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81–313 PDF 2002

S. Hrg. 107–618

THE ROLE OF THE FINANCIAL INSTITUTIONS

IN ENRON’S COLLAPSE—VOLUME 1

HEARINGS

BEFORE THE

PERMANENT SUBCOMMITTEE OF INVESTIGATIONS

OF THE

COMMITTEE ON

GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

JULY 23 AND 30, 2002

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

JOSEPH I. LIEBERMAN, Connecticut, Chairman

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

FRED THOMPSON, Tennessee

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel

RICHARD A. HERTLING, Minority Staff Director

DARLA D. CASSELL, Chief Clerk

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

CARL LEVIN, Michigan, Chairman

DANIEL K. AKAKA, Hawaii,

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

SUSAN M. COLLINS, Maine

TED STEVENS, Alaska

GEORGE V. VOINOVICH, Ohio

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

PETER G. FITZGERALD, Illinois

ELISE J. BEAN, Acting Staff Director and Chief Counsel

ROBERT L. ROACH, Counsel and Chief Investigator

KIM CORTHELL, Minority Staff Director

MARY D. ROBERTSON, Chief Clerk

(III)

C O N T E N T S

Opening statements: Page

Senator Levin ................................................................................................ 1, 161

Senator Collins .............................................................................................. 5, 165

Senator Lieberman (ex officio) ..................................................................... 9, 167

Senator Thompson (ex officio) ......................................................................... 11

Senator Bunning ............................................................................................... 12

Senator Carper ................................................................................................. 23

Senator Fitzgerald....................................................................................... 45, 195

Senator Cleland ................................................................................................ 49

Senator Dayton ................................................................................................. 169

Senator Durbin ................................................................................................. 199

WITNESSES

TUESDAY, JULY 23, 2002

Robert L. Roach, Counsel and Chief Investigator, Permanent Subcommittee

on Investigations; accompanied by Gary M. Brown, Special Counsel, Committee on Governmental Affairs ......................................................................... 14

Lynn E. Turner, former Chief Accountant, Securities & Exchange Commission, Broomfield, Colorado ................................................................................... 26

Pamela M. Stumpp, Managing Director, Chief Credit Officer, Corporate Finance Group, Moody’s Investors Service, New York, New York; accompanied

by John C. Diaz, Managing Director, Power & Energy Group, Moody’s

Investors Service, New York, New York ............................................................ 29

Ronald M. Barone, Managing Director, Utilities, Energy & Project Finance

Group, Corporate and Government Ratings, Standard & Poor’s, New York,

New York; accompanied by Nik Khakee, Director, Structured Finance

Group, Standard & Poor’s, New York, New York ............................................. 31

Jeffrey W. Dellapina, Managing Director, JPMorgan Chase Bank, New York,

New York; accompanied by Donald H. McCree, Managing Director, J.P.

Morgan Securities, Inc., New York, New York; and Robert W. Traband,

Vice President, JPMorgan Chase Bank, Houston, Texas ................................. 58

David C. Bushnell, Managing Director, Global Risk Management, Citigroup/

Salomon Smith Barney, New York, New York .................................................. 92

Richard Caplan, Managing Director and Co-Head, Credit Derivatives Group,

Salomon Smith Barney North American Credit/Citigroup, New York, New

York ....................................................................................................................... 94

Maureen Hendricks, Senior Advisory Director, Salomon Smith Barney/

Citigroup, New York, New York ......................................................................... 96

James F. Reilly, Jr., Managing Director, Global Power & Energy Group,

Salomon Smith Barney/Citigroup ....................................................................... 97

TUESDAY, JULY 30, 2002

Robert Furst, former Managing Director, Merrill Lynch & Co., Dallas, Texas .. 171

Schuyler Tilney, Managing Director, Global Energy & Power, Global Markets

& Investment Banking, Merrill Lynch & Co., Houston, Texas ........................ 172

G. Kelly Martin, Senior Vice President and President of International Private

Client Division, Merrill Lynch & Co., New York, New York ............................ 173

Page

IV

ALPHABETICAL LIST OF WITNESSES

Barone, Ronald M.:

Testimony .......................................................................................................... 31

Prepared statement with attachments ........................................................... 282

Brown, Gary M.:

Testimony .......................................................................................................... 14

Bushnell, David C.:

Testimony .......................................................................................................... 92

Prepared statement .......................................................................................... 316

Caplan, Richard:

Testimony .......................................................................................................... 94

Prepared statement .......................................................................................... 323

Dellapina, Jeffrey W.:

Testimony .......................................................................................................... 58

Prepared statement .......................................................................................... 312

Diaz, John C.:

Testimony .......................................................................................................... 29

Prepared statement with an attachment ....................................................... 278

Furst, Robert:

Testimony .......................................................................................................... 171

Prepared statement .......................................................................................... 337

Hendricks, Maureen:

Testimony .......................................................................................................... 96

Prepared statement .......................................................................................... 330

Khakee, Nik:

Testimony .......................................................................................................... 31

Prepared statement .......................................................................................... 282

Martin, G. Kelly:

Testimony .......................................................................................................... 173

Prepared statement .......................................................................................... 339

McCree, Donald H.:

Testimony .......................................................................................................... 58

Prepared statement .......................................................................................... 312

Reilly, James F., Jr.:

Testimony .......................................................................................................... 97

Prepared statement .......................................................................................... 334

Roach, Robert L.:

Testimony .......................................................................................................... 14

Prepared statement with attachments ........................................................... 215

Stumpp, Pamela M.:

Testimony .......................................................................................................... 29

Prepared statement with an attachment ....................................................... 278

Tilney, Schuyler:

Testimony .......................................................................................................... 172

Prepared statement .......................................................................................... 338

Traband, Robert W.:

Testimony .......................................................................................................... 58

Prepared statement .......................................................................................... 312

Turner, Lynn E.:

Testimony .......................................................................................................... 26

Prepared statement .......................................................................................... 265

(V)

EXHIBITS

Page

VOLUME 1

Exhibits for July 23, 2002

101. Enron Prepays, chart prepared by the Permanent Subcommittee on Investigations ..................................................................................................... 351

102. Financial Institution Knowledge of Enron Prepays, chart prepared by

the Permanent Subcommittee on Investigations ......................................... 352

103. Finance Related Asset Sales, Prepays and 125 Sales ($MM) (Source:

August 2001, Enron Corp. Finance Committee Presentation.) ................... 353

ASF—Detail on Prepays, chart prepared by Enron Corp. ........................... 354

104. Impact On Year 2000 Enron Credit Ratios from 1) Adding Outstanding

Prepays to Debt, and 2) Deducting Prepays from ‘‘Funds Flow From

Operations,’’ chart prepared by the Permanent Subcommittee on Investigations ........................................................................................................... 355

Impact On October 2001 Enron Valuation from Adding Outstanding

Prepays to Debt, chart prepared by the Permanent Subcommittee on

Investigations .................................................................................................. 356

105. Chase/Mahonia, chart prepared by the Permanent Subcommittee on

Investigations .................................................................................................. 357

106. Chase/Mahonia Collapsed into Loan, chart prepared by the Permanent

Subcommittee on Investigations .................................................................... 358

107. Yosemite I (Citigroup), chart prepared by the Permanent Subcommittee

on Investigations ............................................................................................. 359

108. Yosemite I (Citigroup) Collapsed into Loan, chart prepared by the Permanent Subcommittee on Investigations ...................................................... 360

109. Enron Corp. Bank Presentation, November 19, 2001, Waldorf Astoria,

New York, NY, Debt Issues: Commodity Transactions with Financial

Institutions, ..................................................................................................... 361

110. Project 10, Due Diligence Findings, November 7, 2001, Prepays, prepared

by Citigroup ..................................................................................................... 363

111. What Are Prepays? Why Does Enron Enter Into Prepays?, presentation

charts prepared by Enron Corp. .................................................................... 365

112. Prepaid Transactions Discussion, presentation materials prepared by

Arthur Andersen ............................................................................................. 367

113. Prepay Transaction, memo prepared for Enron Corp. by Arthur Andersen, June 1999 ................................................................................................ 375

114. Andersen email, December 1998, re: Cash vehicles ..................................... 379

115. Why Enron Prepays Were Sham Transactions, chart prepared by the

Permanent Subcommittee on Investigations ................................................ 380

116. Enron Corp. Credit Conference, Credit Profile, January 29, 2000, presentation charts prepared by Enron Corp. ......................................................... 381

117. The Ownership of Mahonia Limited, chart provided by JPMorgan Chase 393

118. Correspondence between Mourant du Feu & Jeune (‘‘Mourant’’) and

Jersey Financial Regulators, re: establishment of Mahonia; and Jersey

incorporation documents ................................................................................ 394

119. Mourant email, November 2001, re: Mahonia et al—Enron trades ........... 410

120. Mourant—JPMorgan Chase email, March 2002, re: mahonia pipeline

imbalances ....................................................................................................... 411

121. JPMorgan Chase email, July 2002, re: Restructuring existing prepays ..... 412

122. Mourant—JPMorgan Chase email, September 2001, re: Prepay Docs ....... 413

123. JPMorgan Chase email, November 1998, re: Pre-pays ................................ 414

124. JPMorgan Chase email, June 1998, re: Enron Forward Sale Transaction ............................................................................................................... 415

125. JPMorgan Chase call memo, June 1999, re: RED ALERT ......................... 416

Page

VI

126. JPMorgan Chase email, June 1999, re: Enron (. . . the business purpose

underpinning the current $500MM prepay exercise is simply that of

efficiently priced funding.) .............................................................................. 417

127. JPMorgan Chase email, May 2000, re: Enron (. . . pricing of an amortizing swap.) .................................................................................................... 418

128. JPMorgan Chase email, July 1998, attaching copy of Prepay pitch presentation ............................................................................................................ 419

129. JPMorgan Chase email, December 2000, attaching Description of Enron

Prepay Transaction ......................................................................................... 433

130. Enron Corp. email, September 2001, re: Chase Prepay (We need your

help to come up with a custom amortization schedule/volume schedule

that looks like a ‘‘normal commodity swap.’’) ............................................... 435

131. Enron Corp.-JPMorgan Chase email, September 2001, re: Prepay with

copy of Chase $350 Million Prepay diagram ................................................ 436

132. JPMorgan Chase email, October 2001, re: Enron ($5B in prepays!) .......... 438

133. JPMorgan Chase email, November 2001, re: Enron Exposure ................... 439

134. Correspondence from JPMorgan Chase to the Permanent Subcommittee

on Investigations, dated July 18, 2002, regarding names of J.P. Morgan

Chase & Co. clients and counterparties that engaged in commodity

prepaid forward transactions with a special purpose vehicle ..................... 441

135. Security Agreement between Mahonia Limited and The Chase Manhattan

Bank, December 1997 ..................................................................................... 442

136. Excerpts of Enron Corp 10K for 2000 ........................................................... 465

137. JPMorgan Chase email, November 2000, re: Call Report for Enron North

America Corporation ....................................................................................... 474

138. Structuring Summary, Enron Corp.—1996 Prepay ..................................... 476

139. Structuring Summary, Enron Corp.—1997 Prepay ..................................... 482

140. Structuring Summary, Enron Corp.—1998 Prepay ..................................... 490

141. JPMorgan Chase, October 1997, re: Enron Exposure $350MM Prepaid. ... 491

142. JPMorgan Chase email, December 2000, re: Enron Prepay Transaction

(. . . need to form Mahonia III . . .) ............................................................ 492

143. Correspondence from JPMorgan Chase to four Members of the U.S.

House of Representatives, dated March 27, 2002, regarding Enron and

Mahonia ........................................................................................................... 493

144. Global Loans Approval Memorandum, December 21, 1998, prepared by

Citicorp ............................................................................................................ 513

145. Citigroup email, September 2000, re: My take on how to explain ECLN .. 523

146. Citibank presentation, Enron: Yosemite funded prepaid ............................ 524

147. Enron Interoffice Memorandum from Tax Planning Department, January 10, 2000, re: Yosemite I Withholding ...................................................... 529

148. Walk Through of Prepay, charts prepared by Enron Corp. ......................... 537

149. Yosemite Funds Flow Diagram, chart prepared by Enron Corp. ................ 543

150. Facsimile from Maples and Calder to Citibank, dated November 2, 1999,

re: Delta Energy Corporation (the ‘‘Company’’) ............................................ 544

151. New Account Information, Delta Energy Corporation, September 1994,

prepared by Citicorp ....................................................................................... 545

152. Correspondence from The Givens Hall Bank to Citibank, N.A., February

1999, re: Delta Energy Corporation and Vega Energy Corporation fee

notes ................................................................................................................. 548

153. Delta Energy Corporation Resolutions, June 26, 2001 ................................ 550

154. Citibank email, May 2001, re: prepaid script between Citibank/Enron/

Delta ................................................................................................................. 552

155. Global Loans Approval Memorandum, September 19, 1999, prepared

by Citibank (Truman) ..................................................................................... 553

156. Enron Corp. email, November 2001, re: an investor spoke to someone

at citi and received info on delta. . . . We need to shut this down. ............ 559

157. Yosemite Update; Optional Use as Prepay Funding Vehicle, Enron presentation charts ................................................................................................ 562

158. ‘‘Credit-Linked Notices (‘CLNs’),’’ May 2001, Derivatives Capital Markets,

Citibank/Salomon Smith Barney presentation ............................................. 564

159. Yosemite, Issues/Timeline, chart prepared by Enron Corp. ........................ 580

160. Citibank Memorandum to Project Yosemite Working Group, February

1999, re: Initial thoughts on structures ......................................................... 581

161. Citigroup, Inc. list of clients or counterparties that engaged in prepaid forward transactions with a special purpose vehicle ........................... 582

162. Citigroup, Inc. email, April 1999, re: Enron/Project Roosevelt ................... 584

Page

VII

163. Citigroup email, April 1999, re: Enron/Consent to Amendment to Roosevelt Transaction .............................................................................................. 586

164. Global Loans Short Form Approval Memorandum, April 26, 1999, prepared by Citibank (Roosevelt). ....................................................................... 588

165. Citigroup email, April 1999, re: Enron/Roosevelt Update .......................... 591

166. Salomon Smith Barney Presentation to Enron on Capitalization, September 20, 1999 .............................................................................................. 592

167. Salomon Smith Barney High Yield Commitment Committee Memorandum, April 2001, Enron—$1 Billion—Credit Linked Note .................... 603

168. Salomon Smith Barney Investment Grade Commitment Committee—

New York Memorandum, April 2001, ECLN II ........................................... 604

169. Salomon Smith Barney Investment Grade Commitment Committee—

Europe Memorandum, November 1999, Yosemite II ................................... 611

170. Salomon Smith Barney Investment Grade Commitment Committee—

New York, October 1999, Yosemite I ............................................................ 619

171. Salomon Smith Barney Investment Grade Commitment Committee—

New York, August 2000, Yosemite III, CLN I .............................................. 629

172. Citigroup email, September 2001, re: Enron (. . . better breakdown of

where they make their money . . .) ............................................................... 636

173. Yosemite Securities Trust I, Supplement (to Offering Memorandum dated

November 4, 1999) .......................................................................................... 637

174. Enron Corp. 10-Q, June 30, 1999 .................................................................. 644

175. Citicorp email, October 2001, re: Enron (‘‘relationship’’) ............................. 651

176. Yosemite Securities Trust I Financing, December 22, 1999–2000, chart

provided by Enron Corp. ................................................................................ 653

177. Citigroup email, June 2001, re: Prepaid Overview, attaching chart, Summary of Pre-Paid Accounting and Tax .......................................................... 654

178. Citigroup email, April 2001, re: Enron Credit Approval ............................. 656

179. Citigroup email, October 2001, re: Enron (. . . do we have incremental

debt capacity . . .) .......................................................................................... 657

180. Citigroup email, November 1999, re: Yosemite II (Europe) (. . . I have

been encouraged, from a risk point of view, to try to stay in compliance

in the near term;) ............................................................................................ 658

181. Citigroup email, November 1999, re: Yosemite II (Europe) (. . . we still

have an exposure issue . . . limits are limits . . .) ...................................... 660

182. Citigroup email, September 1999, re: Yosemite (. . . terminate the price

risk . . .) .......................................................................................................... 662

183. Citigroup email, August 2000, re: Citibank and Delta relationship (. . .

Delta is not controlled by Enron, . . . Citi had it set up several years

ago.) .................................................................................................................. 664

184. Transcripts of JPMorgan Chase audio tapes:

a. Transcripts of JPMorgan Chase audio tapes dated September 13,

September 20, and October 3, 2001 .......................................................... 665

b. JPMorgan Chase audio tapes dated September 13, September 20,

and October 3, 2001 ................................................................................... *

c. Transcripts of selected JPMorgan Chase audio tapes ............................. 668

d. Transcripts of selected JPMorgan Chase audio tapes ............................. *

185. Additional JPMorgan Chase/Enron Corp. Documents in Support of July

23, 2002, Testimony (and Appendices) of Robert Roach, Chief Investigator, Permanent Subcommittee on Investigations:

a. The Chase Manhattan Bank Facsimile, October 1996, re: Enron 96—

4 Term Sheets, Draft sheets for prepaid sale options 2001 .................... 979

b. Documents related to fees paid Mourant, Mahonia and JPMorgan

Chase in relation to prepay transactions:

1. Letter from Mourant & Co. to Chase Investment Bank Limited

regarding fees due to Mahonia Limited for its participation in

the ‘‘Enron V’’ (Prepay) transaction, December 1996 ....................... 984

2. Fee Letter from JPMorgan Chase to Enron North America Corp.,

September 2001 ................................................................................... 985

3. Mourant & Co. invoice sent to The Chase Manhattan Bank for

reimbursement of expenses related to Mahonia Limited, October

2001 ...................................................................................................... 986

c. JPMorgan Chase email, December 1996, re: Enron Natural Gas Marketing (Mahonia Limited) ........................................................................... 987

d. JPMorgan Chase email, November 1997, re: Heads-Up memo; Upsize

to previously approved Enron Prepay ....................................................... 988

Page

VIII

e. JPMorgan Chase Memorandum, September 1998, re: Enron Prepays

(1996 & 1997). Includes detail on use of surety bonds to provide

credit enhancement for prepay structures ............................................... 989

f. Enron Corp.-JPMorgan Chase email, June 2000, re: June 2000 gas

prepay. Includes detail on pricing methodology for prepay transactions .......................................................................................................... 991

g. JPMorgan Chase-Mourant email, June 2000, re: Enron-MahoniaChase Transaction. Includes instructions from JPMorgan Chase attorney that documents are acceptable and may be executed by Mahonia . 992

h. Mourant-JPMorgan Chase email, September 2000, re: Mahonia Limited. Includes detail on fee arrangement for certain prepays ................. 993

i. JPMorgan Chase email, November 2000, re: Call Report for ENRON

NORTH AMERICA CORPORATIO (sic) ................................................... 999

j. JPMorgan Chase email, December 2000, re: Prepay Update #2 12/18 .. 1001

k. JPMorgan Chase email, September 2001, re: Enron Prepay (. . .

clearly they will take any money they can get now . . .) ......................... 1002

l. Documents related to Arthur Andersen’s request to Enron Corp. for

representations as to the nature of the relationship between Mahonia

and JPMorgan Chase:

1. Enron Corp. email, September 2001, re: Rep Letter for Mahonia ... 1003

2. Letter from Enron Corp. to Mahonia Limited, September 2001 ..... 1005

3. Letter from Mahonia Limited to Arthur Andersen LLP, September 2001 ......................................................................................... 1006

m. Letter from Mahonia Limited to The Chase Manhattan Bank, September 2001, re: Mahonia’s appointment of JPMorgan Chase as its

agent ........................................................................................................... 1007

n. Mourant-JPMorgan Chase email, October 2001, Fwd: Enron Swap

Transaction. Includes attached Mourant-JPMorgan Chase emails

from December 2000-September 2001 ...................................................... 1009

o. Amended Complaint, United States District Court, Southern District

of New York. JPMorgan Chase Bank, Plaintiff, against Liberty Mutual Insurance Company, et al., Defendants, June 2000, with attachments ........................................................................................................... 1016

p. Letters between JPMorgan Chase and the Permanent Subcommittee

on Investigations, July 2002, re: details of prepay transactions between JPMorgan Chase and Enron Corp. ................................................ 1087

q. Letter from JPMorgan Chase to the Permanent Subcommittee on

Investigations, July 2002, re: names of JPMorgan Chase’s clients

or counterparties, in addition to Enron, that engaged in prepaid forward transactions with a special purpose vehicle (‘‘SPV’’) ..................... 1099

r. Letters between JPMorgan Chase and the Permanent Subcommittee

on Investigations, July 2002, re: relationship and dealings of

JPMorgan Chase to Mahonia Limited ...................................................... 1100

s. Facsimile from JPMorgan Chase to the Permanent Subcommittee on

Investigations, April 2002, re: JPMorgan Chase/Enron transactions

and fees ........................................................................................................ 1111

186. Additional Citigroup/Enron Corp. Documents in Support of July 23,

2002, Testimony (and Appendices) of Robert Roach, Chief Investigator,

Permanent Subcommittee on Investigations:

a. Global Loans Approval Memorandum, October 19, 1999, prepared

by Citibank (Yosemite I) ............................................................................ 1122

b. Enron Corp. Finance Committee Meeting, August 13, 2001, Chief

Financial Officer Report, Interest Rate Exposure, Finance Related

Asset Sales, Outstanding Financings and Debt, ASF-Detail on Outstanding Fundings, and ASF-Detail on Prepays ..................................... 1131

c. Enron presentation charts, Yosemite Update, Evolution, of Yosemite,

Optional Use as Prepay Funding Vehicle, Yosemite Cost Analysis,

Yosemite Prepay Analysis, and Conclusions & Recommendations ......... 1139

d. Enron Corp. documents on details of Yosemite/ECLN structures ......... 1152

e. Enron Corp. charts, What are Prepays, Why Does Enron Enter into

Prepays, Actual Prepay Synopsis Overview, Actual Prepay Synopsis ..... 1166

f. Citigroup email, November 1999, re: Yosemite II (Europe) ..................... 1170

g. Facsimile from Maples and Calder to Schroders, September 2001,

re: Delta Energy Corporation ..................................................................... 1182

h. Facsimile from Maples and Calder to Milbank Tweed, Hadley &

McCloy, November 1999, re: Delta Energy Corporation (the ‘‘Company’’) .......................................................................................................... 1184

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i. Enron Corp. email, June 2001, re: Delta Letter, attaching . . . sample

letter with the representations that Andersen would like Delta to confirm. .............................................................................................................. 1187

j. Facsimile, re: remittance of funds to Bank of Bermuda and payment

instructions for the account of Schroder Cayman Bank and Trust

Company Limited, Reference to Delta Energy Corporation ...................... 1189

k. Correspondence from The Givens Hall Bank to Citibank, N.A., February 1999, re: Delta Energy Corporation and Vega Energy Corporation fee notes ............................................................................................... 1191

l. Enron/Delta Swap Confirmation; Enron/Citibank Swap Confirmation; and Delta/Citibank Swap Confirmation, all dated December 22,

1999 .............................................................................................................. 1194

m. Enron/Delta Swap Confirmation and Citibank/EnronSwap Confirmation Drafts, dated November 2, 1999 ............................................. 1231

n. Citigroup email, November 2001, re: Citibank Unwind Amounts ......... 1251

o. Citigroup email, December 2001, re: Ene [Enron] (Want to make sure

swaps are terminated first thing and that delta terminates simultaneously so that we don’t have any mismatch.) .......................................... 1253

p. Correspondence from Citigroup to the Permanent Subcommittee on

Investigations, dated May 2, 2002, regarding Citigroup/Enron transactions and fees .......................................................................................... 1254

q. Enron Corp. Project Yosemite, January 1999 presentation .................... 1263

r. Report of Independent Public Accountants, To the Trustholders of Yosemite Securities Trust I, April 2001, draft financial statements and

notes for 2000 and 1999 ............................................................................. 1276

s. Yosemite Securities Trust Ltd., Notes to Financial Statements, December 31, 2000 ................................................................................................. 1284

t. Arthur Andersen LLP Memorandum, dated August 18, 2000, re:

$500,000,000 8% Enron Credit Linked Notes due 2005 Authorization

to Sign .......................................................................................................... 1287

u. Enron Corp. letter to Arthur Andersen LLP, dated August 25, 2000,

regarding Andersen’s ‘‘comfort’’ letter issued in connection with the

issue and sale of Enron Credit Linked Notes .......................................... 1288

187. Additional Documents Related to JPMorgan Chase Prepays:

a. JPMorgan Chase email, August 1996, re: Prepaid Forwards—Loans

Vs Derivatives (Please arrange to report the prepaid forwards as loans

effective as of August 31, 1996.) ................................................................ 1290

b. JPMorgan Chase email, September 1996, re: Loans/Borrowings Documented as Derivatives ................................................................................ 1294

c. JPMorgan Chase email, October 1997, re: Loans/Borrowings Documented as Derivatives ................................................................................. 1299

d. JPMorgan Chase email, October 1997, re: Sampoerna Deal (I understand the form of the transaction, rather than its economic substance,

will govern in this case.) ............................................................................ 1300

e. JPMorgan Chase email, November 1997, re: Loans/Borrowings Documented as Derivatives (Based on our discussions, it was concluded

that such transactions which are confirmed with the counterparty

as derivatives should be reported in Trading Assets/Liabilities—Risk

Management Instruments and marked to market.) .................................. 1303

f. JPMorgan Chase email, July 1999, re: DISGUISED LOANS (We are

making disguised loans, usually buried in commodities or equities

derivatives (and I’m sure in other areas).) ................................................. 1304

g. JPMorgan Chase email, June 1999, re: Prepaid Forwards (All of

us have been grappling for years with the issue of determining when

a structured transaction is more a kin to a loan or a derivative.

There are no easy answers.) ....................................................................... 1306

h. JPMorgan Chase Memorandum, August 1999, re: DBF’s (Loans disguised as derivatives are now known as Derivatives Based Funding.

(DBF’s)) ....................................................................................................... 1312

i. JPMorgan Chase email, March 2000, re: Accounting for Compound

Instruments .................................................................................................. 1317

j. JPMorgan Chase email, March 2000, re: Prepaid Forwards (Pat

O’Brien’s group has entirely dropped their proposal to change the accounting of Prepaid Forwards. This is good news.) .................................. 1319

k. JPMorgan Chase email, March 2000, re: Prepaid Forwards .................. 1321

Page

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l. JPMorgan Chase email, January 1999, re: Enron CLO Discussion

(Rating agency knowledge of existing deals. Some deals that are less

know (sic) to the agencies may come to light if they are placed in

newly formed rated vehicles. This could well cause some heartburn

for Enron) ..................................................................................................... 1323

m. JPMorgan Chase email, June 2000, re: Enron prepays ......................... 1326

n. JPMorgan Chase email, July 2000, re: Restructuring existing prepays 1328

o. JPMorgan Chase email, March 1998, re: Enron Natural Gas Marketing/Mahonia/Parco .............................................................................. 1330

p. JPMorgan Chase Memorandum, April 2002, re: PARCO Secured Loan

to Mahonia .................................................................................................. 1331

q. JPMorgan Chase email, November 2000, re: Call Report for Enron

North America Corporatio (sic) ................................................................. 1332

r. JPMorgan Chase email, December 2000, attaching JPMorgan Chase

Memorandum re: Project Mahonia—$330 Million Forward Sale Natural Gas Contract Enron Financing Objectives ........................................ 1338

s. JPMorgan Chase email, April 1999, re: Mahonia Ltd. ............................ 1340

t. Mourant email, November 1997, re: Mahoniia (sic) /New Enron

Transaction .................................................................................................. 1343

u. JPMorgan Chase-Mahonia correspondence, December 1992, attempting to identify a Jersey company to serve as SPC in prepay ................. 1344

v. Mahonia Limited, Minutes of the First Meeting of Board of Directors,

December 29, 1992 ..................................................................................... 1347

w. Mahonia Limited, Certificate of Incorporation (States of Jersey), December 1992 ............................................................................................... 1355

x. Mourant & Co.-Chase Investment Bank Limited correspondence, November 1993, attaching invoices for prepay transactions with Chase ... 1360

y. Mourant Memorandum, November 1995, re: Chase-Mahonia transaction ........................................................................................................... 1366

z. Mourant List of The Chase Manhattan Bank SPV Group (‘‘Stoneville’’

Companies) .................................................................................................. 1367

aa. The Chase Manhattan Bank description of ownership/purpose of

The Eastmoss Trust and Mahonia Limited ............................................ 1368

bb. The Chase Manhattan Bank-Mahonia Facsimile, December 2000,

re: Stoneville Aegean Board of Directors Minutes in connection with

Enron-Mahonia transaction ..................................................................... 1371

cc. Mourant & Co. Limited Annual Review on Mahonia Limited, ending

22/5/01 ...................................................................................................... 1379

dd. JPMorgan Chase-Enron email, September 2001, re: Rep Letter for

Mahonia .................................................................................................... 1384

ee. Mourant-Enron email, September 2001, re: Mahonia Confirm ............ 1386

ff. Mahonia Limited letter to Arthur Andersen LLP, September 2001,

re: representing the nature of Mahonia’s operations .............................. 1388

gg. Chase Memorandum, August 1996, re: list of Chase prepays .............. 1389

hh. Chase-Mahonia-Occidental Petroleum prepay ...................................... 1391

ii. Chase email, May 1999, re: accounting for Ocean Energy, Inc. prepay 1398

jj. Chase presentation, December 22, 1999, on Hunt Oil Company prepay ............................................................................................................... 1399

kk. JPMorgan Chase email, August 2000, re: Columbia Prepay, attaching copy of Columbia Energy Group Structuring Summary ................. 1414

ll. Chase correspondence to Michael Kopper, Director, Enron Capital

and Trade Resources, October 1994, re: Prepaid Crude Oil Forward

Sale .............................................................................................................. 1424

mm. Chase-Enron correspondence, May 1999, regarding Chase review

of Enron on and off-balance sheet capital structure ........................... 1431

nn. Chase presentation, Commodity Prepay Exposure Discussion, January 27, 2000 .............................................................................................. 1438

oo. Chase handwritten note, undated, re: Pre-paids (Mahonia lends

Enron $ in exchange for a promise that Enron will deliver . . .

to Mahonia) ............................................................................................... 1447

pp. Chase memorandum, December 2000, re: Project Mahonia—$330

Million Forward Sale Natural Gas Contract Enron Financing Objectives ........................................................................................................... 1448

qq. Fleet-Chase email, December 2000, re: Mahonia Forward Sale .......... 1453

rr. Chase email, February 2001, re: MTM for Prepays ............................... 1456

ss. Chase email, October 2001, re: Enron Prepaids ..................................... 1458

Page

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VOLUME 2

188. Additional Citigroup/Enron documents related to Projects ‘‘Roosevelt,’’

‘‘Truman,’’ and ‘‘Nixon’’:

a. Enron Corp. Facsimile to Citicorp, December 1998, re: Prepay structure .............................................................................................................. 1461

b. Citigroup email, December 1998, re: Call Report—Project Roosevelt

(Enron) ........................................................................................................ 1462

c. Citigroup Credit Memorandum (Enron), December 1998 (Roosevelt) .... 1466

d. Citigroup Facsimile, December 1998, Project Roosevelt, Overview of

Major Issues ................................................................................................ 1473

e. Citigroup Facsimile, December 1998, Project Roosevelt, Status Report . 1475

f. Citigroup Facsimile, December 1998, Enron—Project Roosevelt, Issues . 1478

g. CMAC Minutes, June 22, 1999, Prepaid Oil Transaction ....................... 1482

h. Citigroup email, September 1999, re: Enron-Roosevelt (. . . our expectation was now that the deal would not be repaid until December).

Our approval to extend deliveries was done verbally.) ............................ 1484

i. Enron Corp. email, November 1999, re: Truman financial prepay diagram, attaching Crude Prepay 9/29/99 (. . . TD [Toronto Dominion]

provides the commodity swap . . .) ........................................................... 1485

j. Enron Corp. email, November 1999, re: Y2 [Yosemite II] ....................... 1487

k. Global Loans Approval Memorandum, December 7, 1999, prepared

by Citibank (Nixon) .................................................................................... 1491

l. Citigroup email, December 1999, re: Yosemite 2—Interim Solution,

attaching Derivative Credit Form .............................................................. 1496

189. Additional Documents Related to Yosemite and Enron Credit Linked

Note (CLN) Transactions:

a. Yosemite and CLN Payment Structures ................................................... 1500

b. Project Yosemite, Enron Corp. presentation ............................................. 1501

c. Citigroup Transaction Memorandum, Enron: Project Yosemite, April

1999, (This purpose of this memorandum is to obtain preliminary

approval to seek a mandate to provide Enron’s top tier banks with

$500MM to $1,500MM of Enron default protection.) ............................... 1506

d. Citigroup email, August 1999, re: Rating Agency Discussions ............... 1511

e. Citigroup Transaction Memorandum, Project Yosemite, $[1.0] Billion

Credit Default Swap Structure Referencing Enron Corp., 10-21-99 ....... 1513

f. Salomon Smith Barney Interoffice Memorandum, October 26, 1999,

re: Follow-up to Yosemite CMAC meeting ................................................. 1519

g. Citigroup Memorandum, October 29, 1999, Yosemite Securities Trust

I, Linked Enron Obligations (LEOs), Frequently Asked Questions ........ 1523

h. Moody’s Investors Service letter to Yosemite Securities Trust I, November 18, 1999, re: $750,000,000 8.25% Series 1999-A Linked Enron

Obligations due 2004 ................................................................................. 1526

i. Standard & Poor’s letter to Solomon Smith Barney Inc., November

18, 1999, re: Yosemite Securities Trust I, $750,000,000 8.25% Series

1999-A Linked Enron Obligations (LEOs) due November 15, 2004 ........ 1527

j. Citigroup email, November 1999, re: Project Yosemite (. . . I am afraid

that if we ever had to defend this we would either (a) embarrass

the client or (b) lose the accounting argument.) ........................................ 1529

k. Citigroup email, November 1999, re: Enron—Various (Yosemite: . . .

A portion of the proceeds will be used to repay our Project Roosevelt

(Delta).) ....................................................................................................... 1532

l. Citigroup email, November 1999, re: Enron Credit (. . . I am not

willing to approve another incremental exposure on Enron, . . .) .......... 1533

m. Enron Debt Security [Series 1999-A], November 18, 1999 ..................... 1534

n. Citigroup email, November 1999, re: Enron-Yosemite II, Citigroup

purchase of Yosemite II certificates ......................................................... 1541

o. Citigroup email, December 1999, re: Enron Failure to Pay on Prepaid 1543

p. Citigroup Chart, Derivative Transactions Associated With The Yosemite Structure, January 2000 ....................................................................... 1545

q. Citibank Memorandum, March 29, 2000, re: Project Yosemite—Yosemite Co. Structured Credit Derivative Transaction .................................... 1546

r. Citigroup email, April 2000, re: Project Yosemite—Revenue Recognition ............................................................................................................... 1551

s. Citigroup email, April 2000, re: Enron ..................................................... 1556

t. Citigroup Memorandum, August 13, 2000, Enron Credit Linked Notes

Trust (‘‘Enron CLN’’), Frequently Asked Questions .................................. 1560

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XII

u. Citigroup Script document, undated, detailing Enron Credit Linked

Notes (CLN) Swaps .................................................................................... 1564

v. Citigroup email, October 2000, re: Enron Follow-up (Royal Bank of

Canada as holder of $50 million Enron Credit Linked Notes) ............... 1566

w. Citigroup email, October 2000, re: Enron Follow-up .............................. 1569

x. Citigroup email, October 2000, re: Enron Follow-up (. . . upon a

credit event we can legally deliver the prepaid swap to be used to

pay the noteholders.) ................................................................................... 1571

y. Citigroup email, October 2000, re: Enron (. . . we ended up consolidating the trust . . . and we treated the prepaid swaps as a loan

. . . for RBC purposes.) ............................................................................. 1574

z. Citigroup email, November 2000, re: Enron CLN Transaction—SFAS

133 Accounting for Prepaid Swaps ............................................................ 1575

aa. Citigroup Memorandum, May 2, 2001, Enron Credit Linked Notes

Trust II Senior Notes Offering (‘‘Enron CLN II’’), Frequently Asked

Questions ................................................................................................... 1579

bb. Solomon Smith Barney Memorandum, May 2, 2001, Enron Sterling

Credit Linked Notes Trust Senior Notes Offering (‘‘Enron CLN II’’),

Frequently Asked Questions ..................................................................... 1588

cc. Citigroup email, June 2001, re: Prepay Diagram, attaching chart,

$250 Million Prepay .................................................................................. 1593

dd. Citigroup email, June 2001, re: Enron (. . . there is an earnings

impact, except that it is neutralized by offsetting trades . . .) .............. 1595

ee. Enron Corp. Memorandum, September 20, 2001, re: Citibank/Delta

Prepay Transactions (. . . some concerns with respect to the structure

of the prepay transactions . . .) ............................................................... 1596

ff. Citigroup email, November 2001, re: ene [Enron] prepaid update (. . .

let enron out of paying half of the libor breakage (about 250k) on

the early termination of the prepaid. . . .) ............................................... 1597

gg. Enron email, December 2001, re: AXA Enron Credit Linked Note ...... 1598

hh. Citigroup email, November 2002, re: Enron II Documentation (CLN

II) ............................................................................................................... 1599

ii. Summary of Enron CLN Accounting Treatment ..................................... 1612

jj. Enron Credit Linked Notes Trust Certificates, SFAS 133 Fair Value

Hedge Documentation (Citibank/Royal Bank of Canada Total Return

Swap) ........................................................................................................... 1613

190. Additional Documents Related to Citigroup/Delta Relationship:

a. Milbank Tweed email, November 1999, re: Delta ................................... 1618

b. Delta Energy Corporation letter to Enron Corp., November 18, 1999,

representing the nature of Delta’s operations ......................................... 1622

c. Enron Corp. email, June 2001, re: Sample Swap Co Letter .................... 1623

d. Enron-Citigroup email, June 2001, re: Delta Letter ................................ 1624

e. Delta Energy Corporation letter to Enron Corp., June 2001, re: Delta

Energy Corporation .................................................................................... 1626

f. Citigroup email, June 2001, re: reps (lydia got on and stated that

the reps are facts that we believe are true, and the rationale for the

letter is to confirm that Delta is not a spv that needs to be consolidated

on the b/s) .................................................................................................... 1627

g. Citigroup email, August 2000, re: questions regarding Delta ................ 1628

h. Citigroup email, undated, re: Prepaid Transaction ................................. 1629

191. Additional Documents Related to Transfer of Yosemite Certificates to

Whitewing:

a. LJM, December 1999, Benefits to Enron Summary (At year-end 1999,

Enron sold LJM2 the equity in Yosemite structure.) ............................... 1630

b. SE Raptor L.P. Letter of Understanding to LJM2 Co-Investment, L.P.,

Attn: Andrew S. Fastow, December 30, 1999, re: . . . proposed acquisition by SE Raptor L.P. . . . of the Yosemite Certificates . . .............. 1631

c. LJM Approval Sheet, February 8, 2000, Deal Name: Yosemite .............. 1635

d. Enron Corp. Interoffice Memorandum, February 23, 2000, re: LJM2

Investment in Certificates of Beneficial Interest in Yosemite Securities

Trust I ......................................................................................................... 1638

e. Enron Global Finance email, February 2000, re: calculation (Yosemite

Certificates) ................................................................................................. 1639

f. Enron Corp. email, undated, re: Yosemite Certificates ............................ 1641

g. Wire Transfer Requests, February 28, 2000, re: SE Acquisition, L.P.,

LJM2 Co-Investment, L.P., Enron Corp. and Whitewing ........................ 1642

Page

XIII

h. Enron Corp. letter to LJM2 Co-Investment, L.P., Attn: Andrew S.

Fastow, March 8, 2000, (. . . Enron agrees to pay LMJ2 $100,000.) .... 1645

i. General Partner, LJM2 Co-Investment, L.P. draft letter to Limited

Partners, describing LJM2 purchase and sale of Yosemite Trust Certificates ......................................................................................................... 1646

j. Enron Corp., Yosemite Equity Sale Project ‘‘Yes’’, November 10, 2000 ... 1649

k. Enron Corp. Whitewing Investment Proposal, Yosemite Securities

Company Ltd, December 12, 2000 ............................................................ 1659

l. Dewey Ballantine LLP Memorandum, December 13, 2000, re: Osprey

Consent-Yosemite (Consent in connection with the Whitewing’s acquisition of Yosemite Trust Certificates) ........................................................ 1665

m. Enron Corp./Citigroup/Milbank email, February 2001, re: Yosemite

Securities Company Ltd. (Yosemite Certificate holders) ......................... 1673

n. Enron Corp. email, November 2001, attaching Yosemite I Transaction

and Credit and Subordination Agreement between SE Acquisition and

LJM2 ........................................................................................................... 1677

o. Citigroup email, December 2001, re: Ene [Enron] settlements ............... 1680

192. Additional Citigroup Documents:

a. Citibank/Solomon Smith Barney reprint of a December 6, 1999, Investment Dealers’ Digest regarding Enron/Yosemite .............................. 1681

b. Citigroup/GCIB Checkings on Michael Kopper/LJM .............................. 1682

c. Citigroup Internal Memorandum, January 24, 2001, re: Review of

LJM2 (Enron Fund) and Recommendations for LJM3 (. . . LJM2

principals argue that Enron would make the Fund whole should it

suffer losses because the vehicles that the Fund invest in are critically

important to Enron’s ability to manage its earnings.) ............................. 1683

d. Citigroup, Enron Credit Review, August 2001 ......................................... 1684

e. Presentation of Enron Corp., Direct and Indirect Liability Schedule,

October 24, 2001 ......................................................................................... 1692

f. Summary of Enron’s Capital Market Exposure with Citigroup, October

29, 2001 ........................................................................................................ 1704

g. Citigroup, Project 10, Due Diligence Findings [Enron], November 7,

2001 ............................................................................................................. 1706

h. Letters between Citigroup and the Permanent Subcommittee on Investigations, July 2002, regarding prepay transactions between

Citigroup and Enron Corp.; names of Citigroup’s clients or

counterparties, in addition to Enron, that engaged in prepaid forward

transactions with a special purpose vehicle (‘‘SPV’’); Citigroup’s relationship with Delta Energy Corporation, etc. .......................................... 1825

i. Letters between Citigroup and the Permanent Subcommittee on Investigations, July 2002, regarding Citigroup’s relationship with Delta

Energy Corporation ..................................................................................... 1841

j. Citigroup letter to the Permanent Subcommittee on Investigations,

August 7, 2002, regarding steps Citigroup is taking to ensure that

the balance sheet effect of structured financing is transparent to investors ................................................................................................................ 1850

193. Additional Enron Corp. Documents Related to Prepay Transactions:

a. Enron Capital & Trade Resources Interoffice Memorandum, August

1997, re: Prepaid Hydrocarbon Companies (The purpose of the Prepaid

Contract is to provide cash flow to Enron Corp. in order to meet

its cash flow objectives.) ............................................................................. 1853

b. Enron Corp Bank Presentation, November 19, 2001, Waldorf Astoria,

New York, New York, (selected pages of presentation) ........................... 1858

c. Enron prepay guarantee coverage, Off Balance Sheet Debt .................... 1930

d. Enron Surity Bonds Summary, March 10, 2002 ..................................... 1931

e. Enron Corp. Interoffice Memorandum, re: Enron Annual Reviews for

Doug McDowell, 1999 and 2000 ................................................................ 1932

f. Enron email, June 2001, re: Citibank Prepay, attaching presentation

entitled Enron North America, $250 Million Prepay ............................... 1941

g. Draft Enron Letter to Milbank, Tweed, January 2001, re: Tax Forms

and Administrative Matters for Delta Energy Corp. ................................ 1948

h. Enron Corp. Interoffice Memorandum, November 2001, re: $750 Million Yosemite Debt—Recourse v. Nonrecourse .......................................... 1949

i. Enron Corp. Letter to the Permanent Subcommittee on Investigations,

July 2002, re: accreditation records of Delta Energy and Mahonia ........ 1953

j. Enron Risk Assessment and Control Deal Approval Sheet, APEA Tax

Exempt Prepay, April 29, 1999 ................................................................... 1954

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XIV

k. Enron Corp. Memorandum, June 30, 1999, re: Federal Income Tax

Treatment of Prepayments ......................................................................... 1961

l. Enron Corp. (Tax Planning Department) Interoffice Memorandum,

April 2000, re: Yosemite I Withholding for Year 2000 ............................. 1974

m. Enron Corp. (Corporate Tax Planning Department) Interoffice Memorandum, April 2001, re: Enron Credit Linked Notes Due 2005 ............. 1976

n. Enron Corp. (Global Finance Tax Department) Interoffice Memorandum, November 2001, re: $750 Million Yosemite Debt—Recourse

v. Nonrecourse ............................................................................................ 1981

194. Documents Related to Additional Financial Institutions Involved in

Enron Corp. Prepays:

a. Credit Suisse First Boston email, December 2000, re: Prepaid Swap

(The net effect for ENE [Enron] is raising $150mm . . . and not

treated as debt. . . .) .................................................................................. 1985

b. Credit Suisse First Boston email, December 2000, re: URGENT/decision required-status on Eneron [sic] oil linked loan (I have raised

issues to date on reputational risk. . . .) .................................................. 1986

c. Credit Suisse First Boston email, December 2000, re: Enron-Prepaid

Oil Swap (Further, I want to clarify the reputational risk of this

transaction. . . .) ........................................................................................ 1987

d. Credit Suisse First Boston email, December 2000, re: docs/guarantee

approval (. . . DO NOT include any representations on accounting

driven transactions) .................................................................................... 1988

e. Credit Suisse First Boston email, September 2001, re: Enron Oil

Trade (. . . special request/favor from Ben [Glisan].) ............................. 1989

f. Credit Suisse First Boston email, September 2001, re: PLEASE CALL

ME IMMEDIATELY/ENRON-RELATED CREDIT ISSUE (. . . emergency request for a $150 million prepaid facility . . . in return for

the left pole position on a $1B benchmark bond deal. . . .) .................... 1990

g. Credit Suisse First Boston letter to the Permanent Subcommittee

on Investigations, April 24, 2002, regarding Enron-related transactions and fees involving Credit Suisse First Boston or Donaldson,

Lufkin & Jenrette Securities Corporation ................................................ 1991

h. Fleet Bank email, December 2000, attaching copy of Project Mahonia

Memorandum ............................................................................................. 2007

i. JPMorgan Chase email, December 2000, re: Fee Letter on December

2000 Prepay ................................................................................................. 2009

j. Enron Corp. email, July 2001, attaching copy of Project Camelot

(Barclays) presentation ............................................................................... 2013

k. Enron Corp., EGM Inventory Financing, August 2001, Transaction

Structure, (EGM sells inventory to SwapCo (a third party entity controlled by but NOT affiliated to Barclays . . .) ....................................... 2019

l. Sullivan & Cromwell (on behalf of Barclays Capital) letters to the

Permanent Subcommittee on Investigations, May and November,

2002, attaching list of transactions involving Barclays Capital and

Enron Corp. and its affiliates ..................................................................... 2023

195. The Wall Street Journal Editorial, July 29, 2002, Enron’s Enablers ......... 2043

196. Clarifications for the record of Mr. John C. Diaz and Ms. Pamela M.

Stumpps, Moody’s Investors Service, dated August 15, 2002 ..................... 2044

Exhibits for July 30, 2002

201. What Merrill Knew, chart prepared by the Permanent Subcommittee

on Investigations ............................................................................................. 2046

202. Nigerian Barge Chronology, prepared by the Permanent Subcommittee

on Investigations ............................................................................................. 2047

203. a. Nigerian Barge Transaction, chart prepared by the Permanent Subcommittee on Investigations ...................................................................... 2049

b. Nigerian Barge Transaction, Enron Guarantee/LJM2’s Purchase,

chart prepared by the Permanent Subcommittee on Investigations ...... 2050

204. a. Factors Leading to Non-Recognition of Revenue in a Sales Transaction

Under Generally Accepted Accounting Principles, chart prepared by

the Permanent Subcommittee on Investigations ..................................... 2051

b. How Nigerian Barge Deal Failed to Meet Generally Accepted Accounting Principles, chart prepared by the Permanent Subcommittee on

Investigations ............................................................................................. 2052

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XV

205. Merrill Lynch Analysts’ Relationship With Enron And Impact On Fees,

chart prepared by the Permanent Subcommittee on Investigations .......... 2053

206. a. Transcript of excepts from a videotaped presentation about LJM2

made by Andrew S. Fastow and Michael J. Kopper of Enron Corporation on or about September 16, 1999, for Merrill Lynch’s Private

Equity Group representatives ................................................................... 2054

b. Videotape of excepts from a videotaped presentation about LJM2

made by Andrew S. Fastow and Michael J. Kopper of Enron Corporation on or about September 16, 1999, for Merrill Lynch’s Private

Equity Group representatives. .................................................................. *

c. Full videotaped presentation about LJM2 made by Andrew S. Fastow

and Michael J. Kopper of Enron Corporation on or about September

16, 1999, for Merrill Lynch’s Private Equity Group representatives ..... *

207. Merrill Lynch Appropriation Request Cover Page for Enron Nigerian

Barge Equity, 1999 ......................................................................................... 2059

208. Merrill Lynch Interoffice Memorandum, December 1999, re: Enron Corp.

(Jeff McMahon, EVP and Treasurer of Enron Corp. has asked ML to

purchase $7MM of equity. . . .), with attached Nigeria Barge Project

Sell Down ........................................................................................................ 2064

209. Merrill Lynch email, January 2002, attaching Americas Credit Flash

Report: Week ending 12/23/99 and 12/17/99 ............................................. 2068

210. Draft Merrill Lynch Agreement Letter to Jeff McMahon of Enron Corp.,

December 23, 1999, re: Enron Nigeria Barge Ltd. ....................................... 2071

211. Merrill Lynch Agreement Letter to Andrew S. Fastow of Enron Corp.,

December 29, 1999, re: Enron Nigeria Barge Ltd. ....................................... 2074

212. Preliminary Information Memorandum re: Enron Nigeria Barge Ltd.,

December 1999, with handwritten notes, . . . reputational risks i.e. aid/

abet Enron income stmt. manipulation ......................................................... 2079

213. Notes of Paul J. Wood, Director of Corporate Credit, Merrill Lynch,

re: Nigerian Barge Equity (Brown hates deal) ............................................. 2105

214. Limited Liability Company Agreement of Ebarge, LLC, dated December

29, 1999 ........................................................................................................... 2107

215. Share Transfer Forms from Enron Nigeria Barge Limited to Ebarge,

LLC, dated December 30, 1999 ..................................................................... 2114

216. a. Enron Nigeria Power Holding, Ltd. and Ebarge, LLC, Loan Agreement, dated December 29, 1999 ................................................................ 2117

b. Enron Nigeria Barge Holding Ltd. and Ebarge, LLC and Enron Nigeria Barge Ltd., Shareholders’ Agreement, dated December 29, 1999 ..... 2136

217. Benefits to Enron Summary, Deal Name: Bargeco, 6/29/00 (. . . promising that Merrill would be taken out by sale to another investor by

June, 2000.) ..................................................................................................... 2157

218. Merrill Lynch email, June 2000, re: Ebarge LLC (. . . getting questions

concerning Ebarge, LLC. It was our understanding that Merrill Lynch

IBK positions would be repaid its equity investment as well as a return

on its equity by this date. Is this on schedule to occur?) .............................. 2158

219. Merrill Lynch email, June 2000, re: Ebarge Letter-Enron, attaching draft

letter to Enron Corp. from Merrill (Enron has agreed to purchase the

shares from Ebarge by June 30, 2000) .......................................................... 2159

220. Merrill Lynch email, January 2002, re: eBarge (. . . the arrangement

called from them to pay interest of 15% per annum on such investment.) . 2161

221. Merrill Lynch email, May 2000, re: Ebarge LLC (. . . calculation of

the income accrual for Ebarge LLC. . . .) .................................................... 2163

222. Share Purchase Agreement between LJM2-Ebarge, LLC and ML IBK

Positions, Inc., dated June 29, 2000 .............................................................. 2164

223. Merrill Lynch email, January 2002, re: Ebarge LLC confirmation of

15% equity return rate. (. . . could not locate anything on the 15%

equity return.) .................................................................................................. 2173

224. Merrill Lynch email, January 2002, re: Ebarge (What happened is 15%

or $525,000 was the equity return. . . .) ....................................................... 2174

225. Merrill Lynch email, January 2002, re: Ebarge (the interest on the loan

was to be paid by Enron. . . .) ...................................................................... 2175

226. Merrill Lynch email, January 2002, re: Ebarge LLC (Poor poor Kira

and Joe!!!!) ...................................................................................................... 2176

227. a. Merrill Lynch LJM2 Investment Summary (Ebarge LLC), June 2000 .. 2177

b. Enron Risk Assessment And Control Deal Approval Sheet on Nigeria

Power Holding, Ltd. Divestiture, dated November 2000 ......................... 2182

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XVI

228. Notes of Kevin Jordan, Enron Accountant, re: Nigerian Barge transaction ............................................................................................................... 2191

229. Merrill Lynch email, June 2000, re: Ebarge and LJM2 (It appears that

the way we are getting out of the Enron investment on MLIBK Positions

books ($7.0m + interest) is having LJM2 Co-Investment LP buy us out

through LP Capital Calls, in which MLIBK is also a limited partner.) ..... 2192

230. Timeline of Pertinent Information, Ebarge, LLC ......................................... 2193

231. Summary of Merrill Lynch Enron-Related Investment Banking Compensation (By Business Segment), chart prepared by Merrill Lynch .......... 2194

232. Merrill Lynch email, June 2000, re: LJM2 (The Committee (Debt Markets Commitment Committee) is being asked to consider $10MM share

of a $65MM 364-day liquidity facility for the LJM2 Co-Investment LP.

. . . Please respond with your Yes/No vote at your earliest convenience).

Follow-up Merrill Lynch email ...................................................................... 2195

233. Merrill Lynch Interoffice Memorandum, July 2000, re: Request for an

Exception to Policy for a $10MM Loan commitment to LJM II .................. 2200

234. Merrill Lynch email, November 2001, re: LJM—updated summary (They

all committed to this loan, as did we, because of the Andy Fastow/

Enron relationship. . . .) ................................................................................ 2201

235. Merrill Lynch Interoffice Memorandum, February 2001, re: Enron (ML

recently lost the mandate to underwrite $1.25 billion of zero coupon

convertible debt because Enron does not believe ML is a financial partner. . . . Merrill Lynch has decided to help Enron underwrite and syndicate these types of deals.) ............................................................................ 2202

236. Merrill Lynch email, July 2001, re: Enron—rawhide (I just heard back

from James and he told me that Enron will definitely not tie our loss

to new business.) ............................................................................................. 2203

237. Merrill Lynch email, July 2001, re: LJM2/Enron (. . . we took a substantial P/L hit for selling Zephyrus, not something we want to repeat.

. . .) ................................................................................................................. 2204

238. Merrill Lynch email, December 2001, re: Structured loan transactions

(. . . a snapshot of the structured loans in the portfolio are as follows.

. . .) ................................................................................................................. 2205

239. Merrill Lynch Interoffice Memorandum, April 1998, re: Enron Common

Stock Offering, Background, Merrill Lynch’s analyst relationship with

Enron ............................................................................................................... 2206

240. Merrill Lynch email, January 1999, re: Enron Account Update (. . .

regarding our difficult relationship in Research . . . two significant

mandates by Enron.) ....................................................................................... 2209

241. Merrill Lynch email, February 1999, re: Enron Mandate/Lay Letter

(. . . it might be appropriate for you to send a note to Ken Lay at

Enron thanking him for a recent mandate to serve as a co-manager

on a 12 million share common stock offering ($775MM).) ........................... 2210

242. Merrill Lynch Interoffice Memorandum, December 1998, re: Andy

Fastow (SVP & CFO of Enron) visit on December 4th) ............................... 2211

243. Merrill Lynch Calling List for the Enron Corp. common stock offering,

dated April 28, 30, and May 4, 1998 ............................................................. 2212

244. Merrill Lynch Interoffice Memorandum, March 2001, re: $40.0 million

participation request from Enron Corp. . . . in funding a five-year Senior

Secured Credit Facility for Zephyrus Investments, LLC .............................. 2225

245. Commitment Committee Information, Zephyrus Investments, LLC/Enron

Corp., March 2001 .......................................................................................... 2233

246. Merrill Lynch Interoffice Memoranda, October 1999, re: Skilling (Enron)

Questions on LJM2 ......................................................................................... 2235

247. Merrill Lynch LMJ2 Co-Investment LP, Fee Calculation ............................ 2237

248. Merrill Lynch email, November 2001, re: LMJ2, attaching Investor Status Summary, as of 9/30/01 ............................................................................ 2238

249. Merrill Lynch LJM2 Co-Investment, L.P., Private Placement Memorandum ............................................................................................................ 2240

250. LJM2 Co-Investment, L.P., Limited Partner Groups ................................... 2289

251. LJM2 Co-Investment, L.P., Schedule II, Information Regarding Limited

Partners, As of November 12, 2001 ................................................................ 2292

252. LJM Investments, Annual Partnership Meeting, October 26, 2000, presentation ............................................................................................................ 2293

253. Merrill Lynch LJM3 Appropriation Request ................................................ 2337

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254. Merrill Lynch email, November 2000, re: ML investment in LJM III

(. . . there will probably be substantial interest in re-doing the employee

vehicle early next year.) .................................................................................. 2340

255. Merrill Lynch email, December 2001, re: ML/LJM2 Co-Investment, L.P.

Capital Call ($140K Commit) (YOU MUST BE JOKING. . . .) ................ 2342

256. Merrill Lynch Interoffice Memorandum, December 1998, re: Enron Corp.

Loan Commitment (The loan commitment is required by Enron’s accountants to insure that the structure receives off-balance sheet treatment.) ...... 2344

257. Merrill Lynch email, May 2000, re: Enron Net Works (. . . Enron not

worried about debt on the balance sheet, as they can structure around

it.) ..................................................................................................................... 2346

258. Merrill Lynch email, May 2000, re: Enron Net Works (Off Balance sheet

debt—Not a primary driver because Enron believes they can structure

anything to be off balance sheet.) ................................................................... 2348

259. Merrill Lynch email, April 2001, re: Enron meetings (. . . they do a

bunch of balance sheet deals similar to your barge deal. . . .) ................... 2349

260. a. Merrill Lynch email, December 1999, re: New Account Opening (Delaware LLC to Cayman Island—Tax Reasons.) ........................................... 2350

b. Merrill Lynch email, March 2000, re: Ebarge LLC (. . . we have

converted the entity to the Cayman Islands . . . ..................................... 2351

261. List of Merrill Lynch employees investing in LJM2 .................................... 2352

262. Enron Corp. draft letter/edits on Enron Nigeria Barge Ltd. sale ............... 2354

263. Bargeco Encomics, LJM2 document .............................................................. 2359

264. Enron Risk Assessment and Control Deal Approval Sheet, Nigeria Barges

Equity Sell Down, January 13, 2000 ............................................................. 2360

265. Dan O Boyle, 2000 Deals and Accomplishments .......................................... 2364

266. LJM Investments, Benefit Summaries ......................................................... 2367

267. LJM2 Co-Investment, L.P. Facsimile, May 2001, to Price Waterhouse

Coopers, re: Enron Nigeria Barge Ltd. ......................................................... 2374

268. Merrill Lynch letter to the Permanent Subcommittee on Investigations,

April 2002, regarding Merrill Lynch Transactions with Enron-Related

Entities (1997 to Present) ............................................................................... 2379

269. Letters between Merrill Lynch and the Permanent Subcommittee on

Investigations, August-November 2002, regarding follow-up questions

from July 30, 2002 Subcommittee hearing ................................................... 2390

* May be found in the files of the Subcommittee

(1)

THE ROLE OF THE FINANCIAL INSTITUTIONS

IN ENRON’S COLLAPSE—VOLUME 1

TUESDAY, JULY 23, 2002

U.S. SENATE, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC.

The Subcommittee met, pursuant to notice, at 9:34 a.m., in room

SD–106, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding.

Present: Senators Levin, Cleland, Carper, Lieberman (ex officio),

Collins, Bunning, Fitzgerald, and Thompson (ex officio).

Staff Present: Linda J. Gustitus, Chief of Staff, Senator Levin;

Mary D. Robertson, Chief Clerk; Robert L. Roach, Counsel and

Chief Investigator; Stephanie E. Segal, Professional Staff Member;

Ross Kirschner, Deputy Investigator; Jamie Duckman, Professional

Staff Member; Edna Falk Curtin, Detailee/General Accounting Office; Rosanne Woodroof, Detailee/Department of Commerce OIG;

Lani Cossette; Alex DeMots; David Berick (Governmental Affairs

Committee/Senator Lieberman); Cecily Cutbill (Senator Carper);

Tara Andringa, Kathleen Long, and Clark Cohen (Senator Levin);

Kim Corthell, Republican Staff Director; Alec Roger, Counsel to the

Minority; Claire Barnard, Investigator to the Minority; Meghan

Foley, Staff Assistant; Jessica Caron, Intern; Gary Brown and Bob

Klepp (Governmental Affairs Committee/Senator Thompson); Holly

Schmitt (Senator Bunning); Jennifer Bonar (Senator Fitzgerald);

and Felicia Knight (Senator Collins).

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. The Subcommittee will come to order.

Enron was the first in the recent wave of corporate scandals, but

it continues to instruct us on what has gone wrong in corporate

America and what needs to be reformed. Earlier this month, the

Permanent Subcommittee on Investigations released a report on

the role of the Board of Directors in the collapse of Enron. It found

that the Board had failed in its fiduciary duty to protect Enron

shareholders and that it shares responsibility for Enron’s deceptions and its bankruptcy. Today we will look at financial institutions and the role that they played in Enron’s collapse.

It is now common knowledge that Enron engaged in accounting

deceptions to convince investors, lenders, analysts, and the public

that the company was in better financial shape than it really was.

In examining the role that financial institutions played in Enron’s

demise, we are focusing on one type of so-called ‘‘structured fiVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 81313.TXT SAFFAIRS PsN: SAFFAIRS
2

nance’’ transactions that Enron referred to as ‘‘prepays’’ and that

they used to obtain billions of dollars in financing for Enron without showing any additional debt on its books. I believe that most

will conclude, after we hear today’s testimony, that Enron’s use of

these prepays to disguise debt was an accounting sham, and to

carry out the deceptions Enron had the help and the knowing assistance of some of the biggest financial institutions in our country,

including JPMorgan Chase and Citigroup.

It should be noted that Enron was not the only company using

sham prepays in the way it did. Both Chase and Citicorp have

shopped the prepay structures around, and other banks and other

companies have engaged in similar transactions, which is also why

our investigation of this subject is so important.

Prepays, in concept, are simple and legitimate. They are arrangements in which a company is paid in advance to deliver a service

or a product at a later date. But the prepays constructed by Enron

and banks like Chase and Citigroup were phony prepays. There

was an appearance of a product to be delivered at a later date, but

the reality was different. No product was intended to be delivered;

the transaction was in reality a loan; but it was disguised so no

loan would appear on Enron’s books.

This structured deception had that clear purpose. There is a big

difference in the financial world between cash that comes from

business activity versus cash that comes from a loan, and there is

supposed to be a big difference in the accounting treatment. Increased business activity can boost a company’s credit rating and

stock value. In contrast, greater debt levels can lower a company’s

credit rating and stock value.

In a few minutes, we will hear from the chief investigator of the

Permanent Subcommittee on Investigations Staff, Robert Roach,

who will describe the intricacies of how these phony prepays

worked for Enron. We will then hear from two major credit agencies, Moody’s and Standard & Poor’s, who will testify that despite

following Enron quite closely, they were unaware of the extent and

nature of Enron’s prepays which, had they known of them, would

have significantly affected Enron’s credit ratings. We will also hear

from the former chief accountant at the Securities and Exchange

Commission, Lynn Turner, about the shady accounting Enron used

to hide the prepay debt and deceptively increase operational cash

flow.

The last two panels will be JPMorgan Chase and Citibank who

were the biggest banking participants in Enron’s phony prepay activities. We will show how the banks arranged for Enron to carry

out these so-called prepays by using offshore shell companies which

the banks controlled, like Mahonia and Delta Energy—companies

which have no employees, no offices, and operate in secrecy jurisdictions, that make it tough for law enforcement to uncover or understand their relationships to the banks behind them.

The offshore entities were passthroughs, controlled by banks, and

helped disguise the loans so that they wouldn’t show as debt on

Enron’s financial statements. Those offshore entities were not the

independent entities which they needed to be in order for the promises of future delivery of commodities to them to be legitimate preVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 81313.TXT SAFFAIRS PsN: SAFFAIRS
3

pays. We will also hear how the banks acted to limit public disclosure of Enron’s prepay obligations.

Central to the issues today is evidence indicating that Chase and

Citicorp knew what Enron was doing, assisted Enron in those deceptions, and profited from their actions. Take a look at this chart

which contains excerpts taken from internal documents at Enron,

its auditor Arthur Andersen, and Chase and Citibank. Each discusses Enron’s so-called prepays.

First is an internal presentation from Enron’s own accounting

department. It states: ‘‘Why Does Enron Enter into Prepays? Off

balance sheet financing (i.e., generate cash without increasing debt

load).’’ That is Enron’s statement of why it enters into prepays:

‘‘i.e., generate cash without increasing debt load.’’

Then there is an internal email from Chase which has this to say

about Enron’s prepays: ‘‘Enron loves these deals as they are able

to hide funded debt from their equity analysts because they (at the

very least) book it as deferred rev[enue] or (better yet) bury it in

their trading liabilities.’’ That is what Chase had to say and what

they knew about these prepays.

A Citigroup email makes a similar point: ‘‘E[nron] gets money

that gives them c[ash]flow but does not show up on books as big

D Debt.’’

And Andersen, of course, knew what was going on. Its internal

email states: ‘‘Enron is continuing to pursue various structures to

get cash in the door without accounting for it as debt.’’ Now, those are excerpts from just a few of the documents which

our Subcommittee uncovered that show that Enron’s prepay activity was well known to its participants but hidden from everybody

else. Each knew that Enron’s prepays were designed to manipulate

its financial statements, not to achieve business objectives. Each

also knew that Enron was booking prepay proceeds as trading activity instead of loans, even though no trade or sale was ever intended. Phony prepays produce misleading financial statements.

And that is what happened here.

When Enron collapsed and declared bankruptcy in December

2001, it had about $5 billion in outstanding so-called prepays that

were virtually unknown to the company’s creditors, investors, and

business associates. And this disguised debt contributed significantly to the Enron meltdown and the huge loss to Enron’s shareholders, the people who depended on that stock for their pensions,

people who had saved all their life and who had worked hard for

these investments. The debt was disguised. It contributed to the

meltdown and to the huge loss to those people.

Today we are going to shine the light in an area where complexity has been used to hide the truth. Hopefully we will cut

through the darkness and place appropriate levels of responsibility

on those who participated in these schemes.

[The prepared statement of Senator Levin follows:]

PREPARED STATEMENT OF SENATOR LEVIN

Enron was the first in the recent wave of corporate scandals and continues to instruct us on what has gone wrong and what needs to be reformed. Earlier this

month the Permanent Subcommittee on Investigations released a Subcommittee report on the role of the Board of Directors in the collapse of Enron. It found that

the Board had failed in its fiduciary duty to protect Enron shareholders and shares

4

responsibility for Enron’s deceptions and bankruptcy. Today we are looking at financial institutions and the role they played in Enron’s collapse.

It has become common knowledge that Enron engaged in accounting deceptions

to convince investors, lenders, analysts, and the public that the company was in better financial shape than it really was. In examining the role that financial institutions played in Enron’s demise, we are focusing on one type of so-called ‘‘structured

finance’’ transaction Enron referred to as ‘‘prepays’’ and used to obtain billions of

dollars in financing for Enron without showing any additional debt on its books. I

think most will conclude after we hear today’s testimony that Enron’s use of these

prepays to disguise debt was an accounting sham, and to carry out the deceptions

Enron had the help and knowing assistance of some of the biggest financial institutions in our country—including JPMorgan Chase and Citigroup. By the way, Enron

was not the only company using sham prepays in the way it did. Both Chase and

Citicorp have shopped the prepay structures around, and other banks and other

companies have engaged in similar transactions.

Prepays, in concept, are simple and legitimate. They are arrangements in which

a company is paid in advance to deliver a service or product at a later date. But

they didn’t stay legitimate with Enron and banks like Chase and Citigroup which

together began constructing complex, phony prepays that resulted in Enron obtaining billions of dollars that were in reality undisclosed loans to Enron. There was

an appearance of a product to be delivered at a later date, but the reality was different. No product was intended to be delivered; the transaction was in reality a

loan; and it was artfully disguised so no loan would appear on Enron’s books.

Enron used these so-called prepays to obtain approximately $8 billion in financing

over about 6 years. On its financial statements, Enron reported the prepays as energy trading activity instead of debt, giving the false impression that the money

from the prepays was part of Enron’s ordinary business activities, instead of the

loans they really were.

The purpose of all the complexity was to hide a loan, so it wouldn’t appear as debt

on Enron’s books.

This structural deception had a clear purpose. There’s a big difference in the financial world between cash that comes from business activity versus cash that

comes from a loan, and there is supposed to be a big difference in the accounting

treatment. Increased business activity can boost a company’s credit rating and stock

value. In contrast, greater debt levels can lower a company’s credit rating and stock

value.

In a few minutes we will hear from the Chief Investigator of the PSI Staff, Robert

Roach, who will describe the intricacies of how these phony prepays worked for

Enron. We will then hear from two major credit agencies, Moody’s and Standard

and Poor’s, who will testify that despite following Enron quite closely, they were unaware of the extent and nature of Enron’s prepays which, had they known of them,

would have significantly affected Enron’s credit ratings. We will also hear from the

former Chief Accountant at the SEC, Lynn Turner, about the shady accounting

Enron used to hide the prepay debt and deceptively increase operational cash flow.

Then we will hear from JPMorgan Chase and Citigroup who were the biggest participants in Enron’s phony prepay activities. We will hear how the banks arranged

for Enron to carry out these so-called prepays by using offshore shell companies the

banks controlled, like Mahonia and Delta Energy, which have no employees and no

offices, and operate in secrecy jurisdictions that make it tough to uncover or understand their relationships to the banks behind them. We will also hear how the

banks acted to limit public disclosure of Enron’s prepay obligations.

Central to the issues today is evidence indicating that Chase and Citicorp knew

what Enron was doing, assisted Enron in the deceptions, and profited from their actions. Take a look at this chart which contains excerpts taken from internal documents at Enron, its auditor, and Chase and Citibank. Each discusses Enron’s socalled prepays.

First is an internal presentation from Enron’s own accounting department. It

states: ‘‘Why Does Enron Enter into Prepays? Off balance sheet financing (i.e., generate cash without increasing debt load).’’

Next is an internal email from Chase which has this to say about Enron’s prepays: ‘‘Enron loves these deals as they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred rev[enue] or (better

yet) bury it in their trading liabilities.’’

A Citigroup email makes a similar point: ‘‘E[nron] gets money that gives them

c[ash] flow but does not show up on books as big D Debt.’’

Andersen of course knew what was going on. Its internal email states: ‘‘Enron is

continuing to pursue various structures to get cash in the door without accounting

for it as debt.’’

5

These are a few of the documents my Subcommittee uncovered that show that the

Enron’s prepay activity was well-known to its participants, but hidden from everyone else. Each knew that Enron’s prepays were designed to manipulate its financial

statements, not to achieve business objectives. Each also knew that Enron was booking prepay proceeds as trading activity instead of loans, even though no trade or

sale was ever intended. Phony prepays produce misleading financial statements.

That’s what happened here.

When Enron collapsed and declared bankruptcy on December 2, 2001, it had

about $5 billion in outstanding so called prepays that were virtually unknown to

the company’s creditors, investors, and business associates. This disguised debt contributed significantly to the Enron meltdown and the huge loss to Enron’s shareholder.

Deception piled on deception. There are many who are responsible for the massive

loss to people relying on pension funds and stock investments. Today we’ll shine the

light in an area where complexity had been used to hide the truth. Hopefully we’ll

cut through the darkness and place appropriate level of responsibility on the banks

who participated in these schemes.

Senator LEVIN. Senator Collins.

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. Thank you, Mr. Chairman.

Today is the second in a series of hearings held by the Permanent Subcommittee on Investigations into the events that contributed to the collapse of the Enron Corporation. More than 6 months

ago, the Subcommittee embarked on a comprehensive investigation

of Enron in an effort to gain understanding and insight into what

appears to have been a colossal failure of virtually every mechanism that is supposed to provide the checks and balances on which

the integrity of our capital markets depend.

I would like to take a moment to praise Senator Levin and the

dedicated Subcommittee staff on both sides of the aisle who have

been tireless in their efforts to unravel the complex transactions

that were purposely designed to confound and confuse. This undertaking has been enormous, and I greatly appreciate the diligent

work that has gone into this investigation.

The Subcommittee’s first hearing examined the role of Enron’s

Board of Directors in the company’s collapse and found that the

Board failed to play its required role as the guardian of the corporation’s shareholders. The Board’s failures, of course, are only

part of the story.

We know now, nearly 8 months after Enron filed for bankruptcy

protection, that a web of conflicts of interest, accounting improprieties, high-risk transactions, and the appropriation of corporate assets by Enron executives contributed to the company’s collapse.

Today, we will examine the pivotal role of another set of players

in the Enron story: The financial institutions.

The Subcommittee’s investigation has revealed that certain financial institutions knowingly participated in, and indeed facilitated, transactions that Enron officials used to disguise debt and,

thereby, make the company’s financial position appear more robust

than it actually was.

Through the use of structured finance vehicles that included a

series of prepaid forward contracts and related swaps, Enron received billions of dollars in cash. A prepaid forward contract, or

prepay, is essentially a forward sale agreement in which the buyer

receives an up-front payment in exchange for a commitment to deliver goods or services in the future. As the Chairman indicated,

6

prepays are perfectly legitimate when used correctly, and they are

common in the energy industry. When a bona fide prepay is used

for a genuine business transaction, it is a perfectly legitimate

means to provide needed cash to the seller and a desired commodity to the buyer.

However, as was the case with much of what went on at Enron,

these transactions were neither simple nor as they seemed on the

surface. Many of the so-called prepays, in fact, were not prepaid

forward contracts at all. They did not transfer price risk. They did

not use independent third parties. They were not entered into because the purchaser actually wanted oil or gas, nor were their

terms driven by anything other than a desire to achieve an accounting end. Instead, they were elaborate circular transactions

that were designed to disguise what were essentially loans totaling

billions of dollars.

The facade of a prepay enabled Enron to misrepresent the cash

it received as funds obtained from the company’s operations rather

than from financing. From an accounting standpoint, this is a critical distinction. Loans appear on the company’s balance sheet as

cash from financing or debt. A higher debt load raises questions

about the company’s borrowing power and ability to generate future profits, and it affects its credit rating. Cash flow from operations, on the other hand, enhances the appearance that the company is doing more business than it actually is and implies that

such revenue, because it is from the company’s core operations, is

likely to continue in future periods.

Enron wanted these deals to be covered in a shroud of secrecy

because they knew that they could not stand up to the scrutiny of

the light of day. Furthermore, they wanted them to be limited to

as few investors as possible in order to maintain the facade. In fact,

an internal Enron document explains that the continued use of

these transactions ‘‘is a sensitive topic for both the rating agencies

and banks and institutional investors. The ability to continue minimizing disclosure will likely be compromised if transactions continue to be syndicated.’’

Maintaining an investment grade rating was vital to Enron. Had

the rating agencies been privy to the circular nature of these transactions, they would have considered them to be financing or loans,

and they would have factored that fact into the ratings. Full disclosure of Enron’s source of capital might well have resulted in a

downgrade of its rating.

Although many banks ultimately invested in these transactions,

JPMorgan Chase and Citigroup were two of the principal banks involved. Their deals enabled Enron to keep some $8 billion of debt

off its balance sheet and, as a result, misrepresent its financial status to the rating agencies and to the investing public.

JPMorgan Chase and Citigroup are two of the Nation’s most

prestigious financial institutions. That is why I find their involvement so shocking. It appears as though they were willing to risk

their reputations to keep an important client—Enron—happy. They

participated in crafting the structure of these transactions. They

used special purpose, offshore vehicles of their own making as the

‘‘independent’’ third parties. They clearly understood Enron’s motivation for wanting to use the prepay structures to hide the true

7

source of the company’s cash flow. This charade led to Enron’s

never-ending need for more cash in order to pay off previous prepays, creating a merry-go-round of refinancings at the expense of

investors.

While the majority of professionals in corporate America are ethical people, the public’s faith in corporate integrity and professional

judgment has been severely compromised by recent corporate scandals. The markets have been buffeted by both Enron and more recent revelations of corporate wrongdoing. The resulting crisis of

confidence is not about the market system but, rather, the information that underpins its very validity, the information about the performance of companies whose shares are traded by investors

around the world.

Some accountants, lawyers, investment bankers, analysts, and

corporate executives, whose integrity and competence are critical to

our system of free markets, have directly contributed to this crisis.

Some have failed in their professional responsibilities and made it

easier for the direct participants to get away with presenting a

misleading picture to investors. The question now is how to restore

trust and confidence in the markets and corporate America. Tougher laws, clearer standards, and sure and swift enforcement are part

of the answer.

Fundamentally, however, restoring faith in America’s capital

markets requires that all the players perform their jobs—not just

government regulators and prosecutors, but lawyers, accountants,

investment bankers, market analysts, corporate management, and

boards—in accordance with the spirit as well as the letter of the

law. We all share in the responsibility for making our markets operate as efficiently, transparently, and fairly as possible. It is time

to stop the practices that are beneficial to a select few and harmful

to thousands.

The testimony that we will hear this morning about the role of

financial institutions in the Enron debacle should yield valuable

lessons for strengthening our free market enterprise system, for restoring public confidence in our capital markets, and ensuring that

small investors, in particular, have access to complete and accurate

information to guide their investment decisions.

[The prepared statement of Senator Collins follows:]

PREPARED OPENING STATEMENT OF SENATOR COLLINS

Today is the second in a series of hearings held by the Permanent Subcommittee

on Investigations into the events that contributed to the collapse of the Enron Corporation. More than six months ago, the Subcommittee embarked on a comprehensive investigation of Enron in an effort to gain insight and understanding of what

appears to be a colossal failure of virtually every mechanism that is supposed to

provide the checks and balances on which the integrity of our capital markets depend.

I would like to take a moment to praise Senator Levin and the dedicated Subcommittee staff on both sides of the aisle who have been tireless in their efforts to

unravel complex transactions that were purposefully designed to confound and confuse. The undertaking has been enormous, and I appreciate all the work that has

gone into this investigation.

The Subcommittee’s first hearing examined the role of Enron’s Board of Directors

in the company’s collapse and found that the board failed to play its required role

as the guardian of the corporation’s shareholders. The Board’s failures, of course,

are only part of the story.

We know now, nearly eight months after Enron filed for bankruptcy protection,

that a web of conflicts of interest, accounting improprieties, high risk transactions,

8

and appropriation of corporate assets by Enron executives contributed to the company’s collapse. Today, we will examine the pivotal role of another set of players

in the Enron story: The financial institutions.

The Subcommittee’s investigation has revealed that certain financial institutions

knowingly participated in, and indeed facilitated, transactions that Enron officials

used to disguise debt and, thereby, make the company’s financial position appear

more robust than it actually was.

Through the use of structured finance vehicles that included a series of prepaid

forward contracts and related swaps, Enron received billions of dollars in cash. A

prepaid forward contract, or prepay, is essentially a forward sale agreement in

which the buyer receives an up-front payment in exchange for a commitment to deliver goods or services in the future. Prepays are commonly used in the energy industry. When bona fide prepays are used for genuine business transactions, they are

a perfectly legitimate means to provide needed cash to the seller and a desired commodity to the buyer.

However, as was the case with much of what went on at Enron, these transactions were neither simple nor as they seemed on the surface. Many of the socalled prepays, in fact, were not prepaid forward contracts at all. They did not

transfer price risk. They did not utilize independent third parties. They were not

entered into because the purchaser actually wanted oil or gas, nor were their terms

driven by anything other than a desire to achieve an accounting end. Instead, they

were elaborate circular transactions that were designed to disguise what were essentially loans totaling billions of dollars.

While these transaction were incredibly complicated, they essentially boil down to

the following scenario. Enron entered into a contract with an offshore entity to deliver oil or gas at a date certain in the future in exchange for an up-front cash payment. The offshore entity, created by or at the behest of the bank, made the upfront payment to Enron with funds provided by the bank. In many cases, no oil or

gas ever really changed hands. The banks understood up-front what their ultimate

return would be because they hedged their risk, sometimes with Enron itself. The

offshore entity supposedly participating as a trading counterparty, in reality, made

nothing but preset fees, and Enron received an infusion of cash without having to

disclose it as a loan on its balance sheet.

The facade of a prepay enabled Enron to misrepresent the cash it received as

funds obtained from the company’s operations rather than from financing. From an

accounting standpoint, this is a critical distinction. Loans appear on a company’s balance sheet as cash from financing or debt. A higher debt load raises questions

about a company’s borrowing power and ability to generate future profits and affects

its credit rating. Cash flow from operations, however, enhances the appearance that

the company is doing more business that it actually is and implies that such revenue, because it is from the company’s core operations, is likely to continue in future

periods.

Enron wanted these deals to be covered in a shroud of secrecy because they knew

they could not stand up to scrutiny in the light of day. Furthermore, they wanted

them to be limited to as few investors as possible in order to maintain the facade.

In fact, an internal Enron document explains that the continued use of these transactions ‘‘is a sensitive topic for both the rating agencies and banks/institutional investors. The ability to continue minimizing disclosure will likely be compromised if

transactions continue to be syndicated.’’

Maintaining an investment grade rating was vital to Enron. Had the rating agencies been privy to the circular nature of the transactions, they would have considered them to be financing or loans, and they would have factored that into their

ratings. Full disclosure of Enron’s source of capital might well have resulted in a

downgrade of its rating.

Although many banks ultimately invested in these transactions, JPMorgan Chase

and Citigroup were two of the principal banks involved. Their deals, known as

Mahonia and Yosemite, respectively, enabled Enron to keep eight billion dollars off

its balance sheet and, as a result, misrepresent its financial status to the rating

agencies and the investing public.

JPMorgan Chase and Citigroup are two of the nation’s most prestigious financial

institutions. Yet, it appears as though they were willing to risk their reputations

to keep Enron, an important client, happy. They participated in crafting the structure of these transactions. They used special purpose, off shore vehicles of their own

making as the ‘‘independent’’ third parties. They clearly understood Enron’s motivation for wanting to use the prepay structures to hide the true source of the company’s cash flow. This prepay charade led to Enron’s never-ending need for more

cash in order to pay off previous prepays, creating a merry-go-round of refinancings

at the expense of investors.

9

While the majority of professionals in corporate America are ethical people, the

public’s faith in corporate integrity and professional judgment has been severely

compromised by recent corporate scandals. The markets have been buffeted by both

Enron and more recent revelations of corporate wrong doing. The resulting crisis of

confidence is not about the market system but rather the information that underpins its very validity, the information about the performance of companies whose

shares are traded by investors around the world.

Some accountants, lawyers, investment bankers, analysts, and corporate executives, whose integrity and competence are critical to our system of free markets,

have directly contributed to this crisis. Some have failed in their professional responsibilities and made it easier for the direct participants to get away with presenting a misleading picture to investors. The question now is how to restore trust

and confidence in the markets and corporate America. Tougher laws, clearer standards, and swift and sure enforcement are part of the answer.

Fundamentally, however, restoring faith in America’s capital markets requires

that all the players do their jobs-not just government regulators and prosecutors but

lawyers, accountants, investment bankers, market analysts, corporate management

and boards–in accordance with the spirit, not merely the letter, of the law. We all

share in the responsibility for making our markets operate as efficiently, transparently and fairly as possible. It is time to stop practices that are beneficial to a

select few and harmful to thousands.

The testimony we will hear this morning about the role of financial institutions

should provide some answers, and should yield valuable lessons for strengthening

our free enterprise system, restoring public confidence in our capital markets, and

ensuring that small investors, in particular, have access to complete and accurate

information to guide their investment decisions.

Senator LEVIN. Thank you very much, Senator Collins. Senator

Lieberman.

OPENING STATEMENT OF SENATOR LIEBERMAN

Senator LIEBERMAN. Thanks, Mr. Chairman. I thank you and

Senator Collins and your staffs, the staff of the Permanent Subcommittee on Investigations, for your continuing inquiry into the

workings of the Enron Corporation and specifically for the meticulous work that you have done in preparing for this hearing, which

I think is some of the most significant work that this Permanent

Subcommittee on Investigations has ever done, and the history of

this Subcommittee is already a proud one.

The work that you have done and the opening statements that

you, Senator Levin, and Senator Collins have given amount to a

shocking indictment of the great companies that were involved here

and a profoundly unsettling picture of the way in which good people at the top of America’s economy did some very bad things that

have now brought our economy to a very unsettled state and greatly diminished the wealth and security of millions of people, including millions of middle-class Americans who came into the stock

market over the last decade.

Today, you focus on an aspect of Enron’s activities that has not

received much attention, and that is the role of some of the Nation’s—indeed the world’s—largest financial institutions. To feed

Enron’s need for cash without appearing to incur debt on its balance sheet, the banks apparently created complex transactions that

disguise their true nature and ultimately the true nature of

Enron’s financial condition.

Enron’s lenders apparently even convinced a number of the Nation’s largest insurance companies to provide performance bonds

covering the risk of Enron’s default.

As one judge put it in a case brought against Enron’s insurance

companies who were balking at paying off these bonds, and I quote,

10

‘‘Taken together, then, these arrangements now appear to be nothing but a disguised loan,’’ end of the quote from a judge.

In Connecticut, Enron worked out a strikingly similar deal with the Connecticut Resources Recovery Authority where a $220 million investment loan to Enron was disguised as a series of energy

transactions in which no energy was actually transferred to Enron.

The result, in a chain of reactions, has been extraordinary increases in fees for municipalities throughout the area served by the

Connecticut Resources Recovery Authority.

Mr. Chairman, all of these transactions are deeply troubling.

They are added evidence that the behavior exhibited by top Enron

officials was not limited to a single company. Remember in December when Enron declared bankruptcy and collapsed, we were told

that its problems were not systemic. We were told that Enron was

a single bad apple in a barrel of otherwise good fruit. Now we know

better. We know not only that there were other bad apples in that

barrel of corporate America, but that in order for many of Enron’s

deceptions to occur, Enron needed partners, companies that would

agree to be on the other side of questionable trades and transactions.

So the cancer of corporate greed and deceit spread. In the case

of billions of dollars of disguised loans, Enron’s partners were the

world’s largest financial institutions—institutions with proud and

respected names.

Now, I don’t know whether disguising loans as commodity contracts is illegal, but I do know that it allowed Enron to run roughshod over what is supposed to be the hallmark of our securities

markets, and that is, individual and corporate investors’ access to

accurate information about the financial health of publicly traded

companies. Enron and its financial partners seem to have designed

these transactions, that the Subcommittee has investigated and

will illuminate today, explicitly to thwart that ideal.

Sadly, millions of average investors are painfully aware of the

consequences of making decisions based on untruthful or inaccurate information, and today’s hearings give us one more example

of how people at the top of America’s economy betrayed the great

American middle class which put its hope in the markets and how

important it is for us to act together through government and

through the private sector to restore investor confidence.

As Senator Levin and Senator Collins particularly said, we

should, and I believe will, adopt tough new laws to punish and

deter such corporate greed and malfeasance. Business organizations such as the stock exchanges should and are acting constructively and progressively to adopt measures of self-regulation and

self-policing. But I must say, Mr. Chairman, as I prepared for this

hearing today and was struck at how, again, good people were

drawn into bad practices, in the end we all have to acknowledge

that the law cannot be everywhere and that business self-regulation, stock exchange rules cannot be everywhere; that ultimately,

particularly in a democracy, many of the most critical decisions are

made in the privacy of one’s own conscience.

And if I may veer from where one normally goes at these hearings, I was thinking, in reading the record for the hearing today,

of something I once learned that was written in the Talmud, which

11

is that in the hour when our own lives are over and individuals are

brought before the heavenly court, four questions will be asked, so

the rabbis tell us. And the first, amazingly, is: Did you conduct

your business affairs honestly? Not, did you believe in God? Did

you follow all the particular rituals of your faith? But, did you conduct your business affairs honestly? Because it is in conduct that

we ultimately reflect the extent to which we have embraced a set

of values.

The other thing I remember having studied once is that of all the

metaphorical crowns that one may earn in life, the most important

is the crown of a good name. And we have here some corporations

that have earned very good names that apparently by the action

of individual people in them have sullied those good names.

Senator Levin, Senator Collins, I again commend you and your

staff for conducting this extraordinary investigation, for bringing to

light the facts that will be revealed today, and in that sense for

crying out to those who hold power within America’s economy to remember what the facts of your investigation show so clearly that

too many forgot, which is, if I may paraphrase from the Bible; Man,

people do not live by quarterly earnings reports alone.

I thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Lieberman.

Senator Thompson, let me call on you, but first let me thank you

and Senator Collins. Your staff has been part of a truly dedicated

team of staffers which has brought us to this point, and I think it

really represents the best in us as Senators that we and our staffs

work this closely together on such a very complex kind of an investigation involving literally millions of pages that have to be reviewed. And I want to thank you both for the staff work that has

been so dedicated.

OPENING STATEMENT OF SENATOR THOMPSON

Senator THOMPSON. Thank you, Mr. Chairman. I could not agree

with you more about the work of the staff. I was very pleased to

see Gary Brown from Nashville, whom I have known since before

he became a lawyer, come up and assist in this, and he and Mr.

Roach have worked very well together.

This document that these gentlemen have produced is really remarkable. I would hope that everyone would have the opportunity

to see not only Mr. Roach’s statement today but the document that

I believe is attached to it or is an exhibit that will be a public

record. It is indeed detailed and complex.

As you know, Senator Lieberman, I have been spending a little

time on homeland security and a few other things, but as I got into

this very recently, I was very surprised at what I saw. I usually

like to wait until the evidence is in before I make too many comments. But I think the comments in this case are right on, from

all you can tell from the record and actually hearing from both

sides.

And I come away with the feeling that our checks and balances

have let us down. We have checks and balances not only in government but in our private sector, in our free economy. And we expect

auditors, lawyers, raters, and bankers to deal in certain ways; otherwise, bad things happen. And we have certainly seen a lot of bad

12

things happen. But, unfortunately, the lessons we learned at our

mama’s knees about the overwhelming power of money sometime

turned out to be true. These investment bankers are making hundreds of millions of dollars in fees to set up these deals and pay

themselves back in many cases. They are the ones who receive the

money in many cases.

So the transactions are very complicated, but the motivations are

not, unfortunately. Apparently what the average person, anyway,

and I assume even the average sophisticated institutional investor

would assume was debt magically turned out to appear to be cash

flow from business. And instead of the debt-to-capital ratio going

up, it went down, the company, therefore, appearing to be in better

shape than it was.

I understand that we will hear testimony that everybody did it,

that, oh, Enron fooled us again. They have to be the smartest people in the world because they fool the smartest people in the world,

apparently, consistently over a period of years, while those smart

people were, of course, making many millions of dollars off of being

fooled. But perhaps everybody did it, perhaps the securities fraud

laws tolerate it, but I venture to say we will have an opportunity

to find out. It is not this body’s job, but I venture to say that we

will have an opportunity to find out whether or not the securities

fraud laws encompass these sorts of activities and tolerate it.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Thompson. Senator Bunning.

OPENING STATEMENT OF SENATOR BUNNING

Senator BUNNING. Thank you, Mr. Chairman. I appreciate you

calling this hearing today and all the work that has gone on by

staff to prepare this unbelievable document that we have in front

of us.

Enron’s collapse earlier this year signaled the beginning of a crisis in confidence in this country that continues to have a lasting

effect and is still going on. One of the largest accounting firms is

in ruins. Brokerage firms are under suspicion. And Congress has

spent a lot of its time this year trying to figure out what we can

do to prevent another crisis like this.

Unfortunately, it is clear that Enron was not alone in the shady

financial dealings. Investors have been burned more than once this

year with companies, including WorldCom and Global Crossing,

using questionable accounting practices in business transactions.

Americans across this country are watching their savings and their

pensions dwindle, and many now question the validity of financial

statements, the independence of financial advisors, and the ability

of boards of directors to provide proper oversight.

Personally, I believe it might take a while for average Americans

to feel good about putting their money back into any part of the

stock market, and I can’t blame them. Company after company,

over 1,000 to be exact, have restated their earnings, and all of the

major markets reflect that by being in the tank. We are facing a

crisis, and I hope that the accounting bill we recently passed will

restore at least some of the confidence in the markets.

There is certainly enough blame to go around from Wall Street

analysts to credit rating agencies to Enron executives. Too many

13

people dropped the ball or looked the other way when dealing with

Enron, and now we are all paying for it.

As for today’s hearings, I look forward to learning more about

Enron’s use of prepays, especially with some of the companies that

helped them in this endeavor. I am particularly interested in hearing from these companies what they plan to do in the future to

make sure it is not easy for companies like Citicorp and Chase,

JPMorgan Chase, to use and manipulate the markets by the use

of the vehicles that they did to enhance the cash flow of Enron.

Thank you, Mr. Chairman. I am looking forward to the testimony.

Senator LEVIN. Thank you.

I want to also thank and single out Senator Lieberman, who is

the Chairman of the full Committee, for the strong support that he

has personally given to this investigation and helping us to do

what we needed to do to review the massive materials that we had

to review, and also for his very powerful and eloquent opening

statement.

Let me now introduce our first panel of witnesses this morning.

At the witness table are Robert Roach, a Counsel and Chief Investigator of the Permanent Subcommittee on Investigations. Bob has

been with the Subcommittee for the last 5 years as a valued member of my staff on the Subcommittee. He is accompanied by Gary

Brown, Special Counsel for Senator Thompson on the Minority

staff of the Committee. That is the full Committee on Governmental Affairs.

Gary Brown and Bob Roach represent a very dedicated team of

staffers working together on this Enron investigation for many,

many months. We look forward to hearing their analysis of their

investigation of the role of financial institutions in Enron’s collapse.

Pursuant to Rule VI, all witnesses who testify before the Subcommittee are required to be sworn, and at this time I would ask

the witnesses to please stand and raise your right hand. Do you

swear that the testimony that you give before the Subcommittee

this morning will be the truth, the whole truth, and nothing but

the truth, so help you, God?

Mr. ROACH. I do.

Mr. BROWN. I do.

Senator LEVIN. We will be using a timing system today, and

about 1 minute before the red light comes on, you will see the light

change from green to yellow, which will then give you an opportunity to conclude your remarks. And your written testimony will

be printed in the record in its entirety, but we ask that you limit

your oral testimony to no more than 10 minutes.

Mr. Roach.

14

1The prepared statement of Mr. Roach with attachments appears in the Appendix on page

215.

TESTIMONY OF ROBERT L. ROACH,1 COUNSEL AND CHIEF INVESTIGATOR, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS; ACCOMPANIED BY GARY M. BROWN, SPECIAL COUNSEL, COMMITTEE ON GOVERNMENTAL AFFAIRS

Mr. ROACH. Mr. Chairman, Ranking Member Collins, Members

of the Subcommittee, good morning. Earlier this year, Chairman

Levin directed the Subcommittee staff to investigate the role of financial institutions in Enron’s collapse. The Subcommittee staff—

both Democratic and Republican—have worked for the past 7

months on a bipartisan basis to conduct this investigation. We have

worked together to review over a million pages of documents and

interviewed dozens of witnesses from Enron, Andersen, other accounting firms, credit rating agencies, and a host of financial institutions.

Numerous major financial institutions, both here and abroad, engaged in extensive and complex financial transactions with Enron.

The evidence we reviewed showed that, in some cases, the financial

institutions were aware that Enron was using questionable accounting. Some financial institutions not only knew, they actively

aided Enron in return for fees and favorable consideration in other

business dealings. The evidence indicates that Enron would not

have been able to engage in the extent of the accounting deceptions

it did, involving billions of dollars, were it not for the active participation of major financial institutions willing to go along with and

even expand upon Enron’s activities. The evidence also indicates

that at least in one case these financial institutions knowingly allowed investors to rely on Enron financial statements that they

knew or should have known were misleading.

Our investigation, among other things, focused on one financing

vehicle known as a ‘‘prepay.’’ A prepay is commonly thought of as

an arrangement in which one party pays in advance for a service

or product to be delivered at a later date. Companies use prepays

to receive money up front for services to be rendered in the future.

Enron constructed elaborate, multiparty commodity trades that

they called prepays in order to book the proceeds from prepays as

cash flow from operations. But when all the bells and whistles are

stripped away, the basic transaction fails as a prepay, and what remains is a loan to Enron using an investment bank and an obligation on Enron’s part to repay the principal plus interest. With that

being true, the proceeds of the so-called prepay transaction should

have been booked as debt and not as cash flow from operations.

Now let me describe in general terms why the prepays came

about and how they worked. Mr. Chairman, with your permission,

one of my colleagues will draw this transaction as I describe it.

Now, first of all, Enron needed more cash flow to show that it

could handle its growing debt. One way to address this is for Enron

to go and get a loan from a bank such as Citi or Chase. But that

would add to its debt load, compounding its problem rather than

solving it.

Now, Enron was a merchant energy company. It could engage in

trades, and the cash from this type of activity would be accounted

15

for as trading from business operations. However, if Enron and

Chase entered into a trade of a commodity such as gas or oil, both

parties would be at risk of losing money, depending on the change

in value of the oil or gas. And that would be unacceptable to both

Chase and Enron in this situation because the objective was to get

a fixed amount of cash to Enron, and Chase wanted to be sure it

would get its money back with some interest.

So to protect themselves from this uncertainty, Chase and Enron

would enter into a second transaction, exactly opposite to the first,

which would mitigate or eliminate that price risk. And this is a

hedge.

Now, the only problem with this strategy is that these parallel

transactions that you see over there cannot be accounted for as

legitimate trading activity and would be obvious to auditors. So to

help Enron out with its problems, Chase inserted into the trade

one of its shell corporations, Mahonia, to engage in a series of

trades between three supposedly independent parties.

Now, the trades between each party in the triangle were designed to perfectly offset each other so there would be no price risk.

And this is the basic model of what has come to be called ‘‘the

Enron prepay.’’ Chase forwards a lump sum of money to Mahonia.

Mahonia forwards the money to Enron. Enron sends regular deliveries of a commodity, generally oil or gas, back to Mahonia, and

Mahonia sends it on to Chase.

Now, the advance of cash from Chase and then the advance of

cash from Mahonia to Enron is booked as a trading activity by

Enron rather than a loan, and the proceeds—that is the cash it receives—is booked as cash flow from operations rather than as cash

flow from financing.

The transactions are worked out in advance by all the parties so

that they yield a steady and predictable flow of cash from Enron

to Chase, just like a loan repayment. Interest is embedded in the

repayment schedule, and in the communications we have seen, the

payments are referred to as amortization payments.

The net result is that on the surface this transaction appears to

be a series of arm’s-length trades among independent entities.

However, it is really a set of integrated, prearranged trades that

wash each other out, except for the movement of funds from Chase

to Mahonia to Enron and eventually back to Chase with some interest payments included.

Now, this is a simplified version of what really went on. Actually,

the transactions look more like the charts that we have prepared

for the Citi and Chase transactions. I am not going to go into those

right now. I think they will be discussed a little later, but that is

what they look like. And these transactions fail as legitimate

trades for a number of reasons.

Senator LEVIN. Mr. Roach, let me interrupt you just for one second. I have had a brief consultation here, and you can take longer

than 10 minutes. We are going to withhold many of the questions

so that you will have more time for your presentation.

Mr. ROACH. Thank you, Mr. Chairman.

In order for transactions like the ones used by Enron and the

financial institutions to be legitimately booked as cash flow from

operations and not debt, four elements had to be present: One, the

16

1 Exhibit No. 104 appears in the Appendix on page 355.

three parties had to be independent; two, the trades among the

three parties could not be linked; three, the trades had to contain

price risk; and, four, there had to be a legitimate business reason

for the trades.

The Enron-type prepays we examined failed on all accounts: Two

of the three parties in the Enron trades were related—the banks

and their offshore special purpose entities which the banks established and controlled; the trades among the parties were linked— contracts associated with the trades were designed so that a default in one trade affected the other trades; there was no price

risk—except for fees and interest payments, the final impact of the

trades was a wash; neither the banks nor the banks’ special purpose entities had a legitimate business reason for purchasing the

commodities used in these trades.

Enron used these so-called prepay transactions to obtain more than $8 billion in financing over approximately 6 years, including

$3.7 billion from 12 transactions with Chase and $4.8 billion from

14 transactions with Citigroup. This $8 billion figure is a conservative estimate for the 6-year period based on the documents we

were able to review. The full amount since Enron began using prepays around 1992 may be much larger.

Now, accounting for prepay proceeds as cash flow from operations rather than cash from financing gave the impression that

the money from the prepays was part of Enron’s ordinary business

activities and not debt. Moreover, the Subcommittee has learned

that Enron was simultaneously treating the prepay transactions as

loans on its tax returns in order to claim the interest expense as

a business deduction.

Enron’s practice of using prepay transactions to understate debt

and overstate cash flow from operations made its financial statement look much stronger. That, in turn, helped Enron maintain its

investment grade credit rating and support, even boost, its share

price.

Now, the Subcommittee has done an analysis of what Enron’s financial statements would have looked like had it accurately recorded the prepay transactions as debt. Please look at this chart

which is marked as Exhibit 104 1 in the exhibit books. The chart

shows key figures from Enron’s year 2000 financial statements, the

last audited financial statements that the company filed with the

Securities and Exchange Commission. The financial statements

showed that Enron had total debt in 2000 of about $10 billion, and

funds flow from operations in the range of $3.2 billion.

Now, we know from Enron board presentations that at the end of 2000, Enron had about $4 billion in outstanding financing from

its so-called prepays. And as you can see from the chart, if Enron

had properly accounted for these transactions, its total debt would

have increased by about 40 percent to $14 billion, and its fund

flows from operation would have dropped by almost 50 percent to

$1.7 billion. These are dramatic changes.

Now, the impact on Enron’s key credit ratios would also have

been significant. These credit ratios are the ratios that financial

analysts typically use to evaluate a company’s financial health.

17

Again, looking at the chart, with the inclusion of prepays as debt,

Enron’s debt-to-equity ratio would have risen from about 69 percent to about 96 percent. Its debt-to-total-capital ratio would have

risen from 40 percent to 49 percent, and its fund flow interest coverage, a key measure of a company’s ability to meet its financing obligations, would have dropped by almost half, from $4.07 to $2.37

billion. Now, the credit rating agencies testifying in the next panel

will discuss the significant effect these numbers would have had on

Enron’s credit rating.

Any credit rating downgrade would have had serious consequences for Enron, including raising its borrowing costs, limiting

the investors who could buy the company’s bonds, weakening its

trading status, and possibly triggering certain demand debt repayments at off-balance sheet entities affiliated with the company.

Enron was acutely aware of the importance of its credit rating and

its financial ratios.

Now, the Subcommittee staff has additional analysis regarding

the financial impact that would have resulted if Enron had accurately reflected its prepay proceeds as debt, including drops in the

company’s enterprise value and a significant drop in its implied

share price. In the interest of time, however, I will submit that

analysis for the record and answer any questions you may have

about it. I would also ask that the other appendices to my statement be included in the Subcommittee’s hearing record.

Senator LEVIN. They will be made part of the record.

Mr. ROACH. Now, Enron was able to book prepay proceeds as

cash flow from commodity trades rather than cash flow from loans

only with the assistance of the financial institutions. The banks

provided the funding for the prepays, participated in the required

complex commodity trades, and allowed Enron to use their offshore

entities that they controlled as sham trading partners, for the explicit purpose of allowing Enron to disguise its multi-million-dollar

loans as trading activity.

Internal communications show that it was common knowledge

among Enron, Chase, and Citigroup employees that the prepays

were designed to achieve accounting, not business, objectives and

that Enron was booking the prepay proceeds as trading activity

rather than debt. The evidence indicates that Chase and Citigroup

not only understood Enron’s accounting goal, but designed and implemented the financial structures to help Enron achieve its objectives. Moreover, they accepted and followed Enron’s desire to keep

the nature of these transactions confidential.

By design and intent, the prepays as structured by Enron and

the financial institutions made it impossible for investors, analysts,

and other financial institutions to uncover the true level of Enron’s

indebtedness.

And the financial institutions marketed these structures to other

potential clients. Chase developed a pitch book to sell other companies on Enron-style prepays. The pitch book describes the transactions as ‘‘balance sheet ‘friendly.’ ’’ It also sets out in general

terms Chase’s use of Mahonia in structuring the trades and clearly

explains that the trades are orchestrated to work together. This explanation of the deliberate packaging of the trades flatly contradicts claims that the trades are independent and unrelated.

18

Chase apparently entered into Enron-style prepays with seven

companies in addition to Enron.

Citigroup also developed a presentation to sell companies on

Enron-style prepays, promoting, in particular, the Yosemite structure it had developed to raise money for the prepays from thirdparty investors without explicitly informing them of the transactions. And you can see—well, we had a copy of the Yosemite

structure up earlier. The Citi presentation boasts that the structure ‘‘[e]xpands capability to raise non-debt financing and . . . improve cash flows from operations’’ and ‘‘[e]liminates the need for

Capital Market disclosure, keeping structure mechanics private.’’

Citi sold its prepay structure to two other companies and shopped

the Yosemite structure to 14 other companies.

This shows that Enron is not the only company obtaining loans

disguised as commodity trades and recording cash flows from operations instead of from financing. Major financial institutions are

knowingly assisting and even promoting such transactions, which

would not be possible without their willingness to provide the

funds, the paperwork, and a sham offshore trading partner.

Thank you. Mr. Brown and I would be happy to answer any

questions you may have at this time.

Senator LEVIN. Thank you. I do not have any questions. Your

statement is very thorough and clear analysis, and I will see if any

of my colleagues have questions.

Senator Collins.

Senator COLLINS. Thank you, Mr. Chairman. I only have a couple

of questions, but I, too, want to join in complimenting the staff for

its hard work and the excellent presentation as well as the invaluable assistance that we have received from Mr. Brown.

Mr. Roach, as you indicated, one requirement of a legitimate prepay is that there has to be a legitimate business purpose for the

transaction. During the course of the investigation, were you ever

made aware of a particular need that either of these banks had for

oil or gas, or was the nature of the commodity involved essentially

not relevant from the banks’ perspective?

Mr. ROACH. With respect to these particular trades, it was irrelevant.

Senator COLLINS. So this was not a case where there was a legitimate need for the commodity by the bank; is that correct?

Mr. ROACH. That is correct.

Senator COLLINS. Mr. Brown, you have a great deal of experience

with securities laws and I would like to ask you to comment on an

issue that was not touched on in Mr. Roach’s testimony. Do you believe that securities laws might be implicated in some of these prepay transactions, and specifically I would like you to comment on

how the term ‘‘fraud on the market’’ might apply in the context of

what we are hearing about.

Mr. BROWN. Well, as far as implication of securities laws, sure,

they’re implicated in the mere sale of the Yosemite notes, for example. The sale of the Yosemite notes implicates the securities laws

since those are obviously securities. And so an issue that naturally

arises there is whether or not the investors who bought those notes

received truthful and accurate information, not misleading inforVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
19

mation, in terms of the offering memorandum and any presentations that were made to them.

The term ‘‘fraud on the market’’ is a term that comes up in what

you see in some of these securities class actions, where, quite

frankly in a situation like Enron, over a period of time the company’s stock price is supported in the marketplace by what is false

and misleading information but the public doesn’t yet know about

it. When that becomes known, then the market price drops, and so

people who buy stock during that time period have been defrauded.

How that can be implicated in a situation like this is whether or

not any persons who are actively engaged in assisting the company

in misstating its public financial statements, whether or not those

people can be determined to be engaged in securities fraud and either prosecuted or held civilly liable. So that’s how those would operate.

Senator COLLINS. Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Collins. Senator Lieberman.

Senator LIEBERMAN. Thanks, Mr. Chairman.

And again, thanks to both of you for extraordinary work. Two

quick questions.

Mr. Roach, this one picks up on what Senator Collins asked. The

charts that you gave us showed a trail of commodity transactions,

in your case, oil. Obviously, no oil actually changed hands here; is

that correct?

Mr. ROACH. Well, Senator, there was at times what they would

call physical transfer, but it was really simply a transferred title.

Senator LIEBERMAN. And ultimately, the paper went in a circle;

am I right?

Mr. ROACH. Yes, sir, most of the time it went into a circle, went

through a circle.

Senator LIEBERMAN. So that it came back to where it started,

without any other immediate effect, at least regarding the commodity.

Mr. ROACH. That’s right. On most occasions that’s what happened.

Senator LIEBERMAN. Just to the best of your knowledge, are the

financial institutions with which Enron entered into these trades,

generally in the business of buying and selling commodities?

Mr. ROACH. That gets a little bit beyond my ken. But I can comment on this, that these are financial institutions which engage in

all kinds of commodity transactions, and so they do have businesses which do engage in the trading of oil and gas. But this is

a bit different when they sit down and prearrange it all in advance.

Senator LIEBERMAN. And prearrange it with the third party involved being a corporation that they themselves set up. In other

words, Enron, financial institution, and the third party is of their

own creation.

Mr. ROACH. The bank’s creation, that’s correct.

Senator LIEBERMAN. Mr. Roach, the financial institutions, as I

have seen the press coverage of this leading up to today, argue, and

I presume they will today, that these prepaid agreements are oftenused financing mechanisms and that there is nothing inherently

wrong with using them, either in general or in the specific case of

Enron. In addition, the financial institutions argue that it is not

20

their responsibility to make sure that their clients such as Enron

properly account for and report such transactions.

I wanted to ask you now whether it is your conclusion, based on

the investigation that you and your colleagues have done, that the

financial institutions involved here did in fact know how Enron intended to use these transactions, and in that sense that they aided

and abetted Enron’s intent to mislead investors and credit rating

agencies?

Mr. ROACH. Unquestionably. The documents that we have reviewed show that the financial institutions clearly understood what

Enron’s objective was in engaging in these transactions.

Senator LIEBERMAN. Thank you, gentlemen.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you very much. Senator Thompson.

Senator THOMPSON. Thank you very much.

Gentlemen, thank you very much for the work you have done

here. It is extremely complex for most of us, but I think you have

synthesized it as well as anybody could, and I recommend these exhibits for those who understand these issues and want to know

more about how these things work.

As I look through here, it looks like there are two basic issues

or two basic problems. One has to do with the use of these forward

contracts that you have described, which basically turn liabilities

into cash flow and affects the debt equity ratio. But then there is

another set of issues, it seems to me, where you take issue with

the fact that these investment bankers put out offering memos,

prospectuses, to investors in order to sell these instruments to—I

guess they are all qualified institutional investors. Let us take Yosemite, for example. There is apparently, from looking at your documents, the prospectus did not include substantial debt that should

have been included in that prospectus. Was this debt based on

these contracts that we have been talking about? How do those two

issues interrelate?

Mr. BROWN. It is a couple of things. There is an issue whether

there should have been some additional supplemental disclosure

about what had been identified as off-balance sheet debt and

whether or not that would have been important to the investors

purchasing the notes.

The second aspect of that is whether Enron’s overall

financials——

Senator THOMPSON. Excuse me. Before you get off that. When

you say ‘‘off-balance sheet debt,’’ what are we talking about there?

Mr. BROWN. Well, there were—well, some things like—we’ve all

read about and seen—Jedi, Chewco, and then there was an

analysis done by one of the investment banks, and they’ve subsequently corrected a portion of it, but what they refer to as off-balance sheet or non-debt structures, that it would be very difficult for

someone to pick up and know about, which would affect the debtto-capital ratio and other key financial ratios relied upon by the

credit rating agencies.

Senator THOMPSON. So there was an issue as to how that category of item should be reported.

Mr. BROWN. Right.

Senator THOMPSON. Go ahead.

21

Mr. BROWN. The second aspect of it is what has been alluded to

I guess in several of the Senators’ statements and also in Mr.

Roach’s testimony, and that is just the overall effect of these prepays on Enron’s financial condition in general. I think it is interesting to note that when Enron failed last fall, the big news at that

point was over a 31⁄2-year period, approximately $2.5 billion of debt

was put back on the books. Well, here you are talking about transactions that put $2.5 billion of debt—but not classified as debt—on the books, in a year.

Senator THOMPSON. Are these the prepaid contracts?

Mr. BROWN. Right. And so there is the issue of whether or not

Enron’s financial statements, as a whole, which were incorporated

into these offerings, were rendered false or misleading by the characterization of these transactions as trading liabilities as opposed

to debt, and cash flow from operations as opposed to cash flow from

financing. Now, when Mr. Turner testifies in a little while, he will

be much more qualified than I to tell you about the implications

of those characterizations.

But suffice to say that technically you’ll hear some technical compliance with Generally Accepted Accounting Principles (GAAP)

does not mean that the financial statements or the document is

nevertheless not false and misleading, and there’s law to that effect.

Senator THOMPSON. So breaking it down in the simplest terms,

when the prospectus went out, it did not include some of these

items that you were talking about that at least arguably should

have been disclosed as Enron debt; is that correct?

Mr. BROWN. Right. And again, whether or not the characterization of the debt recordation, characterization of the cash flow, the

known use of the proceeds of the transaction to fund or prepay

other items like that, whether or not that would have been important disclosure in the offering memorandum.

Senator THOMPSON. Well, I think we know what the institutional

investors say about that or are going to say about that. They clearly say that that would have been important to them. If that is important to them, it would have had some impact on their decision

to invest.

Do you know whether or not these mortgage bankers actively

sought to keep from disclosing, keep those items from being

known?

Mr. BROWN. I believe there are some emails which indicate that

when questions started to be raised about what assets are in the

trust, the order comes down, I think, as to shut it down, or ‘‘Let’s

shut this down to keep people from asking about it.’’

Now, inherently, in fairness, there’s nothing wrong with structured finance that includes a blind pool trust. There’s nothing

wrong with that. It’s just when you combine it with all these other

things that you raise potential questions about whether or not

there would have been appropriate supplemental disclosure and

whatnot.

Senator THOMPSON. Such as a three-party deal that was not at

arm’s length, an offshore company that had no business purpose

other than to create the booking entry that was created, that sort

of thing?

22

Mr. BROWN. Yes, sir.

Senator THOMPSON. Thank you, Mr. Chairman.

Senator LEVIN. Thank you.

Following the early bird rule, Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

I would like to ask Mr. Roach, how does Arthur Andersen fit into

how these prepays were structured and accounted for?

Mr. ROACH. Well, Senator, we have seen documents that Arthur

Andersen provided guidance documents to Enron as to what types

of criteria they needed to follow in order to ensure that these transactions comply with accounting rules, and in fact the four points

that I had mentioned in my statement—and I think we will see an

exhibit on it later—those were actually taken from an Arthur Andersen presentation that we acquired under subpoena from Enron,

and we had also seen other documents that discuss that in a similar way.

So they were clearly providing them guidance on what they

should and should not be doing.

Senator BUNNING. How to set up the prepays?

Mr. ROACH. Yes, and saying this is what you need to do in order

to make sure it falls within the accounting rules.

We have interviewed some Arthur Andersen accountants who

worked on this, and the one thing that sort of comes across—it’s

not clear to us, we’re still trying to work this out—it’s not clear

whether they really knew everything that was going on with these

deals. I would say that’s still an open question, but from the interviews thus far, there are certainly some issues that we’ve discussed

with them that they profess that they didn’t know about, and that

could have caused further questions about the way in which these

transactions were accounted for.

Senator BUNNING. In the testimony by JPMorgan Chase that we

will hear later today, they say that neither Chase nor Enron has

an ownership interest in Mahonia and that Mahonia’s officers and

directors made the decision to enter into specific transactions. Do

you know who the officers and directors of Mahonia are, and were

they completely separate from Chase?

Mr. ROACH. We know who they are. It is a group over in the Isle

of Jersey called Mourant & Company. It’s a firm that provides administrative and corporate services to corporations. And those individuals serve as the officers and directors of Mahonia. Material,

which will be discussed later, indicate that while there is probably

a legal separation between Chase and Mahonia, there certainly are

multiple indicia of control over the entity and the way in which the

relationship between Chase and Mourant and then subsequently

Mahonia work.

Senator BUNNING. In other words, Chase controlled Mahonia.

Mr. ROACH. That’s our belief. And it was set up specifically to affect that situation, that the entity would not——

Senator BUNNING. The transactions——

Mr. ROACH. Well, it was set up so that Chase would not own it,

be able to control it.

Senator BUNNING. I understand. But they did it for that specific

purpose.

23

Mr. ROACH. To control it, but not own it, yes. And it was involved

in those other transactions other than those engaged with Enron.

Senator BUNNING. Last question. In your testimony I believe you

said that Enron was treating the prepaid transactions as loans on

its tax returns to get a business deduction, but was not counting

the prepays as loans on its financial statements. Is that correct?

Mr. ROACH. Yes, sir.

Senator BUNNING. How does that happen if you have an accountant? If I did that on my own tax returns, I would go to jail, directly

to jail, and do not pass go and not collect $200, as they say in the

game of Monopoly.

Mr. ROACH. Well, Senator, I’m not a tax expert, but what we

have been told in the course of our interviews is that there are

sometimes situations where for purposes of accounting and financial statements, you can treat cash flow in one way and then for

purposes of taxation treat it as another.

What we do know is that through interviews of the people in the

tax department of Enron and memos that we have obtained, that

there was a judgment made within Enron that they could, for tax

purposes, treat these—the income from these transactions—as

loans.

Senator BUNNING. And still show them in another manner for

the public to see?

Mr. ROACH. Yes, sir.

Senator BUNNING. Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Bunning. Senator Carper.

OPENING STATEMENT OF SENATOR CARPER

Senator CARPER. Thank, Mr. Chairman.

To our witnesses, thank you for being here and for your testimony. I am balancing between a couple of different hearings, and

I missed much of your statement.

Let me just ask a couple of related questions revolving around

the issue of motivation, and I am interested in your thoughts on

what was the motivation for Enron to enter into these transactions? What was the motivation for the banks who were involved

in these transactions? What was the motivation for the investors

to invest in these transactions? And finally, at the end of the day,

who gets left holding the bag?

Mr. ROACH. I guess I do because Mr. Brown is drinking water.

[Laughter.]

I mean it is hard to ascribe motives. What we have seen in documents clearly indicate that the situation with Enron was that it

was showing incredible amounts of income in its financial reports

due to the accounting mechanisms it employed to take advantage

of these long-term contracts that it had been signing. The income,

that high level of income allowed them to acquire a lot of debt. The

problem is when analysts and credit-rating agencies began to look

at the entire financial condition, there was a problem because the

cash flow that Enron was bringing in didn’t seem to be sufficient

enough to support that level of debt. So the problem Enron had

was that it had to bring in more cash in order to show people that

it could carry the debt load that it had.

24

Well, it had some problems. Its assets were not very good, and

in fact, as we’ve seen in a number of cases, probably being carried

on its books at a much higher value then they really were, so selling those assets wasn’t going to help them much. There were problems with trading off legitimately part of its trading book. So they

didn’t have many options left. If they went—and as I said earlier

in the presentations, if they went out and got a loan, that wasn’t

going to help them because that money would be shown as additional debt. So structuring these transactions in the way they did

solved the problem. They could take the cash that they received

from these transactions, and count it as cash flow from business activities, and at the same time not record it as debt. So that is the

motivation here with Enron.

Senator CARPER. I thought that was an excellent explanation.

Mr. ROACH. Thank you. It’s a little more difficult to understand

what the motives of the banks were. I mean, there are certain communications you can see that allow you to infer what’s going on.

I mean clearly Enron was a big player on Wall Street at that period of time. They were doling out lucrative contracts for a lot of

business to a lot of people. And Enron was not shy about telling

the potential suitors that if you want our business, you have to

belly up to the bar. We want to see you involved in our activities

helping us out. And we do see memos to the effect that not only

the two financial institutions that are here today, but other financial institutions were very well aware of that, and were often very

concerned about how what they were and were not doing with respect to Enron’s request affected their ability to get business in the

future. Whether that’s the full motivation I don’t know, and as I

said, I’m trying to be specific here, that we’ve seen this in memos,

that’s maybe one reason, but I don’t want to say that’s fully it or

specifically it.

A little more difficult with the investors, and I think we ought

to let Mr. Brown talk about that.

Mr. BROWN. The investors, particularly in Rule 144A transactions, there are a series of institutions that are always looking

to park funds and get good rates of return, which they were getting

from what at the time everyone would say, Fortune 10 company,

CEO or CFO, and all the other management team were being

praised as the second coming. They’d look at it and people could

very easily say, good return; what’s the risk here? Let me sign up.

And so that’s certainly going to be the motivation from people who

were investing in notes and investing, quite frankly, in the stock.

Who gets left holding the bag, I guess, at the end of the day will

be determined in bankruptcy court and in litigation, where there’s

numerous claims and cross-claims among investors, investment

banks, shareholders, lenders, and the rest. So I mean it will be a

long process determining who ultimately does hold the bag.

Senator CARPER. Thank you both very, very much.

Thanks, Mr. Chairman.

Senator THOMPSON. Mr. Chairman, could I follow up on Senator

Carper’s question a little?

The documentation you have here seems to indicate that in

terms of the motivation of the bankers, that substantial amounts

of these transactions, the money coming in from these transactions,

25

were going to pay off the bankers themselves, from indebtedness

that Enron owed to them; is that correct?

Mr. ROACH. Well, yes, sir. What began to happen—and I think

Senator Collins mentioned this in her statement—I mean it sort of

became a merry-go-round. The money brought in in prepays went

to pay off the earlier prepays. This was particularly true in the Yosemite structure. The first offering for Yosemite was $800 million.

And those funds were provided to the prepaid transaction, and

when Enron received that money it used the $800 million to pay

off two prior prepays, one named Roosevelt and the other named

Truman. I don’t pick the names, I just deliver them.

And in the second Yosemite a similar thing happened. I believe

there was about 200 million pound sterling raised in that offering

and those went to prepay transactions, and they were used to

repay prepays as well.

Senator THOMPSON. So how much of that went to the bankers

though is what I am getting at. Give me the extent of the——

Mr. ROACH. Well, in the end, the banks were the initial source

of the funds for the prepays. So when that would happen—for example, in Yosemite structure what’s really happening here is

Citicorp is transferring the credit risk that it held out into the capital markets.

Senator THOMPSON. For how much? How much credit risk were

they—— Mr. ROACH. Well, they were ultimately on the hook for the entire

amount of the value of the prepay. So, for example, at the time of

Yosemite, I think the remaining value of the Truman prepay was

about $675 million, and the remaining value of the Roosevelt prepay was about $125 million.

Senator THOMPSON. So how much of that were they able to take

care of in the subsequent prepays, all of it?

Mr. ROACH. Well, the entire amount because the entire $800 million raised in Yosemite was used to pay off those previous prepays.

Senator THOMPSON. Thank you, Mr. Chairman.

Senator LEVIN. Thank you very much to both of you again.

And we will now move to our second panel. Let me introduce you

and you can remain standing. This will be very brief. First at the

witness table, we have Lynn Turner, who is a former Chief Accountant with the Securities and Exchange Commission from 1998

to 2001.

From Moody’s Investor Service we have Pamela Stumpp. She is

the Managing Director and Chief Credit Officer of the Corporate

Finance Group. And John Diaz, the Managing Director of Power &

Energy from Moody’s Investors Service.

Ronald Barone, Managing Director of Utilities, Energy & Project

Finance Group, Corporate and Government Ratings; and Nik

Khakee, Director of Structured Finance.

This is a very distinguished panel that we have before us. We

look forward to your testimony. And pursuant to Rule 6, as I indicated, all witnesses who testify before our Subcommittee are required to be sworn. I would ask you to raise your right hands and

ask you this question: Whether or not you swear that the testimony

which you give before this Subcommittee will be the truth, the

whole truth and nothing but the truth, so help you, God.

26

1The prepared statement of Mr. Turner appears in the Appendix on page 265.

Mr. TURNER. I do.

Ms. STUMPP. I do.

Mr. DIAZ. I do.

Mr. BARONE. I do.

Mr. KHAKEE. I do.

Senator LEVIN. Thank you. We would note again that the written

testimony will be printed in the record in its entirety. We ask the

oral testimony be no more than 10 minutes, and that green light

will disappear after about 9 minutes, at which point there will be

a 1-minute warning before the red light comes on, which will give

you the opportunity to conclude your remarks.

Let me start with Mr. Turner.

TESTIMONY OF LYNN E. TURNER,1 FORMER CHIEF ACCOUNTANT, SECURITIES & EXCHANGE COMMISSION, BROOMFIELD,

COLORADO

Mr. TURNER. Thank you, Chairman Levin, Senator Lieberman,

and Senator Thompson. I testified at the first Senate hearing that

was held by the full Committee with Chairman Levin, and at that

point in time as I recall, both Senator Lieberman and Senator

Thompson said this would be a long road and it would take a lot

of determination to get us to the end of it, and I commend all of

you for the fine work that you and the staff have done. To that degree, I think the staff have done a fabulous job in trying to get to

the bottom of the issue.

There’s no question, what we’ve already heard today, that the investors have lost confidence and trust in the markets is absolutely

true. It’s evidenced probably best by the downward spiral that

we’ve seen in the markets that in the last few weeks have even

turned into what some would say is a free fall, and as a result of

that, we’ve seen investors lose in excess of $5 to $6 trillion of value

which is phenomenal.

The impact of that on America and now on our economy is turning out to be very real and in some cases devastating. It is interesting to note that back in 1929, when we had the market crash,

there were only 1.5 million Americans that were affected by that.

Today there’s 85 million Americans. One out of every two Americans are being impacted—voting Americans are being impacted—

by that today. So it has a much broader impact, and as a result,

we’re seeing, I think, the concern, the frustration, certainly the disgust in some cases on the part of Americans with that, although

I think we have to make sure that we understand we can’t paint

all market participants, all people on Wall Street with the same

broad brush. But notwithstanding that, it is important that all

market participants play a key and important role in making sure

that the financial information that is provided to investors has a

high degree of honesty and integrity, and quality and transparency

behind that.

In fact, for the people to my left here to be able to do their job

properly, they have to know that the CEO amendment CFO, the

financial executives, have got the numbers done right, that the

auditors have checked that, that the corporate boards have exerVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
27

cised, like an eagle, their oversight of that process, so that they

then get good quality transparent information from which they can

make judgments. Without that, the credit rating agencies would be

unable to fulfill their responsibility to the public. And with that as

a backdrop, I think the whole Committee and Subcommittee is to

be commended for asking what role Wall Street has played in these

particular transactions, and in particular these two financial questions.

There’s no question that people need to ask things. What was

their role in this in structuring and engineering and financing

these transactions, and then executing them.

As Senator Collins said in her opening remarks, perhaps this is

happening all too often. From my vantage point as the Chief Accountant at the Securities and Exchange Commission, as a CFO,

and as a partner of Coopers & Lybrand, I can tell you quite frankly

it is business as usual. It happens day-in, day-out, every day on

Wall Street. Quite often at the SEC we would spend a significant

amount of time finding these transactions and then trying to put

a lid on them. As the CFO, I was actually urged by members of

Wall Street to undertake accounting that was woefully inadequate

and in violation of the SEC rules. I might note we didn’t do it. I

had a great CEO and a great board, and quite frankly, each one

of the Big Five accounting firms has an on-call group that works

very closely in conjunction with Wall Street in carrying out and designing and engineering these transactions to ensure that they get

disguised and hid from the investors.

And with that though, let’s get into the accounting for just briefly

for a moment here as we try to summarize this. There are so many

of these transactions because they are being done day-in and dayout that the Financial Accounting Standards Board can’t write a

rule for every single one of them. Not enough time, not enough resources to do that. But there are some general guidelines, general

principles. And some of those clearly say, as I outlined in my written statement, that what we do is we look through to the substance

of the transaction, and there are some rules in black and white

that talk about that. And in my statement I note that the SEC, for

example, has objected, and it’s in black and white to transactions

going off-balance sheet when you just came up with a nominally

capitalized SPE like what we have here in Mahonia or Delta, and

just insert that into the transaction, try to get off the balance

sheet.

Task forces of the FASB have also come out in black and white

and talked about situations where securities are issued and purchased, and I’ll say, ‘‘for the sole purpose of achieving a desired accounting results, and the transaction considered individually would

serve no valid business purpose or would not be entered into otherwise.’’ In those situations we look right through the structure to

find out what the substance of it is, and if it’s debt, it needs to go

on the balance sheet as debt.

So as you can see in this particular case, it’s not an issue of

being the gray. This is an issue of black and white. And leaving

these liabilities up in the trading credit risk area, rather than

showing them as a true loan to the bank is just absolutely wrong.

Now, some would argue that who cares—and I think you will hear

28

some arguments as long as it was a liability on the bank, should

we care at all? Or on the balance sheet, at least it’s there. And I

think the answer is very much so. That’s why the SEC has promulgated very clear rules that say each material line time on the balance sheet needs to be separately broken out. You cannot aggregate

them all and just show them one line item on the balance sheet,

and I can guarantee you that as the CFO at my former employer,

if I had prepared financial statements and had just one line item

on my balance sheet and we’re a large international semiconductor,

and I had of gone to either of these institutions and asked them

for financing, just said, liability, hundreds of millions of dollars,

there is no way that their own banking divisions would have ever

given me a loan on that basis.

There’s also a question being raised here about the reporting for

the cash flows. In a statement that the Financial Accounting

Standards Board issued Statement No. 5 on reporting a cash flow,

the FASB decided—and I think appropriately so—by rule, that you

have to break out where the sources of your cash are coming from

so that investors could see is it being generated by normal business

operations or is it coming from the banks who are providing you

financing, or is it coming from sales of assets, so that investors can

currently tell what’s going on with the business and how well management is doing in achieving their goals.

When you turn around and put these cash flows from these financing vehicles up in the statement of cash flow from operations,

then there is no question it misleads investors and there is no

question it will mislead the credit rating agencies, and the analysts

into thinking that the business is doing much better, it’s generating as lot more cash than it really is, which it can then turn

around and use or lacks to use to pay off the bank debt. And to

that degree, I think investors on this particular case were woefully

misled.

It’s also interesting to note that in a court case back in 1969,

that the judge in that, on appeal in the U.S. Court of Appeals for

the second court, noted that notwithstanding what the GAAP rules

are, they kind of provide a minimum floor that if in fact there’s material information out there that investors are entitled to or should

know, then you need to get that information in the filing. The

judge turned around and said that proof of compliance with Generally Accepted Standards was evidence which may be persuasive,

but not necessarily conclusive, and in that case, that the facts were

certified were not materially false or misleading, so he says you got

to go beyond GAAP if there’s material information.

And interesting enough, he goes on to say that when someone becomes aware of something that may be in compliance with GAAP,

but more information is needed, the judge said, ‘‘Once he has reason to believe that this basis assumption is false, an entirely different situation confronts him. At least this must be true when the

dishonesty he has discovered is not some minor peccadillo, but a

diversion so large as to imperil, if not destroy, the very solvency of

the enterprise,’’ which is exactly what we have in the Enron situation. And so with that I think it is just a matter of black and white.

These numbers should have gone on the balance sheet as debt

without a question.

29

1The prepared statement of Ms. Stumpp and Mr. Diaz with an attachment appears in the

Appendix on page 278.

And let me just finish by commending the Senate, the 97 Senators that voted for the Sarbanes Bill. I think the Sarbanes Bill

will help, will go a long ways to solving some of these problems.

Certainly the Auditor Independence Provisions in there would

cease the auditors from being involved in helping structure these

transactions to keep them away from the public, and certainly I

think will bring the confidence of the public back to the market. So

I commend all 97 of you for having taken that serious undertaking.

Senator LEVIN. Thank you very much, Mr. Turner. Ms. Stumpp.

TESTIMONY OF PAMELA M. STUMPP,1 MANAGING DIRECTOR,

CHIEF CREDIT OFFICER, CORPORATE FINANCE GROUP,

MOODY’S INVESTORS SERVICE, NEW YORK, NEW YORK, ACCOMPANIED BY JOHN C. DIAZ,1 MANAGING DIRECTOR,

POWER & ENERGY GROUP, MOODY’S INVESTORS SERVICE,

NEW YORK, NEW YORK

Ms. STUMPP. Good morning, Mr. Chairman, Senator Collins, Senator Lieberman and Senator Thompson, and Members of the Subcommittee.

My name is Pam Stumpp, and I am Managing Director at

Moody’s Investors Service and the Chief Credit Officer for the Corporate Finance Group. I am joined by my colleague, John Diaz, who

is a Managing Director in our Power & Energy Group. On behalf

of Moody’s, we’re pleased to appear before you today at your request regarding your investigation into the role of the financial institutions in the collapse of Enron.

For over 100 years Moody’s has played an important part in providing informed and independent credit analysis to investors. We

are proud of our history as the world’s oldest credit rating agency,

and we’re cognizant of the responsibility that this legacy confers

upon us. It was with this responsibility in mind that we accepted

your invitation to share our views on the critical issues before you.

At a time when America’s faith in the integrity of its corporations

and the stability of its financial markets is badly shaken, we applaud the efforts of this Subcommittee, the Congress, the Securities

& Exchange Commission, to investigate Enron’s failure, and identify the larger lessons that can be learned from the company’s collapse.

We are especially interested in these issues because our ratings

depend heavily upon the integrity of the public financial statements provided by corporations. In our assessment of a company’s

creditworthiness, Moody’s analysts begin with the premise that the

issuer’s SEC filings and audited financial statements are accurate.

We them bring the benefit of our experience and expertise to our

analysis. But as the Enron situation has demonstrated, where the

principle of transparent public disclosure is abandoned, neither we

nor the regulators can properly fulfill our obligations to the market

and investors globally.

Before discussing Enron and related issues in more detail, it is

important for me to note that Moody’s did not have any knowledge,

prior to Enron’s bankruptcy, of the existence of Enron’s prepaid forVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00049 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
30

ward and related swap transactions. Even today our understanding

of the specifics of these transactions is restricted to what we have

gleaned from press accounts and conversations we have had with

the Subcommittee staff at their request. Based on our limited

knowledge, these transactions appear to have been a form of financing. If such transactions had been accounted for as a loan,

Enron’s operating cash flow would have been reduced and its debt

would have been greater. The disclosure of these transactions as

loans would have exerted downward pressure on Enron’s credit rating.

Of course, knowing all that we do know today about the true nature of Enron’s corporate enterprise, it is clear that Enron had not

been an investment grade company for several years. The compounded impact of these transactions alone on Enron’s financial

framework may have resulted in the lower rating and perhaps an

earlier downgrade to below investment grade status. More fundamentally, however, Moody’s would have questioned management’s motivations to have implemented such a structure.

As Moody’s does with all corporate entities, we expressed to

Enron our views regarding its creditworthiness. Specifically Enron

was rated in the Baa category, Moody’s lowest investment grade

level. Entities rated Baa contain speculative elements. We had

communicated to Enron that its Baa rating reflected its high level

of debt relative to its operating cash flow. Consistent with Moody’s

practice not to recommend that corporate issuers follow specific

courses of action, Moody’s did not instruct or suggest that Enron

employee prepaid transactions or other artificial means to increase

operating cash flow or to understate debt levels.

Moody’s did provide ratings for the notes issued by Citibanksponsored Yosemite Trusts I and II, as well as the several Enron

Credit Linked Notes Trusts. We viewed these transactions to be a

means through which Citibank reduced its level of Enron risk. We

have submitted, along with this opening statement a diagram of

the Yosemite structure as presented to us in the offering memorandum. Yosemite was a structure of the type that our structured

finance group examines and rates frequently. The purpose of these

structures is essentially to transfer the credit risks associated with

a particular company to third-party note holders.

In this instance a trust was created that issued notes to investors. Citibank was obligated to make payments to the trust, which

were then passed to investors. Citibank was not obligated to make

these payments if Enron failed to pay on its senior note obligations

or filed bankruptcy. In exchange for principle and interest due

under the notes, the investors assumed the risk that Enron might

go into bankruptcy or fail to pay on its obligations. Therefore, the

likelihood that the note holders would receive the promised returns

on these notes was linked directly to Enron’s creditworthiness.

It should be stressed that structured financing is a common risk

management tool available globally to corporations, financial institutions and State and local governments. It is a recognized method,

for example, of enhancing liquidity and of transferring credit risk

when appropriately implemented. What might seem to be a complex structure can in fact genuinely accomplish one or more of

these goals. The Yosemite transaction transferred Enron risks exVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
31

1The prepared statement of Mr. Barone and Mr. Khakee with attachments appears in the Appendix on page 282.

actly as they intended to. The problem was that the actual Enron

risk was different from that portrayed by Enron’s incomplete and

misleading financial disclosures.

The securities market can only function efficiently with transparent and credible financial information. It is critical to strengthen these elements of our financial infrastructure and bolster investor confidence. As a major consumer of publicly-available information, we support rule changes by the SEC and Congress that

enforce transparency and penalize corporate deception. Furthermore, we endorse a principle-based approach to accounting, rather

than a rules-based approach. Accounting that promotes adherence

to the spirit and the letter of the rules would strengthen the foundations of our financial system.

At this critical juncture, we hope all market participants step forward to offer confidence-building measures. As far as Moody’s is

concerned, we are expanding our knowledge in key disciplines that

have come to influence credit risk. We are recruiting specialist

teams with particular expertise in credit-related areas such as accounting quality, corporate governance and off-balance sheet risks.

These teams will supplement the work of our credit generalists in

their analysis of a company’s creditworthiness. We hope that our

independent assessment of financial reporting and corporate governance will improve market transparency and contribute to the

restoration of confidence in our capital markets.

Finally, as an institution that views its role in the capital markets with both pride and great seriousness, we welcome the opportunity to assist this Subcommittee in examining the shortcomings

of the present system and in working toward effective solutions.

Therefore, on behalf of our colleagues at Moody’s, John Diaz and

I would like to thank you for the opportunity to appear today, and

we look forward to answering your questions.

Senator COLLINS [presiding]. Ms. Stumpp, thank you so much for

your testimony. We only have about 2 minutes remaining in the

vote that is under way, so Senator Thompson and I are going to

go vote. Senator Levin will be back very shortly, and will reconvene

the hearing, but I will put the hearing in recess until he returns.

Thank you for your testimony.

[Recess.]

Senator LEVIN [presiding]. The Subcommittee will begin again.

And I believe Ms. Stumpp has completed her testimony, and so we

will move to Mr. Barone.

TESTIMONY OF RONALD M. BARONE,1 MANAGING DIRECTOR,

UTILITIES, ENERGY & PROJECT FINANCE GROUP, CORPORATE AND GOVERNMENT RATINGS, STANDARD & POOR’S,

NEW YORK, NEW YORK; ACCOMPANIED BY NIK KHAKEE,1 DIRECTOR, STRUCTURED FINANCE GROUP, STANDARD &

POOR’S, NEW YORK, NEW YORK

Mr. BARONE. Good morning, Mr. Chairman, and Members of the

Subcommittee. I am Ronald M. Barone. From 1994 until Enron

Corporation’s bankruptcy in December 2001, one of my roles at

32

Standard & Poor’s Ratings Services was to serve first as an analyst

and then as a manager with respect to Enron.

I am joined today by Nik Khakee, who was the senior analyst involved with our work on the Yosemite and Credit Linked Notes

Trusts. The comments I will make a little later regarding those

trusts were prepared by Mr. Khakee.

On behalf of Standard & Poor’s, we welcome the opportunity to

appear at this hearing. Ratings are a key component of the capital

markets, which have functioned effectively for decades in the

United States, and Standard & Poor’s is recognized as a global

leader in the field of credit ratings and risk analysis. While all parties may not agree with our ratings at all times, Standard & Poor’s

credit ratings have gained respect and authority throughout the investing community because they are widely understood to be based

on independent, objective and credible analysis. The record bears

out Standard & Poor’s emphasis on objectivity and credibility.

There is a longstanding and exceptionally strong correlation between the ratings initially assigned by Standard & Poor’s and the

eventual default record. The higher the initial rating, the lower the

probability of default and vice versa.

Our ratings opinions are based on a company’s audited financial

information and qualitative analysis of the company and its industry sector. We also may have access to certain confidential information of the company, but only to the extent that the company’s

management is willing to provide such information. We use that information and rely upon it.

With regard to Enron Corporation, from 1995 until November 1,

2001, Standard & Poor’s rating of Enron was BBB +, which placed

Enron at the lower levels of investment grade ratings and was well

below what Enron repeatedly and unsuccessfully sought from

Standard & Poor’s.

It now appears, based on what Mr. Roach and Mr. Brown just

testified to, that in addition to the already well-documented deceptions regarding its off-balance sheet partnerships, Enron may have

incurred approximately $4 billion in debt-like obligations structured as prepaid forward transactions and swap transactions. Our

contemporaneous understanding of these types of transactions was

that in the years leading up to its bankruptcy, Enron was employing them to actively manage its trading and marketing positions

and cash flow. While Enron did not provide specific details about

these particular transactions, the generalized information it did

provide, which underpinned our analysis, led us to conclude that

the funds from these transactions were more akin to operational

cash flow than new debt-like obligations.

Despite our repeated requests for complete, timely and reliable

information, Enron did not disclose any information revealing a

link between the prepaid forward transactions and the swap transactions. Similarly, Enron provided no indication that these transactions were in any way related to any of the Yosemite or Credit

Linked Note transactions, despite an explicit inquiry by Standard

& Poor’s regarding the effect, if any, of these structured finance

transactions on Enron’s financial situation. While our knowledge

about the full nature of these transactions and/or any links between them is still limited, any lack of disclosure by Enron of their

33

material aspects would have been yet another flagrant violation of

Enron’s duty and responsibility to provide Standard & Poor’s with

complete, timely and reliable information.

In hindsight, and without full information, it is difficult to assess

the effect full disclosure about these transactions would have had

on our ratings analysis; but the sheer volume of the transactions

suggests that it would likely have been significant.

It is worth noting as well that on no occasion did we advise, consult or suggest to Enron that it should employ these prepaid forward transactions or swap transactions, or any other means to increase cash flow.

The Subcommittee has also requested information regarding our

understanding of the structure and operations of the Yosemite and

Credit Linked Notes Trusts. Each of these trusts was structured as

a standard Credit Linked Notes transaction in which the credit

risk of a particular entity, which in these trusts was Enron, is

transferred to the purchaser of notes issued by the trusts. In such

transactions a counter-party seeks to purchase protection against

the default of a particular issuer. In the first Yosemite transaction,

for example, the protection buyer was Citibank. On the face of it,

by entering into a credit default swap, Citibank protected itself

against a default by Enron. In the event of such a default, Citibank

would receive consideration from the protection seller. Here the

protection seller, the Yosemite I Trust, obtained the funds needed

to pay Citibank in such an event by selling notes and certificates

to qualified institutional buyers.

Because our ratings analysis of the notes issued by these trusts

required us only to focus on the structure of the transactions and

whether the default risk of the trusts notes was a genuine pass

through of the default risk of Enron, our analysis did not include

review of the day-to-day operations of the trusts. As with all such

transactions, it was the trustees’ responsibility to ensure that the

proceeds of the notes were invested in accordance with the terms

of the indenture and that all of the trusts’ operating requirements

were met.

Enron’s demise, along with other recently revealed corporate accounting problems has damaged the public’s confidence in the marketplace and the economy as a whole. Because our ratings ultimately depend upon information provided by the issuer, Standard

& Poor’s has been a long-time champion of complete, timely and reliable disclosure of information and the highest standards of corporate governance.

To that end, while we applaud the recent proposals and recommendations made by the Securities & Exchange Commission,

Standard & Poor’s has already stated publicly our belief that such

proposals are only a partial solution, as they still leave wide room

for interpretation by companies and their accountants about whether certain items qualify for additional disclosure.

We have recently published two articles, which I have included

with my testimony, which focus on the various proposals in light

of Standard & Poor’s ratings practices. We are also in the process

of reviewing current accounting and regulatory requirements with

an eye towards making specific recommendations for improvements

34

1 Exhibit No. 112 appears in the Appendix on page 367.

aimed at fostering greater corporate transparency and restoring

public confidence in the markets. Thank you.

Senator LEVIN. Thank you very much, Mr. Barone.

First, Mr. Turner, if you would take a look at Exhibit 112.1 This

is an Andersen analysis on when a transaction that is being called

a prepay can properly be counted as a trading contract and as cash

flow from operations rather than as debt and cash from financing.

Now, we’ve put that analysis also on a board up here to my right.

We’ve put it on one page to make it easier to use.

In your testimony you said that you agreed with Arthur Andersen’s four key points for determining when a prepay transaction

can be accounted for as a trading contract, and I want to ask you

about a couple of the four elements.

First of all, if a transaction fails to meet any of those criteria,

am I correct that it fails the test for being treated as a trading contract?

Mr. TURNER. Yes. In this case I think that would be true.

Senator LEVIN. In other words, if you fail any of the four, it fails

as a trading transaction; is that correct?

Mr. TURNER. Yes, I would agree. I think that was Andersen’s

analysis, and I would agree with them.

Senator LEVIN. Now, the first criteria is that none of the agreements in the structured transaction may be linked. In your judgment were the transactions involving Enron and Chase and Enron

and Citibank linked?

Mr. TURNER. Yes. Your staff has shown me some exhibits. I don’t

recall which Bates numbers, but it certainly looked like they were

linked to me.

Senator LEVIN. For instance, we understand that Mahonia entered into a contract in which it assigned to Chase all of its rights

to any payment from Enron. Does that constitute linkage?

Mr. TURNER. Yes.

Senator LEVIN. And what effect does that alone have on the accounting for this transaction?

Mr. TURNER. When you link all these transactions together, in

essence what you are seeing is that it’s really just a collapsible

transaction between Enron and the investment banker, in this particular case, which would turn it into being a bank loan on the balance sheet.

Senator LEVIN. So that it would destroy that prepay triangle and

just reduce the transaction to a loan between Enron and Chase?

Mr. TURNER. That’s correct.

Senator LEVIN. Now, you’ve seen some of the evidence the Subcommittee investigation obtained with respect to Mahonia and

Delta and their relationship to Chase and Citibank. That evidence

shows that the banks directed the establishment of those offshore

entities; they controlled the transactions that the offshore entities

entered into; they set up their bank accounts, and they effectively

controlled them since the offshores were shells with no employees,

offices or ongoing business facilities.

Under those circumstances, were Mahonia and Delta independent from Chase and Citigroup?

35

Mr. TURNER. No. As I think the written testimony points out in

a number of places in the accounting literature, where you just insert a nominally capitalized SP with no real business purpose, you

collapse it, and again, you get down to just a transaction between

the investment banker and—the bank loan and Enron.

Senator LEVIN. Now, is it important that they be independent because if they are not independent third entities out there, this is

just simply, in essence, a loan transaction between the bank and

Enron?

Mr. TURNER. That is true. What the accountants are really looking for is do you have three independent parties each taking on a

legitimate business purpose, legitimate business risk behind the

transaction, or is it really just a sham transaction designed to try

to avoid the accounting rules.

Senator LEVIN. Now, another of the Andersen criteria requires

that the parties to the energy trade have an ordinary business purpose for buying or selling the prepay commodity. From what you

can tell, did either Mahonia or Delta have an ordinary business

reason for engaging in energy trading?

Mr. TURNER. No. I think, in fact, a number of the emails and

memos specifically talk about the purpose was to try to hide this

from the balance sheet of Enron and its investors.

Senator LEVIN. Now, Citigroup has said in its prepared testimony that the ‘‘overall cash flow for Enron would be exactly the

same whether Enron used prepaids or entered into a bank loan. In

the case of prepaids,’’ the testimony goes on, ‘‘which are contracts

transacted in Enron’s trading book, Enron booked the cash it received on these contracts as cash from operations, not as cash from

financing.’’ Let me correct my question. Citigroup’s testimony said that the

overall cash flow for Enron would be exactly the same whether

Enron used prepaids or entered into a bank loan. My question to

you is: Is it, in fact, the same?

Mr. TURNER. No. Without a doubt, both the accounting rules,

GAAP, as well as the SEC regulations and SEC disclosure regulations make it very clear that you have to separate out the three

different components of cash flows and report them properly. Those

you generate from normal, ongoing, legitimate business operations,

which is cash that you then might be using in the second category,

and that is financing to pay back loans, so you have to show financing separate, distinct, those funds that came in from a bank loan

separate and distinct from those that you generate from just selling

normal products and goods in the normal course of business.

So they are not the same, and what is so interesting in that testimony is while people say it is the same and it really doesn’t matter, people don’t go to such great lengths and engage auditors, attorneys, accountants, and do all this paperwork and incur all these

costs and time if it doesn’t matter. If it doesn’t matter, you just follow the GAAP rules. But in this case, that is not what happened.

There was a reason that they did this, and that was to hide and

disguise it from investors.

Senator LEVIN. What difference does it make to investors?

Mr. TURNER. Investors need to know what the liquidity of the

business is going to be. Are you going to have the resources to meet

36

your different type of obligations? Is it an account payable that you

may need to pay off in the next 30 days? Or is this going to be a

big debt payment going to come due? It is like you, perhaps, Senator, going and asking a bank for a loan and putting your credit

card receivables, your mortgage on your house, your loan on your

car all on one line and going into the bank and saying, Don’t worry

about it, it’s all one line liability, you don’t need to know any more

information about it. I don’t know of a bank that would make you

a loan on that basis.

Senator LEVIN. This is the way they summarize their argument

in their testimony that is prepared: ‘‘Price risk management liability is a liability, plain and simple. It must be satisfied every bit as

much as debt. Thus, while not recorded as debt, prepaid liabilities

were clearly obligations of the company and visible as such to investors.’’

Do you agree with that?

Mr. TURNER. I couldn’t be in more disagreement with that than

you could get. It is absolutely false. It is wrong. It is counter to the

SEC rules. It is counter to GAAP. And, quite frankly, again, if I

was the CFO at Symbios and approaching either of these banks’

lending group with a set of financial statements where you treated

your liabilities all on one line like that, I can guarantee you—in

fact, I think one of the banks might have even been in the consortium of banks that loaned to me at Symbios—they would have

never, ever accepted those financial statements or given me a loan

on that basis.

Senator LEVIN. Ms. Stumpp, do you agree with that quoted statement of their testimony?

Ms. STUMPP. I don’t agree with their quoted statement. In fact,

I agree with Mr. Turner.

Mr. DIAZ. I would add that from our point of view as a rating

agency, that is definitely misleading because we rely very much on

cash flow to debt as a key measure, on cash flow coverage of interest, and what it’s doing, it’s inflating the cash flow and reducing

the debt. So from our point of view, it has a major impact.

Senator LEVIN. Mr. Barone, do you agree with that quoted statement from Citigroup’s testimony that price risk management is a

liability, plain and simple, that it must be satisfied every bit as

much as debt, thus, while not recorded as debt, prepaid liabilities

were clearly obligations of the company and visible as such to investors? Do you agree with that?

Mr. BARONE. No, not necessarily, Senator. While they may have

appeared as liabilities on the balance sheet under price risk management liabilities, our determination of the credit protection ratios

of Enron would have looked more towards true obligations and not

the short-term nature of what the price risk management liability

may have proved, because it is often offset by assets from price risk

management. And that is how the company had always explained

that their trading books were generally in balance. So, no, it’s definitely concealing an obligation.

Senator LEVIN. And that is highly relevant to you?

Mr. BARONE. Absolutely.

Senator LEVIN. Because it is relevant to investors.

37

1 Exhibit No. 104 appears in the Appendix on page 355.

Mr. BARONE. I would say sure. I’m not an investor, but as someone who evaluates a company’s credit and bonds that are ultimately bought by investors, it trickles downhill there.

Senator LEVIN. Mr. Khakee, did you want to add anything to

that?

Mr. KHAKEE. No. I echo my colleague’s comments.

Senator LEVIN. Thank you.

Now, Chase and Citibank didn’t just go along with Enron and

what Enron wanted to do with its prepays—these so-called prepays, these phony prepays, these fake prepays. Both banks went

further. They tried to sell these Enron-style prepays to other companies. Before doing that, should each bank have done its own accounting analysis of the structure, consult with its own accountants

to determine that the suggested accounting complies with generally

accepted accounting principles? Could the banks reasonably rely

solely on the accounting judgment of a client and say that our client’s auditor said these transactions could be accounted for this

way so that is good enough for us? Shouldn’t they have done their

own analysis, Mr. Turner?

Mr. TURNER. Yes. I actually agree with you on that, Senator, and

I think that is where Judge Friendly was going in the court case

that I mentioned to you before.

If you become aware of evidence, which clearly they were, as it

is cited and referred to in a number of these memos, that there is

something improper going on with the financial statements, then

you have got to—you can’t just stick your head in the sand like an

ostrich. You have got to follow it through and make sure that it is

okay and it is done right. In fact, at times when I was at the Commission, when we were aware of the fact that professionals outside

the company who operate as gatekeepers to make sure the markets

maintain their integrity, when they became aware of things and

did stick their head in the sand and didn’t follow through, then we

did take enforcement actions and did investigate the matters,

which I hope will happen here.

Senator LEVIN. Two final questions from me. Ms. Stumpp, you

say in your prepared testimony—and perhaps I missed it in your

oral testimony—that Moody’s did not have any knowledge prior to

Enron’s bankruptcy of the existence of Enron’s prepaid forward and

related swap transactions. Is that accurate?

Ms. STUMPP. That’s accurate.

Senator LEVIN. Finally, my last question to Mr. Barone. You

have seen the staff analysis. If you look at Exhibit 104,1 this is an

analysis of the impact on Enron’s debt of these sham prepays. I

think it is in the book in front of you also. Do you agree with that

analysis?

Mr. BARONE. Senator, I would agree that treated as a loan, you

would add additional items to the debt line. You would reduce cash

flow, as it states, and you would record a particular amount of implied interest associated with the additional debt. If you are going

to add debt, you must add interest. So in that regard, yes, I agree.

The mathematics of the calculation of the funds flow interest covVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00057 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
38

erage I’m not doing here, but it does not look all that out of bounds.

It looks pretty accurate.

Senator LEVIN. And so their treating this as business income

rather than as a loan, has that significant effect on its credit rating?

Mr. BARONE. As presented here, yes. Going from 4 times interest

coverage to 2.25 times interest coverage, all things being the same,

no change in business risk, no change in strategy, and so forth, yes,

that is significant.

Senator LEVIN. And should this have been treated as a loan in

your judgment?

Mr. BARONE. Not having immediate firsthand knowledge of how

the transaction went down, but based upon the testimony I listened

to today, yes, sir, it should have been treated as an obligation, as

a loan.

Senator LEVIN. And shown as debt?

Mr. BARONE. And shown as debt.

Senator LEVIN. Thank you. Senator Collins.

Senator COLLINS. Thank you, Mr. Chairman.

Mr. Turner, I want to thank you for your usual straightforward

testimony. It is very helpful to us in sifting through the conflicting

messages and testimony that we are getting.

You testified that there is no question that the accounting treatment misled investors. The banks essentially are responding with

two, in my view, contradictory arguments. On the one hand, they

are saying that there were no red flags, an assertion that clearly

is contradicted by all of the internal documents that we have. But

their second argument is, ‘‘it is not our responsibility to make sure

that Enron is reporting the debt correctly; it is not our job.’’

In your opinion, if a financial institution is involved in helping

to create and finance this type of transaction and understands that

they are going to be used by their client to misrepresent the company’s financial position, what obligation does the financial institution have?

Mr. TURNER. Senator, in this particular case I think what concerns me, certainly what had concerned me from my role as an

SEC chief accountant, was the fact that in some of these transactions they were actually going out and raising money from the

public to fund these vehicles. And they had firsthand knowledge of

exactly what was going on, but there was not full and fair disclosure to investors. So they, in essence, withdrew from the investors

their ability to make an informed decision as they were buying

these securities because they didn’t see a clear and transparent picture.

At the Commission and in the markets, you have to rely upon

these gatekeepers to make sure all the material information is provided to investors. When a professional gatekeeper knowingly withholds that information, I think it raises not only the question that

Senator Levin raised in an earlier question about whether or not

they aided and abetted in what happened here, which I certainly

think they did, but I think if I was still at the SEC, we’d certainly

look at whether or not they had a primary obligation under the securities laws since there appears to have been willful knowledge

here of a lack of disclosure to investors that they were raising

39

money from to make that disclosure to them. And I would suppose

that’s certainly one thing that the Commission will turn around

and take a look at.

Senator COLLINS. Let me follow up on that very point. Have you

had the opportunity to review the prospectus that Citigroup created for the Yosemite Trust?

Mr. TURNER. Yes, I have read—I haven’t read every word, but

I’ve scanned through the Yosemite Trust offering.

Senator COLLINS. And what are your preliminary conclusions regarding the accuracy of the representations made of Enron’s financial picture in that prospectus?

Mr. TURNER. One, it refers back to some of the Enron filings that

clearly don’t have this financial information presented as a loan to

it and is telling investors go look at that, notwithstanding the fact

that they clearly knew, as evidenced by their own internal memos,

that it had been kept off those balance sheets as debt. And so I

think there’s a legitimate question here based upon what I’ve been

provided so far to date, that raises the question about whether or

not there were disclosures that the investment bankers were aware

of and should have been aware of based upon their due diligence

that were missing.

Senator COLLINS. It seems to me based on the review of the documents in this case that in the specific instance of structuring the

prepays, that Andersen gave accurate guidance in this instance to

Enron on the criteria that must be satisfied in order for this to be

a legitimate prepay. Would you agree with that?

Mr. TURNER. Yes, I think Andersen did give some good guidance

to the people involved with it, and it’s guidance certainly I would

have used myself if I was still a partner out there in evaluating

whether these would be treated as prepaid trading assets and liabilities or as debt financing. So I think their conclusion, and conclusion as to how to apply it to these transactions were correct.

Senator COLLINS. But the criteria they set out clearly were not

followed.

Mr. TURNER. I would agree with that. In fact, Senator I would

turn around and tell you that some emails or correspondence

makes it appear like people almost attempted to mislead Andersen,

which is highly unfortunate. Again, one of the fine things that the

Senate dealt with in the Sarbanes bill.

Senator COLLINS. Mr. Turner, some people have told us and continue to maintain—and this follows up on a question that the

Chairman asked you—that the technical manner in which Enron

accounted for its obligations under these transactions was really irrelevant because the trading liability or debt would be viewed similarly by the markets.

Could you explain for us further why it does, in fact, matter how

Enron chose to report this cash, whether it reported it as cash from

its trading operations or as a loan?

Mr. TURNER. Yes. In particular on this balance sheet, this balance sheet has a significant amount, billions of trading assets, billions of trading liabilities, and I think a normal reader of these financial settlements would understand that companies’ traders try

to match those assets and liabilities to where they come due at the

same time and offset one another. And as a result, you’re not going

40

to have to be generating a bunch of additional cash flow to be paying down bank debt or meet the interest and principal payments.

But, in fact, that wasn’t the case here. These really weren’t trading assets and liabilities that were going to be offset. They were

bank loans who had debt and principal payments, interest payments that had to be met, and the company wasn’t generating sufficient cash flow to meet those, as we all know now, because it

ended up in bankruptcy.

By being able to pump up the cash flows to make it look like they

were generating a lot of cash and then hide the bank debt so it

looked like they didn’t have a lot of bank debt payments coming

due, it disguised the true nature of what the real liquidity of this

institution looked like. We can tell, quite frankly, we all found out

the day it filed for bankruptcy that it really didn’t have the cash,

didn’t have the liquidity. The only thing it did have was a lot of

bank debt that we found out for the first time was off-balance

sheet.

Senator COLLINS. Ms. Stumpp, many analysts have described

Enron’s finances as ‘‘verging on the impenetrable,’’ and, in fact, one

stock analyst described it as a ‘‘black box.’’ Did your rating agency

have difficulty in ascertaining the true picture of Enron’s finances?

Ms. STUMPP. Well, in retrospect, knowing what we all know

now——

Senator COLLINS. I don’t want you to answer in retrospect. I

mean, when you were going through the process, did you find it difficult to analyze and rate Enron because of the complicated and unusual nature of many of its transactions?

Mr. DIAZ. Maybe I can answer that, because I was responsible

for Enron. We certainly looked at Enron as being a very complex

company, mainly because of its trading operations, so we spent a

lot of time trying to understand the risks around the trading and,

as Mr. Turner said, trying to understand the matching of the assets and liabilities.

I think we also spent a lot of time trying to understand the nature of some of the financing that was taking place off-balance

sheet in terms of their investments in international projects.

But the fundamental problem was that we did not see what they

were really doing in terms of the prepaids, which is part of the picture. We also were not able to see the existence of some of the

other off-balance sheet vehicles like LJM and Braveheart and all

those other vehicles that were kept out of the limelight.

So, what looked like a complex but understandable company

really was not. There was a lot of misleading—there was a lot of

deception in the way that they presented the financial statements.

Senator COLLINS. But you felt that you had adequate information

on which to base a rating decision?

Mr. DIAZ. At the time we did because—if we had felt that we

didn’t—we would have either withdrawn—we probably would have

withdrawn the rating. So at the time, based on the information we

had, we did believe that we had adequate information.

Senator COLLINS. Mr. Barone, I am going to ask you the same

question.

Mr. BARONE. Yes, I echo my colleagues’ remarks. While Enron

was certainly a little more complex than some of the other energy

41

credits that we evaluated—we spent a considerable amount of time

trying to delve in and do the analysis, and we believed that we

had—given the information that was provided to us—that it was

full and adequate and enough for us to do the evaluation, certainly.

What we’ve learned in retrospect, obviously is that that was not

necessarily the case.

Senator COLLINS. Mr. Turner, I am going to put you on the spot

here. Did the rating agencies do a good job?

Mr. TURNER. You’re right, you are putting me on the spot. Let

me say this, Senator: I remember back around the middle of October, as this whole thing was imploding on itself, one of the newspaper reporters calling me up and asking me if I would review and

read the Enron financial statements.

I went through and read them in depth at that point in time, and

to be quite honest with you, they raised more questions in my mind

than they answered. They raised a lot of questions because there

were tantalizing little bits of information, but certainly not enough

to analyze the full set of financials from. And the question is: Did

people who were analyzing them, not only the rating agencies but

the stock analysts as well, were they able to go back into Enron— because certainly they get a mosaic of information we don’t get out

in the public. Were they able to go in and get the answers to those

questions? Quite frankly, many of those questions, if answered,

would have told you that those financial statements had been

cooked. And so I think the real question was: Did they go through,

did they ask those questions, did they get the answers to those

questions? Because the financials themselves clearly tee up a lot of

serious questions that we now have the answers to and we know

they’re cooked.

Senator COLLINS. Thank you, Mr. Chairman.

Senator LEVIN. Thank you very much, Senator Collins. Senator

Lieberman.

Senator LIEBERMAN. Thanks, Mr. Chairman. Thank you all for

your testimony.

Mr. Turner, during your oral testimony today, I believe I heard

you say that the kinds of transactions that we are focusing on

today occur day in and day out on Wall Street and in the economy.

Could you expand on that a bit? What do you mean?

Mr. TURNER. Wall Street designs and engineers transactions, not

on their own but with the help of the accounting firms as well as

the law profession, quite frankly, that are intended to obfuscate or

keep information from investors. Off-balance sheet types of

financings, financings that will make things look like equity rather

than debt on the balance sheet, not just the issue of what type of

liability, but whether it’s debt or equity. At the SEC, quite frankly,

they’re very tough to find because they design them with the notion

of keeping them out of the filings, but we would find them from

time to time and then basically have to go through a battle, major

battles, to try to keep—or to try to get investors the information

they needed disclose.

The Financial Accounting Standards Board, out from your State,

Senator, actually has a list of publications that is probably about

four inches thick now and about—there’s thousands of answers in

that on these transactions, and I would guess maybe 70 percent,

42

maybe more of those answers are just for these type of structured

transactions coming out of Wall Street, where they’ve structured

the transaction, tried to get around the FASB rules. We would find

out about them at the SEC, and then asked the FASB to try to deal

with it. I think it’s probably the best indication of just how much

time and effort goes into not only structuring but then trying to fix

the problem and get clear disclosure for investors.

Senator LIEBERMAN. Seventy percent of what was the number

you gave?

Mr. TURNER. There is what’s known as the Emerging Issues Task

Force of the Financial Accounting Standards Board. It’s a group of

people who deal with emerging accounting issues as they arise.

Quite often they arise because the investment bankers have designed these transactions. People have found out about them, and

so then we have to come up with an answer to try to make them

transparent to investors.

Quite frankly, I would say that on a number of occasions even

the accounting firms themselves were appalled by the accounting

that the investment bankers were proposing or the companies were

proposing to use. And to their great credit, we would have the accounting firms call us up, tell us about the transaction, and then

ask us to try to shut it down.

I will tell you I do recall one situation where even the investment

banker was asking everyone to sign a non-disclosure agreement as

they shopped it around so that no one could come and tell the SEC

about it.

Senator LIEBERMAN. And in that case, to use language that you

used, the proposal had the intention to hide and disguise the true

condition of the transaction from investors?

Mr. TURNER. Without a doubt.

Senator LIEBERMAN. I want to go back just real briefly. Seventy

percent of what, in your first answer, were you talking about?

Mr. TURNER. It’s 70 percent of these emerging accounting issues

that this task force has dealt with.

Senator LIEBERMAN. Had to do with these so-called structured

transactions?

Mr. TURNER. Some of them are structured transactions. Some of

them are just pure off-balance sheet type transactions that are—

there’s more than just structured transactions that Wall Street has

used to disguise the real true nature——

Senator LIEBERMAN. Again, with this 70 percent of the emerging

issues, OK.

Mr. TURNER. OK.

Senator LIEBERMAN. Where the intention was to hide and disguise the true condition of the transaction—and, therefore, the

company—from investors? And you are not here just talking about

the kind of prepays that Enron was involved in with the financial

institutions we are talking about, but other structured transactions?

Mr. TURNER. That’s true. And on some of these, there’s very legitimate good business reasons for them to do what they want to

do because of tax reasons or to protect themselves in bankruptcy

court or whatever. But that doesn’t prevent you from turning

43

around and really reflecting the true economic substance on the

balance sheet in the way it should be.

Senator LIEBERMAN. Which, by and large, they were not doing.

Mr. TURNER. Correct.

Senator LIEBERMAN. Would you say that this widespread use of

these structured transactions to conceal the true nature of the

transactions in the company from investors is still going on today?

Mr. TURNER. Yes.

Senator LIEBERMAN. Notwithstanding Enron, WorldCom, Tyco,

ImClone, etc., still going on?

Mr. TURNER. Yes. I would guess that—and it would be speculation, but I would guess that, yes, that’s still true. We’re still seeing

these type of issues come up at the Emerging Issues Task Force.

Senator LIEBERMAN. Let me go on to the credit rating agencies

and pick up on a note, that all of you were before the full Committee earlier, as part of a series of hearings in which we asked

essentially why didn’t the watchdogs bark so that we had warning

about what was happening at Enron in this particular case. Credit

rating agencies are institutions that investors rely on because they

presumably have more information than most investors do to guide

where money should go, and we had very interesting testimony

about the history of the agencies and they played a very important

role in the development of our economy, etc.

Ms. Stumpp, you said in your testimony, ‘‘It is important for me

to note that Moody’s did not have any knowledge prior to Enron’s

bankruptcy of the existence of Enron’s prepaid forward and related

swap transactions.’’ And the folks from Standard & Poor’s had a

similar comment, although not in as crisp a sentence as you did.

So the question that I want to ask, both looking back and looking

forward, is: Why didn’t the credit rating agencies know? Let me put

it another way. We just heard from Mr. Turner, and we are going

to hear later in the hearing from two of the largest financial institutions in the world who are going to testify that the kinds of

structured transactions that they entered into with Enron were

and are common practice in the world of finance.

So if these sorts of prepays are so common, I have got to ask you:

Why didn’t Moody’s and Standard & Poor’s detect them and their

impact on Enron’s true financial condition?

Ms. STUMPP. Well, again, it’s a two-part question, looking back

and looking forward.

Senator LIEBERMAN. Right.

Ms. STUMPP. Looking back, we did ask questions of these companies, but candidly, these transactions were disguised loans, and it

was very difficult, and it would be very difficult from a simple examination of a company’s financial statements to detect them. The

financial statements were deliberately misleading, and it was intended to hide this type of transaction from specifically parties

such as the rating agencies or investors.

What I would say in terms of looking forward is that we are asking more and tougher questions, specifically as it relates to companies in the energy industry. For example, we are asking them if

they have engaged in these types of transactions. There was a company that did disclose as a result of certain prompting that it restated its financials as a result of prepaid transactions. We reVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00063 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
44

viewed that situation and took a rating action and downgraded

that rating in part because of the effects of this.

We’re setting up specialist teams at Moody’s. We are basically

setting up specialist teams to review accounting and corporate governance. In fact, we’re looking to factor that very closely into our

ratings. And we also sent a survey to every single corporate issuer

of rated debt, as well as in other areas of Moody’s, to ask them

about matters such as triggers and off-balance sheet obligations.

Senator LIEBERMAN. So looking back now, are you saying, by describing a commendable and encouraging series of steps you are

taking now and on into the future, that Moody’s was not aggressive

enough in pursuing Enron and trying to obtain information about

the true nature of these transactions?

Ms. STUMPP. I think we were aggressive. I think we asked direct

and difficult questions of Enron, but there was——

Senator LIEBERMAN. They were not telling you the truth?

Mr. DIAZ. Yes.

Ms. STUMPP. Correct.

Mr. DIAZ. Basically, they—for example, we asked them at one

point, to try to understand the scope of their off-balance sheet obligations, to tell us everything they had—whether it was on-balance

sheet or off-balance sheet so that we could make a judgment as to

how we would treat it. So forgetting about the accounting treatment, forgetting about the structuring of transaction, what is the

economic value transaction, and they gave us what they termed to

be the kitchen sink of everything they had, but there was a lot of

information there that was just not given to us. So even when we

were asking directly for information, they were just withholding it.

So in the case of these prepaids, Senator, I think you are alluding to the fact that they are common as long as they are real, legitimate transactions where a commodity is delivered. But in this

case, it was a clear effort at hiding what was really debt from ourselves as well as other investors.

Senator LIEBERMAN. Mr. Barone, from Standard and Poor’s part,

I presume the answer is somewhat the same. I believe that, am I

right, that you as well as Moody’s did rate the Citibank sponsored

Yosemite Trust, is that right?

Mr. BARONE. Yes, that is correct.

Senator LIEBERMAN. So if you did, both of you rated the Yosemite

Trust, therefore, you had some firsthand knowledge of these specific transactions, why did that not lead the credit rating agencies

to see what was going on and ring the bell to alert everyone?

Mr. BARONE. There was limited information provided specific to

the portion of the trust that we were asked to rate. I am going to

defer to my colleague, Mr. Khakee, to explain exactly why we saw

page one, if you will, but never saw page two and page three.

Mr. KHAKEE. Yes. I should distinguish that from the perspective

of performing the analysis, in terms of placing a rating on the

notes that were issued by the Yosemite Trust the focus of the analysis is to make sure that the rating on the notes is consistent with

the underlying company. That was, in this case, Enron. And so the

analysis really focuses on reviewing the documentation to make

sure that the rating is, in effect, a pass-through of the Enron rating.

45

So when you look at the eligible investments criteria, when you

look at any of the dependencies from a credit perspective, our analysis showed that it was very consistent, that investors who purchased a Yosemite note were, in fact, buying the default risk of

Enron. So that was completely consistent.

Senator LIEBERMAN. Yes.

Mr. KHAKEE. What we were never presented with was all of the

other aspects of what Yosemite was tied to.

Mr. BARONE. The issue of the Delta entity and how the swap

moved and so forth was never presented to us when we were asked

to evaluate the Yosemite transaction. It was not, indeed, part of

the credit evaluation of Yosemite. The bankers did not present that

portion of the transaction to us.

Senator LIEBERMAN. My time is up, but that appears to me to be

very focused vision. In other words, you were right in the middle

in looking at Yosemite of the kinds of transactions that infuriate

us today, and you are much more expert at this than I am, but it

bothers me that it did not open the door for you to see what was

happening.

Mr. BARONE. I know you are out of time, Senator, but there was

nothing there to even elicit the second question as to what is beyond all this. There was nothing that sort of hinted at—oh, there

is Delta and there is this swap with the prepay. There was nothing

revealed that prompted us to ask more pointed, more direct, or specific questions regarding the transactions. These credit linked notes

are very common, as I understand, in the structured finance group.

Senator LIEBERMAN. Mr. Diaz, a final question, a very brief answer I am going to ask of you. You indicated that, and I presume

folks at Standard and Poor’s would say the same, the people at

Enron did not tell you the truth, they were not disclosing what

they were doing. Who did not tell you the truth?

Mr. DIAZ. The people that we dealt with in the financial area, the

CFO—— Senator LIEBERMAN. Whose name was?

Mr. DIAZ. Andy Fastow.

Senator LIEBERMAN. All right. Anyone else?

Mr. DIAZ. It would have been Ben Glisan, and Jeff McMahon at

times.

Senator LIEBERMAN. Thank you. Thanks, Mr. Chairman.

Senator LEVIN. Familiar names, I am afraid. Senator Fitzgerald.

OPENING STATEMENT OF SENATOR FITZGERALD

Senator FITZGERALD. Thank you very much, Mr. Chairman, and

all of you, thank you for being here.

After hearing the testimony this morning, I really think that the

transactions we are describing today are along the lines of the ones

that we had hearings on earlier in the year, at least in the Commerce Committee. Enron was borrowing money and booking it as

revenue from operations and going to elaborate steps to keep the

actual liability incurred by virtue of the borrowing off their income

statements.

And whether it is all the off-the-books partnerships, which they

would cause to go out and borrow money and figure out a way to

have the borrowed money then paid to Enron itself, which they

46

would book as income or revenue. They would manage to keep the

indebtedness of the partnership off the books—they did that with

the Blockbuster Video transaction, where they created Braveheart.

They had Braveheart go borrow $115 million from the Canadian

Imperial Bank of Commerce.

Then they sold the worthless asset to the partnership. The partnership paid Enron with the borrowed money. Meanwhile, there

had been some form of credit support from Enron itself over to

Braveheart the partnership, but that was not disclosed to investors.

And at the end of the day, Enron, I think, incurred about $20

billion worth of obligations that they managed not to report as indebtedness on their balance sheet, and when they filed for bankruptcy last December, it was because they had $4 billion in debt

coming due that they had to pay and they did not have the cash

to pay it.

These prepaid transactions, as you have eloquently testified,

were just another means of really borrowing money and getting the

proceeds of the borrowings in a way that they could book it as cash

from operations and keep the liability off their books. So they were

very creative in borrowing money and booking it as income.

I do want to follow up on a few things that have been said. Mr.

Turner, you said that you were very troubled by the sale of the securities to the public, and I guess in the case of Citibank, I have

to say I was much chagrined to learn that Citibank had lent $1.5

billion to Enron and then they had managed to sell securities to

the public to hedge their own position, and I believe when Enron

went bankrupt, then they did not have to pay back the securities

and they wound up, in effect, not losing any money even though

they lent Enron $1.5 billion.

Morgan is in a different position because instead of selling securities to the public to hedge their risk, they got surety contracts

and now the insurers will not pay them on that and they are in

court over that.

But Mr. Turner, your citing your concern actually brings up the

whole issue of the Glass-Steagall Act, which had been in place a

long time. Congress undid it a couple of years ago, but the reason

Glass-Steagall was put into effect back in the early part of the depression was because prior to the stock market crash in the 1920’s,

there had been a pattern of commercial banks/investment banks

unloading bad loans off on the public by selling securities.

I would like you, Mr. Turner, to flush out your concerns here.

When we repealed Glass-Steagall and did away with all remnants

of the law between commercial banking and investment banking,

do you think we made a mistake?

Mr. TURNER. You guys ask tough questions. At the time that

Glass-Steagall was repealed and GLB was put in place, I do know

I had a concern as to whether or not you had legitimate and real

firewalls, and, in fact, I was not the only one. I recall that Chairman Greenspan on more than one occasion was up here testifying

that, in fact, if you went that route, you had to make sure that you

had honest-to-goodness firewalls in between and different subsidiaries set up for securities versus banks, all under his supervision

as overseen from a bank holding company.

47

To that extent, I do agree with Chairman Greenspan that if you

are going to break down the restrictions between the securities

firms and the banking firms, a point I do not necessarily disagree

with in light of the competitive banking and the global international market, I do agree with Greenspan that the securities

firms, you have got to have functional regulation and the securities

firms and banking firms cannot be working together, entering into

transactions together and using the securities arm to try to get

banking business. I think there does need to be some restrictions

put on that and avoided or we will have some problems.

Senator FITZGERALD. Citibank sold these securities to sophisticated investors and did not have to make any disclosures except

those required for sophisticated investors, right?

Mr. TURNER. Right. I think one of the things that really concern

me about the Yosemite thing is you do not see disclosures in there

talking about the fact that Citibank is trying to reduce its exposure

to Enron, either because of its own internal lending caps or perhaps because they really felt that there was risk there. They are

trying to reduce their exposure at the same time they are trying

to increase exposure to outside investors through offering these

notes, and I think it would have been—investors would have wanted, and I think, in fact, some—I was told some investors did drop

out of later deals because they could not get adequate disclosures

and had concerns about that.

And I think investors will come back and say, why did Citibank

not tell us at the same time that they are placing, in essence,

Enron paper with us, because that is where the debt payments and

resources are going to have to come from to repay it, why was

Citibank getting out of their exposure to Enron while they are

turning around and selling these very same type of liabilities off to

investors?

Senator FITZGERALD. We have talked a lot about how Enron took

their debt off the balance sheets and we have uncovered a lot of

ways in which they did it here, which they probably violated technical accounting rules. You did not really have three independent

parties with this Delta-Yosemite transaction, and so forth.

But from the testimony of many of you, I guess you are very concerned about how companies in America are taking debt off their

balance sheet and I am wondering, should we in Washington try

to close down loopholes in the law which were in the accounting

regulations which allow companies to do this?

There are some well-established and legal ways of taking debt off

the balance sheet. A simple one is if you have a building, do a salelease back and you get rid of your mortgage. A lot of companies do

that. However, you are not really fooling anybody by doing that.

Airlines take debt off their balance sheet by selling aircraft and

then leasing them back. I suppose you guys are not fooled by that

because you look for things like that. But now, you really have to

look for a lot more sophisticated ways of taking debt off the balance

sheet.

Would it be helpful if Congress tried to shut down some of those

means by which companies are able to take debt off the balance

sheet? That is to anybody on the panel who would want to address

that.

48

Mr. BARONE. Senator, I do not know if it is helpful to the financial markets to necessarily do away with the use of off-balance

sheet financing. I think the issue is one of greater disclosure and

penalties for those that do not. The airplane leasing, as you noted,

often appears in footnotes and is an integral part of a company’s

financial reporting.

Senator FITZGERALD. Would you like to see tighter requirements

in SEC disclosure laws about the use of off-balance sheet financing?

Mr. BARONE. Yes, sir. Senator, we actually have a position paper

on that that is included in my testimony.

Senator FITZGERALD. Mr. Turner, what do you think about that?

Mr. TURNER. Senator, I would turn around and tell you that I believe, as a businessman, as a former businessman, that those financial statements, not only for investors but for management purposes, really need to reflect what is going on with the business. If

you are structuring off-balance sheet financing because of tax purposes or others, so be it. I have got no problem with that. But at

least show them in the financial statements for what they really

are. Show them as debt. To the extent that we have things that

are really debt that are off the balance sheet, it just does not ring

true with the average investor out there and it is what has caused

us a loss in the confidence.

So I do believe Congress or the financial accounting standard setters ought to turn around and do something that, in essence, says

we are going to put debt on your balance sheet if you have to use

your own resources or cash to pay it. Just putting it in the footnote,

quite frankly, is like just putting stock options in the footnote, and

that does not get the job done, either.

I think if we are going to tell the rest of the world we have got

the most transparent markets in the world, which we do, clearly

do have today, then we have got to uphold that leadership and

make these financial statements real and real to the investors and

put the debt on the balance sheet.

Senator FITZGERALD. One final question, if I could. It has been

reported in the Wall Street Journal on February 11, 2002, that Bob

Rubin of Citibank called Peter Fisher, Undersecretary of the Treasury for Domestic Financial Markets, to ask that ‘‘a Treasury official

ask credit rating agencies to give Enron a break.’’ We know that

Mr. Fisher, from other reports, declined to do that. Did anybody

from Citibank call any of your agencies to lobby you to give Enron

a break?

Mr. BARONE. No.

Ms. STUMPP. No.

Senator FITZGERALD. No? Did you have any banks call you to

lobby you to give Enron a break?

Ms. STUMPP. [Nodding affirmatively.]

Mr. BARONE. No.

Senator FITZGERALD. OK. That probably would be a warning sign

to you, if a bank called you directly and asked you to give a break

to somebody.

Senator LEVIN. Senator Fitzgerald, did someone shake their head

no? I am sorry. You said no?

Senator FITZGERALD. Were you all saying no?

49

Senator LEVIN. Were the answers on the record as being no?

Mr. DIAZ. I have testified before, during the events of the week

of November 5, when the Dynegy deal was in progress, we did have

discussions with banks at the time, but we were not lobbied—I

mean, they were looking for us to give the deal a chance to work

out, and I have testified that we held off action because we thought

the probability of the Dynegy deal going through was high and that

the ultimate——

Senator FITZGERALD. The Dynegy deal?

Mr. DIAZ. Dynegy, when Dynegy was trying to buy Enron. I

think that is what you are referring to, at that time, during that

time frame.

Senator FITZGERALD. And you were having calls from banks asking you to hold off on your downgrading of Enron’s debt at that

time?

Ms. STUMPP. We received a call from a bank requesting a meeting following a time when we were going to downgrade Enron’s rating. We had that meeting. I would not characterize the call as ‘‘give

Enron a break.’’ It was, ‘‘could we have a discussion in recognition

of the fact that this is an important issue’’ and that there was basically new and material information that the banks wanted to convey to us.

Senator LEVIN. Thank you. I am going to call on Senator Cleland.

I just want to note for the record that the Sarbanes bill does contain a provision, I think, along the lines that Senator Fitzgerald

was referring to, which would significantly tighten the rules for the

display and disclosure of off-balance sheet financing, so there is at

least some movement in that direction. I think that is a very important area that Senator Fitzgerald got into, but I do believe that

significant provision is part of the Sarbanes bill.

Senator Cleland, I think I am going to call on you. Technically,

you have not had an opportunity yet. Senator Cleland.

OPENING STATEMENT OF SENATOR CLELAND

Senator CLELAND. Thank you very much, Mr. Chairman.

Mr. Turner, I would say that I am on three committees that have

been investigating Enron, the Commerce Committee, the Governmental Affairs Committee, and this Permanent Subcommittee on

Investigations, and each hearing increases the ‘‘Alice in Wonderland’’ quality of this incredible investigation. It gets curiouser and

curiouser.

We started off basically by looking at Enron officers. I indicated

that in combat, officers eat last, but in this combat, Enron officers

ate first. Then we looked at the accountants and found out the accountants were not accounting and the auditors were not auditing.

And now we find that the lending institutions, the great financial

services institutions, JPMorgan, Citigroup, Bankers Trust,

Barclays, Connecticut Resource Recovery Authority, Credit Suisse,

First Boston, Fleet Boston, Morgan Stanley, Royal Bank of Canada,

Royal Bank of Scotland, Toronto Dominion were involved and $8

billion of loans that on any balance sheet in America, kept by any

little accountant in any little hometown in Georgia would have

been listed as a liability and not an asset.

50

What I would like to know from you is, how in the world can

some of the finest minds in finance in the world with these great

institutions participate in something like this? It seems like it

would be more difficult to sneak sunrise by a rooster than to sneak

$8 billion of liabilities and transform them into assets with these

great financial institutions looking on. What happened?

Mr. TURNER. Oh, I think people are running down the yellow

brick road in Oz-land.

Senator CLELAND. Well, we are not in Kansas anymore.

Mr. TURNER. Yes, we are not in Kansas anymore. [Laughter.]

When you would see these meetings occur between the investment bankers and the attorneys and the accountants as they designed these type of transactions, it became a combination of a

game, a herd mentality, if you will, a very competitive, let us beat

the other banker out and try to come out with another vehicle that

we can sell some and raise fees off of. They really lost their compass and lost sight of the fact that, really, what makes those investment banking firms are the investing public and the markets,

but instead became much more focused on making fees.

And as the industry changed from a commission-based, profit-oriented organization 30, 40 years ago to one that is driven by investment banking fees and that is where their compensation is, I think

that change in profits, that change in compensation, that change

in structure and what really made the investment banking firms

and Wall Street changed their behavior to one of looking out for investors to one of let us make a buck and let us see what we can

go around the rules—— Senator CLELAND. Would you say that was infectious greed?

Mr. TURNER. It was infectious greed——

Senator CLELAND. Mr. Greenspan was suggesting——

Mr. TURNER [continuing]. Like a bad case of cancer.

Senator CLELAND. Ms. Stumpp, what happened?

Ms. STUMPP. Well, I would say that in this regard, financial institutions do engage in structured transactions and in financial engineering as part of their history. In this case, it is perhaps not,

again, the structure, although we recognize the outcome of the

structure was to boost cash flow and to not show appropriate debt

or the actual level of debt that was on the books, but it was the

disclosure. It was the treatment of this transaction. The disclosure

and the treatment were not clear so that people could not really see

the true picture of the financial health of Enron. So what I would

say is that perhaps it was financial engineering going a little too

far, but the disclosure element was particularly problematic.

Senator CLELAND. Mr. Barone, what happened?

Mr. BARONE. I think you hit it on the head, Senator, about the

greed issue. I mean, it is obviously a blatant attempt to hide and

disguise various transactions to make a company look better. I believe we were defrauded. I believe we did a fine job in our attempt

to try to uncover various additional debt, liabilities, and so forth,

but you do not know what you do not know, and that which was

concealed made it extremely difficult to paint a true picture of

Enron’s creditworthiness. I think it may have started out with one

intent, but it clearly was a snowball rolling down the hill and it

just kept building.

51

Senator CLELAND. I think it is the ultimate in fuzzy math and

it has cost the teachers’ and employees’ retirement pension funds

in my State almost $127 million in losses.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Senator Cleland. Senator Carper.

Senator CARPER. Thanks, Mr. Chairman, and to our witnesses,

welcome and thank you for being here today.

I would ask, Mr. Turner, I do not think anyone has asked you

any questions today, so maybe I will throw one your way. How does

the—I will call it the Sarbanes legislation that we have been in

conference on now—how does that legislation reduce, if at all, the

likelihood that other companies like Enron will try to use prepaid

forward transactions or a device like that to deceive?

Mr. TURNER. I think there are actually some excellent provisions

in the Sarbanes bill. I do not think it is an end-all for this problem

and you should be careful about that, but there is a very important

provision in there that says that the executives are going to have

to sign off on the financial statements, not just based upon whether

they are GAAP, but whether or not they fairly present the real true

economic picture of the balance sheet and the income statement of

these companies, and I think that provision is going to make the

executives think twice. They can no longer hide behind GAAP as

a result of that provision in that legislation. They are going to have

to turn around and make sure it presents a true economic picture.

In the list of prohibited services that has been, unfortunately, severely opposed by some members of the House, it has a prohibition

on some services, the nature of which the auditors would typically

do in these type of situations, so it will cut off the ability of the

investment bankers to go get the assistance from auditors in turning around and trying to structure these things. As long as we can

hang on to that list of nine provisions, I think it will go a long ways

and I really hope we do not lose those things in conference.

I think the additional legal provisions, including some strengthening of what the SEC regulations are and who they can go out

and reach, give them reach that will allow them to go after these

type of situations and professionals who were not at the company

but nonetheless aided and abetted in this type of false and misleading financial reporting.

I think all of those components of the Sarbanes bill are just very

good, very excellent, very outstanding, are going to ensure that we

have some independent gatekeepers as well as some people inside

who can no longer just try to get around the rules.

Senator CARPER. Let me ask our other witnesses, do you want to

comment on the same question? If not, I can ask another question.

Before coming to the Senate, I was privileged to be Governor of

Delaware for 8 years and well before that to be Treasurer of the

State for 6 years. I remember when Delaware had the worst credit

rating of all 50 States. We were tied for dead last with Puerto Rico,

and they were embarrassed. That is how bad it was. We were

closed out of credit markets, literally could not sell bonds, notes. It

was a bad time. You folks were all over us, Moody’s and Standard

and Poor’s, all over us in the bad old days back in the 1970’s and

did not let us get away with anything.

52

When I see what Enron got away with, the question comes to

mind. I know others have probably asked this question, but how

did they get away with it without you folks knowing what was

going on?

Mr. BARONE. Well, Senator, I would assume that in Delaware,

you did not defraud the agencies by not presenting a full, clear,

and accurate picture of the financial well-being or lack thereof of

the State.

No, I think they got away with it through deception, through

fraudulent disclosure, lack of disclosure, insufficient disclosure, and

not for a lack of asking by us. My colleague pointed to the kitchen

sink document that we all were privy to. We asked what obligations do you have that were not on-balance sheet. We always had

a tug of war with Enron as to what off-balance sheet obligations

we should effectively put back on their balance sheet. They clearly

disclosed many things that were not on-balance sheet and even

came to some agreement with us that, yes, certain things probably

should be added back.

What we did not know is that there was another book full of

things that should have been added back to the balance sheet and

considered obligations. That is how they got away with it.

Senator CARPER. Anyone from Moody’s?

Mr. DIAZ. Yes. I think, fundamentally, I agree with Mr. Barone.

It is a lot of use of financial engineering, lack of disclosure, lack

of transparency, and basically never refusing to answer a question

when we probed, but giving us misleading answers and withholding information. I spoke about the kitchen sink, where we

asked them to give us a list of all their financial obligations, and

they—clearly, a lot of the partnerships were not included in that

information. We are not auditors, so we do not go and look at the

books, but it is basically a—I think they got away with it for a

while, but ultimately, that kind of situation is not sustainable, and

that is what happened.

Senator CARPER. What are you doing different today at Standard

and Poor’s or at Moody’s to ensure that companies like Enron do

not get away with this sort of thing in the future?

Mr. BARONE. I think we have a degree of healthy skepticism

when probing companies for information. I think history is a great

teacher. You learn a lot from looking back. For many of the energy

firms, we are asking about prepaid deals: If they did them, to describe them and disclose them. We are also asking about trading

activity as well, not that we had not asked similar questions before,

but I think we just have a greater skepticism. We are a little bit

more critical. Our skills are honed even further. I mean, time is a

great educator.

Senator CARPER. Thank you.

Ms. STUMPP. I would say, for Moody’s, I mentioned this a few

moments ago, but we are asking more and tougher questions. With

respect to the energy merchants themselves, we have asked them

about their engagement in prepaid forward transactions, particularly as a result of the disclosure of Project Alpha in connection

with Dynegy. Some companies have told us that they have, again,

been approached to do these deals. Some of them have told us they

53

declined to do some of these deals. At this point, few have indicated

that they have done any of these deals.

We plan, as a result of the information that we understand today

and from what we have read in the papers, to follow up and have

written correspondence with these companies, asking them to affirm to us that they are not engaged in these prepaid forward

transactions, or if they are, to disclose it to us and the level of such

activity.

We are setting up at Moody’s specialist teams in connection with

experts who can help us with accounting and corporate governance

matters. We have gone out to the entire corporate finance rated

universe and asked them information on off-balance sheet obligations and on ratings triggers and we produced a report last week

on our survey of ratings triggers.

Senator CARPER. Thank you very much. I might add, Mr. Chairman, just as a postscript, the State that used to have the worst

credit rating of any State in the Nation ended up, I think about

2 or 3 years ago, thanks to companies here plus one that is not,

Delaware ended up with a AAA credit rating. So, miracles do happen. Thank you.

Senator LEVIN. Well, one of the reasons for its dramatic improvement is one of our colleagues who is sitting right to my right. Senator Carper was then Governor of the State, and he is much too

modest to take credit for it, but he deserves a great deal of that

credit for his State’s improvement.

Talking about credit ratings, let me ask you just one final question. You have all indicated that the prepays here should have been

booked as loans. They were disguised loans. Instead they were

booked as cash coming in from business operations. And my question is this. If they had been properly booked, how would that have

affected your ratings? First let me ask you, Ms. Stumpp.

Ms. STUMPP. Unequivocably it would have resulted in a lower

rating. And the magnitude today—it is quite dramatic, the magnitude of the reduction in cash operations and the increase in debt,

and we would have had a lower rating on Enron.

Senator LEVIN. Mr. Barone.

Mr. BARONE. The same here, Senator. We would have had a

lower rating on Enron for certain—significantly. How far? How

much? I couldn’t necessarily pass that judgment right now, but it

could have easily been non-investment grade, two notches below or

three notches below where it was before its demise.

Senator LEVIN. Senator Fitzgerald.

Senator FITZGERALD. If I could just ask a final question. I think

we are probably going to break for lunch here.

Senator LEVIN. No, we have decided that we are going to go right

through lunch, I am afraid. This is becoming a very unhappy tradition of this Subcommittee.

Senator FITZGERALD. So I don’t get lunch?

Senator LEVIN. Well, I don’t want to go that far. In the back

room maybe we will give you a sandwich.

Senator FITZGERALD. All right. Well, let me—if I could—there

has been a vast increase in the level and amount of securitizations

in this country in the last maybe 20 years. A lot of financial institutions take their credit card receivables, securitize them, and

54

later—and then they book all the revenue after they sell the receivables, they book that as revenues.

Presumably they are setting aside some kind of reserves in case

they have—they have to set aside reserves for the purchaser, I

think, in most cases, but sometimes there is not really good disclosure of whether the securitizations are with recourse to the issuer.

And this comes up in Enron because it appears that some of the

monetization transactions that Enron did, they led the ratings

agencies to believe were non-recourse to Enron and it turned out

they were recourse.

I am wondering if you from the rating agencies have any general

thoughts on the level and amount of securitizations out there. A lot

of companies have accelerated their earnings by securitizing assets,

and I wonder to what extent investors are aware of lurking liabilities out there. Quite often I read that some company had to take

a charge-off because all of a sudden somebody was going after them

to make good on a portfolio of securities that they securitized.

Would any of you care to comment on that? Mr. Khakee, you are

a Director of Structured Finance Group at Standard & Poor’s,

would you care to comment on that?

Mr. KHAKEE. Yes, I would, actually, Senator. I think there is

nothing fundamentally or inherently wrong with structured finance. I think that it is important to try and understand the differences between the types of transactions that you are alluding to.

In a typical asset-backed structured financing, what is being

securitized are receivables. The credit risk of those receivables is

based on the underlying payments or cash flow streams that are

coming in. You mentioned credit card transactions. You could also

look at mortgages that are being securitized.

I think it is clear that securitization has benefited the vast number of consumers. It has brought down, most likely, the overall cost

of financing, and mortgage financing is a very important part of

the overall economy. So I think structured finance, when used

properly and when explained properly, is an important tool.

When you refer to credit-linked notes, which in this case are the

Yosemite transactions, that is not so much a securitization per se.

The investors are investing in a different type of risk. It is directly

linked to Enron, and it is quite clearly stated as such. When one

is investing in a securitization, one is investing in a capital structure. The rating, if you will, when we issue a rating, reflects the

risk that they are taking, given the place in the capital structure

that they are investing.

So I think it is important to try and differentiate across the various products inside of structured finance. But if you want to aggregate and just make a comment on structured finance, I think it is

a very important part of the overall ability of businesses——

Senator FITZGERALD. Are you seeing more companies, though,

pushing the envelope on securitizing products and not fully reporting the amount of recourse that is still available to the issuer of

the securities?

Mr. KHAKEE. One of the fundamental parts of our criteria when

we review structured financings is non-recourse and non-consolidation. To the extent that we are able to de-link the rating on a structured finance from the origination company—the bank that

55

securitizes the credit card receivables or the bank that securitizes

the mortgages—non-consolidation and non-recourse are a very fundamental part of that analysis.

To the extent that we can receive the appropriate opinions and

comfort that is being achieved, that gives us the comfort to issue

ratings that de-link from the source of the original receivables. To

the extent that is not achieved, you have not achieved certain elements of structured finance, which is to de-link from the origination company.

Senator FITZGERALD. So you are very careful to look at whether

all those elements have been met to justify calling it a securitization transaction and that the company is justified in taking the

securitizations revenues into earnings when they do? I mean, you

carefully look at that?

Mr. KHAKEE. Yes, those aspects of criteria are fundamental parts

of the analysis that any analyst would execute with regard to reviewing a structured financing.

Senator FITZGERALD. But in the case of Enron, they were able to

persuade the rating agencies that a lot of their monetization contracts, I won’t call them securitizations, were non-recourse, were

they not, when in fact they were recourse?

Mr. KHAKEE. Well, I can’t comment on the—— Mr. BARONE. I can handle that. No, in many cases, we would put

back certain obligations that, while legally may have been non-recourse to Enron, there was an economic incentive, a moral incentive, or some other incentive and reason to include non-recourse

debt in determining its credit rating. I would say there are many

cases where they just never told us these obligations existed that

had recourse, real or otherwise, to Enron. And I think that should

be distinct.

Mr. DIAZ. In our case, that was the reason we were trying to get

a hold of all the off-balance sheet debt, so we can take a good look

at what the underlying economic benefits were and what the underlying recourse was. If we can make up our own minds, even if

it was legally—in some cases, we can have project financings that

are legally non-recourse and you can actually have a structure that

says that. But if we think that the asset is an integral part of the

company’s strategy, we would actually count that as part of the

credit ratios.

Mr. TURNER. Senator Fitzgerald, if I could address that for just

a moment. At the Commission, I think we were concerned about

the point you raise, and I think it is a very—it is an excellent, valid

question. There have been trillions of dollars done in securitization

and the monetization of assets, and there is no question that while

originally we were monetizing high-quality credit card portfolios,

now we are down to monetizing much more risky assets. And I

think it is exposing the markets to some additional risk, and I am

very concerned about that.

And we were seeing not only monetization of assets, but we were

also seeing financial instruments going out with triggers in them,

that if troubles happened with the company, that if it didn’t pan

out, all of a sudden that trigger would turn these companies into

a death spiral. In fact, you would often hear that these financial

instruments did have a death spiral.

56

Senator FITZGERALD. We had such triggers in the case of Enron.

Mr. TURNER. And those have not been adequately disclosed.

There is no question about it. And I think there does need to be

greater disclosure of that. We need to get greater disclosure of any

financial instruments or off-balance sheet financings that might result in the risk of those coming back to the issuer. In particular,

if the issuer is going to have to use cash or other resources that

it might have to pay those, then that risk needs to be disclosed.

And today, it is not being disclosed.

Ms. STUMPP. Senator, if I could just add on to that. Last week,

Moody’s released a report, Moody’s Analysis of Ratings Triggers.

And what we found in looking at all ratings triggers was that less

than a quarter of the rating triggers—and this is based on company-supplied information—are disclosed in companies’ SEC filings. So less than half—and less than, actually, 25 percent, according to the data compiled on issuer feedback to us—is disclosed in

the SEC filings. Now, this is based on all types of triggers, including some that are relatively benign.

Senator FITZGERALD. Are they supposed to disclose it, those triggers? Or is it just some of them are voluntarily doing it and they

are under no obligation?

Ms. STUMPP. Well, what we found in reviewing the data was that

the less-risky type triggers—those dealing with pricing grids—were

the ones that were typically disclosed, whereas the ones that basically revolved around the riskier types of triggers—puts, acceleration, default—were the ones that were not always typically disclosed.

So in answer to your question, we would certainly support

heightened disclosure, particularly as it relates to off-balance sheet

with recourse, and what are the types triggers or factors that

would cause the debt to come back on to the balance sheet. This

needs to be emphasized and the disclosure needs to be improved.

Mr. TURNER. This is a point where I couldn’t agree more with

Ms. Stumpp. And in fact, in the rule proposals that have been put

out by the Commission, this is a big hole that are in those rule proposals, because this type of disclosure would not be required even

under the new rule proposals.

So I think those need to be enhanced significantly for this reason. And certainly my experience was just like Ms. Stumpp’s in

finding that companies weren’t disclosing them notwithstanding

the fact that there are some SEC rules that say if you have something that could significantly impact the liquidity of the company,

unless you are certain it is never going to happen, unless you are

certain it is remote, even if you don’t know whether it is going to

happen or not, you have to disclose it. And we are just not seeing

those type of disclosures being made today.

Mr. BARONE. Senator, in a similar vein, as Ms. Stumpp noted, we

had also published a white paper on ratings triggers. We even listed the companies we thought had serious exposure—which did not

necessarily produce a rating change, but meant that should a rating change occur, the company’s creditworthiness could spiral out

of control.

And just going to your other line of questioning, I don’t know if

you were here before, but I pointed out that—in my testimony—we

57

have a white paper that was titled ‘‘Accounting Abuses and Proposed Countermeasures,’’ where we support many of the items the

SEC is proposing and information that is in the Sarbanes Bill as

well.

Senator FITZGERALD. If the Chairman would indulge me, could I

ask about their opinion on the accounting matter you and I discussed?

Senator LEVIN. We can, but we are going to have to move on to

our third panel. So if you want to just briefly get their opinion on

that.

Senator FITZGERALD. Real quick. I mean, one of my theories here

is that the reason we have seen such a rash of overstatements of

earnings in the last year or so is that managers have a motivation,

a powerful motivation, to at all times keep their earnings per share

high and their stock price high. And that is the vast increase in— exponential increase in the issuance of stock options in the last few

years, which aren’t accounted for on the income statement. They

are treated like manna from heaven. In the case of Enron, the top

29 executives cashed in $1.1 billion worth of stock options in the

last 3 years before they put the company in bankruptcy. When you

have executives who can make tens or hundreds of millions of dollars by keeping their stock price high by doing whatever possible

to report higher per share earnings, at a certain point you have a

powerful motivating force to bend the rules.

What do the rating agencies think about my and Senator Levin’s

proposal to encourage companies to account for stock option compensation expense, instead of the current system where they just

ignore it except in a footnote.

Mr. BARONE. We would support greater disclosure of stock options in the financial statement reporting.

Mr. DIAZ. I would support that. I would say that stock option is

a form of compensation, it should be taken into account as such

when you are looking at a company’s net income and earnings potential.

Senator LEVIN. Mr. Turner—I am sorry. Ms Stumpp.

Ms. STUMPP. Yes, I would agree. And it should be done on a basis

that is consistent so that companies can be evaluated on the same

accounting-standard basis.

Senator FITZGERALD. Right now, a company that pays its managers in cash has to report an expense. But if they pay the managers in options, there is no expense there. So it has to make it

hard for you to get an apples-to-apples comparison. Is that correct?

Mr. BARONE. That is correct, yes.

Mr. DIAZ. You have to make certain assumptions as to how much

those are worth. And yes, you could be off. So, yes.

Senator LEVIN. Well, we are doing our best to end the misuse of

accounting relative to this stealth compensation. Mr. Turner, do

you have any comment on the stock option issue? Should they be

treated as compensation?

Mr. TURNER. Unquestionably they should be treated as compensation. As the former Vice President, Chief Financial Officer of

a major high-tech company in this country, I can tell you that I

participated with many of the leading high-tech companies in surveys in which we all characterized the options as expense. I would

58

1The prepared statement of Mr. Dellapina appears in the Appendix on page 312.

be more than willing to share that with the Subcommittee. We

even had our standard methodology for measuring those. These executives that say they can’t measure the value of an option, we all

knew what the value was that we were giving employees. And if

a manager, if an executive can’t figure out what he is paying employees in the form of paper versus cash, then quite frankly, probably he shouldn’t be sitting in that company as an executive.

Senator FITZGERALD. What about a company that pays, like, a

law firm bill or some vendor’s bill in stock options? High-tech companies do that all the time. They will pay a law firm in stock options.

Mr. TURNER. We would record that as expense. And I will tell

you, Senator, I recorded compensation expense for options in my financial statements and it never caused me a problem. It made it

much more transparent.

Senator LEVIN. The temptation is great to pursue that issue because we put a lot of time in on it, and I hope we can still obtain

that reform, this Congress, but we are going to have to move on.

We thank this panel for your appearance here, and we will now

move to our third panel.

Donald H. McCree, the Managing Director of Morgan Chase;

Robert Traband, the Vice President of Morgan Chase Bank in

Houston; and Jeffrey Dellapina, who is Managing Director of Morgan Chase Bank in New York. And I would ask you to please stand

and raise your right hands.

Do you swear that the testimony that you will give before this

Subcommittee will be the truth, the whole truth, and nothing but

the truth, so help you, God?

Mr. MCCREE. I do.

Mr. TRABAND. I do.

Mr. DELLAPINA. I do.

Senator LEVIN. Thank you for appearing here today. And we will

again use that same timing system, which we have announced.

And I believe that Mr. Traband is going to begin, is that correct?

Mr. TRABAND. I hand it off to my colleague.

Senator LEVIN. Mr. Dellapina first?

Mr. DELLAPINA. Yes, sir.

Senator LEVIN. Fine. Please proceed.

TESTIMONY OF JEFFREY DELLAPINA,1 MANAGING DIRECTOR,

JPMORGAN CHASE BANK, NEW YORK, NEW YORK, ACCOMPANIED BY DONALD H. McCREE, MANAGING DIRECTOR J.P.

MORGAN SECURITIES, INC., NEW YORK, NEW YORK; AND

ROBERT W. TRABAND, VICE PRESIDENT, JPMORGAN CHASE

BANK, HOUSTON, TEXAS

Mr. DELLAPINA. Mr. Chairman and Members of the Subcommittee, my name is Jeffrey Dellapina. I am a Managing Director in the Credit and Rates Group of JPMorgan Chase & Co. I am

accompanied by my colleagues Don McCree, a Managing Director,

and Robert Traband, a Vice President. I was involved in the Enron

prepay transactions beginning in 1997. Mr. Traband is based in

Texas, and worked on the Enron account beginning in 1999. Mr.

59

McCree currently serves as senior credit officer for the JPMorgan

Chase Bank. He was not involved in the transactions that are

being discussed today. He is here because the Subcommittee requested a senior banker who could address broad policy issues. I

am presenting this oral statement on behalf of the three of us.

JPMorgan Chase & Co. is a holding company. Through our subsidiaries and affiliated companies we offer global financial services,

have operations in more than 50 countries, and serve more than 30

million consumers and the world’s most prominent corporate, institutional, and government clients, including over 90 percent of the

Fortune 1000 companies. JPMorgan Chase & Co. and its subsidiaries and affiliated companies employ nearly 100,000 people

throughout the United States and worldwide.

Our institution has an established reputation for integrity, and

we welcome the opportunity to appear today at the invitation of the

Subcommittee. In accordance with the Subcommittee’s request, this

statement will focus on and provide background information with

respect to the prepaid natural gas and oil forward contracts involving JPMorgan Chase and Enron.

At the outset, we wish to emphasize two significant points. First,

prepaid forward contracts have been used for many years and are

widely recognized as an entirely proper tool to enable businesses to

increase their liquidity and diversify their sources of funding. Second, we do not provide accounting services to our clients. In the

U.S. financial system, those are responsibilities that are properly

assigned to the client’s management, advised by its auditors, both

internal and external, guided by generally accepted accounting

principles.

Before we turn to the Enron prepaid forward transactions, we

would like to talk generally about corporate finance and prepaid

forward commodity contracts in order to place these specific transactions in their proper context.

Senior financial officers of major corporations are continuously

working to ensure that their companies’ ongoing access to capital

will enable asset growth and business prosperity. The management

process includes taking actions to maintain liquidity and diversify

the corporation’s source of funds. In support of these objectives,

lawyers, accountants, commercial bankers, and investment bankers

all work with clients to structure financial transactions that have

favorable characteristics within the parameters of existing accounting, tax, and legal requirements.

Financing can be obtained in a multitude of ways, including, for

example, common equity, preferred stock, loans, commercial paper,

and other debt securities and, in the case of financial trading firms,

repurchase and forward agreements. These are other forms of

transactions that are designed to meet particular financing needs,

commonly referred to as ‘‘structured finance’’ transactions. The

structured finance market is very large, and is participated in by

the world’s major financial firms. Examples of structured finance

transactions include collateralized debt obligations, such as mortgage-backed securities and credit card securitizations, debt-equity

hybrid securities, leases of all varieties, convertible bonds and convertible preferred stock.

60

Prepaid forward commodity transactions are also a form of structured finance. In forward commodity transactions, which are common in many industries, the parties enter into a contract for sales

and deliveries of the commodity at future dates. A prepaid forward

provides for payment to be made at the inception of that contract.

The specifics of structured finance transactions may differ significantly from client to client as we and other financial firms participate in transactions to meet the specific needs of each client. What

these transactions have in common is increased liquidity and the

diversification of funding sources. Diversification of funding sources

is a matter of prudence. Throughout recent history, there have

been numerous events that have had an adverse impact on the

ability to access one or more funding sources and on the cost of

doing so. Diversifying sources of financing mitigates a corporation’s

exposure to such events and enables it to maintain and expand its

core business.

Let me now turn to the specifics of the Enron transactions themselves. Let me first emphasize that the more than 20 transactions

before you were not all identical.

In 1992, Enron approached the Chase Manhattan Bank, one of

the four predecessor banks that have now all been merged into

JPMorgan Chase, with a request that it enter into a prepaid forward transaction. At that time, there was some uncertainty as to

whether Chase, as a national bank, was authorized to accept physical delivery of a commodity. Therefore, the 1992 transaction was

accomplished by having a special purpose entity, or SPE, take delivery of the commodity. SPEs are companies that are established

for a particular purpose. They are widely used in structured finance transactions. As the people working on the transaction were

located in London, a Jersey SPE was used.

From 1993 through 2001, Enron entered into a total of 11 more

prepaid transactions involving Chase. Ten of the transactions were

with Mahonia Limited and one was with Mahonia Natural Gas

Limited, both Jersey Channel Islands SPEs. All but one of these

transactions were physically settled transactions, meaning that

they were settled with deliveries of gas and oil. The last transaction was financially settled, meaning no commodity was delivered, although the cash payment was to be determined by the price

of natural gas.

Prior to continuing with the chronology, we would like to address

Mahonia. Mahonia is beneficially owned by a charitable trust. Neither Chase nor Enron has any ownership interest in Mahonia. No

employee or officer of Chase or Enron served as an officer or director or held shares in Mahonia. The directors and officers of

Mahonia make the ultimate determination as to whether or not to

enter into a transaction. Those directors and officers are neither

appointed nor controlled by Chase or Enron. The use of entities

like Mahonia is standard activity in structured finance.

In the Enron prepaid forwards. the SPE entered into a prepaid

forward contract with an Enron subsidiary using funds provided by

Chase. The prepaid forward transaction created not only credit

risks for Chase, but performance, delivery, and commodity price

risks as well. As mitigants for these transactions—as mitigants for

these risks, the transactions included an Enron Corp. guarantee, a

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1 Exhibit No. 111 appears in the Appendix on page 365.

performance letter of credit or a surety bond, and either exchangetraded futures contracts or over-the-counter derivative contracts

with Enron Corp. Although the last prepaid transaction was financially settled, similar risks and mitigants were present in that

transaction, the sole difference being that no physical delivery was

required. Originally, the commodity purchased from Enron was

sold into the broader market. After Chase was capable of taking

physical delivery of gas or oil, Chase purchased the commodity

from Mahonia and in turn sold physical gas or oil into the market.

Beginning in the late 1990’s, Chase entered into contracts to sell

its gas or oil positions to Enron, which was by far the largest market participant.

All of the prepaid transactions in which the Subcommittee has

an interest were undertaken at the initiative of Enron. Chase understood that the transactions originally had tax benefits for

Enron. Later, Chase learned, Enron no longer received tax benefits

from the transactions but chose to continue to engage in prepaid

forward transactions for other corporate purposes. Enron management informed Chase that the prepaid forwards served to monetize

the unrealized profit in its trading book. Enron also advised Chase

that the rating agencies wished to see more cash generated from

its growing trading activities.

There have been allegations in the media that the prepaid forward transactions were disguised debt or a disguised loan. The prepaid forwards were undoubtedly financing, as all contracts are that

involve prepayment features, but every financing is not a loan.

These transactions had different features, benefits, and risks than

loans.

These prepaid transactions were accounted for on the books of

JPMorgan Chase consistent with GAAP. It is our understanding

that Enron reported these transactions as liabilities on its balance

sheet in accordance with GAAP; in other words, they were not offbalance sheet transactions. As I stated earlier, however, the manner in which Enron accounted for these transactions on its books

and in its financial statements was a matter for Enron and its

management and auditors.

As the Subcommittee is aware, JPMorgan Chase was one of several financial firms that provided financial services to Enron. We

have been one of the parties substantially harmed by its failure, incurring hundreds of millions of dollars in losses. JPMorgan Chase

welcomes this opportunity to answer the Subcommittee’s questions

today and will continue to cooperate with the Subcommittee’s inquiry. This concludes our oral presentation, and we would be

pleased to respond to your questions.

Senator LEVIN. Thank you, Mr. Dellapina. Mr. Traband.

Mr. TRABAND. He was representing all three of us.

Senator LEVIN. It is very clear that Enron saw prepays as a way

to get cash without reporting it as debt. If you will look in your

books at Exhibit 111,1 exhibit books in front of you, there is a page

from an Enron document on prepays. ‘‘Why does Enron enter into

prepays?’’ ‘‘Off-balance sheet’’—the first bullet. ‘‘Off-balance sheet

financing.’’ That is, it generates cash without increasing debt load.

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2 Exhibit No. 139 appears in the Appendix on page 482.

2 Exhibit No. 123 appears in the Appendix on page 414.

Now let us see how Chase saw the prepays. Take a look, if you

would, at Exhibit 139.2 This is one of Chase’s structuring summaries, the documents which are used to gain credit approval for

a financial transaction. It echoes that same thing.

In the past 3 years—if you look at—near the bottom of the front

page there—in the past 3 years Enron has utilized the prepaid sale

as a mechanism to address a number of needs, including refreshment of Section 29 credits and sourcing funds classified as liabilities from price risk management as opposed to long-term debt.

So Chase is clearly aware that that is one of Enron’s motives, to

classify that income as price risk management rather than longterm debt.

Now, I also want to refer you now to Exhibit 123.2 This is an

email from George Serice—I believe that is how he pronounces his

name—who is an investment banker with Chase. And the third

paragraph reads as follows:

‘‘Enron loves these deals, as they are able to hide funded debt

from their equity analysts, because they, at the very least, book at

as deferred revenue or, better yet, bury it in their trading liabilities.’’

That is what Chase knew.

Now, does this email not provide some pretty compelling evidence as to what Chase knew? ‘‘Enron loves these deals’’? This is

1998, November. ‘‘Enron loves these deals, as they are able to hide

funded debt from their equity analysts . . .’’ better yet—even better than deferred revenue—they ‘‘bury it in their trading liabilities.’’

Do you have any comment on that email?

Mr. TRABAND. Yes. This email predates my involvement with

Enron, but I can tell you my own understanding of the purpose of

the prepays and how I viewed them.

Senator LEVIN. I am not asking you that question. You could

have testified to that. My question is do you have any comment on

that email? This is a Chase person here, now, acknowledging what

Enron is doing—acknowledging. They love these deals. It allows

them to hide funded debt. They can bury this in their trading liabilities—which is exactly what happened, and Chase knew it in

1998. Do you have any comment on this email, Mr. McCree?

Mr. CREE. I think I would view that as a casual commentary by

an employee that, frankly, was not informed as to the completeness

of the entirety of the transactions.

Senator LEVIN. Would you agree it is a devastating commentary?

Mr. MCCREE. Well, I don’t know, devastating. I don’t think he

was fully informed as to Enron’s intention or the full structure of

the Mahonia as they were put together.

Senator LEVIN. Are you embarrassed by that?

Mr. MCCREE. I am confused by it.

Senator LEVIN. You are not embarrassed by this?

Mr. MCCREE. I think it is an unfortunate statement. I don’t

think it bears resemblance to how we as an institution view the

transactions that were undertaken here.

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1 Exhibit No. 128 appears in the Appendix on page 419.

Senator LEVIN. OK, Mr. Dellapina. You are in this email.

Mr. DELLAPINA. I don’t—— Senator LEVIN. Do you have any comment on that?

Mr. DELLAPINA. Yes, I don’t recall receiving it or responding to

it. But I certainly have had a chance to look at it recently, and I

believe that it is inaccurate. I believe that prepaid forwards are

fundamentally different than funded debt.

Senator LEVIN. When you say it is inaccurate, are you saying

that Enron did not love those deals?

Mr. DELLAPINA. I am unfamiliar with why that comment was

raised.

Senator LEVIN. But you are not saying that is inaccurate?

Mr. DELLAPINA. I am saying the reference to funded debt, which

is throughout this document, I believe to be inaccurate.

Senator LEVIN. But I want to get back to this question. Here you

got a Chase email that you received, or at least you are referred

to in the email, that says Jeff Dellapina and Bob Mertensotto

worked on a deal this summer where they took out a couple of

older prepaid PLCs with these surety bonds. Jeff is also working

on another prepay for Enron now.

That is you. It is the only ‘‘Jeff’’ in here.

And then it says something, and I want to ask you whether or

not you deny its accuracy. ‘‘Enron loves these deals, as they are

able to hide funded debt from their equity analysts’’—do you deny

that, first of all, that Enron loved those deals for that reason?

Mr. DELLAPINA. Mr. Chairman, I have no reason to believe why

they would love them or why they would not love them, and its impact on equity analysts.

Senator LEVIN. All right. Do you deny that Enron loved these

deals not just because they could hide it, but because they could

bury it in their trading liabilities? You are not able to deny that

either, are you?

Mr. DELLAPINA. I know that the transactions, or at least it was

represented to the bank that the transactions were reflected in

their trading liabilities. The references to ‘‘bury’’——

Senator LEVIN. The word here in the Chase memo is ‘‘bury.’’ Does

that embarrass you?

Mr. DELLAPINA. It confuses me as well. I believe it to be inaccurate.

Senator LEVIN. Now, here is Chase’s—well, let me just say this.

If I were Chase, I would be embarrassed. I would be ashamed of

that email. Let me just get that on the record. But I am not sure

what will embarrass or shame you, so let me go on to Exhibit 128.1

Here is your prepay pitch. Now, you are making a pitch for prepays. And the introduction says the following about prepays. And

this is—I think it is page 3 of this Exhibit, where it says ‘‘Introduction.’’ Let me just—so that I connect both Mr. Traband and Mr.

Dellapina to this particular document. There is an email, which is

the front page of Exhibit 128, which shows a copy of this going to

Mr. Dellapina, and it is to Mr. Traband, and it says, this is P&C.

What does that mean?

Mr. DELLAPINA. I believe P&C means private and confidential.

64

Senator LEVIN. And not for distribution? So only use this for your

own education. OK?

Now, on, I think it is page 3, but in any event, it is the page

which is headed by ‘‘Introduction.’’ It says: ‘‘Prepayment received

for a forward sale of inventory: Fixed quantity; specific delivery location(s).’’ It is an ‘‘Alternative source of finance,’’ and its ‘‘Balance

sheet ‘friendly’.’’ And then on page 5, it says the following: ‘‘Attractive accounting

impact by converting funded debt to ‘deferred revenue,’ or longterm trade payable.’’ Isn’t the ‘‘balance-sheet friendly’’ aspect of prepays a selling point

which Chase stressed when it pitched this product to other companies? Is that an accurate statement?

Mr. TRABAND. In the course of our dialog with our clients we certainly discuss the merits of transactions, and among those are accounting or tax issues. At the end of the day, we are not—we do

not advise them on those issues and they go back and talk to their

own accountants and attorneys.

Senator LEVIN. Part of your pitch, is it accurate to say, is that

these prepays have an attractive accounting impact by converting

funded debt to deferred revenue or long-term trade payable? Isn’t

that what you represent to people who are hearing that pitch?

Mr. TRABAND. That is certainly in the pitch. And there are different forms of liabilities that appear differently on the balance

sheet. Ultimately all are liabilities. And for different types of financing transactions, one may more accurately reflect the transaction.

Senator LEVIN. At least this is part of your pitch that you made?

Mr. TRABAND. That is part of the pitch.

Senator LEVIN. So on the next page of the pitch book is the

phrase ‘‘attendant tax benefits.’’ Now, is it not the case that the

funds that Enron received from these prepays could be considered

by them as a loan for tax purposes?

Mr. TRABAND. I can’t speak to the tax treatment of these transactions.

Senator LEVIN. What are the attendant tax benefits? Can that

not be treated as a loan? Is that not one of them?

Mr. TRABAND. I don’t know what the attendant tax benefits are.

Senator LEVIN. Well, who was making the pitch?

Mr. DELLAPINA. I may have——

Senator LEVIN. Dellapina made the pitch. So what did——

Mr. DELLAPINA. I may have contributed to the pitch as well. I am

not a tax professional and do not understand tax. What I believe

it refers to, and again, this is not an expert opinion, but that the

use of a prepaid forward could be used either as current income or

possibly treated as taxable income on a deferred basis. That is current taxable income. That is about the extent of the tax knowledge

that I have.

Senator LEVIN. Is the interest paid deductible, do you know?

Mr. DELLAPINA. There is no interest paid on a prepaid forward.

Senator LEVIN. Are the fees or the payments deductible?

Mr. DELLAPINA. I am not familiar with the accounting.

Senator LEVIN. Are any of you familiar with the tax benefits

which you pitched to companies?

65

Mr. MCCREE. No, I think what we would likely say in a situation

like that is the tax attributions of any deal, structured finance, prepaid, will be dependent upon the tax characteristics of the individual company. And that would be a matter between their tax advisors and themselves. But in our experience, prepaids had certain

tax attributes which were attractive to a variety of our clients.

Senator LEVIN. Would you agree, Mr. McCree that one of the tax

attributes—one of the attributes—was the attractive accounting

impact by converting funded debt to long-term trade payable?

Would you agree that is something which is attractive, that you

made a pitch to—— Mr. MCCREE. I don’t know about——

Senator LEVIN [continuing]. Potential clients?

Mr. MCCREE. I think the ability for, certainly in Enron’s case,

the company to treat this as a trading liability, which is how they

treated it based on advice from Andersen, was an attractive feature

to the prepaids.

Senator LEVIN. And you pitched you could convert funded debt

to deferred revenue or long-term trade payable?

Mr. MCCREE. I don’t know the answer to that. I don’t know if

that was——

Senator LEVIN. You don’t know if your company made—— Mr. MCCREE. That is what it says.

Senator LEVIN. Well, this is your company.

Mr. MCCREE. Yes, it is.

Senator LEVIN. Are you familiar with that document?

Mr. MCCREE. I have never seen it.

Senator LEVIN. Are you familiar with that document, Mr.

Traband?

Mr. TRABAND. I recall distantly that document.

Senator LEVIN. Mr. Dellapina.

Mr. DELLAPINA. I am familiar with, yes, components of the document.

Senator LEVIN. All right. So that is one of the attractive attributes of this particular approach, is that not correct? And you

made that pitch to companies, right?

Mr. DELLAPINA. Yes, I don’t recall the specific details of the

pitch. One of the parties that would do a transaction like a prepaid

forward would be a producer of a commodity, and it—it would probably be a pretty accurate way of portraying a forward sale, and the

actual forward sale of the commodity as a deferred revenue item.

And actually raising finance in that manner.

Senator LEVIN. What companies did Chase sell this product to?

Can you give us the list?

Mr. MCCREE. Mr. Chairman, if possible, and as a general matter,

we at JPMorgan, both from an individual standpoint and a corporate standpoint, guard the confidentiality of our clients closely

and believe in keeping their information private. So if it would be

possible not to go into specific company names, that would be important to us as a policy matter. If you insist we do it, we are

happy to do it.

Senator LEVIN. Is it accurate to say that one, two, three, four,

five, six, at least seven companies bought that pitch?

Mr. MCCREE. I don’t know—do you know?

66

1 Exhibit No. 118 appears in the Appendix on page 394.

Mr. DELLAPINA. I do not know whether all seven of those companies were actually pitched.

Senator LEVIN. Can you give us the number of companies which

bought this approach from Chase?

Mr. DELLAPINA. Well, I can tell you there were seven companies

that entered into transactions, as we supplied to the Subcommittee,

with Mahonia. I cannot confirm that they were pitched. The prepaid forward transactions were fairly well known in the market,

and I can’t confirm that I pitched this to all seven of those.

Senator LEVIN. Can you tell us how many you did pitch it to?

Mr. DELLAPINA. I cannot tell you what number of companies I

pitched it to.

Senator LEVIN. Now, Mr. Turner on the previous panel said there

are a number of criteria that prepaid transactions must meet before they can be considered real trades and accounted for as such.

They have to be independent trades among independent parties,

there must be price risk, among other criteria.

Mr. Dellapina, were the trades that made up the Chase prepaid

transactions with Enron independent trades between independent

parties?

Mr. DELLAPINA. Yes, I believe they were.

Senator LEVIN. Let us look at Mahonia now, just to see how independent Mahonia was. If you look at Exhibit 118.1 First, this is

from a firm, a law firm in the Channel Islands, are these offshore

folks that you work with? Mourant? It says, ‘‘our clients, Chase

Bank & Trust Company Limited.’’ So, now, Chase is the client of

Mourant, this offshore Channel Island firm—so it represents

Chase. And here is the letter that goes to the Registrar of New

Corporations and Trusts in Jersey. And the letter says the following: ‘‘Our clients, Chase Bank & Trust Company Limited . . . are

considering promoting from time to time specific purpose vehicles

for use in particular banking transactions. The possible areas in

which the SPV’s could be used are numerous, but at this stage it

can be foreseen that the likely use for them would be:’’—and then

the letter lists one of the reasons as ‘‘where a company wishes to

raise finances not by way of borrowing but by way of a related

transaction.’’ That is number one.

Now, the letter goes on to say, if you look at the top of page 2:

‘‘For obvious reasons, it is important that the SPV’’—the special

purpose vehicles—‘‘are controlled by Chase.’’

‘‘. . . It is important that the SPV’s are controlled by Chase.’’

And I want you to remember those words.

But for accounting and other requirements it is not desirable

that they are wholly owned by Chase. Accordingly, Chase is considering establishing a charitable trust which would own all the

shares of a holding company, which in turn would wholly own the

various SPVs.

Are you familiar with that letter?

Mr. DELLAPINA. I have never seen that letter from 1986, so—— Senator LEVIN. Do you have any reason to doubt its authenticity?

You, Mr. McCree, are you familiar with this letter?

67

Mr. MCCREE. No, never seen it.

Senator LEVIN. Your lawyers haven’t gone over this with you,

this letter?

Mr. MCCREE. No.

Senator LEVIN. This is the first time you are seeing it, all of you?

Mr. MCCREE. Yes.

Mr. TRABAND. Yes.

Mr. DELLAPINA. The first time.

Senator LEVIN. OK. So here goes. Your lawyer says it is important SPVs are controlled by Chase, but for accounting and other requirements it is not desirable that they be wholly owned by Chase:

‘‘Accordingly, Chase is considering establishing a charitable

trust’’—Chase is considering establishing a charitable trust— ‘‘which would own all the shares of a holding company which in

turn would wholly own the various SPVs.’’ And there is a second letter in this packet here, April 29, from

the Jersey office, telling the incorporating law firm that such an

entity would not be a problem.

Next document, then, is May 13. It shows that—excuse me, the

next document is May 12, received on May 13, showing that East

Moss Limited has in fact been formed.

Then if you will skip to the letter after next, which is the one

that Chase’s attorney, James Mourant, wrote to the Jersey agency

on May 29, 1986, to explain a financial transaction that involved

Chase and East Moss Limited. And this is what he wrote—if you

will look at the middle of page 2: ‘‘In order that the U.S. authorities could be entirely satisfied

with the arrangements it was considered preferable that my firm’s

trust company act as trustee of the charitable trust and administer

East Moss rather than Chase Jersey.’’ So now we have Chase’s agent, a trust company of Chase’s agent,

Mourant, acting as trustee of the trust. OK?

Now, the next document is Mahonia’s registration form to the

Jersey Commercial Relations Department. And we can see there

that when Mahonia was formed in 1992, Chase’s agent, Mourant,

was listed as the owner. Do you see that, down—number 7, beneficial owner? It is your agent, Mourant.

So, any doubt in your mind that Chase controlled Mahonia?

Mr. MCCREE. Well, I would say that Chase did not control

Mahonia and Chase did not own Mahonia. It was set up as a separate special purpose—— Senator LEVIN. Who did own Mahonia?

Mr. MCCREE. A charitable trust.

Senator LEVIN. And who owned the charitable—who established

the charitable trust?

Mr. MCCREE. I don’t know the answer to that.

Senator LEVIN. Well, it is in this letter. Chase established the

charitable trust.

Mr. MCCREE. I am just looking at this letter—the 1986 letters

referred to a bid by Dixon’s for Woolworth’s. It looks to me like a

completely unrelated transaction. I have never seen the letters before, so I don’t know the specifics as to the transactions that are

referenced to in the 1986 letters and the linkages between

Mahonia. I just don’t know the answer to that, Senator.

68

1 Exhibit 118 appears in the Appendix on page 394.

Senator LEVIN. Well, take a look again at that May 19, 1986, letter.‘‘Further to our application to incorporate an investment holding

company to be called East Moss Limited, I am writing to give you

further details.’’ This is your agent writing the registrar, now, in Jersey. And

right in the middle: ‘‘I should begin by mentioning that although this particular

transaction is part of a Chase scheme’’—that is your agent’s

words—‘‘for various reasons, one of my firm’s trust companies will

in fact be acting as trustee of the charitable trust.’’ Your agent’s trust company—are you with me so far—is going to

be the trustee and administering East Moss Limited. Any problems

so far?

Mr. DELLAPINA. Mr. Chairman, may I just make a comment?

Senator LEVIN. Sure.

Mr. DELLAPINA. None of us have seen this email before—this letter before. And the suggestion that Ian James was our agent or our

attorney, I do not understand that. For the period of time——

Senator LEVIN. The suggestion by whom?

Mr. DELLAPINA. That he was our attorney.

Senator LEVIN. Whose suggestion?

Mr. DELLAPINA. I think the suggestion—at this hearing.

Senator LEVIN. No, the suggestion by your attorney. ‘‘Our clients’’—do you see that? Exhibit 118?1 Our clients, Chase? It is not

the suggestion here; it is your lawyer’s statement that he represents you. Now, who pays his fees? Who pays Mourant’s fees?

Mr. DELLAPINA. On the transactions that I have been involved

with, we have—the Chase Manhattan Bank has paid the fees for

Mourant.

Senator LEVIN. There you go. Mourant writes the letter, says he

is your lawyer. You are paying his fees. Mourant’s trustee is running the charitable trust that owns the holding company that owns

Mahonia. You can put as many layers on this as you want, but it

comes right back to it. Your agent has a trust which is the trustee

of a charitable trust which owns a holding company which owns

Mahonia.

Folks, is there any doubt about what I am saying, in your mind?

This may be the first time that you are seeing it, but you are seeing it. It is right in front of you. Do you have any reason to doubt

that?

Mr. MCCREE. I just—my understanding is that we do not own

Mahonia, we do not control Mahonia.

Senator LEVIN. Who gave you the understanding you don’t control Mahonia? Who told you that?

Mr. MCCREE. It might have been Jeff.

Senator LEVIN. Jeff, who told you you don’t own Mahonia?

Mr. DELLAPINA. When I started doing the transactions, I understood this to be an independent SPE, from our attorneys. I don’t

recall specifically who would have conveyed that information. We

have always known Ian James to be the attorney for Mahonia. And

yes, Ian James with Mourant’s fees have been paid by the Chase

69

Manhattan Bank. We don’t view this as entirely uncommon. It is

not uncommon, for example, in a closing of a home mortgage that

a client would pay a bank’s attorney’s fees. But we have always

known—I have always known Ian James to be the attorney for

Mahonia.

Senator LEVIN. You pay their fees.

Mr. DELLAPINA. We do pay their fees.

Senator LEVIN. And this is the first you ever heard that you folks

established Mahonia? This is the first you have ever heard of that?

Mr. DELLAPINA. Mr. Chairman, when Enron approached

JPMorgan Chase to do a prepaid forward transaction, as we described in the statement, Chase—we were not sure as to whether

Chase could take physical commodities at that point. Chase did at

the time approach Mourant and ask if there was an SPE that

would be interested in entering into the transaction. That is to the

best of my information. I was not in the group at the time.

Senator LEVIN. Who pays all the costs associated with the administration of Mahonia.

Mr. DELLAPINA. Those costs are paid by Chase.

Senator LEVIN. Not just the legal fee?

Mr. DELLAPINA. Not just the legal fees.

Senator LEVIN. And who pays Mahonia’s annual Jersey statutory

charge?

Mr. DELLAPINA. I am not sure of the answer.

Senator LEVIN. Do either of you know? Well, let me tell you:

Chase does. You pay the annual charge, you pay the legal fees, you

pay the administrative costs, you established Mahonia. Your lawyer is the agent for it. And you are telling me you don’t have any

control over Mahonia? You are under oath. You are telling me

Chase has no control over Mahonia?

Mr. MCCREE. I don’t believe we control the individual decisions

of Mahonia.

Senator LEVIN. Do you have any control over Mahonia at all, Mr.

McCree?

Mr. MCCREE. Not to my knowledge.

Senator LEVIN. Mr. Traband.

Mr. TRABAND. Not to my knowledge.

Senator LEVIN. Mr. Dellapina.

Mr. DELLAPINA. To the best of my knowledge, Mahonia and its

attorneys—— Senator LEVIN. Despite all that.

Mr. DELLAPINA. I do not believe we control Mahonia.

Senator LEVIN. You have no control over it. Does your agent control it, Mr. McCree?

Mr. MCCREE. I don’t believe so.

Senator LEVIN. Is Mourant——

Mr. MCCREE. I don’t know who the board of directors of Mahonia

is, but I believe the board of directors of Mahonia controls the decisions of that company.

Senator LEVIN. Do you know who is on that board?

Mr. MCCREE. I do not off the top of my head.

Senator LEVIN. Do you know who is on that board, Mr. Traband?

Mr. TRABAND. I don’t know who is on the board.

Senator LEVIN. Mr. Dellapina.

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1 Exhibit No. 184(a) appears in the Appendix on page 665.

Mr. DELLAPINA. I believe I know at least one individual who is

on the board.

Senator LEVIN. Who is that?

Mr. DELLAPINA. I believe Ian James. He is a director of Mahonia.

Ian James is an attorney at Mourant.

Senator LEVIN. And that is the law firm that you pay the fees

to, right?

Mr. DELLAPINA. That is the law firm that represents Mahonia.

Senator LEVIN. And you pay the fees to.

Mr. DELLAPINA. And we paid their fees on these structured

transactions.

Senator LEVIN. Do you know whether Mahonia has ever entered

into a commercial transaction in which Chase was not involved?

Mr. DELLAPINA. I do not believe so.

Senator LEVIN. Mr. Traband.

Mr. TRABAND. I am not aware of any.

Senator LEVIN. Mr. McCree.

Mr. MCCREE. I do not know.

Senator LEVIN. Did Chase serve as Mahonia’s agent in the prepays, Mr. Dellapina?

Mr. DELLAPINA. I believe that we served as an agent for commercial transactions.

Senator LEVIN. Did Chase serve as Mahonia’s agent in the prepays?

Mr. DELLAPINA. I believe that is correct.

Senator LEVIN. Mr. Traband.

Mr. TRABAND. I don’t know the answer.

Senator LEVIN. Mr. McCree.

Mr. MCCREE. I am sorry, I don’t know.

Senator LEVIN. You don’t know.

Now, Exhibit 184(a) 1 is a transcript of part of a phone conversation which was recorded apparently by Chase.

Mr. Dellapina, let me address this to you. This is a transcript of

part of a phone conversation that you had with Mr. Traband here,

Mr. Serice, who wrote that honest letter about what the motives

here were of Enron, and Joe Deffner and Lisa Bills of Enron, and

it was on September 13, 2001, and if we can play that conversation,

do we have that? Do you see the transcript in front of you at the

bottom of page 7—I am sorry, at the bottom—it is in Exhibit 184.

[Audio tape played.]

Senator LEVIN. Let’s go back now in the transcript. Ms. Bills—

this is the best that we understand. We need to have—excuse me,

Mr. Garberding, I guess, is speaking here first. ‘‘We need to have

a specific rep letter that a representative of Mahonia signed that

reference a certain point.’’ Ms. Bills: ‘‘Which is, yes, separate from

Chase. It doesn’t have Chase showing up anywhere on the fax letterhead or anything along those lines, a separate fax number, etc.’’

Mr. Dellapina. ‘‘Oh, talk about it, yes.’’ Mr. Deffner. ‘‘That goes to

the same point you were raising’’—you were raising—‘‘earlier, Jeff,

that from your side you also want to make sure that Mahonia

seems independent.’’ ‘‘Seems independent.’’

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1 Exhibit No. 142 appears in the Appendix on page 492.

Mr. Dellapina, if Mahonia is independent, you don’t need to

make it seem independent.

Mr. DELLAPINA. I entirely agree with that statement. To the best

of my understanding——

Senator LEVIN. Why do you want to make it seem independent?

Mr. DELLAPINA. I don’t believe I would have wanted it to seem

independent.

Senator LEVIN. It says right here though——

Mr. DELLAPINA. I believe it is independent.

Senator LEVIN. ‘‘That goes to the same point you were raising

earlier, Jeff, that from your side you also want to make sure that

Mahonia seems independent.’’ That’s the point you were making,

Jeff.

Mr. DELLAPINA. Mr. Chairman, that’s a statement by another individual.

Senator LEVIN. Did you disagree with that?

Mr. DELLAPINA. I disagree that I——

Senator LEVIN. No. Did you disagree with it on the phone conversation, Mr. Dellapina?

Mr. DELLAPINA. I did not challenge that point on that phone conversation.

Senator LEVIN. No, you didn’t challenge the fact that you had

made that point earlier. The representation that was made here by

Deffner that ‘‘That goes to the same point you were raising earlier,

Jeff, that from your side you also want to make sure that Mahonia

seems independent.’’ Do you deny ever making that point?

Mr. DELLAPINA. I do not believe that Mahonia is not independent. I believe it is independent.

Senator LEVIN. Do you deny under oath that you stated earlier

in this conversation or sometime before that you also wanted to

make sure that Mahonia seems independent or words to that effect? Do you deny having said that?

Mr. DELLAPINA. Mr. Chairman, I don’t recall what I said in that

conversation or in an earlier conversation.

Senator LEVIN. OK. Now take a look at Exhibit 142.1 This is an

email from an attorney at Chase to Mourant. Your lawyer, your

agent. You pay him.

The second line down there, it says—so this is now from an attorney at Chase to the attorney in the islands there, the Jersey Islands. ‘‘At this point, while not a certainty, it looks like we will

need to form Mahonia 3.’’

‘‘We will need to form Mahonia 3.’’

‘‘In addition to entering into the prepay with Enron North America, this entity will be entering into a contract to sell its rights to

receive gas under the prepay agreement to a group of purchasers,

including Chase. In this connection, the purchasers will appoint

Mahonia 3 to act as its agent in handling the sale of the natural

gas delivered under the Enron contract. The purchaser of the gas

in this contract will be Chase. Chase will then sell the gas pursuant to a fixed price forward contract to Stoneville Aegean, an SPV

that entered into transactions introduced by Chase in the early to

72

1 Exhibit No. 120 appears in the Appendix on page 411.

mid-1990’s. Stoneville will then sell the gas pursuant to a fixed

price forward contract to Enron.’’ Great specificity as to what Mahonia 3 is going to be doing during the next so-called prepay.

So Mahonia 3 was created and it did engage in so-called prepay

with Chase and with Enron. Now, Mr. Dellapina, Mahonia is an

independent entity. Why is a lawyer from Chase telling Mahonia’s

administrators that ‘‘we will need to form Mahonia 3’’? If Mahonia

is independent, why is Chase telling Mahonia’s administrators

that?

Mr. DELLAPINA. In this structured transaction, I believe as is

common in other structured transactions, the bank introduces the

idea of a transaction to a party, in this case the law firm that had,

in fact, formed or identified Mahonia for the first transaction. So

raising this as a new opportunity for this attorney seems consistent

with what would be done in a structured transaction, to the best

of my knowledge.

Senator LEVIN. So now your attorney—or, excuse me, Chase’s is

describing in great detail what contractual arrangements this supposedly independent entity you are going to decide to enter into

when it hasn’t even been formed yet? You are laying out all the

specifics of contractual arrangements that an independent entity is

supposed to apparently make decisions on, and that entity hasn’t

even been formed yet. In fact, you are telling someone to form that

entity. You call that independence? Is that your definition of independence?

Mr. DELLAPINA. The use of SPVs in these transactions are designed to create independent legal agreements, an independent legality in the transactions. Ultimately we will explain to you later

that that legal independence did, in fact, create financial—additional financial risk to us and additional financial harm.

Senator LEVIN. Exhibit 120,1 if you will take a look at it, February 28, 2002. This is an email between two employees of your

agent, Mourant & Company, administrator of Mahonia. In this

email, one employee reports that Chase has just informed her that

it discovered that Mahonia was inadvertently omitted from the gas

delivery agreements related to one of the 1998 prepay transactions.

Four years, nobody was even aware of the fact that Mahonia was

omitted from the agreement, so title to the gas was never transferred to Mahonia.

Then she writes the following: ‘‘Accordingly, new pipeline agreements need to be completed, reflecting the providers delivering to

Mahonia, who in turn deliver to JPMorgan.’’ ‘‘New pipeline agreements need to be completed. He will forward

the paperwork to me by fax and would be grateful if the directors

would consider execution as soon as possible.’’ Were those papers delivered, do you know, Mr. Dellapina?

Mr. DELLAPINA. I do not know.

Senator LEVIN. You are not familiar with this?

Mr. DELLAPINA. I’m not familiar with this email.

Senator LEVIN. No. Are you familiar with the problem?

Mr. DELLAPINA. Generally. Not specifically.

73

Senator LEVIN. Generally, were you familiar that Mahonia was

left out of one of these transactions and you had to go back and

create new papers to include it?

Mr. DELLAPINA. I don’t know that Mahonia was left out of the

transaction. I don’t—what I generally understand is that there was

an operational issue—it wasn’t appropriately booked on an operational basis with the pipeline. But I don’t know much more than

that.

Senator LEVIN. You’re not familiar with the fact that there was

a discovery of an anomaly that it was left out of a transaction? This

is the first time you are hearing about that?

Mr. DELLAPINA. No. I am generally aware that there was an

operational issue that it was not actually booked properly.

Senator LEVIN. Not booked properly. Mahonia was left out, right?

Mr. DELLAPINA. I don’t understand ‘‘left out.’’

Senator LEVIN. You don’t understand what?

Mr. DELLAPINA. ‘‘Left out.’’

Senator LEVIN. Omitted. Wasn’t included.

Mr. DELLAPINA. All of the legal paperwork was executed. I understand that the issue was relating to the actual communication

with the pipeline company and the actual recording by the pipeline

company.

Senator LEVIN. Was there a new pipeline agreement that was

completed reflecting the providers delivering to Mahonia, who then

in turn delivered to JPMorgan?

Mr. DELLAPINA. That I am not aware of.

Senator LEVIN. Let me read you one line from this memo. ‘‘Greg

has just called to advise that JPMorgan’s agents have arranged to

settle the invoice and that they do not need our instruction. Have

also advised that they have just discovered anomalies in the Texas

Eastern Pipeline agreements in respect to certain trades, whereby

the pipeline agreements are made directly between the providers

and JPMorgan, effectively bypassing Mahonia.’’

How’s that for a definition of ‘‘left out’’? Is that better? Were you

familiar with—are you familiar with the fact that Mahonia was bypassed inadvertently?

Mr. DELLAPINA. Inadvertently, I am familiar that on the pipeline

records, the gas does not note Mahonia in the title chain.

Senator LEVIN. Are you aware of the fact that this was described

as an inadvertent bypassing?

Mr. DELLAPINA. That it was described as that?

Senator LEVIN. Yes.

Mr. DELLAPINA. No. I have not seen this email before, and I’m

not familiar with that.

Senator LEVIN. All right. But you are generally aware of the fact

that Mahonia was inadvertently bypassed in one of these deals in

the booking?

Mr. DELLAPINA. Yes.

Senator LEVIN. All right. Now, if Mahonia is an independent

company and it was bypassed for 4 years, would you say that it is

particularly an independent company? If someone discovers 4 years

later that Mahonia was bypassed in a booking, no one discovered

it for 4 years, is that your definition of independent company?

74

Mr. DELLAPINA. Mr. Chairman, we have transacted prepaid forward physical transactions with Enron and Mahonia since 1992,

and there was a discovery made that in one transaction there was

inappropriate communication to the pipeline which didn’t specify

exactly how the volumes were flowing.

With SPVs, we are not suggesting that this SPV had a vast operation and that it was designed to get into a vastly detailed commercial activity. The SPV was designed in the structured transaction

or served the role in the structured transaction to create legal independence among contracts.

Senator LEVIN. You said ‘‘legal independence.’’ Are you distinguished that from actual independence?

Mr. DELLAPINA. I don’t know the definition of ‘‘actual independence.’’ The history——

Senator LEVIN. Real.

Mr. DELLAPINA [continuing]. Of the transactions——

Senator LEVIN. Real-world independence.

Mr. DELLAPINA. Legal independence.

Senator LEVIN. Does that distinguish from real-world independence?

Mr. DELLAPINA. I don’t know the answer to that.

Senator LEVIN. OK.

Mr. DELLAPINA. We began these transactions in 1992 for the reasons we described, that is, Chase’s—the lack of clarity as to our

ability to take physical oil and gas back in 1992. The purpose of

Mahonia at that point was to enable that physical delivery, and

throughout the period in which we’ve been involved with Mahonia,

we’ve always recognized it as a legally independent entity.

Senator LEVIN. Which didn’t have a vast operation, in your

words, right?

Mr. DELLAPINA. No, it did not.

Senator LEVIN. As a matter of fact, it was a shell. It was created

by Chase, wasn’t it, solely for your transactions? That is its registration statement. Is that correct? I went through the registration

statement with you. That is the purpose of Mahonia, to assist you

in transactions. There is no operations, except to assist you.

Mr. DELLAPINA. That is correct. They work on structured transactions with us. That is correct.

Senator LEVIN. All right. So when you say they didn’t have vast

operations, don’t try to sell us on the concept that they were anything other than a shell corporation created by you to assist Chase,

run by your agent, Mourant—who you paid, whose fees, Mahonia’s

fees you paid, and you are going to try to leave it with this Subcommittee that in your judgment you honestly believe that this

Mahonia was not under the effective control of Chase? Is that your

testimony, Mr. Dellapina?

Mr. DELLAPINA. To the best of my knowledge, when I worked on

these transactions I did not understand that we controlled this

company. We did not own it, and we did not enter into documentation on their behalf.

Senator LEVIN. You were aware of the fact that it was created

to assist Chase, was owned by a trust, which was in turn owned

by your agent, was created for you, you paid all of its registration

fees, you paid all of its administrative fees, you paid its legal fees.

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1 Exhibit No. 118 appears in the Appendix on page 394.

And are you telling this Subcommittee that in your honest judgment Chase did not effectively control Mahonia?

Mr. DELLAPINA. Mr. Chairman, I am not sure that I have the

legal knowledge to define—— Senator LEVIN. I am just asking you for your honest judgment.

I am not asking you for a legal opinion. I am asking you from what

you know.

Mr. DELLAPINA. I understand—I think I understand the question.

And I will again say that we—I fully recognize that this is an SPV

that was working on these transactions for a purpose. Originally it

was to accommodate the physical transfer of oil, which the bank at

that time did not do. And continuing throughout the evolution of

these transactions, which occurred over 10 years and changed form

over time, the transaction—the company was recognized independently as a legal entity.

Senator LEVIN. I am going to go back to my question, because

you say you understand it.

Mr. DELLAPINA. I did understand the question—— Senator LEVIN. I am asking you for your honest judgment. Did

Chase effectively control Mahonia?

Mr. DELLAPINA. I don’t believe that we controlled Mahonia.

Senator LEVIN. Mr. McCree, do you want Chase to stand by that

answer?

Mr. MCCREE. Yes.

Senator LEVIN. In your judgment, Mr. McCree, do you believe

that Chase did not effectively control Mahonia, given all the facts

we have laid out here—it was created for you, owned and operated

by your agent, you paid all of its fees, you paid its legal fees, you

don’t know of any example where it did anything for any other

company from Chase, and you want as a representative of Chase

to tell this Subcommittee that in your honest judgment Chase did

not effectively control Mahonia?

Mr. MCCREE. My understanding, Mr. Chairman, is that Mahonia

was controlled by a charitable trust, which was governed by a

board of directors which made independent decisions on the individual transactions that were forwarded to them for consideration.

Senator LEVIN. Are you aware of the fact that Mahonia was

owned by your agent, operated by your agent, that Chase paid all

of its legal fees, registration fees, and administrative fees, and that

there was no—its sole purpose for coming into existence was to assist Chase? Are you aware of all those facts?

Mr. MCCREE. My understanding is it was owned by a charitable

trust, not by our agent.

Senator LEVIN. Who owns the charitable trust?

Mr. MCCREE. I don’t know the answer to that.

Senator LEVIN. Well, we went through the letter.

Mr. MCCREE. I’m not sure who owns the charitable trust. I believe a charitable that was established, but I’m not—I am not fluent in the entirety of the legal structure of the ownership structure

of Mahonia—or the charitable trust, sorry.

Senator LEVIN. Well, do you want to read your agent’s letter

again? April 24, first letter in Exhibit 118,1 page 2. You see, when

76

you use offshore jurisdictions this way, it is kind of hard for us to

subpoena them, by the way. But let’s read what they say. This is

1986. Page 1 of the letter, it says, ‘‘Our clients, Chase.’’ Here’s page

2. ‘‘For obvious reasons, it is important that the SPVs are controlled by Chase.’’ He’s lying? Is your lawyer lying?

Mr. MCCREE. Well, I don’t—this is a 1986 letter.

Senator LEVIN. Which created Mahonia.

Mr. MCCREE. Did it create Mahonia?

Senator LEVIN. Led to it.

Mr. MCCREE. I do not know——

Senator LEVIN. Well, let’s just keep reading it. ‘‘For obvious reasons, it is important that the SPVs are controlled by Chase.’’ Was

it important that the SPVs be controlled by Chase?

Mr. MCCREE. I have no idea what SPVs——

Senator LEVIN. Is it important that the SPVs that you used, that

they created, are controlled by you?

Mr. MCCREE. No, I don’t believe so, but I don’t know the specifics

of this individual transaction. I really have no knowledge of a 1986

transaction.

Senator LEVIN. Well, we are going to have to get the answer from

Chase then. If you don’t know the answers to this, we are going

to need to get the answer. And if we have to get your president

here to do it, we are going to get it, because this is shameful. This

is shameful that you are not owning up to something that your

lawyer did in 1986 on your behalf, creating an entity on your behalf, saying here, ‘‘For obvious reasons, it’s important the SPVs are

controlled by Chase. But for accounting and other requirements,

it’s not desirable that they be wholly owned by Chase. Accordingly’’—what does your lawyer, your agent say? ‘‘Chase is considering establishing a charitable trust which would own all the

shares of the holding company, which in turn would wholly own

the various SPVs.’’

Did Chase establish a charitable trust? Yes or no.

Mr. MCCREE. I just—Mr. Chairman, I do not know the entirety

of the context of this letter, the time frame, or anything. So I feel

uncomfortable describing what was being described in this letter.

I don’t know the answer to that.

Senator LEVIN. We thought you would be prepared to answer

questions here for Chase today, and I guess you are not.

Mr. MCCREE. Not this one. I apologize.

Senator LEVIN. This goes to the heart of the matter here. This

goes to the heart of a deception as to whether Mahonia was an

independent entity. Because if it is not, it is a loan. Everyone acknowledges that. If Mahonia is not independent, it is a loan. It has

got to meet three other criteria, too, which we haven’t gotten to.

But this isn’t just a question.

Mr. MCCREE. I would say I would be happy—or we would be

happy to provide additional information on this matter. I don’t

have the full context. My understanding is Mahonia is an independent entity.

Senator LEVIN. Yes. Well——

Mr. MCCREE. And I apologize for that.

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1 Exhibit No. 131 appears in the Appendix on page 436.

Senator LEVIN. When we sent Chase a letter, we expected that

they would send somebody that could answer questions about control.

All right. Keep going now. ‘‘It is not desirable that they be wholly

owned by Chase. Accordingly, Chase is considering establishing a

charitable trust’’—you don’t know if they did or not, right?

Mr. MCCREE. I have no idea.

Senator LEVIN. ‘‘. . . which would own all the shares of the holding company which in turn would wholly own the various SPVs.’’ It is a shell, and it is a shell game, and Chase should own up

to it, be honest about it, and it is not. And this Subcommittee is

going to get the answers from Chase to that question. Who do you

suggest we call here as a witness who can answer the question?

Mr. MCCREE. I don’t know. I will have to find out who was involved in the transactions at the time.

Senator LEVIN. Turn, if you would, to Exhibit 131.1 Now, Exhibit

131 is a diagram that was sent to you by email by an Enron employee, and I believe it is addressed to you, Mr. Dellapina. This diagram works on the details of the prepay transactions, and it was

sent to you less than 2 days before the $350 million prepay between Chase, Mahonia, and Enron was signed. The diagram shows

all three legs of the transaction, the expected price, and the general

terms of the arrangements between the three parties. That is on

page 2. Do you follow me so far?

Mr. DELLAPINA. Yes.

Senator LEVIN. So these trades were developed as a package

deal, is that true?

Mr. DELLAPINA. Yes.

Senator LEVIN. Now, in these transactions, the contract between

Mahonia and Enron and the contract between Mahonia and Chase

were identical in terms of volumes and delivery dates, and the financial terms were only slightly different to reflect the fees that

Mahonia would receive for participating as a party in the transaction. Is that correct?

Mr. DELLAPINA. I believe that’s correct.

Senator LEVIN. So Mahonia essentially received a fee for participating in these transactions. Is that correct?

Mr. DELLAPINA. That is correct.

Senator LEVIN. But one of the four criteria for a legitimate prepay was not met here by your own testimony, because there cannot

be this kind of linkage. They are all part of—this was a package

deal. You have just testified to us under oath.

Mr. DELLAPINA. Mr. Chairman.

Senator LEVIN. Yes.

Mr. DELLAPINA. I am not familiar with the four criteria for a prepay.

Senator LEVIN. They have been testified——

Mr. DELLAPINA. I saw this earlier, and I was—I don’t believe that

I was ever asked to review that. That would have been out of my

scope, and I’m not familiar with——

Senator LEVIN. According to the testimony this morning, for

there to be a legitimate prepay you need a number of things. One

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1 Exhibit No. 138 appears in the Appendix on page 476.

of them has got to be independent parties which are not involved

in a package deal transaction which is linked together.

When you look at the diagram that was showing the last prepay,

it was signed in 2001. All the transactions are financially settled.

All the legs use the same amount of gas, pegged to the exact same

price. All of the payments are fixed. The same amount of funds go

in and out of Mahonia and into Enron. The only difference is that

Chase picks up an extra $6 million, and now there is risk that one

party may not pay, but that is true in any loan. That is not price

risk.

Is there any price risk in this transaction, Mr. Dellapina?

Mr. DELLAPINA. The price risk in this transaction initiates with

the transaction between Enron and Mahonia, and then the transaction between Mahonia and Chase. That price risk is being

hedged with a swap between Enron and Chase.

Senator LEVIN. So there is no price risk at the end of the game

when you put it all together; is that not correct?

Mr. DELLAPINA. Provided that all parties, in fact, perform on the

contracts, there is no speculative price risk, the price risk materializes in the form of a pretty large counterparty credit exposure.

Senator LEVIN. But there is a credit risk. So there is a credit risk

here, but not a price risk. Is that correct?

Mr. DELLAPINA. The price risk will only materialize if the credit—the counterpart does not perform.

Senator LEVIN. Why don’t we just get a straight answer to this

question? In other words, there is a credit risk here, but not a price

risk; is that not correct?

Mr. DELLAPINA. There is a credit risk.

Senator LEVIN. You are not willing to say there was no price

risk. Even though every party was perfectly hedged and guaranteed here, you are not willing to answer the question was there a

price risk before this Subcommittee?

Mr. DELLAPINA. There was not a speculative price risk in the

transaction. There was not when the transaction was concluded.

We certainly look at prices, and the movement in prices will, in

fact, affect our credit exposure.

Senator LEVIN. Mr. McCree, do you want to comment on that?

Do you agree with that? Was there a price risk here?

Mr. MCCREE. There’s certainly a credit risk. The magnitude of

the credit risk moves in a scenario that we have to now based on

market prices, I believe.

Senator LEVIN. Try my question. Was there a price risk here?

Mr. MCCREE. Not at the outset of the transaction. There was, but

it was hedged.

Senator LEVIN. Now, in Exhibit 138—and, by the way, price risk

is another criteria which has been testified to as absolutely essential for there to be a legitimate transaction here. It would not count

as debt.

Let me point you to Exhibit 138.1 This is Chase’s own description

of one of these transactions, and it comes right out and it clearly

states the objective. It is in the middle of—let me see if I can get

you the right page here. It is right under that—see the black bar?

79

‘‘The transaction calls for Chase to advance funds to a special purpose corporation formed by Chase in the Channel Islands,

Mahonia, Limited.’’ Does that sound familiar? Do you agree at least

that you formed Mahonia? Mr. McCree, did you form Mahonia?

Mr. MCCREE. I think we asked Mourant & Co. to consider forming Mahonia.

Senator LEVIN. I see. To consider forming Mahonia, not even to

form it. This is your document.

Mr. TRABAND. I think the language used in this document is

loose and inaccurate.

Senator LEVIN. That is a problem with a lot of Chase documents.

Let me tell you, that is exactly the problem. So your document

here, which says that this special purpose corporation which was

formed by Chase in the Channel Islands, Mahonia Limited, that is

not true; is that what you are saying? This isn’t 1986, folks.

Mr. TRABAND. I think what we would say is——

Senator LEVIN. This is 1996.

Mr. MCCREE. Mr. Chairman, I think what we would say is Chase

arranged for the establishment of Mahonia.

Senator LEVIN. I see.

Mr. MCCREE. But once it was established, it was controlled by

its board of directors—— Senator LEVIN. Which were controlled by your agent.

Mr. MCCREE. No, by its board of directors. And we believe it was

all done in accordance with law.

Senator LEVIN. So this is not an accurate statement in this

Chase document. Is that the bottom line? You didn’t form it?

Mr. MCCREE. We arranged for the formation—— Senator LEVIN. You just caused it to be formed.

Mr. MCCREE. We arranged for the——

Senator LEVIN. You arranged for it to be formed, but you are not

willing to say you—that this is formed by you. You just paid somebody else to form it.

Mr. MCCREE. Correct.

Senator LEVIN. So if I go and tell somebody, hey, I am building

a new house, you are just saying literally that means I have got

to go out and build it myself rather than paying to build it; is that

correct? That is the way you use language at Chase?

Mr. MCCREE. No. I think it’s—I think—— Senator LEVIN. Come on, you formed Mahonia. That is the common-sense version. You formed it. You paid for it to be formed. You

caused it to be formed. You formed it. You created it. You brought

it into existence.

Mr. MCCREE. We asked our attorney and Mourant & Co. to establish a special purpose entity for the——

Senator LEVIN. And they did it.

Mr. MCCREE [continuing]. Purpose of doing this—yes.

Senator LEVIN. And they did what you paid them to do, didn’t

they? Right?

Mr. MCCREE. Yes.

Senator LEVIN. OK. Let’s keep going beyond that. ‘‘Mahonia in

turn enters into a forward gas sales contract, referred to as a prepay, with an Enron subsidiary, Enron Natural Gas Marketing. An

integral part of the prepay is the execution of a series of commodity

80

1 Exhibit No. 184(a) appears in the Appendix on page 665.

and interest rate swaps which result in a known cash flow stream.’’ ‘‘Known cash flow stream.’’ That is a pretty good definition of eliminating price risk, wouldn’t you say, steady repayment of funds? Mr.

Dellapina.

Mr. DELLAPINA. Yes, we were trying to eliminate price risk.

Senator LEVIN. Mr. Dellapina, isn’t it the case when you look at

these so-called prepays that they are nothing more than a big circle

designed to get Chase loans to Enron and back to Chase? Just a

circle, isn’t that true?

Mr. DELLAPINA. Mr. Chairman, these transactions were started

in 1992, the form of which changed over the ensuing 11 years or

so that the transactions were being done with Enron. There were

elements of the transaction that were designed to mitigate price

risk. Towards the end of the transactions, there were elements of

it that were designed to also mitigate the physical delivery risk.

But there are structural differences which we believe make these

fundamentally different than loans. And if you have a moment, I’d

like to go through the differences with you.

Senator LEVIN. Well, why don’t we just address my questions, if

you would.

Mr. DELLAPINA. Excuse me, Mr. Chairman?

Senator LEVIN. I would rather you just respond to my questions,

if you would. I want to talk to you about the way you characterized

the last prepay, the $350 million prepay. Wasn’t that characterized

as a circular deal, Mr. Traband?

Mr. TRABAND. Characterized as a circular deal?

Senator LEVIN. One that went in a circle.

Mr. TRABAND. Well, I mean, my understanding is that—— Senator LEVIN. Like that triangle you just saw there.

Mr. TRABAND. My understanding is that there was a prepaid

swap and a separate commodity swap.

Senator LEVIN. Would you call that a circular deal?

Mr. TRABAND. I don’t know if I’d call that a circular deal.

Senator LEVIN. You did. Do you want to hear yourself, a telephone conversation that Chase recorded?

Mr. TRABAND. I have no doubt to question you there.

Senator LEVIN. You described it as a circular deal. What did you

mean by that?

Mr. TRABAND. I don’t recall.

Senator LEVIN. You don’t recall what you meant, 2001,

September——

Mr. TRABAND. I’m sure I was addressing the fact that we were

trying to mitigate our price risk.

Senator LEVIN. Let’s listen to the tape, Exhibit 184(a),1 so you

can follow it. This is Mr. Ballentine. Can we start over? Is it possible? The first voice we think is Mr. Ballentine who is saying,

‘‘Jeff, why do they want to hedge with gas where it is now?’’ Then

Mr. Dellapina, then Mr. Traband.

[Audio tape played.]

Senator LEVIN. Did you hear that, ‘‘it’s amortizing debt’’? Did you

hear Mr. Ballentine say that?

Mr. TRABAND. I heard him say that.

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1 Exhibit No. 131 appears in the Appendix on page 436.

Senator LEVIN. Is that accurate?

Mr. TRABAND. I think he was using the term ‘‘debt’’ interchangeably with the term ‘‘credit’’?

Senator LEVIN. He was using the term ‘‘debt’’ interchangeably

with the term ‘‘credit.’’

Mr. TRABAND. There was credit risk in the transaction that

would be apparent in a debt transaction as well, they have common

characteristics.

Senator LEVIN. OK. What do you mean by ‘‘back-to-back swap’’?

That term is used, ‘‘back-to-back swap.’’ What does that mean?

Mr. TRABAND. I think we were referring to the fact that we were

entering into the prepaid swap and the subsequent commodity

swap to hedge the price risk.

Senator LEVIN. What did you mean when you said this is a circular deal that goes right back to them?

Mr. TRABAND. I think we were reflecting that this is a structured

financing.

Senator LEVIN. Is that a term you use a lot, ‘‘circular deal’’?

Mr. TRABAND. I don’t believe so.

Senator LEVIN. Let me just conclude with a couple questions

here. First, Mr. Traband, Mr. Dellapina, who are the people at

Enron whom you dealt with on the prepays? Let me start with you,

Mr. Dellapina.

Mr. DELLAPINA. The principal individual I dealt with was Joseph

Deffner.

Senator LEVIN. The one who we talked about before?

Mr. DELLAPINA. Yes.

Senator LEVIN. And who else?

Mr. DELLAPINA. The only other individuals I would have dealt

with would have worked for Joseph, and their names, I believe,

were Lisa Bills and Michael Garberding. Those are the two names

I recall.

Senator LEVIN. Mr. Traband, who did you work with at Enron on

the prepays?

Mr. TRABAND. On the actual prepay transactions, I worked with

Joe Deffner and Lisa Bills and had reason to discuss the prepays

with others.

Senator LEVIN. OK. One exhibit I want you to look at, we haven’t

looked at it yet but it has been referred to this morning is Exhibit

131.1

Before you look at that, have any of you ever spoken with Jeff

McMahon at Enron? Mr. Dellapina.

Mr. DELLAPINA. I have not spoken directly to Jeff McMahon.

Senator LEVIN. Mr. Traband.

Mr. TRABAND. Yes, I had occasion to speak with Jeff McMahon.

Senator LEVIN. On prepays?

Mr. TRABAND. Generally, yes.

Senator LEVIN. On prepays?

Mr. TRABAND. Yes.

Senator LEVIN. Mr. McCree.

Mr. MCCREE. No.

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1 Exhibit No. 132 appears in the Appendix on page 438.

Senator LEVIN. Now, on Exhibit 131, this is an October 2001 exchange of emails at Chase, and here is one person—when the bank

is learning that, to its surprise, Enron had $5 billion in prepays

outstanding, an amount which was greater than Chase even had

expected. And here’s the conversation: One employee of Chase says,

‘‘$5 billion in prepays!’’ The other one says, ‘‘Shut up and delete

this email.’’

Any of you involved in this conversation? Mr. McCree.

Mr. MCCREE. No.

Senator LEVIN. Are you familiar with it?

Mr. MCCREE. No, not to my knowledge.

Senator LEVIN. Mr. Traband, are you familiar with it?

Mr. TRABAND. I was not part of this conversation. I’ve subsequently seen the email.

Senator LEVIN. You have seen the email?

Mr. TRABAND. Just in preparation for this meeting.

Senator LEVIN. It was not deleted.

Mr. TRABAND. I’m sorry?

Senator LEVIN. Was the email not deleted?

Mr. TRABAND. We are all aware that our email does not get deleted. It’s archived for a period of time.

Senator LEVIN. I gave you the wrong exhibit number. It is Exhibit 132.1

OK. Mr. Dellapina, do you know who participated in this conversation?

Mr. DELLAPINA. I’m just turning to this now. I am not familiar

with that.

Senator LEVIN. Here we have got one Chase employee telling the

other to shut up and delete the email. Does that trouble you, Mr.

McCree? Are you embarrassed by that?

Mr. MCCREE. Yes. But I’m not sure what it means.

Senator LEVIN. It means delete the email.

Mr. MCCREE. No, I know. But it’s—I don’t know the context, but

yes.

Mr. TRABAND. If I could just say something?

Senator LEVIN. Yes.

Mr. TRABAND. We are all aware that our emails are archived for

a period of time and that it’s not possible to delete an email. So

I think that was said in jest and not meant to be taken seriously.

Senator LEVIN. Mr. McCree, let me just ask you the final question. You represent one of the most important financial institutions

in the country, and you have a reputation to maintain. Yet you use

entities and secrecy jurisdictions, arguing that you don’t control

them, when I think it is obvious to any reasonable person looking

at this that you created it and you control it. You maintain the fiction here that you don’t control it, ignoring all of the evidence, producing none, by the way, to counter it other than the fact that your

understanding is that it is independent. But I went through all of

the control mechanisms, all of the indicators of control, so you

maintain that you don’t effectively know Mahonia even though it

was created for you, run by your agent, paid for by you.

83

You then helped to create a situation here where you have got

prepays that, according to the experts that we have had, do not

meet the criteria for prepays. They are linked transactions, for one

thing. The parties are not independent, at least if you can accept

all of the evidence that says Mahonia is really controlled by Chase,

and they are treated as loans. There are many indicators we have

that they are treated as loans.

So you are now, as Chase, participating in this entire picture

where billions of dollars of cash coming into Enron, which should

have been treated as loans, if it had been treated as loans, would

have affected their credit rating and a lot fewer people would have

been stung by Enron. And they produce documents which are misleading, documents which bury it. Your own employees says Enron

loves these kinds of transactions because they can hide debt and

they can bury it.

Is Chase at all troubled by this? Do you find this troubling at all?

I don’t mean the fact that you are here. I hope you find that troubling.

Mr. MCCREE. Yes.

Senator LEVIN. But I mean the fact—are these facts at all troubling to Chase?

Mr. MCCREE. Let me answer it this way: In establishing the

transactions with Mahonia, we believed that we were in compliance

with all relevant laws, all accounting standards, all tax standards.

We had no reason to believe then that we were not, and we have

no reason to believe now that we are not.

We also believed that Enron at the time was in compliance, and

particularly with its accounting regulations, and was reflecting

these transactions in accordance with GAAP on their balance sheet.

I find it personally troubling and hard to understand in terms of

Chase doing something wrong here how that would jibe with the

financial loss that we suffered as a firm in the entirety of the

Enron transactions and, frankly, in many of these prepay transactions. So as to the difference between a loan and a prepaid contract, aside from whether the accounting was appropriate at the

time or not, we suffered multiple legs of loss due to the structure

of these transactions, some on the commodity risk, some on delivery risk, and we are in litigation on some with the sureties.

We do find it troubling. We find what is happening in the financial system in general troubling right now. I’ll echo what a few people said up here earlier. We applaud the efforts that the Congress

is going about in terms of reform and transparency of the financial

accounting system and financial system in general. We believe we

have as high an interest as a major principal lender across corporate America in this transparency.

As it relates to JPMorgan, we have significantly increased our attention to diligence, to probing questions around our clients’ financial statements, to purpose of transactions, and we are rethinking

the way we conduct business on a going-forward basis in the new

environment that we operate in today.

Senator LEVIN. Well, you have plenty of reason to believe that

your company controls Mahonia. You were given reason to believe

today. Would you agree with that, that you now have reason to believe that your company controls Mahonia?

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Mr. MCCREE. I continue to repeat what I said before—— Senator LEVIN. Yes, I know that, but—— Mr. MCCREE [continuing]. Which is I—— Senator LEVIN. But you heard reasons here today that are reasons to believe that Chase controls Mahonia.

Mr. MCCREE. I believe Mahonia was controlled by its board of directors. They made the decisions.

Senator LEVIN. You didn’t hear anything today which gives you

any reason to believe that Chase controlled Mahonia?

Mr. MCCREE. No.

Senator LEVIN. OK. Well, let me tell you, both the board of directors of Mahonia—we think all the board of directors of Mahonia

work for your agent. They are all working for that law firm. You

can try to avoid it, but you can’t. Responsibility comes right back

to you. You can sit here repeating that you believed it was independent despite overwhelming evidence that you control it. You use

an offshore jurisdiction in a secrecy jurisdiction. The evidence that

we were able to obtain nonetheless dramatically demonstrates that

Mahonia was created for Chase, created by Chase, paid for by

Chase, controlled by Chase, run by Chase’s agents, fees paid for by

Chase, and yet you sit here and just repeat the mantra that you

believe it was independent. That does not satisfy the responsibility

of a major bank. You have got a greater responsibility than to do

that. And I must tell you that I think that this is just one example

of why the American people have lost confidence in Wall Street,

that we have a bank that is participating in Enron’s effort, known

to the bank—we have those emails—to turn debt into operating income. Your people knew that. That is in those emails. They knew

that this is what Enron was up to. They love to do it. They love

to hide it. And to just sit here and to try to tell this Subcommittee

that you believe Mahonia is independent and you believe that this

transaction was not, in fact, a phony prepay, even though, by the

way, your own testimony here today indicates quite clearly that

these transactions were linked, those three legs were linked together, you acknowledge that here today, which by expert testimony means it was not, in fact, a transaction which could qualify

as a legitimate prepay.

We are going to have to hear from folks at Citibank to answer

questions that you could not answer or would not answer here

today, but your testimony today here just seems to me is part of

a picture which I find mighty disturbing. I would like to see that

picture change. I hope we are going to do our share here in Congress in a constructive and positive way. But it is going to take

some recognition on the part of our financial institutions that

things have got to change. You can’t have people writing emails

back and forth to each other saying, hey, these kind of transactions

are just what Enron loves, they can hide debt, and just ignore it

as though that is not going on inside of your own bank.

So we will ask your folks to answer the questions that you could

not or would not answer relative to the control of Mahonia. We will

refer all of this testimony and the exhibits to this Securities and

Exchange Commission and to the Department of Justice. And I will

call upon Senator Fitzgerald in case he has questions of this panel.

Senator FITZGERALD. Thank you, Mr. Chairman.

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I just wanted to go back and be very clear in my own mind about

the extent of JPMorgan Chase’s understanding of the nature of the

prepay transactions.

Now, as I understand it, JPMorgan is trying to force certain insurers to pay an obligation pursuant to surety bonds that were

backing Enron’s performance on some of these prepays. Is that correct, Mr. Dellapina?

Mr. DELLAPINA. Yes, Senator, several of the prepay transactions

that were done beginning in 1998 had a credit diversification benefit to those transactions which were surety bonds from major insurance companies in the United States. Those insurance bonds,

those insurance companies worked with Enron and came to us and

asked us to participate in the transactions—— Senator FITZGERALD. So Enron got those insurance companies to

offer the surety bonds. It wasn’t JPMorgan Chase that went out

and got the insurance policies?

Mr. DELLAPINA. That is correct, Senator.

Senator FITZGERALD. OK. Now, you are suing certain insurers

asking them to perform under their surety bonds. That is correct?

Do you know the names of the insurers that you are suing?

Mr. DELLAPINA. I know several of the names, sir.

Senator FITZGERALD. Can you give us a few of those? It is in a

public record—— Mr. DELLAPINA. The Traveler’s Insurance Company, Chubb, St.

Paul.

Senator FITZGERALD. Traveler’s is owned by—who are they

owned by?

Mr. DELLAPINA. I believe Citigroup.

Senator FITZGERALD. OK. That will be interesting. This is very—

a lot of connections here. So you are suing Traveler’s, Chubb, and

other insurers, asking them to pay.

Now, according to published reports, the insurance companies

are saying we are not going to pay because these weren’t real prepay transactions, these were just loans. Is that correct that that is

the defense of the—in essence, that is the defense of the insurance

companies?

Mr. DELLAPINA. Senator, I am not familiar with all of the defenses raised by the insurance companies. I disagree with that

characterization that they’re loans, if that’s, in fact, what they’re

making as a characterization.

Senator FITZGERALD. My understanding from published reports is

that they are saying these aren’t—these were just loans and that

they were misled. For the record, I guess the case is styled

JPMorgan Chase Bank v. Liberty Mutual Insurance Company,

Traveler’s, St. Paul, Continental Casualty, National Fire Insurance

Company of Hartford, Firemen’s Fund, Safeco, another Traveler’s

indemnity company, Federal Insurance Company, Hartford Fire Insurance Company, and Lumbermen’s. Those are the defendants.

My understanding is that those insurance companies are maintaining that this was just a loan and that they were misled on the

nature of the transaction. Your position is they weren’t loans. Is

that correct?

Mr. DELLAPINA. I’d prefer not to speak in context of that outstanding litigation, but if you are asking me with respect to the

86

1 Exhibit No. 123 appears in the Appendix on page 414.

prepays outside of the litigation and not taking into account what

their defense might be, I do believe that the characteristics of these

transactions are fundamentally different from a loan and have different risks associated with them.

Senator FITZGERALD. So your personal opinion is that these are

different than loans, but earlier Senator Levin produced Exhibit

123,1 which was an email to Karen Simon that was cc’d to you, Jeffrey W. Dellapina, on 11/25/98, and this is the email. Is it written

by George Serice? George Serice I believe wrote this. That is where

it was said that ‘‘Enron loves these deals.’’ He is talking about prepays. He says, ‘‘Jeff is also working on another prepay for Enron

now.’’ That is you, I presume. He said, ‘‘Enron loves these deals as

they are able to hide funded debt from their equity analyst.’’ Well, it would seem to me that whoever wrote this email knew

that these prepays were a way of hiding what was essentially a

loan, doesn’t it?

Mr. DELLAPINA. Senator, as I mentioned to the Chairman, I do

not believe that that email is accurate, and prepaid forwards are,

in fact, a form of financing, but not all forms of financing are loans.

I’m not an accountant, but I believe there are very different characteristics of the prepaid forward transaction and the loan. Some of

those characteristics are as follows: This is a commercial contract

between a buyer and seller that is not satisfied in dollars. It is satisfied in goods and/or services. With the prepaid forward, the final

market value of this contract and the actual goods that are being

delivered will only be known at the delivery, and as opposed to a

loan where it is a set dollar amount that is going to be paid at maturity.

There are very—there are probably three or four additional risks

in prepaid forward transactions that are not present in a loan and

that, regrettably, have caused us to suffer additional losses in these

transactions, losses that are incremental to any losses we would

have suffered if it was just a loan.

Those risks are commodity price risks, account receivable collection risk, and these transactions, through the first 5 or 6 years of

these transactions, the physical commodities were delivered into

the market. Over the last several years, the physical commodities

and the natural gas was actually delivered to Enron. That was not

an essential part of the transaction and was not part of the transaction for the first 6 years. The decision to sell the commodity to

Enron, which has been characterized as a circle, actually introduced an entirely new credit risk for us. We could have sold that

gas, as we had in the past, prior to the time I was there, to other

market participants, and we would have taken the risks that those

participants would have paid for that commodity.

When Enron bought the natural gas in the latter transactions,

we assumed an entirely new credit risk. And to summarize that,

when Enron went bankrupt, they owed us an additional $32 to $35

million for natural gas that had been delivered to them, and they

did not pay that.

Senator FITZGERALD. How much does Enron owe you now?

Mr. MCCREE. In total?

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Senator FITZGERALD. Yes.

Mr. MCCREE. I’m not sure. Right now, as of—— Senator FITZGERALD. As of the bankruptcy—— Mr. MCCREE. December 19, which is when we announced, I

think. Have to look at my notes—$2.6 billion.

Senator FITZGERALD. $2.6 billion? At about the time of their

bankruptcy, and that’s when you last calculated it?

Mr. MCCREE. I’m not sure. I just haven’t seen the figure lately.

Senator FITZGERALD. Now, would you know, Mr. McCree, how

much they owed you back in, say, May 2001?

Mr. MCCREE. No, but Mr. Traband may.

Mr. TRABAND. I don’t recall specifically how much they owed us,

but it, I would imagine was, something greater than $2 billion.

Senator FITZGERALD. Over $2 billion in May 2001

Mr. MCCREE. In the latter—I don’t know the question, but we actually increased our credit exposure in a number of different ways

through the fall of 2001, prior to the bankruptcy.

Senator FITZGERALD. Can you give me in rough terms—it started

apparently in 1992, Mr. Dellapina was saying, with this structured

financing. Was that when your relationship with Enron started?

Mr. DELLAPINA. I do not believe any of us were involved with

Enron in 1992. I do not believe it was the only transaction or the

only relationship with Enron back then.

Senator FITZGERALD. But in rough terms would you know how

much was owed to JPMorgan back in 1997, 1998, 1999, 2000, or

2001?

Mr. MCCREE. No, but we can certainly provide that information.

We would be happy to do that.

Senator FITZGERALD. If you could provide that later, we would

appreciate that.

Now, I want to call your attention to—I don’t know if this is an

exhibit. This is an analyst report by Anatol Feygin, dated May 18,

2001. The headline is: ‘‘Enron Corp, Enron Weakness Not Explainable Fundamentally.’’ In this report, your firm, J.P. Morgan Securities, Inc.—and I

guess that is your company, Mr. McCree—via its analyst, Anatol

Feygin, is rating Enron as a buy and setting a 12-month price target at $120 a share, even though Enron was then trading at

$52.20. I am wondering how much exposure specifically you had to

Enron at the time this report was put out, and so I would ask if

for the record, Mr. McCree, you could provide exactly how much indebtedness was owed your company.

One of the concerns I have is that analysts do not always have

to disclose to the people that they are offering their research reports to the full gamut of potential conflicts that they have, and in

the case of Enron owing large amounts of money, over $2 billion,

to JPMorgan Chase, I am concerned whether that would have influenced in any way the research reports.

Now, Mr. Feygin testified before this Subcommittee in February

about his coverage of the Enron Corporation and explained why he

made the recommendations that he did. Do you think that this potential liability of your firm to the fortunes of Enron would have

had any impact at all on the ratings that Mr. Feygin or other

JPMorgan analysts would give to Enron?

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Mr. MCCREE. No. I believe we have very stringent and very thorough Chinese Wall policies which would segregate any public research professional from any kind of relationship material, size of

exposure whatsoever that we would have on the banking side of

the firm. And we, as a general matter, lend material amounts of

money to virtually all of the Fortune 1,000 companies and we hold

our responsibilities around confidentiality and wall issues very,

very seriously.

Senator FITZGERALD. Do you believe Mr. Feygin would have

known that Enron owed your firm over $2 billion?

Mr. MCCREE. I don’t know how he would know that.

Senator FITZGERALD. Because that is done over on the bank side;

is that correct, the loans or the prepay transactions were done over

there on the bank side and you are over at J.P. Morgan Securities?

You say you have a firewall there.

Do either of the other of you want to comment on that issue as

to whether Mr. Feygin could have been in any way influenced by

the debt owed to your bank by Enron?

Mr. TRABAND. I’m not aware of how Anatol could have been

aware of our exposure. I would—I certainly never had any conversation with him about that, and would not have had any.

Senator FITZGERALD. Do you know Anatol?

Mr. TRABAND. Only by reputation.

Senator FITZGERALD. Have you ever talked to him?

Mr. TRABAND. I requested information from him once, and the

firewalls work that public information can be shared to private, but

private cannot go to public.

Senator FITZGERALD. Did you ever have any conversations with

him about Enron?

Mr. TRABAND. Not that I recall.

Senator FITZGERALD. Mr. Dellapina, did you ever have any——

Mr. DELLAPINA. I have never met Anatol and have never spoken

with him to the best of my knowledge.

Senator FITZGERALD. You don’t know him?

Mr. DELLAPINA. I don’t.

Senator FITZGERALD. Mr. McCree.

Mr. MCCREE. Never met him.

Senator FITZGERALD. You have never met him, even though he

works within J.P. Morgan Securities, so you never talked to him.

Well, with that, Mr. Chairman, let me ask one final question. All

of the approximately $2.6 billion now owed to JPMorgan Chase,

how much of that is covered by surety bonds, and they may be disputed whether the surety bonds are good, but assuming they are

good, how much of that is covered by surety bonds?

Mr. DELLAPINA. I believe that the amount is slightly over $900

million.

Senator FITZGERALD. So even if you could collect on the surety

bonds, you would be out approximately another $1.6 or $1.7 billion;

is that correct?

Mr. TRABAND. Our total exposure at the time of the bankruptcy

was $2.6 billion. Not all of that was unsecured exposure to Enron.

Senator FITZGERALD. How much of it was secured?

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Mr. TRABAND. I think—and I am trying to recall the numbers. I think that unsecured exposure was roughly $600 or $700 million

dollars.

Senator FITZGERALD. Now, are you terming the loans for which

you had, or the prepaid transactions for which you had—— Mr. TRABAND. Yes.

Senator FITZGERALD. Now, it’s interesting, these prepaid transactions show up basically as debt in Enron’s bankruptcy filing,

right, that you are just another creditor that they are going to blow

out just like they would blow out somebody who had given them

a straight-up loan?

Mr. TRABAND. Well, all of their creditors appear in their bankruptcy filing including accounts payable creditors.

Senator FITZGERALD. Right. But we have gone along with not

calling these prepaid transactions loans. Mr. Dellapina was explaining why it is not necessarily a loan, but we see that at the

end of the day when there is a bankruptcy filing the debtor is just

treating you like a bank that had given it an extension of credit

pursuant to a promissory note and they are going to blow you out

in bankruptcy court in their reorganization or their liquidation. Of

that $2.6 billion you said approximately $600 million was unsecured, the rest of it was secured. Are you describing the liability

that is owed to you that is covered or potentially covered by surety

bonds as secured?

Mr. TRABAND. Certainly prior to the bankruptcy we viewed it

that way.

Senator FITZGERALD. OK.

Mr. TRABAND. We obviously have not successfully collected.

Senator FITZGERALD. But that is not really security. That is a

credit enhancement. That is a credit guarantee. It is not the collateral.

Mr. TRABAND. Yes, that’s correct. I used ‘‘secured’’ broadly. Credit

enhanced or secured.

Senator FITZGERALD. So of the $2.6 billion, if you cannot recover

from the surety bonds, you will lose $900 million and then another

$600 million is unsecured. So you might have about $1.5 billion

that is actually secured and you think you could get repaid on?

What is your collateral for the $1.5 billion that you think is secured?

Mr. TRABAND. That varies. For example, $400 million would be

related to the pipeline loans that were entered into in November

prior to their bankruptcy.

Senator FITZGERALD. And you got good security for that?

Mr. TRABAND. We got good security for that. And there are other

transactions. At the time of the bankruptcy we had credit exposure

to their Florida Gas Transmission affiliate, which was subsidiarylevel financing. It was not technically secured, but it was not to

Enron Corp. So we were—the $2.6 billion is aggregate exposure to

Enron and Enron-related entities.

Senator FITZGERALD. Now, is the bank carrying—what percent- age of the $2.6 billion had the bank reserved for and what percentage are you carrying as nonaccrual?

Mr. MCCREE. I do not know the nonaccrual or reserve. I believe

we have written off roughly $450 million of that exposure.

90

Senator FITZGERALD. You have written off $450 million—— Mr. MCCREE. In the fourth quarter of this year, last year.

Senator FITZGERALD. Presumably you have set aside reserves—— Mr. MCCREE. Yes. I just don’t know what the number is.

Senator FITZGERALD. You do not know the number.

Mr. MCCREE. I think the general—just to finish, the general

comment I would make on this is, we have the largest exposure we

believe of any institution in the world to Enron. We feel as—I’ll use

the word—defrauded as anybody else in connection with the broad

happenings at Enron. We believe that we acted in accordance with

law, in accordance with GAAP, and from a reputational standpoint,

which, Mr. Chairman, you referenced, that we upheld our general

reputation and tried to do things as the rules were written. That

is not saying the rules were right or the rules were wrong. I think

as we go forward, as I said before, transparency is a fantastic development and we applaud that. I would—or we would caution

about throwing the whole structured finance industry out based on

the effects of what Enron did. We think that the fundamentals of

structured finance, the legal basis on which structured finance is

done, and the constructs supporting the industry need to have— need to be looked at, but once the rules are looked at and well articulated, they are a fundamental diversification of funding sources

and a powerful tool for corporations around the world, specifically

in the United States, if used responsibly.

Senator FITZGERALD. So even though you may have lost an awful

lot of money by engaging as a banker for an entity that was heavily

engaged in monetization transactions, you are not at all less enthusiastic to do more securitization transactions in the future?

Mr. MCCREE. I would say we are much more diligent in terms

of how the transactions are put together, the extent of questions

that are asked around the transactions and the underlying broad

financial condition of the companies that we interact with.

Senator FITZGERALD. Do you know if any banks declined to do

the transactions that you did for Enron before they came to you;

are you aware of that?

Mr. MCCREE. I don’t know the answer to that.

Mr. TRABAND. Don’t know.

Senator FITZGERALD. OK. Mr. Chairman, I yield the floor back to

you.

And thank you, gentlemen for being here. I think it took a lot

of courage to come before this Subcommittee and answer our questions. Thank you.

Senator LEVIN. Well, I do not think they had a heck of a lot of

choice, but nonetheless, we are glad that you were here, and structured transactions and arrangements clearly do have a purpose,

Mr. McCree, if they are legitimate. And if they are illegitimate and

if they are deception, they not only do not have a purpose that is

acceptable, they have indeed a very deleterious and a very negative

effect on people who have invested their savings and on the economy as a whole.

When you say in your final comment, Mr. McCree, that the move

to transparency that is going on now is fantastic or words to that

effect, the whole purpose of these prepays, as used by Enron, and

in which you participated, was to hide the nature of the transVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00110 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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action. So we are glad that you testify that you welcome a move

to transparency. I must tell you that is one of the things that was

missing here, that it was an effort here to hide, in the words of

that email, that Chase email, that were so devastating here, which

caused losses, huge losses to so many people. Chase may have been

stung by Enron. Apparently it was. You are going to take some

losses too. But that in no way can justify any participation of

Chase in the losses of others. The fact that you yourself may have

lost isn’t in any way going to excuse your participation in the deceptive practices that Enron perpetrated.

And that is going to be for others to judge. It is going to be for

the SEC and the Department of Justice, and I guess in civil court

where you are right now. You have got cases that are existing in

court that are brought by a number of people, and you, yourself apparently are bringing suit on some surety arrangement. So some of

those issues will be resolved elsewhere.

But we will close your panel here by thanking you for coming

today. We will be calling upon people at Chase to give us the answers to those questions relative to Mahonia, and we will now

stand adjourned because—excuse me one minute.

Do we have votes?

We will excuse you, and we will hold off calling our next panel

until after we return, which will be perhaps as long as 20 minutes

because we have two roll calls I believe back to back. Thank you.

We will recess for about 20 minutes.

[Recess.]

Senator LEVIN. The Subcommittee will come back to order, and

I now would like to call our final panel of witnesses for today.

David Bushnell, the Managing Director of Global Risk Management at Citigroup; James Reilly, Jr., the Managing Director of

Salomon Smith Barney, which is a member of Citigroup; Richard

Caplan, the Managing Director and Co-Head of the Credit Derivatives Group at Salomon Smith Barney North American; and finally,

Maureen Hendricks, Senior Advisory Director of Salomon Smith

Barney. And I would ask you to please rise and raise your right

hands.

Do you solemnly swear that the testimony that you will give to

the Subcommittee today will be the truth, the whole truth and

nothing but the truth, so help you, God?

Ms. HENDRICKS. I do.

Mr. BUSHNELL. I do.

Mr. REILLY. I do.

Mr. CAPLAN. I do.

Senator LEVIN. Thank you. We will use the same timing system

as we did this morning for your statements, so please keep your

oral testimony to no more than 10 minutes, but we will print any

written testimony in the record in its entirety, and the red light

will come on after 10 minutes, but the green will change to yellow

after about 9 minutes to give you a chance to conclude your remarks.

And according to this, Mr. Reilly, you are to start I believe; is

that correct?

Mr. BUSHNELL. Actually, Mr. Chairman, I am going to start.

Senator LEVIN. OK. Mr. Bushnell.

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1The prepared statement of Mr. Bushnell appears in the Appendix on page 316.

TESTIMONY OF DAVID C. BUSHNELL,1 MANAGING DIRECTOR,

GLOBAL RISK MANAGEMENT, CITIGROUP/SALOMON SMITH

BARNEY, NEW YORK, NEW YORK

Mr. BUSHNELL. Good afternoon, and thank you for the opportunity to come to speak with you today.

My name is David Bushnell, and I’m a Managing Director at

Citigroup’s Global Corporate and Investment Bank. I am head of

its Risk Management Division. That division functions as an independent control unit over our operating businesses.

Our institution recognizes the importance of the work that this

Subcommittee is doing with respect to its examination of Enron’s

collapse. Enron’s failure was a pivotal event in American business.

In the space of a few short months, Enron went from an investment grade credit, ranked seventh in the Fortune 500, to bankruptcy. Like many others, Citigroup lost money as an Enron lender. More importantly, investors have lost money, employees have

lost jobs, and the public has lost confidence in our financial markets.

The integrity of our markets and the integrity of our borrowers

and their financial statements is of utmost importance to us. We

therefore commend the Subcommittee’s efforts to understand the

factors that caused or permitted Enron’s stunning collapse, and we

encourage changes in our accounting or other rules that will protect against what happened here.

During our business relationship with Enron we thought we were

dealing with honest managers who had legitimate business purposes for the transactions we did with them. We believe that Enron

was making good faith accounting judgments that were reviewed

by Arthur Andersen, which was then the world’s premier auditing

firm in its sector. We believe that the Audit Committee of Enron’s

board exercised meaningful supervision over the company’s accounting policies and procedures.

The emerging facts suggest that Enron was not the company that

we thought it was. If what has been reported out turns out to be

the case, large-scale self dealing, inflated assets, management that

was inattentive or worse, a subservient board, and a failure of accounting controls, we would not have done the business we did

with Enron.

But let me be clear. While we regret our relationship with Enron,

we acted in good faith at all times. Our employees, including the

bankers who are here today, are honest people doing honest business. They did transactions that were common throughout the financial markets and they believe those transactions were entirely

appropriate.

The focus of this hearing is structured finance and the accounting rules that apply to the types of structured transactions that

Enron used. My colleagues will talk to you about some of the specifics, but I want to emphasize that like every other institution in

the financial services industry, we design financing structures for

a diverse set of clients against a background of accounting, tax, and

legal rules. Some of those accounting rules are complicated and

subject to interpretation by accounting experts. If specific rules do

93

not work the way they should, then they should be fixed. Moreover,

changes are needed to increase accounting oversight and the reliability of companies’ financials.

I must stress, however, that we do not dictate our clients’ accounting practices. Once we are satisfied that a client’s proposed

tax and accounting treatment seem reasonable, the accounting

judgments are left to the client and its accounting professionals

who have complete access to all of the information. And this, I

would submit, is as it should be. It has always been the law and

accepted practice that companies are permitted to rely on the certified financial statements of the party on the other side of the

transaction. The auditors are experts in understanding the accounting rules, and the auditors are in possession of detailed information about the companies’ entire financial picture.

Recent regulatory initiatives appreciate that responsibility for

the accuracy of financial statements, that it must rest with the

companies’ management and auditors as evidenced by the recent

SEC rule requiring CEOs and CFOs to certify the accuracy of their

financial statements, and the legislative proposal strengthening the

independence and oversight of the accounting function.

At Citigroup I oversee a comprehensive process for reviewing

structured finance transactions. Our Commitment Committee is responsible for reviewing equity and fixed income securities

underwritings to ensure that we are comfortable with the transactions and so that we protect our reputation for high-quality

financings and retain investor confidence.

Our Capital Markets Approval Committee—you’ll hear us call it

CMAC here—reviews structured financing products and approves

only those transactions that it concludes are appropriate. For example, the Enron—the Yosemite transactions, about which this

Subcommittee has expressed interest, were reviewed and approved

by our CMAC. We pride ourselves on our reputation for being an

institution with integrity. If a transaction raises potential accounting, tax, legal compliance, regulatory, or appropriateness issues for

us or our clients, or otherwise exposes us to reputational risk, the

CMAC evaluates those risks to ensure that our institution is comfortable in completing the transaction. This is not to say that we

substitute our judgment for that of our clients, or their tax, accounting or legal advisers. Responsibility for those judgments remains with them.

Thus, when we agreed to structure prepaid transactions for

Enron, we relied heavily on the assurances that its outside auditor,

Arthur Andersen, had reviewed these transactions. Enron told us

that Andersen believed the proposed accounting treatment for the

prepaids was appropriate. And while I’m not an accounting expert

and no one on this panel is, the accounting treatment seemed reasonable to the members of our CMAC.

I am sure that the Subcommittee understands that at the time

these transactions were done, Arthur Andersen was considered the

preeminent accounting firm whose word carried weight and gave

comfort. Certainly now, with all of the information that’s come to

light, it’s easy to question Andersen’s review. And indeed, the information contained in your Subcommittee’s recent report on Enron’s

board is striking for what it reveals about Andersen’s own concerns

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1The prepared statement of Mr. Caplan appears in the Appendix on page 323.

about the risk of Enron’s accounting methodologies, but we learned

about these reservations only after the fact.

The sobering facts about Enron set forth in this Subcommittee’s

recent report make clear that much stronger oversight of the accounting profession is needed. The report also suggests that a rulebased accounting system such as American GAAP may be too susceptible to abuse. It perhaps should be supplemented by more of a

principle-based system. We would also support rules requiring

greater management accountability, more stringent board oversight

and greater board independence. These rule changes are essential

if we are going to re-establish the trust that is necessary to the efficient functioning of our economy.

Thank you, and I look forward to answering your questions.

Senator LEVIN. Thank you very much, Mr. Bushnell.

Mr. Caplan, are you next?

Mr. CAPLAN. Yes.

TESTIMONY OF RICHARD CAPLAN,1 MANAGING DIRECTOR

AND CO-HEAD, CREDIT DERIVATIVES GROUP, SALOMON

SMITH BARNEY NORTH AMERICAN CREDIT/CITIGROUP, NEW

YORK, NEW YORK

Mr. CAPLAN. My name is Rick Caplan. I am a Managing Director

of Citigroup’s Corporate and Investment Bank, and Co-Head of the

North American Credit Derivatives Group, one of several groups at

Citi that structure financings for sophisticated corporate clients.

A prepaid swap transaction, the transaction you have invited us

to talk about today, is a form of structured finance. Structured

financings have been used over the past several decades by virtually all sophisticated companies as a way of raising money. While

many structured financings have the same impact as a loan, they

often are treated differently for accounting purposes. There are

many examples of loan-like transactions that have different accounting treatments, including financing tools that support much of

this Nation’s trading and fixed income securities, such as repurchase agreements or repos and reverse repos, widely-used insurance products such as guaranteed investment contracts and finite

insurance, equipment trust certificates widely used in the airline

industry and common project finance strategies such as synthetic

leases.

As this Subcommittee is aware, Enron made extensive use of

structured finance. Indeed, from 1995 through 2001 Fortune Magazine selected Enron as the most innovative company in America.

And in 1999, Enron’s CFO, Andrew Fastow, was awarded CFO

Magazine’s Excellence Award for Capital Structure Management,

based on the unique financing techniques he pioneered.

For all of Enron’s innovation and sophistication, the prepaid

swap transactions we are discussing today, were hardly a unique

financing technique. Prepaid swap transactions and similarly commodity-based financings have been widely used in the power and

energy industry since the 1970’s. In essence a prepaid swap contract involves an up front cash payment by one party in return for

an obligation by another party to deliver a commodity for the cash

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value of that commodity at some point in the future. In the prepaid

engaged in by Citibank with Enron, Enron received cash up front

in exchange for Enron’s obligation to deliver at some point in the

future a specific quantity of gas or oil or its financial equivalent.

The prepaids provided Enron with an ability to raise cash

against certain long-term assets, which as we understood it, helped

Enron address a disconnect between the revenue and cash flow in

its trading book. Enron told Citibank that because of the way auditors, including its auditors, Arthur Andersen, accounted for

prepaids, Enron could use prepaids to bring its cash flow in line

with its revenues. As Enron explained, because prepaids were comprised of commodity trades, executed in Enron’s trading book,

Enron’s financial obligations on these trades, were recorded in its

trading book as a trading liability, termed price risk management

liability, and the cash generated by these trades would be disclosed

in its cash flow statement as cash flow from operations.

Enron assured Citibank that its accounting treatment of

prepaids had been fully vetted by Arthur Andersen, which at the

time was one of the Nation’s leading accounting firms. The accounting position we understood Enron was taking seemed reasonable

based on our understanding of the then-existing accounting rules

and guidelines. I should add that Citibank did not advise Enron,

nor would it advise any client as to the appropriate accounting

treatment of any transaction. Some have suggested that prepaids

are off-balance sheet or that the liabilities that Enron incurred as

a result of these financings somehow were disguised or hidden.

That simply is not true. Enron’s obligations on these financings

were clearly reflected as liabilities on Enron’s balance sheet, and

denominated as I said before, as a price risk management liability.

A price risk management liability is a liability, plain and simple,

that must be satisfied every bit as much as debt. Thus, while not

recorded as debt, prepaid liabilities were clearly obligations of the

company, and visible as such to investors.

There also has been a suggestion that Enron somehow was able

to generate extra cash flow by using prepaids instead of loans. That

also is not accurate. The overall cash flow for Enron would be exactly the same whether Enron used prepaids or entered into a bank

loan. In the case of prepaids, Enron booked the funds it received

on these contracts in its cash flow statement as cash from operations, not as cash from financing. We understood that Arthur Andersen has fully vetted this accounting treatment as well. Another

point I would like to address is the confusion that has arisen between prepaids and Credit Linked Notes. There is no necessary

linkage between the two. Prepaids exist without Credit Linked

Notes. Credit Linked Notes exist without prepaids.

A Credit Linked Note is simply a security through which an investor takes on the credit risk of a particular company without actually purchasing a bond issued by that company. Credit Linked

Notes are well recognized financial instruments. Citi structured

Enron Credit Linked Notes called Yosemite and the ECLNs. These

instruments were sold to the largest and most sophisticated institutional investors in several Rule 144A offerings. As with every offering that Salomon Smith Barney brings to market, the Enron

Credit Linked Notes and the underlying prepaid financings that

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1The prepared statement of Ms. Hendricks appears in the Appendix on page 330.

the notes funded were fully vetted and reviewed. The firm’s stringent internal control processes are designed to safeguard Citi’s reputation through careful screening of potential transactions. The

Credit Linked Notes and the underlying prepaid financings were

approved only after undergoing this screening process. I believe

that our conduct in arranging the prepaids and in selling Enron

Credit Linked Notes was entirely appropriate. We arranged these

financings for what appeared at the time to be one of America’s

best and most admired companies. We used the financing structure

that had been commonly employed in the energy and power industry for many years, and we relied on the fact that Enron’s accounting treatment of these transactions was blessed by one of the Nation’s leading accounting firms and seemed reasonable under the

then-existing accounting rules and guidelines.

Thank you, and I look forward to answering your questions.

Senator LEVIN. Thank you, Mr. Caplan. Ms. Hendricks.

TESTIMONY OF MAUREEN HENDRICKS,1 SENIOR ADVISORY DIRECTOR, SALOMON SMITH BARNEY/CITIGROUP, NEW YORK,

NEW YORK

Ms. HENDRICKS. Thank you, Mr. Chairman, and Members of the

Subcommittee. My name is Maureen Hendricks, and I am currently

a Senior Advisory Director at Salomon Smith Barney. From 1999

until May 2001 I was the head of Salomon Smith Barney’s Global

Energy & Power Group, with the responsibility for the Enron account.

As you have heard quite often Enron was a significant user of

structured finance, which is simply a way of providing cash to a

company through means other than traditional bank loans. And far

from being faulted for it, at the time, Enron was celebrated for its

innovative financing techniques.

One project that I worked on for Enron was the Yosemite structure, which was designed as a way for Enron to do structured finance in the capital markets. As it happened, the structured financing underlying the Yosemite offerings was a prepaid. Prepaid

are a commodity-base structured financings that were widely used

in the energy sector. Production payments, which I structured back

in the 1970’s, are precursors of the prepaids at issue here today.

And like prepaids, they originally had certain accounting advantages over straight loans.

At the time that we structured the Yosemite deals, I had absolutely no reason to believe that there was anything wrong with

prepaids or with Enron’s proposed accounting treatment for them.

Indeed, it appeared very familiar. Moreover, we understood from

Enron that Arthur Andersen had fully vetted the accounting treatment. In shepherding the Yosemite offering, I oversaw the due diligence that we conducted of Enron in close cooperation with our outside counsel. I believe that we asked the company to answer questions. I regret to say that it appears from all that has recently been

disclosed that we were not provided with the right answers by

Enron management. It also appears that the audited financial

statements upon which we relied were not accurate and did not

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1The prepared statement of Mr. Reilly appears in the Appendix on page 334.

present fairly Enron’s financial condition. I believe the decision to

approve these transactions was an appropriate one based on the information that had been provided to me and my team. I continue

to believe that structured finance, if used by honest companies,

whose books are reviewed by responsible auditors, serves a valuable function in our Nation’s economy. However, with the benefit

of hindsight and the raft of recent disclosures about Enron, I deeply regret that our firm ever entered into transactions with this

company.

Thank you.

Senator LEVIN. Thank you very much. Mr. Reilly.

TESTIMONY OF JAMES F. REILLY, JR.,1 MANAGING DIRECTOR,

GLOBAL POWER & ENERGY GROUP, SALOMON SMITH BARNEY/CITIGROUP

Mr. REILLY. Thank you, Mr. Chairman and Members of the Subcommittee. My name is Jim Reilly. I am a Managing Director of

the Global Power and Energy Group at Salomon Smith Barney. I

have spent more than 25 years as a banker covering the energy industry, and I have spent virtually my entire banking career in the

city of Houston.

I was a relationship manager for Enron and its predecessor companies since the 1980’s, first at Bankers Trust, later at Citibank,

and finally at Salomon Smith Barney. Relationship managers work

closely with a particular group of clients in order to understand

best their needs. We help them access the full range of resources

and expertise available at the firm. Thus, if a client came to me

with a particular financing objective, I would put it in touch with

the appropriate group at Citibank or Salomon Smith Barney that

was best positioned to help accomplish its goals. While in most

cases I have a general familiarity with the transactions that my

firm arranges for the clients, I do not structure these transactions

and typically am not close to the details.

I am aware that questions have now been raised about my references in certain emails to what the New York Times reported

were ‘‘secret oral agreements.’’ There were no ‘‘secret deals.’’ The

facts are these. In December 1998 Citibank and Enron entered into

a $500 million 3-year prepaid swap transaction for the delivery of

oil and natural gas. Agreements were entered into with insurance

companies to guarantee the delivery of the oil and natural gas. It

was understood that Enron would likely settle this contract early

within several months, but that informal expectation did not affect

the basic 3-year agreement between the parties. In April 1999

Citibank was prepared to syndicate the deal to other banks to

spread its risk. Enron preferred that Citibank not do that for reasons having to do with other unrelated credit needs of Enron.

Enron paid down a $375 million portion of the contract around that

time and expressed its intention to settle the rest of the contract

several months later in September, an informal expression of intent not unlike its original December 1998 indication that it expected to settle the contract early.

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1 Exhibit No. 144 appears in the Appendix on page 513.

2 Exhibit No. 145 appears in the Appendix on page 523.

There was no binding agreement between Enron and Citibank

that Enron would in fact settle the contract at that time. There

was still a 3-year derivative contract covered by 3-year insurance

contracts. Indeed September 1999 came and went without Enron

settling the contract. No one took action or considered taking action

against Enron because there had been no binding or enforceable

agreement that Enron had broken. In short my emails about the

paperwork not reflecting Enron’s intention to settle the contract

ahead of time were meant only to alert my coworkers that Enron

was intending to take Citigroup out of the transaction. No one read

that language to refer to a binding or enforceable agreement, and

that’s not the way it was intended.

On a more personal note, I have lived in Houston for virtually

all of my working life. Every day I see the tragedy that Enron’s demise has wrought on my home town, and it saddens me greatly.

It is for that reason that I want to thank this Subcommittee for the

thorough and detailed investigation it is conducting.

I look forward to answering your question.

Senator LEVIN. Thank you very much, Mr. Reilly.

First though let me ask you a question, Mr. Caplan. Do you

agree that there was an objective on the part of Enron to structure

these transactions so that the cash obtained by Enron would be reported in the cash flow statement as funds flow from operations,

rather than as funds flow from financing or debt?

Mr. CAPLAN. I would say, Mr. Chairman, that was the express—

one of the express objectives of the company in entering the

financings.

Senator LEVIN. And that you were aware of that objective?

Mr. CAPLAN. Absolutely.

Senator LEVIN. Exhibit 144,1 if you would have a look at that.

This is a loan approval memo. The exhibits are in the books in

front of you there.

On page—it is under No. 7, Key Success Factors under the word

‘‘story’’ in the middle. It said there—and this is a Citicorp document—that the prepaid forward structure will allow Enron to raise

funds without classifying the proceeds from this transaction as

debt. Is that correct?

Mr. CAPLAN. That is correct.

Senator LEVIN. That was clearly known to you. Now, Exhibit

145,2 this is a September 2000 email in which a Citicorp employee

discusses how to present the Yosemite transaction to potential investors. In it he demonstrated he understood that the purpose and

the benefits of prepaid transactions included allowing Enron to

generate cash flow without increasing the company’s reported debt,

and right in the—at the beginning where it says, ‘‘First, I would

go through the prepaid on a stand-alone basis, and get into why

a company does it, gets cash flow, shows up as other liability not

debt.’’ And then in the middle where it says, that ‘‘Enron pays back

a fixed stream over time, net net, economically like a loan.’’ Then

near the bottom, about 5 lines up, it says, ‘‘E’’, Enron, ‘‘gets money

that gives them [cash flow] but does not show up on books as

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1 Exhibit No. 146 appears in the Appendix on page 524.

Debt.’’ So that was very clearly understood, that they were trying

to have cash flow come from business transactions and not appear

as debt on their books; is that correct?

Mr. CAPLAN. Yes, sir, I would say it’s very correct because this

transaction that’s described here and we’re discussing today is a

form of structured financing, and there are many forms of structured financing out there that have loan-like characteristics that

people don’t call loans. So none of this would be unusual in this

kind of—in speaking about something like this, even saying something like ‘‘net net, economically like a loan,’’ I think that’s a true

statement, but that you could say about a lot of different products

that companies enter into.

I think a good example is a synthetic lease, where a company

wants to buy a building, and they can kind of do it one of two

ways. One way they can do it is go to the bank and borrow the

money to buy the building and record that borrowing as a loan on

its books. Alternatively, what the company can do is go to the bank

and say, ‘‘You bank, buy the building and lease the building to us

for the economic life of the building, and we’ll call that a lease, and

we won’t record that on our books as debt, we’ll record it as lease

payments.’’ And I think the point of this is that there are many different ways to structure financings, and they’re all based on interpretations of accounting rules by internal accountants and by outside auditors that are within the companies own purview and not

the responsibility of the banks.

Senator LEVIN. Well, maybe we will look at synthetic leases next

year, but we are looking at prepays at the moment.

If you look at a memo on Yosemite I, this is——

Mr. BUSHNELL. Excuse me, Senator. What number exhibit is

that?

Senator LEVIN. I was just going to get to that. Exhibit 146.1 This

is a chart prepared by Citibank. Now, this chart was prepared by

Citibank and completed prior to the Yosemite I offering. The numbers do not correspond to the numbers involved in the Yosemite I

prepay, but it is illustrative of how various features of the transaction are calculated. Is it not true that the amount of oil or the

gas used in the Enron Citi prepays was determined by the amount

of money that Enron was getting? In other words, you back into the

amount of oil and gas that is the basis of the transaction; is that

correct?

Mr. CAPLAN. The ways the transactions were structured is that—

again, like in other alternative forms of financing, the company

came and said they wanted to receive funds of a certain amount,

and then the transactions were structured so that you created a

barrel equivalent or a gas equivalent of that amount of funds and

attached a price to it. So I think that, yes.

Senator LEVIN. So they did not decide first how many barrels of

oil they wanted to sell in advance; they decided first about how

much money was needed, and then they translated that into the

current or predicted future price of oil; is that correct?

Mr. CAPLAN. I think that is a fair way to say it.

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1 Exhibit No. 147 appears in the Appendix on page 529.

2 Exhibit No. 148 appears in the Appendix on page 537.

Senator LEVIN. Now, a memo on Yosemite I which was prepared

by the Enron Tax Department described the prepay transaction

funded by Yosemite I as a prearranged integrated transaction.

That was a memo on Yosemite I prepared by the Enron Tax Department. Would you agree with that description of the prepay

transaction, a prearranged integrated transaction?

Mr. CAPLAN. I’m actually not clear what that means. That

sounds like a tax term for describing the transaction, and we

weren’t privy to their internal tax memos or what their tax treatment of the transactions were, so I feel like I can’t really comment

on the use of that term.

Senator LEVIN. That term appears at the bottom of page 1 of Exhibit 147.1 You see it down there?

Mr. CAPLAN. I’m sorry. Where is it?

Senator LEVIN. See at the last line, where it says ‘‘prearranged

integrated transaction?’’

Mr. CAPLAN. Yes.

Senator LEVIN. That is an Enron document, but my question to

you is do you think that is an accurate description of the prepay

transaction that Citibank, Delta and Enron were engaged in?

Mr. CAPLAN. I would say that the legs of the transaction were

certainly arranged at the closing of transaction. I’m not sure—

again, I’m not sure if that’s a tax term, integrated transaction. So

I don’t really know how to comment on that. The legs of the transaction were all executed on the same day.

Senator LEVIN. Simultaneously?

Mr. CAPLAN. On the same day at the same time, yes.

Senator LEVIN. Now, Exhibit 148 is your chart.2

Mr. CAPLAN. I think this might be an Enron chart.

Senator LEVIN. Is that an Enron chart? Yes, you are right, it is

an Enron chart. It is called a Prepay Walk Through. This is a prepay walk through. It reviews a Citibank, Delta and Enron prepay,

and it is a little difficult here to read, but it reports one important

point in a box next to the name of each entity in the transaction,

and that is that each entity in that triangle is completely hedged.

In other words, there is no price risk. Can you read that? Are you

able to read that?

Mr. CAPLAN. Yes, I am.

Senator LEVIN. The top box, it is kind of hard to read, but it says

‘‘Delta’’ at the top and then it says ‘‘Debt is now completely

hedged,’’ underneath the word ‘‘through.’’ Do you see that?

Mr. CAPLAN. Yes, I can read it.

Senator LEVIN. And then down at the right it says Citibank or

‘‘Citi is now completely hedged.’’ See that?

Mr. CAPLAN. Yes.

Senator LEVIN. And then on the left it says ‘‘Enron’’ and then it

is kind of hard to read because it has got black ink over it, but it

says, ‘‘Enron is now completely hedged and has only limited exposure to Delta.’’

Mr. CAPLAN. Yes, I can read that.

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Senator LEVIN. So at that point there is no price risk; is that correct?

Mr. CAPLAN. I think on the beginning of the transaction, in the

first leg of it, the price risk is created, and then that price risk is

hedged away by entering into the next two legs. So when all the

legs are executed, the price risk, the intent is to eliminate the price

risk.

Senator LEVIN. And that was done all at the same time?

Mr. CAPLAN. It was done all at the same time.

Senator LEVIN. When those three legs were put together, there

was no price risk?

Mr. CAPLAN. When the transaction was—when all the legs were

executed, the price risk was eliminated, which I think this is an interesting piece of paper to look at because it clearly indicates that

Enron, and I would think therefore their accountants, understood

the nature of the transaction and the way that the legs worked together.

Senator LEVIN. And so did Citibank.

Mr. CAPLAN. And absolutely, so did Citibank.

Senator LEVIN. And the parties worked together to arrange that?

Mr. CAPLAN. We worked with Enron to structure the transaction

so that our risks were hedged and that it met their requirements.

Enron worked with their accountants to set the transaction up so

that they could book the transaction as they saw fit, but we did not

get involved in their accounting decision, nor do we get involved in

any company’s accounting decisions.

Senator LEVIN. Who represented Delta?

Mr. CAPLAN. Delta was represented by a firm in the Cayman Islands called Maples and Calder.

Senator LEVIN. But in that particular transaction who represented them?

Mr. CAPLAN. In this particular——

Senator LEVIN. Yes. When you were putting together that triangle, who represented Delta?

Mr. CAPLAN. Maybe we should spend a couple minutes—— Senator LEVIN. Not quite yet. Who represented Delta when you

put together—you said the same day they were all—— Mr. CAPLAN. Well, the way the transactions were documented

is—in these kinds of structured financings, usually the investment

bank prepares the documentation, so our counsel, Milbank Tweed,

prepared all of the documentation. Delta had its own counsel, but

that counsel’s role was somewhat limited in the transaction.

Senator LEVIN. Well, was it there at all?

Mr. CAPLAN. Yes, it was definitely there because they reviewed

the documents and had to prepare board resolutions and do all the

things that make Delta an independent entity for accounting purposes, which is what’s relevant here.

Senator LEVIN. Who paid Milbank Tweed?

Mr. CAPLAN. Mainly in these transactions Enron paid Milbank

Tweed.

Senator LEVIN. So Delta’s lawyer was paid by Enron?

Mr. CAPLAN. Delta’s lawyer—it depended on the transaction— honestly, I don’t remember exactly, but Delta, some of the fees for

Delta’s lawyers were paid by us, some were paid by Enron, some

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were paid by spreads in the transaction where amounts were— where when you netted out the three legs of the transaction, there

was a spread left at Delta, and that paid some of the fees to their

lawyers and their management and that sort of thing. It’s a very

typical kind of arrangement for the bank to make those payments

or——

Senator LEVIN. So what did Delta pay?

Mr. CAPLAN. What did Delta make?

Senator LEVIN. Pay.

Mr. CAPLAN. Pay?

Senator LEVIN. You paid part of it, Enron paid part of the

Milbank fee. What did Delta pay? What part of the fee did Delta

pay?

Mr. CAPLAN. To its lawyers?

Senator LEVIN. Yes.

Mr. CAPLAN. I’m not clear that they paid any of their fees to

their lawyers. Only if there was spread left in the transaction that

was there to pay lawyers, but it was never intended that Delta was

going to have huge sums of money to pay—to pay its lawyers or

anyone else.

Senator LEVIN. How about any sums of money?

Mr. CAPLAN. It was intended to have sums of money, yes.

Senator LEVIN. Have a spread?

Mr. CAPLAN. To have—yes, there were always earnings at Delta

in these transactions, because there were transaction costs associated with using Delta as the special purpose entity in the deal.

Senator LEVIN. But you do not think they paid Milbank on this

one; you think it was either you or Enron?

Mr. CAPLAN. Yes. It was either us or Enron. Enron paid all of

the—until they went into bankruptcy, they paid all of the Milbank

bills. Some remained outstanding.

Senator LEVIN. Now, in the prepays involving, or most of the prepays involving Enron, Citibank, and Delta, did commodities ever

change hands?

Mr. CAPLAN. All of the prepaid transactions that I worked on

were financially settled, which means that there is no change of

commodities between parties. In the commodities market you can

do transactions that are either physically settled by delivery of the

commodity, or you can financially settle the contract by just exchanging payments based on the price of whatever the commodity

reference is.

Senator LEVIN. And can you tell in advance in this particular one

whether it was intended that commodities actually be transferred?

Mr. CAPLAN. Absolutely not, because these were financially settled arrangements.

Senator LEVIN. It was never intended that the commodities——

Mr. CAPLAN. I think in some of the earlier prepaids that predate

my time at Citibank, and I think a large part of the reason Delta

was set up in the first place was because there was going to be a

physical delivery of commodities, and Citibank, as a bank, under

its regulatory regime, wasn’t able to take physical deliveries of

commodities, so I think the intent was there, but when I got involved, financial settlement was the way—was the method of settlement of choice.

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Senator LEVIN. Looking again at that Exhibit 148, would you

agree that the point here was to eliminate price risk, ensure that

the funding source get its money; in other words, to perfectly hedge

the transaction; would you agree with that, that was the intent?

Mr. CAPLAN. I’m sorry. Where are you reading that?

Senator LEVIN. Exhibit 148, that transaction that is described

there with that triangle, the intent of that was to ensure that the

funding source get its money, price risk be eliminated, and that it

be a perfectly hedged transaction.

Mr. CAPLAN. Absolutely, because as a bank, we don’t look to take

on commodity risk. We look to take on credit risk. So any time we

enter into a transaction that creates some commodity risk, the first

thing we do as a prudent risk management exercise is to go and

hedge that commodity risk. So that was absolutely the intent.

Senator LEVIN. All of the parties were hedged in that one?

Mr. CAPLAN. All of the parties were hedged in this one, yes.

Senator LEVIN. Now, as we learned earlier today, it is important

that the third party be independent of the first two parties or the

other two parties. So we are now going to talk a bit about Delta.

Delta, as we understand it, was formed in the Cayman Islands

in 1993. Do you know who formed Delta?

Mr. CAPLAN. Yes, absolutely. It was formed by Citibank, much as

Citibank forms special purpose entities to do lots of structure finance transactions, much as other institutions in the market form

special purpose entities.

Why they’re called special purpose entities is they are formed to

do a specific purpose, and we formed it—we were involved in setting it up and identifying a law firm that could draft the papers,

and paying that law firm in the Cayman Islands.

Senator LEVIN. You paid the law firm?

Mr. CAPLAN. Absolutely.

Senator LEVIN. To set up Delta?

Mr. CAPLAN. We paid the law firm to set up Delta. We—much

as we do in many of these—whether it’s a credit card receivables

transaction, mortgage securitization, we set Delta up for accounting and legal purposes as an independent entity. We were trying

to satisfy accounting tests then in existence which still apply today,

and Delta’s been—as you just noted, Delta’s been around since

1993. It’s been vetted through our accounting system over that period of time, and it remains for accounting purposes an independent entity.

Senator LEVIN. And who effectively controls Delta? Putting aside

the accounting purpose, who effectively controls Delta?

Mr. CAPLAN. I’m not sure——

Senator LEVIN. Common sense terms.

Mr. CAPLAN. Common sense terms, when you’re talking about

SPVs, I don’t think they’re that relevant.

Senator LEVIN. Just in conversation here, I am asking you a simple question. Who has effective control of Delta?

Mr. CAPLAN. I’m not certain what—regardless of who has effective control of Delta, I’m not certain why that’s a relevant aspect

of any of this.

Senator LEVIN. We will decide the relevance of it. But why don’t

you try to answer the question. Who has effective control of Delta?

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Mr. CAPLAN. I would say the directors of Delta, because it’s, as

a legal matter and as an accounting matter, and I know that you’re

saying not to look at this as an accounting matter, but I think the

only way you can look at Delta is from an accounting perspective,

because the only reason it’s there is to satisfy the rule-based system of accounting that we have. It’s very similar to—I mean ‘‘control’’ is a tough word for me to work with. It’s very similar to the

word ‘‘gain’’ in the tax code. There are multiple definitions of ‘‘gain’’ depending on the circumstance you’re talking about at the moment,

and ‘‘control’’ has that same connotation, and I think the relevance

of ‘‘control’’ here—— Senator LEVIN. It has nothing to do with gain. It has to do with

who controls the entity, that is all. But in any event, has Delta

ever entered into a prepay transaction in which Citibank was not

involved?

Mr. CAPLAN. No, it has not.

Senator LEVIN. Was it created to assist Citibank?

Mr. CAPLAN. It was absolutely created to assist Citibank.

Senator LEVIN. And is it owned by a charitable trust?

Mr. CAPLAN. It is.

Senator LEVIN. Called Grand Commodities Corporation?

Mr. CAPLAN. That’s my understanding.

Senator LEVIN. And who has control of that trust?

Mr. CAPLAN. I’m not certain of who controls that trust.

Senator LEVIN. Do you know, Mr. Bushnell?

Mr. BUSHNELL. No, I don’t, Senator.

Senator LEVIN. Do you know, Ms. Hendricks?

Ms. HENDRICKS. No, sir.

Senator LEVIN. Do you know, Mr. Reilly?

Mr. REILLY. I don’t, Senator.

Senator LEVIN. Could Citibank control that trust?

Mr. CAPLAN. Not to my knowledge.

Senator LEVIN. Could it?

Mr. CAPLAN. It would be pure conjecture to answer that, but——

Senator LEVIN. As far as you know, who—when you want Delta

to do something, you notify some lawyer down there in the Caymans?

Mr. CAPLAN. Yes, absolutely. Again, this—— Senator LEVIN. And you pay that lawyer’s fees or Enron does,

right?

Mr. CAPLAN. It depends on the transaction. It’s been different in

every one. But, again, I don’t find any of that unusual for

structured——

Senator LEVIN. I am not arguing usual or unusual. In fact, it is

probably mighty discouraging that it is very usual. The fact that

it is common doesn’t mean that it is not deceptive. The question

is whether or not a common practice was put here to a deceptive

purpose. That is the issue here. You have got a lawyer down in the

Cayman Islands. It is a secrecy jurisdiction. You can’t pierce that

veil. Some trust is created, just the way it was—we just went

through that with Chase. Some trust is created. In the case of

Chase, Chase’s lawyers created the trust. We don’t know who created this trust. You don’t know who created this trust. We are

going to try to find out, if you will be cooperative.

105

Along that line, by the way, will you agree to authorize Maples

and Calder in the Cayman Islands to give the Subcommittee all

documents relating to the formation, ownership, and activities of

these entities? Will you give us that authority?

Mr. CAPLAN. I think we’d have to defer to counsel to answer that

question.

Senator LEVIN. Will you let the Subcommittee know whether you

will give us that authority?

Mr. CAPLAN. Absolutely.

Senator LEVIN. Why do you do this in the Caymans, a secrecy jurisdiction? Why aren’t you just open about these kind of things?

You are forming an entity. The operations of that entity are hidden. It has got to be independent or else this whole thing doesn’t

work. It doesn’t work for other reasons, by the way, which it seems

to me you have already pretty well cleared. It was all done at one

time. There is linkage between the transactions. According to our

experts here, this doesn’t even qualify in any event, no matter who

owns Delta.

But putting that aside just for a moment, why are you forming

this kind of entity in the Cayman Islands, in a secrecy jurisdiction?

And why do you hesitate to say that you will give us authority to

try to pierce that secrecy to find out who owns that trust which

holds the stock in Delta? That is troubling and I want to know your

answers, either you or Mr. Bushnell.

Mr. BUSHNELL. I think I would answer in a couple of ways, Senator. I think the reason why we want to check with counsel is we

don’t know if we are able to enforce anything on—— Senator LEVIN. I didn’t say that. I said authorize.

Mr. BUSHNELL. Authorize to ask. We certainly could ask. Whether they’ll respond to that or not, I don’t know what their terms and

bylaws and conditions are.

Senator LEVIN. Are you then saying that you will—that Citibank

will authorize us to—that you will authorize them to turn over any

documents that they have to this Subcommittee?

Mr. BUSHNELL. Again, Senator, that is something that I want to

discuss with counsel.

Senator LEVIN. OK. Then let’s go back to the Caymans. Why do

you do this in secrecy jurisdictions? Why not do it in daylight?

Mr. BUSHNELL. Do you want to answer that, Mr. Caplan?

Mr. CAPLAN. Yes, I don’t think that there’s anything really nefarious about doing it in the Caymans. Again, you have to step back

and put this in perspective of what this business is. And the structured finance business has developed over the last 30 years, and

a lot of it is around using these special purpose entities, and you

often set them up in different jurisdictions. And I think the main

reason you use the Caymans is there’s tax neutrality in the Caymans. It’s not because we are trying to hide something. All the

transactions that we’ve done with Delta you see in these papers.

We have fully disclosed what we have done with Delta. I don’t

think we’re trying to in any way—— Senator LEVIN. We don’t know who Delta is. We can’t find out

from the Caymans—— Mr. CAPLAN. I think the reason for that is there’s not much to

know about Delta. It’s a special purpose entity——

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1 Exhibit No. 112 appears in the Appendix on page 367.

Senator LEVIN. I think you are right. It is a shell.

Mr. CAPLAN. It satisfies accounting requirements to be an independent entity, and that was the sole purpose for setting it up.

That was the sole purpose for its use. And I think that if you would

examine other special purpose entities used by Citibank and other

banks and other corporations in receivables financings or mortgage

financings, you will find that they have very similar characteristics

to Delta. And if the Subcommittee thinks that that’s an appropriate

thing to spend its time on, we would applaud anything that makes

things clearer to people in the market.

Senator LEVIN. You would applaud making things clearer to the

market including—— Mr. CAPLAN. Yes.

Senator LEVIN [continuing]. The nature of Delta. And yet you are

reluctant to authorize us to find out everything that we can from

Delta. You have to check with counsel.

OK. But, at any rate, let me go back to one of the criteria for

this to be a true trading—for a prepay to be a trading contract, according to the experts before us, the purchaser of the gas must

have an ordinary business reason for purchasing the gas, not in

substance be a special purpose entity established just to get a secured investment in a dead instrument from a gas supplier.

Now, that is what our experts say a legitimate prepay has got

to meet, and you have just told us twice this entity was created

purely for accounting purposes, no intention whatsoever that that

purchaser of the gas have an ordinary business reason for purchasing it. So, whether or not we pierce that veil around Delta—

and we are going to keep trying—according to the experts here,

this is not a legitimate prepay by your own testimony because

Delta was created solely for accounting purposes, you have told us

twice. It does not have an ordinary business reason, which it must

have, for purchasing the gas. It cannot in substance be a special

purpose entity. You just told us that is all it is, is a special purpose

entity.

Do you want to respond to that? Because you have just, it seems

to me, proven what we have, what our staff has, I think, very thoroughly proven in not only that way but in a lot of other ways as

well. But do you want to comment on that?

Mr. CAPLAN. Well, might I ask what that document you’re referring to is?

Senator LEVIN. This is the document which the experts here—

which we had this morning. It is not a document. These are the

criteria for a legitimate prepay.

Mr. CAPLAN. Is it in the exhibit book?

Senator LEVIN. It is not in the exhibit book. It is—what is the

exhibit number? Exhibit 112?1

We asked the experts that we had this morning about the document which Arthur Andersen prepared for its customers saying

that for prepays to be treated as trading contracts, the following

attributes must exist, and then if you will look at page 4, the purchaser of the gas must have an ordinary business reason for purchasing the gas, not in substance be a special purpose entity estabVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00126 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
107

lished just to affect a secured investment in the debt instrument

from the gas supplier. We asked them, our experts, whether or not

those criteria, in fact, must be met in order for there to be a legitimate prepay transaction that would appear as a business expense

or a business operation on the books rather than a debt. They all

said yes this morning. Do you have any reason to doubt that that

is accurate?

Mr. CAPLAN. Just briefly looking through this, I think this is a

very interesting document because it’s a document prepared by

Enron’s auditors. So, clearly, Enron’s auditors had to—— Senator LEVIN. It is by Arthur Andersen.

Mr. CAPLAN. Right, which is——

Senator LEVIN. Arthur Andersen, at least at that moment, was

known as a legitimate firm which——

Mr. CAPLAN. Absolutely.

Senator LEVIN [continuing]. Set up the caution. Here Arthur Andersen is being cautionary here. They are telling their client, if you

are going to have a legitimate prepay, you have got to follow certain rules. It is certainly nice to hear Arthur Andersen laying down

certain rules for Enron. They told Enron for prepays to be treated

as trading contracts, in other words, not as debt, the following attributes must exist, and then they listed here—this attribute

doesn’t exist in the contract that you just mentioned.

Mr. CAPLAN. Well, what’s interesting to me about this exhibit is

that if truly that is Arthur Andersen’s opinion and Arthur Andersen knew of the entire transaction as described in the Enron documents you’ve just shown me, I would say either one of two things

happened: Arthur Andersen concluded that these criteria were met

because they gave a clean audit opinion for Enron through all the

periods—and I see this document has a 1997 reference in it, so it’s

clear that this was in existence for a while; and if our transactions

didn’t meet these criteria, which I’m seeing for the first time,

frankly, and Arthur Andersen still gave a clean opinion, then what

does that say about what Arthur Andersen was doing?

Senator LEVIN. But they didn’t know who Delta was. And you do.

Mr. CAPLAN. Why, then—— Senator LEVIN. They are just telling their client Delta has got to

be—they just lay it out here. Delta has to have an ordinary business reason for purchasing the gas. They are notifying their client

of that.

Mr. CAPLAN. But then I——

Senator LEVIN. They don’t know who Delta is. You do.

Mr. CAPLAN. Absolutely.

Senator LEVIN. You just told me that Delta must have an ordinary business purpose for purchasing the gas, not in substance be

a special purpose entity. You knew they were a special purpose entity. You said twice, of course, that is all they are. So unless you

disagree with that criteria for what is a legitimate prepay, you

have demonstrated why this was not a legitimate prepay. And yet

it appeared on the books as a legitimate prepay.

Mr. CAPLAN. Senator, could I—— Senator LEVIN. You referred investors to those books, by the way.

Mr. CAPLAN. I would actually disagree with the statement that

Arthur Andersen had no knowledge of Delta.

108

Senator LEVIN. Forget that. If they had knowledge of Delta and

knew then that it violated their own criteria, then they are culpable. I am not talking about Arthur Andersen. We have had them

here. We will have them again. I am talking about you folks. You

folks knew by your own testimony that Delta did not have an ordinary business purpose for purchasing the gas. It was a special purpose entity. You have told us that twice. So unless that criteria is

wrong—and we had an expert here this morning that said it is not

wrong, by the way—you folks knowingly participated in a transaction characterized as a prepay which, in fact, was not a prepay.

Now, do you disagree with this criteria as being accurate?

Mr. CAPLAN. I disagree with—I have no basis for—I mean, this

is an accounting interpretation, so I have no—I’m not an accountant. I have no basis for determining what the right criteria are for

a prepay to be treated as a prepay on a company’s books. That is

between the company and its auditors.

We were of the belief that Enron in connection with its accountants had done whatever disclosure to its accountants, had reached

whatever conclusions, we were fully of the belief that Andersen was

fully aware of every aspect of this transaction. So if these are the

requirements that Andersen was setting out, which we had no

knowledge of prior to this point, then clearly Andersen must have

thought they were met. Why else would they give an unqualified

opinion to the financials?

Senator LEVIN. Let’s come back to you. You have an accountant,

don’t you, Citibank?

Mr. CAPLAN. Absolutely.

Mr. BUSHNELL. Yes, sir.

Senator LEVIN. Doesn’t Citibank tell you the same thing, that in

order for a prepay to be treated as a trading contract, that the purchaser must have an ordinary business purpose and not be a special purpose entity? Isn’t that what your accountant tells you?

Mr. BUSHNELL. The accountants in this transaction for Citibank,

we classified this as a trading asset, Senator.

Senator LEVIN. Did your accountant—— Mr. BUSHNELL. For purposes—— Senator LEVIN. Has your accountant notified you or ever told you

that the purchaser of gas must have an ordinary business purpose

for purchasing gas and not be a special purpose entity? Have you

ever been told that?

Mr. BUSHNELL. I don’t know what their interpretation——

Senator LEVIN. Not interpretation. Have you ever been informed

of that by your accountant?

Mr. BUSHNELL. No.

Senator LEVIN. Who is your accountant?

Mr. BUSHNELL. Our accountant at this time is KPMG.

Senator LEVIN. And who was it then?

Mr. BUSHNELL. It was KPMG.

Senator LEVIN. If there is no third party here that is independent

that has the characteristics of not just being created for the purpose and being a special purpose entity, then it is a loan. Now, unless you disagree with that, that is what you end up with here, is

that you have a loan and that has got some huge implications because it wasn’t treated as a loan on the books. Andersen—I am inVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00128 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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1 Exhibit No. 150 appears in the Appendix on page 544.

formed that Andersen asked for a representation that Delta was

independent. Enron wrote Citibank and worked on the letter saying that Delta was independent. Is that accurate?

Mr. CAPLAN. There was a representation——

Senator LEVIN. Did Citibank ever work on a letter——

Mr. CAPLAN. Yes.

Senator LEVIN [continuing]. Which represented that?

Mr. CAPLAN. I think this is the point that I’m trying to make,

is that Andersen knew fully well about Delta and requested certain

representations be made by Delta saying—effectively certifying its

status as a special purpose entity that was separate from Citibank.

So Andersen fully knew exactly what Delta was and still came to

the conclusion that these transactions should not be treated as

loans but should be treated as trading assets.

Senator LEVIN. You are saying Andersen knew that this was a

special purpose entity established just for that purpose, not because it was interested in buying gas, you think Andersen knew

that?

Mr. CAPLAN. I think they knew that.

Senator LEVIN. And did you join in the analysis of this letter that

represented that—with Enron representing that Delta was independent?

Mr. CAPLAN. I was involved in the creation of that letter, yes.

Senator LEVIN. Now, we have an Exhibit 150,1 a fax from the

law firm in the Cayman Islands. This is Maples and Calder, a firm

that represents Delta that is paid for by other folks like you.

Maples and Calder wrote Citibank about a request for information

regarding Delta. If you could take a look at Exhibit 150, the Delta

attorneys asked Citibank for permission to respond to the request.

At least that is what it looks like to me, Exhibit 150 in the middle:

‘‘I noted that this information could not be disclosed until we had

received authorization from our client.’’

Maybe I best go back a little bit here. ‘‘Regarding Delta Energy

Corporation (the ‘Company’)’’—here’s the email. We’ve ‘‘been contacted . . . Milbank Tweed in relation to this Company.’’ That’s

Delta. ‘‘They’ve requested the information outlined in the attached

email. I noted that this information could not be disclosed until we

had received authorization from our client. In connection therewith,

I should be grateful if you would kindly confirm whether it is acceptable to you for this information to be provided.’’

Are you familiar with that?

Mr. CAPLAN. Yes.

Senator LEVIN. Now, you have no control over Delta. Why would

Maples and Calder be seeking permission from Citibank?

Mr. CAPLAN. Again, I think it goes to the reason you set these

special purpose entities up, and it is not a question of control. We

were the person that sponsored it. We were the person that used

it. I don’t think it’s unusual that Maples and Calder, who we used

to set up Delta, would contact us asking if this was OK to talk

about with another law firm. The point, again, with the SPVs is

that they’re separate, independent for accounting and legal purVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00129 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
110

1 Exhibit No. 151 appears in the Appendix on page 545.

poses, but that doesn’t mean that Citibank doesn’t have a continuing role in the way they operate.

Senator LEVIN. Well, it looks like you gave permission to

Milbank Tweed to get information on Delta, and I am just wondering why you can’t do the same for us.

Mr. CAPLAN. I just have to defer that question.

Senator LEVIN. The exhibit, if you would, take a look at Exhibit

151.1 And this is page 2 of the exhibit, and it is part of accountopening documentation for Delta Energy at Citibank. And given

the Subcommittee’s attention to money-laundering issues, we

checked to see what due diligence was performed by Citibank on

Delta before the account was established, and the document contains the following notation: ‘‘We will not be’’—this is page 2. ‘‘We

will not be obtaining any documentation because of the internal nature of the account.’’ Why would Citibank consider the Delta account to be an internal

account if you did not have some control over Delta?

Mr. CAPLAN. I think it just goes back to why we set Delta up.

I mean, obviously I’m just in the past few days familiar with this

document. But if you subscribe to the theory that in these kind of

transactions the bank sets up special purpose entities to perform

specific roles, then setting up a bank account for that entity would

be part of the overall structuring of the deal and would not be unusual. And I would bet that if you were to examine our records on

other SPVs or other banks’ records on SPVs that you would find

similar documentation in pretty much every transaction out there.

Senator LEVIN. It goes on to say, ‘‘It will be controlled’’—and they

are referring here to the account. ‘‘It will be controlled exclusively

by the Houston office until it is transferred to Citibank, New York,

at which time it’’—that is, Delta’s account—‘‘will be controlled exclusively by New York.’’ So you are controlling Delta’s account?

Mr. CAPLAN. I think that’s, again, a typical thing in structured

financing. You don’t allow funds out of accounts in the entire structure because this is one of the control mechanisms you put in place

that is a prudent risk management technique so your SPV—because your SPV, Delta in this instance, could theoretically go off

and do business with other parties. So one of the ways—— Senator LEVIN. One of the control mechanisms you put in place,

you finally got there.

Mr. CAPLAN. I would call it more of a risk management mechanism.

Senator LEVIN. It slipped. The word ‘‘control’’ slipped from your

lips. One of the control mechanisms which you put in place.

Mr. CAPLAN. Control of a bank account means that you don’t

allow disbursement of funds without a sign-off, effectively, which

we would call a risk management practice that is prudent so that

if the SPV—if the management of the SPV turned—decided to go

off on some jaunt and enter into some transaction with another

bank, for instance, our funds would not be at risk.

Senator LEVIN. Well, it slipped out there. That was just one of

the control mechanisms. But you are going to help us find out all

the rest of them.

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1 Exhibit No. 152 appears in the Appendix on page 548.

Exhibit 152,1 this is the bill sent by Citibank by Givens Hall

Bank and Trust Company of the Cayman Islands, the company

that provided administrative services for Delta. The bill for services

related to the management and administration of Delta Energy,

and you can see Givens Hall bills Citibank. Why? For supplying

the board of directors, shareholders, etc., to the company and its

parent company and administering the overlying trust for the year

ending December 31, 1999. So Citibank is paying for the administrative costs relating to Delta. Is that correct?

Mr. CAPLAN. Again, very typical in these kind of transactions.

Yes, it’s correct.

Senator LEVIN. You can repeat the word ‘‘typical,’’ but the answer comes out the same way. You were paying——

Mr. CAPLAN. Yes, absolutely.

Senator LEVIN [continuing]. For these administrative costs.

Mr. CAPLAN. Absolutely.

Senator LEVIN. It is very typical for you to control the entity that

you create. That is typical. That is essential. In fact, you want to

control its bank account, you say, because just on some theory that

some day this creation of yours might somehow or other decide to

go off in some different direction for some unexplained reason.

Mr. CAPLAN. That’s correct.

Senator LEVIN. Now, Givens Hall has been replaced by Schroder

Cayman Bank and Trust Company as the administrator of Delta.

Who owns Schroder, do you know?

Mr. CAPLAN. It’s an independent, Schroder.

Senator LEVIN. Wasn’t this acquired by Salomon Smith Barney

in the year 2000?

Mr. BUSHNELL. Mr. Chairman, perhaps I could answer that. In

2000, we acquired a part of the Schroder’s organization.

Senator LEVIN. I am sorry. ‘‘Part’’ was the word?

Mr. BUSHNELL. A part of the Schroder’s organization. It did not

have to do with funds administration. That remains an independent company that is not under the Citibank umbrella.

Senator LEVIN. Let me yield here to Senator Fitzgerald.

Senator FITZGERALD. Thank you, Mr. Chairman. And I thank all

of you for being here.

I want to shift gears just a little bit. How much money does

Enron owe Citibank and its—your holding company is Citicorp,

right, and all of you work for—— Mr. BUSHNELL. Mr. Fitzgerald, it’s Citigroup.

Senator FITZGERALD. Citigroup, OK. That is the bank holding

company. It owns Citibank, it owns Salomon Smith Barney, and it

owns Traveler’s.

Mr. BUSHNELL. That’s correct.

Senator FITZGERALD. How much money is owed to Citigroup and

its subsidiaries by Enron, say the last time you looked at that time

question? I imagine you looked at it at the time of their bankruptcy

filing.

Mr. BUSHNELL. Yes, we did, Mr. Fitzgerald, Senator. We could

get the Subcommittee the exact number, so this is from my recollection, but at time of bankruptcy filing, the total exposure to

112

Citigroup was about $1.2 billion. That was comprising three major

components that you’ve discussed in the organizational structure of

Citigroup. There were bonds, Enron bonds, and indeed—— Senator FITZGERALD. How much were the bonds?

Mr. BUSHNELL. To my recollection, the bonds were—had an

amount of about $150 million face. That’s what they were purchased for. At the Traveler’s Insurance Company there was—— Senator FITZGERALD. Direct bonds of Enron Corporation.

Mr. BUSHNELL. Those were corporate bonds, that’s correct. Not

only Enron but Enron subsidiaries that went under different

names. But that’s correct.

Senator FITZGERALD. OK.

Mr. BUSHNELL. Then there was about $300 million of the indemnity company’s indemnification risk in the Mahonia transactions.

So when we look at overall exposure, we looked at that as a risk.

Senator FITZGERALD. Is that Traveler’s?

Mr. BUSHNELL. That’s a Traveler’s Indemnity Company.

Senator FITZGERALD. But you are contesting that you owe

anything—— Mr. BUSHNELL. We are contesting that we owe anything on that.

Senator FITZGERALD. And why are you contesting that? Aren’t

you saying that JPMorgan Chase knew that its prepay transactions

were really loans?

Mr. BUSHNELL. No. What we’re contesting is that under New

York State law, indemnity companies are not allowed to guarantee

financing transactions of any type.

Senator FITZGERALD. When you offered the guarantee, you didn’t

recognize it was a financing transaction?

Mr. BUSHNELL. We did not recognize it, and that’s, in essence,

what the documents that were disclosed to us at the Traveler’s——

Senator FITZGERALD. And you are saying it was a financing

transaction. You believe it—you are now saying it was a financing

transaction.

Mr. BUSHNELL. What was issued, in essence, was—the indemnification bonds are for performance bonds. That is what the indemnity companies are authorized to do under insurance law. If

this was a financially settled transaction, they’re not allowed to indemnify financial settlements, only commodities and other services

settlements.

Senator FITZGERALD. Do you think JPMorgan—are you contending that JPMorgan Chase knew it was a financing transaction

or didn’t know?

Mr. BUSHNELL. I don’t know—I’m not—I don’t know what

JPMorgan Chase thought they——

Senator FITZGERALD. You don’t know what they knew, so you

don’t—it’s not your position at Citibank that—or at Traveler’s that

JPMorgan Chase knew it was a financing transaction that they

were getting a surety contract for?

Mr. BUSHNELL. I am not aware of what our position is in that

litigation, Senator. I know the basics of the outlined litigation between the indemnity company and JPMorgan Chase.

Senator FITZGERALD. OK. Back to this $1.2 billion in indebtedness: $150 million in Enron Corporation or corporate subsidiary

bonds; $300 million in indemnity.

113

Mr. BUSHNELL. Exposure, as potential.

Senator FITZGERALD. Indemnity exposure?

Mr. BUSHNELL. Correct. And we had about $650 million at time

of filing of secured exposure, secured by assets within the Enron

group.

Senator FITZGERALD. Is that a loan, a direct——

Mr. BUSHNELL. That was a loan.

Senator FITZGERALD. A $600 million loan.

Mr. BUSHNELL. Yes.

Senator FITZGERALD. Secured by collateral of Enron. What was

the collateral?

Mr. BUSHNELL. Pipelines.

Senator FITZGERALD. OK. Was that——

Mr. BUSHNELL. Two pipeline systems.

Senator FITZGERALD. Was that financing you did after the bankruptcy?

Mr. BUSHNELL. No. We did that before the bankruptcy.

Senator FITZGERALD. OK. You are secured on that.

Mr. BUSHNELL. And we——

Senator FITZGERALD. And so that is the total of your exposure,

$650 million in secured lending, $300 million in indemnity exposure, and $150 million in bonds.

Mr. BUSHNELL. No, we need a little bit more to get to $1.2 billion, if my math is correct. We had about $150 million of unsecured

exposure. Some of that was loan exposure, and some of that was

contractual exposures in trading with them for foreign exchange,

for interest rate swaps, for commodity trades. So we had those unsecured exposures added up.

Senator FITZGERALD. OK. I want to ask you about the off-thebooks partnerships that Congress—at least in the Commerce Committee we were examining these heavily last winter. Enron, as you

know, created apparently a couple thousand off-the-books partnerships. Many of them were borrowing money. Enron would sell assets to the partnerships and book revenue from the sale of assets.

They would kind of do it in the way to encourage the perception

that these were revenues from recurring operations rather than

one-time sales.

It was reported on page 73 of the Powers report that Citigroup

invested bank funds—I imagine Citibank funds—in at least one of

these partnerships, LJM2. Is that true?

Mr. BUSHNELL. Yes, it is, Senator. A point of clarification. When

I discussed the $150 million of corporate bond exposure, we would

have included the $15 million—I believe the number was $15 million, but, again, we can get the Subcommittee the exact number—

as investment exposure, maybe is a better way to term it, in that.

And, again, I can get you the exact entity within the Citigroup family which had that. I doubt that it was Citibank NA, but instead

a different structure that would have made that investment.

Senator FITZGERALD. Could be Salomon Smith Barney?

Mr. BUSHNELL. No, not Salomon Smith Barney either. Perhaps

a holding company at Citigroup or a different investment vehicle.

Senator FITZGERALD. That invested the $15 million, but they invested in it in LJM2. That money isn’t owed by Enron to Citibank

114

or whoever invested that money. In fact, that is not a loan. That

was an investment, right, an equity investment?

Mr. BUSHNELL. That’s correct.

Senator FITZGERALD. So they lost that.

Mr. BUSHNELL. That’s correct.

Senator FITZGERALD. Do you know who at Citigroup was responsible for managing the Citigroup investments in these partnerships?

Mr. BUSHNELL. I know at the senior level. I don’t know who

would have—that would have been Todd Thompson who runs the

investment group.

Senator FITZGERALD. Todd Thompson.

Mr. BUSHNELL. Todd Thompson.

Senator FITZGERALD. Would he have been the one to sign off on

the investment in LJM2?

Mr. BUSHNELL. I’m not aware of what their sign-off procedure is,

Senator, for that portion of Citigroup, how they handle——

Senator FITZGERALD. But in his office or his group?

Mr. BUSHNELL. Somewhere within his division there must have

been, since we made the investment, some sort of vetting process

and approval process to take that in.

Senator FITZGERALD. Now, some of the class action lawsuits that

have been filed that named JPMorgan and Citigroup allege that

JPMorgan Chase and Citigroup administered the financial affairs,

such as profit distribution and capital calls, of LJM2. Is that correct?

Mr. BUSHNELL. Senator, I don’t know what the structure was,

who the administrative agent might have been from the bank for

LJM2.

Senator FITZGERALD. Was the bank an administrator or——

Mr. BUSHNELL. Again, I don’t know.

Senator FITZGERALD. Does anybody know? You don’t know the

answer to that?

Mr. BUSHNELL. No, sir.

Senator FITZGERALD. Is it possible that any of the employees, executives, or director of Citigroup personally invested in any of the

Enron partnerships such as LJM2?

Mr. BUSHNELL. I don’t know, Senator, the answer to that question, if any did. We have a fairly stringent policy in Citigroup

regarding investments by any individuals that would have been

vetted through our compliance and responsibility function, but——

Senator FITZGERALD. Does anybody know if any——

Mr. BUSHNELL. No, sir.

Senator FITZGERALD. OK. Then can you answer that question in

writing and give it to us and tell us, survey the office, find out if

any employees, executives, or directors of Citibank invested in any

of the Enron partnerships?

Mr. BUSHNELL. Yes, we will, Senator, and put that in writing.

I’ve been informed by our counsel behind me that no individuals

did invest, no Citigroup individuals did invest in LJM2.

Senator FITZGERALD. So your testimony is that no employees, no

executives, and no directors of Citigroup invested as individuals in

any of the Enron partnerships, any of the 2,000 partnerships?

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Mr. BUSHNELL. The only one, again, that I’ve just been passed

a note from counsel refers to LJM2. But we could get that information for you, Senator, if that—— Senator FITZGERALD. I would appreciate a written response to

that survey.

Now, it has been reported that Mr. Rubin, currently the vice

chairman of Citigroup, made calls to the Undersecretary of the

Treasury and to Moody’s Investor Services in an attempt to assist

Enron days before they filed for bankruptcy. Do you know if that

is true?

Mr. BUSHNELL. I don’t know if that’s true, Senator.

Senator FITZGERALD. Does anybody know if that is true?

Ms. HENDRICKS. I have no knowledge.

Mr. CAPLAN. I don’t know.

Senator FITZGERALD. Has any of you ever talked to Mr. Rubin

about Enron?

Mr. BUSHNELL. No.

Mr. CAPLAN. No.

Senator FITZGERALD. None of you have?

Mr. BUSHNELL. I have talked to Mr. Rubin about Enron in a general discussion when it was going into bankruptcy. We had several

high-level meetings, as you could attest to a situation, and he was

in attendance at those, but not about anything having to do

with——

Senator FITZGERALD. So the New York Times reported on February 21, 2002, that Mr. Rubin made those calls to the Undersecretary of Treasury and to Moody’s Investor Service, and you are saying you are not sure if that New York Times report is accurate?

Mr. BUSHNELL. I have no knowledge of accuracy or inaccuracy.

Senator FITZGERALD. Does anybody? Can you find out an answer

to that and clarify that in writing what Mr. Rubin’s contacts were

with the administration and provide that to the Subcommittee? I

find that fairly incredible that something like that is reported in

the New York Times and you don’t know whether that is true,

there is no investigation to find out whether that is true, nobody

cares whether your vice chairman called the Undersecretary of the

Treasury?

Did you ask Mr. Rubin to get involved, Mr. Bushnell?

Mr. BUSHNELL. No, I did not.

Senator FITZGERALD. Are you aware of anybody who may have

asked Mr. Rubin to get involved?

Mr. BUSHNELL. No, I’m not.

Senator FITZGERALD. Do you think he just came into work 1 day

and it popped into his head, I’m going to pick up the phone and

call the Undersecretary of the Treasury and ask them to see what

they can do to help Enron out?

Mr. BUSHNELL. I don’t know what was going on in his head. Senator, we’d be happy to respond to the question in writing for you,

if that helps.

Senator FITZGERALD. Mr. Caplan, do you have no knowledge, too?

Mr. CAPLAN. No, sir, I’m not at that level of the organization, unfortunately.

Senator FITZGERALD. Are you, Mr. Bushnell? You talk to Mr.

Rubin.

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Mr. BUSHNELL. I do talk with Mr. Rubin. But I did not question

him about his phone calls or involvement with either Moody’s or

governmental officials.

Senator FITZGERALD. Either of you talk to Sandy Weill about

Enron Corporation?

Mr. BUSHNELL. I did.

Senator FITZGERALD. And what was the nature of that conversation?

Mr. BUSHNELL. The nature of that conversation was many conversations about our exposures across Citigroup—how we were

going to deal with them, what was likely to happen in terms of financing, debtor in possession financing after they filed for bankruptcy, and——

Senator FITZGERALD. Is it possible Mr. Weill asked Mr. Rubin to

call the Undersecretary of the Treasury?

Mr. BUSHNELL. I wouldn’t know, Senator.

Senator FITZGERALD. Did you ask him for help?

Mr. BUSHNELL. I did not ask Mr. Weill or Mr. Rubin for help.

Senator FITZGERALD. Ms. Hendricks.

Ms. HENDRICKS. Yes, sir?

Senator FITZGERALD. Have you talked to Mr. Rubin or Mr.

Weill——

Ms. HENDRICKS. No, sir, I have not.

Senator FITZGERALD [continuing]. About Enron?

Ms. HENDRICKS. No, sir.

Senator FITZGERALD. Mr. Reilly.

Mr. REILLY. No, I have not, Senator.

Senator FITZGERALD. Salomon Smith Barney, were they going to

be an advisor or were they hoping to get the business to advise

Enron on their merger with Dynegy? Any of you aware?

Mr. REILLY. Yes, Senator, we were—Salomon Smith Barney was

the co-advisor with JPMorgan.

Senator FITZGERALD. You were.

Mr. REILLY. Yes.

Senator FITZGERALD. And so you hoped that that merger would

go through at the time? I mean, you were trying to put it together;

is that correct?

Mr. REILLY. We were, again, one of the advisors.

Senator FITZGERALD. Moody’s or Standard & Poor’s—I can’t remember which one of the credit agencies—said that they were getting calls from banks urging them to not lower Enron’s credit rating, to give it some time because they wanted this merger to go

through. Are you aware of anyone at Citibank calling Moody’s,

Standard & Poor’s, or any other credit agency urging them not to

lower the credit rating of Enron prior to this merger?

Mr. BUSHNELL. Senator, I’m not aware of the people involved. I

know that there were conversations between the rating agencies

and Enron during this time when the possibility of a merger existed and that as advisors we would have been involved in those

meetings as to the possibility of the merger happening or not and

what its influence on the business and ratings might have been.

Senator FITZGERALD. Any of the others care to comment on that?

Mr. Reilly, do you have any knowledge of attempts by anyone withVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00136 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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in the Citigroup holding company to contact the rating agencies

around the time of the Dynegy transaction?

Mr. REILLY. Senator, I would echo what Mr. Bushnell said.

Senator FITZGERALD. Mr. Reilly, do you know how much money

in fees Citigroup or Salomon Smith Barney would have realized

had the Dynegy-Enron deal gone through?

Mr. REILLY. Not precisely, Senator.

Senator FITZGERALD. Roughly?

Mr. REILLY. It was in the tens of millions.

Senator FITZGERALD. Forty-five million sound about right?

Mr. REILLY. I don’t recall the exact figure, but that number

wouldn’t surprise me.

Senator FITZGERALD. I would like to go to your analyst Raymond

Niles at Salomon Smith Barney. I gather that he tracked Enron for

you, and on October 26, 2001, he downgraded Enron from a speculative buy to a speculative neutral. This followed the October 16 restatement, I think, that caused Enron to report a $618 million

third quarter loss and disclosed a $1.2 billion reduction in shareholder equity.

Now, Mr. Niles, like Mr. Fagin from JPMorgan Chase, testified

before this Subcommittee earlier this year and gave his reasons for

making the recommendations he did make.

Do you think that the indebtedness of Enron to Citibank in any

way, shape, or form had any influence on the analyst ratings, on

Mr. Niles’ ratings?

Mr. BUSHNELL. No, I don’t, Senator. We have stringent internal

controls, even if there was a desire to retain private side information from public side information, Mr. Niles is a public side analyst.

He has access to public information. Clearly, as bankers and as advisors, we had a lot of private side information, and we have a

strict internal compliance process known in the industry as a Chinese wall, but a firewall that prevents information from flowing between those private side information to the public side.

Senator FITZGERALD. But Salomon Smith Barney was owed

money, not just Citibank but Salomon Smith Barney——

Mr. BUSHNELL. Salomon Smith Barney, the legal entity, had

trading exposures—contracts—which caused us to end up as we

are—an unsecured creditor.

Senator FITZGERALD. You are an unsecured creditor in the bankruptcy, and you are telling me that Mr. Niles—there is no way that

he could have known that, that the company he worked for was

owed money by Enron.

Mr. BUSHNELL. That’s—he did not know the amount that we

would have had—or if he had——

Senator FITZGERALD. Did he know that money was owed?

Mr. BUSHNELL. Don’t even know if he—he would not have had

access to that information.

Senator FITZGERALD. Would anybody who did know that Enron

owed Salomon Smith Barney money have been in a position to influence Mr. Niles in any way?

Mr. BUSHNELL. Again, Senator, that would definitely be against

our internal compliance rules as well as lots of others. So we don’t

feel that that would have happened.

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Senator FITZGERALD. If I could ask you a few questions about the

Delta transactions, we have established that Citigroup has a subsidiary in the Cayman Islands known as Delta.

Mr. CAPLAN. I would not term them a ‘‘subsidiary.’’ Senator FITZGERALD. OK. What would you term it?

Mr. CAPLAN. They are an independent special purpose entity that

we’ve used in these transactions, but it is definitely not a subsidiary of Citigroup.

Senator FITZGERALD. And it is out of your control?

Mr. CAPLAN. For accounting purposes, which I think is the relevant regime, it’s out of our control.

Senator FITZGERALD. Who owns it?

Mr. CAPLAN. A charitable trust.

Senator FITZGERALD. OK. And we had some discussion about this

before. And what is the name of the charitable trust?

Mr. CAPLAN. I think it’s something called Grand Cayman Commodities Corp.

Senator FITZGERALD. Who established that trust?

Mr. CAPLAN. I’m not sure. Delta predates my time at Citibank.

Senator FITZGERALD. And what is the charitable business of the

charitable trust?

Mr. CAPLAN. I’m not sure of that either. But, again, the purpose

of Delta, it was established by us. We had the entire—— Senator FITZGERALD. I thought it was established by a charitable

trust.

Mr. CAPLAN. It was established by Citibank, it was sponsored by

Citibank, and a charitable trust—— Senator FITZGERALD. I thought you just said that Delta was established by a charitable trust.

Mr. CAPLAN. Delta is owned—I’m sorry for using the wrong word.

Delta is owned by a charitable trust, but it was sponsored and put

together by Citibank to use in these particular type of structured

financing transactions, and, again, it’s very similar to special purpose entities we create—— Senator FITZGERALD. Who is the trustee of the charitable trust?

Mr. CAPLAN. I’m not certain of that.

Senator FITZGERALD. Can you find that out and put that in writing to our Subcommittee, please?

Mr. CAPLAN. Certainly.

Senator FITZGERALD. Who is in control of the—does this charitable trust do whatever Citibank tells it to do?

Mr. CAPLAN. The charitable trust?

Senator FITZGERALD. Yes. You told them to establish Delta, and

they just go ahead and do that?

Mr. CAPLAN. The charitable—all the charitable trust did was buy

the shares of Delta.

Senator FITZGERALD. So is Delta a corporation?

Mr. CAPLAN. Delta is a corporation.

Senator FITZGERALD. And the charitable trust—— Mr. CAPLAN. Is the owner.

Senator FITZGERALD [continuing]. Bought the shares?

Mr. CAPLAN. Correct.

Senator FITZGERALD. Did you ask the trustees of the trust to buy

the shares?

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Mr. CAPLAN. Of the—yes.

Senator FITZGERALD. What year was this?

Mr. CAPLAN. Nineteen-ninety-three.

Senator FITZGERALD. How much did the charitable trust pay for

the shares?

Mr. CAPLAN. I’m not even sure that they paid for them. They

own the shares. They may have been contributed to the charitable

trust. That’s typically—when you set up a special purpose vehicle

to act in a role in one of these structured financings, you typically

take the ownership interest and contribute it to a charitable trust.

So I don’t think there was any payment by the—I mean, the purpose of the charitable trust is that it’s supposed to hold the shares.

Again, it’s a very generic concept in structured finance.

Senator FITZGERALD. Well, now I think whoever the trustees of

this charitable trust that are holding shares in Delta might regret

that they are holding them because there could be some liability

attached to that, couldn’t there, with all the lawsuits that have

been filed regarding ways in which Enron’s debts were concealed

from the public? I would like to know who the trustees of this charitable trust were, and I would appreciate it if you could provide

that to the Subcommittee.

Mr. CAPLAN. Yes, Senator.

Senator FITZGERALD. Any information. Is this charitable trust directly or indirectly controlled by Citibank?

Mr. CAPLAN. Not to my knowledge.

Senator FITZGERALD. It is independent of Citibank?

Mr. CAPLAN. That’s my understanding.

Senator FITZGERALD. Is it a U.S.-based charitable trust?

Mr. CAPLAN. I don’t think so. I think it’s a Cayman Islands-based

charitable trust.

Senator FITZGERALD. OK. Delta was established in 1993. Has it

had any business transactions that were not related to Enron?

Mr. CAPLAN. Yes, it has. With, I think, Arcla Energy Corporation, and I think the other one was Hess.

Senator FITZGERALD. With two other energy—— Mr. CAPLAN. Yes.

Senator FITZGERALD. Only with energy corporations.

Mr. CAPLAN. Well, I think that is because of the reason why— again, when you establish these special purpose entities, they are

established for a special purpose. That’s kind of where the name

comes from. And in this case, Delta was established to do commodity swap transactions, and those commodity swap—and where

that business—my understanding of where that business started

was, again, in the oil—in the energy and power industry, these prepay transactions were fairly typical. And they started to come to

banks to do them, but banks, at least at that time, weren’t able to

hold physical commodities such as oil. So Delta was established for

the special purpose of being able to hold physical commodities of

oil.

Senator FITZGERALD. Who first suggested setting up Delta?

Whose idea was that?

Mr. CAPLAN. I’m not sure of the answer to that.

Senator FITZGERALD. Were you around in 1993, Mr. Caplan?

Mr. CAPLAN. No. I didn’t join the bank until 1997.

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Senator FITZGERALD. So it was already up and running?

Mr. CAPLAN. It was up and running, had been used multiple

times for these kind of transactions.

Senator FITZGERALD. How many times do you think it has been

used for these types of transactions?

Mr. CAPLAN. I think it’s about—well, it’s all the Enron transactions and the Hess one, and I just want to correct one thing

which I think we need to straighten out. We’re not sure whether

it was used by Arcla. I was led to believe that, but I’m just handed

a note saying it may not have been. So we’ll find out the answer

to that.

Senator FITZGERALD. OK.

Mr. CAPLAN. But it’s been used probably ten—about ten times.

Senator FITZGERALD. Do you think it was Citigroup that came up

with the idea establishing this company, Delta, or do you think it

was Enron or some other energy company?

Mr. CAPLAN. I mean, again, we’ve done these transactions with

counterparties such as other banks, so, for example, we did a transaction with Enron where Toronto Dominion was—it was either Toronto Dominion or Barclay’s was in the place that Delta is in in

these deals. So I’m not sure whether it was something that

Citibank decided to establish or was established in connection with

here’s a transaction, we need a party to hedge commodity risk

with, let’s—is there someone in the market we can use, or is there

a more efficient way to do it.

Senator FITZGERALD. If you could find out who incorporated

Delta and provide that—— Mr. CAPLAN. There’s a law firm in the Cayman Islands called

Maples and Calder who we hired to incorporate Delta.

Senator FITZGERALD. You hired them to——

Mr. CAPLAN. Yes.

Senator FITZGERALD. OK. So Citibank really hired the law firm

to incorporate Delta.

Mr. CAPLAN. Yes, which is what—again, we do this all the time.

This is standard operating procedure in the structured finance industry. If you go to any other bank out there that engages in these

kind of transactions or any corporation that does receivable sales

or anything—or mortgage sales, any of those things, you will find

that special purpose entities are created in the middle of these

transactions to serve different purposes, but they’re all kind of

formed the same way. The bank involved pays the costs of setting

it up, makes sure that it’s set up in a way that for accounting purposes it is an independent entity. And then it goes on to serve

whatever purpose it’s been created for, but, again, it’s a very standard concept in structured finance.

Senator FITZGERALD. Now, Citibank, isn’t it true that Citibank

attempted to lay off some of its position in Enron, Enron owed it

a lot of money and Citibank attempted to lay off some of that risk

by selling Enron-linked securities, including the Delta loans as

notes? Is that correct?

Mr. CAPLAN. The whole purpose of the Yosemite transactions was

to take credit risk that was resident in the bank market and move

it to the bond market, because the bond market is able to accept

longer——

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Senator FITZGERALD. OK, credit risk that was a risk that

Citibank was absorbing—— Mr. CAPLAN. Citibank or other banks.

Senator FITZGERALD. Citibank and other banks.

Mr. CAPLAN. Yes.

Senator FITZGERALD. You were maybe the lead lender? How

many other banks were involved?

Mr. CAPLAN. The way the transactions worked is the money— Enron would refinance transactions with the proceeds it received in

the transactions we entered into. So I’m not certain exactly how

many other banks they used, but that was the stated purpose of

the transaction.

Senator FITZGERALD. How much money did Enron owe to

Citibank that Citibank was able to offset by selling bonds?

Mr. CAPLAN. In the first transaction that we did?

Senator FITZGERALD. Yes.

Mr. CAPLAN. I think it was $125 million.

Senator FITZGERALD. And how many more transactions did you

do?

Mr. CAPLAN. We did, I guess, four transactions in total.

Senator FITZGERALD. Laying off a total of how much?

Mr. CAPLAN. $2.4 billion.

Senator FITZGERALD. You laid off $2.4 billion—— Mr. CAPLAN. But it’s not—again, that’s not all of our exposure.

It was exposure—— Senator FITZGERALD. How much of it was yours?

Mr. BUSHNELL. Senator, in the first transaction, I think the

transaction you were referring to was the $800 million issuance, of

which $125 million was repaid to Citibank and $675 million, if my

math is correct, would then have been repaid to other banks. And

I don’t know in each of the separate—— Senator FITZGERALD. Ms. Hendricks, you were actually in charge

of the—— Ms. HENDRICKS. Yes, Senator.

Senator FITZGERALD [continuing]. Yosemite investments; is that

right?

Ms. HENDRICKS. I was the senior investment banker at Salomon

Smith Barney at the point at which Enron first approached us to

discuss the concept of using the public capital markets in a structured finance way to enable them to raise capital which would

allow them to repay bank structured financings.

Senator FITZGERALD. Money that they owed to you.

Ms. HENDRICKS. And others.

Senator FITZGERALD. So they got the proceeds from——

Ms. HENDRICKS. Absolutely.

Senator FITZGERALD. From the bonds that they issued——

Ms. HENDRICKS. Absolutely.

Senator FITZGERALD [continuing]. And used it to repay to you.

Ms. HENDRICKS. Absolutely. And the purpose for that was so that

they could continue to get new capital from us, which they subsequently did in a series of transactions, which was all part of their

original purpose for structuring the Yosemite deals.

Mr. CAPLAN. And if I could add something to that, when we marketed the Yosemite deals, the purpose that we used in the marVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00141 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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keting, that we told investors why we were doing the deals, was

to shift credit risk from the bank market to the bond market,

which is a deeper market, which—one of the main purposes of this

transaction was the bank market is typically a short-term market,

and Enron had a lot of long-term assets and wanted to extend its

liabilities.

Senator FITZGERALD. You are saying Enron came to you and

asked you to do this. It was not any concern that you had at all

with Enron’s ability to repay the money it owed to Citibank.

Ms. HENDRICKS. No, Senator, perhaps I could answer that. When

Enron came to us, the presentation that they made was that they

were at a point—— Senator FITZGERALD. When did they come to you with this?

Ms. HENDRICKS. Well, I started covering the account in 1999,

early 1999, so this is really about then. And the discussions were

100 percent around that they were beginning to feel constrained in

terms of the use of the bank debt markets, constrained relative to

not a concern that we had about the credit quality of the company,

but constrained in terms of the opportunities that they saw to grow

their company.

Putting ourselves back, I mean, it’s hard to do today, but going

back into the psyche of 1999, Enron was a firm proponent that they

had a very novel and different business model which could be applied to a variety of different industries.

Senator FITZGERALD. They sure did.

Ms. HENDRICKS. Yes, Senator, they did. But at the time, virtually

everyone—— Senator FITZGERALD. OK, let me ask you this: Enron wants to

switch away from borrowing from banks to borrow from the public.

So why doesn’t Enron—why don’t you at Salomon Smith Barney

help them issue corporate bonds of the Enron Corporation? What

is wrong with that? Why couldn’t you have just issued corporate

bonds and repaid the indebtedness to you?

Ms. HENDRICKS. We absolutely could have done that. The request

of the company was to help them resolve something that had been

widely discussed in all of the public market information on the

company, which was that as a result of mark-to-market accounting,

they were required to recognize as revenue mark-to-market—they

were required to recognize as revenue their price risk management

book. And, unfortunately, there was no attendant cash flow associated with that.

When they came to us, their comment was that what they wanted to do—and they’d had these discussions with the rating

agencies——

Senator FITZGERALD. Well, what difference does it make if there

was no attendant cash flow with that?

Ms. HENDRICKS. They needed——

Senator FITZGERALD. The banks had to start doing mark-to-market. When Citibank used to just report your bonds at what you

paid for them, and when they changed to mark-to-market, banks

started to account for their bond portfolio every day. And, yes,

there was no cash flow associated with that.

Ms. HENDRICKS. Yes, but——

Senator FITZGERALD. So what?

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Mr. BUSHNELL. Maybe I could answer that, Senator, with, again,

the complexities that we deal with. We have bonds in Citigroup

that are mark-to-market. We have bonds in Citigroup that are historical cost basis. It depends on the—— Senator FITZGERALD. Then whether they are held for trading or

for long-term investment.

Mr. BUSHNELL. Correct. But the intent of it is they’re trading,

they’re mark-to-market. If they’re held for investment, they’re usually held at an accrual-based process. If I could also, Senator—I

misstated some information. On the first Yosemite I transaction,

the $800 million, we were repaid $350 million of the $800 million,

not $125 million. That is the information that I have.

Senator FITZGERALD. Go back, Ms. Hendricks, explaining why

Enron Corporation did not issue bonds, why they instead, you did

this Yosemite transaction.

Ms. HENDRICKS. Their objective was to monetize their future

cash flows, and the proceeds from those monetizations were going

to be used——

Senator FITZGERALD. That is another way of saying borrow, is it

not?

Ms. HENDRICKS. Senator, we have had a lot of discussion today

with respect to the use of structured financing. There is no question is it a financing. There is no question it is the economic equivalent of a financing. It is structured in such a way so that we’ll

achieve certain accounting or tax or regulatory issues. In this case,

it was an accounting issue, but it was an accounting issue that was

represented to us that had been created as a result of the tremendous growth in their trading book and the advent of mark-to-market accounting.

The conjunction of those two, at a time when they believed there

was phenomenal additional investment opportunities, resulted in,

and this is frankly widely discussed in a number of the public-market documents, including reports from Moody’s and Standard &

Poor’s, at a time when they thought that there were significant investment opportunities that would not generate cash for a 3-year

period. So what they were trying to do is to monetize the cash from

an existing asset base that they had, which was their trading portfolio and reinvest that in assets which were publicly disclosed——

Senator FITZGERALD. They could have done that by issuing bonds

and pledging the assets that you referred to as collateral for the

bonds.

Ms. HENDRICKS. Yes.

Senator FITZGERALD. What I am asking you is why do the Yosemite transaction instead of issuing bonds? You can monetize anything by issuing bonds, and what I am asking you is why did you

work with Enron, not to help them issue corporate bonds, if they

wanted to go to the public markets, as opposed to the bank markets to borrow from, but why did you help them do Yosemite?

Mr. CAPLAN. Maybe I could help on that answer. The purpose of

Yosemite was to allow Enron to continue to do structured finance

in the bank market because they thought there was a lot of value

to the way they structured their balance sheet, and they felt that

banks were the most capable or the best clearing house to do structured finance through. So that the idea with Yosemite was to creVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00143 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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ate a mechanism where we, as a bank, could move credit risk from

the bank market to the capital markets and extend the tenor of

bank-type financing.

Senator FITZGERALD. So explain to me how Yosemite worked. Explain exactly how that worked.

Mr. CAPLAN. Yosemite is actually a relatively—I know that it has

been perceived as something very complex, but at the end of the

day, it is a relatively simple idea. We went to the market and

raised money, and the note-holders in Yosemite took the credit risk

of Enron, and the way they took that credit—— Senator FITZGERALD. You sold them notes?

Mr. CAPLAN. We sold them notes of a trust.

Senator FITZGERALD. Of a trust.

Mr. CAPLAN. That they were credit-linked notes, and they were

linked to the reference credit of Enron. So, if Enron went bankrupt,

note-holders would take Enron risk, and they were paid a spread

that was above Enron straight bond spreads for taking that risk

because of the more complex nature of the transaction.

Senator FITZGERALD. They got a higher return than they would

have gotten from Enron bonds.

Mr. CAPLAN. Right, because Enron bonds are publicly offered.

They were very generic in a way, and these were Rule 144A offerings. You were buying—— Senator FITZGERALD. What was the return? What was the interest rate on the—— Mr. CAPLAN. To give you an example, in the first transaction, the

return relative to Enron, to straight Enron debt, was about 1 percent above, the annual return was about 1 percent above straight

Enron debt. So investors were getting paid that extra return for

not only taking the credit risk, but understanding the structure

that we devised.

Senator FITZGERALD. Was the indebtedness that Enron indirectly

incurred by virtue of this Yosemite transaction, was that indebtedness reflected on their balance sheet?

Mr. CAPLAN. Well, the Yosemite transaction did not create indebtedness for Enron. All the Yosemite transaction did was create

a credit transfer mechanism for Citibank, but then Citibank turned

around and did the prepaid transactions with Enron, which showed

up as liabilities on their balance sheet. So what we told investors

when we marketed the deal is that any credit risk that Citibank

is effectively hedging using this structure, that credit risk starts

with Enron and is disclosed in their financial statements.

Senator FITZGERALD. Your testimony here is that there was no

desire on the part of Citibank to limit their exposure to Enron that

caused you to engage in this Yosemite transaction, that it was all

Enron’s idea. You didn’t hit your lending limits with Enron. You

liked Enron as a credit. You would have kept loaning to Enron. It

was Enron that came to you and said let us get rid of this loan,

this money we owe to Citibank, and let us change it this transaction with Yosemite and have Salomon Smith Barney basically

sell this indebtedness off to public investors who will own these

notes.

Mr. BUSHNELL. Maybe I can address that, Senator, to help a little bit.

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We have, in terms of our own exposures to any corporation, we

have internal limits that we set against individual obligors or companies that is in accord with our perceived riskiness of them. Obviously, the higher rated credit, not only by the rating agencies, but

done independently by us, we would be willing to extend more

money to a higher rate of credit. Those limits are well beneath our

legal lending limit. We are strong believers in——

Senator FITZGERALD. What is your legal lending limit?

Mr. BUSHNELL. I believe right now our legal lending limit for

Citibank N.A., the largest bank in our chain, I think it is upwards

of $5.5 or $6 billion. So the limits——

Senator FITZGERALD. What is your internal lending limit?

Mr. BUSHNELL. Again, generally, you would have to refer to that

via both the rating of the company and the maturity or duration

of the risk that we were taking on. So the shorter the time frame

you might be willing to take more risk, it was only for a 6-month

or a 9-month transaction versus something that has 7 years’ worth

of credit risk. But to give you an indication for a BBB-rated company, our 2 to 5 year maturity side would be on the order of about

$400 to $425 million that we would, in general, not want to have

any more exposure. This is prudent risk diversification.

Senator FITZGERALD. Four hundred and?

Mr. BUSHNELL. Of equivalent, unsecured credit.

Senator FITZGERALD. This——

Mr. BUSHNELL. This internal guideline.

Senator FITZGERALD. That is your internal guideline.

Mr. BUSHNELL. Yes, Senator.

Senator FITZGERALD. Four hundred and fifty million dollars, but

at one time, Enron owed you as much as $2.4 billion.

Mr. BUSHNELL. I am not sure it got quite that high, but we had

larger exposure than that. It was over our internal guidelines, and

we had an active desire, not because we were concerned about credit quality, but from a portfolio management process, we do not believe in putting too many eggs in any one basket.

Senator FITZGERALD. So you did have a desire to get rid of some

of this exposure; is that not correct?

Mr. BUSHNELL. That is correct.

Senator FITZGERALD. Ms. Hendricks, you had said it was just

Enron coming to you wanting to do this Yosemite transaction. Now

Mr. Bushnell is saying that you had an internal desire at Citibank

to get rid of some of this exposure of this one company.

Mr. BUSHNELL. Senator, I think the understanding is my bank

is not unique in that, and what was happening, and what the company was expressing, and what this entire transaction was set up

to do was a lot of the banks were getting to their limit. Enron was

a very fast-growing company, and so there were lots of capital

needs, and the banks were providing it, but even though they liked

the credit, they obviously continued to extend money, etc.

They were starting to reach their internal prudency thresholds,

if you will, and the purpose of the Yosemite transaction was to provide relief, if you will, on those banks so that by accessing the public capital markets so that the banks could continue in their activities in Enron.

126

1 Exhibit No. 181 appears in the Appendix on page 660.

Mr. CAPLAN. I would just add to that, one of the reasons I am

personally involved in this deal, is I run the credit derivatives business at Citibank, and what we do with credit derivatives is move

risk off of our books through swap contracts, which is effectively

what we did here, and we do it for prudent risk-management purposes, so that we maintain a diversified lending book and that we

do not have too much exposure to any one obligor. It is not necessarily the financial health of that obligor.

Senator FITZGERALD. Oftentimes you lay off that risk with other

big banks, though, do you not?

Mr. CAPLAN. We lay it off all different ways. We have done other

Rule 144A offerings, where we have laid off risk in a very similar

manner to this transaction.

Senator FITZGERALD. Were you doing that prior to the legislation

that passed a couple of years ago to repeal Glass-Steagall? Have

you been doing that a long time?

Mr. BUSHNELL. Yes, Senator. We have been using various means

of credit mitigation, including insurance contracts from insurance

companies, including other banks, and that was prior to the passage of Gramm-Leach.

Mr. CAPLAN. The credit derivatives business has been evolving

over time, been around since 1996, I would say.

Senator FITZGERALD. The credit derivatives business has only

been around since 1996?

Mr. CAPLAN. In any large-scale way. I mean, I think there were

small transactions done prior to that, but nothing like it is today.

Senator FITZGERALD. Is that the first time you started laying

them off in Rule 144A offerings?

Mr. CAPLAN. I think the first—some of that predates me. I know

of one Rule 144A offering that we did in 1998 where we laid off

several million dollars of a diversified basket of names.

Senator FITZGERALD. I do not know if the Chairman has called

your attention to Exhibit 181.1 This is an email from William Fox,

dated November 10, 1999, to, among others, James F. Reilly, Niels

Kirk and also to William Fox—William Fox sending an email to

himself, I guess. But Mr. Fox in this email said, ‘‘In spite of all of

the repayments that we have or will receive from Condor and Yosemite, we still have an exposure issue as it relates to obligor limits; there is a developing view that limits are limits and not to be

exceed—’’ he must have meant not to be exceeded. ‘‘This is something we will have to deal with. Also, we do not have room for incremental assets of $200 to $300 million over year end. I will discuss with Reilly later today for current status and review of options.’’ Mr. Reilly, do you remember this email?

Mr. REILLY. I do, Senator.

Senator FITZGERALD. Did you subsequently discuss with Mr. Fox

this email or the issues raised therein?

Mr. REILLY. Certainly the issues raised there.

Senator FITZGERALD. Who is Mr. Fox?

Mr. REILLY. He was then, and is currently, the head of Citibank’s

Global Energy & Mining Group.

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Senator FITZGERALD. What was Mr. Fox’s message to you? It

sounds to me like he was concerned that you had too much exposure to Enron, and he is referring to Yosemite, and was he encouraging you to hurry up and get the Yosemite transactions done?

Mr. REILLY. No, that is not the intent of this email. There was,

by date—I do not remember the precise date in which Yosemite I

actually closed, but there were discussions about looking at what

became Yosemite II in Europe and what this bridge, I believe what

this bridge was dealing with was whether or not, if we could not

get Yosemite II closed by the end of the year, would we consider

making another loan on our books.

Senator FITZGERALD. Did you have a position on that issue? Did

you favor making more loans to Enron at the time?

Mr. REILLY. What was happening was going back to Mr. Fox’s

comment is that, and as Mr. Bushnell said earlier, there is in place

a framework called the obligor limits, and we were, I think, over

time—this is my characterization—over time we would try to manage all clients down and into that obligor limit range. That does

not mean that there are not exceptions from time-to-time, and so

we were moving in that direction, and so the question here was

were we prepared to put on an additional amount of credit exposure in light of those obligor limits.

Senator FITZGERALD. Would you have favored it, taking on an additional amount?

Mr. REILLY. In fact, we did take on the additional amount, Senator.

Senator FITZGERALD. You did, and did you favor taking on the

additional amounts?

Mr. REILLY. Yes, I did.

Senator FITZGERALD. You did.

Now, Ms. Hendricks, why do you not finish up with what you

started. I interrupted you, and we went to others. You started to

explain how the Yosemite transactions worked. You said that

Enron came to you and wanted to switch from tapping bank debt

to tapping public debt.

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. So who came in to ask you for help? Did

Mr. Fastow come to you?

Ms. HENDRICKS. No. Actually—— Senator FITZGERALD. Mr. Glisan.

Ms. HENDRICKS. No, Mr. Glisan was not in charge of the company. I think it would have been Jeff McMahon.

Senator FITZGERALD. Jeff McMahon came to you.

Ms. HENDRICKS. Yes.

Senator FITZGERALD. And he asked you to put this together.

Ms. HENDRICKS. He or members of his team. It was a collective

conversation.

Senator FITZGERALD. Did you know roughly when that was?

Ms. HENDRICKS. Well, in early 1999.

Senator FITZGERALD. Early 1999, and explain to me what you did

with Yosemite. You said that you created a trust. Was Yosemite a

trust?

Ms. HENDRICKS. Senator, the first thing I would have done on

the investment banking side is, first, make sure that Jim Reilly,

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who was my colleague on the commercial banking side, was aware,

and he would have done the same with me. And then the second

thing we would have done is created a team of product specialists

who would have sat down with us with the company and attempted

to brainstorm solutions to the problem that the company was presenting to us.

Senator FITZGERALD. Did you sit down with Mr. Reilly at that

time?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. You two collaborated on this?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. And you came up with the idea of Yosemite?

Ms. HENDRICKS. No, sir. I am not smart enough.

Senator FITZGERALD. Who came up with that idea?

Ms. HENDRICKS. Mr. Caplan and colleagues of his in the Credit

Derivatives Group.

Senator FITZGERALD. These are the credit derivatives guys.

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. They were the only ones smart enough for

that. Again, go back and walk me through this transaction slowly,

how this worked. You started to explain about the trust and the

notes.

Mr. CAPLAN. The place to really start is the financings that

Enron was doing in the bank market, and there were a variety of

financings. So the real premise was Enron came to us and said we

do a lot of financing in the bank market, we like doing our financing in the bank market—— Senator FITZGERALD. Not just at Citibank, but all other banks.

Mr. CAPLAN. All over the place.

Senator FITZGERALD. Did they take all of their bank borrowings

from all over the world and come to you and ask you to—— Mr. CAPLAN. And they said one of the problems we have with

bank financing is that it is short term, for the reasons that Mr.

Bushnell just explained.

Senator FITZGERALD. Right.

Mr. CAPLAN. So we would like—but the rest of our balance sheet,

we have a lot of long-term assets, so we have got long-term assets

and short-term liabilities. That seems like a recipe for disaster at

some point, if you do not manage those things.

So what their premise was is we are a growing company. We

have to be careful thinking about our liquidity plans for the future,

and one of the tenets of a carefully thought-out liquidity plan is to

better match your assets and your liability maturities.

So the thought was where can you get longer term debt, effectively or where can you place your credit risk in the longer term

market? The logical place is the bond market because investors will

invest for longer terms there.

So, understanding that they wanted to have the flexibility to continue to finance in a sophisticated way in the bank market, but

wanted to move the credit risk out into the capital markets, we developed Yosemite, which basically the idea behind Yosemite is Yosemite is just a credit default swap written from the bond

market——

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Senator FITZGERALD. Yosemite is a what?

Mr. CAPLAN. It is basically a credit default swap, and I will explain what that means.

Senator FITZGERALD. What is Yosemite from a legal standpoint?

Mr. CAPLAN. From a legal standpoint, the first deal was a trust;

the second deal was a Channel Island Corporation; and the other

deals were trusts.

Senator FITZGERALD. Yosemite I was a trust.

Mr. CAPLAN. Yes.

Senator FITZGERALD. Was a Cayman Islands trust?

Mr. CAPLAN. A Delaware business trust.

Senator FITZGERALD. A Delaware business trust.

Mr. CAPLAN. So we set up Yosemite. Yosemite issued notes and

certificates and held the proceeds of those notes and certificates

and invested them—it basically had the ability to invest in several

different things, which were not disclosed to——

Senator FITZGERALD. How much did Yosemite I raise?

Mr. CAPLAN. It raised $750 million of notes and $75 million of

equity or certificates—equity for tax purposes.

Senator FITZGERALD. Who gave the equity?

Mr. CAPLAN. It was a combination of Citibank and Enron.

Senator FITZGERALD. So Citibank invested its own bank funds?

Mr. CAPLAN. Not directly. It is a little complicated. Actually, a

Fleet Boston, Fleet Bank’s conduit, which is something called Long

Lane Master Trust, I mean this is the essence of structured finance, right? Fleet Boston’s conduit called Long Lane Master Trust

actually bought the Citibank half of the equity, and then that entity, Long Lane Master Trust entered into a swap with Citibank,

where we took the risk on the equity, and we effectively paid them

a financing cost for buying the equity, plus a spread for their——

Senator FITZGERALD. That sounds like really you were behind all

of the equity then.

Mr. CAPLAN. Well, no, that was only on half of the equity and

then Enron, through some entity, bought the other half.

Senator FITZGERALD. Yes, but if you are paying somebody else to

invest their half, to take half the equity, you are really putting together all of the equity.

Mr. CAPLAN. The only purpose of having the equity in the transaction was a tax reason, which was to get the notes treated as debt

for tax purposes. So the equity had——

Senator FITZGERALD. Are these notes Yosemite issues, are they

so-called NIPs?

Mr. CAPLAN. No.

Senator FITZGERALD. No.

Mr. CAPLAN. No, they are credit-linked notes.

Senator FITZGERALD. And they are strictly debt.

Mr. CAPLAN. For tax purposes, they are debt.

Senator FITZGERALD. For other purposes, are they equity?

Mr. CAPLAN. No, they are not equity for any purposes. They are

strictly debt. They offer it under an indentured——

Senator FITZGERALD. It is not the new-fangled combination

debt——

Mr. CAPLAN. There is no special——

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Senator FITZGERALD. So you issued notes and certificates. Are

the certificates the equity certificates?

Mr. CAPLAN. Yes, exactly.

Senator FITZGERALD. So you raised $750 million in notes and $75 million in equity. You raised that $750 million in notes, is that

promissory notes?

Mr. CAPLAN. No. The trust would issue notes to the market

through an indenture—— Senator FITZGERALD. What is the note, a promissory note?

Mr. CAPLAN. It is more like a bond. I guess you could call it a

promissory note.

Senator FITZGERALD. Well, a bond is a note.

Mr. CAPLAN. Yes.

Senator FITZGERALD. So a bond or a note——

Mr. CAPLAN. So there was an indenture under which——

Senator FITZGERALD. But there is a promise to repay, right?

Mr. CAPLAN. Yes, by the trust.

Senator FITZGERALD. Yosemite was obligated to repay—— Mr. CAPLAN. Exactly.

Senator FITZGERALD [continuing]. The purchaser of the note.

What increments were those notes in? You sold $750 million in

notes. Did you sell them in $75-million chunks or $5-million

chunks?

Mr. CAPLAN. I think the minimum denomination was a million

dollars.

Senator FITZGERALD. Do you know how many investors you got?

Mr. CAPLAN. I think in the first deal it was less than 100.

Senator FITZGERALD. So you had 100 people invested—— Mr. CAPLAN. All in the Rule 144A market, which is qualified institutional buyers.

Senator FITZGERALD. Could you give me examples of some of the

Rule 144A market buyers?

Mr. CAPLAN. It is kind of all of the major—it is other banks, it

is pension funds, it is insurance companies. To be a qualified institutional buyer, you have to have at least $100 million in investable

assets. So it is large institutions.

Senator FITZGERALD. So pension funds, the State pension funds

and so forth could have bought those.

Mr. CAPLAN. If they met the requirements for buying the notes,

they could, if they had a qualified asset manager and that sort of

thing.

Senator FITZGERALD. Do you see any risk with the new breakdown of Glass-Steagall, where a bank could have, and I am not

saying this is what happened, but say you have a bad loan, a bank

is enabled to sell securities to the public to take that bad loan off

their books, do any of you see any risk in that, in the new rules

we have created by repealing Glass-Steagall in the last couple of

years? Do any of you care to comment on that? Then I will turn

this back to the Chairman.

Mr. BUSHNELL. Senator, I think raising funds in the capital markets, in the public markets, and where those proceeds go is something that has been quite common. When you do a bond offering

in the public markets, the proceeds are fungible, and what the

issuer does with those monies, they may pay down banks, they may

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pay down certain banks and not other banks. They may pay down

payables that they owe. They may do lots of different things with

that. It generally flows into that.

So we have stringent rules that I have discussed internally that

would not let the public side know what our own exposures were

as a means to manage risk. So I think that, at this point in time,

we are comfortable with those internal controls.

Senator FITZGERALD. Does Citibank feel, in any way, misled by

Enron, Mr. Reilly?

Mr. REILLY. Certainly. Do you mean, with respect, just broadly,

Senator?

Senator FITZGERALD. Yes. You were a lending officer at Citibank

for them. Do you feel you were misled by them in any way?

Mr. REILLY. I think, Senator, in the 8 or 9 months since Enron

declared bankruptcy, an awful lot of stuff has been in the press and

has come out through committees and other reports, and I would

say that if all of that turns out to be true, then, yes, we would feel

very misled.

Senator FITZGERALD. Do you feel that selling the Yosemite securities to the public, that in doing so, Citibank contributed to misleading the people who bought those securities in any way?

Ms. HENDRICKS. No, sir.

Senator FITZGERALD. You do not?

Ms. HENDRICKS. No, sir.

Senator FITZGERALD. Why do you say that?

Ms. HENDRICKS. Because on the basis of the information that we

had at the time and the publicly audited financial statements that

we had and on which we had every reason to rely, and I would

echo, and perhaps state more strongly, Mr. Reilly’s conclusion. I do

feel misled, and I would say that we disclosed what we knew to be

correct. And in accordance with generally accepted accounting principles, the purpose of Yosemite was to deliver senior unsecured

credit of Enron to the public markets, which is, in fact, as the

structure worked, and it was disclosed, throughout the prospectus,

that that is what we were going to be doing.

Senator FITZGERALD. Maybe the Subcommittee has it, but I

would love to have a prospectus for Yosemite.

Ms. HENDRICKS. Absolutely.

Senator FITZGERALD. If you could provide that for me. I want to

thank you. All of you have been very good. You have been good at

explaining some of these transactions. I used to be a general counsel for a bank holding company, but we were much smaller, and

we were not this fancy. We stayed away from things that got too

complex. We were very simple. We liked the collateral, in the bank

vault, in the basement.

This has been a real learning experience, and you have been very

helpful, and I appreciate the indulgence of the Chairman of the

Subcommittee. You have been very kind to this non-ranking Member to let me go on for quite some time.

So thank all of you for being here.

Senator LEVIN. Mr. Caplan, one of your colleagues apparently

thought that there was a need to put a little more window dressing

on some of these transactions, and I would ask you to look at ExVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00151 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
132

1 Exhibit No. 154 appears in the Appendix on page 552.

hibit 154.1 Exhibit 154 is a May 9, 2001, memo to you from a colleague named Timothy Swanson. He added a minimal charge of

one penny to the price spread between the purchase and sale price

of the oil involved in this prepay to make it seem a little more like

a true trade.

He reports to you that he told another Citi employee that, ‘‘The

charge makes the prepaid structure a little more like a true trade.’’ That is a pretty good example, is it not, of where Citi employees

felt the transactions were not real trades? They had to do something like a penny, which is totally nominal, as he points out, just

to make him look like real trades.

Do you remember this memo?

Mr. CAPLAN. I do, in fact.

Senator LEVIN. Did you call him up and say, Hey, wait a minute.

These are real trades. We do not——

Mr. CAPLAN. Actually, yes.

Senator LEVIN. You called him right back and said these are

real?

Mr. CAPLAN. What I would say is that the economics of the trade,

what the various parties were going to receive, were negotiated

into the transaction already and what all of this represents is,

frankly, another group who started working on these trades late in

the day, trying to put some more revenues through. In fact, the one

basis point per annum on the whole transaction, this additional

revenue that Mr. Swanson was attempting to——

Senator LEVIN. Which is totally nominal, you would agree? It is

one penny. It is a totally—— Mr. CAPLAN. It is $315,000.

Senator LEVIN. But its purpose is to make——

Mr. CAPLAN. Its purpose was to make more money.

Senator LEVIN. No, the purpose, it says right here, is to make the

prepaid structure more like a true trade. That is what it says here.

Did you call back and say—— Mr. CAPLAN. I did, and I said I do not think that that is necessary to make this trade work. And, in fact, the Kelly that is referenced, the Kelly McIntyre referenced in this email, is not a

Citibank employee. She is an Enron employee, and Enron came——

Senator LEVIN. Who is an Enron employee?

Mr. CAPLAN. Kelly McIntyre, who—— Senator LEVIN. Is Timothy Swanson?

Mr. CAPLAN. Timothy Swanson is a Citibank employee. Kelly

McIntyre, who this email is referring to, is an Enron, was an Enron

employee. What ended up happening in this transaction is we executed the transaction without this additional one-basis-point

spread because Enron thought the transaction was a real transaction, had vetted it again with their auditors, and felt that this

was just Citibank trying to make more money, and they were unwilling to pay the additional amount that we had asked for.

So they said that is very nice that you would like to make more

money, but, sorry, we think this transaction works as is, and we

are not going to pay you additional fees to do something we think

already works.

133

Senator LEVIN. But the stated purpose in the memo was not to

make more money. The stated purpose was that it would make the

spread a more real transaction. That is what was stated here,

twice.

Mr. CAPLAN. I think that that’s—I’m sorry.

Senator LEVIN. ‘‘I told her the change makes the prepay structure more like a true trade.’’ My question to you is: Are you testifying then you called Timothy Swanson and said you don’t have to

make this look like a true trade, it is a true trade?

Mr. CAPLAN. Yes.

Senator LEVIN. You called Mr. Swanson.

Mr. CAPLAN. Absolutely. I called—in fact——

Senator LEVIN. That is fine. That is good enough.

Mr. CAPLAN. Yes.

Senator LEVIN. You called him back and said——

Mr. CAPLAN. Yes.

Senator LEVIN [continuing]. No need to add a penny——

Mr. CAPLAN. In fact, what I said was Enron won’t agree to this

because they think it’s a true trade already.

Senator LEVIN. The penny is, in fact, diminutive. You would

agree to that, right?

Mr. CAPLAN. No, I would not——

Senator LEVIN. You would not agree with that?

Mr. CAPLAN. It’s $315,000 additional revenue to Citibank.

Senator LEVIN. I understand, but you would agree——

Mr. CAPLAN. Present value.

Senator LEVIN. You disagree that the penny is, in fact, diminutive, then. You think that’s false.

Mr. CAPLAN. It’s figured to be an incremental one basis point on

the whole transaction. I don’t think $315,000 is a diminutive

amount of money.

Senator LEVIN. You disagree with that, too.

Mr. CAPLAN. I would disagree with that as well, yes.

Senator LEVIN. And that its purpose was to make this look like

a true trade.

Mr. CAPLAN. Yes.

Senator LEVIN. Was that the reason for his recommendation?

Would you agree to that?

Mr. CAPLAN. No. The reason for his recommendation was to

make more money on the trade, plain and simple.

Senator LEVIN. That is not what he says here, though, is it?

Mr. CAPLAN. I understand——

Senator LEVIN. So now I am asking you, he in this memo said

that the purpose of the incremental penny was to make it look like

a true trade. Is that not true?

Mr. CAPLAN. That is true. That is what the memo says.

Senator LEVIN. I want to get to the Yosemite structure now. Investors here were told, as I understand it, only that the trust

would invest in Enron-related investments. They did not know specifically what the money was invested in.

Mr. CAPLAN. Yes, that is correct.

Senator LEVIN. So nobody was supposed to know specifically

what the $800 million was going to be invested in.

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1 Exhibit No. 156 appears in the Appendix on page 559.

By the way, Ms. Hendricks, did Mr. McMahon know that the

funds from the Yosemite trusts were going to be used to finance

the Enron prepays?

Ms. HENDRICKS. Senator, I believe that when we first started the

conversation on this, there was discussion of a number of different

assets that were considered before it was determined that it would

be prepaids that were used. So I’m not sure that at the first conversation with Mr. McMahon that it was expressly stated that it

would be used for prepaids, although clearly that was one of the

alternatives.

Mr. CAPLAN. If I might, when the transaction was executed in

November 1999, Mr. McMahon absolutely knew what the bank financing was going to be, that it was going to be a prepay transaction. I mean, it’s a $750 million transaction. The treasurer of the

company would want to know where the money is going and how

it’s coming in, and he was absolutely involved in that process.

Senator LEVIN. Did he know that the funds from the Yosemite

trusts were going to be used to finance Enron prepays?

Mr. CAPLAN. Absolutely. He himself was on the road show for the

first deal, so he was intimately aware of the details of the transaction and its intended uses.

Senator LEVIN. He told us something very different, by the way.

In Exhibit 156,1 if you would take a look at that now, this is a

memo from Doug McDowell, an Enron employee who was heavily

involved in working with you on the Yosemite structure, I believe.

Is that correct?

Mr. CAPLAN. That is correct.

Senator LEVIN. And this is what he wrote, that ‘‘Apparently an

investor spoke to someone at Citi and received info on Delta. This

person at Sumitomo is now calling us asking about Delta now. We

need to shut this down.’’ Did you shut it down?

Mr. CAPLAN. This is a very interesting email.

Senator LEVIN. Did you shut it down?

Mr. CAPLAN. It turned out that the information on Delta had

come not from Citibank but from Enron. And we had agreed— again, we’ve talked about the purpose of the transaction to maintain flexibility and that the investments in Yosemite would not be

disclosed to investors. So we had agreed with Enron that we would

not tell investors about Delta, and it turned out in this instance

that it wasn’t Citibank telling Enron about Delta. It was—sorry,

the investor. It was Enron telling the investor.

Senator LEVIN. Whoever it was who told the investor, you agreed

that information should not go to the investors?

Mr. CAPLAN. Our agreement with Enron was not to disclose the

details of the Delta deal. It was a confidential deal from their perspective.

Senator LEVIN. Do you think it is appropriate for an investment

bank to shut down the flow of information when an investor requests that information?

Mr. CAPLAN. I think it’s appropriate to meet our obligations

under whatever contractual arrangement we have, and it was exVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00154 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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tremely clear in the disclosure document for Yosemite that investors would not learn the trust investments. So investors had no

right to know what was in the trust until Enron filed bankruptcy.

Senator LEVIN. My question, though, is: Do you think it is appropriate for an investment bank not to respond to a request for information, to agree to that?

Mr. CAPLAN. I think it’s appropriate—I think ‘‘appropriate’’ is not

the right—respectfully—— Senator LEVIN. That is my word. But, no, I—— Mr. CAPLAN. I understand that’s—— Senator LEVIN. That is my question. Do you think it is appropriate for an investment bank to agree to deny information to a

prospective investor who seeks information?

Mr. CAPLAN. I think unless the investment bank has a legal obligation in a transaction such as this to disclose the information, the

investment bank is completely within its rights not to disclose the

information. And, in fact, in some of the transactions I was talking

about earlier where we did similar Rule 144A offerings and used

credit default swaps, we have the same blind trust concept, and investors have asked for information in those transactions as well,

and we have again declined to provide the information on the same

theory.

Senator LEVIN. I think then that your answer is yes.

Mr. CAPLAN. I think my answer is a little different than yes.

Senator LEVIN. It is appropriate to agree to refuse to provide information on request to a prospective investor. Is that correct?

Mr. CAPLAN. As long as we don’t have a legal obligation.

Mr. BUSHNELL. If I could add to that, Senator.

Senator LEVIN. Sure.

Mr. BUSHNELL. In many instances—and we’ve discussed with

Senator Fitzgerald that we are in possession of material, non-public information, and should an investor ask that of an investment

bank, it is entirely inappropriate for us and would be indeed a violation of securities law to give that information up.

Ms. HENDRICKS. Senator, if I might?

Senator LEVIN. Sure.

Ms. HENDRICKS. It is specifically stated in the offering document

for Yosemite I that we would not tell investors what was in the

trust. And I think that’s the point that Mr. Caplan—the distinction

that Mr. Caplan is trying to draw, is that the fundamental underlying credit of the investor—that the investor was purchasing was

Enron senior unsecured, and that was unrelated to the assets that

were held in the trust. And because we were not going to disclose

at the outset what was in the trust and were not going to disclose

on an ongoing basis what was in the trust, it was inappropriate for

us to be discussing that after we had specifically stated that we

were not going to.

Senator LEVIN. Do you know why Enron wanted to keep the

Delta prepay secret?

Mr. CAPLAN. As in many of their structured financings, they required confidentiality as part of the transaction, and that’s true,

again, in many structured finance transactions. You don’t disclose

the details of it. There are often proprietary aspects of it that you

don’t wish your competitors to get a hold of.

136

Senator LEVIN. But you know that they were also trying to avoid

showing debt. You have already testified to that. Is that correct?

Mr. CAPLAN. It’s not that they were trying to avoid showing debt.

They were trying to classify this as a price risk management

liability——

Senator LEVIN. Instead of——

Mr. CAPLAN. Which is a liability.

Senator LEVIN. Instead of debt.

Mr. CAPLAN. Instead of a loan, yes.

Senator LEVIN. Try not to show it as debt. Why do you avoid that

word? You say they don’t want to show it as a loan.

Mr. CAPLAN. Actually, no reason.

Senator LEVIN. I say they don’t want to show it as debt.

Mr. CAPLAN. That’s fine. Debt——

Senator LEVIN. Why do you——

Mr. CAPLAN. They do not—they wanted to show it as price risk

management liability and not as debt.

Ms. HENDRICKS. Not as funded debt, correct.

Mr. CAPLAN. Not as funded debt.

Senator LEVIN. Now, you say in your testimony today that price

risk management liability is a liability, plain and simple. It must

be satisfied every bit as much as debt. And thus, while not recorded as debt, prepaid liabilities were clearly obligations of the

company and visible as such to investors.

Every witness on our second panel—Moody’s, Standard & Poor’s,

Mr. Turner—disagreed with your statement. Were you here when

they disagreed with that?

Mr. CAPLAN. I was not.

Senator LEVIN. Did you hear that? Were you watching or do

you——

Mr. CAPLAN. Yes, some of it.

Senator LEVIN. Mr. Turner, former chief accountant at SEC, said

it was clearly wrong, your statement, that there is a huge difference between showing something as debt and showing something as price risk management liability.

Who supports your position? Has your accountant told you that

there is no difference between showing something as price risk

management liability and showing it as debt? Have you been informed of that by somebody?

Mr. CAPLAN. Well, again, I think this is a—it’s an accounting

question and——

Senator LEVIN. Has your accountant told you there is no difference?

Mr. CAPLAN. Well, I think that a liability is a—it’s an obligation

to repay. I think that’s a legal definition, not an accounting concept. But the accounting concept here was—if the books of Enron

didn’t properly reflect what their true debt was, then I think that’s

a matter you have to take up with their accountants and not with

their bankers. We don’t have control——

Senator LEVIN. But you are the one who said there is no difference whether it is shown as debt or whether it is shown as price

risk management. You are making that statement.

Mr. CAPLAN. Yes.

137

Senator LEVIN. Now you are telling me take that up with their

auditors, with Enron’s auditors.

Mr. CAPLAN. I’m making the statement that a liability is a legal

obligation. I’m not making a qualitative statement as to where

something should appear on a company’s balance sheet. That is not

within the purview or the role or the responsibility of a bank. That

is between a company and its auditors.

Senator LEVIN. Mr. Bushnell, do you agree that it makes no difference if an obligation is shown as price risk management liability

or as debt, that a liability is a liability?

Mr. BUSHNELL. I think—— Senator LEVIN. Do you agree with that statement?

Mr. BUSHNELL. I think that in the bankruptcy situation that

Enron is now in, there are many people that are in the same

position——

Senator LEVIN. I am not talking about a—I am not talking about

that. I am talking about before the bankruptcy, before that happened. Do you agree that a liability is a liability, it doesn’t make

any difference, it has to be satisfied whether it is debt or price risk

management? Do you agree with that? Is that Chase’s position? Excuse me. Is that Citibank’s position?

Mr. BUSHNELL. Citibank’s position is—from a credit aspect is

there are many different types of liabilities, and the correct accounting classification is important for us to understand the nature

of the credit.

Senator LEVIN. So it does make a difference where it shows?

Mr. BUSHNELL. What the correct accounting aspect is, yes.

Senator LEVIN. Right. So the issue then is not—as Mr. Caplan

has said, look, it was shown in their books—that is his testimony

here—that it was reflected in their books, that it was disclosed in

Enron’s books, and a liability is a liability, plain and simple, that

has to be satisfied. Price risk management liability has to be satisfied every bit as much as debt. While not recorded as debt, prepay

liabilities were clearly obligations of the company and visible as

such to investors. We had the former chief accountant of the SEC

saying he couldn’t disagree with the statement more. Mr. Caplan,

representing Citibank, has made that statement.

Mr. BUSHNELL. I don’t think Mr. Caplan’s statement is inconsistent at all. I think what he was trying to—— Senator LEVIN. Inconsistent with what?

Mr. BUSHNELL. Inconsistent with what I just said, Senator.

Senator LEVIN. Is it Citibank’s position?

Mr. BUSHNELL. Is that the correct classification of a liability is

an accounting concern, and that classification differential is important.

Senator LEVIN. And it matters.

Mr. BUSHNELL. And it matters.

Senator LEVIN. And if it is buried somewhere in the financial

statement under a false label, that matters?

Mr. BUSHNELL. If the accounting for it was certified by its board

of directors, its chief financial officer, and its independent accounting firm, that would make a difference.

Senator LEVIN. But if it is buried somewhere under a false label,

that would matter, wouldn’t it?

138

Mr. BUSHNELL. It would matter what the classification of that is,

yes.

Senator LEVIN. It would make a difference. It would be significant. It is important, then, as to whether or not it is put in the

proper category, that an obligation isn’t an obligation, that there

are——

Mr. BUSHNELL. That all—— Senator LEVIN [continuing]. Different obligations—— Mr. BUSHNELL [continuing]. Items on the balance sheet, Senator,

both the assets and liability, are put in their correct accounting

structure is important for fundamental analysis, yes. We rely on

accounting firms and boards of directors and the management of

companies to put those assets and liabilities in the correct positions

in the balance sheet, both on the asset side and the liability side.

That is their responsibility.

Senator LEVIN. It is also your responsibility, it seems to me, not

to participate in a deception. Would you agree that that is the

bank’s responsibility? I know you are not going to agree you did

participate in a deception. I am sure you are not going to agree

with that.

Mr. BUSHNELL. That’s correct.

Senator LEVIN. But would you agree that you have a responsibility not to participate in a deception?

Mr. BUSHNELL. We have a responsibility to our clients, both investors and to the customers who need capital, to do things in accordance with the rules as they’re established. And the rules that

were established, whether they are tax rules, whether they are accounting rules, whether they’re regulations for commodity trading

or banking, yes, we have an obligation to stay within those rules.

And we let the experts who determine what those rules should be

as well as interpret exactly what they are do that.

Senator LEVIN. I am really surprised that you can’t answer that

question with a yes, that you have an obligation not to participate

in a deception. It seems to me that is an easy one, that that one

doesn’t have to be hedged.

Mr. BUSHNELL. I thought that’s what I answered, Senator. I

think the answer is yes in a more English verbiage or—it depends

on what the definition of a deception is.

Senator LEVIN. Any way you want to define it. You can define

it any way you want. Don’t you think that the bank has an obligation not to participate in a deception? You define deception.

Mr. BUSHNELL. Yes.

Ms. HENDRICKS. Senator, might I add something to that discussion?

Senator LEVIN. Sure.

Ms. HENDRICKS. I did listen this morning to the presentation on

the expert panel, and I for one was a little surprised at the testimony in the context that I have in front of me—a report that was

written by Moody’s in 1998 that refers to under risks and weaknesses of the credit, significant off-balance sheet liabilities, including $1.3 billion in guarantees, $1.4 billion in transportation agreements, and $4.4 billion invested in projects of unconsolidated subsidiaries globally add significant leverage to Enron’s capital position.

139

1 Exhibit No. 157 appears in the Appendix on page 562.

This is a direct lift from footnotes of Enron’s financial statements, and had Lynn Turner read the financial statements which

he said he did, he would obviously have seen this. And I would

posit that $1.3 billion in guarantees, while not listed as funded

debt, certainly is a liability of the company that one would take

into consideration in thinking about its overall financial obligations. And I think that’s the distinction that we’re trying to draw,

is that as specifically determined under accounting that it is not

listed, in fact, unlike price risk management assets and liabilities,

it’s not on the balance sheet. It’s in the footnotes, which arguably

are an integral part of the balance sheet.

But I do think that there is perhaps—there was perhaps some

overstatement with respect to the issues this morning.

Senator LEVIN. Take a look at Exhibit 157,1 if you would please.

This is an Enron document. In the middle of it, it says, ‘‘The

Citibank swap combined with the Enron credit link notes provides

for a unique black box feature which provides considerable flexibility for substitution.’’ Two dots down, ‘‘Black box allows Enron

the ability to provide a permanent takeout feature for highly structured transactions in the capital markets while limiting disclosure

of prepay to Citibank.’’

And then on the next page, at the bottom, ‘‘The use of prepays

as a monetization tool is a sensitive topic for both the rating agencies and bank institutional investors. The ability to continue minimizing disclosure will be compromised if transactions continue to

be syndicated.’’

Do you believe that is a legitimate purpose—to minimize disclosure? Were you aware that that was Enron’s purpose? Anyone.

Ms. HENDRICKS. I’ll take that. I think I would say a couple of

things. One, this is obviously not a document that we prepared and

prior to the preparation for this meeting had not seen, or at least

I have not seen.

This is the first that I’ve heard about use of prepays as a monetization tool being a sensitive topic. Quite the contrary, again, in

that report that I just referenced by Moody’s in December 1998,

there is, if not a specific reference to prepays, a definition of prepays in there and an acknowledgment that the company was doing

that.

Further, we had been told by Enron that the agencies were supportive of their monetization of their price risk trading book, provided that the book was either in balance or in a net asset long position and, therefore, were not aware of this comment about it

being a sensitive topic, etc.

Senator LEVIN. Were you aware—I would like to just move on a

little more quickly. Were you aware of the fact that Enron did not

wish to have to explain the details of any of the assets to investors

or rating agencies?

Ms. HENDRICKS. The assets of the trust?

Senator LEVIN. Yes.

Mr. CAPLAN. That was the primary purpose of the transaction.

Ms. HENDRICKS. Yes, absolutely.

Senator LEVIN. So you were aware of that.

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1 Exhibit No. 158 appears in the Appendix on page 564.

Mr. CAPLAN. Yes.

Ms. HENDRICKS. Absolutely.

Senator LEVIN. And Citi was aware that that lack of disclosure

was a fundamental goal of the Yosemite structure?

Ms. HENDRICKS. Absolutely.

Mr. CAPLAN. It wasn’t—let me just correct——

Senator LEVIN. I am not saying you are agreeing that it was improper. I am just saying you agree that that was a purpose of that

structure.

Mr. CAPLAN. Right. The disclosure in Yosemite made clear that

investors would not learn about the credit risks that were being

hedged through the transaction.

Senator LEVIN. You then began to tout the black box feature, did

you not, Exhibit 158? 1 Take a look at it. This is, I believe, is page

33. This is a Citibank document where you are now trying to sell

the feature of this kind of structure, SPV investments purchased

by the SPV are unknown to the investors and the rating agencies.

Mr. CAPLAN. We were very successful in marketing the Yosemite

deal to investors, so we tried to duplicate the concept with other

capital-intensive borrowers such as Enron, because we thought the

concept had a lot of merit, the concept of moving credit risk, but

leaving other risks in the bank market, so yes.

Senator LEVIN. All right. But also selling—that one of the benefits of the structure is to mask what was being done with the

funds. You touted that as one of the benefits.

Mr. CAPLAN. It wasn’t so much mask. It was provide flexibility

in the bank market, effectively.

Senator LEVIN. Unknown to the investors, right?

Mr. CAPLAN. Yes, but that’s consistent with the disclosure——

Senator LEVIN. I am not saying it is not consistent. That is what

masking means. You keep it hidden.

Mr. CAPLAN. It’s consistent with the disclosure in the Yosemite

offering document that investors would not know the trust investments. We were effectively just duplicating that concept for other

borrowers.

Senator LEVIN. How many companies used this same structure

after you made a pitch to them? Do you know?

Mr. CAPLAN. We did one structure like this with one company,

but it was primarily done in the bank market.

Senator LEVIN. So you didn’t sell any structures similar to Yosemite?

Mr. CAPLAN. In the Rule 144A market we did not.

Senator LEVIN. OK. Let me check with Mr. Reilly on Project Roosevelt. You talked about this before. This consisted of two prepays,

$310 million natural gas prepay and $190 million oil prepay. The

purpose was to supply Enron with $500 million in cash at year end

because another financing deal fell through. According to the

memos that you wrote, although this transaction was written up as

a 3-year deal, it was Enron’s intention to repay the $500 million

by May 1, 1999, Citibank held off syndicating the $500 million loan

that it made to Enron with the expectation that it would be repaid

141

1 Exhibit No. 162 appears in the Appendix on page 584.

2 Exhibit No. 144 appears in the Appendix on page 513.

3 Exhibit No. 164 appears in the Appendix on page 588.

4 Exhibit No. 163 appears in the Appendix on page 586.

by May 1, and the prepaid oil and gas deliveries were also delayed

until after the expected repayment date.

Now I would like you to look at Exhibit 162.1 It is a memo you

wrote on April 19, 1999, reporting that Enron indicated it could not

repay all the $500 million by May 1. It asked if it could pay off the

$310 million gas prepay by May 1 and delay repayment of the $190

million oil prepay until November or December. It asked you to

hold off syndicating the $190 million until after the new repayment

date and characterized it as a favor.

You allowed Enron to defer repayment of $125 million until September 30, and you delayed syndication of the loan and deliveries

of the oil until after the September 30 repayment date.

So now Project Roosevelt is billed as to commodity prepays.

Enron promised that it would repay the money within 5 months.

You held off syndicating the loan and scheduling deliveries until

after the expected repayment. Enron asks to delay the repayment

of some of the funds. You push back the syndication and delivery

dates.

So far am I OK?

Mr. REILLY. Generally, yes, Senator.

Senator LEVIN. OK. Now, it sounds to me more like a short-term

loan than a commodity deal. You keep pushing back the delivery

date until after full repayment is scheduled to be made, and let’s

take a look here. I quoted from Exhibit 162, so we will move on

to Exhibit 144.2

OK. We are on Exhibit 144. This is the initial loan approval

memo for this transaction, and it gives us some insight as to what

is really going on.

Under the subheading ‘‘Story’’ on page 7—or it is not page 7, but

it is Item 7—it reads the following: ‘‘The prepaid forward structure

will allow Enron to raise funds without classifying the proceeds

from this transaction as debt (it is accounted for as ‘deferred income’). This is a common method of raising non-debt financing

among energy companies.’’ So it was very clear to you that this prepay forward structure will allow Enron to raise funds without

classifying the proceeds from this transaction as debt. Right?

Mr. REILLY. That is correct, Senator.

Senator LEVIN. OK. Now, Exhibit 164,3 the loan approval memo

for the extension notes,‘‘The company has verbally agreed to repay the remaining $125 million by September 30, 1999.’’ However, in

another memo, which is Exhibit 163,4 you write the following: ‘‘Although they have agreed to prepay by 9/30, the papers cannot stipulate that as it would require recategorizing the prepaid as simple

debt.’’ Our records cannot reflect what they’ve agreed to. That is

very clear. Your records cannot stipulate that they have agreed to

prepay by 9/30.

Mr. REILLY. Senator, I——

Senator LEVIN. That’s your words, isn’t it?

Mr. REILLY. Yes, those are the words, but if I might, I think as

I referred to in the opening, my opening statement, that ‘‘agreeVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00161 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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ment’’ is probably—is a word that could mean different things, but

in this particular case, there had been discussions with the client

about the likelihood that they would repay the transaction or prepay the transaction before it ran the full term.

Having said that, the transaction was structured to go to full

term, and in the intervening period between the initial closing of

the Roosevelt transaction and when we were getting to the point

of dealing with the syndication, potential syndication of the transaction, Enron had also begun the process that ultimately became

the Yosemite transaction, which then gave other opportunities,

other ways that structured transactions—may or may not have

been a prepay, but structured transactions might have been funded.

So I think what we had was a statement of intention on the part

of the company, but not in any way a binding agreement on the

part of the company, and I think, as evidence of that, they did not

prepay the transaction along those schedules.

Senator LEVIN. Twice you used the term ‘‘agreement.’’ You are

saying both times you were inaccurate.

Mr. REILLY. I would say that no one that read that—I did not

intend that to mean that it was a binding agreement, and no one

in my institution felt that a binding agreement had been made.

Senator LEVIN. That is not the issue. They agreed to something.

But you said you cannot be much more explicit than this. This is

contemporaneous. The papers cannot stipulate that. That is very

explicit. This is not some casual comment. You write down here,

‘‘They’ve agreed to prepay by 9/30, but the papers cannot stipulate

that.’’ How much more precise can you be here, folks? You are saying those papers have got to keep that oral. It is an oral agreement. For God’s sake, you cannot make a record of that. Why? It

would require recategorizing the prepaid as simple debt. Now we

talk about participation of the bank.

Mr. REILLY. No, I——

Senator LEVIN. Oh, yes. Now we are talking about your role because your papers—the papers here cannot reflect the reality,

which was an agreement. It has got to be kept oral. It cannot show

in the papers why that would be debt. That is what Enron did not

want, debt reflected on their books. You cannot tell me it makes

no difference how obligations are described in books. There is no

way you can persuade anybody of that. They were fighting, struggling to make sure debt did not appear on their books. They went

through all kinds of contortions and other companies went along

with them, using offshore items, companies’ entities to filter

through money that were not real entities at all, controlled by, you

do not know if you did or not. The record is pretty clear. But you

go through all these contortions. They went through all these contortions to avoid debt being shown on their books for one very clear

reason, it would hurt their credit rating, hurt their stock price, and

now your bank, in a very specific clear way, in your words, the papers cannot stipulate that they have agreed to what they have

agreed to orally. Why? It would require recategorizing the prepaid

as simple debt.

What can be clearer than that?

143

1 Exhibit No. 165 appears in the Appendix on page 591.

Mr. REILLY. Senator, I think if you took all of the papers, emails,

approval memos throughout the life of the Roosevelt transaction,

which was really from December 1998 until near the end of the

year in 1999, I think that there are—when that is discussed, it is

discussed in some cases as an intention, in some cases as an expectation. In the two references you’ve made to what I’ve said, it does

say agreement. There was no—I am telling you again, there was

no agreement in any—— Senator LEVIN. No oral agreement?

Mr. REILLY. No contractual sense, no agreement, no—— Senator LEVIN. No oral agreement?

Mr. REILLY. No, there was no commitment on the part of the

company to repay those loans, none.

Senator LEVIN. Was there an oral agreement?

Mr. REILLY. No, there was not.

Senator LEVIN. You said there was.

Mr. REILLY. I understand that.

Senator LEVIN. You lied in this memo.

Mr. REILLY. No, I don’t believe I did. I believe that—I believe

that——

Senator LEVIN. Says there was an oral agreement.

Mr. REILLY. I believe what I said in the agreement, which was

understood by the individuals who are the recipients of that agreement, was telling them that they would—that it was likely that the

transaction would be repaid.

Senator LEVIN. It did not say ‘‘likely.’’ I want to read you your

words. These are your words at the time. ‘‘The company has ver- bally agreed to repay the remaining $125 million by September

30.’’ They verbally agreed. I said, ‘‘Did they orally agree?’’ You said, ‘‘No.’’ Your memo says they did. Which is true?

Mr. REILLY. They did not.

Senator LEVIN. The memo is wrong?

Mr. REILLY. The memo was wrong.

Senator LEVIN. A contemporaneous memo that you wrote at that

time was in error, and then the second memo, 4/28/99, is also in

error; is that correct, that they have agreed to prepay by 9/30; that

is wrong?

Mr. REILLY. It is the same situation. What they have said is that

they would—their intention was to repay, prepay. Sorry.

Senator LEVIN. Who are you telling that they made this agreement? Who are you representing that to in the bank?

Mr. REILLY. That list of people that are on this.

Senator LEVIN. Why would you tell them that there was an

agreement if there was not?

Mr. REILLY. Again, Senator, I believe that those individuals do

not—did not believe that that was a binding contract on the part

of the company to make prepayments.

Senator LEVIN. If you would take a look at Exhibit 165.1 OK,

about the fifth line down. We have—let us start at the top. It is

from you. ‘‘We have agreed the following with Enron: On 5/1 Enron

will prepay the $310 million natural gas portion. The $190 million

oil portion will remain outstanding. Deliveries scheduled for May/

144

June/July/August/September will be rescheduled to sometime after

10/1—there will, therefore, be no amortization until after 9–30.

They have agreed to prepay that amount no later than 9/30. The

paperwork cannot reflect their agreement to repay the $190 million

as it would unfavorably alter the accounting.’’

What can be clearer? How many more times do I have to read

your own words to you in different memos?

Mr. REILLY. Senator, I will say the same thing again.

Senator LEVIN. I expect you would.

Mr. REILLY. And that——

Senator LEVIN. ‘‘The paperwork cannot reflect their agreement to

repay the $190 million as it would unfavorably alter the accounting.’’ Whose accounting?

Mr. REILLY. Enron’s.

Senator LEVIN. It would have to show as a debt, would it not?

Mr. REILLY. Well, Senator, this—the Roosevelt——

Senator LEVIN. If there was an agreement, it would have to show

as a debt, would it not?

Mr. REILLY. Senator, if the—I think we’ve acknowledged here

both generically structured finance and Enron specifically did in

fact undertake transactions in which they could categorize capital

raising as non-debt, whether it be prepaids or the like. So there’s

no reason to back away from that.

It’s also mentioned in other emails that their intention, should

they prepay, was to refinance it with other commodity-based transactions, which I think sticks with the same line of intent that they

had when they closed this deal in December 1998.

Senator LEVIN. Now, let me ask my question again. If there were

an agreement to repay to $190 million, it would result in their

being required to list this as a debt, would it not?

Mr. REILLY. I believe that if we had redone the documents and

required it to be paid on a given day, because it was a physical delivery prepay, that you simply couldn’t meet that physical delivery

schedule on any 1 day.

Mr. CAPLAN. Senator, I would add——

Senator LEVIN. That is not responsive.

Mr. REILLY. I’m sorry. I’ll try——

Senator LEVIN. I am asking a fairly direct question. If there was

an agreement to pay that money to you by that fixed date of September 30, that would have required them to account for this as

a loan, would it not?

Mr. REILLY. If there had been an amendment to the document

so that there was a binding contractual agreement, I understood

from the company that that could recategorize the transaction.

Senator LEVIN. As a——

Mr. REILLY. As debt.

Senator LEVIN. Debt. Hard to get that word out of your testimony here, but we are going to keep getting it. You can fuzz it up.

You can put words around it, but my question is so direct, and your

answer tends to be so indirect. And I do not know—I think I know

why, but you ought to be straightforward here. You have said it in

your own words. If this is shown as a specific date to repay this,

then it would change their accounting and they would have to show

145

it as a debt. And you knew that. Is that correct? If the documents

were rechanged——

Mr. REILLY. Senator——

Senator LEVIN. I got all that.

Mr. REILLY. Can I go back and just read——

Senator LEVIN. No, I do not think so. I want to go on to the next

question. I do not want to go backward. I want to go forward here.

I am going to just try one more time, because it seems to me it is

so clear what I am asking.

If the documents reflected an agreement on the part of Enron to

pay that money back to Citibank by that specific date, Enron would

have been required to show that as a debt on their books; is that

not true?

Mr. REILLY. I believe that is true, although that particular accounting judgment was not mine. That was what I understood from

the——

Senator LEVIN. And that is what you wrote in this memo, this

email, did you not?

Mr. REILLY. Yes.

Senator LEVIN. That is something that you worked with them to

avoid, did you not? You left that agreement out of those documents,

did you not?

Mr. REILLY. Senator, again, there was no agreement.

Senator LEVIN. I understand.

Mr. CAPLAN. Senator, could I add something to clarify this maybe

a little bit?

Senator LEVIN. Yes. Well, yes, try to clarify it. Not if it is going

to ‘‘fuzzify’’ it.

Mr. CAPLAN. I’ll try not to ‘‘fuzzify’’ it. September 30 comes along,

there is no repayment of this transaction. So, one, if there was a

real agreement to repay it, then they breached that agreement, and

we did not do anything about that. And usually on multimillion

dollar transactions, if companies breach their agreement, we tend

to do something about it.

Also I would add that there are other discussions of other types

of agreement around this transaction such as syndication strategy

and what the ‘‘agreement’’ with the company is on that. But you

won’t find anything in the documents on a syndication strategy, because I think the word ‘‘agreement’’ is being used very loosely here,

and I think why my colleague, Mr. Reilly, is struggling, is that

there wasn’t—if you went to the company, they would tell you they

were not agreeing to do anything. They were telling—they were expressing an intention which got us comfortable in making a credit

decision, but that intention was not—did not rise to the level of an

obligation. And I think that is kind of the basic difference, and I

think it is unfortunate that Mr. Reilly used the word ‘‘agreement,’’

but I don’t think that’s supported by the facts surrounding the

transaction.

Senator LEVIN. When they did not pay by that fixed date, was

there a understanding that they could pay by a later date? Was

there any conversation about them paying at a——

Mr. CAPLAN. I was not privy to those conversations.

146

Senator LEVIN. Who is? Mr. Reilly, are you privy as to what happened when they did not pay by the date they said they would pay

it by?

Mr. REILLY. They did not.

Senator LEVIN. And then there was an understanding, representation, whatever word you want?

Mr. REILLY. Ultimately that—ultimately.

Senator LEVIN. But they said they would pay it by another time,

right, in another way?

Mr. REILLY. Well, I think—I’m not sure exactly what you’re referring to, but I believe—— Senator LEVIN. What happened on that date when they did not

pay it? Was there not an understanding at that point as to how

and when they would pay it?

Mr. REILLY. Well, we kept the existing transaction documents in

place. We did change the amortization schedule, and it was the understanding of the parties that Roosevelt transaction would likely

be retired to the proceeds from the first Yosemite transaction.

Senator LEVIN. That was the understanding, not the agreement,

the understanding?

Mr. REILLY. That’s correct, Senator.

Mr. CAPLAN. I think our credit approval—— Senator LEVIN. There is no difference between—— Mr. CAPLAN. Our credit approval indicates that we had approved

the transaction for the full tenor of the transaction which is very

typical in derivative transactions, and in many instances counterparties early terminate those kind of transactions. So our credit approval didn’t indicate that this was a shorter transaction in any

way based on Mr. Reilly’s communications.

Senator LEVIN. Did Citibank represent to the sureties that it expected real commodity deliveries?

Mr. REILLY. I never had a conversation with the sureties.

Senator LEVIN. Who would know most about that? Who had conversation with the sureties, anybody here?

Mr. CAPLAN. I was not involved in that transaction.

Senator LEVIN. Mr. Bushnell.

Mr. BUSHNELL. I did not.

Senator LEVIN. Ms. Hendricks.

Ms. HENDRICKS. No, sir.

Senator LEVIN. Let us see. Why do I not yield to my colleague,

Senator Fitzgerald? I have more questions, but let us go back and

forth.

Senator FITZGERALD. All right. Thank you very much.

Ms. Hendricks, my understanding is that you were the Citibank/

Salomon Smith Barney investment banker that was in charge of

the Yosemite transactions; is that correct?

Ms. HENDRICKS. Yes, I was the Salomon Smith Barney investment banker, sir.

Senator FITZGERALD. And is it correct that on September 9, 1999,

you had to make a presentation to the Investment Grade Commitment Committee of the bank in New York regarding some of

Enron’s obligations, specifically regarding Project Condor; is that

correct?

Ms. HENDRICKS. Yes, sir.

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1 Exhibit No. 166 appears in the Appendix on page 592.

Senator FITZGERALD. Now, you made the presentation on September 8. Robert Rubin was present for that presentation; is that

not correct, according to the minutes of the meeting?

Mr. BUSHNELL. Excuse me, Senator, if I could clarify. We have

two Robert Rubins at Citigroup. The Robert Rubin that this was

referring to was a Senior Managing Director in the Salomon Smith

Barney entity. He had come from Shearson Lehman. He sat on our

Capital Commitments Committee. That’s not the Robert Rubin that

was Treasury Secretary.

Senator FITZGERALD. So that is not the Mr. Rubin we were talking about before?

Ms. HENDRICKS. No, Senator.

Senator FITZGERALD. It is another Robert Rubin. You made a

presentation to that Investment Grade Commitment Committee, is

that correct, on September 8, 1999?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. Did they ask you to do a follow-up report

to them?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. And why did they ask you to do a followup report?

Ms. HENDRICKS. As part and parcel of the discussion that we had

related to this transaction, there were a number of questions from

the Subcommittee, which is an extremely rigorous investigative

body prior to any transaction that we do, about the amount of disclosure in Enron’s public financial statements. And I was specifically asked that if one included—and I believe the question that

was asked of me was off-balance sheet debt, but that was a catchall term for basically all of the liabilities that we could think of.

Senator FITZGERALD. That were off-balance sheet, that were not

in their public financials; is that——

Ms. HENDRICKS. Well, frankly, that were in footnotes, OK? So

whether or not you categorize that as off-balance sheet, whether or

not you categorize certain things that might be listed as non-debt,

as debt items, etc., the question that was asked of me is if you included all of those items, is this still an investment grade company?

Senator FITZGERALD. And what is the debt to equity ratio?

Ms. HENDRICKS. No. I was not asked that question. I was asked

the question, is this still an investment grade company?

Senator FITZGERALD. And how do you determine if it is?

Ms. HENDRICKS. My approach was to go back with my team and

say, all right, we don’t have a lot of time here. Let’s do the most

rigorous, most punitive, in terms of including everything we can

think of, analysis that we possibly can of the company’s overall leverage.

Senator FITZGERALD. And what did you come up with? Is that not

the exhibit that is Exhibit 166?1 Is that not the report that you

prepared in response to——

Ms. HENDRICKS. That is correct, Senator.

Senator FITZGERALD [continuing]. The Investment Grade Commitment Committee’s request?

148

Ms. HENDRICKS. That is correct, Senator.

Senator FITZGERALD. And you found that Enron, on a GAAP basis, what they totally reported was total debt of $12,056,000,000;

is that correct? That would be on the second page of your report

dated September 20, 1999; is that correct?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. And then you found that Moody’s was

aware of additional off-balance sheet items, such as $4.4 billion in

investments in unconsolidated subsidiaries, off-balance sheet guarantees of $1.3 billion, transportation commitments of $1.4 billion

for a total of $5.7 billion?

Ms. HENDRICKS. Yes, and that’s a mathematical mistake. That

should be $7.7 billion, I believe.

Senator FITZGERALD. That should be $7.7 billion, OK. And then

beneath, where you put that——

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. Seven point one billion dollars in additional

off-balance sheet liabilities——

Ms. HENDRICKS. Disclosed in their footnotes, yes, sir.

Senator FITZGERALD. And that Moody’s was aware of?

Ms. HENDRICKS. Correct, in the report that I mentioned earlier.

Senator FITZGERALD. And while the publicly-reported financials

show a GAAP debt to capitalization ratio of 49 percent, you calculate that the GAAP debt plus Moody’s off-balance sheet liabilities

was 56 percent; is that correct?

Ms. HENDRICKS. Yes, and that’s an error. Using the $7.1 billion,

it should be 60 percent.

Senator FITZGERALD. Sixty percent, OK. Then you came up—if

you have this document here, on this next page—I want to hold

this up so we are carefully talking about the same document here.

There is a document that says, ‘‘SSB.’’ I suppose that is Salomon

Smith Barney—‘‘Additional Known Structures’’—so these are additional structures you knew of—‘‘other off-balance sheet items,’’ and

you come up with an additional $6 billion in off-balance sheet liabilities; is that correct?

Ms. HENDRICKS. That’s what’s on this page, yes, sir.

Senator FITZGERALD. Is the math on this page correct?

Ms. HENDRICKS. The math on this page is correct.

Senator FITZGERALD. And then you have a little line here of

GAAP debt plus Moody’s liabilities, plus the Salomon Smith Barney known structures, brings the debt to equity ratio to 65 percent;

is that correct?

Ms. HENDRICKS. That is correct.

Senator FITZGERALD. So you were aware that really their debt

level was higher than would appear in their publicly-available financial reports as of the date of this report, September 20; is that

correct?

Ms. HENDRICKS. Well, Senator, if I might, on that sheet that you

just held up, if you look further in your materials, you’ll see that

we provided the Subcommittee with a list of those assets that we

feared at the time, but could not—were not absolutely certain, we

were double counting. We threw them in because we wanted to be

as punitive as possible, but we recognized that we were being negatively sloppy in our analysis. And so a number of those items—and

149

1 Exhibit No. 166 appears in the Appendix on page 592.

frankly, we were sloppy not only in the calculation that I’ve just

admitted to, but also in our terminology, when we call that SSB

additional known structures.

Senator FITZGERALD. But you were aware that there were significant substantial off-balance sheet liabilities that were out there

that Moody’s did not necessarily know about and that were not necessarily self-evident from the publicly available financial statements filed by Enron; is that correct?

Ms. HENDRICKS. Senator, the answer to that question is no, because I did this calculation to be as negative as I could, not to demonstrate that I knew things that weren’t in the information. As a

consequence of that, I knew we were double counting, and I subsequently then——

Senator FITZGERALD. Were you double counting—was everything

double counted or just a few items on there double counted?

Ms. HENDRICKS. Most of the items were double counted. I think

if you look in your exhibits at—if you continue on in that same exhibit, Exhibit 165.1 If you keep turning pages, you’ll get to the

part—that same chart, where it lists the double-count.

Senator FITZGERALD. I, maybe, see that you are saying about $3

billion of the additional $6 billion is double counted.

Ms. HENDRICKS. It turns out that leases as well are on the balance sheet, or actually picked up in the Moody’s report I believe.

So there were a number of items here. I think the principal item

that is on the balance sheet is the——

Senator FITZGERALD. When did you realize you had double counted?

Ms. HENDRICKS. I knew it when I was doing the calculation, but

I couldn’t be certain, and so after we prepared this analysis and I

was able to demonstrate that this was still an investment grade

company, which is the next page of this presentation, which was

the whole purpose of doing the presentation, was to get to this final

page, and to be able to demonstrate that even throwing in things

that I knew to be double counting, even though I couldn’t precisely

give you the numbers, which I subsequently did. I subsequently

went back and said, OK, the Marlin financing is in Note 9, and the

Firefly financing is electro and that’s Note 9, and the Sutton Bridge

financing is a Rule 144A Euro bond and that is in the public domain.

When I was subsequently able to go back and get that specific

data, we absolutely corrected the information. But at the time my

objective was not to be accurate. My objective was to be as conservative as I conceivably could be, and to demonstrate first to my own

satisfaction and second to the Subcommittee’s satisfaction, that

this was still an investment grade company. And that is what the

final page of this presentation demonstrates to me and to my satisfaction at the time.

When I subsequently was able to go back——

Senator LEVIN. What page are you looking at?

Ms. HENDRICKS. I’m sorry, sir. If you go to the last page——

Senator LEVIN. Just the number at the bottom.

150

Ms. HENDRICKS. Down at the bottom, page 4, comparable companies, the last page of that exhibit.

Senator LEVIN. OK, thank you.

Ms. HENDRICKS. What we did was to say here are companies that

are in the same industry that are subjected—financing themselves

in the same way. And, Senator, the reason I derive so much comfort from this presentation was because I did not adjust these other

companies’s numbers of any form of off-balance sheet activity.

Senator FITZGERALD. I am looking at comparable companies. This

is document CITISPSI 0031098.

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. Here you are just disclosing the GAAP indebtedness. It says, ‘‘The following is a review of the GAAP debt

capital ratio of certain comparable companies.’’ And then you have

Enron listed, and it seems like here you have backed out the offbalance sheet liabilities.

Ms. HENDRICKS. No, sir. This is the——

Senator FITZGERALD. Well, how do you come up with a debt to

equity ratio of 48.7 percent here?

Ms. HENDRICKS. Because all of these are debt-to-cap. When you

look at AES Corp, when you look at Sonat, for this to be apples

to apples on this page, I showed Enron’s number. But on the prior

page and on the previous page——

Senator FITZGERALD. Yes, but you are aware of substantial offbalance sheet liabilities of Enron, which you have just demonstrated in the prior pages.

Ms. HENDRICKS. They were disclosed in the footnotes to the financial statements.

Senator FITZGERALD. All of those liabilities?

Ms. HENDRICKS. No. Maybe, I’m obviously not being clear.

Senator FITZGERALD. I see what you are saying, that you know

that the publicly reported GAAP debt to capital ratio of AES Corp

was 78 percent.

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. And that does not make reference to any

off-balance sheet liabilities that company may have.

Ms. HENDRICKS. Correct.

Senator FITZGERALD. I understand that. But are you saying the

only thing that is relevant to determine whether a company is investment grade are its GAAP basis liabilities, and that all of those

off-balance sheet obligations are irrelevant in deciding whether it

is investment grade?

Ms. HENDRICKS. Senator, what I’m saying is the question that

you asked me first was do I recall this presentation and what was

I asked in the presentation, and what was the purpose of my response presentation. I was asked if including the off-balance

sheet—loose language—liabilities of this company would still—if

we included those, would the company still be an investment grade

credit.

This is the analysis that I did and this is the analysis that I sent

to the Chairman of the Subcommittee, and subsequently had either

a telephone or over-lunch conversation. I mean I don’t think it was

an actual presentation where I went back to the committee with

151

the material, but it was a discussion in which I said we have done

an incredible stress testing.

Senator FITZGERALD. So you persuaded the committee that this

was an investment grade company, that Enron was, and you

should go forward with the public offering or the Rule 144A sale

of securities?

Ms. HENDRICKS. Yes, Senator.

Senator FITZGERALD. Did anybody question you on that?

Ms. HENDRICKS. No, Senator, and what I represented was that

we would, from this point forward, do a thoroughly rigorous analysis, which we did in each subsequent Commitment Committee

presentation.

Senator FITZGERALD. Was your compensation in any way tied to

how many deals you brought in and persuaded the company to underwrite?

Ms. HENDRICKS. No. In any direct way, no. We’re not paid on a

commission basis. My compensation, as the global head of the

group, was primarily a function of the global revenues of the firm

of which Enron was less than 10 percent.

Senator FITZGERALD. So if you did not generate any business all

year, it would not really affect your compensation?

Ms. HENDRICKS. No, I wouldn’t say that. I would think they

might question whether or not I should still be the head of the

group.

Senator FITZGERALD. Can it not be said that they expect you to

generate some deals?

Ms. HENDRICKS. Absolutely, sir.

Senator FITZGERALD. You try to generate deals for the bank,

right?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. But at the same time you do not want your

firm to underwrite something it should not.

Ms. HENDRICKS. Senator, in my belief, there is no level of fee

compensation that justifies risking the firm’s reputation, and there

is absolutely no way that we would have done this transaction to

do this transaction if we thought there was an issue.

Senator FITZGERALD. Are bankers at Salomon Smith Barney penalized if they sell bad securities to the public that do not get repaid?

Ms. HENDRICKS. In my opinion, absolutely.

Senator FITZGERALD. In your opinion. Is that any part of a written compensation policy for the bankers there?

Ms. HENDRICKS. No, because we do not have written compensation policies, sir.

Senator FITZGERALD. There is nothing written, it is all just—who

decides what your compensation is?

Ms. HENDRICKS. My boss.

Senator FITZGERALD. Who is your boss?

Ms. HENDRICKS. At the time, the Global head of the investment

bank.

Senator FITZGERALD. And you do not know on what criteria he

bases your compensation?

Ms. HENDRICKS. No, sir, I think I have a general idea of the

criteria——

152

Senator FITZGERALD. What are they?

Ms. HENDRICKS. But there is no contractual arrangement.

Senator FITZGERALD. Do you think that they look favorably,

when it comes to compensating you, on how many deals you generate?

Ms. HENDRICKS. Yes, and I think they would look very favorably,

very unfavorably on me for doing transactions that resulted in either a loss of prestige for the firm or an economic loss.

Senator FITZGERALD. Would you not think this transaction resulted in somewhat of a loss of prestige?

Ms. HENDRICKS. Absolutely.

Senator FITZGERALD. Were you penalized at all in your compensation?

Ms. HENDRICKS. I believe I was, sir, yes.

Senator FITZGERALD. You were. OK. Now, on November 4, this

is a supplement to the offering memorandum, dated November 4,

1999, for Yosemite Securities Trust I. When did you actually sell?

Ms. HENDRICKS. I am sorry, Senator. Could you say that one

more time for me. I am sorry.

Senator FITZGERALD. This is the prospectus for Yosemite Securities Trust I.

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. For the notes, and I asked you for that before, and lo and behold my staff had one. What was the date that

you sold the Yosemite securities, that you actually closed the sale

of those notes?

Ms. HENDRICKS. I do not know.

Mr. CAPLAN. It is November 4, 1999.

Senator FITZGERALD. That is the date of this supplement. It says,

initially, ‘‘Purchasers expect to deliver the securities on or about

November 18.’’

Mr. CAPLAN. Oh, I am sorry.

Senator FITZGERALD. So somewhere around November 18.

Mr. CAPLAN. Sorry. It was November 18th.

Senator FITZGERALD. In this prospectus, you do disclose certain

risk factors that you knew of. The underwriter is Salomon Smith

Barney; is that correct?

Ms. HENDRICKS. Yes.

Senator FITZGERALD. That is the company you work for, right?

Ms. HENDRICKS. Yes, sir.

Senator FITZGERALD. We have established that Salomon Smith

Barney knew of some of the off-balance sheet liabilities by September 1999 of Enron. Did you disclose any of those off-balance

sheet liabilities in this offering prospectus?

Ms. HENDRICKS. Senator, I do not mean to quibble with terminology, but it is relevant I think to this discussion. I do not agree

that these are off-balance sheet liabilities. That was a sloppy term

that we used in our presentation material, but virtually all of the

transactions——

Senator FITZGERALD. Was it material information—let me put it

that way—what you prepared for the Investment Grade Committee? It was apparently material enough for you to tell your committee before they went forward with it. Was it material——

153

Ms. HENDRICKS. No, sir, I did not believe that was material nonpublic information for us to disclose to the committee—I mean, to

the public.

Senator FITZGERALD. Why were you disclosing it to the committee? If it is not material, why are you wasting their time?

Ms. HENDRICKS. One, because they asked me to, but, two, most

importantly, this was a flawed analysis that anyone could have

done in reading the financial statements and which I think Lynn

Turner referred to this morning in terms of when you read through

these financial statements, there are a number of questions that

are asked. At the point at which I did the analysis, it was inaccurate, and had we disclosed it, it would have been misleading.

Having said that—— Senator FITZGERALD. It was overly conservative.

Ms. HENDRICKS. There was no legal requirement to disclose it,

and what we disclosed is what we believe is the legal requirement.

As I am sure you know, our underwriting activities are extremely

carefully monitored, and we do exactly what it is appropriate for

us to do, recognizing that to step outside of those boundaries is to

subject both investors and ourselves to risk.

Mr. CAPLAN. And we relied upon experts in determining what

the appropriate disclosure in this instance was and received legal

opinions consistent with that—— Senator FITZGERALD. Who is your law firm?

Mr. CAPLAN. In this transaction, we actually received two different legal opinions on the securities law issues. One was from

Millbank Tweed basically on the Yosemite structure, and then Vinson & Elkins, who is—— Senator FITZGERALD. Vinson & Elkins?

Mr. CAPLAN [continuing]. Who is Enron’s legal counsel, as you

know, gave a 10b-5 opinion——

Senator FITZGERALD. They opined that your disclosures were sufficient.

Mr. CAPLAN. That the disclosure, the Enron-related disclosure, in

particular, was sufficient, as well as received a comfort letter from

Enron’s accountants that the information incorporated by reference

and included in the document was proper.

Senator FITZGERALD. So let me just get this straight. You, Ms.

Hendricks, that whole analysis you did for your Investment Commitment Committee, the presentation, dated September 20, where

you itemized the off-balance sheet liabilities of Enron Corporation,

you do not believe that was material information that someone who

might want to invest directly or indirectly in Enron needed to be

aware of?

Ms. HENDRICKS. I believe that all of that information was public

information, that anyone could have done the analysis that I did,

that the liabilities were not off-balance sheet, and that, no, I did

not need to disclose it.

Mr. CAPLAN. Which was verified by our experts, effectively.

Senator FITZGERALD. All of that information was disclosed, and

so you did not believe it needed to be detailed in any risk-factor

statement in your offering memorandum?

Ms. HENDRICKS. No, sir. I know that in this morning’s presentation, there was discussion by the staff with respect to requireVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00173 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
154

1 Exhibit No. 168 appears in the Appendix on page 604.

ments for supplemental disclosure, but we did not believe that that

was appropriate or necessary.

Senator FITZGERALD. So is your position that if it is disclosed in

publicly available documents, even if the disclosure is obtuse, you

would admit that the disclosure in the footnotes is fairly obtuse

with respect to these off-balance sheet liabilities, would you not?

Your position is that if it is somewhere in the publicly available reports, even if it is buried in an obscure footnote, that you do not

have to further disclose it or highlight it.

Ms. HENDRICKS. Senator, my position is that this was a Rule

144A transaction that was being sold to QIBs, which are the largest, most sophisticated institutional investors in the world and that

our obligation here was to incorporate, by reference, which we did,

the financial statements of Enron which were audited by a reputable accounting firm at the time and that that was the standard

of required disclosure, which we met.

Senator FITZGERALD. Well, I appreciate that. Mr. Chairman, if

you want to——

Senator LEVIN. We are going to take a 10-minute recess for the

sake of our witnesses, and our staff, and I think ourselves. We will

recess for 10 minutes.

[Recess.]

Senator LEVIN. We will come back to order.

I want to pick up where Senator Fitzgerald left off and refer you

to Exhibit 168,1 Page 21. Now this was prepared, as I understand,

Ms. Hendricks, by the time you have gotten to Yosemite IV,

through all of these transactions involving Yosemite; is that correct?

Ms. HENDRICKS. Is this Yosemite IV, Senator? I am sorry. I just

turned right to——

Senator LEVIN. That is OK. If you go back to Exhibit 168.

Ms. HENDRICKS. April 16.

Senator LEVIN. All right.

Ms. HENDRICKS. Yes, sir.

Senator LEVIN. What is this document?

Ms. HENDRICKS. This is the Commitment Committee memorandum that would have been prepared for the Investment Grade

Commitment Committee.

Senator LEVIN. This is after Yosemite IV?

Ms. HENDRICKS. No, this would have been——

Senator LEVIN. Just before Yosemite IV?

Ms. HENDRICKS. Prior to, yes. This would have been the approval

for Yosemite IV, sir.

Senator LEVIN. So, by now, you have gone through this kind of

an assessment as to what the appropriate amount of what previously had been called additional known structures, off-balance

sheet items, etc. You have now got to the point where you are

about to take up Yosemite IV, right? You have done it for Yosemite

I, you have done it for Yosemite II, you have done it for ECLN I,

haven’t you?

Ms. HENDRICKS. Yes, and this is actually ECLN II. I know that

the staff refers to it as Yosemite IV, but——

155

Senator LEVIN. OK. We will call it either ECLN II or Yosemite

IV interchangeably, correct?

Ms. HENDRICKS. Yes, sir.

Senator LEVIN. Now what you have testified to is that these figures appeared in the Enron financial statement; is that correct?

Ms. HENDRICKS. Yes, Senator.

Senator LEVIN. As a matter of fact, and this is the critical question, these items are financings, are they not?

Ms. HENDRICKS. Yes, Senator.

Senator LEVIN. They are.

Ms. HENDRICKS. Yes, Senator.

Senator LEVIN. They appear as financings in the financial statements of Enron?

Ms. HENDRICKS. No, Senator. It would depend on the structure

as to how they are accounted for.

Senator LEVIN. My question is did they appear as financing in

the financial statements of Enron?

Ms. HENDRICKS. They would have been listed on the balance

sheet or in the footnotes as obligations of the company. I am not

trying to be difficult, Senator. I am trying to make sure I understand what you are asking.

Senator LEVIN. I thought that they were listed in that big item

called price risk management liabilities, were they not?

Ms. HENDRICKS. The prepaids are, yes, sir. Receivable financing,

for example, would not have been.

Senator LEVIN. Let us just talk about the prepaids.

Ms. HENDRICKS. OK.

Senator LEVIN. Prepaids were listed in price risk management liabilities; is that correct?

Ms. HENDRICKS. They were included, yes, Senator.

Senator LEVIN. In the Enron financial statements.

Ms. HENDRICKS. In the Enron audited financial statements, yes,

Senator.

Senator LEVIN. But you know that they are financings, do you

not?

Ms. HENDRICKS. Senator, I know that they have monetized the

future cash flows, yes, sir.

Senator LEVIN. You know they are financings, do you not?

Ms. HENDRICKS. Yes, sir.

Senator LEVIN. You use that term all of the time.

Ms. HENDRICKS. Yes, Senator.

Senator LEVIN. They do not appear as financings, do they, in the

Enron financial statement?

Ms. HENDRICKS. They appear as liabilities, Senator.

Senator LEVIN. Not as financing.

Ms. HENDRICKS. Senator, I——

Senator LEVIN. Is that not correct? They do not appear as

financings in the Enron financial statement; is that correct?

Ms. HENDRICKS. I believe that the generally accepted accounting

principles required them to be disclosed, as their auditors told

them they had to disclose them; that these are price risk management liabilities of the firm that what—— Senator LEVIN. I am talking here about the prepays.

Ms. HENDRICKS. Yes, of Enron.

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Senator LEVIN. They are not financings.

Ms. HENDRICKS. They were structured financings. I mean, they

were loans, they were structured financings. You have used different terms——

Senator LEVIN. No, I have not. You told your board that they are

financings.

Ms. HENDRICKS. Well, we called them off-balance sheet

financings, Senator, and they are not off-balance sheet either.

Senator LEVIN. But they are financings.

Ms. HENDRICKS. Well——

Senator LEVIN. You treat them as financings to your board. You

tell them your financings. We have been told all day long by the

folks who were trying to defend this stuff that the oil prepaids are

financings. That is the argument you have all been using.

Ms. HENDRICKS. Correct.

Senator LEVIN. OK, if they are financings, they do not show up

as financings on the Enron financial statement as financings. Do

they?

Now that is a very precise question. Do they show up on the

Enron financial statement as financings?

Ms. HENDRICKS. Nowhere on the Enron financial statement, that

I am aware of, does anything show up as financings.

Senator LEVIN. They show up——

Ms. HENDRICKS. They show up as long-term debt, but not

financings.

Senator LEVIN. They do not show up at all as debt or financings,

do they?

Ms. HENDRICKS. I am not aware of anything that shows up as

financings.

Senator LEVIN. Including oil prepaids.

Ms. HENDRICKS. Including oil prepaids.

Senator LEVIN. So now you believe the oil prepaids are

financings. They do not show up on the Enron financial statement

as financings; are you with me so far?

Ms. HENDRICKS. I am with you, sir.

Senator LEVIN. But you tell investors that they can rely on the

financial statements of Enron which you incorporate by reference

in your offering——

Ms. HENDRICKS. Yes, Senator.

Senator LEVIN [continuing]. Even though that financial statement, which you incorporate by reference, leaves off the fact that

there are this many prepaids that you treat as financings when you

deal with your own board; is that factually correct, what I just

said?

Ms. HENDRICKS. No, this is not our board. I am sorry.

Senator LEVIN. Excuse me, to the committee.

Ms. HENDRICKS. OK.

Senator LEVIN. You are right.

Ms. HENDRICKS. There is a difference.

Senator LEVIN. You are right. I am sorry. To the committee that

you presented this to, you presented this as a financing; is that correct?

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Ms. HENDRICKS. Yes, sir, I presented this as off-balance sheet

financings, which is incorrect, but it definitely is presented as specific things that we were aware of, yes.

Senator LEVIN. And you believe it is a financing, do you not, the

prepaids?

Ms. HENDRICKS. I believe that it is a structured financing, yes,

sir.

Senator LEVIN. You do, the prepaids.

Ms. HENDRICKS. Yes, sir.

Senator LEVIN. But they do not appear on the financial statement of Enron as a financing, do they?

Ms. HENDRICKS. No, sir, they do not. They appear as price risk

management liabilities.

Senator LEVIN. And you incorporate that financial statement, by

reference, in your offering, do you not?

Ms. HENDRICKS. Yes, sir, we do.

Senator LEVIN. Therefore, you are incorporating something which

is not accurate.

Ms. HENDRICKS. I disagree with that, Senator.

Senator LEVIN. You present to your Capital Committee this is a

financing. It does not show as a financing on the financial statement that you incorporate, by reference. It shows as something

else, something very different, which everyone here has finally acknowledged, which is a risk management liability.

Ms. HENDRICKS. Senator, we disclose, throughout this memorandum to our Commitment Committee, that these transactions

are accounted for under generally accepted accounting principles

under price risk management and asset liabilities. And when we

are asked by them what the business purpose is of engaging in

these transactions, we gave the same response that we gave to

your Subcommittee earlier this morning with respect to our belief

that this was a legitimate business purpose as an attempt to monetize future cash flows.

I also further believe that this type of transaction was described

in the report by Moody’s in 1998. I think there are references that

are made to it in other transactions, but if you are asking me if,

specifically——

Senator LEVIN. That is my question, very specifically.

Ms. HENDRICKS. And I gave the answer, no, these are not listed

as financings and, no, it would not have been appropriate for us to

include them because, under generally accepted accounting principles, they are not financings, and it would have been

inappropriate—— Senator LEVIN. Prepaids are not financings.

Ms. HENDRICKS. Under generally acceptable accounting

principles——

Mr. CAPLAN. But again, I think that is not even our decision.

Senator LEVIN. I thought that you have been arguing all

afternoon that they are financings.

Mr. CAPLAN. We consider them financings because we take credit

risk in them.

Senator LEVIN. Good. So that is—yes.

Mr. CAPLAN. However, the accountants are the ones that are

charged with disclosing them where they should be disclosed in the

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financial statements. So you are asking us to indicate whether we

think an accounting principle is right or wrong, and I do not think

we are in a position to do that.

Senator LEVIN. No, I am not. I am asking you a simple question.

You presented to your committee here these prepays as financing,

which you have been arguing they are all afternoon, and they are

not shown as financings on the financial statement of Enron, which

you incorporate by reference in your offering. Those are factual

statements.

Ms. HENDRICKS. Correct.

Senator LEVIN. Mr. Caplan, who were the people at Enron whom

you dealt with on the prepays and on the Yosemite structure?

Mr. CAPLAN. Starting, I guess, from the top of the organization,

I know that Andy Fastow was aware of them, but I did not have

direct dealings with him—Jeff McMahon, Bill Brown, Doug

McDowell, Jody Coulter, Barry Schnapper, George McKean, Dan

Boyle, I would say those are kind of the primary people—I am

sorry, Ben Glisan, a couple of people in Europe, Trease Kirby, and

Simon Crowe and Paul Chivers, and one other person in Europe,

a woman named Anne Edgley, I would say that is probably the core

group of people.

Senator LEVIN. Mr. Bushnell, this is a question for you.

Chase supplied us with tapes of phone conversations related to

the prepay transactions. They supplied them because all of the

traders calls are taped, and they were under subpoena to produce

all documents, including tapes that addressed Enron transactions.

Now Citigroup received a similar subpoena. Your traders apparently are also taped, their phone conversations. Why has Citigroup

not produced any tapes to the Subcommittee?

Mr. BUSHNELL. I cannot answer that question in terms of why

we might not have responded to that. I believe, Senator, that some

of our traders are taped and others are not, but I am not aware

of the existence of any tape recordings.

Senator LEVIN. Have you inquired?

Mr. BUSHNELL. I have not.

Senator LEVIN. How would you be aware of them if you have not

inquired?

Mr. BUSHNELL. I said I am not aware of the existence of any of

the tapes. I have not asked the question, Senator.

Senator LEVIN. Would you do that?

Mr. BUSHNELL. Yes, sir.

Senator LEVIN. We have asked a number of questions which we

are going to need answers for, for the record, from both of our last

panels. The testimony today and the documents surely paint a very

disturbing picture. Enron came to the banks. It had a clear desire

to get cash, but to show it not as debt, but as something else—cash

flow from operations. The financial institutions provided the structure and the vehicle to create these fake prepaid trades. It attempted to turn debt into cash flow from operations.

The critical third party that was provided were off-shore shell

corporations that existed in secrecy jurisdictions solely for, and as

the creation of, the investment bank.

Just a little bit like the ‘‘Wizard of Oz,’’ when Toto pulls back the

curtain to show the great Oz is no more than just an old man rapVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00178 Fmt 6633 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
159

idly manipulating pyrotechnic devices, when you pull back the curtain of off-shore shell companies, it reveals that the banks were

calling the shots and pulling the strings. There is no other conclusion that any reasonable person can reach, I believe, that effective

control of those two off-shore entities were in the hands of the

banks.

This deception was taken a step further when investments were,

in the Yosemite Trust, sold to persons relying on an Enron financial statement which did not disclose these prepays and which

Citibank incorporated by reference in its offering.

Enron desperately wanted the cash to be booked as prepays, real

prepays, they hoped people would believe, but in order for them to

be legitimate prepays, there had to be independent parties, the

third-party entities could not be controlled by the banks, the trades

could not be linked, and the testimony—it is very obvious here

today—shows that they were linked. There had to be price risk.

Plenty of testimony was that they were all hedged, and there was

no price risk. The purchaser of the commodity had to have an ordinary business reason for purchasing it. That surely did not appear

with either of these off-shore entities.

So the reality was hidden from credit rating agencies, from the

public, from outside investors. I do not believe that Enron could

have done what it did in hiding debt and disguising it as cash flow

from operations without the assistance and participation of the

banks.

All of the documents in the record here are going to be referred,

as I indicated, to the SEC and the Department of Justice. We hope

that the Sarbanes bill will cure some of the problems here, but I

think the problem ultimately has got to be addressed internally by

our major institutions. It is a sad day for me, believe me, when two

institutions like Citigroup and Chase, come before us and, instead

of shedding light on what clearly was the intent here of Enron to

turn debt into operational cash coming in, we find the continuation

basically of an insistence that nothing was done wrong here, that

nobody knew that this was intended to be shown as debt, even

though there is no jurisdiction for it—excuse me—it was intended

to be shown as operational income, even though there is no jurisdiction for it according to the criteria which we had set out to be

shown as anything other than debt.

The answer has got to come not just from additional regulation

and laws, although I think they are appropriate, if done sensibly,

but the ultimate answer here has got to be given at least significantly by our institutions, our banks, our boards of directors, our

corporations. This is a pretty sad story, in my judgment. I know

we have not heard the end of it, but we have reached the end of

the hearing. We thank our witnesses for coming forward. It has

been a long day, I hope an illuminating day. That has been our intention.

We will stand adjourned.

[Whereupon, at 7:25 p.m., the Subcommittee was adjourned.]

(161)

THE ROLE OF THE FINANCIAL INSTITUTIONS

IN ENRON’S COLLAPSE

TUESDAY, JULY 30, 2002

U.S. SENATE, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC.

The Subcommittee met, pursuant to notice, at 9:36 a.m., in room

SD–342, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding.

Present: Senators Levin, Durbin, Carper, Dayton, Lieberman (ex

officio), Collins, and Fitzgerald.

Staff Present: Linda J. Gustitus, Chief of Staff, Senator Levin;

Elise J. Bean, Acting Chief Counsel; Mary D. Robertson, Chief

Clerk; Robert L. Roach, Counsel and Chief Investigator; Stephanie

E. Segal, Professional Staff Member; Ross Kirschner, Deputy Investigator; Jamie Duckman, Professional Staff Member; Edna Falk

Curtin, Detailee/General Accounting Office; Rosanne Woodroof,

Detailee/Department of Commerce OIG; Lani Cossette, Intern; Alex

DeMots, Intern; Kim Corthell, Republican Staff Director; Alec

Roger, Counsel to the Minority; Claire Barnard, Investigator to the

Minority; Jim Pittrizzi, Detailee/General Accounting Office;

Meghan Foley, Staff Assistant; Jessica Caron, Intern; Victor

Marsh, Intern; Tim Henseler (Senator Levin); David Berick (Senator Lieberman); Bill Weber (Senator Durbin); Gary Brown and

Bob Klepp (Government Affairs Committee/Senator Thompson);

Holly Schmitt (Senator Bunning); and Jennifer Bonar (Senator

Fitzgerald).

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. Good morning, everybody.

Last week, the Subcommittee looked at the sham transactions

that Enron used to obtain billions in loans from major financial institutions without showing any debt on Enron’s books. The hearing

revealed that the financial institutions not only were aware that

Enron was engaged in misleading accounting but actively assisted

Enron in its deceptions.

The documentation included an internal email from a Chase

banker reporting how ‘‘Enron loves these transactions because it

can hide debt from its equity analysts.’’ We saw how Chase and

Citigroup helped Enron construct false energy trades by providing

offshore entities, effectively controlled by the banks, to participate

as sham trading partners, the banks that then helped orchestrate

multi-party trades with no price risk that canceled each other out

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except for the equivalent of interest payments by Enron on loans

Enron was trying to hide, and the phony cash flow from operations

Enron was trying to magically create.

Chase and Citigroup did more than just help Enron carry out its

deceptions. They also pitched Enron-style phony prepays to other

companies, further spreading into the U.S. business community the

poisonous practice of misleading accounting.

At the hearing, through the witnesses, and after the hearing,

through statements by their CEOs, the two banks claimed this was

all business as usual, reflecting industry practices, and that their

companies acted properly and with integrity, to use their words.

William Harrison, the CEO from Chase, even lauded Chase’s witnesses because, in his words, they ‘‘stood tall’’ in the face of Subcommittee questioning. Neither company has admitted responsibility for helping Enron doctor its financial statements, much less

admit to any misjudgment or wrongdoing.

The evidence presented at the hearing last week, however, was

clear and convincing. And when the banks’ witnesses were confronted with the documentary evidence that showed the banks

knew that the phony prepays were being used by Enron to book

loans as cash flow from operations in order to keep their credit rating and stock prices up, the witnesses worked hard to obfuscate the

plain meaning of their own words.

Look at the testimony last week of Jeffrey Dellapina of Chase

when confronted with a recording and transcript of a phone conversation in which he participated where an Enron employee said

to Mr. Dellapina, ‘‘That goes to the same point you were raising,

Jeff, that from your side you also want to make sure that Mahonia

seems independent.’’ When questioned about the use of the phrase ‘‘seems independent,’’ Mr. Dellapina challenged the taped conversation. ‘‘I don’t believe I would have wanted it to seem independent,’’ he said.

When asked about an internal Chase document describing

Mahonia as a special purpose entity used in the Enron prepays as

‘‘formed by Chase,’’ Donald McCree, a senior Chase official, testified that the words ‘‘formed by Chase’’ were loose and inaccurate.

When Robert Traband of Chase was asked if he would call the

Enron prepays with Chase a circular deal, Mr. Traband testified he

didn’t know. The Subcommittee then played a tape of a conversation involving Mr. Traband where he specifically described the prepays as ‘‘circular.’’ When asked what he meant by that term, Mr.

Traband said, ‘‘I don’t recall.’’

Citigroup often took the same tack of saying its documents didn’t

mean what they said. When asked about a memo in which a

Citigroup employee suggested adding a penny to the price spread

in an Enron prepay to make the prepaid structure a little more like

a trade, Richard Caplan of Citigroup denied that the memo actually meant what it said.

A similar response was given by James Reilly of Citigroup when

he was asked about three different memos regarding the so-called

Roosevelt prepay. In those memos, Mr. Reilly refers to Enron’s undisclosed agreement to repay $125 million by September 30, 1999,

an arrangement that, if known, would have forced recategorization

of the so-called prepay as Enron debt.

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At the hearing Mr. Reilly said, ‘‘ ‘Agreement’ is a word that could

mean different things, and I did not intend to mean that it was a

binding agreement.’’

In one exchange, when confronted with the discrepancy between

what the memo said and what he was testifying to at the hearing,

Mr. Reilly said, ‘‘The memo is wrong.’’ He was, in effect, disputing

the plain words of three contemporaneously written memos.

And, finally, when David Bushnell was asked whether he agreed

that it is the responsibility of a financial institution like Citigroup

not to participate in a deception, believe it or not, Mr. Bushnell

said, ‘‘It depends upon what the definition of a ‘deception’ is.’’

I guess that is what is meant by ‘‘standing tall.’’

So last week, Chase and Citigroup denied the plain meaning of

words in their own contemporaneous documents. Today, looking at

the prepared statement of Merrill Lynch, it is more of that same

approach: Deny the plain meaning of words in your own documents.

Merrill Lynch will say commitment doesn’t mean commitment,

guarantee doesn’t mean guarantee. They mean something else,

maybe best efforts. And loan doesn’t mean loan. It means purchase.

Last week, we showed how two major financial institutions

helped Enron hide debt. This week, we will see how a major financial institution, Merrill Lynch, helped Enron artificially and deceptively create revenue.

But the underlying truth is the same as last week. Enron

couldn’t have engaged in the deceptions it did without the help of

a major financial institution. Merrill Lynch assisted Enron in cooking its books by pretending to purchase an existing Enron asset

when it was really engaged in a loan.

The accounting sham involved the sale of an interest in three Nigerian barges that operated as floating power stations. Enron

wanted to sell these barges before the end of calendar year 1999

so it could report the sales income as earnings in its 1999 financial

statements. But Enron was unable to find a buyer willing to complete the sale before the end of the year.

In mid-December 1999, Enron asked Merrill Lynch as a favor to

set up a special purpose vehicle, subsequently called Ebarge, to

take an Enron asset—barges, or the income that they might particularly create—for a short period of time for a $28 million purchase price consisting of a $7 million cash payment from Merrill

Lynch and a purported loan of $21 million from Enron to Ebarge.

This transaction would allow Enron’s African Division to book sales

income of $12.5 million. Merrill Lynch agreed, but this is the key:

Only after receiving Enron’s commitment that it would find a buyer

for Merrill Lynch’s interest in the barges within 6 months.

Merrill Lynch also received assurances of a 15-percent return on

its $7 million, plus an immediate payment of $250,000. This socalled sale arrangement violated elemental accounting rules which

allow a seller to book sales income only for a transaction that is

a real sale. Enron’s guarantee to Merrill functioned as an ongoing

obligation that kept Merrill from assuming the risks of company

ownership. In a real sale, the risks and rewards of the asset are

completely transferred from the seller.

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The evidence is clear that Enron and Merrill were aware of this

accounting problem, and in order to facilitate Enron booking the

transaction as a sale, it had to keep Enron’s oral guarantees a secret, omitting it from the documentation and leaving it as an oral

understanding.

As the 6-month deadline approached on June 30, 2000, Merrill

Lynch became concerned that Enron would not fulfill its promise.

On the day before the deadline, LJM2, an investment vehicle run

by Enron’s chief financial officer Andy Fastow, stepped in and took

over an interest in the barges from Merrill Lynch at the previously

agreed upon terms. It paid Merrill Lynch the $7.525 million that

had been assured to Merrill by Enron at the beginning of the transaction, the $7 million principal and 15-percent interest over 6

months, and it assumed the $21 million note that Enron initially

loaned to Ebarge.

By the way, Ebarge never paid any interest on that note, notwithstanding loan documents that required it to do so. Three

months later, in September 2000, Enron and LJM2 sold the barge

interest to a third party.

When you look at the elements of this transaction, it is obvious

that it is not a real sale. Through an unwritten side agreement,

Enron provided a guarantee to take Merrill Lynch out of the deal

within 6 months. Merrill Lynch was guaranteed and received a

specified 15-percent return on its $7 million investment. Merrill

Lynch never received the periodic cash flow payments from the operation of the barges as promised under the agreement and never

complained about it to Enron. Ebarge, the Merrill Lynch special

purpose vehicle, didn’t pay any interest on the $21 million loan advanced by Enron. Enron paid all the costs associated with the formation, operation, and management of Ebarge. In other words, the

risks of owning Ebarge weren’t transferred to Merrill Lynch.

This wasn’t the only troubling transaction that Merrill Lynch

had with Enron. In an April 1998 memorandum, two high-ranking

Merrill Lynch employees informed Merrill Lynch’s president, Herb

Allison, that Merrill had lost a chance to co-manage a large Enron

stock offer solely because Enron objected to what Enron saw as a

lack of support by Merrill Lynch’s Enron analyst John Olson. The

memorandum stated that Enron’s decision to deny Merrill’s participation in the offering was ‘‘based solely on the research issue and

was intended to send a strong message as to how viscerally Enron’s

senior management team feels about our research effort.’’

A few months later, Mr. Olson was gone from Merrill. The new

Merrill analyst assigned to Enron then upgraded the Enron stock

from the equivalent of a neutral to a buy rating. A January 1999

memorandum thanked Mr. Allison for telephoning Kenneth Lay at

Enron about Merrill’s ‘‘difficult relationship in research,’’ and it

projected additional fees from Enron now in the range of $45 million.

Earlier this year, Merrill paid $100 million to the New York

State Attorney General for compromising the independence of its financial analysts in a case not involving Enron.

Among the additional business that Merrill Lynch picked up that

year and the next was handling the private placement offerings for

Enron’s off-balance sheet partnerships LJM2 and LJM3. Merrill

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Lynch was not blind to the conflicts of interest raised by these

partnerships, but Merrill Lynch decided to go ahead, and it helped

raise some $390 million for LJM2. The money that Merrill raised

for LJM2 helped Enron inflate its earnings and mislead investors

and analysts in the way that it did.

Merrill described Enron internally as ‘‘one of its biggest clients’’ and ‘‘the key to its Houston office.’’ In 5 years, from 1997 until 2001, Merrill Lynch received approximately $43 million in fees

from Enron. There is nothing wrong with making money honestly.

It is part of the American dream. But making money by assisting

a company like Enron to engage in misleading accounting or by discouraging analysts to provide honest ratings or by touting a questionable investment is more like a nightmare than a dream. It misleads investors, rewards the wrong companies for the wrong reasons, and produces the situation we are in today with the crisis of

investor confidence.

Today, we will inquire why a company like Merrill Lynch would

risk its reputation to do what it did. Hopefully, when the details

come to light, Merrill Lynch will take action against those who participated in deceptions with Enron and will set a firmer, straighter

course for the future.

Senator Collins.

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. Thank you, Mr. Chairman. Today is the second

hearing held by the Permanent Subcommittee on Investigations examining the role played by some of America’s leading financial institutions in the collapse of Enron. Our investigation has revealed

that certain financial institutions knowingly participated in and,

indeed, facilitated transactions that Enron officials used to make

the company’s financial position appear more robust than it actually was, thereby deceiving shareholders, customers, and employees.

Last week, the Subcommittee examined one such type of transaction. Enron and its bankers, JPMorgan Chase and Citigroup, call

them ‘‘prepays.’’ The evidence, however, revealed them to be nothing more than sham transactions designed to obtain, as one of the

banks continued to tout on its website, ‘‘financial statement-friendly financing.’’

Like so many of the other deals at Enron, the apparent motive

was to portray a false image of the company’s financial health. As

NYU law professor and former judge William Allen noted recently

in a speech, banks such as JPMorgan Chase and Citigroup are supposed to play a valuable role in our system of corporate checks and

balances because they monitor debtors more closely than other providers of risk capital. ‘‘Did the lenders not understand that they

were enabling deception?’’ Professor Allen asked. Much to my dismay, last week’s hearing made clear that they did understand but

chose to proceed anyway.

Our focus this morning is whether Merrill Lynch also participated in enabling Enron to deceive the public. There are four aspects of the Merrill Lynch-Enron relationship that we will examine.

The first involves Merrill’s purchase of Nigerian barges with electricity-generating equipment from an Enron-related entity in late

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1999. This transaction allowed Enron’s African Division to meet its

quarterly reporting target and announce to the financial world that

Enron had sold a $12 million asset.

As with much at Enron, though, the reality was a different story.

Merrill’s purchase of the barges was predicated on Enron’s agreement that it would find another buyer for them within 6 months.

Under a Securities and Exchange Commission accounting bulletin

published that very month, such an arrangement clearly did not

allow the seller to recognize the revenue. Handwritten notes by a

Merrill employee warned that there was a ‘‘reputational risk, i.e.,

aiding and abetting Enron income statement manipulation,’’ but,

nevertheless, Merrill went ahead with the deal.

Second, the Subcommittee will examine actions taken by Merrill

management in response to Enron’s complaints that Merrill’s financial analyst had rated the company less favorably than Enron

would have liked. Enron informed Merrill that it would not be selected as a manager or co-manager of a large Enron stock offering

solely because Enron objected to the rating of its equity research

analyst. Merrill appears to have gone to extraordinary lengths to

placate Enron, and subsequently Merrill was indeed added as a comanager of the offering. After the offer went public, Merrill executives kept Enron’s CFO updated on the activities of the research

analyst. On at least three occasions, Merrill actually sent the CFO

copies of the analyst’s internal list of calls that he made to clients

touting the offering. The analyst in question subsequently left Merrill, and his replacement immediately upgraded Enron. This case

raises troubling questions about conflicts of interest compromising

the integrity of the ratings on which investors rely.

Third, the Subcommittee will pursue Merrill’s decision to participate in an Enron loan syndication. Enron sought Merrill’s participation in a deal that had been arranged by JPMorgan Chase, but

had failed to raise the needed $482 million for an Enron-related

company. Prior to the request, Enron had made clear to Merrill

that it was at ‘‘a distinct disadvantage’’ for obtaining future business from Enron because of its reluctance to use its balance sheet

to support Enron’s business activities. Subsequently, Merrill agreed

to participate in the loan syndication despite indications that the

investment would result in a financial loss. Ultimately, Merrill did

indeed lose approximately $1.6 million in the deal.

Finally, the Subcommittee will closely look at Merrill’s dealings

with an off-the-books partnership headed by Enron’s CFO Andrew

Fastow. His investment company, LJM2, asked Merrill to provide

a $10 million line of credit in connection with a $65 million revolving credit facility. An internal Merrill document advocating the

credit request states, ‘‘Committing to this LJM2 facility will build

Merrill Lynch’s relationship with Andy Fastow and assist Merrill

Lynch in securing future investment banking opportunities with

Enron.’’

Other Merrill emails warned against it, citing the lack of a rating

and the nature of the credit risk. Nevertheless, two of the witnesses scheduled to testify before the Subcommittee this morning

requested an exception to bank policy for the loan for the following

reasons: ‘‘Enron is an excellent client, $40 million in revenue in

1999, $20 million in revenue for 2000 year to date. Andy Fastow

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is in an influential position to direct business to Merrill.’’ In the

end, the prospect of more lucrative business from Enron trumped

those at Merrill who urged caution.

As we learn more about how prestigious financial institutions

participated in transactions that allowed Enron to deceive investors, I am reminded of a congressional hearing almost a century

ago with another banker. In 1912, J.P. Morgan appeared before a

House Subcommittee to be questioned about his firm’s banking

practices. He was asked whether it was true that his bank had no

legal responsibility for the value of bonds it sold to clients. He responded that the banks assumed something even more than legal

responsibility—moral responsibility.

Yet, incredibly, last week, when asked by Senator Levin whether

it was appropriate for a financial institution to act in a manner it

knew was deceptive, one banker responded, ‘‘It depends on what

the definition of a ‘deception’ is.’’ It is this sad and telling quote that sums up the attitude of some

professionals on what their duty is in today’s market. This attitude

must change. The day of the deal that serves no purpose other

than to exploit an accounting loophole and the day when the law

serves as the ceiling rather than the floor on the conduct of Wall

Street professionals and corporate executives must come to an end.

It is important to remember that the Enron debacle is more than

just a tale of one company’s greed. As a result of Enron’s downward

spiral and ultimate bankruptcy, shareholders, large and small, individual and institutional, lost an estimate $60 billion. The collapse

of Enron caused thousands of Americans to lose jobs, to lose their

retirement savings, and to lose confidence in corporate America. It

is time to halt the practices that are beneficial to a select few and

harmful to thousands.

I want to once again commend Chairman Levin for his leadership in this important and thorough investigation. It is my expectation that these hearings will yield valuable lessons for strengthening our free enterprise system, restoring public confidence in our

capital markets, and ensuring that small investors in particular

have access to complete and accurate information to guide their investment decisions.

Senator LEVIN. Thank you, Senator Collins, and thank you very

much for your words and also for your and your staff’s participation and support in this investigation.

Senator Lieberman.

OPENING STATEMENT OF SENATOR LIEBERMAN

Senator LIEBERMAN. Thank you, Mr. Chairman. I want to again

commend you, Senator Levin, and you, Senator Collins, and your

staffs for continuing the very important and very insightful work

that this Permanent Subcommittee on Investigations is doing into

the role of financial institutions in Enron’s collapse. As Chairman

of the full Senate Committee on Governmental Affairs, I am proud

of and grateful for the work that you are doing.

Today, we will examine another set of very troubling transactions between Enron and one of the Nation’s leading financial institutions, Merrill Lynch. We are going to be talking about a number of technical issues today, about highly complex agreements and

168

partnerships that improved the appearance of Enron’s financial

statements but kept investors in the dark about what was really

happening at that company before it was too late for most of them

to save their security. But there are, of course, beyond these details, much larger questions at stake here, and I would like to just

speak for a moment or two about them.

For weeks now, our capital markets have seemed like a mountain climber sliding down a hill, drawn by the forces of gravity, trying to find a ledge to break the fall. In the last several days, it appears that the markets have grabbed onto a ledge, but it is too

early to determine whether that ground will hold and the confidence that is the precondition of growth in the markets has fully

returned.

Obviously, one of the main causes of the fall down the mountain

of our markets has been the collapse of investor confidence, which

is to say the inability of average investors to know who or what to

believe.

We Americans are great risk takers. That is what gives our free

enterprise system its vitality, its seemingly endless supply of new

ideas and ambitious people to turn those ideas into opportunities

and wealth, to grow the middle class. But Americans are also great

pragmatists. We don’t part carelessly with our money. We work

hard to understand the difference between intelligent investing and

reckless gambling. And that practicality is aided and based, in the

case of investments, on the honesty and transparency of our markets.

It is that critical blend of hard-charging risk and hard-won trust

that gives our unique brand of capitalism its strength and its stability. Without risk, our economy couldn’t accelerate. But without

trust, it couldn’t stay on the road.

That delicate balance has clearly been upended since December

2 when Enron declared bankruptcy. Enron and its progeny,

WorldCom, etc., have had a terrible effect on that transparency and

sense of trust. It is now equally troubling, of course, to see truly

venerable firms like Merrill Lynch drawn into this web of actions

that have undermined trust in our markets in the long term for

profit in the short term.

Today’s hearing echoes, in fact, several of the concerns raised

during the full Senate Governmental Affairs Committee’s hearing

on February 27 when we examined particularly that day the role

of Wall Street analysts. Today we are going to be examining the

interrelationship between investment firms and research analysts,

and we are also going to hear evidence, as my colleagues have indicated, that strongly suggests a quid pro quo between Merrill and

Enron regarding the analysis that was given by Merrill Lynch regarding Enron’s stock.

The findings presented by the Subcommittee today regarding this

distortion of the analyst ratings process are totally consistent with

the findings of New York Attorney General Eliot Spitzer’s first-rate

investigation into Merrill’s equity research practices. As a result of

that investigation, Merrill Lynch agreed to a $100 million penalty

and promised to reform its practices.

Hopefully, such conduct will now end, not just at Merrill but at

all the other firms involved, as a result of the very strong bill sponVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00188 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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sored and written by Senator Sarbanes that has passed the Senate

and is on its way to becoming law, which contains tough mandates

that should enhance the independence of the Wall Street analysts

that millions of average investors depend on as they decide where

and how to put their money into the market.

Finally, Mr. Chairman, I think it is important to remember again

that today, as the result of a remarkable revolution that has occurred in our country over the last two decades in which capitalism

has truly been democratized, more than half of the American people have a stake in our capital markets, or at least they did before

the recent crisis in confidence among investors. My guess is they

still do. That money is underpinning people’s hopes for funding a

secure retirement, for sending a child to college, or for buying a

house or starting a new business. Just talk to your friends and

neighbors and coworkers, as I have been over the last several

weeks, and you will be able to measure the very personal impact

on millions of Americans that has resulted from the topics that this

Subcommittee is investigating today.

So while the talk may get technical today, the stakes here could

not be more real for millions of American families. And that is why,

Mr. Chairman and Senator Collins, I want to thank you and your

staffs again for your outstanding work in these investigations

which have told and will continue to tell such riveting stories of

corporate fraud and negligence that I am confident that they will

help bring about not just the corrective legislation, but the business

self-regulation that will restore confidence in our markets and help

those millions of Americans I have spoken of realize those dreams

regarding their retirement, their children’s education, and their

hopes in general for a better life.

For that I thank you, and I think that the people of this country

are and will be thankful for the work that you are doing here.

Senator LEVIN. Senator Lieberman, thank you, and thank you for

the support which you have constantly given to this investigation.

Senator Dayton.

OPENING STATEMENT OF SENATOR DAYTON

Senator DAYTON. Thank you, Mr. Chairman. I certainly would

echo the comments of Senator Lieberman to both you and Senator

Collins and your staffs. I think you have done an extraordinary job

in delving into these matters. I think you have uncovered more information that explains the full scope of Enron’s nefarious schemes

than any other entity in the Congress and, to my knowledge, anywhere in the country. I think you have performed, as Senator

Lieberman has said, an invaluable service to our Nation. You have

helped this Subcommittee and Congress attempt to come to a full

understanding of what has occurred here so that we can prevent

it from happening ever again in this country. You have given the

victims, employees, investors, and the public confidence in our financial institutions.

I note that in the beginning many wondered how it was that this

company could have gone so far and concealed so much and built

such a web of financial transactions that proved to be unreliable

and ultimately worthless. It was clear from your previous hearing

that they did not engage in these transactions alone. In fact, they

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1 Exhibit No. 195 which appears in the Appendix on page 2043.

could not have carried out this web of deceit and this scope of financial transactions and deceived so many other parties for so long

without willing collaborators; collaborators who saw it in their financial interest to do so, even at the deception of their own investors, their own other clients, and certainly at the expense of their

own corporate integrity.

The Wall Street Journal yesterday said, and they are not the

type to easily bash business, but they said that with the evidence

they have looked at, the banks, referring to Citigroup and Morgan,

deserve the beating that they are now getting. And I would ask

unanimous consent that this editorial be included in the record,

Mr. Chairman. I think it is unusual and well-deserved support of

the work of the Subcommittee.1

I think it also bears putting it into the record now so that it

helps sets the context that the victims of these schemes that go beyond the corporations involved. As they said here, the investors

who bought into these, the insurance companies, investors in

Enron, the banks’ investors and shareholders, and of course, the

employees of these companies, have suffered from these transactions. Those who put their faith and trust in these institutions

and suffered the consequences were a lot of real, regular Americans. They were not the ones with deep pockets, not the ones who

walk up and down Wall Street, not the ones who have limousine

service and show up every day with three-piece suits. These are

people who work for a living. These are people whose retirements

depended upon these investments. These are people in many cases

whose life savings were wrapped up in these investments. They are

people who had every reason to believe that they were being led

not only to make good investments, but they were being given accurate and appropriate information by those who were counseling

them, including their brokers.

This hearing today, Mr. Chairman and Ranking Member, gets

into, I think, a very important area. Were people who were induced

to invest in Enron and its subsidiaries given accurate information

by those in the know, or was that information compromised by the

very institution that they were relying upon to provide that information?

Both of you have noted in your opening remarks—and we will

delve into it further—the scope of the financial relationship that

Merrill Lynch has evidently had with Enron and its other operations. I note that in its July 26 public statement, the company

seems to take a somewhat different tack in that regard. It notes

that a couple of its employees have been notified that they are subject to a Department of Justice investigation. It says here that Merrill Lynch, however, has been advised that it is not a target or a

subject of the Department of Justice’s investigation, and is cooperating fully with this Subcommittee. It goes on to say Merrill

Lynch’s dealings with Enron were limited. As has been reported previously, they included a $7 million equity investment in a company established to operate energy generation barges and Merrill

Lynch’s role as a private placement agent for the LJM2 partnership. Merrill Lynch strongly believes its dealings with Enron and

171

1The prepared statement of Mr. Furst appears in the Appendix on page 337.

LJM2 were appropriate and proper based upon what it knew at the

time. Merrill Lynch also believes that based on the information

currently available to its employees, its employees also behaved

properly in the Enron transactions.

I think it will be particularly interesting today, Mr. Chairman,

to see how those statements reconcile with the evidence that this

Subcommittee has uncovered.

Thank you.

Senator LEVIN. Thank you so much, Senator Dayton. As always,

you have put your finger on some very, very significant points.

I now call as witnesses Robert Furst and Schuyler Tilney. Mr.

Furst was a former Managing Director for Merrill Lynch at Dallas.

Mr. Tilney is Managing Director of Global Energy and Power, Global Markets & Investment Banking for Merrill Lynch in Houston,

Texas.

The first order of business today is to swear you both in as witnesses, and I would ask you to please stand and to raise your right

hands. Do you swear that the testimony that you will give to this

Subcommittee today is the truth, the whole truth, and nothing but

the truth, so help you, God?

Mr. FURST. I do.

Mr. TILNEY. I do.

Senator LEVIN. You have prepared statements for today informing the Subcommittee that you both are invoking your Fifth

Amendment right against self-incrimination and that you both,

therefore, will refuse to testify today. You may proceed with your

written statements now, and then we will clarify that issue.

First, Mr. Furst.

TESTIMONY OF ROBERT FURST,1 FORMER MANAGING

DIRECTOR, MERRILL LYNCH & CO., DALLAS, TEXAS

Mr. FURST. Thank you, Mr. Chairman, Madam Ranking Member,

and members of the Subcommittee. My name is Robert Furst, and

I appear here today voluntarily. In anticipation of testifying before

you today, I met voluntarily with the Subcommittee’s staff 2 weeks

ago for nearly the entire day. As your staff has no doubt informed

you, I cooperated fully with them, answering all of their questions

to the best of my ability, reviewing a number of documents and

providing information that I believed—and still believe—will assist

the Subcommittee in understanding the investment banking transactions at issue here today. At the time I met with the staff, I intended to appear today and testify truthfully, fully, and to the best

of my ability.

Since I met with the staff, however, I have learned that the matter in which the Subcommittee is interested is also the subject of

an investigation by the U.S. Department of Justice. As much as I

would like to advise the Subcommittee of my view as to whether

there was anything questionable concerning one of the investment

banking transactions my colleagues and I worked on at Merrill

Lynch, my lawyers have advised me that any such statement may

constitute a waiver of my constitutional rights under the Fifth

Amendment. As I am sure the Subcommittee knows, and as my

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1The prepared statement of Mr. Tilney appears in the Appendix on page 338.

lawyers have informed me, the U.S. Supreme Court last year reaffirmed the principle that because, ‘‘truthful responses of an innocent witness . . . may provide the government with incriminating

evidence from the speaker’s own mouth,’’ even innocent witnesses

may assert their Fifth Amendment right not to answer questions.

I, therefore, respectfully advise the Subcommittee that I intend to

assert my constitutional privilege under the Fifth Amendment in

response to the Subcommittee’s questions today.

Thank you.

Senator LEVIN. Mr. Tilney.

TESTIMONY OF SCHUYLER TILNEY,1 MANAGING DIRECTOR,

GLOBAL ENERGY AND POWER, GLOBAL MARKETS & INVESTMENT BANKING, MERRILL LYNCH & CO., HOUSTON, TEXAS

Mr. TILNEY. Mr. Chairman, Ranking Member, Members of the

Subcommittee, my name is Schuyler Tilney, and I am a Managing

Director at Merrill Lynch. As you may know, 2 weeks ago, I met

with Robert Roach, special counsel—excuse me—the majority counsel and chief investigator of the Subcommittee; Gary Brown, special

counsel, as well as other members of the Subcommittee staff. I answered all of the questions they asked me concerning the subjects

of today’s hearings. I believe they would agree that I was fully cooperative and forthcoming about the facts that I knew, and that I

did my best to answer every one of their questions. I met with the

Subcommittee staff voluntarily, and I fully anticipated that I would

appear before you today to answer your questions.

Unfortunately, since that time, I have been advised that one of

the transactions to be covered today is the subject of an investigation by the Department of Justice. Therefore, I have reluctantly accepted my lawyer’s advice to decline to answer questions at this

time based upon my constitutional right not to do so. I am profoundly saddened that I must make this decision, and I am mindful

of the significant personal and professional consequences that follow from my decision not to give testimony at this time. I look forward to the day that I can satisfy all of the concerns the Subcommittee may have on these matters.

Thank you.

Senator LEVIN. Mr. Furst, is it your intention to refuse to answer

any and all questions directed to you by the Subcommittee today?

Mr. FURST. Yes, it is.

Senator LEVIN. Mr. Tilney, is it your intention to refuse to answer any and all questions directed to you by the Subcommittee

today?

Mr. TILNEY. On the advice of my lawyer, it is.

Senator LEVIN. With that understanding, you having invoked

your right to assert your constitutional privilege, you are both now

dismissed.

I will now call Kelly Martin, Senior Vice President and President

of International Private Clients for Merrill Lynch in New York.

Before I administer the oath to Mr. Martin, I will just make one

other comment about witnesses today. We have one other witness,

Dan Bayly, who we invited to testify today who is a current Merrill

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1The prepared statement of Mr. Martin appears in the Appendix on page 339.

Lynch employee and who is familiar with a number of issues being

discussed today. Despite our earlier efforts, his counsel did not

offer to make him available to the Subcommittee staff for a prehearing interview until approximately 9 p.m. last night, and then

for a very limited period of time, which was not an acceptable proposal. Consequently, the Subcommittee staff will be taking his deposition immediately following the close of today’s hearing.

Mr. Martin, would you please stand and raise your right hand?

Do you swear that the testimony you are about to give to this Subcommittee will be the truth, the whole truth, and nothing but the

truth, so help you, God?

Mr. MARTIN. I do.

Senator LEVIN. You may proceed now with your statement.

TESTIMONY OF G. KELLY MARTIN,1 SENIOR VICE PRESIDENT

AND PRESIDENT OF INTERNATIONAL PRIVATE CLIENT DIVISION, MERRILL LYNCH & CO., NEW YORK, NEW YORK

Mr. MARTIN. Thank you, Mr. Chairman.

Mr. Chairman and Members of the Subcommittee, thank you for

the opportunity for me to speak with you today. My name’s Kelly

Martin. I’m a senior vice president at Merrill Lynch and president

of the International Private Client Division. During most of the relevant time period, I was head of Merrill Lynch’s Global Debt Markets Division.

As the Subcommittee has requested, I am here to speak about

Merrill Lynch’s policies and practices relating to its relationships

with publicly traded companies. I was not personally involved in

any of these transactions which will be reviewed today.

As the Chairman said, another Merrill Lynch executive, Dan

Bayly, chairman of Investment Banking, will be available—was

available to testify today and will be interviewed by the Subcommittee subsequently.

I will do my best to answer your questions accurately and from

an overall Merrill Lynch perspective. However, please be advised

that Mr. Tilney and Mr. Furst had primary relationship responsibility with Enron at the time of the transactions in question. We

have addressed in our written statement all the transactions that

the Subcommittee has asked about. For purpose of this oral statement, we will discuss our relationship with Enron, the December

1999 purchase of an equity interest in certain barges, and our overall research coverage.

By way of background, Merrill Lynch believes that our limited

dealings with Enron were appropriate—— Senator LEVIN. Mr. Martin, let me interrupt you just for a

minute. Could you bring that mike as close as possible to your

mouth? A little more.

Mr. MARTIN. How’s that?

Senator LEVIN. Better. Thanks. You are getting there.

Mr. MARTIN. By way of background, Merrill Lynch strongly believes that our limited dealings with Enron were appropriate and

proper based on what we knew at the time. At no time did we enVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00193 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
174

gage in transactions that we thought were improper. We welcome

the opportunity to discuss them with you.

At the outset, all of us in this room recognize the enormous harm

caused by the collapse of Enron. The facts that now have come to

light about Enron, however, were not known at the time of the

transactions discussed below. All of us now have the significant

benefit of hindsight. Our decisions, however, had to be made with

the facts—based on the facts that we knew at the time.

At the time we conducted business with Enron, it was not a discredited, bankrupt company as it is today. It was instead the

world’s leading integrated electricity and natural gas company—a

company of enormous stature and prestige.

In 1999, Enron reported revenues of $40 billion. It was ranked

as the most innovative company in the world for 5 straight years

by Fortune 500 company CEOs, board members, and senior management who participated in this survey. In addition, it was ranked

as the top company for ‘‘Quality of Management.’’ It was literally

the textbook example of a modern American success story.

Moreover, at the time we dealt with Enron, it was known to have

extensive in-house and outside expertise. Enron’s CFO, Andrew

Fastow, had been awarded CFO Magazine’s ‘‘Excellent Award for

Capital Structure Management.’’ Its CEO, Jeffrey Skilling, had

been a partner at McKinsey & Company, a leading management

consulting firm in the world. Enron had one of the most widely respected boards in the country. Arthur Andersen was viewed

throughout the world as a leader among independent auditing

firms. Vinson & Elkins, Enron’s principal outside counsel, was one

of the leading law firms in Texas.

Our firm dealt with Enron at an arm’s-length relationship and

made business decisions based on information that was then available. We relied on Enron’s accountant’s opinions, its board approvals, its lawyers’ opinions, its audit committee oversight, and other

governance processes, and felt justified at the time in believing

Enron’s financial representations. In addition, the transactions

were subject to a significant amount of Merrill Lynch internal approval processes and included review with business, legal, and

other personnel who had no personal stake in the specific outcomes. At no time did we engage in transactions that we thought

improper.

Merrill Lynch’s relationship with Enron. Merrill Lynch is one of

the leading, world’s largest diversified financial institutions. At the

time of 1999, we had revenues of approximately $22 billion. Our investment banking revenues for that year were some $3.7 billion.

Enron was not a significant contributor to Merrill Lynch’s revenues

or earnings. It represented two-tenths of 1 percent of the total average annual investment banking fees for the firm—two-tenths of

1 percent.

Between 1997 and 2001, Enron retained advisers to assist it in

43 strategic transactions. Enron retained Merrill Lynch to act as

adviser on one transaction during the 5-year period of time. At

least 10 other firms performed more advisory assignments for

Enron during this period, including two firms that, added together,

performed a total of 23 such assignments.

175

Although Merrill Lynch participated in debt and equity offerings

for Enron, the relationship was modest. From time to time, Merrill

Lynch also participated in credit lines for Enron. Here, too, however, we had a minimal role. We did not participate in most of the

credit lines, and our commitments to Enron represented less than

3 percent of those deals that we participated in with them. We

were never a lead lender in any loan syndicate. We did not participate in any of the billions of dollars of prepay financing transactions that the Subcommittee examined last week. We discuss

below the transactions that the Subcommittee has asked us to address.

The barge transaction. Questions have been raised whether it

was appropriate for Enron to record a December 1999 transaction

with Merrill Lynch as a sale. In that transaction, a Merrill Lynch

entity—Ebarge, LLC bought shares of a company that entitled

Ebarge to be part of the cash flows from the sale of energy to be

produced by generators on three barges. Merrill Lynch’s investment

exposure in the transaction was $7 million. Merrill Lynch agreed

to the transaction largely to build a relationship with Enron and

believed that it was likely, although not certain, that a third party

unaffiliated with Enron would ultimately purchase Merrill Lynch’s

shares in that company.

Merrill Lynch does not know, even today, whether Enron’s accounting treatment for this transaction was correct. We were not

advising Enron on the appropriate accounting treatment for this

transaction. In general, when we act as a purchaser or a seller, we

are not asked for and do not provide advice on the other party’s accounting treatment; rather, we expect them and their experts to determine the appropriate accounting treatment unto themselves.

This is a market practice and fully in accord with all legal standards. Furthermore, there was no understanding by Merrill Lynch

that Enron or any entity related to Enron would buy back Merrill

Lynch’s shares. In fact, Merrill Lynch had a contrary understanding—that an independent third party was likely to buy Merrill Lynch’s interest.

There was no guarantee, hidden or otherwise, that Merrill Lynch

would receive a certain rate of return. The purpose of not including

a reference to any questions—to any guarantee in the written

agreement was not to hide it; it was because there was no guarantee and Merrill Lynch was at risk. The written purchase and

sale agreement expressly provided that it was the entire agreement

of the parties, and that it superseded any other understanding related to the purchase and sale. Had Enron not succeeded in finding

a buyer for our interest, our only recourse would have been to try

to find a buyer ourselves.

Three, we did anticipate that an independent third party—an

Asian trading company, which we understood was close to agreeing

to the principal terms of the purchase of the shares—would potentially buy Merrill Lynch’s interest, but Merrill Lynch knew that it

was at risk and knew that it had no remedy if the company failed

to go forward and Enron and Merrill Lynch failed to find a purchaser.

Four, the transaction was, in fact, a purchase of equity interest

rather than a loan. Merrill Lynch owned the shares and was at

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risk until it was able to sell or re-sell those shares. Though it

hoped and expected to be able to re-sell those shares at a profit,

it had no guarantee that would happen.

Five, Merrill Lynch played no role whatsoever in determining

Enron’s own accounting for the transaction.

Six, nevertheless, we considered a number of issues presented by

the transaction. Consistent with Merrill Lynch’s internal procedures, the transaction was considered by a committee of individuals that included credit, legal, and other personnel who had no

personal stake in the proposed transactions and who are expected

to consider a wide range of issues and risks raised by a given

transaction. Before deciding to proceed with this transaction, the

committee did what it was supposed to do: It considered the issues,

including whether the transaction could be used to manipulate

Enron’s income statements, and concluded that Merrill Lynch’s

participation in the transaction was appropriate.

Among the factors considered: Merrill Lynch was, in fact, at risk

in the transaction; Enron’s accounting for the transaction had been

vetted with and approved by Enron’s outside auditors; Enron and

its experts were among the most knowledgeable in the world on

structured finance; the transaction itself was so small relative to

Enron, which had $40 billion in revenues in 1999, that it seemed

inconceivable that the transaction could be used to manipulate

Enron’s earning statements.

Research coverage. The Subcommittee has asked about Enron’s

complaint in 1998 concerning Merrill Lynch’s research coverage of

Enron and whether as a result Merrill Lynch’s research ratings

were compromised.

The facts are: In 1998, an internal memorandum indicated that

Enron was not going to invite Merrill Lynch to participate in an

underwriting of Enron’s common stock because Enron was disappointed with our research coverage. The memorandum asked

senior executives to place a call to Enron executives for the purpose

of reconsidering their decision, citing our longstanding relationship

with the company and leadership position in the natural gas industry.

We understand that such a call was made, and ultimately Merrill

Lynch participated as a co-manager in the transaction, which occurred in May 1998.

At no time was Merrill Lynch’s research compromised. In fact,

our analyst retained his intermediate neutral rating throughout

the entire time in question. His neutral rating extended from at

least July 1997 through August 1998, at which time he left the

firm.

In October 1998, after this analyst joined a new firm—after he

joined his new firm, this former analyst initiated Enron coverage

with a rating of accumulate.

In 1998, the Merrill Lynch analyst who assumed coverage of

Enron, along with continuing his coverage of other companies in

the sector, also initiated his coverage of Enron with accumulate.

In 2001, our analyst was one of the first to downgrade Enron.

In conclusion, we thank the Members of the Subcommittee for

this opportunity to come before you today and present information

that may be helpful in your investigation into Enron’s collapse. We

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1 Exhibit No. 208 appears in the Appendix on page 2064.

2 Exhibit No. 244 appears in the Appendix on page 2225.

3 Exhibit No. 258 appears in the Appendix on page 2348.

4 Exhibit No. 259 appears in the Appendix on page 2349.

5 Exhibit No. 256 appears in the Appendix on page 2344.

fully support your efforts and want to assist in restoring investor

confidence in capital markets. Merrill Lynch intends to be an industry leader in helping to ensure that America’s capital markets

are governed by the highest ethical standards.

Had we known at the time what we know today, we would not

have conducted business with Enron. Without the benefit of hindsight, however, and based on the information available to us at the

time, we strongly believe that our actions were appropriate and

proper.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you, Mr. Martin.

Our questioning today will proceed as follows. Senator Collins

and I will each take 20 minutes for questioning. We will then turn

to our colleagues based on the early-bird approach for 10 minute

rounds of questions.

Enron was one of the most aggressive companies asking Merrill

Lynch to put its money to work on behalf of Enron. Enron’s CFO,

Andrew Fastow, made it very clear to Merrill Lynch that investment in Enron ventures was an important part of the relationship

building process. The message from Enron was unambiguous. ‘‘We

give business to people who lend us money and put their balance

sheet to work for us.’’ Merrill Lynch wanted to respond to Enron’s

demands.

Exhibit 208 1—and these exhibits are all in front of you, Mr.

Martin—is a December 1999 memo on the Nigerian barge deal. It

stated that ‘‘Enron views the ability to participate in transactions

like this as a way to differentiate Merrill Lynch from the pack and

add significant value.’’

Exhibit 244 2 is a 2001 memo to senior Merrill officials, reporting

that Merrill Lynch was going to try to put its money to work for

Enron. ‘‘Merrill Lynch agreed to seek ways to commit its balance

sheet to selected situations that were uniquely value added to the

company.’’ Commit its balance sheet. Now, that was simply because

Enron had informed Merrill Lynch of the following. That ‘‘Merrill

Lynch is at a distinct disadvantage because of Merrill’s reluctance

to use its balance sheet to support Enron’s activities.’’

At the same time Merrill Lynch was fully aware of what Enron

was trying to do, structure deals so that debt was hidden off-balance sheet and cash flow was manufactured. Look at what Merrill

Lynch said about Enron deals in discussing a planned $3 billion

public offering. An internal Merrill Lynch memo, Exhibit 258 3 said

the following: ‘‘Enron believes they can structure anything to be off

balance sheet.’’

The Nigerian barge transaction was referred to as a ‘‘balance

sheet deal.’’ That is Exhibit 259.4

In another transaction, Exhibit 256,5 Enron asked Merrill Lynch

to give a special purpose entity a loan that would never be used

‘‘to ensure that the structure receives off balance sheet treatment.’’

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1 Exhibit No. 208 appears in the Appendix on page 2064.

2 Exhibit No. 204 appears in the Appendix on page 2051.

3 Exhibit No. 207 appears in the Appendix on page 2059.

So Merrill Lynch knew full well that Enron was trying to structure deals so that debt was hidden off-balance sheet and cash flow

was manufactured. And yet it still participated in Enron deals.

The first question. Mr. Martin, would you agree that it is Merrill

Lynch’s responsibility not to participate in a financial deception?

Mr. MARTIN. Absolutely.

Senator LEVIN. Now, on the Nigerian barge deal, a subsidiary of

Enron was trying to see projected future cash revenues from 3

barges that it owned in Nigeria. When the sale of that interest fell

through, Enron sought Merrill Lynch’s help in completing a transaction by the end of the year to meet Enron’s revenue targets. If

you look at Exhibit 208,1 this is a memo describing the Enron proposal. ‘‘Jeff McMahon, Enron Vice President, Treasurer of Enron,

has asked Merrill Lynch to purchase $7 million of equity in a special purpose vehicle that will allow Enron Corporation to book $10

million of earnings. The transaction must close by 12–31–99. Enron

is viewing this transaction as a bridge to permanent equity, and

they believe our hold will be for less than 6 months. The investment would have a 22.5 percent return.’’ So Merrill knew that Enron wanted to complete a transaction by the end of 1999 so it could book the $12 million in earnings or $10

million in earnings to assist Enron. A special purpose vehicle was

created called Ebarge to hold the interest in the barges. It is our

understanding that Enron paid all the costs of creating that special

purpose vehicle. Ebarge was funded by a $7 million cash contribution from Merrill Lynch and a $21 million seller-financed loan from

Enron. Ebarge then transferred $28 million to the Enron subsidiary. The issue is whether accounting rules allowed Enron to

show the proceeds from this transaction as income on their financial statement.

Exhibit 204 is a chart.2 According to the first chart which covers

the relevant accounting rules, Enron was prohibited from taking

credit in its books for the barge sale if any one of the following happens: If Enron had significant obligations for future performance to

directly bring about the resale of the Nigerian barge interest by

Merrill Lynch; or if the risks of ownership did not transfer from

Enron to Merrill Lynch; or another factor that can prohibit recognition of a sale is if Merrill Lynch paid no interest on the financing

provided by Enron.

Now, let us just look at the first two points, that Enron guaranteed a resale, and that Merrill Lynch was promised by Enron that

it would receive back its equity investment plus a rate of return.

The documents clearly show a commitment to Merrill Lynch that

it would be bought out within 6 months. Exhibit 207 3 is the internal Merrill Lynch document written by Robert Furst, who was before us earlier today, requesting funds for the barge transaction.

‘‘Enron is viewing this transaction as a bridge to permanent equity, and’’—and here are the key words—‘‘they have assured us

that we will be taken out of our investment within 6 months.’’

Further down on that page. ‘‘Enron will facilitate our exit from

the transaction with third party investors. Dan Bayly will have a

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1 Exhibit No. 209 appears in the Appendix on page 2068.

2 Exhibit No. 218 appears in the Appendix on page 2158.

3 Exhibit No. 219 appears in the Appendix on page 2159.

conference call with senior management of Enron confirming this

commitment to guarantee the Merrill Lynch take out within 6

months,’’ confirming this commitment to guarantee the Merrill

Lynch take out within 6 months.

The conference call did take place, and according to Mr. Furst

and Mr. Tilney, who participated in that call, and who were interviewed by our staff, Mr. Fastow represented during that call that

Enron would get Merrill Lynch out of the deal within 6 months.

That is what Mr. Furst and Mr. Tilney told our staff.

Now, Merrill Lynch continued to represent its understanding

that it had a commitment from Enron. If you will look at Exhibit

209,1 this is a December 23, 1999 weekly Merrill Lynch report

memo. Now, this is a Merrill Lynch document, and here is what

it says. ‘‘Most unusual transaction of the week was IBK’’—and that

is Merrill Lynch’s investment bank division—‘‘was IBK request to

approve Enron Corporation relationship loan.’’ That is Merrill

Lynch’s word, loan. Merrill Lynch asked to invest $7 million in a

Nigerian power project relationship loan.

Within that same internal Merrill Lynch weekly report it said

the following: ‘‘This transaction will allow Enron to move assets off

balance sheet and book future cash flows currently as 1999 earnings, approximately $12 million. IBK was supportive based on

Enron relationship, approximately $40 million in annual revenues

and assurances from Enron management that we will be taken out

of our $7 million investment within the next 3 to 6 months.’’ In

writing, contemporaneously, the word ‘‘assurances.’’ Mr. Furst and Mr. Tilney told our staff that the deal would not

have gone forward without that assurance from Enron.

After negotiations over the arrangement, Enron agreed to repay

Merrill Lynch’s money plus a 15 percent rate of interest and an up- front $250,000 fee, making the effective interest rate 221⁄2 percent.

This understanding on Merrill Lynch’s part continued throughout

the next 6 months. And then as the 6-month deadline approached,

Merrill Lynch’s officials, including those at high levels, raised the

issue of this guarantee.

In a June 13 email, Exhibit 218,2 one Merrill Lynch employee,

who also served as the Vice President, Assistant Secretary and Assistant Treasurer of Ebarge wrote the following: ‘‘As we approach

June 30, I am getting questions concerning Ebarge, LLC. It was

our understanding’’—understanding—‘‘that Merrill Lynch IBK positions would be repaid its equity investment as well as a return on

its equity by this date. Is this on schedule to occur?’’ Note the contemporaneous word ‘‘our understanding.’’

On June 14, just the next day, a Merrill Lynch employee drafted

a letter, reminding Enron of the agreement regarding Ebarge. This

is Exhibit 219.3 It stated, by Merrill Lynch employee contemporaneously: ‘‘Enron has agreed to purchase the shares from Ebarge by

June 30 for a purchase price net of the balance on the loan from

Enron Nigeria Power of $7,510,976.’’ Note the word ‘‘agreed.’’

Now, before that letter was actually sent, Enron called and informed Merrill Lynch that a buyer had been identified. This was

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1 Exhibit No. 222 appears in the Appendix on page 2164.

LJM2. But the situation has repeatedly been made clear. Enron

had made a commitment to get Merrill Lynch out of the barge deal,

and pay Merrill the $7 million and its promised rate of return.

And as the share purchase agreement, Exhibit 222,1 between

Ebarge and LJM2 shows the price paid by LJM2 was $7,525,000,

which is exactly equal to what Merrill Lynch was promised by

Enron, at 7 million in equity, plus a 15 percent rate of return for

the 6 months.

Now, given that, all that, contemporaneous and in writing, and

these are on Merrill Lynch’s own documents. I am not even going

to take the time now to go to the LJM documents which make specific reference to the promise to Merrill that it would be taken out

using the same words by another investor by June. But given all

that, how can you possibly say that there was no understanding by

Merrill Lynch that Enron or any entity related to Enron would buy

back Merrill Lynch’s shares. Do you have personal knowledge, by

the way, of any of this, or are you just giving the statement here

for Merrill Lynch?

Mr. MARTIN. Mr. Chairman, I was not involved in any of these

transactions in any detail whatsoever.

Senator LEVIN. So when you gave the statement earlier, you are

just giving the statement, position of Merrill Lynch, not your own

personal information; is that correct?

Mr. MARTIN. Yes. I’m here—I believe the request of the Subcommittee was to have a senior Merrill Lynch person who could

comment on policy. That was my original role. But I’ll play that

role and any other role—— Senator LEVIN. We of course expected that we would have the direct testimony, which we did not get, but we have the statements

made by the two witnesses who used their Fifth Amendment privilege, the statements to our staff, which I have now reflected, but

I also, in addition to that, have now gone through all kinds of contemporaneous documents which show that there was a commitment, a promise, an assurance, over and over again. Yet it is Merrill Lynch’s position that those words were not true.

Mr. MARTIN. Let me try, in the position that I’m in, to frame that

out from a Merrill Lynch perspective and try to shed some light on

our view, first and foremost of this as an equity investment. And

again, this is from an overall Merrill Lynch point of view. And the

documents that you went through, I have seen some over the last

few days, and in and of themselves each of these documents have

sort of multiple words on them, some with, on the same page,

‘‘loan’’ and ‘‘equity’’, ‘‘equity’’ and ‘‘loan.’’ So I can’t comment on

each and every one of the documents.

But this is what I can shed some light on, again from a Merrill

Lynch perspective. The process internally that we used to make

this decision on the barge was as follows.

Senator LEVIN. Could you pull the mike a little closer, please?

Mr. MARTIN. OK. And again, I think this was instructive how we

looked at things. First and foremost, this transaction went to a

committee internally at Merrill Lynch called the Debt Markets

Commitment Committee, otherwise known as the DMCC. It went

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1 Exhibit No. 216(a) appears in the Appendix on page 2117.

there to be vetted, and it went there for a decision in December.

That committee did talk about this transaction, but they could not

make a decision on the transaction. The reason they could not

make a decision on the transaction is the Merrill Lynch Debt Markets Commitment Committee has no authority to make equity decisions. So it was kicked to—up to Tom Davis, who is President of

the Capital Market Group. And the reason it was kicked up to Tom

Davis in the Cap Market Group is he is the only person—he was

the only person in the investment banking world who can make an

equity decision. So he had to get involved.

Third, where this transaction was booked internally was an area

called IBK Positions, which if you’ve read through this multitude

of documents, was in there in various places. And the only thing

in IBK positions, the only things that can be put in IBK positions

are equity investments. So the decisionmaking process on this

transaction internally at Merrill Lynch, the vetting process internally at Merrill Lynch, the governance process internally at Merrill

Lynch, and last but not least, how this transaction was booked and

where it was booked was equity, equity, equity. With regard to conversations that took place between individuals at Merrill Lynch

and Enron, between various documentation and Enron about guarantees, this is my understanding of the discussions. My understanding of the discussions are that we of course, Merrill Lynch,

are not in the business of buying barges. We are in the business

of making private equity decisions, and we do that, and we do that

in a multitude of things.

The discussions with Enron were we do not want to be in this

investment long term but as a relationship with you, a growing relationship with you, this is something that we will do from an accommodation point of view. From where I sit in the seat I sit in

and the background I have involved with all of these transactions,

I can’t comment specifically on conversations that may or may not

have taken place between various individuals. Thank you.

Senator LEVIN. All the expenses of this special purpose entity

were paid for by Enron; is that correct?

Mr. MARTIN. That’s my understanding.

Senator LEVIN. Is it common for a special purpose entity which

is used by Merrill Lynch to have all of its associated costs paid for

by another entity?

Mr. MARTIN. It is not unusual.

Senator LEVIN. Exhibit 216(a) 1 is the loan agreement between

Enron and Ebarge related to the $21 million so-called loan from

Enron Nigeria Power Holding, Limited. The loan to Ebarge had an

interest rate of 12 percent per year. The first repayment of principal and interest, $773,000, was due April 30. Was that payment

received?

Mr. MARTIN. I don’t believe so, no.

Senator LEVIN. If this were a true equity investment and that interest were due, would not Merrill Lynch have written to the person owing it the money, saying, hey, where is the $773,000?

Mr. MARTIN. Ultimately, yes.

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Senator LEVIN. Not ultimately. I am talking about on April 30

when it was due.

Mr. MARTIN. Mr. Chairman, I mean ultimately. Merrill Lynch

has hundreds and thousands and tens of thousands of these arrangements, so ultimately from the financial accounting department somewhere, they would be sending out a notice.

Senator LEVIN. So if this were a true equity position, that notice

would have gone out, would it not have?

Mr. MARTIN. At some point in time it would have gotten out.

Senator LEVIN. Did it?

Mr. MARTIN. I do not know.

Senator LEVIN. Pardon?

Mr. MARTIN. I don’t know if it went out.

Senator LEVIN. We have been informed it did not go out.

Mr. MARTIN. OK.

Senator LEVIN. Ebarge never made a single one of those payments, neither the principal nor the interest.

Merrill Lynch not only, or Ebarge not only, borrowed the money

from Enron, the $21 million, but to perhaps clarify a point I was

just making, Merrill Lynch did not receive the scheduled cash flow

payments from the operations of the barges as you were supposed

to receive under the terms of the agreement. Is that correct?

Mr. MARTIN. That’s my understanding, yes.

Senator LEVIN. And you never complained about that; is that correct?

Mr. MARTIN. That’s also my understanding.

Senator LEVIN. So this so-called loan to Ebarge from Enron on

which interest was due, Ebarge never received a notice of that, and

the amount of money owed Merrill Lynch, scheduled cash flow payment from the operation of the barges that they were supposed to

receive under the terms of the agreement, they were never received

and there was never a complaint about that as well.

My last question, because my time is up. Ebarge did not have a

bank account, as we understand it, and in February or March

2000, Ebarge was re-domiciled from Delaware to the Cayman Islands at the request of Enron.

Now, if this was a Merrill Lynch company, why did Merrill

Lynch re-domicile it at the request of Enron, and why did Enron

want it domiciled in the Caymans?

Mr. MARTIN. Mr. Chairman, I’m not the—I’m not sure specifically with regard to this transaction why the special purpose vehicle may have been moved from one domicile to another.

I know overall that using the Cayman Islands as a domicile often

has tax advantages for offshore entities, and that is often why

things are moved to the Cayman Islands.

Senator LEVIN. Well, do you know whether or not Ebarge ever

paid U.S. taxes?

Mr. MARTIN. I do not know.

Senator LEVIN. So here in summary appears to be what happened. There is an unwritten side agreement that you have no evidence did not occur, and there is a huge amount of contemporaneous written evidence that it did occur, that Enron provided a

guarantee to take Merrill Lynch out of the deal within 6 months.

Merrill Lynch was guaranteed and received a 15 percent return on

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1 Exhibit No. 212 appears in the Appendix on page 2079.

its $7 million payment. Merrill Lynch never received the periodic

cash flow payments from the operation of the barges as promised

under the agreement, never complained about it to Enron. Ebarge

did not pay any interest on the $21 million loan advanced by

Enron. Enron paid all the costs associated with the formation, operation and management of Ebarge, the Merrill Lynch special purpose vehicle. It is very clear, it seems to me overwhelmingly clear,

that in fact the risks of owning Ebarge were not transferred to

Merrill Lynch and indeed there was never a real sale by any of the

accounting standards which have to be applied before the term

‘‘sale’’ can be applied to a transaction.

And so the December 23, 1999 weekly report of Merrill Lynch,

its own internal report, had it exactly right. This was a relationship loan. The accounting rules indicate it was not a real sale. Merrill Lynch knew it, Enron knew it, and yet Enron booked $12 million in income from the proposed sale or supposed sale, and that

was a deception in its financial statement, and Merrill Lynch was

a participant in that deception.

Senator Collins.

Senator COLLINS. Thank you very much, Mr. Chairman.

Mr. Martin, I realize that you have no direct knowledge of these

transactions, you were not personally involved, and in some ways

I feel that you must have drawn the short straw to be here today.

Mr. MARTIN. I volunteered actually.

Senator COLLINS. But nevertheless the testimony that you presented on behalf of Merrill Lynch raises so many troubling questions, particularly since much of what you’ve presented appears to

be directly contradicted by interviews conducted by the Subcommittee, and by documents from your company.

You started out by saying ‘‘at no time did we engage in transactions that we thought were improper.’’ Are you saying that there

were no red flags that made you think that something troubling or

unusual or deceptive was going on?

Mr. MARTIN. No. We, as is in many of these pages, transactions

all the time have issues, have questions, have risks. So our processes are designed internally to actually vet those before we do the

transaction, and only if—and I want to underscore that—only if we

feel comfortable with all the risks will we go ahead with the transaction from our point of view.

Senator COLLINS. But I do not see how you could possibly feel

comfortable with these transactions given the information that is

provided within your firm’s documents. For example, Mr. Furst told

the Subcommittee that Merrill was very much aware that Enron

needed to try to inflate it earnings and to have a better return for

its African division. There is ample evidence that Enron had significant obligations for future performance to bring about the resale

of the Nigerian barges. And so that raises questions of whether the

risk of ownership ever really transferred from Enron to Merrill.

There is a very persuasive question raised by one of Merrill’s

high-ranking employees, Jim Brown, in Exhibit 212,1 in which he

specifically raises reputational risk of aiding and abetting Enron’s

income statement manipulation. Is that not a huge red flag?

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Mr. MARTIN. These are all—Senator, these are all red flags. Jim

Brown’s notes here talk about questions that he had going into this

committee meeting, the DMCC which I mentioned previously. Foreign tax, environmental, operating performance, failure to complete, foreign ownership, reputational risk, these are all things that

Jim Brown, in his capacity as a senior member of the Merrill

Lynch committee, would have talked and raised about at that committee meeting.

Senator COLLINS. But he specifically raises the issue of financial

statement manipulation.

Mr. MARTIN. Correct.

Senator COLLINS. Did that not put you on guard that Enron

might be cooking its books through this transaction?

Mr. MARTIN. Again, I wasn’t, ‘‘A’’, in this meeting, and ‘‘B’’ in this

transaction, but the way our processes work—and we Merrill

Lynchers spend a lot of time making sure that of the millions of

transactions that we do on a yearly basis, that they are vetted as

thoroughly as possible.

So my assumption is that this was discussed and the various

people sitting around the table, which included legal and credit, relationship management, bankers, corporate finance, that they went

through all of this and they got assurances, either from Enron or

from Enron’s advisers, that these things could be satisfied from our

point of view, Merrill Lynch’s point of view.

Again, we can’t—we can’t impose—we cannot look through our

clients and know everything that they’re going to do with all parts

of their transactions, but we do the best we can to make sure that

transaction at hand for us is vetted properly and as fully as possible.

Senator COLLINS. You seem to imply in your statement that the

answer to the issue of financial statement manipulation was, ‘‘that

the transaction was so small relative to Enron that it seemed inconceivable that the transaction could be used to manipulate

Enron’s income statements.’’ On the one hand that sounds to me

like you are saying it is OK if they cheat a little, but aside from

that issue which is troubling to me, did it not occur to Merrill that

Enron might be engaging in similar transactions with other partners, and therefore, there might be significant implications for the

accuracy of its financial statements? If Enron was pushing so hard

for Merrill to complete this transaction that one of your high-level

employees raised a red flag about the risk to Merrill Lynch’s reputation, why was that not pursued more? Why did it not occur to

Merrill Lynch that this might be the tip of the iceberg?

Mr. MARTIN. A few things in response, Senator. One thing is the

reference to the size of the transaction is—to put it in perspective,

from a Merrill Lynch point of view, and from an Enron point of

view, I suspect, what the singular transaction was, we, in our written and opening statement, were also trying to respond to the Subcommittee’s questions about our, Merrill Lynch’s knowledge and active involvement with Enron in their own manipulations, which is

clearly not true.

Red flags, to your question on red flags. Enron was a very aggressive client. Enron was, as I said in the opening statement, recognized by everybody in the United States and perhaps globally,

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1 Exhibit No. 208 appears in the Appendix on page 2064.

2 Exhibit No. 209 appears in the Appendix on page 2068.

from Wall Street to government to consulting to academia as the

future way that American companies could potentially be run. It

was $40 billion in revenue. It was an aggressive company. Their

whole thesis, as stated publicly in multiple situations, was physical

assets aren’t needed; financial assets and off-balance sheet assets

are the way to go. That was stated everywhere in every article

about Enron and their philosophy about how to build their business.

So clearly, we were focused on working with them as a growth

company, as a big company, as a seeming industry leader, certainly

in their industry and corporate America. We, however, had never—

never at any one point in time would we do something that we

thought would be wrong, but there would be no way that we could

possibly know, with a $40 billion company, all the various transactions that they were doing.

Senator COLLINS. Let me tell you of another red flag that was

raised by Merrill Lynch. Mr. Furst raised the issue of how a $7

million sale of these barges could be booked as $10 million or earnings. Could you explain why that did not cause concern?

Mr. MARTIN. No. Again, I think—I do not know where that comes

from but——

Senator COLLINS. It is Exhibit 208.1

Mr. MARTIN. We knew—Exhibit 208?

Senator COLLINS. Yes.

Mr. MARTIN. What we are most concerned about at Merrill Lynch

is the $7 million of risk, which is why I went through, somewhat

painstakingly, where we booked the transaction. You know, once

again, I don’t have a comment on what Enron would book in their

financial statements on their books and records based on either

this transaction or any other transaction.

Senator COLLINS. On page 7 of your testimony you state that the

transaction was in fact a purchase of an equity interest rather than

a loan, correct? That was your testimony today?

Mr. MARTIN. Yes, Senator.

Senator COLLINS. I would like you to look at Exhibit 209,2 the

second page. It is a Merrill Credit Flash Report, and there is a

summary that clearly describes the Nigerian barge transaction as

a loan. It says, ‘‘The most unusual transaction of the week’’—I

guess we should take some comfort that it was unusual—‘‘the most

unusual transaction of the week is the IBK request to approve

Enron Corporation relationship loan.’’ How is it that Merrill Lynch

is maintaining this morning that this was the purchase of an equity interest, when the credit flash report put out by Merrill Lynch

describes it as a loan?

Mr. MARTIN. Senator, if you’ll look down on that page in the first

sentence, the same page, it says: ‘‘Requested by Enron Corporation

to make a $7 million equity investment.’’ There are other documents that have both—as I said to Mr. Chairman, there are documents that use the words ‘‘equity’’ and ‘‘loan’’ and ‘‘commitments’’

quite interchangeably, which is why I, from my seat, and what I

can help you with from an understanding point of view, is if you

186

follow how we made the decision to do this transaction, who can

make a decision how the decision was made and where the decision

ultimately—where the transaction was ultimately placed within

Merrill Lynch, it was all equity. So the language on all of these

various pages is actually somewhat contradictory almost on each

and every one of these pages. So on the same page, after they talk

about a relationship loan, they talk about a $7 million equity investment.

Senator COLLINS. I want to follow up on the question that Senator Levin asked you about the understanding that Merrill Lynch

had that there would be a resale of the barges within 6 months

time. You testified that there was no understanding by Merrill

Lynch that Enron or any entity related to Enron would buy back

Merrill Lynch’s shares. And you go on to say that, in fact, Merrill

Lynch had a contrary understanding that an independent third

party would likely buy Merrill Lynch’s interest.

My first question is then, regardless of whom you thought the ultimate purchaser was going to be, the clear understanding was that

you were going to be stuck with these barges for only 6 months;

is that correct?

Mr. MARTIN. Again, I wasn’t involved specifically in this transaction, but the—it is my understanding that the discussions with

Enron went along the lines of initially continued to increase the

business relationship. They needed us to do something with regard

to these barges. We are not in the business of buying barges. We

can do equity investments. We obviously had discussions with

Enron that we would like their help in getting out of this investment, and it’s their business and they know the industry, and as

a leading corporation in this sector, they would be most likely to

help us. But we were fully prepared, again, fully prepared as a corporation to take that $7 million investment, and potentially over

time, write it down if we still had to carry it.

So there was a hope, and there was an anticipation that we could

get out of this investment over the course of 6 to 12 months, but

again, I—from all of the things that I understand, there were not

very specific timelines with regard to specific dates.

Senator COLLINS. In fact, was there not an understanding that

Enron was responsible for finding a buyer?

Mr. MARTIN. Again, I believe the understanding was that Enron

would go to great lengths to help us seek a potential other buyer

for this asset. They had been working very closely with, as I said

in the opening statement, an Asian corporation who was a potential buyer of these barges, and got very close, apparently, to being

able to make the purchase. So we were relying on Enron’s expertise

in their own industry to help us find potential other buyers over

time, which is correct.

Senator COLLINS. Mr. Furst told the Subcommittee that without

the guarantee or assurances that Enron would find a buyer for the

barges within that set time, Merrill would not have gone through

with the deal. Do you contest the accuracy of that?

Mr. MARTIN. I don’t actually know Mr. Furst, so I don’t know exactly what he said or didn’t say. I suspect, again, from a point of

view of process, what would have been asked of the investment

bankers is if we have to make an investment, a private equity inVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00206 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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vestment to enhance a client relationship, how over time are we

going to get out of this? So from his point of view as an investment

banker trying to do a transaction, he may have had that view. I

don’t think necessarily that would have been the Merrill Lynch &

Co. view.

Senator COLLINS. Are you aware that other Enron employees

were becoming concerned as time went on that Merrill Lynch was

still stuck with the barges and, in fact had drafted a letter about

the possible resale of the barges back to Enron or some other

party?

Mr. MARTIN. I was not aware, no. These are Enron concerns.

Senator COLLINS. These are Merrill Lynch concerns to Enron.

Mr. MARTIN. Some of the——

Senator COLLINS. Expressed to Enron, that there still had not

been a buyer.

Mr. MARTIN. Some of the documentation that the Chairman

walked us through were from different parts of Merrill Lynch,

some accounting, some finance, some banking, and it is not unusual, particularly in finance and accounting, that they have certain things that they are supposed to track. So their concern would

be—they would be doing their job based on what they were told as

far as expected returns and expected exit of the investment.

Senator COLLINS. The reason this issue is so important is that

if this is not a true sale, then it violates the Generally Accepted

Accounting Principles for Enron to represent it as such, and it also

violates the SEC bulletin on revenue recognition and financial

statements. It seems to me that the deal had four characteristics

that suggest that this was not a true sale. First, Enron did have

significant obligations for future performance to directly bring

about the resale of the barges. Second, the risks of ownership do

not, in my judgment, seem to have truly been transferred from

Enron to Merrill, given that agreement. Third, Merrill did not pay

interest on the financing provided by Enron. And fourth, Enron appears to have paid all of Merrill’s costs of the transaction. Do you

disagree with any of those facts?

Mr. MARTIN. Well, I think, Senator, the question you are asking

me is from Enron’s point of view, and Enron and their advisers, accounting advisers, was this a true sale from their point of view, is

not something that we, Merrill Lynch, spent a lot of time on. What

we spent our time on was, again, we—it was our understanding

that we had an equity investment, that we had to book it in the

right place, that we had to have an exit strategy, that we needed

help on the exit strategy. And that was our concern. Our concern

was for Merrill Lynch shareholders, that $7 million, and make sure

that the $7 million was booked the right way and that there was

some rational strategy to get out of it.

Whether that was from an Enron point of view proper GAAP accounting, is it’s an Enron and Enron adviser topic.

Senator COLLINS. I just cannot accept that answer when one of

your employees raised the issue of whether Enron was using this

transaction to manipulate its financial statement.

Mr. MARTIN. Correct. That was one of—in Jim Brown’s statements of the questions he had, I’m sure—again, I wasn’t in that

meeting and I wasn’t listening to all the dialogue around his conVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00207 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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cerns, but there must have been conversation around that specific

topic, that he got comfort that that actually couldn’t happen from

our standpoint.

Senator COLLINS. Thank you, Mr. Chairman.

Mr. MARTIN. Thank you.

Senator LEVIN. Thank you, Senator Collins. Senator Lieberman.

Senator LIEBERMAN. Thanks, Mr. Chairman.

Mr. Martin, thanks for your testimony. I must say that in the

testimony today, which I gather is on behalf of Merrill, that people

at Merrill essentially had no idea at the time that any of the interactions between your firm and Enron were questionable or that

Enron might be engaged in deceptive and improper activities. After

reviewing the Subcommittee’s findings and listening this morning

to your testimony and answers to the questions Senator Levin and

Senator Collins have posed, I must tell you that it is hard to see

how an experienced, respected, sophisticated company like Merrill

Lynch missed what was going on here.

Let me just take this LJM2 agreement interaction, for instance,

that people at Merrill knew because the firm was the private placement agent, because Merrill was itself an investor, and because almost 100 of Merrill’s employees were investors in LJM2, that Mr.

Fastow was on both sides of LJM’s transactions with Enron. In

fact, Merrill apparently advertised that fact in its private placement memorandum. And Merrill also said in the memorandum

that two other gentlemen, also Enron finance insiders, Mr. Kopper

and Mr. Glisan, would also be managing LJM. Later, when Merrill

was trying to sell the Nigerian barges that it temporarily bought

from Enron, it was LJM2 that bought the barges from Merrill, so

there was awareness there as well.

So I must say it is hard for me to understand how Merrill Lynch

did not understand that LJM, in its transactions, for which Merrill

provided hundreds of millions of dollars in financing, represented

a very risky and questionable corporate strategy for Enron, or is

the point here really—and again, this is hindsight—that that did

not matter to Merrill Lynch? In other words, as you said at one

point, that Merrill Lynch was evaluating risk to Merrill Lynch in

this series of transactions with Enron and its spinoffs, and not risk

to the investors in Enron as a result?

Mr. MARTIN. Senator, thank you for the questions. Broad topic of

LJM2, it’s quite a broad topic. First and foremost we were the

placement agent, which means we found people who were interested in this concept with these people for these type of investments in primarily the institutional market, some fairly sophisticated investors. We, again, in our own corporate due diligence, we

raised the flags significantly about how Mr. Fastow, how are we to

be—how was it going to be made clear, and how was Enron going

to ensure that there was in fact no conflict, and how could they

govern that? How could they actually govern the fact that they had

a CFO who was in Enron and also was the managing partner for

what in and of itself was a private equity alternative investment

fund? We debated that internally, and again, in some of these

records here that I’ve become familiar with, we even had a call

with Jeffrey Skilling, the President of Enron, to say, ‘‘How are you,

Mr. Skilling, going to make sure? Are you comfortable with this?

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Are you comfortable that there is a Chinese wall, that decisions

will not be compromised, that it will not be to Enron’s detriment

or benefit and vice versa for LJM2?’’ His answer, again—and this is my understanding, having not

been involved in all these conversations—his answers were very

clear, that he knew all about how this was set up; he was extremely comfortable and had a lot of confidence with Mr. Fastow

and the dual roles he was going to play; that it was vetted and approved by their own board of directors and it was vetted and approved by all their various advisers.

So I agree with your question/statement that we, Merrill Lynch,

should have had red flags on the LJM2 contract. We did have

them. We vetted them as far as we possibly could.

With regard to the complication within LJM2 and what exactly

was going on in LJM2, the type of constructs, the type of financing,

the type of assets, I would offer up that we didn’t understand actually what was going on in LJM2, we, Merrill Lynch, but I would

also offer up that nobody did, because there were other people who

invested in LJM2 who were at least as sophisticated as Merrill

Lynch. We all got the statements about their investments. We all

got the updates with regard to what kinds of transactions they

were doing or not doing. None of us spotted, or none of us connected the dots from activity in LJM2 and the potential consequences on both LJM2 and Enron. We just didn’t—we either

didn’t connect the dots or we didn’t necessarily know all the connections, but we didn’t, and none of the other investors in LJM2

did either.

Senator LIEBERMAN. Here is my concern about that. The more I

hear about this case, the more it seems to me that Enron, perhaps

not uniquely, but Enron was like a poisonous spider spinning a

web for its own benefit, in which it was engaging and entrapping

a whole host of very reputable financial institutions, including your

own, but your entrapment was not unknowing, or in some sense,

unwilling, because the web that—the poisonous web that Enron

was spinning, nonetheless had some attractive qualities to it for

you. It had a business relationship, it had fees. And that ultimately

what Merrill was doing was what at the base level one expects a

business to do, which is to protect itself from undue risk.

But the question is, because it just does seem to me that you had

an access to so much inside information as a result of your participation in these deals—and I do not mean improper inside information—I mean the kind of information, you know, the poor suckers

as they turned out to be who were investing their 401(k) plans or

institutional investors who were investing hundreds of millions of

dollars in Enron did not have, and the information that the board

of directors of Enron and the auditors and all we now know were

not aggressively, independently trying to get out to the public, that

one of the breakdowns in the system here was that great companies like Merrill Lynch did not blow the whistle, did not accept that

extra measure of responsibility and say, ‘‘Hey, we are protecting

our risk in this deal with Enron and LJM and LJM2, but this thing

stinks, and maybe we do not see the whole picture.’’ We could not

see the whole picture of what Enron was up to; you could not see

the whole picture.

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But should not folks at Merrill have seen enough to have said, ‘‘Hey, we do not want to be part of this,’’ because in the end maybe

you ended up aiding and abetting the improper, perhaps illegal behavior of the executives of Enron?

Mr. MARTIN. I think, Senator, that again trying to go back, it is

hard to go back in time, very hard. I take your point and that is

a level and a role that Merrill Lynch frankly aspires to play which

is over and above the next transaction or the next 10 transactions.

What is in the long-term best interest of—at Merrill Lynch, our clients and frankly the markets themselves, and we have tried to

play that role, not just in the United States, but around the world.

Speaking purely personally—and my dealings with Enron were

quite limited—it was a very complicated company. We, for a living,

are financial experts or parts of financial experts. Clearly in hindsight, it would have been great to put this whole puzzle together

and blow the whistle. It was a very hard puzzle. It was almost a

multidimensional puzzle. It is a role that we aspire to play. It is

a role that we try to play, frankly. And for the snippets of information that we had—and I hear what you say about inside information, legal inside information—the balance sheets, the tax structures, the operating complexity of these type of companies are geometric, no one counterpart, be it commercial bank or investment

bank, for a company like Enron was, frankly could ever see enough

to actually know that whole dimensional puzzle.

Senator LIEBERMAN. Let me interrupt you because my time is up.

But I want to ask you—my colleagues will come, I am sure, to the

question of the relationship between Enron and the analyst at Merrill who was giving the adverse ratings on Enron, and what

Merrill’s executives’ conduct toward them said about what you

knew about what was happening there.

But my final question, and I ask for a brief answer. This is one

of those knowing all we know now, and having been through the

torment the market and the economy has been through as a result

of Enron and its progeny, has anything changed at Merrill Lynch?

In other words, if you saw what you saw, if today this deal came

in, would it raise enough red flags so somebody at Merrill would

have said, ‘‘We can protect our risk. Merrill’s going to be all right

in this deal, but this thing smells and we should not be part of it?’’

Mr. MARTIN. Senator, we are continuously changing and trying

to improve all of our processes. The processes that we went

through on all of these transactions were as complete as we could

make them at the time with the information we had at the time.

Again, in perfect 20/20 hindsight, we would have the same processes and spend more time on them and have more discussion on

them, and hope to get the answers that were more complete in this

multidimensional puzzle called Enron.

Senator LIEBERMAN. Well, I hope that if one like this came

through the door today, that the folks at the top would make sure

the folks who were dealing with it would blow the whistle. Thank

you.

Mr. MARTIN. Thank you.

Senator LEVIN. Senators Dayton, Fitzgerald, Durbin, and Carper,

in that order.

Senator DAYTON. Thank you, Mr. Chairman.

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1 Exhibit No. 239 appears in the Appendix on page 2206.

Mr. Martin, I do not agree with the view that you drew the short

straw to be here. It seems to me, based on your comments and lack

of direct knowledge about these events so far, that you were selected very carefully to represent the company. They selected you

because of your minimal knowledge of the events and incidents

about which you were going to be asked today so that the company

could issue a press statement saying it was cooperating fully with

the Subcommittee, when it was in fact providing as little information and confirmation or informed a denial as possible. I just want

to say for the record, I do not consider that to be cooperating with

the Subcommittee at all.

Since you do not really have any of the answers based on your

lack of involvement, I am not going to ask you many questions. I

would like to put into the record and at the end get your overall

observation on this matter regarding the analyst who did not give

Enron the rating which they thought they were deserving, going

back to 1998. I also note, just to set the context, you refer to how

little the financial relationship was with Enron for Merrill Lynch.

You, throughout your testimony on behalf of the company, minimized that relationship, but yet these memoranda and that subsequently stressed some of these deals which others have referred to

and others which are questionable on their nature, questionable on

their value as stand-alone transactions, refers to Enron, for example, one memorandum has one of the most critical relationships in

the Houston office, also in another matter refers to Enron as providing $40 million in revenues for Merrill Lynch in 1999 and $20

million to be expected in the year 2000. These are not insignificant

amounts of money. It seems clear that one of the reasons to engage

in some of these transactions on Merrill Lynch’s account was in the

hopes of obtaining additional financial relationships with the company in subsequent years. There is nothing wrong with that unless

the transactions themselves are wrong.

But this particular matter is a memo from Rick Gordon and

Schuyler Tilney to Herb Allison. It is dated April 18, 1998. It is Exhibit 239.1 It is on Merrill Lynch stationery and it is an interoffice

memorandum, so I assume it is an accurate or valid document. It

is asking Mr. Allison to call two senior executives of Enron, Ken

Lay, the Chairman and Chief Executive Officer, and Jeff Skilling,

President and Chief Operating Officer, regarding Merrill Lynch’s

participation in Enron’s contemplated $750 million common stock

offering.

It goes on to say, ‘‘Enron was notified approximately 6 weeks

ago’’—this is April 1998—‘‘by Moody’s Investor Service, that it is

considering downgrading Enron’s debt due to the increase in the

company’s leverage over the past few years. After several meetings

with Moody’s to better understand its concerns, Enron determined

that it needed to undertake a large common stock offering to avoid

a credit rating downgrade. The company is extremely sensitive

with regard to the confidentiality concerning this transaction. Past

equity offerings undertaken by the company have been leaked in

advance of the offerings with negative consequences to the stock

price. Therefore, Enron solicited advice from only Merrill Lynch reVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00211 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
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garding the size and terms of and market receptivity to the offering. We were obviously apprised of the transaction in the strictest

confidence and were informed that no other investment banks

would be contacted in order to lessen the likelihood of a leak.’’

It goes on to say that ‘‘the expectation at Merrill Lynch, which

is certainly understandable, is that they would be selected by

Enron to serve as the lead manager.’’ Given that they were the

only investment bank to be contacted for advice on the transaction,

that would be my knowledge and experience, a very reasonable expectation.

‘‘However,’’ it goes on to say, ‘‘our research relationship with

Enron has been strained for a long period of time. Our equity research analyst at Enron is John Olson. He has a poor relationship

with Jeff, and particularly Ken for several reasons.’’ This being Ken

Lay, the Chairman and Chief Executive Officer, and Jeff Skilling,

President and Chief Operating Officer. Those are pretty high-level

people in this $40 billion Enron company to have a poor relationship with.

It goes on to say, ‘‘Enron’s Chief Financial Officer, Andy Fastow,

called last night to inform us that Merrill Lynch would not be selected as lead manager of the offering, and further, that we would

not even be included as a co-manager. He stated that the decision

was based solely on the research issue and was intended to send

a strong message as to how ‘viscerally’ Enron’s senior management

feels about our research effort.’’

Now, this was pretty apparent that Enron plays hardball or

played hardball. Here is the Chief Financial Officer calling to inform your associates that after all this work, after all this advice

on a very confidential basis, you are not going to be the lead manager. You are not even going to be a co-manager because they are

just unhappy with the rating that the analyst has been giving the

company. It is a rating which would seem to be warranted by the

very transaction here. You had been asked to advise and were rejected from participation, mainly to issue a large common stock offering in order to avoid a credit rating downgrade by Moody’s,

which would certainly have a major impact on the price and value

of the stock.

So all of this seems to be, quite understandably, troubling to

Merrill Lynch and to others. Mr. Olson, as you note in your testimony, then, without changing his rating, leaves in August. It may

be a coincidental event, but it does raise some questions as to exactly why he departed from Merrill. Then his successor, who your

testimony notes did not issue a revised rating or an upgrade until

November. It is surprising that you would leave such a major company without someone following it on an active basis or issuing an

immediate revision to the rating. There is a gap there from August

to November, and maybe you can fill in that gap.

But the fact is that the rating was increased by your successor

analyst, is an institutional rating, and is backed by Merrill Lynch.

It is not Mr. Olson or his successor as an individual. It has all the

backing, all of the prestige and all of the credibility of Merrill

Lynch in terms of its clients and others who are aware of those recommendations.

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1 Exhibit No. 240 appears in the Appendix on page 2209.

It certainly seemed to have had a beneficial result with regard

to the relationship with Enron. There is a memo from Mr. Tilney

to Mr. Allison, Exhibit 240,1 on January 15, 1999; after these various personnel shifts have taken place. It says, ‘‘On a positive note,

I want to update you on recent developments in our relationship

with Enron, since you spoke to their CEO, Ken Lay, last spring regarding our difficult relationship and research. It is clear that your

responsive message was appreciated by the company, and any animosity seems to have dissipated in the ensuing months. To that

end, we have recently been awarded two significant mandates by

Enron; the first to lead-manage the $1.5-billion IPO of their water

company, which is expected to file in late February, and the second

to raise a $1-billion private equity fund on behalf of the parent,

which is expected to kick off in early March. Total fees to Merrill

Lynch for these two transactions alone should be $45 to $50 million.’’ These are pretty high-stakes evaluations then that your research

analysts make. Does this happen on a regular basis that the chief

financial officers of companies call to inform your one side that

they are not going to be invited to be a lead manager because they

are dissatisfied with a rating that has been given by your research

analyst? Does that typically result then in the departure of the research analyst a couple months later and a subsequent upgrade in

the rating? Is that a common occurrence at Merrill Lynch or is this

unusual? Do you have any knowledge of that aspect of the company?

Mr. MARTIN. Senator, let me answer a few of your initial concerns, and I will get to that. First of all, Merrill Lynch

cooperates—— Senator DAYTON. I would like you to answer the question I just

asked. Is this a typical occurrence or not?

Mr. MARTIN. It is a typical occurrence for a CFO of a corporation

to follow extremely closely what all of the analysts are saying.

Senator DAYTON. That was not my question, sir. My first

question is, is it a typical occurrence for the CFO to call and inform

your investment bankers that they will not be selected to be the

lead manager because they are viscerally dissatisfied with the rating that the company has provided?

Second, is it typical then that the analyst involved, who did not

change his rating, departs within a couple of months after that

matter?

Third, is it typical that the successor analyst raises the rating?

Fourth, is it typical then that it is followed by these kinds of

awards by the company? Those are the four questions.

Mr. MARTIN. It is not atypical to get investment banking business with research being part of that decisionmaking process.

Senator DAYTON. If your rating of the company is good enough,

then you get the investment banking business? If your rating of the

company is not good enough, then you do not get the investment

banking business?

Mr. MARTIN. If your following of the company is complete, if your

following of the company is consistent, if your following of the comVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00213 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
194

pany is reflective of what the company thinks of their story, it is

part of their decisionmaking process who then would get investment banking business. That is absolutely true.

Senator DAYTON. Is that practice typical in your company and in

the industry, as you know it?

Mr. MARTIN. It is typical that the research topic is part of the

investment banking process. That is typical both at Merrill Lynch,

and I assume for the rest of the industry.

Senator DAYTON. So you and the company are typically then

placed under enormous pressure, if you want these very lucrative

investment banking awards, to have your rating of the companies

reflect the positive regard with which the executives or the management of that company wants to be evaluated.

Mr. MARTIN. I think the investment banking clients want the research analysts to understand their company and reflect that accurately, as opposed to the ratings.

Your second question, I believe, Senator, was or one of the questions was, in research coverage, the gap August to November. What

happens at Merrill Lynch—I can’t speak for the rest of the Street—

is when a new analyst takes over a company, they need time to

analyze the company, which is what happened and is very typical.

Senator DAYTON. I accept that that is the case.

Do you know any of the circumstances concerning the departure

of Mr. Olson?

Mr. MARTIN. I know some of them. I believe what occurred within the Research Department was, because of the way the energy industry itself was starting to segment, you had trading companies,

you had physical companies, you had financial companies, that we

reorganized our research group, and we put under one analyst four

or five companies that were similar. So we had Enron, and Coastal,

and Williams and several other companies that, to us and to the

analyst community, looked similar, as far as activity goes.

Senator DAYTON. I have one other question regarding a transaction in April. Mr. Tilney sent copies of Mr. Olson’s Enron call list

to Mr. Fastow when Mr. Olson was under some scrutiny, and this

transaction, the sale of the additional stock was going through.

These are, I assume, clients of his or Merrill Lynch’s that he is calling to pitch or at least make aware of this offering, but he is also

the analyst who is providing the rating at this point, which is, unless he has changed it, really, not a neutral, not a buy.

Is this typical also that the call sheets are sent to the—— Mr. MARTIN. Yes.

Senator DAYTON. So that they are aware that he is on board sufficiently enough that he is pitching the company and the stock sale,

even though he does not approve of it?

Mr. MARTIN. His rating, actually, specifically was neutral short

term, and positive long term. So he had a one rating as far as a

long-term investment. It is typical and accepted practice that in an

offering, whether it is equity or debt, that our marketing effort and

who we talk to would be shared with particularly the CFO, who is

particularly interested in who is buying the stock or who isn’t buying the stock, and why not.

Senator DAYTON. So he is rating the company, and that is the official Merrill Lynch rating of the company. He is also pitching the

195

1 Exhibit No. 212 appears in the Appendix on page 2079.

sale of the stock. Is he aware then that the sale of this or the

issuance of this stock is for the purpose of satisfying Moody’s and

bringing down the debt-to-equity ratio of the company? Is he aware

of that when he makes these pitches?

Mr. MARTIN. I am not sure what he would or would not have

been aware of, but clearly—— Senator DAYTON. The others were aware. The people in the investment banking side were aware.

Mr. MARTIN. There would be a Chinese wall between certain information that he would or would not have. He clearly would know

there would be an equity issuance coming.

Senator DAYTON. There was not a Chinese wall, though, when

Mr. Fastow called to basically tell you that he was dissatisfied with

the rating; therefore, he was not going to give you the business. I

mean, he is effectively bridging that wall.

Mr. MARTIN. The Chinese wall is an information wall.

Senator DAYTON. I find your comments, then, and I take you at

your word, sir, about the commonality of this matter to be extremely disturbing. My time has, I guess, expired, so I will relinquish the microphone, but I think if this is the case, Mr. Chairman,

that this is typical, then I think it raises a serious question whether the ratings that investors are depending on have any credibility

whatsoever. It seems like it is a free-for-all and a very intense competition to get the very lucrative investment banking relationships

and to increase the profits from them. Therefore, the analysts or

the companies are evidently under severe pressure from the companies that they are rating to make those ratings conform to the company’s desires or they are going to lose the business, and I think

that is very alarming.

Mr. MARTIN. Senator, let me just follow on that the ratings, and

who can change ratings, and when to change ratings is completely

controlled by Compliance. As and when there are activities going

on, the ratings get frozen. There is a black-out period where ratings cannot be changed up or down if there is an activity, if there

is a capital market activity going on.

Senator DAYTON. But the fact is, your subsequent analyst raised

the rating of the company, and Merrill Lynch was rewarded, as the

January 1999 memo indicates, with a couple of very lucrative investment banking relationships with Enron. So there was definitely

a very direct reward immediately following that change.

Thank you, Mr. Chairman.

Senator LEVIN. Thank you. These are disturbing questions, indeed, that you have raised. Senator Fitzgerald.

Senator FITZGERALD. Mr. Martin, thank you very much for testifying today.

Mr. MARTIN. Thank you.

OPENING STATEMENT OF SENATOR FITZGERALD

Senator FITZGERALD. I would like to turn your attention to Exhibit 212 in your book.1 Exhibit 212 is a fax from Rob Furst, who

was in your Dallas office, to Jim Brown at Merrill Lynch. Can you

tell me who Jim Brown is? Do you know?

196

Mr. MARTIN. Senator, Jim Brown, I believe, has been or is the

senior person in charge of Structured Finance.

Mr. FITZGERALD. Senior person in charge of Structured Finance?

Mr. MARTIN. Structured Finance.

Mr. FITZGERALD. Where is he located?

Mr. MARTIN. Physically? He is in New York. I believe he is located in the Investment Banking group.

Mr. FITZGERALD. So this fax is from Rob Furst to Jim Brown in

Structured Finance in New York.

The cover page of the fax, it says, ‘‘Twenty-six pages are being

faxed,’’ and it includes some handwritten notes that appear to outline some of the risks of the Nigerian barge transaction for Merrill

Lynch. It says, ‘‘foreign tax, environmental, operating performance,

failure to complete.’’ It says, ‘‘No repurchase obligation from

Enron.’’ Do you know whether those notes were written by Mr. Brown or

by Mr. Furst?

Mr. MARTIN. It is my understanding they were Mr. Brown’s notes

to go into a meeting.

Mr. FITZGERALD. So this is Mr. Brown in Structured Finance,

and he wrote the last risk at the bottom which says, the handwritten note of Mr. Brown says, ‘‘Reputation risk; i.e., aid and abet

Enron income statement manipulation.’’

Does that suggest to you that Mr. Brown, in charge of Structured

Finance, feared that this whole Nigerian barge transaction was designed to assist Enron in manipulating their income statement?

Mr. MARTIN. Senator, what this list would indicate to me is that

Mr. Brown, first of all, was doing a very thorough job. He was, to

himself, writing down all of the potential risks, and again, having

not been at that specific meeting, had each and every one of these

vetted to his satisfaction.

Mr. FITZGERALD. So he must have discussed the reputational

risk; i.e., aiding and abetting Enron income statement manipulation, he must have discussed that at a meeting with other people

in the Structured Finance office in New York?

Mr. MARTIN. He would have discussed it, again, I assume he discussed it, he would have discussed it at a meeting that had people

from Legal, and Credit, and Product, and Banking all together. He

would have gone through a list and wanted to get comfort from his

seat that these things were not a problem.

Mr. FITZGERALD. So there would have been a whole group of people at Merrill Lynch who would have been made aware of that risk

that this transaction was designed to manipulate Enron’s income

statement, but they nonetheless went forward with this?

Mr. MARTIN. No, I think that this was a question, these are a

series of questions and risks. So there would have been a group of

people—again, having not been at the meeting, it is hard to be

exact—but I would surmise there would have been a group of people, and each and every one of these risks would have been discussed from different points.

Mr. FITZGERALD. Let me ask you this. You are here, you have no

firsthand knowledge of the Enron transactions, but you do speak

for Merrill Lynch to answer questions about their policies.

Mr. MARTIN. Sure.

197

Mr. FITZGERALD. What is the policy, within Merrill Lynch, when

it comes to assisting with transactions that are designed to manipulate your clients’ income statement?

Mr. MARTIN. The policy is unequivocally not to do them.

Mr. FITZGERALD. Not to do it.

Mr. MARTIN. Absolutely.

Mr. FITZGERALD. What if a transaction comports with GAAP, and

it is legal, but really it has no economic purpose, and the only reason to do it is to gin up the earnings, the reported earnings of the

company? It seems to me that Enron engaged in thousands of those

types of transactions, many of which do seem to have comported

with GAAP.

If the sole purpose of a transaction was to manipulate the income

statement, but it is legal, and it comports with GAAP, would Merrill Lynch do the deal?

Mr. MARTIN. If the transaction was legal, and if it had sign-off

from Enron’s advisers, our judgment, we would have a discussion,

we would have a discussion about, if it was in a gray area, whether

we reputationally wanted to do that or not.

Mr. FITZGERALD. And that is apparently what went on here.

From my standpoint, I think it is very apparent that Merrill

Lynch, whether wittingly or unwittingly, became the investment

banker to a big Ponzi scheme at Enron, along with other investment banks. You were very involved in setting up LJM2, the purpose of which, as far as I can tell, was to help Enron book fictitious

earnings. You were involved in the Nigerian barge situation.

I guess, rather than beating you up by going through individual

transactions, and I think the Subcommittee has many documents

they are going to want to continue to ask you about today, I would

want to ask you a broader question. I feel that Congress is actually

ignoring the root cause of why companies are manipulating their

earnings.

Just today in The New York Times, on the front page of the Business Section, it was disclosed that top managers at Qwest Communications cashed in $500 million worth of stock options in the last

couple of years. They have all since left the company. There is a

new CEO, Dick Notebaert, who happens to be from my State of Illinois, and now he is restating the earnings. But those previous

managers have gotten very rich on their stock options, and the

long-term investors are left holding the bag.

I actually think it is Congress’s fault that we have created this

situation, because back in 1993–1994, Congress put a gun to the

head of the Financial Accounting Standards Board and made them

back down from their Rule 123, which was going to require companies to expense stock option compensation on their income statements. I think that would have at least been some discipline on

corporate America.

In the case of Enron, the top 29 managers cashed in $1.1 billion

worth of stock options. Most of those managers left the company

by the time it hit the wall. Unfortunately for Ken Lay, he had to

come back because Jeff Skilling left. He had lined up, himself, had

lined up a job with another company. My suspicion is they all knew

it was a house of cards.

198

My guess is tons of Enrons are out there goosing their earnings,

trying to keep their earnings per share high to keep the options in

the money so the senior managers can cash in those options. You

are seeing cases of companies actually accelerating their earnings

and deferring their expenses, like WorldCom did. They just capitalized expenses.

What is Merrill’s perspective, as an investment banker who sees

a lot of companies on a day-to-day basis? Do you think this is a

worry out there that Congress has given executives in corporate

America, 90 percent of their compensations now coming from stock

options, some of the executives are in a position to make tens or

hundreds of millions of dollars by fictitiously posting earnings? Do

you think that those stock options are a potential motivating factor

in causing corporate America to fictitiously goose their earnings?

Mr. MARTIN. I think stock options, in addition to other things,

would be a contributing factor to behavior, which may not be perhaps in the long-term best interests of shareholders. It may be a

contributing factor. I think the short-termism and the pressure to

perform, as viewed by all of the analysts, which we just previously

spoke about, by shareholders, by boards is intense and seems to be

getting more intense.

I think the true alignment, particularly of the officers of a company, with the long-term success and value creation of a company,

would be a very worthwhile thing and something that, although I

have never spoken to Merrill Lynch directly about it, I assume that

Merrill Lynch would be very supportive of that.

The alignment of risk, the proper risks and rewards for the people at corporations making these decisions—we all make a lot of

decisions. The big decisions take years, and years and years to unfold, whether they are right or they are wrong. So linking those together and alignment of responsibility, accountability, and rewards

would be something that we would be supportive of.

Mr. FITZGERALD. Now Merrill Lynch itself uses stock options, do

they not, in their employee compensation?

Mr. MARTIN. Yes, we do.

Mr. FITZGERALD. And you, yourself, have stock options; is that

correct?

Mr. MARTIN. I have a few, yes.

Mr. FITZGERALD. You have a few. Now does that give your investment bankers the incentive to help drive up business however possible to keep the earnings flowing so that their individual stock options can stay in the money, and they can cash them in before they

expire? Do you think that that is itself an incentive within Merrill

Lynch to ignore the reputational risk to Merrill Lynch to go ahead,

get those extra fees, keep Enron as a client? What do you think?

Mr. MARTIN. I think that we have a saying, at least at Merrill

Lynch, that no transaction or no one person’s bottom-line P&L, one

person being a business unit, is more important than the reputation of Merrill Lynch. That is the way we behave and act.

Mr. FITZGERALD. Do you know whether Mr. Furst got any stock

options and whether he has cashed them in? And now my guess is

he’s leaving the company; is that correct?

Mr. MARTIN. I believe he is no longer with us.

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Mr. FITZGERALD. Can you look into that and tell us what stock

options he has exercised, and maybe he has already profited from

that.

Mr. MARTIN. OK.

Mr. FITZGERALD. Well, with that, I suppose we will have further

opportunities to get into more specifics this afternoon.

Incidently, Senator Levin and I have a bill that would kind of

undo some of the ill effects from Congress’s actions in 1993–1994.

I am pleased that some companies are voluntarily expensing their

stock option compensation expense. I am very fearful that there are

many more Enrons out there and that the root cause of it is powerful motivation in the hands of managers to book current earnings,

cash in their stock options. They can leave the company before the

restatements. Their fortune is assured, but the long-term investors

are left holding the bag.

I wish that Congress would have the courage to address this. It

seems to me that almost every executive in America who has stock

options is dead set against having to record them as a compensation expense on their income statements, and the earnings of almost every company in America are grossly overstated because the

compensation expense is just ignored on the income statement.

But thank you very much, Mr. Martin.

Mr. MARTIN. Thank you.

Senator LEVIN. Thank you, Senator Fitzgerald. Senator Durbin.

Senator DURBIN. Thank you, Mr. Chairman.

Mr. Martin, thank you for being here.

Mr. MARTIN. Thank you.

OPENING STATEMENT OF SENATOR DURBIN

Senator DURBIN. For the record, before joining this inquiry into

the corporate culture of America, I would like to take a moment

and make an observation about the notion of justice in America. If

you follow the morning papers, you realize that a professional basketball player is in the news for misdemeanor charges that he engaged in threatening conduct, and because of that threatening conduct, he faces a maximum jail term of 5 years.

I want to make a point of that for the record because all that we

have heard and described about the conduct of the Enron Corporation. As we sit here today, there is still not a single officer of Enron

who has been charged by this government for any wrongdoing.

That professional basketball player faces more jail time than any

officer of Enron today as we enter into this discussion.

Second, I would like to note that there is a Hollywood actress

who has been accused of shoplifting, and I would like to make a

point that whatever the amount that she shoplifted, she is facing

the prospect of more jail time than any of the employees of Merrill

Lynch who were involved in what led to the agreement between the

State of New York and Merrill Lynch, because of conflicts of interest and deception by the employees of Merrill Lynch when it came

to the selection of stocks. I am going to ask Mr. Martin for some

detail on that in a moment, but what I have read in press accounts

suggests that analysts at Merrill Lynch were intentionally deceiving the clients of that company about their true feelings concerning

the value of companies, compromising in the process the savings,

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the investments, the retirements, and sometimes the lives and futures of a lot of innocent people.

The net result of that misconduct was a fine on Merrill Lynch in the amount of $100 million, a substantial amount of money for

the average person. But according to the New York Times, that fine

represented less than one-third of what Merrill Lynch paid for office supplies and postage in the previous year.

As I said, I hope that we will keep in perspective the notion of

justice in America when we are talking about misdemeanor charges

and jail time for shoplifting and threatening conduct that far exceed any of the penalties which we are imposing on wrongdoers in

this corporate corruption scandal.

Mr. Martin, tell me, if you will, why Merrill Lynch agreed to pay the $100 million to New York and other States.

Mr. MARTIN. Senator, I am not in a position to answer that. I

was not involved in those discussions, the dialogue, the decisionmaking process. Unfortunately, I am just not in a position to answer that question.

Senator DURBIN. Well, do you know? I mean, what is your position at Merrill Lynch?

Mr. MARTIN. I run the International Private Client business.

Senator DURBIN. Are you aware of the nature of the charges

against Merrill Lynch which led to the payment of this fine?

Mr. MARTIN. Only broadly.

Senator DURBIN. Can you tell me, broadly, what they were?

Mr. MARTIN. I think there was an allegation that there was undo

influence by certain parts of the firm on our research process.

Senator DURBIN. How was that manifest? Was it not manifest in

emails that were brought to the attention of the attorney general

of New York, where analysts at Merrill Lynch were, in fact, advising clients to buy certain stock which they had personally said in

email was not valuable or not of great worth; is that not the nature

of this charge?

Mr. MARTIN. Senator, I am just not prepared to have a dialogue

on that.

Senator DURBIN. Mr. Martin, I am glad you are here today, but

you are of very little value to us, and perhaps that is why you are

here today.

Mr. MARTIN. Thank you.

Senator DURBIN. You were able to suggest that you are carrying

the banner for Merrill Lynch, but just have plausible deniability on

every single thing that we ask. Thanks for joining us, nevertheless.

Let me ask you about your testimony because I am curious.

There are two things that come out of your testimony that do not

square. One is, early in the testimony, on page 4, where you go to

great lengths to suggest that the relationship between Merrill

Lynch and Enron was modest and minimal. Those are your words.

Do you recall that part of your testimony?

Mr. MARTIN. Yes, Senator.

Senator DURBIN. And then on page 10, when you talk about the

problems dealing with research in your testimony and the lengths

to which your company went, to try to win back the confidence of

your buddies, your friends and colleagues at Enron, you refer to

this as a longstanding relationship worthy of these extraordinary

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1 Exhibit No. 240 appears in the Appendix on page 2209.

efforts. That seems to be in contrast. At one point, this is a client

of very little importance, and then by page 10, it is a client that,

when it expresses misgivings about your ratings by Merrill Lynch

of Enron, is worth all of this extra effort to win back their friendship. Can you explain the difference?

Mr. MARTIN. Senator, there is a difference between relationship—the importance of the Enron relationship, again, going back

in time, was accurately stated; large, important relationship.

Again, $40 billion in revenue, growth company, leader in the industry, leader in technology, leader in the thought processes of corporate America, so it was a critical relationship for us, no doubt.

The facts are, from a business point of view, it was a small account. Again, our investment banking revenues, which I went

through on page 4, $3.5 to $3.7 billion of investment banking revenues on an annual basis, and the Enron investment banking fees

to us were two-tenths of 1 percent of that number. So it was a

small account as far as activity, a very important account as far as

both current relationship and potential relationship.

Senator DURBIN. Mr. Martin, I could dwell on that particular

comment because, in a memo on January 18, 1999, someone from

the Investment Banking Division notified your president on an update on Merrill’s relationship with Enron, since your president

spoke to Mr. Lay concerning ‘‘our difficult relationship in Research,’’ and went on to say, in so many words, things are back on

track between Enron and Merrill Lynch now, since we have got

some new ratings out. And he concluded by saying, ‘‘Total fees to

Merrill Lynch for two transactions,’’ which are referred to here, significant mandates by Enron alone would be worth 1 ‘‘$40 to $50

million.’’ So, when you talk about a million dollars, and $2 million and $8

million, it appears that this email raises a question as to whether

it was a much larger relationship, but I do not want to dwell on

the difference in dollars and how big it was to your bottom line.

I guess it really comes down to a more fundamental question.

For the individual investor relying on Merrill Lynch’s recommendations and analysis to make important life decisions about

their savings and their pensions, whether Enron represented 1 percent or 10 percent of your bottom line is insignificant. They trusted

you. They believed that you were the cop on the beat; that Merrill

Lynch was giving them good, solid information. But instead of

being the cop on the beat, you were the dog in the lap.

It appears that what occurred here is that once pressure was put

on Merrill Lynch, because this seventh largest corporation in

America disapproved of being rated neutral, that your officers, including your president, scrambled, hat in hand, to try to win back

the love and affection of Enron. I mean, by every indication, that

is what occurred. How does that, in any way, enhance Merrill

Lynch’s reputation for trustworthiness?

Mr. MARTIN. The research process that we have at Merrill Lynch

is extremely rigorous. It is separate from the rest of the firm. We

probably cover more stocks, and more locations, and more countries

in the world than any other institution.

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If you look at the facts about our research and the performance

of the stocks that the research recommends, it is, year in and year

out, if not the leader amongst the top two or three leaders as far

as providing accurate, concise, balanced research on companies.

Enron, in question, the various analysts that we had, the two different analysts, each came up with the conclusion that, from a

long-term perspective, that Enron was a company to buy. They

were not alone in that. There were 40 or 45 other analysts on Wall

Street who also covered Enron, almost all of them as positive. We

try very hard and work very hard, as a research provider, to give

unbiased, consistent, long-term research to our individual investors

and our institutional investors, and we do not get everything right

as human beings, but we very much take seriously the responsibility we have.

Senator DURBIN. Mr. Martin, I think there are enough disclaimers on everything that the stock analysts do to give their recommendations and say past performance will not necessarily predict future results and so forth. I know that. I own stock. Most people do in this country. I understand those disclaimers, and I understand people can miscalculate and guess something big is going to

happen or something bad is going to happen, neither of which occurs.

But what has been raised here is a question of conflict of interest

and deception, and that is much different. To make an honest mistake in analyzing the future performance of a company is one

thing, to be so intricately enmeshed in the business dealings of

Enron that your company is not playing it straight is another

thing.

The point I would like to close with is this. You have repeatedly

made reference to a Chinese wall. I might just say, as far as that

analogy is concerned, that a Chinese wall may have been a great

challenge to breach a thousand years ago, but it is not today, and

I happen to believe that without strong laws and meaningful penalties, the Chinese walls built by corporations are not enough to restore the confidence of the average person in this process. If that

confidence is not restored, not only will your company suffer, but

this economy will suffer.

Thank you, Mr. Chairman.

Mr. MARTIN. Thank you.

Senator LEVIN. Thank you, Senator Durbin.

You just told Senator Durbin that ‘‘Research is separate from the

rest of the firm.’’ Why was Olson then peddling the Enron stock offering?

Mr. MARTIN. Organizationally, the way it is structured in Merrill

Lynch is Research reports to Research who reports to somebody

who is executive vice president on the Executive Committee who

reports to the president. So Research is not imbedded in the investment bank or the consumer business. It is a separate entity. It is

a separate function. It obviously has dealings with the different

parts of the firm, but it is run as a separate function with checks

and balances.

Senator LEVIN. Which reinforces my question. Why was he peddling stock then?

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1 Exhibit No. 243 appears in the Appendix on page 2212.

Mr. MARTIN. He was not—I do not know what he was doing. I

do not necessarily think he was peddling stock.

Senator LEVIN. Have you not seen the notes that you made reference to before? You said it was ordinary that notes of conversations that somebody like he would have in offering stock would be

made available to the company whose stock offering it was. You

said that was very common.

Mr. MARTIN. It is not unusual.

Senator LEVIN. My question is why was he peddling Enron stock

if he is an analyst, when you said the Research Division is separate

from the rest of the firm? It is a very fundamental question.

Mr. MARTIN. The role of the analyst, in a capital market transaction, is usually to provide content and depth of a topic. So the

role he most likely played was talking to accounts with the sales

people, and the accounts asking him in-depth questions that only

an analyst can answer about Enron.

Senator LEVIN. Enron seemed to have so much trouble with his

analysis that they wanted him removed from the scene. So it is not

just making phone calls and getting responses, he was analyzing

Enron; is that not correct?

Mr. MARTIN. He is the analyst for Enron.

Senator LEVIN. My question is what is he doing then peddling

Enron stock if there is a Chinese wall.

Mr. MARTIN. In that process—— Senator LEVIN. There is not even a wall.

Mr. MARTIN. In that process, in the distribution process, the analyst would provide, the analyst would be the content expert for

both the industry and that company, and they would provide that

expertise to the account base and to the sales force to give them

answers to questions that they were going to have.

Senator LEVIN. So you are saying he did not initiate calls?

Mr. MARTIN. No, he is going to be making——

Senator LEVIN. Let me ask that clearly. Are you saying he did

not initiate calls; he only was responding to calls?

Mr. MARTIN. No. With regard to what he was doing specifically,

I do not know. What I am trying to respond to and give you a

frame of reference on is that an analyst can be involved, and will

often be involved, if there is an equity issuance, to provide what

an analyst has spent a lot of time doing, which is depth of coverage

and content.

Senator LEVIN. Can you take a look at Exhibit 243.1 These are

calling lists from John Olson for the Enron Corporation common

stock offering as of today. It says call list. He goes through all of

the calls.

No. 2, likes the story; No. 5, likes the story; left voice mail,

Enron story, No. 7; No. 8, Enron story; No. 9, Enron story; No. 12,

Enron story. He is telling the Enron story. No. 13, will probably

pass.

He is not responding to questions here. He is pitching. In fact,

in your own words, I think he said he was pitching.

Will consider it. He is leaving all of these voice mails. He is not

responding to inquiries here. He is leaving voice mails with the

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1 Exhibit No. 207 appears in the Appendix on page 2059.

Enron story. He is pitching. Day after day after day he is pitching.

There are three different days of call sheets here. That is not a

Chinese wall. There is no wall. You have got your Research people,

who are supposed to be making a pitch for the stock that you are

selling, and that is one of the most disturbing features of this matter.

Do you have any further comment on this?

Mr. MARTIN. Again, Mr. Chairman, it is—I see this list of clients,

it is not unusual for a Research person to work with the institutional sales group, because these are all institutional sales people,

about trying to provide insight into the company that they are analyzing, but I cannot speak for all of these various calls and things.

Senator LEVIN. Do you want to qualify or rethink your statement

about Research being separate from the rest of the firm?

Mr. MARTIN. Well, I will qualify it. The organizational construct

of Research is designed at Merrill Lynch to provide an organizational distinctiveness to that function.

Senator LEVIN. Well, it may be created for that purpose, but it

sure as heck is not functioning in that way, by your own evidence.

You have got a pitch man here in your Research Department.

Mr. Martin, let me ask you about another document. You told me

earlier that the Debt Management Commitment Committee

bumped the decision on the barge transaction upstairs. I want to

go back now to the barge transaction, and you mentioned, I think,

that it may have gone to Tom Davis.

Now the Subcommittee staff has been informed that the decision

was sent to either Mr. Davis or Mr. Bayly. So is it possible that

Mr. Bayly, instead of Mr. Davis, made the decision on this?

Mr. MARTIN. Again, I do not have the direct knowledge or involvement, but from a process point of view, the person who should

have made the decision is Tom Davis.

Senator LEVIN. Will you take a look at Exhibit 207,1 because Mr.

Bayly, I take it, was one of the—can you give us his title?

Mr. MARTIN. He is chairman of Investment Banking.

Senator LEVIN. Chairman of Investment Banking?

Mr. MARTIN. The Investment Banking team.

Senator LEVIN. Now this, if you look at Exhibit 207, this is what

the chairman of Investment Banking is going to do, according to

the notes of Mr. Furst. If you look at the bottom now, here is the

chairman of the Investment Banking Committee.

‘‘Dan Bayly will have a conference call with senior management

of Enron confirming this commitment to guaranty the ML takeout

within 6 months.’’ That is what Mr. Furst’s memo says. That is

what the head of this Subcommittee is going to do. He is going to

confirm a commitment to guarantee the takeout.

Now do you know whether that conference call, in fact, took

place?

Mr. MARTIN. I believe it did take place.

Senator LEVIN. Do you have the notes of that or a tape of that

call?

Mr. MARTIN. I do not, no.

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Senator LEVIN. Have you done an investigation as to what he

said in that call?

Mr. MARTIN. I have not, no.

Senator LEVIN. Has Merrill?

Mr. MARTIN. I do not know if Merrill has.

Senator LEVIN. This is the most critical issue on this matter that

the Subcommittee is looking at this morning, is whether or not that

guarantee was made the way all of the evidence, contemporaneous

and in writing, says it was made. This is directly on point. ‘‘Dan

Bayly will have a conference call with senior management of Enron

confirming the commitment to guaranty the takeout,’’ and you are

coming before this Subcommittee and telling us that you do not

even know if Merrill Lynch has asked Mr. Bayly whether or not

that call, in fact, contained that kind of—— Mr. MARTIN. I assume they either have or are, but I do not know,

in fact, whether that has occurred.

Senator LEVIN. I do not assume either. I wish I could.

Would you get us the notes of any conversations that Merrill

Lynch has had with Mr. Bayly about that call?

Mr. MARTIN. Yes.

Senator LEVIN. Why did you not inquire about that before you go

there today, since it is such a central matter?

Mr. MARTIN. The original role I was asked to play was to provide

a Merrill Lynch perspective, a policy perspective, and a broad perspective on ML and Co, and how it, particularly from a process

point of view, would have been involved in all of these, which is

what I spent the last several days doing. So the role I was expected

to play is the role I am trying to play. I was not going to get prepared to discuss each and every one of these transactions, having

not been in them.

Senator LEVIN. Mr. Martin, you have testified here today that

there was no guarantee, and you have said that under oath. Here

is a document which says that Mr. Bayly will have a conference

call with the management of Enron confirming this commitment to

guarantee, and you are appearing in front of this Subcommittee,

under oath, saying you have made no inquiry, you do not know

whether or not Merrill Lynch has made any inquiry as to the content of that call, as to whether Mr. Bayly, in fact, said that.

I find that totally impossible, frankly, to accept because you are

representing a firm. You made the statement today there was no

guarantee, and yet, and no understanding by Merrill Lynch that

Enron or any entity related to Enron would buy back Merrill

Lynch’s shares. How can you make that statement without having

made the inquiry or knowing about whether or not Merrill Lynch

has even inquired of Bayly, who is the head of your Credit Division

there, about the content of that conference call? I do not even know

how you could come before this Subcommittee and make the statement that there was no understanding, in the face of this document

saying that the head of your whole division here was going to confirm that understanding.

Mr. MARTIN. Again, Mr. Chairman, it is, in my preparation for

my role here, I knew that there was—had been made aware that

there was a conference call. I am not aware of what the content

of that conference call was, having not been on it. Again, I know

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it is easy to assume, but my assumption is that Merrill Lynch has

spoken with Mr. Bayly at some length about this topic and we

would be happy to send you all of the notes and information on

that.

Senator LEVIN. Mr. Martin, let me wind up this segment by just,

on this particular issue, and I am going to be moving on to the

other aspects, after I call upon Senator Collins, but basically the

claim that the barge deal was a purchase by Merrill Lynch and

that there was a real sale by Enron is just simply unbelievable,

and the documents of Merrill Lynch are just so full of references

to a guarantee, and a commitment, and an assurance that is contemporaneous, that it is incredible to believe that this was a real

purchase.

The fact that it was booked as a purchase by Merrill Lynch is

not evidence of the fact that it was a real purchase; in fact, quite

the opposite. The question is why would Merrill Lynch book this

as a purchase, in the face of all of the contemporaneous evidence

that, in fact, it was a ‘‘relationship loan,’’ to use the words of a

Merrill Lynch employee. That is the issue. It is not evidence that

it was a purchase. It raises the question very dramatically as to

how could it be booked as a purchase in the face of all of that contemporaneous, documented evidence.

There is also, in addition to that contemporaneous evidence, the

statements of employees of Merrill Lynch to the staff of this Subcommittee that Merrill Lynch would not have entered into the

transaction, but for the pledge by Enron to take out Merrill Lynch

from the barge transaction within 6 months. Enron, in fact, found

a buyer on the date that it had promised, and it had to do so by

using its own entity of last resort, LJM2. The agreement up front

that you were going to get the $250,000, and then 15-percent interest on the $7 million was very clear. It is exactly what you got

when LJM2 transferred the $7 million on the scheduled date.

So the claims of Merrill Lynch here are too thin, and we are not

that naive. There was all of the motivation in the world to book

this as a sale to please Enron and to make sure that Enron’s own

financial treatment and deception was not countered by the way in

which Merrill Lynch treated it in its own books. You tried to stuff

a loan into what was supposed to be the skin of a sale, but the skin

is just too thin, and I think we can see right through it, and hopefully you can, too, at Merrill Lynch.

Senator Collins.

Senator COLLINS. Thank you, Mr. Chairman.

Mr. Martin, I want to go back to the issue of John Olson’s calls,

because like the Chairman, I am convinced that these were calls

where he is trying to sell the stock, as opposed to your explanation

of answering questions from institutional investors. By my quick

count, it looks like Mr. Olson made at least 110 calls. Let me give

you some of the comments, just taking three of the calls, one of

them Mr. Olson noted.

One records his conversation with a Rod Mitchell at the Mitchell

Group. He says, ‘‘Wants to buy cheaper. He is a bargain hunter.’’

Another one is with Barbara Friedman from John Hancock.

‘‘Likes the idea. Will consider it. Does not own now.’’

207

A third, Barry Allan at Putnam. ‘‘Thinks the price is too high.

Might buy at $44 to $45.’’

Would you agree that these are calls where Mr. Olson was trying

to sell the stock?

Mr. MARTIN. Senator, as we went through the information before,

having not been there and having not listened to phone calls, and

who was there, and who was not there, it is hard for me to answer.

The answer is I do not know.

Senator COLLINS. If you look at the comments that Mr. Olson recorded, and it is clear that he initiated the call because in many

cases his comment is ‘‘left voice mail/Enron story,’’ what other conclusion could one reach?

Mr. MARTIN. Again, the role of an analyst in these discussions

can be multiple, but the one, I do not know what he was speaking

about, I do not know if he was the only person on the phone call,

I do not know if there were other sales people, I do not know if he

was playing a role that was supportive. I just do not know.

Senator COLLINS. Mr. Martin, on three occasions Merrill sent

Enron executives copies of these call sheets listing Mr. Olson’s

calls. Is it common for Merrill to provide companies like Enron

with copies of analysts’ internal call sheets to clients?

Mr. MARTIN. During a deal, during a capital market deal, it is

not uncommon to, particularly with CFOs of corporations, to share

with them feedback on specific, for specific clients. It is not uncommon.

Senator COLLINS. If Mr. Olson was making calls touting the

stock, as I believe is evident from the call sheets, and he was a research analyst responsible for rating the stock, is Merrill precluded

from having a research analyst make such calls as a result of its

settlement with the New York State attorney general?

Mr. MARTIN. That, Senator, I do not know, specifically. I would

be happy to follow up on that.

Senator COLLINS. Are you unfamiliar with the attorney general’s

settlement?

Mr. MARTIN. I am familiar with it in broad terms.

Senator COLLINS. Do you think Enron’s complaints about how it

was rated by this research analyst would have been handled differently now that Merrill Lynch has entered into a settlement with

the attorney general?

Mr. MARTIN. Again, I do not know the specifics of the agreement—agreement and agreements—that we have in the settlement

with the New York attorney general. I can say with regard to

Enron and its ratings, again, both Olson and the new analyst had

the same exact rating as far as long term. And, in fact, when Olson

moved from Merrill Lynch to another firm, even before our analyst

came out, he came out with a short-term buy and a long-term buy.

So, with regard to our behavior and change specific to the New

York attorney general, I just—I’m not in a position to answer that.

Senator COLLINS. Was Mr. Olson forced to leave or encouraged

to leave because Enron complained to Merrill about his ratings?

Mr. MARTIN. It is my understanding it was not specifically tied

just to Enron; it was tied to——

Senator COLLINS. Was that one of the factors?

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1 Exhibit No. 242 appears in the Appendix on page 2211.

Mr. MARTIN. I believe not. What we were doing in the Research

group at the time was there was a whole host of these companies

that seemed to look like—looked different. So, specifically, Williams

Company, and Coastal and a few others, we wanted to group together under one analyst. So there was a restructuring of analyst

coverage. And so a bunch of companies that heretofore been covered by different people were put under one analyst. So his job, his

specific job was eliminated as the restructuring occurred.

Senator COLLINS. Is it your testimony that Mr. Olson’s departure

was not, in any way, connected to the criticism that Merrill executives received from Enron?

Mr. MARTIN. That is my testimony.

Senator COLLINS. Thank you, Mr. Chairman.

Mr. MARTIN. Thank you.

Senator LEVIN. Just an additional question or two relative to the

Olson matter. Has Merrill Lynch made an investigation as to

whether or not there were conversations with Mr. Olson about his

analysis of Enron stock?

Mr. MARTIN. I am sorry, Mr. Chairman. Was there an investigation by Merrill Lynch on his analysis of Enron?

Senator LEVIN. Has Merrill Lynch asked—have they investigated

whether there were discussions with Mr. Olson about his analysis

of Enron stock?

Mr. MARTIN. I do not know.

Senator LEVIN. That is a very important issue before the Subcommittee, obviously, today, and would you make inquiry as to that

and send us a copy of those notes of conversations relative to that

subject and any investigation into that?

I would think that Merrill Lynch would want to investigate that.

Since it has made the claim that there is a wall, one would think

that it would want to see whether or not, in fact, there was such

a wall or whether it functioned in any semblance of way during

this process. It sure did not look like a wall to me, it looked like

a ditch.

But if you would furnish that, for the record.

Mr. MARTIN. Yes, I will do that.

Senator LEVIN. Thank you. You do know that Mr. Allison did call

Ken Lay and Jeff Skilling in an attempt to have Merrill Lynch inserted as a co-manager, those calls were made?

Mr. MARTIN. That is my understanding, yes, sir.

Senator LEVIN. Do you know what Mr. Allison told Mr. Lay and

Mr. Skilling in those calls?

Mr. MARTIN. No, I do not.

Senator LEVIN. Would you make inquiry—I would think that

that would be a fairly important issue to Merrill Lynch; it is to

us—and let us have a copy of that inquiry when you make it?

Mr. MARTIN. Yes. We’ll have that done.

Senator LEVIN. Exhibit 242 1 has been referred to in some detail.

I am not going to go over the material that Senator Dayton and

others have gone over in this regard, except to point out in the

middle line there called ‘‘Background’’ that this is to Dan Bayly

from Schuyler Tilney, and it says, ‘‘As you know, Merrill Lynch was

209

1 Exhibit No. 206(a) appears in the Appendix on page 2054.

nearly excluded from Enron’s $750 million common stock offering

earlier this year. So this mandate is critical to reigniting our relationship with Enron.’’ That is how important it was to Merrill

Lynch.

Do you know whether or not any supervisor or anybody above

the analysts in the chain of command at Merrill Lynch ever discussed with Mr. Olson the fact that Merrill Lynch lost a lucrative

deal solely because of his or, in part, because of his research activity? Do you know whether or not any supervisor or anyone above

him——

Mr. MARTIN. Mr. Chairman, I do not know.

Senator LEVIN. Would you make inquiry and let us know?

Mr. MARTIN. Yes.

Senator LEVIN. And, if so, what the result of that inquiry was.

Mr. Martin, you said a moment ago that it is your testimony that

Mr. Olson’s departure was ‘‘not in any way related to his Enron

rating.’’ That is not our understanding, and I am wondering whether you wish to qualify your statement.

Mr. MARTIN. I thank you for the opportunity to qualify, but I am

comfortable with the statement, Mr. Chairman.

Senator LEVIN. You what?

Mr. MARTIN. I am comfortable with the original statement.

Senator LEVIN. Thank you.

Let me turn now to LJM2. In September 1999, Andrew Fastow,

Enron’s chief financial officer, and Michael Kopper, his right-hand

man, made a presentation to a Merrill Lynch investment team to

pitch a proposal for LJM2, which is a private investment fund established to make its money primarily from transacting business

with Enron.

Mr. Fastow was to be the general manager and then equity holder of LJM2 at the same time he continued his job as Enron CFO.

Three others—Mr. Kopper, Ben Glisan, and Anne Yaeger—would

also work at LJM2, while maintaining their full-time jobs at Enron.

In September, Mr. Fastow was looking for help in raising about

$200 million in capital for LJM2. Without that money, LJM2 could

not do anything. It was the fuel that LJM needed to act. Mr.

Fastow made his pitch to Merrill Lynch on September 16, 1999, at

its offices in New York.

During the course of the Subcommittee investigation, Merrill

Lynch provided a 50-minute videotape that captured some of Mr.

Fastow’s pitch to the Merrill Lynch team, and we have edited that

tape down to about 7 minutes. And I would ask that it run now,

but before it starts running, there is a transcript which is available. I think this is Exhibit 206(a).1

I wonder if we could just play these excerpts.

[Videotape played.]

Senator LEVIN. We will come back to that chart in a minute, why

LJM2 is unique.

[Videotape played.]

Senator LEVIN. Mr. Martin, were you at that briefing?

Mr. MARTIN. No, Mr. Chairman.

210

1 Exhibit No. 246 appears in the Appendix on page 2235.

Senator LEVIN. This Subcommittee has already looked at the

LJM2 transaction in some depth at earlier hearings, and what we

found after interviewing 13 Enron board members and a number

of corporate governance and accounting experts is that, as far as

any of them knew, it was unprecedented for a publicly traded company to allow its CFO, the person with the greatest access to the

company’s money flows and profit margins to set up his own investment fund to do business directly with the company.

Now Merrill was obviously aware of the conflicts of interest. If

you look at Exhibit 246,1 this is from Schuyler Tilney and Robert

Furst, the two people who were before us early this morning, briefly. The subject is, ‘‘Skilling Questions on LJM2.’’ ‘‘We would like to have a conversation with Jeff about LJM2. Our

questions are as follows:’’ And then No. 3, ‘‘Are you comfortable with the internal mechanics put in place to resolve the conflict-of-interest issue? Have these

internal policies been reviewed with internal and external counsel

and the board?’’ Now that is the question which Merrill Lynch is asking Fastow,

who is involved in the conflict. Of course, his answer comes back,

if you will see the next document, where it says that on October

11, which is 4 days after that first memo, Mr. Tilney first spoke

with Jeff Skilling, president and COO of Enron Corporation. ‘‘We

asked Jeff the questions listed on the memo. It was apparent he

has spent a great deal of time on LJM2 matters, and he is comfortable,’’ it says here, ‘‘with the conflict-of-interest issue for the following reasons,’’ and then gives the reasons that he, the person

who is involved in the conflict or who, on behalf of Enron, approved

the conflict is saying why he approved it on behalf of the corporation.

But that does not, it should not satisfy Merrill Lynch. Merrill

Lynch now has the problem, the dilemma, which was raised by

your own people as to whether or not you want to participate in

a transaction where there seems to be a conflict. Instead of asking

the company that is involved, it would seem to me you would ask

your own legal counsel as to whether or not it would be appropriate

to participate in that transaction and to sell that LJM2 stock.

My question to you is did you get a legal opinion about the ethics

issue from your own counsel?

Mr. MARTIN. Mr. Chairman, I do not know the answer to that

question.

Senator LEVIN. If you would find out if you did, would you send

us a copy; and if you did not, would you let us know, for the

record——

Mr. MARTIN. And that is a legal opinion on the conflict topic.

Senator LEVIN. On that conflict question.

Mr. MARTIN. OK.

Senator LEVIN. As to why, since there was a question raised as

to whether or not there was not a clear conflict, which there was,

and it was waived by the Enron board, but nonetheless it was a

clear conflict, to have their CFO deal with them from an outside

investment firm with inside information that he had.

211

1 Exhibit No. 249 appears in the Appendix on page 2240.

So now if you look at Exhibit 249,1 which is the private placement memorandum that Merrill put together to convince qualified

investors, like pension funds, insurance companies and banks, to

invest in LJM2, and here is what it says. It says that ‘‘Under Mr.

Fastow’s management, the partnership expects to have the opportunity to co-invest with Enron in many of Enron’s new investment

activities and the opportunity to acquire existing Enron assets on

a highly selective basis, and the access to deal flow should provide

the partnership with unusually attractive investment opportunities. The partnership will be managed on a day-to-day basis by a

team of three investment professionals who all currently have senior-level finance positions with Enron—Fastow, Kopper and

Glisan—who will continue their current responsibilities with

Enron, while managing the day-to-day operations of the partnership.’’

So that is repeating the pitch that Mr. Fastow made to you. If

you take a look at the chart on page 2 of this transcript, this is

what Mr. Fastow was telling you at Merrill Lynch why LJM2 is

unique. Preferred access to proprietary deal flow is No. one; four,

ability for LJM2 to evaluate investments with full knowledge; five,

LJM2 speed and knowledge advantage—knowledge, knowledge,

knowledge. Inside, by the way, inside information because of

Fastow’s dual role.

Do you know whether or not anyone from Merrill contacted the

Enron board about LJM2?

Mr. MARTIN. Mr. Chairman, I do not know specifically, no.

Senator LEVIN. Would you inquire of that?

Mr. MARTIN. Yes.

Senator LEVIN. Had anyone from Merrill spoken to the board, by

the way, they would have learned that the board had not authorized anyone and did not waive the conflict of interest rules relative

to anyone but Fastow to participate in LJM2. Glisan and Kopper,

both listed in your placement memo, were violating Enron’s ethics

rules, because they did not get a waiver, by working at LJM2 in

addition to their inside position at Enron.

Were you aware of that at Merrill?

Mr. MARTIN. No, I was not.

Senator LEVIN. The Subcommittee report on the Enron board

concluded that ‘‘No company ought to set up a fund like LJM2 because the conflicts of interest overwhelm any internal controls that

are set up to supposedly keep the fund fair.’’ We also know now

that LJM2 was one of the primary devices that Enron used to cook

its books through phony asset sales and other transactions that

produced about $2 billion in funds flow in a 6-month period and

through accounting shams, such as the so-called Raptor hedges

that Enron used to hide a billion dollars in stock losses at the same

time that Mr. Fastow and LJM2 investors lined their pockets with

millions of dollars in profits in just 2 years at the expense of

Enron’s shareholders.

Looking back at this, do you believe that Merrill should have gotten outside advice before agreeing to underwrite the private offerVerDate 11-MAY-2000 15:16 Dec 10, 2002 Jkt 000000 PO 00000 Frm 00231 Fmt 6601 Sfmt 6601 81313.TXT SAFFAIRS PsN: SAFFAIRS
212

ing of LJM2, given the fact that Merrill was aware of a conflictof-interest situation?

Mr. MARTIN. Mr. Chairman, I believe that, from a due-diligence

point of view, that we should have done everything possible to ensure that we got comfortable with the conflict.

Senator LEVIN. Let me conclude by saying just a few words about

today’s hearing and last Tuesday’s hearing, because we have been

looking at, and we continue to look at the role of financial institutions and Enron’s collapse.

Last week’s hearing looked at Citibank and Chase and their role in $8 billion of financing that Enron never reported on its books as

debt.

Today we looked at Merrill Lynch and its willingness to put its ‘‘balance sheet to work’’ for Enron in order to position itself to get

Enron’s business.

We have looked at a number of troubling interactions between Merrill and Enron. First, the Nigerian barges. We looked at a $28-

million transaction involving Nigerian barges that Enron used to

improperly inflate its 1999 earnings by $12.5 million, after claiming an end-of-the-year sale to Merrill, but the sale to Merrill was

conditioned on a guarantee, a guarantee that Enron would take

Merrill out of the deal within 6 months and pay Merrill not only

a $250,000-up-front fee, but also a 15-percent return on Merrill’s

cash investment of $7 million. That guarantee meant there was no

real sale at all.

Merrill has contradicted, in its testimony, the contemporaneous

documents, saying that those documents do not really mean what

they say. Well, that is what last week’s inadequate, and may I say

feeble, explanation was as well.

The facts are that the documents show that Merrill got a promise

from Enron to take them out of the deal within 6 months at a specified profit and that LJM2 met that promise by buying Merrill’s interest in the barges by the end of June for $7.25 million. Nothing

says it more eloquently than the internal document at Merrill

Lynch that says that the most unusual transaction of the week was

the request to approve Enron’s relationship loan.

The second transaction we looked at had to do with a $750-million Enron stock offering, from which Merrill was initially excluded

by Enron due to Merrill’s analyst’s visceral reaction—excuse me—

due to Enron’s visceral reaction to Merrill’s investment research on

the company.

Within months of Enron’s complaint, the analyst who had given

Enron the equivalent of a neutral rating had left Merrill, a new analyst was assigned to the company, and by November 1998, Enron’s

investment rating was upgraded to the equivalent of a buy.

The third one was the LJM2 offering. We looked at Merrill’s lead

role in underwriting the $390-million private offering of LJM2, the

off-the-books partnership which was run by Enron’s CFO, who had

clear conflicts of interest, and that was a major contributor to

Enron’s accounting deceptions and downfall. Merrill was aware of

the potential conflicts involved in LJM2, but did not seek, apparently, outside legal counsel or other advice on whether it should

participate in that underwriting. In the end, it helped raise the

money which LJM2 used to help Enron cook its books.

213

Our investigation indicates that Enron could not have engaged in

the extent, and to the extent, of the deceptions that it did without

the knowing assistance and participation of major financial institutions.

The purpose of these hearings has been, and will continue to be,

to set out what happened, to provide a record for possible legislative action. Of course, it is not our job to determine whether the

facts that we have laid out constitute violations of securities laws

or other laws prohibiting corporate misconduct. We will turn over

the findings, and the information and the evidence, to the Securities and Exchange Commission, the Department of Justice, and

other law-enforcement agencies who have the responsibility to

make those determinations. But it is our job to build a legislative

record to show what needs to change to help prevent financial institutions from participating in or contributing to accounting deceptions, to alter investment research or to finance questionable transactions.

Important advances were made by the Sarbanes accounting reform bill, which I strongly supported, which has now passed both

Houses of Congress and which is awaiting the signature of President Bush. Additional steps are being taken by the SEC, the New

York Stock Exchange and other bodies. The key to the success,

however, of the changes which need to be made is whether the financial institutions themselves will address the problem that needs

correction.

So far, the institutions which have appeared before us—Citibank,

Chase and Merrill—have not acknowledged any problem in the

way in which they handled Enron. And while the case histories

presented during these hearings of the problems that indeed were

in existence and did exist with the way in which financial institutions handled Enron, these three financial institutions are not the

only ones that dealt improperly with Enron.

So the question that now needs to be asked and which we will

leave this hearing with is whether the financial institutions in this

country are going to acknowledge the problems, step up and make

the changes that need to be made internally as a result of the

events that have been so tragically unfolding in the fall of Enron

and since.

I can only hope that the financial institutions will carry out their

responsibility, and I know that each of us on this Subcommittee are

determined that we will carry out our responsibility.

We thank you for coming forward today, Mr. Martin, and we will

stand adjourned.

Mr. MARTIN. Thank you, Mr. Chairman.

[Whereupon, at 1:03 p.m., the Subcommittee was adjourned.]

(215)

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Æ