LJM (Lea Jeffrey Michael) - Illustrative Transactions With LJM - Rhythms NetConnections

Rhythms NetConnections

In March 1998, Enron invested $10 million for 5.4 million shares of Rhythms NetConnections, a then private broadband provider. After Rhythm went public, shares skyrocketed and Enron found itself with $300 million worth of Rhythm stock in May 1999. However, a lock-up agreement forced Enron to hold its shares until the end of 1999. Owing to Enron's mark-to-market policy, Skilling's worries about Rhythm's volatility led to LJM1 carrying forth a convoluted transaction.

First, Enron transferred with severe locking restrictions 3.4 million shares of Enron stock worth $276 million at the time to LJM1 at a reduced price of $168 million. Then, LJM1 capitalized one of its subsidiaries, LJM Swap-Sub, with $80 million of its restricted shares and $3.75 million in cash. Finally, Swap-Sub placed a put option on 5.4 million shares of Rhythms stock owned by Enron. Under the option, Enron could require Swap-Sub to purchase the shares in June 2004 at $56 a share. Hence, Enron's stock price was now tied to Rhythms' stock price. If Enron's stock did well and Rhythms' sank, then Swap-Sub could reimburse Enron using its Enron shares and provide Enron a profit. More importantly, the deal allowed Enron to use this "trapped" value of the Rhythm put option to bolster its income statement and keep its stock price inflated.

However, unlike a true economic hedge that utilizes the equity of a direct competitor (in this case a direct competitor of Rhythms NetConnections), this "hedge" would fail disastrously if both Enron stock and Rhythms stock dropped. Despite this concern and the obvious conflict of interest involved in having Fastow run it, the accounting firm Arthur Andersen approved it.

In April 2000, owing to the decreasing value of Rhythms stock and a calculated 68% chance that the hedge would default, Enron unwound the transaction. As per agreement, Swap-Sub took from Enron its $207 million-valued Rhythms stock, but instead returned unrestricted Enron stock supposedly valued $234 million. The Enron shares were, however, still under contractual restrictions and should have been devalued to around $161 million. Thus, Enron posted a slight profit instead of a true $70 million loss.

Read more about this topic:  LJM (Lea Jeffrey Michael), Illustrative Transactions With LJM

Famous quotes containing the word rhythms:

    His style is eminently colloquial, and no wonder it is strange to meet with in a book. It is not literary or classical; it has not the music of poetry, nor the pomp of philosophy, but the rhythms and cadences of conversation endlessly repeated.
    Henry David Thoreau (1817–1862)