Many may want Enron to go down in history as a company that cooked its books with financial witchcraft practiced only by a select few evil doers. But accounting “subterfuge” — often using derivatives in the $95 trillion unregulated over the counter market — is prevalent throughout not only the energy industry but all of corporate America. It is common practice to try and create the perception of financial health rather than report economic reality, law professor Frank Partnoy said recently in shocking testimony before the Senate Committee on Government Affairs.

“Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was,” said Partnoy, who is professor of law at the University of San Diego School of Law. “Many other companies do the same.”

Partnoy believes 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 toward 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,” said Partnoy. “Unfortunately, current rules allow companies to employ derivatives and special purpose entities to make accounting standards diverge from economic reality.”

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,” said Partnoy.

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,” he said.

“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,” said Partnoy.

In his testimony, he used several examples to illustrate how accounting loopholes provided the opportunity, perhaps even the incentive, for Enron to deceive its shareholders. A 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, 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.”

But those activities that did involve energy were particularly critical to maintaining the profitability of Enron’s other operations. However, they eventually ended up contributing to its collapse.

Most of what Enron represented as its core businesses were not making money, said Partnoy. “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.”

Partnoy said 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.

One way it did this was to have traders split their profits from a trade into two columns in a spreadsheet. One column included the portion of the actual profits to be used in current financial statements, but the other column, ironically labeled the ‘prudency’ reserve, included the remainder to be used in the future to wipe out losses in other areas of Enron’s business. Over time, tens of millions would be built up in prudency reserves.

“Enron’s ‘prudency’ reserves did not depict economic reality, nor could they have been intended to do so,” said Partnoy. “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 were used, for example, to protect against potential losses from long-term derivatives contracts, which were difficult to value. To the extent Enron was smoothing income using these reserves, it was misstating the volatility and current valuation of its trading businesses, and misleading its investors.

“Reserving funds to offset losses in other parts of your company is a very common practice,” one veteran energy trader said, confirming Partnoy’s testimony. “You like to blend your contribution to the corporate bottom line over a 12-month period. You don’t want to show a huge uplift in the first quarter because some trader made $75 million. All that does is prompt questions about what kind of risk you had to make that money. Then you start getting into some real touchy exposure issues. It also would make investors wonder how often you could replicate it. ‘If you made that $75 million in one quarter do we extrapolate that you are going make $300 million over the year.'”

Another way derivatives frequently are used is to misstate profits and losses by mismarking “forward curves,” Partnoy said. A forward curve is a list of forward prices, and like any firm involved in trading derivatives, Enron had risk management and valuation systems that used forward curves to generate profit and loss statements. In fact Enron was the biggest single source of forward quotes in the energy industry giving it tremendous power to manipulate the curves it quoted to its own advantage.

“It appears that Enron traders selectively mismarked their forward curves, typically in order to hide losses,” Partnoy told the Committee. “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.

“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.” Partnoy said one Enron marketer who already had recorded a substantial profit for the year decided to reduce his recorded profits so he could push them forward into the next year, which he wasn’t yet certain would be as profitable.

The veteran trader NGI interviewed confirmed that manipulating the forward curve in various energy products also is a very common practice among other companies in the energy industry. “There are certain products that aren’t readily quoted. Nymex natural gas doesn’t trade out past three years so you have to go to the OTC market for any quote for 2006-2015 for gas on the inlet side of a power plant, for example. Where do you go for that? Well for the last two years you just went to EnronOnline or called up somebody at Enron because they were the ones who maintained that curve. They were the ones who provided the liquidity for it to trade and quoted the bid/offer when you called up. Almost every other company would have quoted Enron with a built in profit.

“‘Point and Click’, what we called EnronOnline, got people in a very bad habit,” the trader added. “We did not realize that first of all 100% of all those trades on there were over-the-counter derivatives, balance sheet financing.

“After Enron’s fall, almost across the board, people have really tempered their activity, but everybody was going down that path. Now they’ve stopped quite a bit. I think there were some trade mandates that said ‘look we are not out there to trade for the sake of trading; trade for a reason, and trade on behalf of assets and customer deals.'”

Those are some of the less known but widely practiced activities that led to Enron’s downfall. But Partnoy also mentioned the now well known usage of special purpose partnership entities to hold risky investments while providing Enron with immediate capital.

Enron set up special partnerships to invest in technology stocks, for example, by contributing a small investment to the entity with a promise to maintain that entity’s value through ENE stock contributions in exchange for a large immediate loan. In that way, it was shielded from declines in the entities technology stock investments while at the same time benefiting from the loan. Of course, this scheme eventually required Enron to shift a significant amount of stock to the entity when its value plummeted.

Another more obscure accounting method was mentioned in an infamous footnote, No. 16, in Enron’s 2000 annual report on page 49. The company stated, “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.”

It’s only possible to understand the sentence after reading an August 2001 memorandum describing the transaction (and others) from one Enron employee, Sherron Watkins, to Enron Chairman Kenneth Lay, said Partnoy.

Because dark fiber –which is Internet cable that has not been “lit,” or is not carrying Internet data — is difficult to value, Enron was able to set up a partnership to buy some of its dark fiber at an inflated price, thereby, providing justification for a large loan and setting a value standard that was higher than reality for its remaining dark fiber assets.

Enron sold dark fiber it initially 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,” said Partnoy. The partnership entity, 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 [in which Enron agrees to maintain the value of the company, LJM2, by contributing its own stock]. 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…,” Partnoy explained.

“It’s very difficult to detect the flaws in plastic surgery, but it’s not impossible,” he said. “You have to look hard enough and in the right places.

“A few sophisticated analysts understood Enron’s finances based on that disclosure; they bet against Enron’s stock,” said Partnoy. “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.”

Arthur Andersen was not alone in not reporting these activities. Securities analysts and credit rating agencies arguably should have spotted them, too, said Partnoy.

“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?

“Congress also must decide whether, after 10 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,” he said. “It is time for Congress to act to ensure that this motto does not apply to U.S. financial market regulation.”

The veteran energy trader added that he thinks the industry already is reacting to Enron’s fall and the likelihood there will be new derivatives regulations. Many companies are changing many of these dangerous financial practices, he said. “I think we need to report results as they are. Show the profits when you make them, and the losses when you realize them. You also should not have the right to choose your auditor. It should be chosen from the six firms randomly. And you can’t have consulting business with them.”

Mark-to-market accounting, which relies on a forward curve, needs more standardization, he said.

“There’s a balance sheet sticker shock that the industry is going to be worried about. A lot of these companies that are supposed to be pipelines and physically oriented are three to four times as big in derivatives. And no one knows that. FASB 133 requires them for the first time ever to report Nymex and OTC positions in the annual reports for 2001. We are going to get some real interesting inventory numbers on outstanding and open positions in the OTC markets.

“There are going to be a lot of folks calling chairmen and presidents saying, ‘Hey I thought you were in the pipeline and the physical trading business,'” the trader said. “It’s going to remove them from the pipeline investment group and put them in the merchant banking industry which includes companies with different risk components and much higher credit requirements. To be a merchant bank you have to have an ‘A’ credit, and that’s something Enron could never get in the whole life of their company. And that’s what killed them.”

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