Enron Corp. - University of California | Office of The President

comparable securities in the market, it was prohibitively expensive to hedge Rhythms commercially.
Enron was also looking for a way to take advantage of an increase in value of its own stock. But
under GAAP, a company cannot recognize an increase in value of its own stock (including forward
contracts) as income. See APB No. 9, 28.
455. To circumvent GAAP, Enron sought to use what it viewed as this "trapped" or
"embedded" value of Enron stock. LJM1 was formed for this purpose and, immediately thereafter,
the Rhythms transaction closed, on 6/30/99. The transaction had three principal elements: First,
Enron released 3.4 million shares of Enron stock for transfer to LJM1, which on 6/30/99 had a value
of $276 million. Enron, however, restricted the shares to preclude their sale or transfer for four
years. The value of the shares was discounted by approximately $108 million (or 39%) to account
for the restriction. The restriction did not, however, preclude LJM1 from pledging the shares as
security for a loan. In exchange for these Enron shares, LJM1 gave Enron a note (due on 3/31/00)
for $64 million. Second, LJM1 capitalized Swap Sub (a limited partner in LJM1) by transferring
1.6 million of the Enron shares to Swap Sub, along with $3.75 million in cash. Third, Enron
received from Swap Sub a put option on 5.4 million shares of Rhythms stock, under which Enron
could require Swap Sub to purchase Rhythms shares at $56 per share in 6/04. The put option was
valued at approximately $104 million.
456. The purported "hedge" that Enron obtained on its Rhythms position with Swap Sub
that was used as a justification to allow Enron to report gains and losses on its income statement was
never a true economic hedge. This was because Swap Sub's ability to make good on the Rhythms
put rested on the value of the Enron stock. As a consequence, Swap Sub could perform on the put
only if Enron stock performed well. Under this scenario, if Rhythms stock declined, any losses
would to be absorbed by the value in the Enron stock, but if Enron stock and Rhythms stock both
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