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Had the Information Been Known... Lessons from Enrons Insolvency

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The concept of solvency is an important one for the analysis of a company in bankruptcy. A company is generally considered solvent if the fair market value of its assets exceeds its debts, and insolvent if its debts exceed the fair market value of its assets. The standard of fair market value commonly used in the determination of solvency is embodied in IRS Revenue Ruling 59-60. This ruling states that fair market value is the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, with both parties having reasonable knowledge of relevant facts.

The determination of fair market value and the solvency of a firm often hinge upon which facts should be considered in the derivation of solvency. The consideration of relevant facts typically includes information that was known or knowable as of the date of the valuation, whether disclosed to the marketplace or not. It is crucial to distinguish between facts that were in existence but not publicly known until after the solvency assessment date, and information that was unknowable as of that date. Such unknowable "hindsight information" is generally excluded from a solvency analysis.

Any assessment of solvency typically values the company's assets and debts as they existed as of the date of the solvency analysis, and does not include an increase in asset value or decrease in debt that could be obtained through a hypothetical recapitalization or restructuring.

To illustrate these key solvency concepts, it is useful to consider Enron Corp., one of the largest and most complex corporate bankruptcies in U.S. history.

Consider, for example, the task of valuing Enron's assets. For many years prior to its bankruptcy, Enron had migrated away from its traditional natural gas pipeline business to become a major merchant energy trader. Enron also purchased and developed a bewildering portfolio of energy assets and businesses, ranging from Dabhol, a power plant in India, to Elektro, an electric utility in Brazil. However, by as early as 1997, the largest portion of the company's "reported" operating profits came from its gas and power trading. For the fiscal year ended Dec. 31, 2000, $2.3 billion of Enron's reported $2.5 billion in earnings before interest and taxes came from Enron Wholesale Services, the energy trading arm of Enron Corp.

Even on an "as reported" basis (which inflated Enron's profits from trading and concealed large losses in the company's unprofitable Broadband and Retail Energy Services divisions), Enron's value as a business clearly depended on its ability to trade. In turn, this ability to trade rested on the company's maintenance of an investment grade credit rating. Without credit, counterparties worried about default risk would require high levels of collateral to do business with Enron, thereby destroying the company's trading volumes and margins. In addition, Enron's trading contracts commonly included a clause allowing for cancellation should either party suffer a "material adverse change" such as the loss of its investment grade credit rating. Documents produced following Enron's bankruptcy show that the company was well aware of the importance of its investment grade credit rating, and that many of its special-purpose entities and transactions were designed to lower its debt and improve its cash flows so as to maintain its investment grade credit rating. When Enron lost its investment grade credit rating in late November 2001, the company's trading operations ground to a halt and were never restarted.

In the wake of Enron's bankruptcy, the credit rating agencies made it clear that had they known the truth about Enron's debts, financial mismanagement and accounting fraud, they would have assigned the company a noninvestment grade credit rating at least as far back as 1999. Moreover, Ronald Barone, a Managing Director at Standard & Poor's, testified that the company would not have been rated at all. Any valuation of Enron's trading assets for the purposes of solvency should consider this testimony. Certainly, for periods significantly earlier than 2001, it is only appropriate to value Enron's trading operation as though its credit rating had been lost, its trading operation was no longer a going concern, and its in-the-money trading contracts were subject to revocation.

Similarly, a solvency analysis generally considers the value of a company's debts had all relevant facts about those debts been known. For example, in Enron's third quarter 2001 Form 10-Q filed with the SEC, the company claimed debt totaling $14.3 billion as of Nov. 16, 2001. In a private presentation given to its bankers just three days later, the company admitted to debts totaling more than $38 billion. The difference between these two figures was made up by a variety of financing vehicles that hid debt in off-balance sheet special-purpose entities, or misclassified it on Enron's balance sheet. A solvency analysis of Enron, or any other company for that matter, typically includes all the debt for which that company is liable. Furthermore, note that the determination of debt for the purposes of solvency typically requires that substance prevails over form. Even if one were to hypothetically assume that Enron's methods of accounting for its debts were in accordance with GAAP (and work by experts such as the Enron examiner makes it clear that they were not), solvency usually requires that all debt obligations be accounted for regardless of where they appear, whether on a company's balance sheet or as off-balance sheet liabilities.

A solvency analysis typically includes the assets and debts of a company as they existed at a particular date. It is generally unacceptable to hypothesize values that might have been obtained had a recapitalization or restructuring taken place. For example, following the company's bankruptcy, an Enron employee claimed that he could restart and profitably operate Enron's trading operation with the infusion of $6 billion in additional capital.

While it is always possible that a business might have a different value when in different hands, or under different circumstances, such additional capital was never actually at Enron's disposal. Therefore, it cannot be considered in valuing Enron's trading assets for the purpose of solvency.

Following the bankruptcy, the Enron estate developed plans to distribute the company's assets to its creditors. The bankruptcy estate also filed claims against its bankers, accountants and trade counterparties. When determining solvency, one cannot reduce Enron's debt by hypothetical settlements of its liabilities for less than their stated value. Generally, the determination of a company's assets and debt for the purposes of solvency includes its assets and debts as they existed at the date of the solvency analysis.

Summarizing a solvency analysis is typically performed with full consideration of all knowable relevant facts and circumstances, but without allowing the analysis to be influenced by hindsight. A solvency analysis typically includes all assets and debts of a company. While a company such as Enron may place certain of its debts and assets off-balance sheet, substance generally prevails over form when determining an entity's solvency.

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Friday, December 1, 2006

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