Enron and the Derivative Market

According to Frank Partnoy's article: Enron and the Derivatives World, Enron structured itself into a derivative trading firm. A Derivative is defined as a financial security instrument whose payoff is linked to another, previously issued security. Derivatives involve the buying, selling, or transferring of risk. Derivatives can be traded in two ways: through unregulated markets and regulated exchanges. Many of Enron's success with derivatives focused on the unregulated markets (also known as Over the Counter Markets). Enron collapsed due to two reasons; both involve the use of derivatives. The use of derivatives outside of the company such as transactions with the Special Purpose Entities (SPE). The other cause to the collapse of Enron was due to the use of derivatives inside the company.

Enron may have been perceived to be an energy business when it was first created in 1985 due to the merger of InterNorth and Houston Natural Gas. As the company progressed throughout the years, they have transformed themselves into a full-blown OTC derivatives trading firm (Partnoy, pg. 170). Enron's trading operations are not regulated or audited by the United States security regulators; therefore, the OTC derivatives market are not deemed securities.

Following Enron's collapse, the Commodity Futures Trading Commission (CFTC) began to fight for the regulation of Over the Counter derivatives but failed to do so. Congress rejected the proposal and made it clear that the markets will stay unregulated. Therefore, OTC markets have become a ticking time bomb which Congress has fully chosen not to defuse (Partnoy 171).

Derivatives Outside Enron

Previously stated above, Enron collapsed due to two reasons, one of them being the use of derivatives outside of the company. Enron had deals derivative deals with several of its 3000 subsidiaries and partnerships, ones that stand out the most are JEDI, LJM, and Raptor. Enron also used derivatives with the help of the SPE to shield assets from the quarterly financial reports. Therefore, Enron used derivatives to inflate the value of their assets by using put and call options. Enron used special purpose vehicle and derivatives to improve their financial statements by hiding losses on the stock market, hiding debt due to the financing of unprofitable business developments, and inflated the value of its business despite losing money. Enron was known as an energy and gas company, but all of their derivative transaction did not follow their business model or involve energy at all.

Hiding Losses on the Stock Market through the use of Derivatives:

Enron hid hundreds of millions of dollars in losses on its investments in specific technology-based companies such as Rhythms Net Connection Incorporated. Rhythms Net Connection was a subsidiary under Enron, which was a startup telecommunications company. Enron invested around $10 million into this technology company. As the Dot.Com boom struck, Enron's stake in Rhythms company was now worth hundreds of millions of dollars. Enron did this with several other startup companies as well and experienced the same results, skyrocketing stocks which brought the company a ton of money in return.

Following this, Enron entered itself into a series of transactions with the Special Purpose Entity (SPE). Two companies that stood out with the SPE was Raptor and LJM1. When the Dot.com boom came to an end, the technology companies that Enron invested into started to decline. Enron found itself losing more money through these stock then they were making. Therefore, Enron exchanged its shares of stock in these technology companies for a loan. Raptor later issued its own securities to investors and kept the cash from the investors as a profit. What made this work was the price swap derivative which was used between Enron and Raptor. Enron gave stock to Raptor if its assets declined in value. The more assets that declined for Raptor, the more stock Enron posted. Enron was committed to maintaining Raptors $1.2 billion value, so if either Enron or Raptors stock declined, Enron issued more and more to Raptor. These derivative transactions carried the risk of diluting the shareholders of Enron if either stock were to drop in value. Due to the securities that Raptor issued to Enron, investors of Raptor were buying Enron's debt, not the new startup companies stock (such as Rhythm). Although the investors thought they were buying into the rising stocks of these startup technology companies, the money was going straight to Enron and used to help get the company out of debt following the crash of the Dot.Com boom.

Hiding Debt Incurred by Unprofitable Business through the use of Derivatives:

Enron used two Special Purpose Entities to hide debt incurred to finance new and unprofitable businesses. Joint Energy Development Investments Limited Partnership (JEDI) and Chewco Investments Limited Partnership (Chewco) where the two SPE's. Since Enron owned 50% of JEDI, they could report the company as an unconsolidated equity affiliate. If Enron owned over 50% of JEDI, then Enron would have to release all of their financial statements due to the accounting laws. JEDI was subjected to the same rules, JEDI could issue equity and debt securities since they owned 50% of the company.

Derivatives permitted Enron to avoid consolidating these Special Purpose Entities. Similar to Raptor, Enron used derivative transactions with Chewco. In its financial statements, Enron took the position that, although it provided guarantees to unconsolidated subsidiaries, those guarantees did not have a readily determinable fair value, and management did 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 (Partnoy, pg. 174). Enron disclosed around $2.1 billion of derivatives transactions with related entities and recognized profits of about $500 million similar to those transactions. Enron is not the only business or company for the use of accounting deception through derivatives to make themselves look better than they really were.

Inflating the Value of its Troubled Business using Derivatives:

Enron inflated the value of certain assets it held by selling a porting of those assets to the Special Purpose Entity at an inflated price. With the assets Enron still held onto, they then inflated those prices as well to match the amount of the assets they just sold. Partnoy breaks down a line from Enron's 2000 annual report: 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. Partnoy states that the related party is LJM, which was a company that had a partnership with Enron. LJM was ran by Andrew Fastow who was Enron's Chief Financial Officer (COO). Dark fibers refer to a type of Bandwidth that Enron traded as part of its broadband business. Enron traded the right to transmit data through fiber optic cables through its broadband business. Enron's fiber optic cables ranged for over 40 million miles throughout the United States. Only a small portion of these cables were lit meaning they worked, while the majority of these cables were dark and needed to be upgraded or fixed. Partnoy states: Enron sold dark fiber, which at the time was 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 (Partnoy, pg. 176). As Dark Fiber was a falling business, Enron was able to drive of the value and make a substantial profit.

Overview of Enron's Outside use of Derivatives:

These are three prime examples on Enron's use of derivatives dealing with outside companies. Enron paid hundreds of millions of dollars in fees to both investment banks and commercial banks for their work on assorted and various aspects of business. Enron also included fees to these banks for derivative transactions, but the banks failed to reveal to the investors the derivative problems that faced Enron. Along with paying the banks, Enron also paid outside law firms that failed to correct the issues related to the use of derivatives and the SPE. Therefore, these actions made Enron an excellent stock to invest in through the 2000-2001 years. Enron paid off three credit rating agencies as well: Fitch, Moody's, and Standard & Poor's to make the company look like a good investment. Despite Enron filing for bankruptcy in December of 2001, these three credit rating agencies still gave Enron a good investment rating grade. These agencies played a vital role for Enron special purpose entities to work. A good investment grade was the batteries that kept Enron alive.

Derivatives Inside Enron

Derivatives problems associated with Enron went much deeper than outsider investors and the Special Purpose Entities. Enron's core business model was strictly not making enough money, which is why Enron shifted from an energy company to the buying, selling, and 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 their profits and losses systematically in order to make their trading businesses appear less volatile than they were (Henriques, 2001). Employees used fake numbers and accounts to create false profits and losses for the derivatives that Enron traded. The derivative traders that Enron faced were highly pressured to meet specific earnings and requirements. To meet these requirements, many of the traders hid losses and over exaggerated profits.

Enron's derivative traders were required to keep records of every transaction and state whether it was a profit or a loss. These profits and losses were supposed to be recorded to keep the company's economy in reality. These traders split the profit into two columns instead of one. The first column would contain the actual earnings to Enron's financial statements while the second column, called prudency reserve, would include the remaining amount. Prudency Reserves explained: Say a derivative trader earned a profit of $5 million, of that $5 million the trader will record in the first column that Enron profited $4 million and in the second column put $1 million into the prudency reserves (Natarajan, 2017). Enron's prudency reserves were set aside into a specific account. The account can only be accessed when the company experienced losses and can use this money to offset the losses. This account would protect traders from financial losses for several years. Traders did not anticipate this as a wrongful act, but the use of prudency reserve accounts are not accepted business practices. Prudency accounts also misinterpreted the company's current evaluation of the trading business, which consequently, mislead investors as well. These fraudulent claims on Enron's financial statements do not give investors an accurate understanding of where the company stands.

Not only did Enron misreport their derivative positions but also misstated their profits and losses by mismarking future curves. A forward curve is defined as a list of forward rates for a given range of maturities, and a forward rate is the price or rate a person can buy something in the future. Forward curves are very important in the trading of derivatives because it values the derivative contract today. In Enron's case, the traders mismarked their forward curves to hide losses. Enron traders did this because they make their money on profits, therefore, by hiding losses they are more likely to make more money. Traders used mismarked and misleading forward curves for approximately three years. In the more obscure markets, traders were more aggressive on the mismarking of forward curves. For instance, if a trader in the smaller markets reached max profit for the year, they would reduce their profits for that year and push the forward into the following year so they can assure themselves a future profit.

Enron used VAR, value at risk, which captured a 95% confidence interval for a one-day holding period. Enron never reports their VAR during the year so the investors would not know how risky Enron was. Enron used misleading VAR numbers, for instance, Enron reported VAR for what it called its commodity price risk??”including natural gas derivatives trading $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 (Partnoy, pg. 182).

Enron's derivative trading operations are still unclear today. In February of 2000, Enron reported $7.2 billion in profit in regards to derivative but stated in December of 2000 they made $21.6 billion. Either Enron's derivative contracts and operations made a 33% increase within the 11 months, or the company was misleading their investors through false financial statements.

The Conclusion of Enron and the Derivative Market

Enron was originally an energy company which transformed itself into a derivative trading firm that made billions of dollars trading, buying, and selling derivatives. This was accomplished through mismarking forward curves, prudency reserves, use of technology stocks, fiber optic bandwidth, and retail gas and power. Enron used experts to hide losses through the use of derivatives. Enron is not the only institution to blame for these occurrences; law firms, auditors, banks, Special Purpose Entities, securities analysts, and credit rating agencies. All played a major role in Enron's use of derivatives which ultimately caused the company to collapse.

Could Enron Happen Again?

In 2007 Theodore di Stefano wrote an article called Enron: Could it Happen Again? Stefano states that a corporate board of directors is the major protection to the recurrence of an Enron-like scandal. In 2002 the Sarbanes-Oxley Act (SOX) was passed following the Enron scandal. It protects investors, employees, and the public from fraudulent activities made by a corporation. This act enforces strict reforms to improve financial disclosures and prevent accounting fraud. SOX gives the audit committee specific responsibilities and assignments to complete a company's financial statements along with legal and regulatory compliance. Sox states that it wants a minimum of three people as audit committee members, all who need to be independent. These audit committee members cannot be members of the company's management team and all must be financially literate. To prevent another scandal like Enron from occurring; management, stockholders, employees, rating agencies, and board members all need to work together in a legal and professional business manner. SOX has done a great deal to reduce the possibility of another Enron. However, the fact remains that, human nature being what it is, there will be future financial scandals, but probably with far less impact than the Enron scandal. I don't think we'll ever see the day that corporate governance is scandal-free. There will always be people in high positions who have too much ambition, power or ego. Although I believe there will always be corporate scandals, I doubt that we'll witness another scandal of Enron's magnitude in the future. (Stefano, 2007).

Capital and Money Markets

I choose Enron and their use of derivatives as my term paper topic. I watched a movie in high school called Enron: The Smartest Guys in the Room. I never heard of Enron at that time and was eager to see what this movie was about. I found the entire story of Enron to be fascinating, yet it made me curious. I have completed projects on Enron in the past, but I always discussed the accounting aspect of the scandal. I never knew that derivatives played such a major role in the collapse of the company. As the semester comes to an end, I learned several dozen new financial terms, instruments, and formulas. The last chapter, chapter 10, we discussed Derivatives, Securities Markets, Future Contracts, and Options. Everything I learned throughout this course helped me to write this paper because Enron used all of these to make money, hide losses, and strive as a business; as I stated throughout the entire essay. If it weren't for this class I would have been entirely unaware what all these terms and structures meant; as a result, this assignment would have been very challenging to complete.

Work Cited

1. Derivatives at root of Enron collapse, expert says - Rediff.com India News, 25 Jan. 2002,
   www.rediff.com/money/2002/jan/25enron1.htm.
2. di Stefano, Theodore. Enron: Could It Happen Again? ECommerceTimes.com, 2 Feb. 2007,
   www.ecommercetimes.com/story/55489.html.
3. Henriques, Diana B. ENRON'S COLLAPSE: THE DERIVATIVES; Market That Deals in Risks Faces
   a Novel One. The New York Times, The New York Times, 29 Nov. 2001, www.nytimes.com/2001/11/29/business/enron-s-collapse-the-derivatives-market-that-deals-in-risks-faces-a-novel-one.html.
4. Natarajan, Manju. Enron Scam- Role of Derivatives. LinkedIn SlideShare, 8 Mar. 2017,
   www.slideshare.net/manjunatarajan/enron-scam-role-of-derivatives.
5. Partnoy, Frank. PDF. Enron and the Derivatives World - Researchgate.net.
   www.researchgate.net/publication/265008940_Enron_and_the_Derivatives_World.

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