In December, 2001, just prior to filing for bankruptcy, Enron Corporation had approximately $2 billion in cash and no debt coming due. Despite its infamous financial chicanery, it still appeared to be a viable, profitable firm. So why did Enron go bankrupt? Was it because of the fraud, or was there another reason?
At the annual conference of the Association of Certified Fraud Examiners late last month, former Enron Chief Financial Officer Andrew Fastow, who served six years in prison for his part in Enron's deceptions, offered an explanation. In a keynote speech, he said Enron went bankrupt because of" decisions" made in October 2001. He didn't say which decisions. But after hearing Fastow speak twice to my Financial Statement Accounting class and reviewing independent evidence, I think I have good idea. It appears that Enron's final fatal mistake was to try to support its stock price instead of living up to key contractual obligations required to maintain its credit rating.
Enron owned the largest natural gas pipeline system in the U.S., was the largest trader of natural gas and electricity, owned the largest wind power company, and owned a large electric utility in the Northwest. These divisions all generated consistent earnings and cash flows. Enron also owned two "prospective" businesses: Enron Broadband (the first company to offer live video streaming and one that was establishing the largest "cloud storage" system at the time) and Energy Services (providing services to help other companies make their facilities more energy efficient) that weren't producing earnings but weren't a significant drain on the company in late 2001 and, at least with hindsight, represented significant opportunities. The company also had three divisions — Water, International, and Merchant Investment — that were saddled with underperforming and over-valued assets.
What caused Enron to go bankrupt?
What caused Enron's bankruptcy was, quite simply, the loss of its investment-grade credit rating. Without investment-grade status, counter-parties in its trading business (its largest and most profitable segment) either refused to trade with Enron or demanded collateral (which Enron could not post). The loss of the investment-grade designation also accelerated other debt maturities.
So, what caused Enron to lose its investment grade rating? Were the problems at International, Water, and Merchant Investment too big to overcome? No. Were the rating agencies aware of Enron's oft-maligned financing structures? Yes. Did the rating agencies understand that the acceleration of debt maturities brought on by a downgrade could cause a bankruptcy? Yes.
Enron was rated BBB+ (or the equivalent) by all three rating agencies, which typically include all off balance sheet debt when determining a rating. Enron had created multiple non-consolidated Special Purpose Entities (SPEs) that were levered 97/3, meaning $97 of debt to each $3 of equity. Enron's court-appointed bankruptcy examiner estimated the SPEs comprised $14 billion of off-balance sheet debt. Adding the SPEs to Enron's balance sheet would cause Enron to lose its investment-grade rating.
Enron's solution was to alter the nature of its SPEs. A typical SPE requires a company to make cash payments to the SPE if its assets fall in value. Enron created Contingent Equity Vehicles (CEVs) wherein Enron pledged to issue new equity, rather than cash, in the event of asset impairment. By way of illustration: including the CEVs on the balance sheet adds $14 billion to assets and $14 billion to liabilities. In the worst-case scenario of a 100% impairment of the CEVs' assets, Enron's assets and equity (retained earnings) would then fall by $14 billion. However, Enron then could essentially convert the $14 billion CEV debt into equity by issuing new shares. The net result is a drop in assets and debt (equity falls with the decline in assets but goes back up with the issue of new equity) to Enron's exact balance sheet position without the CEVs. This is why the rating agencies could exclude the SPE debt.
The key feature of these CEVs is that they required Enron to issue the new equity, and they required the lenders and other counterparties to accept new equity in lieu of cash. Firms are often unable to issue new equity at just the moment they need it most, but here Enron could. In essence, these financing structures were a "fail safe" designed to ensure that Enron's balance sheet remained investment grade.
Enron's unpleasant choice
As the value of the assets in the SPEs became impaired, Enron faced an unpleasant choice: issue new equity as promised, thereby diluting current shareholders and causing a drop in stock price, or risk a loss of Enron's investment-grade rating and potentially destroy the firm.
Enron's CEO at the time, Ken Lay, decided against issuing the stock (and against living up to the financial structure created by Fastow), apparently believing that (a) dilution would cause an even greater loss of confidence than would the impairment of Enron's balance sheet from including the SPEs and (b) the rating agencies would back down. Instead, the rating agencies downgraded Enron, the trading operations were forced out of business, $4 billion of debt was accelerated, and Enron was forced to file for bankruptcy.
The stability of share price is a metric many managers and investors look at when evaluating the "quality" of a firm. However, in situations where a firm must maintain access to capital markets (e.g. a rapidly growing firm) or must maintain an investment-grade rating for contractual or business purposes (e.g. a financial firm), trying to manage a firm's stock price is clearly secondary to maintaining its credit rating (i.e. it is imperative to maintain the trust of the rating agencies). The financing structures built to protect Enron in just such an event were unwound. Ironically, the company's bankruptcy might have been avoided had Enron lived up to the promises in those oft-maligned financing structures.
--Reprinted from Harvard Business Review