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.
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