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. 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. 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. 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. 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. 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. 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.