Role of Derivatives in Enron Scam – The Legendary Scam

Astha MishraKritika Chainani

Manju NatarajanTarun Matta

Vibhor Mittal

Enron and 9/11 marked the end of an era of individual freedom and the beginning of personal responsibility.

Jeffrey R. Immelt

Timeline

In 2000, Enron shares skyrocketed

to $90.56

In 1998 Andrew Fastow became

CFO

Lay with Skilling created a new

division in 1990 called Enron

Finance Corp.

Enron create a “Gas Bank”—to

buy and sell gas –Energy Derivatives

In 1985, Enron was born from the merger of Houston

Natural Gas and InterNorth, a

Nebraska pipeline company.

Dec 2 , 2001 Enron files

bankruptcy and stock price

closes at $0.26

Nov 8, 2001 Enron admits

that they have been inflating its

income by around $586 million since

1997

Oct 22 , 2001 Share price fell

to $20.75

Oct 16, 2001 Enron reports

$618 Billion loss and 1.2 Billion

write off.

Oct 12 , 2001 Arthur Andersen tells auditor to

destroy all Enron's file except basic documents

Aug 14, 2001 Lay again takes

over as CEO

Feb 12,2001 Skilling become

CEO

Rise of Enron– In 1985, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska

pipeline company.

– Enron’s created a “gas bank” in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks.

– Including setting up of power generation plants in developing countries and emerging markets including The Philippines (Subic Bay), Indonesia and India (Dabhol).

– Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.

– Company transformed its image as a trading business.

– In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion.

Rise of Enron– They were ready to create a market for anything that anyone was willing to trade:

futures contracts in coal, paper, steel, water and even weather.

– They created of Enron Online (EOL) in October 1999.

– In July 2000 of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return.

Key Players Involved in the Scam

Business Strategy– Creation of forward market in natural gas.

– Enron bought and sold tomorrow’s gas at a fixed price today.

– Adaption of marked to market accounting , in which they anticipated future profits from any deal were accounted for by estimating their present value rather than historical cost.

– Skilling began advocating a novel idea by promoting the companies aggressive investment strategy like the company did not really need any assets.

– This plan helped Enron make largest wholesaler of gas and electricity with $27 billion traded in a quarter.

Role of derivatives..– It reduced Enron’s tax payments.

– It inflated Enron’s income and profits

– It inflated Enron’s stock price and credit rating

– It was used to hide losses in off balance sheet subsidiaries

– To fraudulently misrepresent Enron’s financial condition in public reports.

Special Purpose Entities– Enron created partnerships structured as Special purpose entities, that could borrow

from outside investors without having to be consolidated into Enron’s balance sheet, if at least 3% of SPE total capital was owned independently of Enron.

– It created 3000 partnerships started about 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI(Joint Energy Development Investments).

– Enron initially thought of these partnerships as temporary solutions for temporary cash flows problems.

– Enron later used SPE partnerships under 3% rule to hide bad bets it had made on speculative assets by selling these assets to the partnership in return for IOU backed by Enron stock as collateral( over $1 billion by 2002).

Important SPE owned by Enron

1. BRAVEHEART2. JEDI3. CHEWCO4. LJM 1 and LJM SWAP SUB L.P. 5. LJM 26. RAPTORS 1,2,3 AND 4

JEDI and CHEWCO

More complications from Enron..

CHEWCOBARCLAY’S BANK

BIG RIVER&

LITTLE RIVERJEDI

WILLIAM DOBSON &MICHAEL KOPPER

CALPERS

ENRON

$240 millionGuarantee

Credit of $132 million

$1,25,000

$383 million

$11.4

million

Loan given by Barclay’s for a cash reserve of $6.6 million (security) given by JEDI.

Using Derivatives to Hide Losses on Technology Stocks

– Enron took advantage of the dot.com boom and traded internet bandwidth.

– The value of Enron’s online transaction was huge($880 billion).

– Enron hid hundreds of millions of dollars of losses on its speculative investments in various technology-oriented firms, such as Rhythms Net Connections (start-up telecommunications company).

RaptorEnron

Owned by LJM1

Issued securities to investors

Using Derivatives to Hide Losses on Technology Stocks

– “Price swap derivative”—between Enron and Raptor.

– In this price swap, Enron committed to give stock to Raptor, if Raptor’s assets declined in value.

– The more Raptor’s assets declined, the more of its own stock Enron was required to post. Because Enron had committed to maintain Raptor’s value at $1.2 billion, if Enron’s stock declined in value, Enron would need to give Raptor even more stock.

– This derivatives transaction carried the risk of diluting the ownership of Enron’s shareholders if either Enron’s stock or the technology stocks Raptor held declined in price.

– Because the securities Raptor issued were backed by Enron’s promise to deliver more shares, investors in Raptor essentially were buying Enron’s debt, not the stock of a start-up telecommunications company

– This ended when the dot.com bubble burst and by 2001 shares of Rhythms Net Connections were worthless. Enron had to deliver more shares to “make whole” the investors in Raptor and other similar deals. In all, Enron had derivative instruments on 54.8 million shares of Enron common stock at an average price of $67.92 per share, or $3.7 billion in all.

– In other words, at the start of these deals, Enron’s obligation amounted to seven percent of all of its outstanding shares. As Enron’s share price declined, that obligation increased and Enron’s shareholders were substantially diluted.

– And here is the key point: even as Raptor’s assets and Enron’s shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

Derivatives inside EnronPrudency reserves:-

– Enron's Derivatives trading operations kept records of the trader’ profits and losses.

– Each trader would report either a profit or loss, in a spreadsheet format.

– Instead of recording entire profit, they split the profit into actual profit which was added into Enron’s current financial and the rest they included in the prudency reserves.

– Which they use to offset their losses.

Mismarking Forward curves:-

– A forward curve is a list of forward rates for a range of maturities.

– This curve is crucial to any derivatives trading operation because they determine the value of a derivative contract today.

– To hide their losses Enron traders selectively mismarked their forward curves.

Whom to be blamed?

Investment &Commercial

bank

Law firmsAndersen

CRA

Enron scam

Impact of Enron – Sarbanes –Oxley, Act 2002

– This Act was enacted on July 30, 2002, also known as the "Public Company Accounting Reform” and “Investor Protection Act“ and "Corporate and Auditing Accountability and Responsibility Act" and more commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law that set new or expanded requirements for all U.S. public company boards, management and public accounting firms.

– It was enacted as a reaction to a number of major corporate and accounting scandals, including Enron and WorldCom. The sections of the bill cover responsibilities of a public corporation’s board of directors, adds criminal penalties for certain misconduct, top management must individually certify the accuracy of financial information.

– Penalties for fraudulent financial activity became much more severe. Also, SOX increased the oversight role of boards of directors and the independence of the outside auditors who review the accuracy of corporate financial statements.

Why wasn’t Enron caught earlier?– Throughout all of this, Enron and its key members were making political contributions to

the white house and congress.– Kenneth Lay donated $100,000 to President Bush in 2000, and in 2001 Bush invited Lay

to become an advisor to his transition team.– In the year 2000, Kenneth Lay met three times with Dick Cheney to discuss energy policy

review.– When the review was published in May 2001, it was very favorable to the Enron and the

energy sector.

– Aug 14, 2001 Jeff Skilling resigned, Kenneth Lay became CEO once again.– Stock prices began to fall, as investors were uncertain about the company’s stability. – This started a chain reaction: Enron had hedged against its own stock, so as long as the

stock price was declining, it could not recover its losses.

Thank You!!!