Investment Banks: The Role of Firms and Their Analysts with Enron and Global Crossing
Published: 2003-03-17T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In the wake of a series of recent corporate scandals and bankruptcies, the Sarbanes-Oxley Act mandated that GAO study the involvement of investment banks with two companies, Enron and Global Crossing. In this report, the term "investment bank" includes not only securities firms but also those bank holding companies with securities affiliated or business divisions that assist clients in obtaining funds to finance investment projects. Since the activities identified in this report are the subject of ongoing and extensive investigations and litigation by competent authorities, it is not our role to determine the propriety of any of the parties' activities. To help the Congress better understand the activities of investment banks with respect to these companies we agreed to provide publicly available information on the roles investment banks played in designing, executing, and participating in certain structured finance transactions, investment banks' and federal regulators' oversight of these transactions, and the role that the banks' research analysts played with Enron and Global Crossing.
section_title: What GAO Found
paragraphs: Certain investment banks facilitated and participated in complex financial transactios with Enron despite allegedly knowing that the intent of the transactions was to manipulate and obscure Enron's true financial condition. The investment banks involved in the transactions we reviewed contended that their actions were appropriate and that Enron had not revealed its true purpose in obtaining their assistance. While investment banks are not responsible for the financial reporting of their clients, if it is proven that the investment banks knowingly assisted Enron in engaging in securities law violations, SEC has the authority to take legal action against them. Oversight responsibility for the investment banks' part in these transactions lay with both the banks themselves and the federal regulators. Investment banks told us that they had vetted transactions involving Enron through their risk management and internal control systems. Since Enron's collapse, these firms reportedly have been taking some steps to strengthen their internal controls, in part because they are now more sensitive to reputation risk. Federal financial regulators noted that before Enron's collapse they had not viewed structured transactions with investment-grade counterparties as particularly high risk in their exams. They subsequently are refining their approach to supervising structured transactions, and bank regulators now plan to include more transactions in their exams. Regulators are currently conducting targeted reviews of structured finance transactions at large firms and plan to develop guidance or best practices that clarify their expectations for sound control and oversight mechanisms. In the wake of the scandals, research analysts at investment banks who made favorable recommendations for failed firms have also come under public scrutiny. Investment banks allegedly pressured analysts covering Enron and Global Crossing to give investors favorable or misleading investment recommendations in order to keep or win lucrative work from the companies, creating serious conflicts of interest. Although the investment banks denied the allegations, several have been investigated by regulators and involved in litigation about conflicts of interest between their research and investment banking departments. Certain federal regulators and self-regulatory organizations have all adopted additional regulations addressing such conflicts. Although investment banks are not typically responsible for their client's accounting, it is a violation of law to facilitate transactions that an investment bank knows will materially misstate the client's financial statements. Since investment banks may be tempted to participate in profitable but questionable transactions, it is especially important that regulators be alert to this and be ready to use their enforcement tools to deter such actions. We are encouraged that investment banks and regulators are strengthening their oversight of the appropriateness of transactions, but it is too soon to evaluate the effectiveness of reforms.

section_title: Letter
paragraphs: The publicity surrounding Enron Corporation’s (Enron) bankruptcy and  the effect on the company’s stockholders and employees has generated a  debate on the activities of investment banks and their role in Enron’s  collapse. Publicly available reports describe complex financial  transactions among Enron, various investment banks, and a variety of  special purpose entities (SPE) that have raised questions about whether  investment banks knowingly and substantially assisted Enron in  deceiving the public about Enron’s true financial condition.
In the wake of this and other recent corporate scandals, the Congress  passed the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act), which  contains multiple accounting, corporate governance, and other reform  requirements. Section 705 of that act requires GAO to study investment  banks’ involvement in the failures of two particular public companies,  Enron and Global Crossing Ltd. (Global Crossing). This report presents  primarily publicly available information on the facts, allegations, and  rebuttals concerning selected investment banks’ involvement with Enron  and Global Crossing. It also presents observations on the issues raised by  the investment banks’ involvement with these companies and on the  actions Congress, regulators, and firms have taken or proposed in  response.
This report focuses primarily on five structured finance transactions  involving Enron and investment banks for the period 1992 through 2001.  We found no publicly available documents on or references to investment  banks’ involvement in designing or implementing structured transactions  used by Global Crossing. Therefore, in this report we discuss other client  relationships that investment banks had with Global Crossing, primarily  through their research analysts. Through the transactions we describe in  this report, investment banks facilitated complex structured finance  transactions, despite allegedly knowing that Enron would use deceptive  accounting and tax strategies. Complaints filed by the Securities and  Exchange Commission (SEC) and individual investors also allege that,  through various transactions, Enron and its officers and directors engaged  in a scheme to defraud investors by inappropriately reporting the  transactions in Enron’s financial statements and consequently  misrepresenting Enron’s true financial condition.
Investigations and litigation are under way in connection with both Enron  and Global Crossing, and it was not our objective to assess, nor should this  report be construed as assessing, the potential culpability of the parties  involved in the transactions discussed in the report. In instances such as  these, if we have good cause to believe that any potential violations of  applicable laws or regulations have occurred, we refer such matters to the  appropriate governmental authorities for their consideration and possible  action.
After taking the above concerns into consideration, we agreed with the  staffs of the Senate Committee on Banking, Housing and Urban Affairs and  the House Committee on Financial Services that the specific objectives of  this report were to (1) identify the roles investment banks played in  designing, executing, and participating in structured finance transactions  for Enron; (2) discuss investment banks’ and federal financial regulators’  oversight of products investment banks design and market to or for their  clients; and (3) discuss the role investment banks’ research analysts  played with Enron and Global Crossing.
To meet our objectives, we reviewed publicly available documents  pertaining to investment bank involvement with Enron in structured  finance transactions and other client relationships. The five transactions  we analyzed exemplify a variety of relationships that Enron had with  several different investment banks and were among those in which  investment bankers allegedly assisted Enron in manipulating its earnings,  but they were not those included in Enron’s restatement of its financials  for the period 1997 through the second quarter of 2001. Although the  investment banks described themselves as passive investors in the  restated transactions, we did not confirm or refute their assertions to that  effect. We did not conduct any evaluative analysis of the recent reforms  Congress, regulators, and some firms have initiated, as not enough time  has passed to allow for such analysis.
The five transactions we selected were discussed at hearings of the Senate  Committee on Governmental Affairs, Permanent Subcommittee on  Investigations (PSI), held in July and December 2002. In completing this  work, we spoke with PSI staff and relied primarily on witness statements,  hearing transcripts, and supporting documents published by the  subcommittee. Throughout this report, we cite several documents used in  the PSI hearings that were specifically relied on for allegations that  investment banks facilitated the transactions with knowledge of Enron’s  use of deceptive accounting and tax strategies. In addition, we interviewed  federal financial regulators and officials from the three investment banks  involved in these transactions. We also reviewed available documents  provided by regulators and the investment banks. Appendix I contains a  full description of our scope and methodology.
We conducted our work in Washington, D.C. and New York, N.Y., between  September 2002 and March 2003 in accordance with generally accepted  government auditing standards.
subsections: section_title: Background
paragraphs: Investment banks play an important role in maintaining the smooth  functioning of the U.S. economy. In that role, they provide many different  services to their clients. In addition to more traditional services such as  securities underwriting, investment banks provide advice on and  assistance in creating different types of structured finance transactions,  including SPE and prepay transactions that are designed to meet the needs  of specific corporate clients. Investment banks’ duties to their clients  depend on the activities in which the investment banks engage. In part  because of the complexity of the transactions investment banks engage in,  transparency in financial reporting is essential if stakeholders (such as  investors) and others are to understand these transactions.
subsections: section_title: Investment Banks Offer Their Corporate Clients a Wide Variety of Services
paragraphs: Investment banks are an important means of allocating capital in the U.S.  economy. In their traditional function of underwriting securities offerings,  according to securities industry data, investment banks arranged over half  of the total financing provided to U.S. nonfinancial businesses in 2001. The  wide variety of services today’s investment banks provide to their  corporate clients fall into two major categories—-securities/capital  markets and advisory services. Table 1 provides a description of services  investment banks provide their corporate clients.
The three investment banks highlighted in this report, like other large  investment banks providing services to large companies, had various  relationships with Enron or Enron-related entities. The investment banks  provided an array of services and products to Enron, including acting as  advisors on mergers and acquisitions, lending money for loan  syndications, underwriting bond and stock offerings, providing research  on Enron securities, providing complex structured finance transactions,  acting as trading counterparties to derivatives transactions, participating  as passive investors (limited partners) in an SPE, and others.
section_title: Structured Financing Includes SPEs and Prepay Transactions
paragraphs: Structured finance is designed by investment bankers and others to help  clients obtain funding on desirable terms and in some cases with favorable  economic, accounting, and tax characteristics. It includes many variants,  including transactions that use SPEs and prepay transactions. An SEC  official has stated that structured finance plays an important role in the  modern business environment and, when used properly, can provide  needed liquidity, funding sources, and investment opportunities and  facilitate risk dispersion. The official also noted that structured finance  transactions have at times been used inappropriately to achieve a specific  accounting or tax result. Sometimes this inappropriate use has been  achieved by violating existing regulations or accounting standards.
subsections: section_title: Special Purpose Entities
paragraphs: In the ordinary course of business, many companies use a variety of  structured financings that involve SPEs to access capital or hedge risk.  An SPE is a legal entity created by another entity (a sponsor) to carry out a  specified purpose or activity, such as to consummate a specific  transaction or series of transactions with a narrowly defined purpose.  SPEs are often used as a financing vehicle that allows a sponsor entity to  transfer assets to the SPE in exchange for cash or other assets the SPE  obtains by issuing debt, equity, or both, to third-party lenders or investors.  Originators of financial assets such as mortgages and consumer credit  have used SPEs extensively; at the end of 2001, such SPEs held over $2  trillion in assets. For example, a sponsor entity could transfer accounts  receivable from credit-card holders into an SPE in exchange for cash. In  this example, the SPE would obtain the cash by issuing securities backed  by the accounts receivable. SPEs may also be established to acquire,  construct, or manufacture assets the sponsor entity uses through leases,  management contracts, or other arrangements. For example, a sponsor  entity could establish an SPE to construct a power plant that was financed  through debt issued by the SPE.
An SPE may take many different forms, including a corporation,  partnership, limited liability company, or trust. When the entity is  properly structured, an SPE’s assets may be legally separate from those of  its sponsor, protecting the SPE’s assets from the risk of the sponsor’s  bankruptcy. This arrangement often reduces credit or other risks for  lenders and investors and thus lowers financing costs for the sponsor.  SPEs may also create certain tax advantages for the participating parties.
Under generally accepted accounting principles and Financial Accounting  Standards Board guidance, SPEs meeting certain criteria do not appear on  the balance sheet of the sponsoring entity. Thus, transactions that provide  financing involving SPEs can be structured so that the assets and liabilities  transferred to an unconsolidated SPE can be removed from the sponsor’s  financial statements. Whether an SPE is consolidated with another entity  is a matter of judgment that involves an assessment of the risks and  rewards of ownership, as well as control over the SPE’s activities. This is  important, because an entity could materially misstate its own financial  statements by, for example, understating its debt or overstating its sales if  it does not properly account for ownership in an SPE. Even though a  sponsor of an SPE might not be required to consolidate the assets and  liabilities of an SPE in its financial statements, the sponsor is required to  either recognize in its financial statements or disclose in the footnotes to  its financial statements the nature of its involvement with the SPE; the  purpose, size, and activities of the SPE; and the maximum exposure to loss  as a result of its involvement with the SPE.
section_title: Accounting for Sales of Financial Assets
paragraphs: Ownership interests in an entity, including an SPE, are considered  financial assets. When assets of this type are sold or transferred to another  entity, Financial Accounting Standards (FAS) 140, Accounting for  Transfers and Servicing of Financial Assets and Extinguishments of  Liabilities, provides the accounting guidance related to the transaction.  In general, when an entity surrenders control of a transferred financial  asset, a sale can be recognized. For a sale to occur, the transferred asset  should be isolated from the transferring entity and its creditors, and the  entity receiving the asset has the right to pledge the asset as collateral or  to sell it. Further, the entity transferring the asset is not allowed to  maintain control of the asset through any agreement that entitles and  obligates it to repurchase the asset. If a transfer of financial assets in  exchange for cash or other consideration does not meet the criteria for a  sale, then the entity transferring the asset must account for the transaction  as a secured borrowing with a pledge of collateral, and the resulting  liability and the asset are reflected on the entity’s balance sheet.
section_title: Prepay Transactions
paragraphs: A prepay transaction involves a contractual agreement between two  parties that combines the economics of a debt obligation with those of a  forward contract, which is a contract for a service or product to be  delivered at a later date. Forward contracts, whether prepaid or not, can  be used to hedge against adverse price moves. For example, if two parties  enter into a forward contract to exchange 100 gallons of gas for $180  ($1.80 per gallon) in a month, the buyer of the gas is protected against a  price higher than $1.80 while the seller is protected against a price lower  than $1.80. In a prepaid forward contract, the payment for the gas is made  at the time of the contract but the gas is delivered in a month; this provides  immediate cash flow to the seller. If this prepay transaction is a loan in  substance and intent, its accounting treatment should be that of a loan.
In the energy business, entities commonly enter into forward contracts for  the purchase or sale of a commodity. Such activities are generally settled  by the physical delivery of the commodity. The contracts are often entered  into based on an entity’s assessment of market movements either to hedge  its position or to speculate on price. Some entities enter into energy  contracts for trading purposes and often settle them with cash rather than  a commodity. In accounting guidance, “energy trading activities” refers to  energy contracts entered into with the objective of generating profits from  changes in market prices. The guidance states that determining whether  an entity is involved in energy trading activities is a matter of judgment  that depends not solely on the terms on the contracts, but also on an  assessment of relevant facts and circumstances related to the entity’s  activities. However, inherent in that assessment is an evaluation of the  entity’s intent in entering into an energy contract.
section_title: Investment Banks’ Duties to Their Clients Depend on the Role the Banks Play
paragraphs: Investment bankers are often retained to advise on a course of action that  a board of directors has already determined to pursue. The banker’s role in  helping the board achieve those objectives is set forth in an agreement  known as an engagement letter, and the banker’s duties to the client are  limited to the terms of that letter. Moreover, the advice that investment  banks provide is largely subjective. However, in some cases courts have  found that an investment banker owes a fiduciary duty to a company if the  investment banker evaluated and considered the appropriateness of  unsuccessful financial transactions that caused the company’s  bankruptcy.
Enron engaged investment bankers to provide advice on and at times to  participate in the creation of SPEs. The duties of the investment bankers  in such transactions depends on the role the investment bankers played. If  the SPE issues securities through a public offering that it sells to investors  in order to raise capital, and the investment bank acquires the securities  from the SPE with the intent to subsequently distribute them, then the  investment bank is acting as an underwriter. As an underwriter, the  investment banker would have duties of due diligence and disclosure.
If investment bankers knowingly or substantially assisted a company—in  this case, Enron—in violating the securities laws, SEC has the authority to  bring an action for aiding and abetting a securities violation. The action  depends on the involvement of the investment banker in the alleged  conduct. SEC must prove three elements in an aiding and abetting a  securities law violation: (1) that a principal committed a primary violation,  (2) that the aider and abettor rendered such assistance knowingly or  recklessly, and (3) that the aider and abettor provided substantial  assistance to the primary violator. In other words:    The first legal element of aiding and abetting is the requirement that an  independent, illegal act exists to which the aider and abettor can be  attached. This independent illegal act or primary violation may be a  misrepresentation, omission, scheme to defraud, or fraudulent course of  business.
The second element of aider and abettor liability is either actual  knowledge of the primary violation on the part of the aider and abettor or  recklessness. However, the law is ambiguous with regard to the level of  knowledge needed to prove aiding and abetting liability. Some courts have  required SEC to prove that the entity aiding the primary violation had  actual knowledge of the violation. However, other courts have found that  recklessness is sufficient. In SEC administrative proceedings, liability  may be based on less than actual knowledge of the violation.
The third element of aiding and abetting, “substantial assistance by the  aider and abettor in the achievement of the primary violation” has been  interpreted as meaning significant assistance to the representations of  others or to the fraud of others. Persons may assist primary violators in  many ways—for example by repeating their misrepresentations, aiding in  the preparation of misstatements, acting as conduits to accumulate or  distribute securities, executing transactions, or financing transactions.
Thus, if SEC determines that there is evidence to allege that investment  bankers provided substantial assistance to Enron in violating the  securities laws and that the investment bankers rendered such assistance  knowingly, SEC could bring a civil action against the investment bankers  that engaged in such conduct. Depending on the forum where the action is  brought, reckless conduct on behalf of the investment banker may be  sufficient.
However, we have observed that some conflict exists among the courts  regarding the level of knowledge required for SEC to bring a claim in court  for aiding and abetting liability. Clearly, actual knowledge of the fraud is a  more difficult standard to prove. If this standard were to be the  requirement, SEC might not be able to successfully pursue all court cases  that could involve actions for aiding and abetting a securities law  violation.
section_title: Transparency in Financial Reporting Is Key to Maintaining Confidence in Capital Markets
paragraphs: In part because of the complexity of many structured finance transactions,  transparency in financial reporting is essential to maintaining confidence  in capital markets. Off-balance sheet transactions and other relationships  with off-balance sheet entities or other persons may have a significant  effect on a company’s financial condition, revenue or expenses, results of  operations, and liquidity. Financial reporting should provide the  information that is useful to current and potential investors, creditors, and  others in making rational investment, credit, and similar decisions. The  information should be comprehensible to those who have a reasonable  understanding of business and economic activities and are willing to study  the information with reasonable diligence.
Financial reporting should also provide the information necessary to  assess the financial condition of an entity, including (1) the amount,  timing, and certainty of cash flows; (2) the assets, obligations, and equity;  and (3) the financial performance during a specified period. Transparent  financial reporting depends on reliable information, sufficient disclosures,  and fundamental assertions about the information presented. For  example, assets are owned and are expected to provide future benefits to  an entity; all known obligations of an entity, as a result of prior events, are  recorded; an entity’s revenues are reported during the period earned; and  an entity’s sources and uses of cash flows are properly classified. If  investors and creditors lose confidence in the financial reporting of an  entity, the consequences to the entity and the marketplace can be  significant.
Both accounting and auditing standards recognize that an entity’s  management is responsible for an entity’s financial reporting, including the  fairness of its presentation in conformity with generally accepted  accounting principles. During an audit, audit standards require an auditor  to obtain written representations from management indicating, among  other things, management’s responsibility for the entity’s financial  reporting. The Sarbanes-Oxley Act reemphasized management’s  responsibility by requiring that an entity’s principal executive and financial  officers certify that the financial statements and other financial  information included in the report fairly present in all material respects  the financial condition and results of operations. The act also imposed  possible disgorgement of any ill-gotten gains on the part of principal  executive and financial officers when an entity is required to restate its  financial statements owing to noncompliance—that is, as a result of  misconduct with any financial reporting requirements under securities  laws.
section_title: The Role of Investment Banks in Enron’s Structured Finance Transactions
paragraphs: Investment banks allegedly actively and substantially helped Enron  deceive its investors and creditors by facilitating complex structured  finance transactions designed to result in misleading accounting and tax  outcomes that benefited the company. Enron used structured finance to  generate recorded sales, decrease taxes, and facilitate prepay transactions  that bolstered operating results and cash flows. Investment banks played  key roles in each of the transactions discussed in this report. (See  appendix II for a detailed description of these transactions and the roles  played by investment banks.) It is alleged that these transactions enabled  Enron to manipulate and obscure its reported results or to avoid tax  obligations in various ways. If so, SEC can bring action against these  investment banks for aiding and abetting securities fraud.
subsections: section_title: Investment Banks Were Involved in Transactions That Enron Used to Generate Recorded Sales and Reduce Taxes
paragraphs: SPEs are often used for legitimate purposes as a financing vehicle, but  they have also been used to inappropriately overstate net income and  understate total debt. For example, an entity that transfers control of an  asset, including the risks and rewards of ownership, to a properly  structured, unconsolidated SPE for cash is generally expected to report  the transfer as a sale and record the gain or loss on the transaction. If an  entity transfers an asset but not all the risks of ownership to an SPE for  cash, then the cash received is generally accounted for as a secured  borrowing (i.e., a loan).
It has been alleged that Merrill Lynch knew that its participation in  Enron’s Nigerian barge transaction aided deceptive accounting by Enron.  The form of Merrill Lynch’s involvement was an equity investment that  would validate a sale by Enron, but it was reported that oral commitments  by Enron minimized Merrill Lynch’s risks and ensured a specified return,  meaning that Merrill Lynch’s investment was in substance a loan and that  therefore there was no valid sale. Publicly available reports describe a  transaction in which Enron reported a gain from selling an interest in  three power barges located in Nigeria to Ebarge, LLC (Ebarge), an SPE  Merrill Lynch created for this transaction. This transaction occurred 2  days before the year-end closing date for Enron’s 1999 financial  statements. It was asserted that Merrill Lynch was not at risk for the equity  investment in Enron’s barges because Enron officials made oral  guarantees to arrange for the resale of Merrill Lynch’s interest in the  barges within 6 months, with a specified return to Merrill Lynch for its  involvement in the transaction. A publicly available Merrill Lynch  document related to this transaction indicates that prior to entering into  the transaction, Merrill Lynch received assurance from Enron that Merrill  Lynch’s investment would be liquidated within 6 months. After attempts  by Enron to sell Merrill Lynch’s interest in the barges to an independent  third party failed, an Enron-related party purchased Ebarge from Merrill  Lynch. Based on the sale price and fees received for the transaction,  Merrill Lynch received the allegedly promised return on its equity  investment. If, as asserted, Merrill Lynch did not have an equity risk in the  barges through Ebarge but instead had a credit exposure to Enron, then  Enron should have reported this transaction as a secured borrowing  instead of a gain on the sale of an asset, reducing the company’s net  income and increasing its debt. If, as alleged, Merrill Lynch knowingly and  substantially assisted Enron in violating the securities laws by improperly  reporting its debt as net income, and if such reporting is a violation of the  securities laws, SEC has the authority to bring an action against Merrill  Lynch for aiding and abetting a securities law violation.
Merrill Lynch officials contended that Enron proposed and structured the  transaction and that Enron also assured Merrill Lynch that its outside  auditors had vetted and approved its accounting for the transaction.  Merrill Lynch officials also contended that the firm provided no  accounting advice to Enron and that Merrill Lynch in fact was at risk in the  transaction because, while Enron orally agreed to make a “best effort” to  find another buyer for the asset, this promise was not a legally binding  guarantee. Officials told us they undertook the transaction as an  accommodation to Enron in the hopes of receiving increased Enron  business in the future. In February 2003, Merrill Lynch said that it had  agreed in principle with SEC, without admitting or denying any  wrongdoing, to pay a fine to resolve civil charges that it aided Enron in  fraudulently overstating Enron’s earnings in 1999. One of the transactions  reportedly included in the settlement was this Nigerian barge transaction.
It has also been alleged that Citigroup Inc. (Citigroup) assisted Enron in  executing transactions, despite knowing that the transactions used  deceptive accounting strategies, in return for substantial fees or favorable  consideration in other business dealings. Publicly available documents  describe transactions referred to as Bacchus and Sundance that involved  Enron, Citigroup, and several SPEs and took place over a 6-month period  beginning in December 2000. PSI and the bankruptcy examiner concluded  that the substance of the transactions for Enron was borrowing, which  instead of being reported as debt was recorded as a sale with a gain that  increased Enron’s net income through deceptive accounting. In these  transactions, Enron sold its ownership in a pulp and paper trading  business to an Enron-created SPE, the Caymus Trust, a transaction for  which Enron recorded a gain. Through a variety of agreements, Citigroup  was to be at risk for $6 million of equity in the Caymus Trust. However, it  has been asserted that Citigroup did not have equity risk because Enron  verbally guaranteed that the $6 million equity investment would be repaid.
A publicly available Citigroup document indicates that “Bacchus is a part  of a program designed to ensure that Enron will meet its year-end  .”
Approximately 6 months after the Bacchus transaction, the Sundance  transaction returned Citigroup’s investment in the Caymus Trust by  redeeming its investment. The Sundance transactions involved the  creation of an Enron-Citigroup joint venture that was allegedly designed to  ensure that Citigroup had no equity at risk. If Citigroup never had equity at  risk in these transactions, then the substance of the transactions was  secured borrowing that Enron should have reported as debt rather than as  a sale. A publicly available document prepared by Citigroup’s Risk  Management Group indicates that the group initially did not approve the  Sundance transaction because, among other things, “the GAAP accounting  is aggressive and a franchise risk to  if there is publicity (a la  Xerox).” If Citigroup knew that Enron had improperly recorded these  transactions and that the reporting by Enron was a violation of the  securities laws, and Citigroup’s conduct substantially assisted Enron’s  violations, SEC would have the authority to bring an action against  Citigroup for aiding and abetting Enron’s securities law violations.
In response to these allegations, Citigroup officials testified at a December  11, 2002 congressional hearing that Citigroup employees had acted in good  faith and had understood that these transactions complied with existing  law and the prevailing standards at the time. Although Citigroup’s internal  review committee had reviewed the transactions, Citigroup officials said  that Citigroup had viewed the accounting decisions as decisions that  would be made by Enron and its accountants. Citigroup noted that Enron  was a Fortune 10 company and that Enron’s auditors from Arthur  Andersen LLP were presumed to know about the transactions and to have  approved their accounting treatment.
Companies such as Enron can use properly structured SPEs to minimize  taxes, but SPEs have also been used to create complex transactions  designed to evade taxes. J.P. Morgan Chase & Co. (Chase) facilitated a  transaction for Enron (referred to as Slapshot), despite allegedly knowing  that the transaction used deceptive tax strategies. Chase designed the  Slapshot transaction, provided the funding, minimized its own risks, and  received substantial fees for facilitating the transaction. The Slapshot  transaction involved Enron, Chase, other lenders, a Chase SPE, and  several Enron affiliates and SPEs in order to refinance an Enron pulp and  paper mill and allegedly to evade Canadian taxes. Publicly available  reports describe Slapshot as a complex series of structured finance  arrangements that all took place during the same day and included a  $1.039 billion loan due later the same day and a $375 million loan due in 5  years and one day. In a publicly available Chase document related to the  design of the Slapshot transaction, Chase indicated that an advantage of  one aspect of the structure of the transaction was that it provided “no road  map for Revenue Canada.” If Chase knowingly and substantially assisted  Enron in evading taxes, resulting in the reporting of incorrect information  in Enron’s financial statements, and such reporting was a violation of the  securities laws, SEC would have the authority to bring an enforcement  action against Chase for aiding and abetting Enron’s securities fraud.
A Chase official testified at a congressional hearing that Chase’s  Structured Finance Group had developed the generic form of this  transaction and had received opinions from two leading Canadian law  firms that the structure and the Canadian tax benefits the transaction  provided were legal and valid.
section_title: Investment Banks Were Involved in Prepay Transactions Enron Used to Bolster Operating Results
paragraphs: It has been alleged that Chase and Citigroup assisted Enron in its  deceptive accounting over a period of years by facilitating several billion  dollars in loans disguised as energy trades and allowing Enron to use  offshore entities that the investment banks controlled as trading partners.  Although prepay transactions are common in the energy industry in  general, the Enron prepay transactions were allegedly unique because they  involved a circular cash flow arrangement among the three parties  involved in the transactions.
Publicly available reports describe several prepay transactions among  Enron, various investment banks, and usually a third-party SPE affiliated  with the investment bank. In these transactions, Enron received cash in  advance and promised to deliver a specific volume of oil or gas in the  future (or the cash value of the commodity). Enron accounted for these  transactions as energy trading activities and reported the prepay  transactions as liabilities from price risk management on its balance  sheet and as cash flows from operations on the statement of cash flows.  However, PSI and the bankruptcy examiner concluded that Enron’s  accounting for the transactions was inappropriate because the prepay  transactions were in substance and intent loans, not trading activities, and  should have been recorded by Enron as debt. Reporting them as debt,  however, would have weakened some of Enron’s key financial ratios, such  as its debt-to-equity ratio. Further, the cash Enron received would have  properly been reported as cash flows from financing activities on the  statement of cash flows and not as cash flows from operations. If it is  proven that the prepays were effectively loans, Enron’s accounting for the  prepay transactions as trading activities could have misled investors and  analysts about the scope of Enron’s trading activities and the nature of its  incoming cash flows. Publicly available Chase and Citigroup documents  indicate that the firms participated with other companies in prepay  transactions that, like Enron’s prepay transactions, often involved an SPE  and no price risk. However, we were not able to determine if these  transactions involved circular cash flows like Enron’s prepay transactions.  If the allegations that (1) the firms knowingly assisted Enron in engaging  in materially fraudulent transactions and (2) the firms’ conduct provided  substantial assistance to the fraud are proven true, SEC would have the  authority to bring an action against them for aiding and abetting securities  laws violations.
Publicly available reports describe prepay transactions among Enron,  Chase, and an SPE (Mahonia, Ltd.) that was created to undertake  transactions for Chase. In these transactions, Enron’s accounting  treatment of the prepay transactions as trading activities was allegedly  improper because in substance and intent the transactions were actually  loans. One publicly available Chase document indicated that “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 revenue or (better yet)  bury it in their trading activities.” Between 1992 and 2001, Enron and  Chase entered into 12 prepay transactions with a combined value of over  $3.7 billion.
In testimony given at a congressional hearing, in an interview with us, and  in documents supplied to us, Chase officials said that they understood that  Enron, with Enron’s auditor’s approval, had treated the prepay  transactions as trading activities. The officials contended that Chase  mitigated risk, as required by banking law, and that the risks of the  different transactions and hedges involved in prepays were different from  those of a loan. Chase provided us with excerpts from other companies’  financial statements that described their prepays as a means of financing,  recorded as liabilities for price risk management. However, we have not  reviewed these transactions and cannot determine if they were similar to  Enron’s prepay transactions.
Another example of an Enron prepay transaction involved Enron,  Citigroup, and a Citigroup-created SPE, Delta Energy, that served as a  third party. The first of these Citigroup prepay transactions in 1993 was  similar in structure to the Chase prepay transactions. However, some of  the later Citigroup prepay transactions involving Delta Energy were  funded by bond offerings to qualified institutional buyers instead of by  Citigroup. By raising funds for the prepay transactions in this fashion, the  institutional investors rather than Citigroup were at risk if Enron should  go bankrupt or default. PSI and the bankruptcy examiner concluded that  Enron’s accounting for these prepay transactions as trading activities was  improper, because in substance and intent the transactions were actually  loans. One publicly available Citigroup document discussing the approval  of an Enron prepay transaction indicated that Citigroup’s “internal  approval for the transaction will acknowledge that  was  basically making a loan.” PSI reported that between 1993 and 2001, Enron  and Citigroup entered into 14 prepay transactions with a combined value  of over $4.8 billion.
Citigroup officials contended the transactions were done in good faith,  complied with existing law and prevailing standards of the time, and had  been reviewed and approved by their internal review committee. Citigroup  officials contended that Enron assured them that its outside auditor had  fully vetted and approved its accounting treatment of prepays.
section_title: Other Enron and Global Crossing Transactions
paragraphs: The three investment banks highlighted in this report also participated as  passive investors in other transactions involving SPEs with Enron.  However, we did not confirm or refute whether, as passive investors, these  financial institutions participated in the management of the SPE. For  example, Chase, Merrill Lynch, and Citigroup were investors as limited  partners in the SPE LJM2 Co-Investment, L.P. (LJM2), contributing a total  of about $40 million. Merrill Lynch also acted as the private placement  agent for LJM2 and in this capacity helped introduce sophisticated  (wealthy) investors to the LJM2 partnership. For its work, Merrill Lynch  testified that it received about $3 million in fees. Also, the investment bank  invested $5 million itself and permitted 96 of its executives to invest about  $16.6 million of their own money in LJM2.
Section 705 of the Sarbanes-Oxley Act mandates that we review  investment bank involvement in the failure of Global Crossing, “including  with respect to transactions involving swaps of fiber optic cable capacity.”  It has been reported in the press, and plaintiffs have alleged in civil  actions, that Global Crossing improperly reported as revenue the proceeds  it received from sales of fiber optic capacity and services in transactions  with counterparties; however, to our knowledge, no investment banks  were involved in these transactions. In these transactions, Global Crossing  and its counterparties entered into simultaneous agreements to purchase  and sell fiber optic capacity and services. In many of these transactions,  the aggregate purchase and sales prices were similar or the same. It also  has been alleged by plaintiffs that these transactions lacked a legitimate  business justification and that, as a result, Global Crossing’s financial  statements were materially misleading to the investing public. In October  2002, Global Crossing announced that it would restate its financial  statements for prior periods based on advice from SEC staff that Global  Crossing’s previous accounting for these transactions did not comply with  generally accepted accounting principles and that the transactions should  be recorded on a historical carryover basis. Global Crossing’s  announcement stated that the company had relied on advice from its  independent advisors and an industry white paper in accounting for these  transactions.
section_title: Investment Banks and Federal Financial Regulators Have Begun Strengthening Their Oversight of Structured Finance Transactions Since Enron’s Collapse
paragraphs: According to the investment banks we spoke with, the transactions  discussed here were vetted through their internal risk management  processes. In the aftermath of their experience with Enron, however, these  firms have become more concerned about possible reputation risk and  thus have reported taking steps to strengthen their risk management  processes. Federal financial regulators saw these steps as positive but  noted that it was too soon to evaluate how well the new policies and  procedures would work. Federal financial regulators also responded to the  issues raised by the Enron collapse. These regulators use a risk-focused  approach to oversight, identifying the most significant risks to a financial  institution and then determining whether appropriate risk management  systems and internal controls are in place. Federal financial regulators  noted that before Enron’s collapse, structured transactions did not pose  significant risks in traditional risk management areas. Since then the  regulators have been considering additional legal and reputation risk  reviews and are looking at ways to further enhance examination scopes  and procedures in this area. In addition, they have confirmed that they will  more extensively sample transactions in examinations that raise issues of  concern.
subsections: section_title: Investment Banks Use Risk Management and Other Internal Control Systems to Approve Structured Finance Transactions
paragraphs: In our market-based economy, market discipline and proper disclosure of  risks are the primary means of controlling risk-taking behavior. When  investors respond to negative information about a company by selling (or  not buying) its securities, the company’s access to capital may be limited  or capital may become more costly to obtain. Investment banks have a  similar but more extensive role: they not only make decisions on the  provision and terms of capital, but also make decisions in other areas,  such as structured finance and whether to participate in and facilitate a  client’s activities.
Investment banks use a variety of control processes and policies—formal  and informal—for reviewing and evaluating whether to enter into a  particular transaction, to expand a business line, or enter into a new  business or product line. These policies and procedures are also used to  establish any conditions, procedures, or parameters applicable to the  transactions, new product or business line. The three investment banks  involved in the transactions discussed in this report all had internal review  and approval processes with independent control processes that were to  review transactions for their appropriateness. Control groups and  business unit representatives involved in the review process generally  operated by consensus. However, in circumstances where the business  unit wished to pursue a transaction despite concerns expressed by a  control group, senior management (management that is, at a minimum,  senior to the business unit directly interested in the transaction) could  exercise the discretion to approve the transaction.
In speaking for several large investment firms, a representative of the  securities industry told us that all investment firms recognized that the  various processes and policies they have adopted for transaction review  and approval are fallible. However, these processes and policies were  designed not to police compliance by clients with accounting or disclosure  obligations, but to ensure that the relevant risks and issues presented by a  transaction or new product or business line are identified and evaluated by  the appropriate control functions. In their view, an investment-banking  firm generally is not in a position to perform an effective policing function  vis-à-vis its client for a number of reasons. First, investment banks  generally (underwritings present a partial exception to this general  principle) will not have access to financial or transactional information  that, although unrelated to the specific transaction under consideration, is  relevant to determining whether the client’s disclosure for a transaction is  appropriate. Moreover, investment-banking firms are frequently not in a  position to make the relevant materiality determinations or to exercise  control over disclosure determinations. Indeed, these determinations are  made in many cases subsequent to the execution of the transactions. The  investment banks expressed the view that it is a client’s senior  management, audit committee, and independent auditors who are in  possession of the information and decisionmaking authority necessary to  exercise an effective gatekeeping role. Therefore, according to these  investment banks, as a policy matter, these are the groups who should be  viewed, and who should view themselves, as responsible for performing  that role.
The transactions that are the focus of this report were reportedly vetted  through the risk management processes of the investment banks involved.  For example, one investment bank told us that it had been engaging in  prepay transactions with Enron for about a decade and that it had closely  reviewed the initial transactions but not subsequent prepays, which were  not seen as a new type of transaction. The investment bank maintained  that because it had not reviewed the later transactions, it had not realized  the extent to which Enron had changed from an energy company to a  financial company over the years. Another investment bank told us that its  risk management reviews of the Enron transactions relied heavily on  Enron’s assurances that the outside auditor for Enron had reviewed the  transactions and considered them appropriate. Representatives of the  investment bank also said that, in their view, the decision to approve the  transactions was appropriate given the information they had at the time.  But they added that if they had known then what they know now about  Enron, they would not have done business with the company. A securities  industry official told us that risk management decisions regarding the  Enron transactions failed not because investment banks did not have  internal control processes but because Enron did not provide these firms  with the whole picture.
Representatives of some investment banks told us that after Enron’s  collapse, their firms became more sensitive to risk management issues,  such as the possibility that some transactions could involve fraudulent or  questionable financial reporting on a client’s part. Based on this  experience, some investment banks told us they had taken steps to  strengthen their risk management, although the processes themselves  remained essentially the same. For example, one investment bank created  a new policy review office to formalize and strengthen the firm’s process  for examining transactions and products. According to the investment  bank’s chief executive officer, the office is intended to help ensure that the  firm does not participate in transactions that its clients do not properly  disclose. The investment bank’s management told us that their risk  management process would not presume that transactions with highly  rated large U.S. corporations were appropriate without asking more  detailed questions. Instead, regardless of the corporation’s size and  reputation, the investment bank would require a closer look at all complex  transactions that could involve fraudulent or questionable financial  reporting. Investment bank representatives also said that accounting and  tax-driven transactions would now get a more thorough review.
Representatives from another investment bank told us that legal and  accounting representations on some transactions would now be obtained  from outside sources. Representatives from yet another investment bank  said that, based on their negative experiences with Enron, they were now  willing to ask more questions about specific transactions. In August 2002,  this investment bank announced a new initiative as one of a series of  enhancements to the controls it imposes on the execution of transactions  that raise legal, accounting, or other reputation issues. This new policy  states that if the transaction would be materially significant for the client,  the investment bank will proceed only if the client commits to disclosing  the transaction’s “net effect” on its financial position. Under this policy,  the focus will be on the economic reality of the transaction, not just its  form. Officials from this firm said that risk management processes do not  necessarily discover corporate accounting fraud on the part of clients.
According to bank regulators, since Enron’s collapse financial institutions  have taken some steps to deal with risk management issues in future  transactions. First, the financial institutions have centralized the process  for establishing, using, and managing SPEs and conducting separate audits  of SPEs’ activities. Second, they have strengthened their review and  approval processes for complex structured transactions in several ways.  For example, management reviews during the approval process now  include a broader range of senior managers from various areas of the  financial institution and focus more closely on assessing customer  motivation and appropriateness. In order to obtain a structured product,  customers are required not only to provide information on disclosures and  accounting treatment but also to comply with strict reporting standards.  Bank regulators said that these are positive steps toward strengthening  internal processes but noted that it is too early to evaluate how well the  changes will work.
section_title: Federal Banking and Securities Regulators Use a Risk-Focused Approach to Overseeing Large Financial Institutions
paragraphs: The Federal Reserve, OCC, and SEC share responsibility for overseeing  the largest complex financial institutions. Each regulator is responsible for  specific activities. The Federal Reserve regulates bank holding companies  and state-chartered banks that are members of the Federal Reserve  System; OCC regulates the activities of nationally chartered banks; and  SEC regulates activities involving securities and firms (broker-dealers)  that trade securities. Banking and securities regulators have different  regulatory missions and focus on different operational aspects of the  entities they oversee. Because commercial banks accept customer  deposits and use those funds to lend to borrowers, banking regulators  tend to focus on safety and soundness. Securities regulators focus on  protecting investors and ensuring that markets are fair. SEC aims to  ensure that public companies fully disclose material information, including  the risks associated with their transactions and their financial condition,  so investors can make informed investment decisions.
Because risks can manifest themselves in different parts of a large  financial institution, it is important for federal financial regulators to be  able to assess the overall risk management activities of the entire  organization. Most large financial institutions have a firm-wide risk  management framework in place to identify and control risk. These  institutions can have complex structures, including parent companies,  affiliates, and subsidiaries, all of which can be involved in different aspects  of risk assessment. The component entities may have one or more federal  financial regulators, or, in some cases, none. Banks and their holding  companies are regulated on a consolidated basis, but in the securities  sectors, SEC-registered broker-dealers are regulated by SEC, even if these  entities are part of a larger holding company. Although those parts of a  securities firm that are outside the broker-dealer may not be regulated by  SEC, SEC has authority to extend its oversight beyond the broker-dealer  to assure that activities in the affiliates do not threaten the soundness of  the regulated entity. SEC officials said that, when appropriate, they have  used this authority to examine the overall risks of affiliates.
The Federal Reserve, OCC, and SEC use a risk-focused exam approach  that concentrates on those products, transactions, and services that are  considered to pose the greatest risks to an individual firm’s overall  financial condition or the financial system as a whole. Risk is the potential  that expected or unanticipated events can cause a firm to suffer losses that  adversely affect its capital and earnings. Table 2 describes selected types  of risk.
Under the risk-focused supervision approach, bank and securities  examiners identify the most significant risks to a financial institution and  then determine whether risk management and internal control systems are  in place to identify, measure, monitor, and manage those risks. Because of  the complexity of the largest financial institutions and the number of  transactions they conduct, bank and securities examiners focus on  assessing the integrity and effectiveness of the institutions’ overall risk  management and internal control systems. As deemed appropriate, bank  examiners also test selected transactions, and SEC reviews the policies  and procedures firms have in place. Federal financial regulators have an  array of tools at their disposal to ensure that regulated entities take  corrective steps when problems are identified. These tools range from  informal supervisory actions such as issuing a deficiency letter (SEC) or  issuing a memorandum of understanding (bank regulators) that details  areas where corrective measures are appropriate to formal enforcement  actions such as cease and desist orders and referrals to other regulators or  law enforcement agencies for civil or criminal sanctions.
subsections: section_title: Federal Financial Regulators Did Not Identify Structured Finance As a High-Risk Area Before Enron’s Collapse
paragraphs: According to federal financial regulatory officials, only a few large  financial institutions offer complex structured transactions such as those  involving Enron, although a variety of other financial institutions may  conduct isolated structured finance transactions. Federal financial  regulators noted that prior to Enron’s collapse they had not viewed  reputation risk from structured transactions as a high-risk area, primarily  because (1) the risk focus was on traditional market, credit, and  operational risks; (2) the size and volume of transactions were small  relative to the total capital of relevant financial institutions; (3) many such  transactions are conducted with investment-grade firms; and (4) with  respect to securities firms, many of the activities may have taken place in  affiliates outside of the SEC-regulated broker-dealer. Banking agency  officials told us that they had each reviewed the accounting for prepay  transactions conducted with Enron at one bank in their respective  jurisdictions and found it consistent with generally accepted accounting  principles. SEC officials noted that their focus is on the policies and  procedures the investment banks have in place for assessing risk and  approving these transactions and only review select transactions to  evaluate whether the policies and procedures have been effectively  implemented.
section_title: Federal Financial Regulators Have Made Changes to Their Oversight Processes As a Result of the Enron Scandal
paragraphs: Federal financial regulators said that since the Enron scandal they have  refined their approach to supervising certain operational aspects of the  institutions that are involved in complex structured transactions. In a  February 10, 2003 response to questions posed to them by PSI, officials of  the Federal Reserve, OCC, and SEC said that staff at their agencies were  continuing to review investment banks’ participation in the complex  financial products, transactions, and practices that have raised significant  legal and accounting questions. Further, in carrying out these reviews, the  federal financial regulators said that they were collaborating on both  specific issues arising from the practices under review and broader issues  relating to the internal control and oversight mechanisms investment  banks need to oversee structured finance transactions. The agencies were  not planning an additional one-time joint review but said they would  continue conferring on the investigations and examinations that were  already under way. The federal financial regulators said that during 2003  they would review and evaluate the actions individual organizations were  taking to strengthen policies and practices in the structured finance  business. Based on the results of these reviews, the agencies intend to  develop consistent guidance and best practices for the entities within their  respective regulatory jurisdictions that they believe are necessary to  clarify their expectations for sound control and oversight mechanisms.
In addition, some of the federal financial regulators have altered their  policies and procedures examination manuals to improve oversight of  structured products and the institutions that use them. In the fall of 2002,  for example, the Federal Reserve issued additional examination guidance  on supervising structured products and SPEs. Further, SEC officials stated  that the agency is drafting a new examination module for structured  finance transactions to be used in examining the risk management and  internal control systems of broker-dealers. SEC has been conducting risk  management and internal control system examinations since 1995, but  limited resources have kept the agency from doing as many exams as it  considers necessary. An SEC official stated that an anticipated budget  increase should allow the agency to increase its staffing and conduct  additional examinations.
section_title: Recent Rules and Legislation Aim to Make Off-Balance Sheet Transaction Reporting and Disclosures More Transparent
paragraphs: In light of Enron’s collapse, legislation and regulations have been adopted  that attempt to restore investor confidence by requiring more disclosure  and transparency in structured finance transactions. One area that has  received particular attention is the disclosure of off-balance sheet  transactions in registration statements and periodic filings. In addition,  SEC is required to study this issue and to produce a report of its findings.
Registration statements and periodic reports contain a “management  discussion and analysis” section for management to explain clearly a  company’s financial condition. According to SEC, as a response to  uncertainty over quality of earnings issues in general, including those  raised by the collapse of Enron, SEC issued a release cautioning company  management to report in this section full explanations of their “critical  accounting policies,” the judgments and uncertainties affecting the  application of these policies, and the likelihood that materially different  amounts could be reported under different conditions or using different  assumptions. Structured finance transactions frequently require the  application and selection of critical accounting policies. SEC issued a  follow-up release proposing rules to codify and expand upon this guidance  in May 2002. According to an SEC official, SEC staff are currently  reviewing the comment letters and developing recommendations for  future SEC action on this topic.
In July 2002, Congress enacted Section 401(a) of the Sarbanes-Oxley Act,  which required that by January 2003 SEC issue final rules providing that  annual and quarterly financial reports filed with SEC disclose all material  off-balance sheet transactions, arrangements, and obligations. On January  22, 2003, SEC adopted rules to implement that section. These rules  stipulate that financial reports that public companies are required to file  with SEC after June 15, 2003 include an explanation of the company’s  financial condition disclosing material off-balance sheet transactions,  arrangements, obligations, and any relationships the issuer has with  unconsolidated entities.
In August 2002, pursuant to Section 302(a) of the Sarbanes-Oxley Act, the  SEC adopted rules to require the certification of an issuer’s quarterly and  annual reports by its principal executive and financial officers. SEC also  adopted rules requiring issuers to maintain and regularly evaluate the  effectiveness of disclosure controls and procedures. Among other things,  the certifications state that the overall financial disclosure fairly presents,  in all material respects, the company’s financial condition, results of  operations and cash flows. A “fair representation” of an issuer’s financial  condition and results of operations and cash flows encompasses the  selection of appropriate accounting policies, proper application of  appropriate accounting policies, disclosure of financial information that is  informative and reasonably reflects the underlying transactions and  events, and any additional disclosure necessary to provide investors with a  materially accurate and complete picture of an issuer’s financial condition  and results of operations and cash flows. Such certification forces the  executive officers to not only certify whether the company’s financial  statements are prepared in compliance with generally accepted  accounting principles, but also whether the financial statements and other  financial information fairly present in all material respects the financial  condition and results of operations and cash flows of the company.
In addition, Section 402 of the Sarbanes-Oxley Act requires that SEC  complete a study by January 2004 to determine not only the extent of off- balance sheet transactions and the use of SPEs but also the degree to  which the economics of such transactions are transparently conveyed to  investors. The act also requires that SEC report to the President, the  Committee on Banking, Housing, and Urban Affairs of the Senate, and the  Committee on Financial Services of the House of Representatives 6  months after the study is completed on the following:    public companies’ off-balance sheet transactions and use of SPEs,  the extent to which SPEs are used to facilitate off-balance sheet  transactions,  the extent to which current rules and accounting principles result in  financial statements that are transparent with respect to SPEs and off- balance sheet transactions,  the extent to which current accounting principles result in the  consolidation of issuer-sponsored SPEs when the issuer carries most of  the SPEs risks and receives most of its rewards, and  recommendations for improving the transparency of reporting off-balance  sheet transactions in public companies’ financial statements.
In response to controversies related to Enron’s use of SPEs, the  accounting guidance related to SPE financial reporting was clarified in  January 2003 when the Financial Accounting Standards Board released  Interpretation No. 46, Consolidation of Variable Interest Entities. In  general, this new guidance requires that an SPE be consolidated with  another entity if that entity is the primary beneficiary of the SPE—that is,  if it absorbs the majority of the risks and rewards of the SPE’s operations.  Specifically, an SPE would be consolidated with its primary beneficiary if  the outside equity investment was not at least 10 percent of its total  assets and is not greater than its expected losses, or if the outside equity  holders in the SPE lack (1) the ability to make decisions about the SPE’s  activities (control), (2) the obligation to absorb expected losses of the SPE  if they occur (risk), and (3) the right to receive residual returns of the SPE  if they occur (reward). Many SPEs that were previously unconsolidated  will be consolidated as a result of the interpretation, starting with their  first fiscal year or interim period beginning after June 15, 2003.
section_title: Conflicts of Interest Reportedly Affected Research Analysts’ Ratings of Enron and Global Crossing
paragraphs: According to some allegations, some research analysts at investment  banks recommended Enron and Global Crossing securities to investors in  order to get lucrative investment bank deals for their firms. Such analysts  are better trained and positioned than the average retail investor to assess  the value of a company’s securities. The value and credibility of their  recommendations depend on their maintaining unquestioned  independence and objectivity in their research and resulting investment  recommendations. The issues surrounding research analysts’ actions in  recommending Enron raise a number of serious questions, primarily  concerning the effectiveness of barriers between the research and  investment banking functions of investment banks. In response to this  concern, regulators have introduced new rules designed to reduce such  conflicts of interest, and a number of other actions have been initiated.
subsections: section_title: Research Analysts Allegedly Issued Misleading Stock Reports
paragraphs: Research analysts study publicly traded companies and make  recommendations about the securities of those companies, often by  issuing research reports. Investors often see research analysts at  investment banks as important sources of information about securities.  However, many factors can adversely affect these analysts’ independence  and objectivity in their research reports, including investment banking  relationships and compensation arrangements tied to investment banking  revenues.
Conflicts of interest reportedly emerged at several investment banks that  made stock recommendations about Enron and Global Crossing. For  instance, research analysts with Merrill Lynch and Citigroup’s Salomon  Smith Barney Inc. (Salomon Smith Barney) who were covering Enron and  Global Crossing allegedly were pressured to issue misleading research  reports on these companies because the companies were current or  prospective investment banking clients. Although PSI did not examine the  research analyst issue, certain documents released at a PSI hearing  suggest that Merrill Lynch terminated a research analyst because he did  not provide a sufficiently favorable rating on Enron that would have  improved the investment bank’s chances of being chosen by Enron to  participate in lucrative investment banking work. Merrill Lynch officials  contended that the analyst was terminated for other reasons and that he  actually raised his rating on Enron while working at another firm, one  month after he had left Merrill Lynch and before Merrill Lynch did so.
A number of class action securities lawsuits allege that a Salomon Smith  Barney research analyst covering Global Crossing Ltd. was pressured to  issue misleading research reports on this company because the company  was a current investment-banking client. The analyst reportedly issued  compromised or misleading research reports containing buy ratings for  the company that had no basis in fact. The complaints also allege that the  analyst provided strategic advice, essentially acting as an investment  banker as well as a research analyst. This relationship between Salomon  Smith Barney’s analyst and its investment bankers was allegedly not  disclosed. Citigroup officials told us that Salomon Smith Barney believed  that the analyst did in fact have a reasonable basis for his analysis and that  the company and the analyst are defending the lawsuits. The analyst in  question resigned in 2002. In addition, Citigroup officials informed us that  Salomon Smith Barney has created a new structure under new senior  management and implemented a number of other steps to strengthen the  independence of its analysts.
section_title: Regulators and Others Have Taken Some Actions to Address Research Analysts’ Conflicts of Interest
paragraphs: The role of research analysts and the potential conflicts of interest  involving them raise a number of issues. The primary one is the adequacy  and effectiveness of barriers between the research and investment  banking functions of investment banks. In June 2001, the New York  Attorney General opened an investigation into the practices of Merrill  Lynch concerning analyst ratings and in May 2002 reached a settlement  with the firm. According to the terms of the settlement, Merrill agreed to  fines of $100 million and significant reforms, including severing the link  between analysts and investment banking.
In May 2002, both NYSE and NASD received SEC approval for rules  addressing conflicts of interest involving analysts at companies that have  an investment banking relationship with firms their analysts cover. The  new rules are intended to reestablish the separation between the  investment banking and research departments of large multiservice  brokerage firms and prevent investment banking personnel from  reviewing or approving research reports prior to publication. Similar  restrictions apply to communications between the research department  and the company being researched, with the additional restriction that the  company being researched is not to be provided with a research summary,  the research rating, or the price target. Further, the rules state that  companies cannot be offered, directly or indirectly, favorable research, a  specific rating, or a specific price target, nor can they be threatened with  changes to research, a rating, or a price target as consideration or  inducement for business or compensation. In addition, both NASD’s and  NYSE’s rule changes require disclosure of financial interests held by the  brokerage firm, analysts, and analysts’ family members and of any other  material conflict of interest associated with recommending a particular  security. Analysts are also subject to trading restrictions with respect to  securities in the subject company. In addition, the rules prohibit research  analysts from receiving compensation in any form—bonus, salary, or  otherwise—based on a specific investment banking services transaction.  According to NASD officials, NASD and NYSE have incorporated the new  rules into their examination programs and have already begun examining  firms for compliance with them. Soon after these rules were adopted,  NASD and NYSE began conducting joint examinations of multiservice  brokerage firms for compliance with the new NYSE and NASD analyst  rules on conflicts of interest.
NASD and NYSE proposed additional rules in December 2002 that are  intended to further manage analyst conflicts. The rules would, among  other things, further insolate analyst compensation from investment bank  pressures, prevent the issuance of “booster shot” research reports, and  require disclosure of a final research report when an analyst terminates  coverage of an issuer. We could not evaluate the overall effectiveness of  the rules because they are so new.
A number of other important steps have been taken to address research  analysts’ conflicts of interest. First, in the last year NASD has brought  many enforcement actions against broker-dealers that have issued  misleading analyst reports without having a reasonable basis for the  statements made in the reports. NASD brought most of these actions  under NASD Rule 2210, which requires broker-dealers to have a  reasonable basis for assertions they make in their research reports. In  April 2002, SEC announced that it had begun a formal inquiry into market  practices concerning research analysts and the potential conflicts in the  relationship between research and investment banking in brokerage firms.  According to SEC officials, as part of this inquiry SEC, NYSE, and NASD  conducted joint examinations of 12 multiservice brokerage firms. The  purpose of the examinations was to ascertain facts, conditions, practices,  and other matters relating to conflicts of interest associated with the work  of research analysts. In October 2002, SEC, NYSE, and NASD announced  that they would work jointly with the New York Attorney General’s office  and the North American Securities Administrators Association to bring to  a speedy and coordinated conclusion the investigations concerning  research analysts. NYSE and NASD conducted joint examinations of the  same firms separate from those examinations that they were conducting  for compliance with the new NYSE and NASD analyst rules on conflicts of  interest. SEC examination staff also participated in these examinations.
A settlement in principle to resolve issues of conflict of interest at  multiservice brokerage firms was announced in December 2002, with 10  large investment banks agreeing to pay over $1.4 billion in sanctions and  agreeing to certain reforms. Among the reforms were an agreement to  sever links between research and investment banking, a ban on allocating  initial public offering shares to corporate executives and directors, an  obligation to contract with at least three independent research firms to  provide research to the brokerage firm’s customers for 5 years, and the  hiring of an independent consultant (chosen by regulators) for each firm  with final authority to procure independent research from independent  providers. Additionally, the settlement would require each firm to make its  ratings and price target forecasts publicly available. The settlement in  principle is subject to approval by the SEC Commissioners.
On February 6, 2003, SEC adopted Regulation AC (Analyst Certification),  which requires that any research report disseminated by a broker, dealer,  or certain associated persons of a broker-dealer include certifications by  the research analyst that the views expressed in the research report  accurately reflect the analyst’s personal views and disclose whether the  analyst received compensation or other payments in connection with his  or her specific recommendations or views. The regulation also requires  analysts to provide certifications in connection with public appearances.  By requiring these certifications and disclosures, according to SEC, the  regulation should promote the integrity of research reports and investor  confidence in the recommendations they contain.
According to SEC officials, SEC examination staff will continue to  examine for issues related to conflicts of interest involving research  analysts in future examinations. SEC, NASD, and NYSE will examine  investment banks for compliance with Regulation AC and self-regulatory  organization rules on such conflicts of interest.
section_title: Observations
paragraphs: Today structured finance transactions such as those Enron entered into  with various investment banks are very complex arrangements designed to  achieve a variety of economic and tax purposes. With such creative  financing, two financial transactions can, for example, have identical  financial or economic outcomes but substantially different tax and  accounting implications. The appropriateness and presentation of such  transactions can hinge, among other things, on the actual purpose and  intent of the transactions involved. Designing, advising on, or participating  in such transactions can be lucrative for investment banks, which compete  vigorously for the business. In the case of Enron, the incentives to  participate in transactions to accommodate the client were strong: the  prospect of handsome revenues and the perceived risk-mitigating factor  that Enron was a large, prominent, investment-grade company whose  outside auditor had reportedly vetted the appropriateness of the  transactions. Given these incentives, the investment banks may have  reduced the weight attached to or overridden their risk-management  systems. These events illustrate that lapses in market discipline can create  significant reputation and legal risks and that adequate due diligence is  always necessary, regardless of the sophistication or prominence of the  counterparties.
Although investment banks have primary responsibility to practice  prudent risk management procedures, prudent procedures do not  guarantee prudent practices. The events surrounding Enron’s collapse  demonstrate the importance of regulatory oversight in identifying and  promptly correcting weaknesses in risk management practices. Prior to  Enron’s collapse, federal financial regulators had not identified the lapses  in investment banks’ risk management practices and the threats reputation  and legal risks posed to firms involved in complex structured transactions  with Enron. Federal financial regulators placed significantly more  emphasis on the regulated firms’ risk of material loss from traditional  risks, such as counterparty default, than they did on less quantifiable  factors such as reputation or legal risk. We are encouraged that investment  banks are beginning to strengthen their risk management practices by,  among other things, gaining additional assurances of the underlying intent  behind and the anticipated accounting treatment and presentation of  complex structured finance transactions they facilitate for their clients.  The purpose and intent behind these complex structured transactions  must be properly understood and transparent. Now, federal financial  regulators need to determine whether these safeguards will be sufficient  and develop a means not only to ensure that the safeguards are  implemented properly and swiftly but also to take steps to more regularly  consider the reputation and legal risks associated with complex structured  transactions in future examinations.
Accounting and auditing standards and securities laws recognize that an  entity’s management is responsible for the fair and accurate presentation  of the entity’s financial statements. Investment banks are not typically  responsible for their client’s accounting. However, it is a violation of the  federal securities laws for investment banks to aid and abet complex  structured financial transactions that will materially misstate a public  company’s financial statements, thereby deceiving investors and creditors.  SEC would have the authority to bring a legal action for aiding and  abetting a securities violation against an investment bank if the investment  bank knowingly gave substantial assistance to its client in carrying out a  violation of the securities laws.
However, we have observed that a conflict exists among the courts about  the level of knowledge that SEC must prove to successfully bring an aiding  and abetting case. As previously discussed, in some courts the level of  knowledge must be actual knowledge, a difficult element to prove. In  other jurisdictions, the proof of reckless disregard for the truth is  sufficient. Depending on where the fraudulent conduct occurred or the  location of potential parties to the suit, SEC may not be able to  successfully pursue all cases that may involve potential aiding and abetting  violations. Since investment banks might be tempted to participate in  profitable but questionable transactions when successful SEC prosecution  is in doubt, it is especially important that regulators be alert to this  possibility and be ready to use the rest of their enforcement tools to deter  such actions.
Another ongoing issue is the potential conflict of interest between  investment bankers and research analysts. The value and credibility of  research analysts’ recommendations depend on the analysts’ unquestioned  independence and objectivity in their research and resulting  recommendations. However, many factors can put pressure on an  analyst’s independence and objectivity, including investment banking  relationships and compensation arrangements tied to investment banking  revenues. SEC, NYSE, NASD, the New York Attorney General, and other  states have taken actions to promote the integrity of research reports and  investor confidence in the recommendations contained in those reports,  but it is too soon to assess the overall effectiveness of these steps. In  addition, SEC, NYSE, and NASD are required to take further actions to  promote the integrity of research reports in compliance with the directives  of The Sarbanes-Oxley Act. This issue will need to be monitored to ensure  that regulatory actions achieve the desired results.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided copies of a draft of this report to the Federal Reserve, OCC,  SEC, and the Department of Justice for their comment. The Federal  Reserve, OCC, and SEC provided technical comments, which we have  incorporated where appropriate. The Department of Justice had no  comment.
We are sending copies of this report to the Chairman and Ranking  Minority Member of the Permanent Subcommittee on Investigations,  Senate Committee on Governmental Affairs; the Chairman and Ranking  Minority Member of the Senate Committee on Governmental Affairs; and  the Chairman and Ranking Minority Member of the House Committee on  Energy and Commerce. We are also sending copies of this report to the  Chairman of the Federal Reserve, the Chairman of the SEC, the U.S.  Attorney General, the Comptroller of the Currency, and other interested  parties. This report will also be available at no cost on GAO’s Internet  homepage at http://www.gao.gov.
This report was prepared under the direction of Barbara I. Keller,  Assistant Director. Please contact her or us at (202) 512-8678 if you or your  staff have any questions concerning this work. Key contributors are  acknowledged in appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine the role investment banks played with Enron Corporation  (Enron) in designing and executing structured finance transactions, we  reviewed public reports and congressional testimony, interviewed private  and public sector officials, and searched the Internet for relevant  information. We selected five transactions involving primarily three  investment banks for our analysis. The transactions do not cover all of the  transactions these investment banks participated in with Enron, nor do  they represent transactions with all of the investment banks with which  Enron had relationships. They do, however, exemplify a variety of  relationships Enron had with a number of different investment banks. The  five transactions were discussed at hearings held by the Senate Committee  on Governmental Affairs, Permanent Subcommittee on Investigations  (PSI),in July and December 2002. These transactions are among those  involving allegations that investment bankers assisted Enron in  manipulating its earnings but are not those included in Enron’s  restatement of its financials for the period 1997 through the second  quarter of 2001. We did not have sufficient public information to determine  the extent of investment bank involvement in the latter transactions. Given  the short time frame and the ongoing agency investigations, we did not do  an independent investigation into the involvement of these investment  banks in possibly aiding and abetting Enron’s alleged securities fraud  arising from these latter transactions. Moreover, the investment banks  described themselves as passive investors, and we did not confirm or  refute their assertions. We interviewed investment bank and federal  financial regulatory officials to obtain their views on information (facts  and issues) presented at congressional hearings regarding some of the  above-mentioned transactions. We also spoke with PSI staff and compared  PSI’s disclosures, such as descriptions of transactions, with information  presented in other publicly available documentation, including the Powers  Report, the bankruptcy court examiner reports, Securities and Exchange  Commission (SEC) complaints, and complaints in private lawsuits.
To determine regulatory oversight of structured financial products, we  interviewed relevant officials at the federal financial regulatory agencies  (SEC, Office of the Comptroller of the Currency , and the Federal  Reserve) about their oversight and examination processes for structured  finance transactions. We also reviewed examination guidance and relevant  GAO reports. To determine investment banks’ risk management and  internal controls processes, we interviewed members of the Securities  Industry Association as well as representatives of the investment banks  whose transactions we analyzed. We also reviewed companies’ annual  reports and literature on financial risk management.
To understand the role investment banks’ research analysts played with  Enron and Global Crossing Ltd. (Global Crossing), we focused on the  alleged conflicts of interest that affected the objectivity and independence  of Merrill Lynch & Co., Inc (Merrill Lynch) and Citigroup Inc.’s Salomon  Smith Barney Inc. research analysts. We relied on congressional  testimony, legal cases, law review articles, settlement agreements, press  releases, and bankruptcy filings for most of our information. To determine  the issues raised and responses taken, we reviewed SEC, New York Stock  Exchange, and NASD rules, proposals, releases, and documents about  their new policies and rules. To determine the standards for aiding and  abetting liability, we relied on case law, statutes, and law review articles.
We found no publicly available documents or references to investment  bank involvement with Global Crossing in its design or implementation of  structured transactions. We discuss other client relationships, primarily  those involving research analysts, that investment banks had with Global  Crossing. For this discussion, we relied on public documents, including  those obtained by the House Committee on Financial Services.
Investigations and litigation are under way in connection with both Enron  and Global Crossing, and it was not our objective to assess, nor should this  report be construed as assessing, the potential culpability of the parties  involved in the transactions discussed in the report. In instances such as  these, if we have good cause to believe that any potential violations of  applicable laws or regulations have occurred, we refer such matters to the  appropriate governmental authorities for their consideration and possible  action. As noted, there are currently ongoing and extensive litigation and  investigations involving Enron and Global Crossing generally.
We conducted our work between September 2002 and March 2003 in  Washington, D.C. and New York, N.Y. in accordance with generally  accepted government auditing standards.
section_title: Appendix II: Investment Bank Involvement with Enron in Five Structured Finance Transactions
paragraphs: This appendix describes five transactions involving investment banks that  assisted Enron Corporation (Enron) in its use of structured finance to  generate recorded sales, decrease taxes, and facilitate prepay transactions  that resulted in beneficial operating results. It has been alleged that  Enron’s accounting for these transactions was deceptive and that  investment banks in various ways knowingly enabled Enron to manipulate  and obscure its reported results or to evade taxes.
subsections: section_title: Enron’s Nigerian Barge Transaction
paragraphs: Congressional hearing documents and an SEC complaint describe a  transaction in which Enron reported a $12 million gain from selling  interest in three power barges located in Nigeria to Ebarge, LLC (Ebarge),  a special purpose entity (SPE) created for this transaction by Merrill  Lynch. This transaction occurred on December 29, 1999, 2 days before the  year-end closing date of Enron’s 1999 financial statements, reportedly to  allow Enron’s African Division to make its earnings target for the year. See  figure 1 for a diagram of this transaction.
Merrill Lynch, through its SPE Ebarge, purchased an interest in the barges  for $28 million from a Nigerian Enron subsidiary. Merrill Lynch provided  $7 million in cash to Ebarge for equity ownership. The remaining $21  million was obtained as a loan from another Enron entity that received no  interest payments from Ebarge. It has been asserted that Merrill Lynch,  through its SPE, Ebarge, did not have equity from the purchase at risk  because Enron officials made oral guarantees to arrange for the resale of  Merrill Lynch’s interest in the barges by June 30, 2000, with a specified  return for Merrill Lynch for its involvement in the transaction. A publicly  available Merrill Lynch document related to this transaction indicates that  prior to entering into the transaction, Merrill Lynch received assurance  from Enron that its investment would be liquidated within 6 months. On  June 29, 2000, after Enron’s efforts failed to sell Merrill Lynch’s interest to  an independent third party, LJM2 Co-Investments, L.P., an Enron-related  party, purchased Ebarge from Merrill Lynch, which ended Merrill Lynch’s  ownership interest in the barges. Merrill Lynch received fees and a return  on its investment that totaled $775,000, equaling the allegedly promised  return to Merrill Lynch for its involvement in the transaction. If, as  asserted, Merrill Lynch through its SPE, Ebarge, did not have an equity  risk in the barges but instead had a credit exposure to Enron, then Enron  should have reported this transaction as a secured borrowing instead of a  $12 million gain on the $28 million sale of an asset. This accounting would  have reduced Enron’s net income and increased Enron’s debt.
Merrill Lynch officials contended that Enron proposed and structured the  transaction and also assured Merrill Lynch that its outside auditors had  vetted and approved its accounting for the transaction. Merrill Lynch  officials also contended that Merrill Lynch provided no accounting advice  to Enron and that Merrill Lynch in fact was at risk in the transaction  because, while Enron orally agreed to make a “best effort” to find another  buyer for the asset, this promise was not a legally binding guarantee and  there was no guarantee that Merrill Lynch would receive a certain rate of  return. Merrill Lynch officials told us they undertook the transaction to  accommodate Enron in the hope of receiving increased investment  banking business from Enron at a later time. In February 2003, Merrill  Lynch said that it had agreed in principle to pay a fine to resolve SEC civil  charges that it aided Enron in fraudulently overstating Enron’s earnings in  1999. The settlement in principle is subject to approval by the SEC. One of  the transactions reported to be included in the settlement was this  Nigerian barge transaction.
section_title: Enron’s Bacchus and Sundance Transactions
paragraphs: Publicly available documents describe another series of transactions,  which Enron recorded as a sale, that involved Enron, Citigroup Inc.  (Citigroup), and several SPEs. These transactions, referred to as Bacchus  and Sundance, took place over a 6-month period beginning in December  2000. PSI and the bankruptcy examiner concluded that the substance of  the transactions was borrowing (i.e., a loan), which instead of being  reported as debt was recorded as a sale with a gain that increased Enron’s  net income. See figure 2 for a diagram of these transactions.
The initial Bacchus transaction took place late in December 2000, just  prior to the year’s end. In this transaction, Enron sold ownership interest  in a pulp and paper trading business to an Enron-created SPE, the Caymus  Trust, for $200 million. The Caymus Trust purchase was funded by a $6  million cash equity investment by FleetBoston and a loan from Citigroup  for $194 million. Enron recorded a $112 million gain from the $200 million  sale of its ownership interest. It was reported that Citigroup assumed the  risks of FleetBoston’s ownership through a total return swap and that  Enron assumed Citigroup’s risk associated with the $194 million loan, also  through a total return swap. The effect of these agreements would indicate  that Citigroup held equity risk of $6 million, or 3 percent, of the $200  million purchase and that Enron retained the remaining risk associated  with the asset. However, it has been alleged that Citigroup, despite its  swap contract with FleetBoston, did not have equity risk for the $6 million  cash investment because Enron officials provided verbal guarantees to  Citigroup to ensure the repayment related to the $6 million investment.
If Enron was in fact the only entity with equity risk, the prescribed  accounting treatment would have been to consolidate the SPE into  Enron’s financial statements and to report the $200 million received as  debt, not a sale. This accounting treatment would not have allowed the  gain of $112 million that Enron recorded in its financial statements and  would have increased Enron’s reported debt by $200 million. The gain  recorded as a result of this transaction represented about 11 percent of  Enron’s total net income in 2000. A publicly available Citigroup document  indicates that “Bacchus is a part of a program designed to ensure that  Enron will meet its year-end .” Another Citigroup document  indicates that technical issues “may make Bacchus unworkable—Enron  continues to try to resolve these unnamed issues.” In this event, a  Citigroup official noted that Enron would likely request a prepay  transaction, which is discussed later in this appendix, for $200 million  instead. It was reported that Citigroup received $500,000 in fees for its  participation in Bacchus, earned about $5 million in interest payments on  the loan, and obtained a $450,000 yield related to the $6 million equity  investment.
The Sundance transaction, which took place about 6 months after the  Bacchus transaction, eliminated Citigroup’s risk from the Bacchus  transaction by redeeming Citigroup’s investment. The Sundance  transaction was initiated by the creation of an Enron and Citigroup joint  venture, referred to as Sundance. Enron reportedly contributed  approximately $750 million to Sundance in various financial assets, future  commitments, and $208 million in cash. Citigroup reportedly contributed  $188.5 million to Sundance, comprising $8.5 million in cash, $20 million of  shares in an Enron SPE, and $160 million in an “unfunded capital  commitment.” It was reported that Sundance immediately used the $208  million in cash to purchase the pulp and paper trading business interest  from the Caymus Trust. The Caymus Trust then paid off the $194 million  loan from Citigroup and returned the $6 million equity investment to  FleetBoston. This activity reportedly eliminated any possible risk to  Citigroup from the Bacchus transaction.
Citigroup agreed to participate in Sundance only after Enron had  structured the joint venture to ensure that Citigroup’s funds were virtually  not at risk; moreover, Citigroup’s returns would not depend on the  operating results of the joint venture. In addition, Citigroup arranged to  receive fees of $725,000 and a specified return of $1.1 million on its  investment in Sundance; Citigroup reportedly did not share in any profits  or increased value. A publicly available document prepared by Citigroup’s  Risk Management Group indicates that the group initially did not approve  the Sundance transaction because, among other things, “the GAAP  accounting is aggressive and a franchise risk to  if there is  publicity (a la Xerox).” This document also indicated the  “mismanagement of the process raises real questions about the discipline  and adherence to policies in the fixed income division .”
At a congressional hearing that examined these transactions, Citigroup  officials testified that Citigroup employees acted in good faith and  understood these transactions to comply with existing law and the  prevailing standards of the time. These officials also testified that their  internal review committee at the time, the Capital Markets Approval  Committee, had reviewed and approved the transactions and that the Risk  Management Group had ultimately approved it as well. Citigroup said it  viewed the accounting decisions as decisions to be made by Enron and its  accountants. Citigroup noted that Enron was a Fortune 10 company and  that Enron’s auditors from Arthur Andersen were presumed to know  about the transactions and to have approved their accounting treatment.
section_title: Enron’s Slapshot Transaction
paragraphs: Publicly available reports describe a complex series of structured finance  arrangements, referred to as the Slapshot transaction, which took place  during the same day and included a $1.039 billion loan due later that day.  These transactions involved Enron, J.P. Morgan Chase & Co. (Chase), a  Chase SPE, and several Enron affiliates and SPEs and were designed to  refinance an Enron paper mill and at the same time decrease Canadian  taxes. Since these transactions were so complicated, we have provided a  simplified diagram of the Slapshot transaction (fig. 3) and a more detailed  diagram (fig. 4).
Chase established a key entity in the transaction, Flagstaff Capital  Corporation (Flagstaff), as a wholly owned SPE and organized a bank  consortium that included three other large banks to issue a $375 million  loan (due in 5 years and 1 day) that would refinance an Enron paper mill.  The $375 million loan and a second loan for $1.039 billion from Chase  were provided to Flagstaff. Prior to Chase’s issuing the $1.039 billion loan  to Flagstaff, it was reported that Chase required Enron to provide $1.039  billion in an escrow account in order to ensure the repayment of the  $1.039 billion later the same day. After Flagstaff received the two loans  totaling about $1.4 billion, it reportedly then loaned the same amount to an  Enron affiliate. Subsequently, multiple loans and other contracts in the  amounts of $375 million, $1.039 billion, and $1.4 billion reportedly were  exchanged by various Enron-related entities. All of these transactions took  place during the same day. A publicly available Chase document indicated  that “only a $375 million net loan from Flagstaff was outstanding at the  end of day one.”
The amounts involved in this transaction are key to understanding how  Enron could reduce its Canadian taxes, which like U.S. taxes may be  reduced by interest payments but not by loan principal repayments. It was  reported that the parties involved in the transactions calculated that $1.039  billion was the net present value of the $1.4 billion due in 5 years and 1  day. The difference between these two amounts equaled approximately  the $375 million loan. Thus, it was reported that Enron would treat the  principal and interest payments on the 5-year and 1 day $375 million net  economic obligation as interest payments on the $1.4 billion loan, reducing  Canadian taxes by about $60 million and providing Enron with additional  financial statement benefits totaling about $65 million over 5 years. In a  publicly available Chase document related to the design of the Slapshot  transaction, Chase indicated that an advantage of one aspect of the  structure was that it provided “no road map for Revenue Canada.” It was  reported that Chase was paid more than $5 million for designing and  orchestrating the Slapshot transaction.
At a congressional hearing that examined these transactions, a Chase  official testified that Chase believed that its participation in the  transactions was legal and followed established rules. He contended that  Chase’s Structured Finance Group had developed the generic form of this  transaction and had received opinions from two leading Canadian law  firms that the structure and the Canadian tax benefits the transaction  provided were legal and valid. Copies of these opinions were provided to  PSI. He went on to say that, with respect to the specific application of the  transaction structure, each party involved in the transactions is  responsible for ensuring that it correctly accounts for the transactions to  which it is a party. At the time, Chase had no reason to believe that Enron  and its external auditors were not doing so.
section_title: Enron’s Prepay Transactions
paragraphs: Although prepay transactions are common in the energy industry in  general, Enron’s prepay transactions were allegedly unique in that they  involved a circular cash flow arrangement among the three parties  involved. Enron entered into prepay transactions with various investment  banks, including Chase and Citigroup. Enron accounted for these prepay  transactions as trading activities, which were reported as liabilities from  price risk management on its balance sheet and as cash flows received  from operating activities on the statement of cash flows. However, PSI and  the bankruptcy examiner concluded that Enron’s accounting for the  transactions was inappropriate because the prepay transactions were in  substance and intent loans, not trading activities, and Enron should have  recorded them as debt and cash flows from financing activities.   Distinctions such as these are important to investors and creditors that  rely on financial reporting in deciding whether to invest in or lend to an  entity.
subsections: section_title: Mahonia Prepay Transaction
paragraphs: Publicly available reports describe prepay transactions among Enron,  Chase, and an SPE, Mahonia, Ltd. (Mahonia), that was created to  undertake transactions for Chase (fig. 5). In these transactions, Mahonia  received cash from Chase in exchange for a commitment to deliver a fixed  volume of gas at a specified future date. The purchase price was  reportedly based on the estimated future market price of gas on the  expected delivery date. At the same time, Mahonia and Enron entered into  an identical contract, with Enron receiving from Mahonia funds that had  originated with Chase. These two contracts resulted in cash for Enron and  a commitment for Chase for the future delivery of a fixed volume of gas.  Enron and Chase would both be at risk for changes in the price of gas.  However, at the same time the two prepay contracts were executed, Enron  and Chase entered into a commodity swap that essentially eliminated the  price risk from the transaction and ensured Chase a specified rate of  return. When Chase received the delivery of gas from Mahonia (which  Mahonia received from Enron) it sold the gas to the market, in some cases  back to another Enron entity. One publicly available Chase document  indicated that “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 revenue or (better yet) bury it in their trading activities.”  Between 1992 and 2001, Enron and Chase entered into 12 prepay  transactions with a combined value of over $3.7 billion.
According to testimony given at a congressional hearing, an interview with  us, and documents supplied to us, Chase officials said that they had  understood that Enron, with its auditor’s approval, had treated the prepay  transactions as trading activities. After discussion with its auditor, Chase  treated the prepays similarly and recorded them as trading assets on its  balance sheet. Chase officials said that the firm entered into swaps to  mitigate risk, as required by banking law, and that the risks of the different  transactions and hedges involved in the prepays differed from those of a  loan. In addition, the different components of the transaction received  separate credit approvals, and each transaction stood on its own—there  were no cross-default provisions and no netting of amounts, as alleged.  Chase officials also maintained that each of the entities involved in the  transaction was legally independent of the others. Chase provided us with  excerpts from other companies’ financial statements describing those  companies' prepays as a means of financing, recorded as liabilities for  price risk management. Chase officials said that they believed Enron  officials’ assertion that Enron’s prepay transactions were being properly  accounted for as liabilities from price risk management in their financial  statements.
section_title: Delta-Yosemite Prepay Transaction
paragraphs: Another example of an Enron prepay transaction involved Enron,  Citigroup, and a Citigroup-created SPE, Delta Energy (Delta), which  served as a third party. It was reported that the earliest of these Citigroup  prepay transactions, beginning in 1993, were similar in structure to the  Chase prepay transactions. However, some of the later Citigroup prepay  transactions involving Delta were funded by bond offerings to qualified  institutional buyers instead of by Citigroup (fig. 6). By raising funds for the  prepay transactions in this fashion, the institutional investors, rather than  Citigroup, were at risk in case of Enron’s bankruptcy or credit default. A  total of six Enron bond offerings were issued through trusts, raising $2.4  billion for the prepay transactions. The first such trust, Yosemite, loaned  the bond proceeds to Delta so Delta could initiate the prepay transactions  involving Enron and Citigroup. The series of transactions that followed  removed price risk, allegedly ensured a rate of return to Delta, and left  Delta with the same risk it would have had if it had loaned money to  Enron. One publicly available Citigroup document discussing the approval  of an Enron prepay transaction indicated that Citigroup’s “internal  approval for the transaction will acknowledge that  was  basically making a loan.” Between 1993 and 2001, Enron and Citigroup  reportedly entered into 14 prepay transactions with a combined value of  over $4.8 billion.
At a congressional hearing that examined these transactions and in an  interview with us, Citigroup officials said that they had entered into the  transactions in good faith and that their employees had understood that  the transactions complied with existing law. The officials contended that  Citigroup’s internal review committee had reviewed and approved the  prepaid swaps and the Yosemite transactions. The officials also said no  inherent connection existed between the notes from the Yosemite  transactions, in which the risk to investors was Enron credit risk, and the  prepays. The proceeds of the notes were used for the prepays, the officials  noted, but could have been used for other transactions, and investors were  not misled about the nature of the transactions. The ultimate problem that  affected the notes, in the officials’ view, was that Enron had declared  bankruptcy for reasons entirely unrelated to the prepaid transactions.
section_title: Appendix III: GAO Contacts and Staff Acknowledgements
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgements
paragraphs: In addition to those named above, Marcia Carlsen, Emily Chalmers,  Orlando Copeland, Julia Duquette, Patrick Dynes, Joe Hunter, Barbara  Keller, Christine Kuduk, Marc Molino, John Treanor, and Sindy Udell made  key contributions to this report.