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Abstract The authors look at the way in which Enron used hedging techniques before the corporate collapse of the organization triggered a crisis of confidence in US business practices and standards. They provide an analysis of how the system was structured and show how the transactions worked before analysing the roots of the company's downfall.
Key words: Hedging, Accounting policy, Business policy
During the 1990's, enron grew rapidly and moved into areas believed to be compatible with its strategy of creating a business around assets which were purchased and developed. This rapid growth required large initial capital investments and yet these businesses were not expected to generate significant earnings or cash flows in the short term, To avoid reporting additional debt from these businesses that would initially have insufficient cash flows to service the debt, Enron chose to use special purpose entities (SPEs)[1] to obtain off-balance sheet financing. These entities borrow directly from outside lenders to carry on the business activities.
Although SPEs are a common business practice for off-balance sheet financing, Enron created SPEs to engage in some questionable hedging activities to keep true economic losses off of their financial statements. This article provides a simplified overview of a very complex situation to help explain Enron's motivation for engaging in hedging activities with their SPEs, the derivative transactions used to accomplish their earnings management, and the condition that existed which ultimately exposed the questionable scheme.
The motivation
In March of 1998, Enron purchased Rhythms Net Connections stock as an investment for $10 million, By May 1999, the value of the stock had soared to $300 million, but Enron could not sell the investment until the end of 1999 because of a lock-up agreement.[2] Concerned that the price of the stock would drop before they could sell the investment, Enron wanted to hedge the gain already recognized by acquiring put options. Because of the size of Enron's position, relative illiquidity and lack of comparable securities, it was virtually impossible to hedge the Rhythms investment commercially. So Enron created an SPE whose business activity was to hedge the Rhythms investment.
From 1999 to 2001, Enron held several investments similar to Rhythms in that they initially soared in value, but were likely to decline...