University of San Diego law professor Frank Partnoy said Enron had used profits from its derivatives trading operation — the full scale of which was little appreciated by investors — to mask losses in its more visible businesses even as some of its employees were fraudulently manipulating those profits. “It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm,” he said in testimony delivered at a Senate Governmental Affairs Committee hearing.
A former Wall Street derivatives trader and white-collar crime specialist, Partnoy has been researching Enron’s business practices for a book he is writing about its collapse. “I have not seen the professor’s testimony, and was surprised to learn about the book that he’ll be marketing soon,” Enron spokesman Vance Meyer said.
In his testimony, Partnoy said Enron reaped huge profits from derivatives. “It made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fibre-optic bandwidth, retail gas and power, water systems and even technology stocks,” he said. “Enron used its expertise in derivatives to hide these losses.”
Derivatives are complex financial contracts whose values are linked to underlying variables such as the prices of commodities, stocks or bonds. They are typically used by sophisticated investors to manage risk. Partnoy said Enron’s use of derivatives both outside and inside the company could be directly linked to its collapse. On the outside, he said, they were used to create the company’s web of off-balance sheet deals with complex financial partnerships known as special-purpose vehicles. “Specifically, Enron used derivatives and special purpose vehicles in three ways,” Partnoy said. “First, it hid speculator losses it suffered on technology stocks,” he said. “Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy service. Third, it inflated the value of other troubled businesses, including new ventures in fibre-optic bandwidth.”