDI II, a sequel). Recall that Enron had kept JEDI off its balance sheet because CalPERS—an independent party—owned and controlled half of it. Fastow proposed replacing CalPERS with a newly created partnership called Chewco Investments L.P. (named after Chewbacca, the furry Wookie from the movie Star Wars, a foolish choice, given that Chewco and JEDI—names derived from the same movie—were supposed to be independent). Chewco would own and control 50 percent of JEDI, so that Enron could keep JEDI off its books.
The machinations of the JEDI-Chewco deal were widely publicized, but the rationale for the deal was not. For more than a decade, creative financiers had been dealing with the recurring problem of finding an independent source of funding, so that a company could move liabilities off the balance sheet. The problem generally arose in the context of leases, and by 1997 it applied to nearly every financial asset. Enron’s attempt to find an independent investor in Chewco was an object lesson in how apparently obscure legal rules were causing new financial products to mutate in wild and unanticipated ways. The solution to the problem involved the Special Purpose Entity.
In the 1980s, airlines often entered into long-term leases for their airplanes, instead of borrowing money to buy them. If the other party to the lease bore a substantial amount of risk with respect to the value of the leased planes, it didn’t seem fair to require the airline to record the entire value of the planes as an asset and the entire value of the amount it owed on the lease as a liability. Instead, the lease would remain “off balance sheet.”
But what if the outside party bore little risk, so that the airline essentially owned the airplanes even though it technically had entered into a lease? If accountants permitted any lease to be off balance sheet, companies would start doing leases in droves, and investors would never know what companies actually owned and owed. To provide some guidance to leasing companies, the Emerging Issues Task Force of the Financial Accounting Standards Board—the same board that unsuccessfully proposed that companies count the value of stock options as an expense—issued an opinion called EITF 90-15, which said, essentially, that companies could move leases off their books if outsiders bore at least three percent of the residual risk of the lease.
This accounting opinion came to be known as the three percent rule, and companies began applying the opinion to transactions other than leases, arguing, for example, that companies did not need to record their dealings with a partnership if an outsider owned more than three percent. Some creative financiers argued that if the rationale applied to an existing partnership, a company also should be able to create a new partnership, sell an outside interest of three percent, and then remove the related assets and liabilities from its books.
The Securities a
nd Exchange Commission was uncomfortable with three percent as a one-size-fits-all bright line. Why not five percent? Or why not a higher percentage for risky deals, and a lower percentage for less volatile ones? Notwithstanding these concerns, the SEC’s Office of the Chief Accountant wrote a guidance letter in 1991, sanctioning the three percent rule, but noting that “a greater investment may be necessary depending on the facts and circumstances.”
With that mixed blessing, the three percent rule became like law, even though there was no real law or even any clear pronouncement by securities regulators supporting it. Instead, parties relied on letters from private law firms opining that it was appropriate in a given deal to remove assets and liabilities from a company’s balance sheet, citing EITF 90-15 and the 1991 SEC guidance letter. The three percent rule was an unsteady foundation for trillions of dollars of structured transactions, but that was precisely what it supported. For companies eager to use newly created SPEs to repackage and sell off mortgages, car loans, and numerous other financial interests, the three percent rule was plenty of justification for moving debts off their balance sheets. A typical SPE closely tracked the rule, with 97 percent debt and three percent stock. The three percent stock was supposed to be owned by an independent, outside party, although frequently it was held by a charitable trust or other entity related to the parties doing the deal. As SPEs became more common, financial firms pushed the envelope on the definition of “independent, outside investment.”
Chewco’s “outside” investors were not really independent of Enron, but they arguably satisfied the rules. Enron cobbled together a three percent investment from Barclays Bank and some partnerships related to an Enron employee, Michael Kopper, and his domestic partner. The investment was not really at risk, because Enron put up cash collateral to guarantee repayment. And the investment was not really independent, because Michael Kopper worked for Enron. But in the new financial-market culture, reality didn’t matter. The key question was whether the deal technically satisfied the rules. Technically, Barclays and the partnerships controlled Chewco. And technically, their money was labeled an outside “equity” investment, even though it was not really at risk.
With these arrangements, Enron could at least argue that Chewco had an outside investor with control. This argument might seem a thin reed, but it was entirely reasonable given how other companies were using supposedly “outside” investors in SPEs. Moreover, it wasn’t up to Enron to decide whether a deal satisfied the SPE rules. That was the job of Enron’s auditor, Arthur Andersen. Andersen’s decision to approve of the accounting treatment for JEDI and Chewco was mired in controversy, and Andersen later claimed it would have made a different decision if Enron had disclosed key details regarding the collateral for the Barclays loan and the role of Michael Kopper and his domestic partner. But at that time, Andersen advised Enron that Chewco qualified as an SPE and, based on this advice, Enron continued to exclude JEDI from its financial statements, reporting its 50 percent ownership only in a footnote.
The bottom line of all these intricate dealings was simple. Enron substituted one outside investor in JEDI for another. And it kept JEDI—which it could now continue to use to make various energy investments—off its balance sheet.
Enron’s dealings in JEDI and Chewco later horrified many individual investors, but the truth was that they were arguably legal, not especially unusual, mostly disclosed, and largely irrelevant to Enron’s collapse. There were enough key details about JEDI and Chewco in the footnotes to Enron’s financial statements to warn off any investor who read them. And even if Enron had included JEDI in its financial statements, its reported income still would have been almost a billion dollars a year, and its reported debt would have been at reasonable levels. Indeed, after Enron later revised its financial statements to include JEDI, the effects were insubstantial compared to the magnitude of Enron’s derivatives trading. To the extent that Enron’s financial statements were inaccurate, the primary reason was not that Enron was violating the rules; instead, it was that the rules of the game had changed so much that companies were permitted to create a fictional accounting reality, which didn’t need to comport with economic reality.
After the JEDI-Chewco deal, Fastow began developing even more complicated transactions, with strange names such as Enron Cash Co. No. 2 or, more creatively, Obi-1 Holdings LLC and Kenobe Inc., keeping with the Star Wars motif.27 Fastow was obviously good at structured finance. In 1999, he received a major award for excellence as a CFO, which stressed his “unique financing techniques.”28
With his new-found expertise, Fastow finally had the road map for dealing with Enron’s $300 million gain on Rhythms NetConnections, and for making himself some easy money. Fastow’s fingerprints were all over his newest partnership, called LJM; even the initials stood for the names of his wife and two daughters. Fastow would be directly involved in LJM, even though the securities laws would require that Enron disclose his involvement. In the Chewco deal, Michael Kopper, not Fastow, had been directly involved, because Kopper was a lower-level employee who fell outside the scope of disclosure rules.29 But Kopper and the related partnerships had made $10 million on a $125,000 “outside” investment—why should Kopper, Fastow’s assistant, make all the money?30
Fastow persuaded Enron’s board of directors that LJM would be of great value to Enron as a purchaser of Enron’s assets, a partner with Enron in new investments, and a counterparty to derivatives agreements to help Enron hedge its risks.31 Fastow also asked the board to give him permission to keep a percentage of the profits from LJM’s deals, even though it created a blatant conflict of interest.32 The proposal sailed through Enron’s hands-off board, with a minimal requirement that Enron officers review LJM’s transactions. The directors later approved a second, similar partnership called LJM2 Co-Investment, L.P. They apparently never imagined that Fastow would make more than $45 million from the partnerships.33
The details of the two LJM partnerships were unknown to Enron’s shareholders, but they were palpable among Wall Street firms, which funded the bulk of the partnerships’ outside investment. LJM was a relatively small partnership, with just two outside investors putting in $7.5 million each: ERNB Ltd., a partnership set up by CS First Boston, and Campsie Limited, a partnership set up by National Westminster, a British bank.34 Fastow also invested $1 million of his own money, bringing the total amount of money raised for LJM in 1999 to $16 million.
LJM2 was more than twenty times the size of LJM, with several hundred million dollars of outside investment from a Who’s Who of the financial markets: investment banks such as Merrill Lynch; commercial banks such as J. P. Morgan Chase; insurance companies such as American International Group; charitable institutions such as the John D. and Catherine T. MacArthur Foundation; retirement funds such as the Arkansas Teacher Retirement System; and even several wealthy individuals such as Leon Levy, former chairman of the Oppenheimer mutual funds, John Friedenrich, a prominent Silicon Valley lawyer, Jack Nash, a New York hedge-fund manager, and even ninety-six employees of Merrill Lynch.35
LJM used its $16 million to purchase from Enron the rights to 3.4 million Enron shares, worth $276 million. Of course, LJM didn’t have $276 million in cash to pay for the shares, so it agreed to make payments over time. Enron imposed a restriction on the shares, so that LJM could not sell them for four years, and therefore deemed that the restricted shares were worth only 60 percent of their value in the market. That restriction, and the resulting discount, were a substantial windfall to LJM. Assuming LJM was willing to hold the Enron shares for four years, they would be worth 40 percent more than it had paid for them, even if Enron’s share price only remained constant.
Then, Enron entered into several derivatives deals with LJM and an LJM subsidiary called “Swap Sub,” purportedly to hedge the risk of Enron’s stake in Rhythms NetConnections. Enron was still barred from selling the Rhythms NetConnections stock during the six-month lockup period, but nothing prevented it from buying a pu
t option from Swap Sub, which would give Enron a five-year right to sell 5.4 million shares of Rhythms NetConnections if its price fell below $56 per share. Effectively, the put option—the right to sell the stock—was an insurance policy on Enron’s investment.
These deals seemed to benefit both Enron and LJM. Enron unlocked some of its gains from Rhythms NetConnections. When the lockup period expired, Enron unwound the deals with Swap Sub and cancelled the put option. But, this time, Enron calculated the value of the put option assuming the shares were unrestricted, so that LJM and Swap Sub received the higher, unrestricted value; in other words, LJM made money when Enron was moving in, and when it was moving out. Although Arthur Andersen apparently allowed Enron to make this calculation based on the higher unrestricted value, which obviously took money from Enron and gave it to LJM, Andersen required that subsequent deals be done using the restricted value.36
All of these transactions were, essentially, just Enron trading with itself, because LJM’s ability to pay Enron depended on the price of the rights to the 3.4 million Enron shares it originally received, and continued to hold, as its major asset. In other words, if Enron’s stock price declined, so would LJM’s assets, and then LJM would not be able to repay its debts to Enron. This was why accounting rules typically did not allow companies to use their own stock to influence their earnings: from an economic perspective, such deals were a sham. Nevertheless, Arthur Andersen permitted Enron to treat the LJM partnerships at arm’s length, and to keep the deals with LJM off its books. Technically, Enron wasn’t using its stock—it was using derivatives instead (the rights to receive its stock in the future).