Enron's Shell Game - A Valuation-Based Perspective[1]
James N. Bodurtha, Jr.*
January 2002
Latest Revision – July 2002
Copyright 2002, all rights reserved.
Abstract
This work is our effort to infer what went wrong in Enron's Treasury from 1997-2001. Over the last 40 years, financial economists and accountants have identified a number of information and incentive issues that both complicate and potentially resolve valuation questions: earnings growth, stock splits, dividend changes, free cash flow limitations, share price-based compensation and hedging of market risks. From its inception until the third quarter of 2001, the Enron Corp. appeared to most observers to understand these information, incentive and valuation concepts. Their financial management practice was lauded as sound and innovative. Obviously, all was not as it seemed.
Our examination of Enron and its related parties focuses on how the associated values could be so drastically inflated. Though much information is surfacing about inflated revenues and other accounting irregularities in the energy and broadband markets, such activity alone cannot permit prolonged over valuation of a company's balance sheet. Instead, we focus on two unique features of Enron's transactions.
First, Enron management was accorded loose reporting requirements and ineffective Board oversight from one quarter to the next. For a number of years, this situation facilitated the rollover of losing investment positions. Enron made these marketable investments under assumptions of rapid deregulation and market integration. This set of investments had significant losses and we identify them as "bad assets." Proper accounting for Enron's bad assets should have led to balance sheet write-downs. Instead, these bad assets were transferred to a related party - special purpose entity (SPE). In order to avoid a write-down on the transfer, Enron had to simultaneously transfer an overvalued asset to the SPE. We define the overvalued assets to be "good assets." Most of Enron's non-consolidated SPE's were sales of both bad and good assets to an SPE against receipt of a note from the SPE.
The second and most important feature of Enron's asset management was own Enron restricted share transfers into the related parties. For Enron, these transfers were made from shares allocated allocated to stock and option plans. In the context of their exchange of these shares for SPE notes, Enron valued these future share claims at the prevailing spot share price. Based on fair value accounting rules, the SPE's valued these shares as future claims. With different accounting treatments of Enron restricted shares for Enron and the related party SPE, undervalued Enron restricted shares and derivative claims on these shares became good assets for the related party.
Generally, Enron shares rose until 2001 and the Enron stock that was transferred to the related parties supported more and more bad asset transfers. The 2001 Enron share price decline left the related party entities with no good assets to support the notes that they had issued to Enron in exchange for both good and bad assets. With the end of the third quarter of 2001, Enron shares had also become bad assets. The SPE notes supported by transferred Enron assets had to be written down, and the whole structure crashed.
* The McDonough School of Business, Georgetown University, Old North 313, 37th & O Streets, NW, Washington, DC 20057, (202) 687-6351, .
Enron's Shell Game - A Valuation-Based Perspective1
Abstract
This work is our effort to infer what went wrong in Enron's Treasury from 1997-2001. Over the last 40 years, financial economists and accountants have identified a number of information and incentive issues that both complicate and potentially resolve valuation questions: earnings growth, stock splits, dividend changes, free cash flow limitations, share price-based compensation and hedging of market risks. From its inception until the third quarter of 2001, the Enron Corp. appeared to most observers to understand these information, incentive and valuation concepts. Their financial management practice was lauded as sound and innovative. Obviously, all was not as it seemed.
Our examination of Enron and its related parties focuses on how the associated values could be so drastically inflated. Though much information is surfacing about inflated revenues and other accounting irregularities in the energy and broadband markets, such activity alone cannot permit prolonged over valuation of a company's balance sheet. Instead, we focus on two unique features of Enron's transactions.
First, Enron management was accorded loose reporting requirements and ineffective Board oversight from one quarter to the next. For a number of years, this situation facilitated the rollover of losing investment positions. Enron made these marketable investments under assumptions of rapid deregulation and market integration. This set of investments had significant losses and we identify them as "bad assets." Proper accounting for Enron's bad assets should have led to balance sheet write-downs. Instead, these bad assets were transferred to a related party - special purpose entity (SPE). In order to avoid a write-down on the transfer, Enron had to simultaneously transfer an overvalued asset to the SPE. We define the overvalued assets to be "good assets." Most of Enron's non-consolidated SPE's were sales of both bad and good assets to an SPE against receipt of a note from the SPE.
The second and most important feature of Enron's asset management was own Enron restricted share transfers into the related parties. For Enron, these transfers were made from shares allocated allocated to stock and option plans. In the context of their exchange of these shares for SPE notes, Enron valued these future share claims at the prevailing spot share price. Based on fair value accounting rules, the SPE's valued these shares as future claims. With different accounting treatments of Enron restricted shares for Enron and the related party SPE, undervalued Enron restricted shares and derivative claims on these shares became good assets for the related party.
Generally, Enron shares rose until 2001 and the Enron stock that was transferred to the related parties supported more and more bad asset transfers. The 2001 Enron share price decline left the related party entities with no good assets to support the notes that they had issued to Enron in exchange for both good and bad assets. With the end of the third quarter of 2001, Enron shares had also become bad assets. The SPE notes supported by transferred Enron assets had to be written down, and the whole structure crashed.
Some Background
In 1984, Ken Lay's first major action as CEO was to fight off a takeover. In response to this threat, he positioned his Houston National Gas predecessor to Enron like "pure-play" Texas gas-gathering and processing companies. This specialization extended into the national natural gas market and, subsequently, the regional electricity markets. Whether or not Enron was as good as its public perception was in these markets is not the topic of this work. Though we provide some background information to set context, our focus is on Enron's post-1997 activity. Unfortunately, this activity saw Enron lose its energy focus and disappear.[2]
Particularly from 1999 on, it appears that Enron was a house of cards, or, more correctly, a shell game. The primary motivations for its accounting and financial transactions seem to have been to keep reported income up, asset values inflated and liabilities off the books. These actions were probably a broad conspiracy, the work of a rogue Treasury department, or hubris and bad luck. Nevertheless, most paths to Enron's gutted corpse are touched by Enron's CFO, Andrew Fastow. Given the continued and pervasive pattern of action and deception, it is hard to see how those who supervised him could not have known something was amiss. Events around March 2001 are particularly troubling. Incredibly, a major source for our analysis, the Enron Board Report of the Special Investigative Committee (pdf), does not provide a thorough analysis of the Board's role in March 2001 and subsequent transactions.
So, what happened to Enron? Based on a reading of public documents, this thesis runs through the following fateful chain of events:
- Growth/Market Integration - Interstate natural gas market deregulation presented an integration and innovation opportunity. In taking advantage of this opportunity, Enron like many energy companies was not cash rich.
- Own Equity Transactions and Derivatives - The structure of a successful partnership revealed two techniques for Enron Treasury departments' financial "Eureka."
a. "Available for Grant" shares from Enron's stock grant and stock option plans.
b. Monetizing gains on derivative hedges of the stock plan in a partnership structure. - Risk Restructure and Shifting - Through another partnership structure, market price risks were shifted into credit risks. For a while, earnings volatility and declines were limited.
- Credit Failure and Default - Deteriorating credit capacity (or simply decreased collateral) in various partnerships was augmented by Enron's own equity-related transactions to prevent write downs of the credit. Ultimately, nothing was left for shareholders and employees of Enron (or much left for creditors.)
Up until it's downfall, Enron's credit ratings had been remarkably stable. Nevertheless, as their leverage grew through outright lending, lending guarantees and the implicit lending associated with many derivative transactions, Enron failed to upgrade their credit capacity.[3] Unfortunately for Enron, they failed to set up such reserve credit capacity. Effectively and contrary to their public pronouncements, Enron held on to its assets and was short of cash.
More importantly, Enron failed to write down poorly performing partnership investments. Subsequently, these losses added up to the level of annual earnings. We believe that this situation could have been remedied with significant "one-time" pain in March 2001. Up until that time, Enron's support of the partnership structures might have been defended. Instead by continuing to exchange restricted stock-related claims with their partnerships, Enron pushed even further. Since Enron's partnership values were falling, they propped up the values artificially by mis-pricing Enron restricted stock-related derivatives in favor of the partnerships and to the detriment of Enron shareholders and employees.
Since auditing for Enron and the partnerships was done by different accounting firms and the limited partners in the partnerships were said to demand confidentiality for the partnerships, such valuation inconsistencies were difficult, if not impossible, to uncover. Only if Arthur Andersen had demanded to see detailed Partnership accounting documents and matched the entries against the associated Enron entries would they have been able to uncover these structures. If those documents were not forthcoming, then their only choice would have been to withhold their audit fairness opinion. In retrospect, it seems clear to all Arthur Andersen should have aggressively sought more information, and without it they would have had to resign.[4]
Financial analysts, the financial press, the famous internal Watkins memo and other negative reviews of the situation focus on declining partnership values, and not on how these values could be supported without showing losses. During this time, Enron's internal risk management and valuation teams were evaluating the certain partnerships and penalizing them for poor performance.[5] The reason that these controls did not hold is that own equity transactions are not accounted for as other equity, currency, debt and commodity investments are. Enron accounted for the fair value of it's restricted shares at the current spot market value. On the contrary, these shares were restricted promises to issue the shares, and the partnerships accounted for them on a future or forward market value basis.
For a stock that pays a low dividend such as Enron, the future-based assessment of value will be greater than the current market-based value. This difference grows for with a greater difference between interest rates and dividend yield and longer maturity. Since the partners in Enron's partnerships owned about 3% of the partnership equity, any transfer of restricted stock to the partnerships ended up being a direct transfer of 3% of any value difference to the general and limited members of the partnerships. The additional 97% of the value difference was simply a transfer of value from Enron shareholders to themselves. Nevertheless, adding this second component of value to the partnerships allowed them to have sufficient creditworthiness in their assets not to be formally questioned.
With every such transfer, more under-performing Enron assets could be moved into the partnerships. Every dollar transferred also generated value and fees for the general and limited partners of these related entities.[6] In his Senate testimony, Enron Finance Committee Chairman indicated that he continued his lack of understanding of this situation: During the hearing, Mr. Winokur was asked about Enron's ongoing liability for the Raptors. “He admitted knowing that Enron had retained a risk despite setting up the Raptor ‘hedges,’ but declined to admit that Enron shares had been pledged as collateral. He stated that the Board had pledged "forward positions on Enron stock," and not Enron stock itself.”[7]
We focus on March 2001 as the prime period for identifying fraud at Enron. In March 2001, Enron's Board authorized 21 million additional restricted shares of stock under a new amendment to their 2001 stock plan.[8] Additionally, the Board authorized a share split. Though we evaluated these actions only from the value transfer perspective, it is important to note that increases in shares available for option grants and a share split are usually indicative of improving firm prospects.[9]s In retrospect, the positive signaling aspect of these Board actions was clearly off.
The availability of stock plan shares provided another opportunity to add more mis-valued Enron restricted share contributions to its partnerships. By rudimentary calculation, at least 12 million restricted shares were added to the Enron partnerships in March 2001. At the then NYSE closing share price of $47, this investment totaled $564 million. In return, Enron received a $568 million dollar note. However, restricted share holder could use these shares as a perfect hedge in a term stock loan. As such, the loan would earn interest on the cash share value over the life of the restricted stock grant. Unlike many restricted share grants, the Enron grants had a fixed maturity date and could explicitly be used as share loan collateral.
With a ten year maturity, $55 stock price; and assuming a 5.6% cash investment return and 2.5% dividend yield, 12 million restricted Enron shares would be worth about $75 on a forward basis. Under the mark to market accounting used in the partnerships, the discrepancy between the $75 owned and the $47 owed to Enron for the shares is $28 per share. To ascertain the value of $28 per share in ten years, we discount this value down to $16.50 per share. The total value of this 12 million restricted share transfer is almost $200 million.[10] At the same time, an additional 18 million shares were transferred to partnerships in a particular derivatives structure. Subsequently, our calculation of the net value of this structure is $568 million. Therefore, our estimate of Enron's March 2001 net value additions to the partnerships is $768 million.[11]