Structured Deals

When companies need more capital, or even just more cash, they turn to investment banks. It is very difficult to help some firms. As an extreme example, consider a firm that is likely to go bankrupt. In bankruptcy, the equity of the firm is taken from the stockholders , who get nothing, and given to some of the creditors. Therefore, investors are not likely to buy additional shares of stock of a firm in financial trouble. The firm would also have trouble borrowing money from banks or from bond investors because these creditors typically do not get all of their money back in bankruptcy. They often get a small fraction of what they are owed and then receive some stock to become the new owners of the firm. Since lenders do not get their money back in bankruptcy court , they are unlikely to lend money to a financially troubled firm.

There are many times when a firm would have trouble raising capital even if it was not on the brink of bankruptcy. For example, the current creditors of a firm may have stipulated in their loan that the firm cannot borrow more money unless they are repaid first. Also, hardly any firms can issue additional stock when investor confidence is low, like in the summer of 2002.

Unfortunately, it appears that investment banks have been active participants in helping some companies secretly raise capital and even fraudulently prop up profits. Enron's strategy was to launch structured deals using special purpose entities (SPE) created in tax havens like the Cayman Islands. The SPEs are formed as partnerships and are used to create the appearance of third-party companies doing business with Enron. The "business" actually turns out to be loans that were recorded as revenue instead of debt. For the structured deals to work, Enron needed complicated structures to fool auditors and regulators. To help create and fund the deals, Enron turned to investment banks.

The use of offshore partnerships to prop up Enron's financial status was greatly accelerated in the summer of 1999. Enron had heavily invested in an Internet start-up called Rhythms NetConnections. Rhythms stock had jumped and the investment of $10 million grew to $300 million ”a $290 million profit! Due to restrictions on selling ownership in the recent IPO, Enron could not sell this stock. Because of its mark-to-market method of accounting, it could book the gain. The mark-to-market method allowed Enron to report its assets at market value instead of the traditional method of using purchase price less depreciation. However, Enron worried that a big decline in price later would require booking a large loss. ^[14] Enron could not get the investment banks to hedge the price risk because of the huge position and the high risk of the start-up. So Enron created the partnership called LJM in the Cayman Islands that would guarantee the profit. ^[15] Enron's CFO Andrew Fastow would run the partnership. In fact, the SPE name LJM comes from the names of his wife and children. The new partnership was funded by Enron stock. Therefore, Enron was really insuring itself. This profit would represent 30 percent of Enron's total profit for the year. However, if both Rhythms' stock and Enron's stock price fell, LJM would not have enough capital to make the guaranteed payment. Enron would then have to reverse the profit and record a loss of $290 million. The large loss would further depress the Enron stock. It created LJM anyway and completed the deal. Enron considered LJM a big success and entered into similar arrangements to hedge other risky tech stock holdings. These arrangements were called Raptor partnerships.

Fastow's position as CFO of Enron and general partner of the SPE in the Caymans presented a serious conflict of interest. He made the deals between Enron and the partnerships that made him rich at the expense of Enron. Fastow made $45 million from running the structured deals. ^[16] The conflict of interest violated Enron's ethics code. But, inexplicably, Enron's board ignored the code and approved the arrangement.

The myriad partnerships created were actually a sophisticated Ponzi scheme. Enron would create fictitious profits to meet earnings expectations. Those profits would have to be offset in the future as losses. As the losses came due, Enron had to continue the process again and create new structured deals to hide (or delay) the losses and generate additional profits. In this way, the deals quickly mushroomed in number and in size. Eventually, the scheme collapsed as Enron's stock price fell in 2001. Many of the partnerships funded with the stock were unable to complete their transactions. Enron was forced to disclose $1 billion in losses that it had previously booked as profits, and the company was forced into bankruptcy.

Consider a simple example of the use of offshore partnerships that Enron used to prop itself up financially. Enron owned three barges located in Nigeria that generated electricity. They were trying to sell the barges, but they had no takers. According to the U.S. Senate investigation, Enron convinced Merrill Lynch to buy the barges for $28 million. Enron assured Merrill Lynch that it would get its money back with profit in six months because Enron would repurchase the barges at that time. Enron wanted to record the sale and capture a $12 million profit in order to meet its earnings expectations. However, the sale of an asset with an agreement to repurchase it is not really a sale. Instead, it is simply a loan with the asset as collateral for the loan. Enron did not want a loan. In fact, it already had too much debt on its books. It wanted the money and the recorded profit without creating more debt.

The solution was for Enron and Merrill Lynch to create another SPE in the Cayman Islands, which they named Ebarge. Ebarge was set up with $7 million in equity from Merrill Lynch and $21 million in debt from Enron. ^[17] In 1999, Ebarge used this capital to purchase the three barges. Six months later, Ebarge was purchased from Merrill Lynch for $7.5 million by another SPE controlled by Fastow called LJM2. ^[18] The $500,000 profit in six months is equivalent to a 15 percent annualized return ”a pretty high interest rate for 1999 and 2000. Including these third-party partnerships made the deal look like a real sale, not a loan. However, Ebarge was controlled by Merrill Lynch and LJM2 by Enron, so the transaction was really a loan. LJM2 finally sold the barges to another company. LJM2 was created after the perceived success of LJM and was capitalized with 20 times more money, mostly from investment banks that wanted to continue doing business with Enron. In the meantime, Enron made its earnings forecast and Merrill Lynch made its profit.

This barge example is only the tip of the iceberg. The Senate subcommittee on investigations charges JPMorgan Chase and Citigroup with partnership arrangements that effectively hid $5 billion worth of debt in the first half of 2001 alone. ^[19] Most of these arrangements are alleged to be in the form of "prepaid" deals. It is not uncommon for energy companies to contract to sell oil, gas, or electricity in advance. An energy user may want to lock in a supply of energy for the future. The energy firm may even offer a customer a discount if he or she pays in advance. This is known as a prepaid arrangement. The energy firm books the revenue.

Congressional investigators claim that the investment banks used prepaid deals to funnel cash to Enron. The cash would fraudulently appear on Enron's financial statements as revenue when it was really debt. The offshore SPEs conducted deals with Enron from 1992 to 2001 that brought $8.5 billion in loans that Enron kept off the books. ^[20] If properly reported, Enron's debt in 2000 would have been 40 percent higher than actually reported and its operations revenue would have been 50 percent lower. However, the investment banks didn't want the oil and gas. JPMorgan Chase and Citigroup are banks, not energy firms or energy traders. They expected to get back the money with interest. These prepay deals also had to take place through offshore partnerships to keep the appearance that the transactions were legitimate business activities. JPMorgan Chase used the entity called Mahonia, while Citigroup backed one named Delta. The banks funded the partnerships with their own capital and also by marketing ownership to institutional investors.

The ongoing charade continued to allow Enron to financially survive and even boosted Enron's stock price. Enron dealt with nearly 700 SPEs in all, many of them with colorful names like Chewco, JEDI, Kenobe Inc., Obi-1 Holdings, Raptor, Southampton, Talon, and Zephyrus. Since many of the partnerships were interlinked, they were at risk of a domino effect if one or two failed. JPMorgan Chase and Citigroup made more than $200 million in fees for their part. ^[21] The longer the charade continued, the more money investors and employees would invest in the company. As the stock price tripled between 1998 and 2000, more investors flocked to the firm. Finally, in the fall of 2001, the dominos fell.

Merrill Lynch has denied that it has done anything wrong and claims that it is not responsible for Enron fraudulently booking loans as revenue. However, that misses the point. Even if Merrill Lynch did nothing illegal, it broke the trust of its clients and the public investor by participating in a scheme that was designed to hide a firm's financial troubles. The bankers had to know that Enron's financial statements were misleading ”at the least. The Senate seems to have some compelling evidence against the banks. It has an e-mail from a JPMorgan Chase banker stating that Enron loves the deals because they are able to hide debt. ^[22] It also has a tape of a phone conversation between two JPMorgan Chase bankers during which one realizes the transactions are just debt and the other banker confirms it. ^[23] As a monitor of the corporation, the investment banks failed. This is of particular concern because JPMorgan Chase and Citigroup are the nation's two largest financial institutions. The banks have tried to soften some of the criticism by enacting their own rules to not finance a company unless the firm publicly discloses the debt. ^[24] Of course, this new policy also implies that the banks weren't concerned about this issue before the pressure from investors and the media.

While we have only detailed the role of investment banks in Enron's structured deals, there is evidence that they have helped other firms create SPEs. JPMorgan Chase pitched these financing vehicles to other firms and entered into arrangements with seven companies. Citigroup discussed the deals with 14 companies and developed them with three. ^[25] JPMorgan Chase and Citigroup may not be the only banks pitching these deals. Smaller deals were structured between Enron and the bankers of Credit Suisse Group, Barclays PLC, FleetBoston Financial Corp, Royal Bank of Scotland Group PLC, and Toronto-Dominion Bank. Indeed, Credit Suisse First Boston has been helping the energy company El Paso Corporation to create complex Enron-style deals in the year after Enron imploded. ^[26] It appears that El Paso is hiding debt in partnerships and booking future revenue as current profits just like Enron.