Andrew Fastow, Enron’s Chief Financial Officer (CFO), devised two limited partnerships in 1999 – the LJM Cayman, LP (LJM1) and LJM Co-Investment LP (LJM2). The underlying purpose for this scheme was to buy back the stocks and stakes of Enron that were performing badly and in this way improve the appearance of the company’s financial statements. These partnerships were formulated exclusively to operate as independent equity investors intended for the special purpose entities that were being exploited by Enron (Bratton 31). Special purpose entities (SPEs) were utilized by Enron to finance and deal with risks related with particular assets. These companies were formed by a sponsor although financed by outside equity investors and debt funding. By 2001, hundreds of SPEs were employed by Enron to conceal its debt (Healy and Palepu 10). The SPEs were exploited for more than simply dodging accounting rules and practices.
Andrew Fastow obtained approval from Enron’s board of directors to be exempted from the company’s code of ethics, since Fastow held the position of CFO, so that he can manage the companies (Mclean and Elkind 193-197). The funding of almost $400 million for the LJM partnerships was backed by JP Morgan Chase & Co., Wachovia Bank, Citigroup Inc., Credit Suisse First Boston, and other investors. $22 million was also put in by Merrill Lynch & Co., the group that promoted the equity, to support these particular SPEs (Bratton 31).
Enron assets valued at over $1.2 billion were transferred to four (4) LJM-related SPEs – Raptor I, II, III and IV, companies with monikers derived from the motion picture series Jurassic Park’s velociraptors. Included in this transfer were millions of common shares of stocks, long term rights to buy millions more of stock shares, and notes payable valued at $150 million. This information was shown in the footnotes of Enron’s financial statement. The SPEs had been utilized to compensate for these transactions by way of the SPEs’ debt instruments. It was also shown in the footnotes that the face value of the debt instruments amounted to $1.5 billion. Moreover, the SPEs notional value of $2.1 billion had been tied up with Enron through derivative contracts (Bratton 33).
Raptor I to IV was capitalized by Enron in such a way that it would appear as though the stocks are issued at a public offering and apply accounting procedures in such manner. The notes payable issued were recorded as assets on Enron’s Balance Sheet, thereby bloating the stockholders’ equity for the equivalent amount (Bratton 38). Later, this manner of accounting for capitalizing the Raptors became questionable with Enron’s auditor, Arthur Andersen, since pulling it out from Enron’s Balance Sheet will decrease the company’s net stockholders’ equity by the same amount of $2.1 billion (Flood 2006).
In time the $2.1 billion derivative contracts had lost substantial value. At the moment when the price of the stock reached its high points, swaps were set up. In more than a year period the portfolio value of the swaps dropped by over $1 billion with the drop in stock prices. The shortfall in value signified that the SPEs notionally were indebted to Enron by over $1 billion under the contracts. In Enron’s annual report (Year 2000), the company declared gain of over $500 million from the swap contracts (applying the fair value method in accounting). This supposed gain compensated the company’s losses in its stock portfolio and was credited to just about a third of the company’s revenues for the year 2000 (Bratton 39).
CFO Fastow and other company executives misinformed the board of directors and Enron’s audit committee in connection with highly risky accounting procedures. They had also compelled Arthur Andersen to disregard the issues. The principal driving force for Enron’s fiscal and accounting operations appear to have been to maintain stated income and cash flow upbeat, to overstate asset values, and to keep liabilities out of the books (Bodurtha 2). These issues collectively led to the bankruptcy of Enron afterward. The greater part of these issues were brought about by the implicit knowledge and explicit actions of Andrew Fastow (CFO), Kenneth Lay (Chairman and CEO), Jeffrey Skilling (President and COO), and other executives. CFO Fastow formulated off-balance-sheet channels, complicated funding structures, and dealings that were so perplexing that only a few can comprehend them even today (Mclean and Elkind 132-133).
The scandal ultimately brought about the bankruptcy of Enron, an energy corporation with headquarters in Houston, Texas. It also led to Arthur Andersen’s dissolution, one of the world’s largest audit firms. Enron made history as America’s largest bankruptcy shake-up at that time as well as audit’s biggest letdown (Bratton 61).
Shareholders saddled almost $11 billion in losses when the price of Enron stock dropped below $1 in November of 2001. The Securities and Exchange Commission started an inquiry into the Enron mess. On the other hand, Dynergy (a Houston-based competitor) proffered to buy out the company at a fire sale acquisition. The arrangement, however, did not materialize. On December 2, 2001, the once mighty Enron succumbed to bankruptcy.
Works Cited
Bratton, Willam W. “Does Corporate Law Protect the Interests of Shareholders and Other
Stakeholders?: Enron and the Dark Side of Shareholder Value.” Tulane Law Review 1275 (2002): 30-40. Print.
Bodurtha, James N. Unfair Values – Enron’s Shell Game. Working Paper. The McDonough
School of Business, 2002. Print.
Flood, Mary. “Spotlight Falls on Enron’s Crash Point.” Houston Chronicle 14 Feb 2006. Print.
Healy, Paul M. and Palepu, Krishna G. “The Fall of Enron.” Journal of Economic Perspectives
17 No. 2 (2003): 3-26. Print.
Mclean, Bethany and Peter Elkind. The Smartest Guys in the Room: The Amazing Rise and
Scandalous Fall of Enron Portfolio. New York: Penguin Group Inc., 2004. Print.
