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Role of Derivatives in Enron Scam –
The Legendary Scam
Enron and 9/11 marked the end of an
era of individual freedom and the
beginning of personal responsibility.
Jeffrey R. Immelt
In 2000, Enron
In 1998 Andrew
Lay with Skilling
created a new
division in 1990
Enron create a
buy and sell gas –
In 1985, Enron was
born from the
merger of Houston
Natural Gas and
Dec 2 , 2001
closes at $0.26
Nov 8, 2001
that they have
been inflating its
Oct 22 , 2001
Share price fell
Oct 16, 2001
$618 Billion loss
and 1.2 Billion
Oct 12 , 2001
tells auditor to
Aug 14, 2001 Lay
again takes over
Rise of Enron
– In 1985, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska
– 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
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.
– 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
– 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
4. LJM 1 and LJM SWAP SUB L.P.
5. LJM 2
6. RAPTORS 1,2,3 AND 4
More complications from Enron..
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
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
– 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
– 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 Enron
– 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?
Impact of Enron – Sarbanes –Oxley,
– 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
– 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
– When the review was published in May 2001, it was very favorable to the Enron and the
– 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.