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Enron and Global Crossing' which was released on March 17, 2003.



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Report to the Senate Committee on Banking, Housing, and Urban Affairs 

and the House Committee on Financial Services:



United States General Accounting Office:



GAO:



March 2003:



Investment Banks:



The Role of Firms and Their Analysts with Enron and Global Crossing:



Investment Banks:



GAO-03-511:



GAO Highlights:



Highlights of GAO-03-511, a report to the Senate Committee on Banking, 

Housing, and Urban Affairs and the House Committee on Financial 
Services.



Why GAO Did This Study:



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. The 

term “investment bank” includes securities firms, affiliates of bank 

holding companies, and bank holding companies with business divisions 

that assist clients in locating or collecting funds to finance 

investment projects. In this report, “investment bank” broadly includes 

multiservice brokerage firm. 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.



What GAO Found:



Certain investment banks facilitated and participated in complex 

financial transactions 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 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 fraudulent transactions, 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 taken 

some steps to strengthen their internal controls, in part, because 

they are now more sensitive to reputational 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 are subsequently 

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 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 involved in legal settlements and 

punitive actions involving conflicts of interest between their 

research and investment banking departments. Federal and state 

regulators and self-regulatory organizations have all adopted new 

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 obscure 

the client’s financial statements.  Since investment banks may be 

tempted to participate in profitable but questionable transactions, 

if SEC prosecution is in doubt, it is especially important that 

regulators be alert to this and ready to use their enforcement 

tools to deter such action.  We are encouraged that investment 

banks and regulators are strengthening their oversight of 

appropriateness of transactions, but it is too soon to evaluate 

the effectiveness of reforms.



www.gao.gov/cgi-bin/getrpt?GAO-03-511



To view the full report, including the scope

and methodology, click on the link above.

For more information, contact Rick Hillman at  (202) 512-8678 

or at or Jeanette Franzel (202) 512-9402.



Contents:



Letter:



Results in Brief:



Background:



The Role of Investment Banks in Enron’s Structured Finance 

Transactions:



Investment Banks and Federal Financial Regulators Have Begun 

Strengthening Their Oversight of Structured Finance Transactions Since 

Enron’s Collapse:



Conflicts of Interest Reportedly Affected Research Analysts’ Ratings of 

Enron and Global Crossing:



Observations:



Agency Comments and Our Evaluation:



Appendix I: Scope and Methodology:



Appendix II: Investment Bank Involvement With Enron In 

Five Structured Finance Transactions:



Appendix III: GAO Contacts and Staff Acknowledgements:



GAO Contacts:



Staff Acknowledgements:



Tables:



Table 1: Services Investment Banks Provide Their Corporate Clients:



Table 2: Selected Types of Risks Faced by Financial Firms:



Figures:



Figure 1: Simplified Nigerian Barge Transaction:



Figure 2: Simplified Bacchus and Sundance Transactions:



Figure 3: Simplified Slapshot Transaction:



Figure 4: Detailed Slapshot Transaction:



Figure 5: Mahonia Prepay Transaction:



Figure 6: Delta-Yosemite Prepay Transaction:



Abbreviations:



AC: Analyst Certification

EITF: Emerging Issues Task Force

FAS: Financial Accounting Standards

LJM2: LJM2 Co-Investment, L.P.

NYSE: New York Stock Exchange

OCC: Office of the Comptroller of the Currency

PSI: Permanent Subcommittee on Investigations

SEC: Securities and Exchange Commission

SFAS: Statement of Financial Accounting Standards

SPE: special purpose entity:



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United States General Accounting Office:



Washington, DC 20548:



March 17, 2003The Honorable Richard C. Shelby

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking, Housing, and Urban Affairs

United States Senate:



The Honorable Michael G. Oxley

Chairman

The Honorable Barney Frank

Ranking Minority Member

Committee on Financial Services

House of Representatives:



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.[Footnote 1] Publicly available reports describe complex 

financial transactions among Enron, various investment banks,[Footnote 

2] and a variety of special purpose entities[Footnote 3] (SPE) that 

have raised questions about whether investment banks knowingly[Footnote 

4] and substantially assisted[Footnote 5] 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).[Footnote 6] 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.[Footnote 7] 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.[Footnote 8] 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[Footnote 9] 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.



Results in Brief:



It is alleged that certain investment banks knowingly and substantially 

assisted Enron in engaging in financial transactions that were intended 

to manipulate and obscure Enron’s true financial condition, thereby 

defrauding its investors, creditors, and others. If certain allegations 

are proven true, SEC would have the authority to bring an action 

against the investment banks for aiding and abetting securities laws 

violations. Some have concluded that the transactions reportedly 

involved deceptive accounting or tax strategies and were allegedly 

designed to help Enron meet year-end revenue targets, inflate operating 

results, or evade taxes. For example, in some transactions certain 

investment banks structured transactions to purchase financial assets 

from Enron. Even though Enron reported these transactions as sales, PSI 

and the bankruptcy examiner[Footnote 10] concluded that the substance 

of the transactions was not sales but secured borrowings (i.e., loans). 

If this charge is true, they should have been reported as debt on 

Enron’s financial statements. In another example, an investment bank 

allegedly designed and orchestrated a transaction intended to enable 

Enron to evade Canadian taxes. If this allegation is true, the 

transaction ultimately would have improperly inflated Enron’s reported 

after-tax earnings. Further, certain prepay transactions[Footnote 11] 

involving investment banks and Enron, which were reported by Enron as 

energy trades, were allegedly disguised loans to Enron from the 

investment banks. If these conclusions are proven, Enron’s accounting 

could have misled investors and analysts about Enron’s financial 

condition. The investment banks involved in the transactions we 

selected for review contended that they had believed their role in 

assisting Enron was proper and that Enron had not disclosed its true 

purpose in obtaining their assistance. While investment banks are not 

responsible for the financial reporting of their clients, if an 

investment bank knowingly and substantially assisted Enron in engaging 

in violations of the securities laws, SEC has the authority to bring 

legal action against the investment bank for aiding and abetting a 

securities law violation. In February 2003, one of the investment 

banks, Merrill Lynch & Co., Inc (Merrill Lynch), said that it had 

agreed in principle to settle a civil complaint with SEC--without 

admitting or denying any wrongdoing--charging that it aided Enron in 

fraudulently overstating its earnings in 1999. As of March 14, 2003, 

this settlement agreement has not been approved by SEC.



Investment banks and federal financial regulators have oversight 

processes for structured products and transactions that investment 

banks offer their clients; however, the recent series of corporate 

scandals has made both investment banks and federal financial 

regulators more concerned about reputation and legal risks and they 

report taking steps to strengthen their oversight processes.[Footnote 

12] Investment bankers that we spoke with told us that structured 

finance transactions are routinely vetted internally through their risk 

management and internal controls systems. Since Enron’s collapse, the 

investment banks have taken some steps to increase their focus on 

reputation and legal risks, including making managerial changes, 

establishing new oversight committees, and strengthening their internal 

review and transaction approval processes. Federal financial regulators 

believe that these are positive steps but noted that it is too soon to 

evaluate how well the new policies and procedures will work in 

practice. Federal financial regulators are responsible for overseeing 

different segments of the large, complex financial institutions that 

engage in structured finance transactions. Federal financial regulators 

use a risk-focused approach to their examination processes for these 

financial institutions, identifying the most significant risks to the 

institution and then determining whether the financial institution has 

the risk management systems and internal controls in place to identify, 

measure, monitor, and manage them. Federal financial regulators noted 

that exams prior to Enron’s collapse did not identify structured 

transactions as a high-risk area that required attention because risk 

assessments did not show that such deals posed a material risk of 

financial loss. In the wake of Enron’s collapse, some regulatory 

officials said they are refining their approach to supervising certain 

aspects of a financial institution’s operations that may cause 

reputation, litigation, and other operational risks in the area of 

complex structured transactions. For example, bank regulators plan to 

more extensively sample transactions in their future exams. Also, 

federal financial regulators are in the process of performing targeted 

reviews of the few large investment banks that are active in complex 

structured transactions and are planning to develop guidance or best 

practices on ways to ensure the transactions are appropriate.



Investment bankers of certain securities firms allegedly pressured 

their research analysts covering Enron and Global Crossing to issue 

favorable or misleading investment recommendations (i.e., buy ratings) 

in order to keep or obtain lucrative investment banking work from the 

companies. Conflicts of interest issues such as these have led the 

public to question the independence and objectivity of favorable 

investment recommendations research analysts make about public 

companies and prospects for their equity securities. The primary issue 

here is the adequacy and effectiveness of barriers between the research 

and investment banking functions of securities firms that offer both 

services. In response to these concerns, regulators have taken a number 

of actions. For example, in May 2002, SEC approved changes to NASD and 

New York Stock Exchange (NYSE) rules that seek to reestablish the 

separation between the investment banking and research departments of a 

securities firm. In December 2002, NASD and NYSE proposed additional 

analyst rules and according to SEC officials will likely propose 

further rules this spring in compliance with the directive in the 

Sarbanes-Oxley Act.[Footnote 13] During the same month, SEC, the New 

York Attorney General’s office, NASD, NYSE, and state securities 

regulators reached a “global settlement” in principle with the top U.S. 

investment banking firms to resolve issues of conflict of interest at 

these firms. As of March 14, 2003, SEC commissioners have not approved 

this settlement. In February 2003 SEC adopted a regulation on analysts’ 

conflicts of interest. Among other requirements, the regulation 

requires brokers, dealers, or certain associated persons of brokers or 

dealers[Footnote 14] to include certifications from the research 

analyst that the views expressed in a research report accurately 

reflect the analyst’s personal views and to disclose whether the 

analyst received compensation or other payments in connection with any 

recommendation or views. It is too soon to evaluate the adequacy of 

these new rules.



This report makes no recommendations. We provided copies of a draft of 

this report to the Board of Governors of the Federal Reserve (Federal 

Reserve), the Office of the Comptroller of the Currency (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 comments.



Background:



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 Offer Their Corporate Clients a Wide Variety of 

Services:



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.



Table 1: Services Investment Banks Provide Their Corporate Clients:



Name of Service: Underwriting; Description of Service: In this role, 

investment banks are financial intermediaries in securities offerings. 

They verify financial data and business claims, facilitate pricing, and 

perform due diligence. Most underwritings are “firm commitment” 

underwritings in which investment banks purchase the securities from 

the issuer and distribute them to the public..



Name of Service: Private placements; Description of Service: Investment 

banks may help corporate clients place securities privately. In these 

transactions, the banks focus on the direct placement of corporate 

securities with investors--for example, by drafting the private 

placement memorandum and contacting and negotiating with potential 

investors..



Name of Service: Venture capital; Description of Service: Investment 

banks provide capital and strategic guidance to some companies and may 

manage venture-capital pools or invest their own capital. They may also 

provide underwriting services or advice on mergers and acquisitions..



Name of Service: Asset-based financing; Description of Service: 

Investment banks help clients obtain financing using existing assets 

and assist with asset securitizations. These transactions involve 

selling securities backed by cash flows from a pool of financial 

assets, such as credit card receivables..



Name of Service: Investment management; Description of Service: 

Investment management operations include managing mutual funds, hedge 

funds, unit investment trusts, leveraged buyout funds, and private 

equity funds..



Name of Service: Merchant banking; Description of Service: Merchant 

banking commits the investment bank’s own capital to facilitate a 

client transaction such as a bridge (or temporary) loan..



Name of Service: Research; Description of Service: Research analysts at 

the investment banks analyze public companies and make investment 

recommendations about the securities of those companies to investors 

through research reports and other means, such as the media..



Name of Service: Other transactions; Description of Service: Investment 

banks structure and implement transactions to allow clients to manage a 

variety of risks. Such transactions may include a variety of 

derivatives..



Name of Service: Corporate advisory services; Description of Service: 

In addition to helping with mergers and acquisitions, investment banks 

assist with corporate reorganizations and advising on other strategic 

matters. Services related to mergers and acquisitions include 

conducting due diligence, preparing a valuation of the business, 

advising the client on the best type of transaction, preparing a 

selling memorandum, participating in negotiations, and assisting the 

client’s board of directors with discharge of their fiduciary duties. 

Investment banks may also facilitate corporate reorganizations by 

recommending the sale of certain assets, issuing special securities 

such as convertible stock and bonds, and even negotiating the sale of 

the entire company. Investment banks may also provide corporate or 

financial advisory services on other strategic matters such as 

divestitures, corporate defense strategies, joint ventures, 

privatizations, spin-offs, proxy and consent solicitations, tender 

offers, exchange offers, and leveraged buyouts..



Source: J.P. Morgan & Co., SEC, and GAO analysis.



[End of table]



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,[Footnote 15] underwriting bond and stock offerings, 

providing research on Enron securities, providing complex structured 

finance transactions, acting as trading counterparties to derivatives 

transactions,[Footnote 16] participating as passive investors (limited 

partners) in an SPE, and others.



Structured Financing Includes SPEs and Prepay Transactions:



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.



Special Purpose Entities:



In the ordinary course of business, many companies use a variety of 

structured financings that involve SPEs to access capital or hedge 

risk.[Footnote 17] 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.[Footnote 18] 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.



Accounting for Sales of Financial Assets:



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.[Footnote 19] 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.



Prepay Transactions:



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.[Footnote 20]



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.[Footnote 21]



Investment Banks’ Duties to Their Clients Depend on the Role the Banks 

Play:



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.[Footnote 22]



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.[Footnote 23]



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.[Footnote 24] However, other 

courts have found that recklessness is sufficient.[Footnote 25] In SEC 

administrative proceedings, liability may be based on less than actual 

knowledge of the violation.[Footnote 26]



* 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.[Footnote 27]



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.



Transparency in Financial Reporting Is Key to Maintaining Confidence in 

Capital Markets:



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[Footnote 28] 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.



The Role of Investment Banks in Enron’s Structured Finance 

Transactions:



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.



Investment Banks Were Involved in Transactions That Enron Used to 

Generate Recorded Sales and Reduce Taxes:



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[Footnote 29] 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.[Footnote 30] 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 [targets].”[Footnote 31]



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 [Citigroup] 

if there is publicity (a la Xerox).”[Footnote 32] 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)[Footnote 33] 

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.”[Footnote 34] 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.



Investment Banks Were Involved in Prepay Transactions Enron Used to 

Bolster Operating Results:



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[Footnote 35] 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.[Footnote 36] 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.[Footnote 37] 

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.”[Footnote 38] 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 [Citigroup] was basically making a loan.”[Footnote 39] 

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.



Other Enron and Global Crossing Transactions:



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.[Footnote 40] 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.



Investment Banks and Federal Financial Regulators Have Begun 

Strengthening Their Oversight of Structured Finance Transactions Since 

Enron’s Collapse:



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.



Investment Banks Use Risk Management and Other Internal Control Systems 

to Approve Structured Finance Transactions:



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.[Footnote 41] 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.



Federal Banking and Securities Regulators Use a Risk-Focused Approach 

to Overseeing Large Financial Institutions:



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.[Footnote 42] 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.



Table 2: Selected Types of Risks Faced by Financial Firms:



Type of Risk: Credit risk; Risk Definition: The potential that a 

borrower or counterparty will fail to perform on an obligation such as 

a loan or contract..



Type of Risk: Market risk; Risk Definition: The risk that adverse 

movements in market rates or prices--for example, interest rates, 

foreign exchanges rates, or equity prices--can affect a firm’s 

financial position..



Type of Risk: Reputation risk; Risk Definition: The possibility that 

negative publicity regarding an entity’s business practices, whether 

true or not, will cause costly litigation or a decline in the customer 

base or revenues..



Type of Risk: Operational risk; Risk Definition: The potential that 

inadequate information systems, operational problems, breaches in 

internal controls, or fraud will result in unexpected losses..



Type of Risk: Legal risk; Risk Definition: The potential that 

unenforceable contracts, lawsuits, or adverse judgments will disrupt or 

otherwise negatively affect the operations or conditions of a firm..



Type of Risk: Liquidity risk; Risk Definition: Arises for the potential 

that an institution will be unable to meet its obligations as they come 

due because of an inability to liquidate assets or obtain adequate 

funding or that it cannot easily unwind or offset specific exposures 

without significantly lowering market prices because of inadequate 

market depth or market disruptions..



Source: Federal Reserve.



[End of table]



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.[Footnote 43] 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.



Federal Financial Regulators Did Not Identify Structured Finance As a 

High-Risk Area Before Enron’s Collapse:



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.



Federal Financial Regulators Have Made Changes to Their Oversight 

Processes As a Result of the Enron Scandal:



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.



Recent Rules and Legislation Aim to Make Off-Balance Sheet Transaction 

Reporting and Disclosures More Transparent:



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.[Footnote 44] 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.[Footnote 45]



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.[Footnote 46]



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.[Footnote 47] In general, this new guidance requires that an 

SPE be consolidated with another entity if that entity is the primary 

beneficiary[Footnote 48] 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[Footnote 49] 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.



Conflicts of Interest Reportedly Affected Research Analysts’ Ratings of 

Enron and Global Crossing:



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.



Research Analysts Allegedly Issued Misleading Stock Reports:



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[Footnote 50] 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.



Regulators and Others Have Taken Some Actions to Address Research 

Analysts’ Conflicts of Interest:



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,[Footnote 51] and require disclosure of a final research report 

when an analyst terminates coverage of an issuer.[Footnote 52] 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[Footnote 53] 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.[Footnote 

54] 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.



Observations:



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.



Agency Comments and Our Evaluation:



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.



Richard J. Hillman

Director, Financial Markets and

 Community Investment:



Jeanette M. Franzel

Director, Financial Management and Assurance:



Signed by Richard J. Hillman and Jeanette M. Franzel:



[End of section]



Appendix I: Scope and Methodology:



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[Footnote 55] 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,[Footnote 56] the bankruptcy court examiner 

reports,[Footnote 57] 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 [OCC], and the 

Federal Reserve) about their oversight and examination processes for 

structured finance transactions. We also reviewed examination guidance 

and relevant GAO reports.[Footnote 58] 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.



[End of section]



Appendix II: Investment Bank Involvement with Enron in Five Structured 

Finance Transactions:



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.



Enron’s Nigerian Barge Transaction:



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[Footnote 59] 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.



Figure 1: Simplified Nigerian Barge Transaction:



[See PDF for image]



[End of figure]



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.[Footnote 60] 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.[Footnote 61] 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.



Enron’s Bacchus and Sundance Transactions:



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.[Footnote 62] 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.



Figure 2: Simplified Bacchus and Sundance Transactions:



[See PDF for image]



[End of figure]



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[Footnote 63] 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 

[targets].”[Footnote 64] 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.[Footnote 

65] 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,[Footnote 66] 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 

[Citigroup] if there is publicity (a la Xerox).”[Footnote 67] This 

document also indicated the “mismanagement of the process raises real 

questions about the discipline and adherence to policies in the fixed 

income division [of Citigroup].”:



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.[Footnote 68]



Enron’s Slapshot Transaction:



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).



Figure 3: Simplified Slapshot Transaction:



[See PDF for image]



[End of figure]



Note: Analysis based on information from the Senate Committee on 

Governmental Affairs, Permanent Subcommittee on Investigations.



Figure 4: Detailed Slapshot Transaction:



[See PDF for image]



[End of figure]



Note: Chase officials and analysis based on information and original 

figure from the Senate Committee on Governmental Affairs, Permanent 

Subcommittee on Investigations.



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.”[Footnote 69]



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.”[Footnote 70] 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.



Enron’s Prepay Transactions:



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. [Footnote 71] 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.



Mahonia Prepay Transaction:



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[Footnote 

72] 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.[Footnote 73] 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.”[Footnote 74] Between 1992 and 2001, Enron and Chase 

entered into 12 prepay transactions with a combined value of over $3.7 

billion.



Figure 5: Mahonia Prepay Transaction:



[See PDF for image]



[End of figure]



Note: Analysis based on information and original figure from the Senate 

Committee on Governmental Affairs, Permanent Subcommittee on 

Investigations.



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.[Footnote 75] 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.[Footnote 76] 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.



Delta-Yosemite Prepay Transaction:



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 

[Citigroup] was basically making a loan.”[Footnote 77] Between 1993 and 

2001, Enron and Citigroup reportedly entered into 14 prepay 

transactions with a combined value of over $4.8 billion.



Figure 6: Delta-Yosemite Prepay Transaction:



[See PDF for image]



[End of figure]



Note: Analysis based on information and original figure from the Senate 

Committee on Governmental Affairs, Permanent Subcommittee on 

Investigations.



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.



[End of section]



Appendix III: GAO Contacts and Staff Acknowledgements:



GAO Contacts:



Richard J. Hillman (202) 512-8678

Jeanette M. Franzel (202) 512-9406:



Staff Acknowledgements:



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.



FOOTNOTES



[1] Enron Corporation is a global energy company.



[2] In this report, the term “investment bank” includes not only 

securities firms but also those bank holding companies with securities 

affiliates or business divisions that assist clients in obtaining funds 

to finance investment projects.



[3] An SPE is a separate entity that is created to carry out a specific 

purpose, activity, or transaction. An SPE is also known as a special 

purpose vehicle.



[4] “Knowingly” has been defined by some courts as actual knowledge of 

a securities law violation or by others as a reckless disregard for the 

truth. 



[5] “Substantially” assisted has been interpreted by the courts as 

meaning significant assistance to the representations of others or to 

the fraud of others.



[6] Global Crossing is a telecommunications company that operates 

worldwide.



[7] In this report, the use of the term “structured finance” is not 

limited to securitization, which is the isolation of a defined group of 

assets that serve as the basis of a financing that is intended to be 

remote, as a legal matter, from the bankruptcy risks of the former 

owner of the assets. By isolating assets, structured financings can 

facilitate access to capital markets, vastly expanding the sources of 

available funding.



[8] We acknowledge that these do not cover all of the transactions 

these investment banks undertook with Enron, nor do they represent 

transactions with all of the investment banks with which Enron had 

relationships.



[9] For purposes of this report, we use the term “federal financial 

regulators” to refer to SEC (securities regulator) and the Board of 

Governors of Federal Reserve System and the Office of the Comptroller 

of the Currency (bank regulators) together. Separately, we may discuss 

them by their name or type of regulator.



[10] Enron filed for bankruptcy on December 2, 2001. On April 8, 2002, 

the Enron Bankruptcy Court authorized the appointment of an examiner to 

inquire into certain transactions that were not reported in accordance 

with generally accepted accounting principles and requested that the 

examiner prepare reports regarding these transactions.



[11] A prepay transaction involves paying in advance for a service or 

product to be delivered at a later date.



[12] Reputation risk is the possibility that negative publicity 

regarding an entity’s business practices, whether true or not, will 

cause costly litigation or a decline in the customer base or revenues. 

Legal risk is the potential that unenforceable contracts, lawsuits, or 

adverse judgments will disrupt or otherwise negatively affect the 

operations or financial condition of a firm.



[13] The Sarbanes-Oxley Act, which was signed into law in July 2002, 

among other things, requires SEC or the self-regulatory organizations 

to adopt rules to address conflicts of interest that can arise when 

research analysts recommend equity securities in research reports and 

public appearances. 



[14] Brokers effect securities transactions for the account of others. 

Dealers engage in buying and selling securities for their own account. 

Associated persons of brokers or dealers are partners, officers, 

directors, or branch managers of a broker or dealer or any person 

controlling, controlled by, or under common control with a broker or 

dealer, or any nonministerial employee of a broker or dealer. 



[15] Loan syndication is a form of financing involving a group of banks 

that agree to advance a portion of the funding.



[16] Derivatives are financial products whose value is determined from 

an underlying reference rate, index, or asset. The underlying includes 

stocks, bonds, commodities, interest rates, foreign currency exchange 

rates, and indexes that reflect the collective value of various 

financial products.



[17] Hedging is a financial technique used to mitigate the risk of loss 

from price fluctuations.



[18] SPEs generally do not include registered investment companies--an 

investment company, such as a mutual fund, is registered with SEC under 

the Investment Company Act of 1940.



[19] FAS No. 140 became effective April 2001 and provides the 

accounting guidance used to determine if a transfer “purported to be a 

sale” should be reported as a sale or a secured borrowing. FAS 140 

replaced FAS 125, which had the same name. FAS 140 revised some of the 

accounting standards for securitizations and other financial assets and 

collateral and requires certain disclosures, but it carries over most 

of FAS 125’s provisions without reconsideration.



[20] To determine the accounting treatment, prepaid forward contracts 
must 

be evaluated under the provisions of Financial Accounting Standards 

Board Statement of Financial Accounting Standards No. 133, Accounting 

for Derivative Instruments and Hedging Activities.



[21] Energy trading activities also include dealing, the activity of 

standing ready to trade--whether buying or selling--for the dealer’s 

own account, thereby providing liquidity to the market. These contracts 

would have to be analyzed under the provisions of SFAS 133 (subsequent 

to its effective date) and Emerging Issues Task Force (EITF) 98-10. The 

EITF sets forth a framework for concluding which energy contracts 

should be accounted for as trading contracts. The model set forth 

generally focuses on an evaluation of the various activities of an 

entity based on all available facts and circumstances. Further, the 

model requires that in the event that a contract is entered into 

outside of a segregated energy trading operation, an entity should 

analyze contracts at inception based on attendant facts and 

circumstances and identify each contract as either trading or non-

trading. See EITF 98-10.



[22] In re Daisy Corporation, 97 F.3d 1171 (9th Cir. 1996) (court 

refused to grant summary judgment to investment banker when debtor 

relied upon banker’s advice and debtor presented evidence that 

investment banker’s advice eventually led to debtor’s bankruptcy); In 

re Healthco Intern, Inc., 195 B.R. 971 (Bankr. D. Mass. 1996). 



[23] Section 11 of the Securities Act of 1933 provides that signers of 

the registration statements, including underwriters, may be held liable 

for materially misleading statements or omissions in a registration 

statement and, therefore, have a duty to independently investigate the 

statements--in other words, to conduct due diligence.



[24] SEC v. Fehn, 97 F.3d 1276, 1288 n. 11(9th Cir. 1996); Hauser v. 

Farrell, 14 F. 3d 1338 (9th Cir. 1994). Section 20(e) of the Securities 

Exchange Act of 1934 (the Exchange Act) provides for aiding and 

abetting liability against any person who “knowingly provides 

substantial assistance to another person” who violates the federal 

securities laws.



[25] Aiken v. Q--L Investments, 959 F.2d 521, 526 (5th Cir. 1992). 



[26] SEC v. Graham, 222 F.3d 994 (D.C. Cir. 2000). SEC may bring 

administrative proceedings for aiding and abetting a securities law 

violation against certain regulated persons, such as broker-dealers. 

See Section 15(b)(4) of the Exchange Act. SEC may also bring an 

administrative cease-and-desist proceeding against any person who is “a 

cause of” another person’s violation due to an act or omission that the 

person knew or should have known would contribute to the primary 

violation. See Section 21C of the Exchange Act. 



[27] Rolf. Blyth, Eastman, Dillon & Co., 570 F.2d 38, 48 (2d Cir. 

1978); Cumis Ins. Soc’y v. E.F. Hutton, 457 F. Supp. 1380, 1386 (S.D. 

N.Y. 1978).



[28] An off-balance sheet item is a financial contract that can create 

gains or losses for an entity but is not reported on the balance sheet 

under generally accepted accounting standards.



[29] In this transaction, Enron sold interest, or ownership, in Enron 

Nigeria Barge Limited an entity whose sole assets were the three 

barges. Ownership interests are considered to be financial assets under 

FAS 140. 



[30] Senate Committee on Governmental Affairs, Permanent Subcommittee 

on Investigations, The Role of the Financial Institutions in Enron’s 

Collapse, Vol. 2, 107th Cong., 2nd sess., 2002, Exhibit 207.



[31] Senate Committee on Governmental Affairs, Permanent Subcommittee 

on Investigations, Fishtail, Bacchus, Sundance, and Slapshot: Four 

Enron Transactions Funded and Facilitated by U.S. Financial 

Institutions, 107th Cong., 2nd sess., 2002, S. Prt. 107-82, Exhibit 

322d.



[32] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 333n.



[33] J.P. Morgan Chase & Co. is the successor to J.P. Morgan & Co. Inc. 

and The Chase Manhattan Corporation, which merged on December 31, 2000. 

Even though virtually all of the Enron-related transactions were 

entered into with The Chase Manhattan Bank, the successor assumes 

responsibility for those deals. Henceforth, for the purpose of the 

report, GAO will use the name “Chase” to refer to the combined company.



[34] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 344. On November 1, 1999, Revenue Canada became the Canada 

Customs and Revenue Agency. Part of the agency’s mission is to promote 

compliance with Canada’s tax regulations.



[35] Enron’s liability for price risk management was the balance sheet 

line item used to account for trading liabilities. Enron also reported 

assets for price risk management activities on its balance sheet. 



[36] Committee on Governmental Affairs, Four Enron Transactions.



[37] Committee on Governmental Affairs, Role of the Financial 

Institutions, Vol. 1, Exhibits 134 and 161.



[38] Committee on Governmental Affairs, Role of the Financial 

Institutions, Vol. 1, Exhibit 123.



[39] Committee on Governmental Affairs, Role of the Financial 

Institutions, Vol. 1, Exhibit 188g.



[40] LJM2 is a Delaware limited partnership organized and managed by 

the then chief financial officer of Enron to make private equity 

investments in the energy and telecommunications sectors.



[41] These committees were usually made up of representatives of the 

accounting, legal, tax, and compliance departments, among others.



[42] Although SEC has limited authority to oversee affiliates of 

broker-dealers, the Market Reform Act of 1990 enables it to collect 

information about the activities and financial condition of affiliates 

and parent firms to assess the risks they pose to the regulated entity. 

Despite its supervisory role, SEC does not have legal regulatory 

authority to examine or set regulatory capital requirements over the 

parents or affiliates of SEC-registered broker-dealers. 



[43] Transaction testing is used to validate examiners’ judgment on the 

reliability of an institution’s internal controls. Transaction testing 

includes examination of underlying support for transactions and the 

reconciliation of internal accounting records and financial reports (to 

evaluate accuracy of account balances), the comparison of day-to-day 

practices to the requirements of policies and procedures (to assess 

compliance with internal systems), and all other supervisory testing 

procedures, such as quality reviews of individual loans and 

investments.



[44] Cautionary Advice Regarding Disclosure About Critical Accounting 

Policies, Release Nos. 33-8040; 34-45149; FR-60 (December 12, 2001). 



[45] Disclosure in Management’s Discussion and Analysis about the 

Application of Critical Accounting Policies, Release No. 33-8098 (May 

10, 2002). 



[46] “Disclosure in Management’s Discussion and Analysis about Off-

Balance Sheet Arrangements and Aggregate Contractual Obligations,” 

Release No. 33-8182 (January 27, 2003). 



[47] This guidance refers to an SPE subject to consolidation as a 

variable interest entity.



[48] For purposes of determining whether an entity is the primary 

beneficiary, an entity with a variable interest (ownership or some 

other financial interests) shall treat variable interests held by its 

related parties as its own interest. 



[49] Prior to this guidance, 3 percent was used as a criterion to 

determine whether to consolidate an SPE with another entity. This 3-

percent test did not originate in a Financial Accounting Standards 

Board standard but rather was contained in a supplement to an EITF 

issue related to leasing transactions involving SPEs and subsequently 

appears to have become the de facto test for all SPEs. 



[50] These analysts are often referred to as sell-side analysts.



[51] A “booster shot” report refers to a favorable research report 

issued around the time of the expiration, waiver, or termination of a 

“lock-up” agreement, which brokerage firms often enter into with their 

clients to restrict the sale of a client’s securities for a defined 

period of time. This proposed provision would prohibit managers and 

comanagers of a securities offering from issuing research reports or 

making public appearances concerning a subject company for 15 days 

prior to or after the expiration, waiver, or termination of a lock-up 

agreement. This provision is intended to address situations in which 

research analysts may issue positive research reports or reiterate 

“buy” recommendations shortly before or just after the expiration of a 

lock-up agreement. Imposition of this 15-day blackout period is 

intended to mitigate and/or eliminate the incentive for a research 

analyst to issue positive research reports and to permit real market 

forces to determine the price at which such securities can be sold 

after the expiration of such agreements.



[52] Self-Regulatory Organizations: Notice of Filing of Proposed Rule 

Changes by the New York Stock Exchange, Inc. Relating to Exchange Rules 

344 (“Supervisory Analysts”), 345A (“Continuing Education for 

Registered Persons”), 351 (“Reporting Requirements”) and 472 

(“Communications with the Public”) and by the National Association of 

Securities Dealers, Inc. Relating to Research Analyst Conflicts of 

Interest, Release No. 34-47110, 68 Fed. Reg. 826 (January 7, 2003). 



[53] The investment banks included Bear Stearns & Co. LLC;’ Credit 

Suisse First Boston Corp.; Deutsche Bank; Goldman Sachs; J.P. Morgan 

Chase & Co.; Lehman Brothers, Inc.; Merrill Lynch & Co. Inc.; Morgan 

Stanley; Salomon Smith Barney, Inc.; and UBS Warburg LLC.



[54] SEC proposed Regulation AC prior to the Sarbanes-Oxley Act being 

signed into law.



[55] For purposes of this report, we use the term “federal financial 

regulators” to refer to the Securities and Exchange Commission, 

(securities regulator) and the Board of Governors of the Federal 

Reserve System and the Office of the Comptroller of the Currency (both 

bank regulators).



[56] William C. Powers, Jr., Raymond S. Troubh, and Herbert S. Winokur, 

Jr., Report of Investigation by the Special Committee of the Board of 

Directors of Enron Corporation, February 1, 2002. This report was 

produced by the Special Committee appointed by Enron and chaired by 

William Powers, Jr., to investigate transactions between Enron and 

entities connected to related parties.



[57] Enron filed for bankruptcy on December 2, 2001. On April 8, 2002, 

the Enron Bankruptcy Court authorized the appointment of an examiner to 

inquire into certain transactions that were not reported in accordance 

with generally accepted accounting principles and requested that the 

examiner prepare reports regarding these transactions.



[58] Risk-Focused Bank Examinations: Regulators of Large Banking 

Organizations Face Challenges, (GAO/GGD-00-48, Jan. 24, 2000); Long-

Term Capital Management: Regulators Need to Focus Greater Attention on 

Systemic Risk, (GAO-GGD-00-3, Oct. 29, 1999); Rick-Based Capital: 

Regulatory and Industry Approaches to Capital and Risk, (GAO/

GGD-98-153, July 20, 1998); Financial Statement Restatements: Trends, 

Market Impacts, Regulatory Responses, and Remaining Challenges, 

(GAO-03-138, Oct. 4, 2002); and Financial Derivatives: Actions Needed 

to Protect the Financial System, (GAO/GGD-94-133, May 18, 1994).



[59] In this transaction, Enron sold interest, or ownership, in Enron 

Nigeria Barge Limited, an entity whose sole assets were the three 

barges. Ownership interests are considered to be financial assets under 

FAS 140. 



[60] Senate Committee on Governmental Affairs, Permanent Subcommittee 

on Investigations, The Role of the Financial Institutions in Enron’s 

Collapse, Vol. 2, 107th Cong., 2nd sess., 2002, Exhibit 207.



[61] It was reported that Merrill Lynch received fees of $250,000 from 

Enron and a $525,000 return on its 6-month investment.



[62] Senate Committee on Governmental Affairs, Permanent Subcommittee 

on Investigations, Fishtail, Bacchus, Sundance, and Slapshot: Four 

Enron Transactions Funded and Facilitated by U.S. Financial 

Institutions, 107th Cong., 2nd sess., 2002, S. Prt. 107-82.



[63] A total return swap is a derivative transaction in which one party 

conveys to the other party all the risks and rewards of owning an asset 

without transferring actual legal ownership of the asset. 



[64] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 322d.



[65] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 322e.



[66] The financial assets were Enron’s ownership interests in various 

paper mills and real property.



[67] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 333n. The memo refers to generally accepted accounting 

principles (GAAP).



[68] The Fortune 500 list, compiled by Fortune magazine, ranks 

corporations by their revenue. Prior to its bankruptcy, Enron was in 

the first 10 and was audited by Arthur Anderson LLP, then a top five 

accounting firm.



[69] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 338.



[70] Committee on Governmental Affairs, Four Enron Transactions, 

Exhibit 344. On November 1, 1999, Revenue Canada became the Canada 

Customs and Revenue Agency whose mission is to promote compliance with, 

among other things, Canada’s tax regulations.



[71] Emerging Issues Task Force (EITF) 98-10, Accounting for Contracts 

Involved in Energy Trading and Risk Management Activities, refers to 

energy trading activities as energy contracts entered into with the 

objective of generating profits on or from changes in market prices. 

Energy trading activities also include dealing, the activity of 

standing ready to trade--whether buying or selling--for the dealer’s 

own account, thereby providing liquidity to the market. 



[72] Swaps can be used to reduce an entity’s risk to changes in prices, 

currency rates, and other factors. The cash flows from swaps should be 

presented on the statement of cash flows in the same category as the 

cash flows from the items being hedged, provided that the accounting 

policy is disclosed.



[73] Not all of the Mahonia prepays ended with gas sales by Chase. On 

September 28, 2001, Chase participated in a $350 million prepay with 

Enron in which Enron’s delivery at maturity was not going to be gas, 

but cash in an amount equal to the spot value of the specified quantity 

of gas. In this transaction, the money Chase received would come (via 

Mahonia) from Enron instead of from sales of gas to the market or back 

to an Enron entity.



[74] Committee on Governmental Affairs, The Role of the Financial 

Institutions in Enron’s Collapse, Vol. 1, Exhibit 123.



[75] Cross-default provisions included in contracts between two parties 

would, on default by one of the parties, put that party in default in 

its other contract(s). Netting provisions in a contract provide that 

mutual obligations are settled at the net, as opposed to the gross, 

dollar value of the contracts.



[76] We have not reviewed these transactions and cannot determine if 

they were similar to Enron’s prepay transactions.



[77] Committee on Governmental Affairs, Role of the Financial 

Institutions, Vol. 1, Exhibit 188g.



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