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It appears that the need to expand operations without losing their credit rating drove Enron to create a mezzanine finance structure involving outside Equity Trusts. Limited Liability Companies, and Limited Partnerships.

The structure was as follows. Legally create an outside limited partnership. Find an outside investor for the LP. Capitalize the LP as follows: outside investor 3%, bank financing 97%. To secure the bank financing, Enron guaranteed the payments on the LP loans and transferred assets to the LP which would secure the debt. Once the LP had received financing, Enron would sell the LP a pipeline, power plant, electric line, gas storage facility etc, for cash. Enron would then use the cash to pay off debt or to build/acquire something else.

If there is at least one outside investor providing 3% of capital, FASB does not require Enron to list the LP as a subsidiary. the LP is now the debtor to the bank, and FASB does not require Enron to disclose the amount of interest charges they were guaranteeing since they are not a current liability except in case of default by the LP. so Enron had fewer assets, less debt, but more potential liability.

of course there are problems. in this case as natural gas prices and wholesale electricity prices fell, many of the LP's could not make their payments, and the potential liabilities became current liabilities. as these current liabilities built up, two things happened. first, Enron's direct creditors began to realize how leveraged Enron was and refused to expand Enron's lines of credit, and second, Enron's clients in the futures contract market began to doubt Enron's lon run viability, so their trading business began to contract. current liabilities up, credit capped, cash flow down - this eventually pushed Enron into bankruptcy.


1. A leverage problem. the LP's were highly leveraged with 3-5% equity, 95-97% debt.
2. Probable conflict of interest. the "outside investors" in most cases appear to have been ex-enron employees, ex-mckinsey employees, close associates of enron managers/directors, or in some cases, actual enron employees, managers and directors (Fastow for example). arms length negotiations on asset sales? unlikely. efficient pricing for the asset sales to the LP's? also unlikely. too much conflict of interest? yes, very likely.
3. Financial statement transparency problems. Enron's guarantees of interest charges added to liabilities in a practical or economic sense, but because of the rules, not in an accounting sense. Hindsight is of course 20-20, but the 3% rule seems, low. No requirement to disclose the potential liabilities from the financial guarantees also seems suspect.
4. Backdoor financing. Did Enron loan cash to individuals to finance the required 3% equity in any of the LP's? The rumour is that some or all of outside investor capital in some of the LP's was actually funded by Enron in the form of a personal loan from the company to an individual. If so, Enron may have been violating the spirit of the FASB and IRS rules.

if you think that is fascinating, wait, there is more. as bank creditors file their papers it is becoming apparent that there were not just a few of these LP's. there were thousands of LP's, trusts and LLC's (Wall Street Journal, 2/21/02). in some cases it appears that LP's owned as little as 10-20 miles of pipeline or electric line, or say, just one electric substation. not only is this going to be possibly the largest bankruptcy in US history, it is probably destined to become the most complex as well because of all of the contracts and the sheer number of unsecured creditors.

what astounds me is that [1] the banks funded all of these LP's [2] moody's and S&P didn't catch on to the actual degree of leverage sooner, and [3] that Enron's publicly traded debt didn't react to the assets sales earlier. the asset transfers went on for years.



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