Beyond Enron

The fate of Andrew Fastow and company casts a harsh light on off-balance-sheet financing.

Asset monetization, off-balance-sheet financing, financial engineering, call it what you will.

When all is said and done, accounting wizardry of this ilk amounts to hiding information from investors. But as Abraham Lincoln knew, you can’t fool all of the people all of the time — not even if you’re a company as lionized as Enron Corp. was. And when it was revealed last October that Enron was responsible for the debt of partnerships managed by its soon-to-be-cashiered CFO, Andrew S. Fastow, investors swiftly punished the company for its deceit, ultimately sending the nation’s seventh-largest company into bankruptcy.

Other companies have flagrantly violated accounting standards to meet Wall Street’s expectations. Sunbeam, Waste Management, and Cendant notably engaged in clear-cut fraud. But none of those companies ceased to be a going concern when their shenanigans came to light. Then again, Enron wasn’t simply managing earnings. The energy giant was seeking to hide from investors billions of dollars of debt, and that is about as fundamental to a company’s financial condition as anything can be.

By now it’s well known that Enron incurred that debt because it needed capital to realize the vision of its famously farsighted leaders — first Kenneth L. Lay, then Jeffrey K. Skilling. And it succeeded, morphing practically overnight from an old-fashioned pipeline operator to an asset-light energy trader. By the end, 90 percent of Enron’s revenues flowed from its energy-trading business — not just in traditional commodities such as oil, gas, coal, and electricity, but also in newfangled markets such as bandwidth and pollution-emission credits.

By now it’s also well known how swiftly Lay and Skilling’s vision evaporated, starting last fall with a flood of bad news: huge write-downs for failed investments in the telecom and water businesses, a reduction of shareholder equity by $1.2 billion, a restatement of earnings for the past five years, a crippling downgrade from the rating agencies. Fastow’s involvement in the limited partnerships came to light, and Enron’s off-balance-sheet chickens came home to roost.

Today, investigators are still trying to ascertain exactly what was going on in Fastow’s financial black box. But the market isn’t waiting for Congress to close up regulatory loopholes, or for the Securities and Exchange Commission to revise its disclosure requirements, or for the Financial Accounting Standards Board to reconsider its rules on consolidations and equity-based transactions. No, the market is punishing the stock of other companies that have lots of off-balance-sheet debt and even a whiff of tricky accounting. “Anybody that is seen to be playing games” is likely to be penalized by investors, says David Tice, a Dallas-based investment manager and short-seller who derisively calls Enron “a hedge fund in drag.”

The bottom line: Enron-bitten investors are in no mood to indulge companies that engage in complicated financial engineering — at least for now.

Back on the Balance Sheet

A growing number of companies that have apparently gone nowhere near as far as Enron did with off-balance-sheet activities are now reeling those activities in, or fending off calls to do so. One, El Paso Corp., a Houston company that owns the country’s largest gas pipeline, has even seen fit to consolidate $2 billion in off-balance-sheet financings in the wake of the Enron debacle. As El Paso explained in a press release accompanying the announcement, “It has become clear in the last month that the market now expects energy companies to maintain lower leverage and more simplified balance sheets.”

The change in heart isn’t limited to Enron’s competitors within the energy industry. Technology companies such as EDS and PeopleSoft now find themselves trying to reassure investors about activities that have been disclosed merely in footnotes to their annual reports. Electronic Data Systems, for instance, has instead decided to report each quarter the full extent of the debts of off-balance-sheet entities designed to finance the purchase of computer systems from customers. PeopleSoft, meanwhile, is under pressure to bring back onto its balance sheet a research-and-development subsidiary that it spun off roughly three years ago but effectively controls.

How different are such activities from Enron’s? Night and day, insist finance executives at EDS and PeopleSoft, and some analysts agree. But investors are punishing their stocks regardless out of fear that such arrangements hide costs.

Yet when PeopleSoft first decided to spin off its R&D subsidiary, Ronald Codd, PeopleSoft’s CFO at the time, insisted that he could convince analysts (and the market along with them) that the subsidiary’s costs should be separated from PeopleSoft’s even if accounting rules were changed to require their consolidation. As it turned out, FASB did change the rules — but exempted PeopleSoft because it had acted beforehand.

Today, however, PeopleSoft finds itself hard-pressed to distinguish its off-balance-sheet maneuvers from Enron’s. To be sure, Codd’s successor, Kevin Parker, contends that “it’s simplistic” to compare the two companies’ activities: the PeopleSoft subsidiary’s costs are fully disclosed, he says, and “we’ve talked very deliberately and very publicly” about the company’s relations with its subsidiary. Parker adds that any decision to reacquire and consolidate the R&D subsidiary would have “very little” to do with investor concerns about PeopleSoft’s accounting practices.

Now You See It…

Beyond investigations and litigation, a key question in the wake of Enron’s collapse is what benefit can be derived from such off-balance-sheet activities if all information concerning them is disclosed. After all, the fundamental purpose of off-balance-sheet financing is to convince the marketplace to dismiss, if not ignore, the risks associated with it. Yet if those risks belong entirely to another party, as total dismissal would require, it stands to reason that their benefits must, too. And if Enron was trying to deny that financial reality, how different was it from that of other financial engineers? Not that much, when you consider what Fastow himself had to say about the subject.

As he explained to CFO back in 1999, the key to Enron’s energy-trading business was the fact that “the counterparties who enter into these contracts with Enron have to be able to take Enron counterparty credit risk.” That meant that Enron needed to be “a strong investment-grade credit.” But Fastow chose to achieve this not through the old-fashioned means of issuing equity (which dilutes existing shares) or selling assets outright (cash doesn’t earn much), but by shifting debt off the balance sheet through special-purpose entities and other unconsolidated affiliates. “We’ve had to be very creative,” said Fastow, who was also careful to emphasize that “we’re very conservative in our accounting approach.”

Prior to Fastow’s appointment as CFO, Enron used a publicly traded subsidiary, Enron Global Power and Pipelines, to raise off-balance-sheet debt. But Fastow preferred private partnerships for this purpose; partnerships, he said, were “much more” cost-effective and flexible.

Explained the CFO: “You can get together with one or two investors and craft a particular structure to meet your and their objectives, which is very difficult if you have a public entity [where] you might have to go with shareholder votes and amendments of charters and the like.” For that reason, Enron bought back the publicly traded shares of Enron Global Power and Pipelines in late 1997 and turned to private partnerships instead.

What’s more, the “flexibility” that Fastow alluded to might have had at least something to do with Enron’s ability to keep information out of the public eye. Indeed, not until its most recent 10-Q, filed last November 19, did Enron make clear to anyone but the rating agencies and, apparently, its auditor why exactly two partnerships were primarily responsible for converting the $3.9 billion in off-balance-sheet debt into Enron’s own obligations, triggering the downgrade in its credit rating to junk status. One such affiliate, a partnership called Whitewing, invested in another, called Osprey, that acquired energy-related assets and other investments. Osprey was financed with $2.4 billion in debt that, it turns out, Enron backed with preferred stock that was convertible to 50 million Enron common shares. According to the disclosure, Enron had agreed to issue more if needed to retire the debt, and if that weren’t sufficient, it would be “liable for the shortfall.”

A similar tale is told through the 10-Q concerning a partnership called Marlin, which helped finance Enron’s unconsolidated subsidiary, the Atlantic Water Trust. Enron’s obligation for $915 million that financed the trust, as was finally made public through the disclosure, would arise if the company experienced a downgrade below investment grade by any of the three major credit-rating agencies. And that’s exactly what happened. With that, the real nature as well as extent of at least some of Enron’s most pressing off-balance-sheet obligations became clear.

So Much For Intangibles

The nature of Enron’s financial maneuvers became clearer in its November 8-K filing, which provided at least an inkling of what the company’s true liabilities might be. Here the company disclosed the first in what it belatedly acknowledged was a series of accounting glitches. Confidence in the company’s finances steadily evaporated, and Enron filed for bankruptcy on December 2. As this article went to press, Enron was sustained only by $1.5 billion in emergency debtor-in-possession financing from its primary lenders, J.P. Morgan Chase and Citibank.

At this point, any hope for Enron’s resurrection rests on what remains of its assets after its debts are satisfied. Its valuable Northern Natural Gas pipeline has been captured by rival Dynegy Inc., as a consolation prize for Dynegy’s failed takeover of Enron. But it may be difficult to sell the power assets and other tangible assets that Enron worked so hard to securitize. And it’s hard to value what remains of its intangibles, such as its online trading system. (At press time, Enron announced it was selling its energy-trading business to UBS Warburg AG.)

Enron’s future, ironically enough, thus depends on the relatively few hard assets it saw fit to keep on its balance sheet. Fastow himself obviously thought it made sense to minimize them. “Most oil and gas companies are just funded on-balance-sheet,” he told CFO in 1999. Therefore, the off-balance-sheet activity Enron engaged in gave it “a structural cost advantage,” insisted Fastow.

Most analysts, consultants, academics, and journalists thought so, too, and held up Enron as an example to follow (including CFO, which gave Fastow an Excellence Award in 1999). Not only did many of Enron’s competitors eventually do so, but so did companies in other industries, though some observers would claim that a few were even better at this game, or at least earlier practitioners.

Among skeptics of this kind of financial engineering is Stephen Wright, a finance professor at the University of London and co-author of Valuing Wall Street, a 2000 book devoted to the then-unfashionable notion of Tobin’s Q, which holds that a company’s market value ultimately equals the replacement cost of its tangible assets. Says Wright: “Not everybody can shift assets off their balance sheet, and when everybody is claiming that they should, clearly there are grounds for suspicion of that claim.”

Having assets on the balance sheet is a much bigger issue now than it was just a year ago, and not just for energy companies. Consider the rise in asset-based lending, which requires assets to be used as collateral. While such lending has long been a source of capital for troubled companies, even investment-grade borrowers are going this route. “Demand is extremely robust,” says an investment banker whose firm specializes in such lending and has had dealings with Enron.

Bank Run

Now, in fact, the rating agencies promise to take a much harder look at off-balance-sheet arrangements. And the additional scrutiny won’t stop there, as Enron’s meltdown is beginning to spark intensive congressional scrutiny of the regulation of the financial and commodity markets (not to mention the adequacy of federal protection of 401(k) plan assets). At a minimum, new standards for disclosure of off-balance-sheet liabilities seem in order. FASB seems to recognize this, as a spokeswoman reports that the accounting body has placed its long-waylaid Consolidations Project back near the top of its agenda. Its key proposal would tighten FASB’s definition of control, and with it the conditions under which the results of a company’s subsidiaries and other affiliates needn’t be consolidated in its own financial statements.

For its part, the SEC says it plans to close certain loopholes in its disclosure requirements. The most relevant one may involve the definition of what constitutes material information, since Enron’s auditor, Arthur Andersen LLP, accepted the company’s claims that much of its off-balance-sheet activities needn’t be disclosed, because the amounts at stake were sufficiently small to be considered immaterial. What more the commission should do here is open to question, however, since it issued guidelines some three years ago that made it clear that size alone wasn’t an appropriate measure of materiality. Indeed, many suggest that a more effective move would be to ban accounting firms from providing consulting services to clients they audit. (Andersen billed Enron $27 million for consulting services in 2000, versus $25 million for auditing work.) Such a ban was proposed by former SEC chairman Arthur Levitt, but was abandoned in the face of industry opposition.

In the end, Enron was a victim of its own success. Just as it billed itself, it was more of an asset-light investment bank than an industrial company weighed down by tangibles. But exactly as can happen with a bank, once a critical mass of customers stopped trusting Enron’s very name — effectively deeming its once-considerable knowledge capital to be worthless — it was only a matter of days before a sufficient number of others, including Dynegy, followed suit, leaving Enron a nearly empty shell.

The salvage job for what remains promises to take a little longer. Whether or not investors continue to punish off-balance-sheet gimmickry, regulators will doubtless start taking it more seriously. At press time, the Justice Department announced that it had formed a task force to coordinate the various federal investigations into Enron. While that may streamline the process, helping Enron emerge from bankruptcy more quickly, it will also expand the potential scope of prosecution of those responsible — to the level of criminality.

That alone should be a red flag for financial engineers everywhere, even if they haven’t plied their trade as fast and loose as Andy Fastow did.

Hide and Seek

Although credit analysts and the company’s auditor insist that Enron’s true condition caught them by surprise, hints of trouble might have been detected earlier than last October, when the company announced its shocking Q3 2001 results.

Fastow himself told this magazine some two and a half years ago how Enron jumped through hoops to hide the debt associated with the acquisition of three New Jersey power plants from Cogen Technologies in 1999. Said Fastow: “We accessed $1.5 billion in capital but expanded the Enron balance sheet by only $65 million.” Enron, like the overall market, was flying high back then, and as Fastow was the first to admit, “that’s a significant amount of leverage you wouldn’t want on the balance sheet.” (Fastow declined to be interviewed for this article.)

A report last September by investment manager David Tice’s firm cited those remarks. At the time Fastow made them, however, the then-37-year-old graduate of Northwestern University’s Kellogg School of Management also insisted that “we’ve completely segregated these assets, so if something were to happen here, given the high leverage, it would not be able to come back at Enron.” As it turns out, much of this purportedly nonrecourse financing has done just that, and belonged on Enron’s balance sheet from the start.

Fastow, who was appointed CFO in March 1998 after eight years with the company, also suggested to us that there was plenty more of Cogen’s type of financing off Enron’s balance sheet. “We have much more complex transactions as well,” he boasted. But only recently did investors begin to care.

The Dogs That Didn’t Bark

Why did Enron ultimately have to consolidate certain off-balance-sheet subsidiaries? And why didn’t those responsible for overseeing Enron’s activities hold it accountable for not doing so?

Prior to its earnings restatement last November, Enron explained to CFO and anyone else who cared to inquire that the assets and liabilities of those subsidiaries — along with their costs — needn’t be consolidated, even if FASB went ahead with its proposal to eliminate the simple 51 percent of voting rights threshold, as the rulemakers periodically threatened to do. Without control, as currently defined, Enron was fully observing U.S. GAAP by accounting for such affiliates through the equity method.

But in the Form 8-K Enron filed to restate its results for 1997 through 2000, the company admitted that three of its affiliated partnerships should have been consolidated after all. The document itself doesn’t make clear why, though analysts suggest that it’s because the other investors in the partnerships might have been Enron employees. Enron’s auditor, Arthur Andersen LLP, contends that Enron did not make available to it a side agreement concerning one of the three partnerships, called Chewco, and that its disclosure would have required that Chewco be consolidated — as well as the other two, because they invested in each other. There, in any case, went $680 million, or 20 percent of Enron’s earnings during that four-year period.

Granted, Enron was absolutely correct in insisting that the restatement didn’t reflect any change in its fundamental financial condition. Yet the argument often advanced in cases of earnings management — that accounting tricks don’t fool investors so long as enough information is disclosed — doesn’t apply here, because Enron simply didn’t provide enough information. Analysts who normally ignore off-balance-sheet treatment of assets and liabilities by adding them back to the balance sheet found that difficult, if not impossible, to do with Enron.

Credit-rating firms are often in a position to demand more information. In fact, credit analysts such as John O’Connor of Duff & Phelps (now part of Fitch) told CFO in June 1999 that he was able to “look through” Enron’s accounting treatment of its unconsolidated affiliates. So, to some extent, did Ron Barone, his counterpart at Standard & Poor’s. As a result, Barone added back into Enron’s debt anywhere from $3 billion to $5 billion of what he understood its off-balance-sheet liabilities to be. But, to say the least, the numbers alone did not tell the whole story. And Enron’s footnote disclosures weren’t nearly enough for other analysts. Even today, Enron’s financial condition “is all Greek to us,” says Carol Levenson, a Chicago-based credit analyst for Gimme Credit research service.

As a result of the fiasco, Fitch, Moody’s, and S&P have all announced that, going forward, they will look more closely at credit “triggers” embedded in equity-backed, off-balance-sheet notes.

What about Enron’s auditor? Andersen CEO Joe Berardino testified before Congress in mid-December that Enron failed to make available critical information while Andersen employees were examining its results for 1997. In January, however, Andersen conceded it had destroyed some information concerning the case. As for Enron’s audit committee, it included Wendy Gramm, who was widely considered a lax regulator when she served as head of the Commodity Futures Trading Commission in the early 1990s. She is also married to Texas Senator Phil Gramm, another regulatory minimalist.


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