Kasus Enron-Edit.docx | Hedge (Finance) | Enron

Enron’s Questionable Transactions An understanding of the nature of Enron’s questionable transactions is fundamental to understanding why Enron failed. What follows is a summary of the essence of the major important transactions with the SPEs, including Chewco, LJM1, LJM2, and the Raptors. This summary extends the comments presented in presented in Chapter 9, “The Credibility Crisis—Enron, WorldCom, & SOX”. Chewco Transactions Chewco Investments LP(1) " was created in November 1997 to buy the 50 percent interest owned by CalPERS, the California Public Employees’ Retirement System, in a joint venture investment partnership called Joint Energy Development Investment Limited Partnership (JL.DI). JEDI had operated since 1993 as a nonconsolidated SPE. (Enron wanted to create a larger unit with capital of $1 billion, and CalPERS asked to be bought out. Chewco was created as a vehicle to attract a replacement for CalPERS and to buy out CalPERS’ interest in JEDI). Originally, Andrew Fastow proposed that he be appointed to manage Chewco temporarily until an outside investor, or counterparty, could be found. According to the Powers Report, Enron lawyers advised against this since his senior officer status would have required proxy disclosure. Instead, Michael Kopper, who worked at Enron for Fastow, a fact known only to Jeffrey K. Skilling on the board of directors,(2) was appointed. Enron planned to guarantee loans for bridge financing to buy out CalPERS’ interest in JEDI, which had been valued at $383 million. The intention was to replace the bridge financing with the investment of an outside investor, but none was found. Enron’s financial year end passed on December 31, 1997; without an independent, controlling outside investor with at least 3 percent of the capital at risk, $11.5 million in this case (3 percent of $383 million), the activities of both JEDI and Chewco had to be consolidated into Enron’s financial statements and on a retroactive basis. Whether through negligence or inability to find a proper counterparty, the accounts of Enron had to be restated to include the dealings of JEDI. “In November arid December of 1997, Enron and Kopper created a new capital structure for Chewco, which had three elements:  $240 million unsecured subordinated loan to Chewco from Barclays Bank PLC, which Enron would guarantee;  $ 132 million advance from JEDI to Chewco under a revolving credit agreement; and  $11.5 million in equity (representing approximately 3% of total capital) from Chewco’s general and limited partners. (3) These financing arrangements are diagrammed in Figure 1.

Essentially, Enron as majority owner put no cash into the SEE. A bank provided, virtually all of the cash, and in reality the so-called 3 percent independent, controlling investor had very little invested—not even close to the required 3 percent threshold. Nonetheless, Chewco was considered to qualify for treatment as an arm’s-length entity for accounting purposes by Enron and its auditors, Arthur Andersen. Enron’s board, and presumably Arthur Andersen, was kept in the dark. Kopper invested approximately $115,000 in Chewco’s general partner and approximately $10,000 in its limited partner before transferring his limited partnership interest to William Dodson [Kopper’s domestic partner].” 4 The rest of the $11.5 million—$11.4, to be exact—was loaned by Barclays Bank to Kopper/Dodson, although the original wording was unusual in that it implied that the monies were for “certificates” that would generate a “yield.” 5 Ultimately, Kopper and Dodson created a series of limited partnerships (LLPs) and limited companies (LLCs) through which to operate their interests, but Kopper was de facto the managing general partner of Chewco. This meant there was no outside investor with 3 percent of equity at risk. Moreover, Barclays asked that $6.6 million be reserved against the $11.4, and the $6.6 million was pledged/deposited with them, so that the resulting net of $4.8 million did not satisfy the 3 percent rule for nonconsolidation. According to the Powers Report, the existence of the $6.6 million reserve was well known at Enron. 6 However, in Congressional Committee testimony, the CEO of Arthur Andersen stated that they had reviewed and approved the financial arrangement as qualifying under the 3 percent rule, and received $80,000 For this advice. 7 The $6.6 million reserve was created as part of a transfer of $16.6 million from JEDI through Chewco to two of the limited partnerships controlled by Kopper and Dodson, namely Big River Funding LLC and Little River Funding LLC. The entire complicated structure created for the Chewco financing transaction can be viewed on page 51 of the Powers Report. The Powers Report goes on to detail several subsequent transactions that took place before Enron unraveled in late 2001 that appear not to have been in the best interests of Enron, including:  Management and other fees paid through to Kopper amounted to $2 million for essentially little work, some of which was done by Fastow’s wife; most of the rest of the work was on time that Kopper was being paid as an Enron employee.  The fee for Enron guaranteeing the Bar-clays loan was under that called for by the market risk assumed.  When it was decided to liquidate JEDI, the buyout of Chewco’s interest was valued at a premium of $1 million by Jeffrey McMahon (then senior vice president, finance and treasurer of Enron). He told Fastow, who undertook to negotiate with Kopper, and came back indicating that Skilling had approved a $10 million payment. 8 Fastow denied this to the Powers committee but declined to comment on a handwritten note from Kopper

that confirmed Fastow’s participation. Ultimately, a premium of $10.5 million was paid. This represented a return of 360 percent.  Kopper demanded later and received $2.6 million in September 2001 as an indemnification against the tax consequences of the $10.5 million premium. Enron’s in-house counsel had originally declined this request, but was overruled by Fastow, who told them that Skilling had approved.  Upon closing the repurchase of JEDI, Chewco was not required to repay the $15 million it had loaned on an unsecured and nonrecourse basis to Kopper and Dodson for them to invest in Osprey trust certificates. Osprey was a limited partner in Whitening Associates, another related company that will be discussed later.  The Powers Report also noted that from December 1997, Enron began to incorrectly pre-book revenue for services not yet provided in regard to the Barclays guarantee fee and the JEDI management fee arrangement that Chewco assumed, in the amounts of $10 million and $25.7 million, respectively. When Enron’s affairs began to unravel in public, the board started an investigation that led to the bankruptcy filing on December 2, 2001. The Powers Report states: In late October 2001, the Enron Board (responding to media reports) requested a briefing by Management on Chewco. Glisan [Ben F. Glisan, Jr., the Enron “transaction support” employee with principal responsibility for accounting matters in the Chewco transaction, signed many of the documents on Enron’s behalf] was responsible for presenting the briefing at a Board meeting on short notice. Following the briefing, Enron accounting and legal personnel (as well as Vinson & Elkins) undertook to review documents relating to Chewco. This review identified the documents relating to the finding of the Big River and Little River reserve accounts in December 1997 through the $16.6 million distribution from JEDI. Enron brought those documents to the attention of Andersen, and consulted with Andersen concerning the accounting implications of the funded reserve accounts. After being shown the documents by Enron and discussing the accounting issues with Enron personnel, Andersen provided the notice of “possible illegal acts” that Andersen’s CEO highlighted in his Congressional testimony on December 12, 2001. Enron’s accounting personnel and Andersen both concluded that, in light of the funded reserve accounts, Chewco lacked sufficient outside equity at risk and should have been consolidated in November 1997. In addition, because JEDI’s nonconsolidation depended on Chewco’s status, Enron and Andersen , concluded that JEDI also should have been consolidated in November 1997. In a Current Report on Form 8-K filed on November 8, 2001, Enron announced that it would restate its prior, period financials to reflect the consolidation of those entities as of November 1997.9

LJM Partnerships and The Raptors: LJM1 On June 28, 1999, the Enron board approved Fastow’s proposal that he invest $1 million and become the sole managing/general partner of LJM1 (LJM Cayman LP), which would raise funds from outside investors that could be used to hedge the possible loss of market value of Enron’s investment in Rhythms NetConnections, Inc. (Rhythms for short), Fastow said that he would receive fees, that the Enron Code of Conduct would require special action (suspension of the code) by the chairman, and that his participation “would not adversely affect the interests of Enron.”10 The Powers Report continues: “LJM1 was formed in June 1999. Fastow became the sole and managing member of LJM Partners, LLC, which was the general partner of LJM Partners, L.P. This, in turn, was the general partner of LJM1. Fastow raised $15 million from two limited partners, ERNB Ltd. ... and Campsie Ltd.” A diagram of the financing of LJM1 can be found on page 70 of the Powers Report. LJM1 ultimately “entered into three transactions with Enron: (1) the effort to hedge Enron’s position in Rhythms NetConnections stock, (2) the purchase of a portion of Enrons interest in a Brazilian power project (Cuiaba), and (3) a purchase of certificates of an SPE called ‘Osprey Trust.’” 11 The Rhythms hedge transaction is significant because it introduces the basic form for future hedge transactions. Per the Powers Report on page 77: In March 1998, Enron invested $10 million in the stock of Rhythms NetConnections, Inc. (“Rhythms”), a privately-held internet service provider for businesses using digital subscriber line technology, by purchasing 5.4 million shares of stock at $1,85 per share. On April 7, 1999, Rhythms went public at $21 per share. By the close of the trading day, the stock price reached $69. By May 1999, Enron’s investment in Rhythms was worth approximately $300 million, but Enron was 7 prohibited (by a lock-up agreement) from selling its shares before the end of 1999. Because Enron accounted for the investment as part of its merchant portfolio, it marked the Rhythms position to market, meaning that increases and decreases in the value of Rhythms stock were reflected on Enron’s income statement. Skilling was concerned about mitigating the volatility caused by these mark-tomarket increases and decreases, and Fastow and Glisan devised a hedging transaction to do so. The arrangement also resulted in Enron recognizing the appreciation in value of Enron’s own stock—a recognition that GAAP does not normally permit except under strict conditions where cash is received for the stock confirming the market value. Their proposal was to capitalize an SPE with Enron stock, and have the SPE hedge the value of the Rhythms investment so that the SPE would pay Enron if the Rhythms investment decreased. This payment would be shown as revenue by Enron and offset the loss in the Rhythms investment on Enron’s books.

Ultimately, $95 million in lost Rhythms’ value was offset and Enron’s income was higher as a result. In addition, Enron re-corded profit on the Enron shares transferred. Unfortunately, LJM1 did not qualify as having 3 percent invested by an independent, controlling general partner (because Fastow was not independent), and the Enron stock was paid for by a promissory note, not cash. Moreover, it became clear that the creditworthiness of the SPE depended upon the Enron shares transferred, and since the value of Enron shares declined in 2000 and 2001, that creditworthiness was eroded below the level required to pay Enron its offsets. Enron, it became obvious, was attempting to hedge itself— largely a game of smoke and mirrors in the absence of outside investment to absorb the economic risk. In spite of these problems, Arthur Andersen and Enron’s law firm, Vinson & Elkins, indicated that the hedge was reasonable, and that it could go ahead as Fastow and Glisan intended. Ultimately, however, on reexamination by Arthur Andersen, it was determined (in October 2001) that the financial statements for 1999¬2001 had to be restated. In November, Enron announced that “it would restate prior period financial statements to reflect the consolidation retroactive to 1999, which would have the effect of decreasing Enron’s net income by $95 million in 1999 and $8 million in 2000.” 12. The Powers Report describes the Rhythms transaction beginning on page 79, with a diagram on page 81 and a discussion of the hedge beginning on page 82. It is noted on page 83 that the equity of the SPE used for the transaction (Swap Sub, of which LJM1 owned part) was negative and thus the transaction could not have qualified for the 3 percent nonconsolidation rule. This sprung from the fact that: “At its formation on June 30, 1999, Swap Sub had negative equity because its liability (the Rhythms put, valued at $104 million) greatly exceeded its assets ($3.75 million in cash plus $80 million in restricted Enron stock).”13 This was what Arthur Andersen found upon reexamination in October 2001. Arthur Andersen’s CEO said: In evaluating the 3 percent residual equity level required to qualify for nonconsolidation, there were some complex issues concerning the valuation of various assets and liabilities. When we reviewed this transaction again in October 2001, we determined that our team’s initial judgment that the 3 percent test was met was in error. We promptly told Enron to correct it. 14 Within two weeks after the transaction closed on June 30, 1999, it was realized that the volatility of earnings had not improved to the degree desired, 15 and four more derivative actions were entered into to make the hedge act more like a swap. These did not cure the problem sufficiently, and due to the continuing concern for the erosion of creditworthiness, the decision was made to liquidate the hedge. In February or March 2000, Vince Kaminski estimated that there was a 68 percent probability that the structure would default, and he claims he relayed this to the accounting group. 16 In early March 2000, negotiations to unwind Swap Sub were begun between Causey and Fastow with Fastow giving the impression that he had no personal interest in the outcome— which he was just negotiating for the limited

partners of LJM1. On March 8, 2000, Enron gave Swap Sub a put on 3.1 million shares of Enron at $71.31 per share, which was $4.12 over the closing price, thus conveying approximately $12.8 million in value to Swap Sub. Perhaps this was by mistake. Subsequently, Fastow proposed that Swap Sub receive $30 million from Enron for the unwind, and this was agreed to. The unwind was completed per an agreement dated March 22, 2000, which was not subjected to an independent fairness examination, nor was the board advised, nor DASH sheets executed. Arthur Andersen reviewed the deal, but said nothing. Not until later was it realized that the value ascribed to the shares reacquired by Enron was as unrestricted shares, and no discounting was employed to reflect that they were restricted. As a result, an estimated $70 million more than what was required was transferred to Swap Sub, and ultimately to Fastow and his associates. 17 In addition, LJM1 was allowed to retain 3.6 million post-split Enron shares related to the original transaction, which, on April 28, 2000, had an undiscounted value of $251 million at closing price.18 Many of Enron’s employees were involved in these transactions, but none were approved to benefit as required by the Enron Code of Conduct, and the board apparently did not know of their involvement. However, the employees benefited mightily, as is detailed later. In May, as noted earlier, McMahon ex-pressed his reservations about Enron accounting and deals to Fastow and was reassigned. Glisan became the new treasurer of Enron.

LJM Partnerships and The Raptors: LJM2 In October 1999, Fastow proposed a second LJM partnership, LJM2 Co-Investment LP (LJM2), where he would serve as a general partner through intermediaries to encourage up to $200 million of outside investment that could be used to purchase assets that Enron wanted to syndicate. This, Fastow said, would provide Enron the funds needed to grow quickly and at less cost than by other means. This was not done blindly, as the following shows: The minutes and our interviews reflect that the Finance Committee discussed this proposal, including the conflict of interest presented by Fastow’s dual roles as CFO of Enron and general partner of LJM2. Fastow proposed as a control that all transactions between Enron and LJM2 be subject to the approval of both Causey, Enron’s Chief Accounting Officer, and Buy, Enron’s Chief Risk Officer. In addition, the Audit and Compliance Committee would annually review all transactions completed in the prior year. Based on this discussion, the Committee voted to recommend to the Board that the Board find that Fastow’s participation in LJM2 would not adversely affect the best interests of Enron. 19

Later, the board reviewed the discussion, and gave their approval. LJM2 was formed in October 1999, and its general partner was LJM2 Capital Management, LP. Limited solicitation developed approximately fifty limited partners raising $394 million including the contributions of the general partner. Again, Fastow arranged a series of intermediaries as follows: “The general partner, LJM2 Capital Management, LP, itself had a general partner and two limited partners. The general partner was LJM2 Capital Management, LLC, of which Fastow was the managing member. The limited partners were Fastow and, at some point after the creation of LJM2, an entity named Big Doe LLC. Kopper was the managing member of Big Doe. (In July 2001, Kopper resigned from Enron and purchased Fastow’s interest in LJM2.)”20