[Senate Hearing 107-871] [From the U.S. Government Publishing Office] S. Hrg. 107-871 OVERSIGHT OF INVESTMENT BANKS' RESPONSE TO THE LESSONS OF ENRON--VOL. I ======================================================================= HEARING before the PERMANENT SUBCOMMITTEE OF INVESTIGATIONS of the COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS SECOND SESSION __________ DECEMBER 11, 2002 __________ Printed for the use of the Committee on Governmental Affairs U. S. GOVERNMENT PRINTING OFFICE 83-485 WASHINGTON : 2003 ____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800 Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001 COMMITTEE ON GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan FRED THOMPSON, Tennessee DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Joyce A. Rechtschaffen, Staff Director and Counsel Richard A. Hertling, Minority Staff Director Darla D. Cassell, Chief Clerk ------ PERMANENT SUBCOMMITTEE ON INVESTIGATIONS CARL LEVIN, Michigan, Chairman DANIEL K. AKAKA, Hawaii, SUSAN M. COLLINS, Maine RICHARD J. DURBIN, Illinois TED STEVENS, Alaska ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Elise J. Bean, Acting Staff Director and Chief Counsel Robert L. Roach, Counsel and Chief Investigator Kim Corthell, Minority Staff Director Mary D. Robertson, Chief Clerk C O N T E N T S ------ Opening statements: Page Senator Levin................................................ 1 Senator Collins.............................................. 7 Senator Bennett.............................................. 10 WITNESSES Wednesday, December 11, 2002 Charles O. Prince III, Chairman and Chief Executive Officer, Citigroup Global Corporate and Investment Bank, New York, New York........................................................... 12 David C. Bushnell, Managing Director, Global Risk Management, Citigroup/Salomon Smith Barney, New York, New York............. 15 Richard Caplan, Managing Director and Co-Head, Credit Derivatives Group, Salomon Smith Barney North American Credit/Citigroup, New York, New York............................................. 16 William T. Fox III, Managing Director, Global Power and Energy Group, Citibank/Citigroup, New York, New York.................. 16 Michael E. Patterson, Vice Chairman, J.P. Morgan Chase and Company, New York, New York.................................... 44 Robert W. Traband, Vice President, J.P. Morgan Chase and Company, Houston, Texas, accompanied by Eric N. Peiffer, Vice President, J.P. Morgan Chase and Company, New York, New York.............. 46 Andrew T. Feldstein, Managing Director, Co-Head Structured Products and Derivatives Marketing, J.P. Morgan Chase and Company, New York, New York.................................... 49 Muriel Siebert, President and Chair, Muriel Siebert and Company, Inc., New York, New York....................................... 66 Richard Spillenkothen, Director, Division of Banking Supervision and Regulation, The Federal Reserve, Washington, DC............ 71 Douglas W. Roeder, Senior Deputy Comptroller for Large Bank Supervision, Office of the Comptroller of the Currency, Washington, DC................................................. 73 Annette Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Washington, DC............. 75 ................................................................. Alphabetical List of Witnesses Bushnell, David C.: Testimony.................................................... 15 Prepared statement........................................... 101 Caplan, Richard: Testimony.................................................... 16 Prepared statement........................................... 103 Feldstein, Andrew T.: Testimony.................................................... 49 Joint prepared statement..................................... 107 Fox, William T. III: Testimony.................................................... 16 Prepared statement........................................... 104 Nazareth, Annette: Testimony.................................................... 75 Prepared statement........................................... 134 Patterson, Michael E.: Testimony.................................................... 44 Prepared statement........................................... 105 Peiffer, Eric N.: Testimony.................................................... 46 Joint prepared statement..................................... 107 Prince, Charles O. III: Testimony.................................................... 12 Prepared statement........................................... 91 Roeder, Douglas W.: Testimony.................................................... 73 Prepared statement........................................... 123 Siebert, Muriel: Testimony.................................................... 66 Prepared statement........................................... 113 Spillenkothen, Richard: Testimony.................................................... 71 Prepared statement........................................... 117 Traband, Robert W.: Testimony.................................................... 46 Joint prepared statement..................................... 107 APPENDIX Permanent Subcommittee on Investigations Staff Report on ``Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions,'' December 11, 2002.............................. 150 EXHIBITS VOLUME I 301. a. GBacchus, The appearance is a sale, chart prepared by the Permanent Subcommittee on Investigations....................... 185 b. GBacchus, The reality is a loan, chart prepared by the Permanent Subcommittee on Investigations................... 186 302. a. GSundance, The appearance is a joint investment, chart prepared by the Permanent Subcommittee on Investigations....... 187 b. GSundance, [The appearance is a joint investment,] The reality is a sham investment by Citigroup, chart prepared by the Permanent Subcommittee on Investigations............ 188 c. GSundance, The agreement included these provisions, chart prepared by the Permanent Subcommittee on Investigations... 189 303. a. G$1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations................... 190 b. G$1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations............... 191 c. GFlagstaff-Hansen $1.4 Billion, Share Subscription/ Assumption/Payment Set Off, chart prepared by the Permanent Subcommittee on Investigations............................. 192 d. G$1 Billion Cash Flow, June 22, 2001, chart prepared by the Permanent Subcommittee on Investigations............... 193 304. GEnron Guarantees Citigroup's ``Equity'' Investment In Bacchus, chart prepared by the Permanent Subcommittee on Investigations................................................. 194 Project Fishtail Transaction: 305. GFishtail deal structure, dated January 21, 2002, prepared by Deloitte & Touche........................................... 195 306. GLJM2 Investment Summary for Fishtail, dated December 20, 2000........................................................... 196 307. GInvestment Return Summary for Fishtail prepared by LJM2.... 199 308. GBenefits to Enron Summary, Deal Name: Ampato (Fishtail), dated December 20, 2000, prepared by LJM2...................... 200 309. GEnron's LJM2 Approval Sheet for Fishtail, dated December 18, 2000....................................................... 201 310. GProject Fishtail/125 Structure............................. 205 311. GStructuring Summary, Project Grinch, dated December 18, 2000, prepared by Chase........................................ 206 312. GProject Grinch LP, summary memorandum prepared by Chase, December 16, 2000.............................................. 208 313. GEnron Corporate Development Asset Inventory, Tentative and Preliminary, EIM, updated 11/25/01............................. 211 314. GEnron Corp. email, December 2000/January 2001, re: 2000 Accomplishments, attaching document, Mike Patrick 2000 Accomplishments................................................ 212 315. GChase fee letter to Enron Corp. signed by both parties, December 20, 2000, re: Fishtail (. . . an advisory fee in an amount equal to $500,000. . . .)............................... 214 Project Bacchus Transaction: 316. GProject Bacchus, deal structure chart prepared by Enron Corp........................................................... 216 317. GTransaction Descriptions: Project Bacchus, Summary and Structure Description, prepared by Enron Corp.................. 217 318. GGlobal Loans Approval Memorandum, December 6, 2000, prepared by Citibank, re: Project Bacchus...................... 219 319. GCitibank email, April 2001, re: Enron Credit Approval ($200mm--Bacchus: SPV where we have a total return swap from Enron for $180 mm and verbal support for the balance . . .).... 223 320. GExecutive Summary, including Bacchus/Caymus Trust Facility, prepared by Citibank........................................... 224 321. GProject Bacchus, 3% Test and Gain Calculation, prepared by Enron Corp..................................................... 225 322. a. GCitibank email, November 2000, re: Enron update (Enron's motivation in the deal now appears to be writing up the asset in question from a basis of about $100MM to as high as $250MM, thereby creating earnings.).................................... 226 b. GCitibank email, November 2000, re: Enron update (. . . but it will be major appropriateness issue as will the first two)................................................. 228 c. GCitibank email, November 2000, re: Enron/Bacchus Summary (They [Enron] have offered to have the CFO discuss this at whatever level of our [Citibank] organization we think necessary to obtain the right comfort)..................... 229 d. GCitibank email, December 2000, re: ENE/Bacchus Update (It is possible, but not certain, that there will be an earnings impact. . . .).................................... 232 e. GCitibank email, December 2000, re: ENE/Bacchus (There are ``technical'' issues with NetWorks which MAY make Bacchus unworkable. . . .)................................. 233 f. GCitibank email, December 2000, re: Enron ([H]owever, the $200 million represents 16.3% and 22.4% of operating cash flow and net income . . .), attaching estimated Enron figures.................................................... 234 g. GCitibank email, December 2000, re: Enron (Based on 1999 numbers would appear that Enron significantly dresses up its balance sheet for year end; . . .)..................... 237 h. GCitibank email, December 2000, re: Enron/Bacchus (The equity component has been approved on the basis of verbal support verified by Enron CFO, Andy Fastow.)............... 239 i. GCitibank email, December 2000, re: Enron/Bacchus (Sounds like we made a lot of exceptions to our standard policies. . . .)..................................................... 242 j. GCitibank email, May 2001, re: Bacchus Unwind (. . . sufficient for the Trust to prepay the notes in full plus break costs.).............................................. 243 323. GCapital Markets Approval Committee, New Project/Complex Transaction Description Guidelines, Enron Corp., Project Bacchus FAS 125 Transaction, 12/11/00 draft, prepared by Citibank....................................................... 244 324. GArthur Andersen LLC Memorandum, December 2000, re: Fishtail LLC Formation/Securitization................................... 246 325. GArthur Andersen email, November 1999, re: Total Return Swaps.......................................................... 250 Project Sundance Transaction: 326. GDescription of the Sundance Transaction, 10/29/01, prepared by Citibank.................................................... 253 327. GCapital Markets Approval Committee (CMAC), Minutes to Meeting, May 16, 2001, Project Sundance (Enron Corp.), prepared by Citibank.................................................... 255 328. a. GChart prepared by Enron Corp., Sundance Steps, Updated May 16, 2001, 5pm.............................................. 257 b. GSundance Steps, Updated May 11, 2001, 5:44 pm........... 259 c. GSundance Steps, Updated June 1, 2001.................... 260 329. GEnron Corp. Presentation, Enron Industrial Markets Finance Presentation of Sundance Industrial Partners, June 1, 2001..... 261 330. GEnron Corp. Presentation, Enron Industrial Markets-- Finance, Presentation of Sundance Industrial Partners to Salomon Smith Barney, NY, August 2001.......................... 264 331. GEnron Corp. Presentation, Enron Industrial Markets-- Finance, Potential paper mill acquisition presentation to Salomon Smith Barney, September 2001........................... 271 332. GFirst cut at questions re Sundance, prepared by Citibank... 280 333. a. GCitibank email, April 2001, re: sundance ([T]he argument for why it is debt even if we take a partnership interest that it is more debt like than equity.)............................. 282 b. GCitibank email, May 2001, re: Enron Slapshot Structure.. 283 c. GCitibank email, May 2001, re: Materials for CMAC meeting, attaching copy of Capital Markets Approval Committee, New Project/Complex Transaction Description Guidelines, Enron Corp., Project Sundance Transaction, prepared by Citibank....................................... 285 d. GCitibank email, May 2001, re: cmac memo ([P]erwein wanted to say that this is a funky deal (accounting-wise.)) 290 e. GCitibank email, May 2001, re: sundance (. . . is a structure that insures, insofar as possible, that it will never get drawn.).......................................... 291 f. GCitibank email, May 2001, re: sundance (. . . I do not understand why we are proposing to do this transaction.)... 292 g. GCitibank email, May 2001, re: Sundance.................. 294 h. GCitibank email, May 2001, re: Treatment for Project Sundance, includes a handwritten comment that contingent capital commitment cannot be drawn since SBHC will dissolve partnership if draws triggers are being approached.)....... 295 i. GCitibank email, May 2001, re: Enron/Sundance (Still an equity investment of sorts (acctg and tax basis for partnership) but is structured in such a way that the 670 bps is guaranteed or we blow the deal. Also our ``invest'' is so subordinated and controlled that it is ``unimaginable'' how our principal is not returned.)....... 296 j. GCitibank email, May 2001, re: Sundance/Firm Investment (. . . it does appear that we will need to have approval at some point from Mike Carpenter . . .)...................... 297 k. GCitibank (Eleanor Wagner) email, May 2001, re: Project Sundance, including draft memo for Michael Carpenter, expressing Risk Management's Concerns...................... 298 l. GCitibank email, May 2001, re: sundance (We do still need Barbara Yastine and Mike Carpenter to approve before we close?).................................................... 300 m. GCitibank email, May 2001, re: Sundance (Approval sits in front of Carpenter waiting for signature.)................. 301 n. GCitibank email, May 2001, re: Memo on Enron-Project Sundance (We (Bill Fox and I) share Risk's view and if anything, feel more strongly that suitability issues and related risks when coupled with the returns, make it unattractive.), attaching May 2001 Dave Bushnell Memorandum to Mike Carpenter.......................................... 302 o. GCitibank email, May 2001, re: sundance ([A]ny word? am getting a significant amount of pressure from enron to execute.).................................................. 305 p. GCitibank email, June 2001, re: Sundance Closing......... 306 q. GCitibank email, June 2001, re: Sundance Approvals (No . . . was given a verbal go ahead . . . Understand signed is to follow.)................................................ 307 r. GCitibank email, June 2001, re: Sundance (Mike then had a conversation with Dave Bushnell, who shared with us Mike's feedback.)................................................. 308 s. GCitibank email, October 2001, re: Sundance Revenues..... 309 t. GCitibank email, October 2001, re: sundance redux, attaching Description of the Sundance Transaction.......... 310 u. GCitibank email, October 2001, re: Enron Exposure on NA Credit Derivs (Note that these equity partnerships, are designed to act as debt exposure . . .).................... 313 v. GCitibank email, October 2001, re: ene transactions (Sundance . . . allows Enron to manage its paper and pulp physical assets and trading business off-balance sheet.)... 315 w. GCitibank email, October 2001, re: sundance (According to Enron, our $28.5MM is being held in bank deposits.)........ 316 x. GCitibank email, November 2001, re: Sundance Paper (ENE wants to ``discuss'' I have not reiterated the imperative nature of request, did NOT waive the BoD stick. . . .)..... 317 y. GCitibank email, November 2001, re: Enron Sundance--the paper trading partnership (Last night we came to terms with Enron for the purchase of our interest in the Sundance partnership.).............................................. 318 334. GCitibank/SolomonSmithBarney Interoffice Memo, May 2001, re: Enron Corp.--Project Sundance (Transactions Overview, Description of the Assets, Economics).......................... 319 335. GAccounting for Investments in Limited Partnerships and Other Joint Ownership Entities, prepared by Enron Corp......... 324 336. GArthur Andersen email, August 2000, re: 4 to 1 test........ 334 Project Slapshot Transaction: 337. GFlagstaff Funding Flows, diagram prepared by Enron Corp.... 347 338. GTransaction Summary, Flagstaff/Enron Transaction, prepared by JPMorgan Chase.............................................. 348 339. GSlapshot Savings, diagram prepared by Enron Corp........... 354 340. GProject Slapshot, Transaction Diagram--@ Closing, June 2001, prepared by Enron Corp................................... 355 341. GStructuring Summary, Flagstaff Capital Corporation, February 2001, (partial) prepared by JPMorgan Chase............ 356 342. GEnron Corp. Stadacona, JPMorgan Chase presentation......... 362 343. GProposal to Enron Industrial Markets, Structured Canadian Financing Transaction (Project ``Slapshot''), January 11, 2001, JPMorgan Chase presentation.................................... 379 344. GStructured Canadian Financing Transaction, Organizational Meeting, February 8, 2001, JPMorgan Chase presentation......... 396 345. GSlapshot Transaction Diagram............................... 416 346. GProject Slapshot, Transaction Components, June 2001, Enron Corp. presentation............................................. 422 347. GJ.P. Morgan Securities Inc./Enron Corp. correspondence, June 2001, re: Tax Comfort Letter--Enron Structured Financing.. 426 348. GJ.P. Morgan Securities Inc./Enron Corp. correspondence, June 2001, re: U.S. Tax Matters--Enron Structured Financing.... 428 349. G206.(f) Agreement between Flagstaff Capital Corporation and Hanson Investments Co., June 2001.............................. 431 350. GCredit Agreement between Hansen Investments Co., Flagstaff Capitol Corporation and The Chase Manhattan Bank, June 2001.... 434 351. GProject Slapshot, Discussion Session, March 2001, presentation prepared by JPMorgan Chase........................ 514 352. GTax opinion letter from Blake, Cassels & Graydon LLP to Enron Corp., June 2001, re: Canadian Tax Consequences of Proposed Financing............................................. 525 353. GTax opinion letter from Blake, Cassels & Graydon LLP to Chase Securities, Inc., November 2000, re: Canadian Tax Consequences of Proposed Financing............................. 544 354. GTax opinion memorandum from Skadden, Arps, Slate, Meagher & Flom LLP to Enron Wholesale Services, August 2001, re: Project Slapshot....................................................... 565 355. GProject Slapshot Structured Financing Fee Letter (Arranger), June 2001.......................................... 593 356. GFee Agreement, between J.P. Morgan Securities Inc. and Compagnie Papiers Stadacona, June 2001......................... 596 357. a. GJPMorgan Chase email, February 2001, re: Some Good News (Slapshot) (Bruce and Eric run the Slapshot product.).......... 600 b. GJPMorgan Chase email, February 2001, re: Project Slapshot (The lawyers have slammed on the brakes until we confirm that the net accounting for the twist we're contemplating will work.).................................. 601 c. GJPMorgan Chase email, February 2001, re: Slapshot (As discussed, the lawyers (especially the tax lawyers) are hesitant to state explicitly Chase's intention to set-off . . . as they wish to keep the documents as ``arm's length'' as possible . . .)......................................... 607 d. GJPMorgan Chase email, May 2001, re: Wed conf call-- discussion points, attaching Enron Discussion Points (May 9, 2001)................................................... 608 e. GJPMorgan Chase emails, February and May 2001, re: Project Rio Grande (a.k.a. Flagstaff Capital Corporation)-- HEADS UP MEMO (Club Bank Target Hold: $60MM . . ).......... 611 f. GJPMorgan Chase email, June 2001, re: Flagstaff I.D. #'s (The $1.1 billion will be repaid same day.)................ 613 g. GCitibank email, June 2001, re: Additional Daylight Overdraft Request from Enron (Enron will require additional daylight overdraft protection on Friday 6/22/2001 . . .)... 614 h. GJPMorgan Chase email, October 2001, re: Flagstaff Syndication Update ([L]ets make sure we lock up Citi and Boa on confidentiality agreements, for what they're worth.) 621 i. GJPMorgan Chase email, October 2001, re: Enron Flagstaff (The message from Enron to them is ``you have to do this.'')................................................... 622 j. GJPMorgan Chase email, November 2001, re: Enron-- Flagstaff (The papers were signed with a $56.25MM target hold to be achieved by 9/30.).............................. 623 k. GEric Peiffer/JPMorgan Chase email, October 2001, re: enron responsibilities (Eric did an outstanding job and took on serious responsibilities.)......................... 624 358. GBill W. Brown, Accomplishments for the First Half of 2001.. 626 359. GDoug McDowell resume....................................... 627 360. GProject Slapshot brief, Project Slapshot Scores!, prepared by Enron Corp.................................................. 629 361. GSundance Transaction, Slapshot Financing, prepared by Citigroup...................................................... 630 362. GEnron Corp. email, December 2000, re: Canadian Financing Proposal (. . . it is a similar version of an arrangement that Morris and I have independently been developing with our Canadian counsel . . .)........................................ 632 363. GEnron Corporation Closing Funds Flows for Slapshot, Closing Date: Friday, 6/22/00, Final................................... 633 364. GMemorandum prepared by Tim Edgar, Faculty of Law, The University of Western Ontario, to the Permanent Subcommittee on Investigations, December 9, 2002, re: Canadian Income Tax Consequences of Flagstaff/Enron Transaction.................... 638 365. GEnron Industrial Markets Finance Presentation of Sundance and Slapshot, March 21, 2001, prepared by Enron Corp........... 646 366. GCiticorp/Citibank Credit Approval, Enron Corporation, December 2000, indicating ``verbal guarantees'' of Project Bacchus ``equity'' (see page Bates #CITI-SPSI 0128921)......... 655 367. GAccounting Schedules for Projects Fishtail and Sundance, prepared by Enron Corp......................................... 680 368. GLetter from Skadden, Arps, Slate, Meagher & Flom LLP (attorneys for Enron Corp.) to the Permanent Subcommittee on Investigations, December 10, 2002, regarding status of the loans, assets, and entities involved in the Slapshot transaction.................................................... 684 369. GJPMorgan Chase email, July 1998, attaching copy of Prepay pitch presentation............................................. 687 370. GJPMorgan Chase email, March-July 1999, re: Prepaid Forwards and Disguised Loans............................................ 701 VOLUME II 371. GEnron Net Works Partners: Valuation Analysis of Contributed Assets, Chase Securities Inc., November 20, 2000............... 1 372. GFishtail LLC, Enron Corp. draft document summarizing Project Fishtail (undated)..................................... 19 373. GAmended and Restated Limited Liability Company Agreement of Fishtail LLC, December 19, 2000................................ 22 374. GSummary of Project Fishtail, prepared by Deloitte & Touche, LLP, for the Powers Report, dated January 21, 2002............. 74 375. GData Sheet Report, Caymus Trust (c/o Wilmington Trust) as of February 22, 2002........................................... 102 376. GAmended and Restated Limited Partnership Agreement of Sundance Industrial Partners, L.P., June 1, 2001............... 103 377. GCitibank email, June 2001, re: Apache Opportunity (Any feedback from Carpenter on Sundance; apparently the deal closed.)....................................................... 175 378. GSenior Bank Contacts, document prepared by Enron Corp...... 176 379. GEnron status as of November 26, 2001 in terms of directors, officers, stock outstanding, and direct subsidiaries........... 177 380. GEnron Corp. Memorandum, October 1, 2000, re: Accounting Enron's Investment in Fishtail LLC............................. 191 381. GAdditional documents regarding Project Bacchus: a. GEnron Corp. Memorandum, December 31, 2000, re: Project Bacchus Transaction Memorandum............................. 196 b. GFishtail Total Costs.................................... 202 c. GCitibank email, October 2000, re: Enron/Project Bacchus (Dan sees NO chance that this deal will not go ahead . . .) 203 d. GCitibank email, December 2000, re: Bacchus Equity (As you know we are looking for a balance sheet provider for the new Enron trade.)...................................... 204 e. GCitibank email, December 2000, re: Enron Bacchus (Citibank GRB have agreed to provide a 9-month facility for the 194 M and also to take the credit risk on the equity portion.).................................................. 205 f. GCitibank fax, December 12, 2000, attaching copy with comments of Global Loans Approval Memorandum, December 6, 2000, re: Project Bacchus (from section on page 3 entitled, Enron Corporate Credit Risk: Enron Corp. will essentially support the entire facility, whether through a guaranty or verbal support.)........................................... 206 g. GCitibank email, December 2000, re: Enron follow-up (Having this source of liquidity during this nanosecond is important in providing certain legal opinions . . .)....... 211 h. GCitibank email, December 2000, re: Enron/Bacchus (. . . the RAP treatment should be that the Banking Book will view the Certificates as if it made a loan in the face amount of the Certificates.)......................................... 212 i. GEnron Corp. email, January 2001, re: Fishtail in EIM Partners (In talking to Jeff, he does not like the way I was proposing that Fishtail went into EIM Ptrs . . .)...... 213 j. GCitibank email, February 2001, re: Bacchus (I had an Enron question regarding the Enron gty provided for Baccus(sp?).).............................................. 214 k. GCitibank email, May 2001, re: phone call with bill brown 215 l. GCitibank email, November 2001, re: Enron Exposure (For Bushnell), attaching Enron exposure table.................. 216 382. GAdditional documents regarding Project Sundance: a. GSundance Earnings (Still Under Negotiation), document prepared by Enron Corp..................................... 218 b. GAdministrative Agent Fee Calculation, document prepared by Enron Corp.............................................. 219 c. GAmended and Restated Sundance Limited Partnership Agreement, June 1, 2001.................................... 220 d. GFinal Sundance Numbers, document prepared by Enron Corp. 293 e. GCitibank email, May 2001, re: Sundance (Re fleet: we shd approach these guys by saying we are rolling the trs they have on bacchus but also adding to it.).................... 295 f. GCitibank email, May 2001, re: Sundance (Thoughts or concerns I had as I read the revised Sundance LP Agreement:)................................................ 296 g. GCitibank email, May 2001, re: sundance (. . . I do not understand why we are proposing to do this transaction. . . .), attaching copy of First cut at questions re Sundance... 298 h. GCitibank email, May 2001, re: Second Sundance question set, attaching copy of Second Set of Sundance Questions.... 301 i. GCitibank email, May 2001, re: Sundance Partnership...... 304 j. GEnron email, May 2001, re: Updated Step by Step Sundance structure Chart--03/22/01.................................. 306 k. GEnron Corp. Presentation, Enron Industrial Markets Finance Presentation of Sundance Industrial Partners, June 1, 2001.................................................... 311 383. GAdditional documents regarding Project Slapshot: a. GFlagstaff Capital Corporation, $375,000,000, Senior Credit Facility, JPMorgan Confidential Information Memorandum, May 2001....................................... 316 b. GEnron Corp. (Morris Clark to Joseph Deffner) email, undated, re: Repatriation of Cash from Enron Canada (It should be noted that repaying the Preferred Shares within the same year as entering into Project Slapshot puts pressure on both of the above factors and, as such, puts the integrity of the transaction at risk.)................. 352 c. GDaishowa Acquisition Structure Steps, charts prepared by Enron Corp................................................. 353 d. GJPMorgan Chase email, February 2000, re: Slapshot-- Frazer Milner Tax Opinion, attaching copy of draft opinion on Re: Canadian Structured Finance Proposal................ 360 e. GHandwritten notes of Enron Corp. re: Project Slapshot... 379 f. GBlake, Cassels & Graydon LLP Memorandum to Enron Corp., January 2001, re: Prepaid Forward Structure................ 387 g. GEnron Corp./Blake, Cassels & Graydon LLP email, February 2001, re: Rider, attaching draft recharacterization rider.. 394 h. GProject Slapshot, Canadian Tax Advantaged Financing Structure for Project Crane & ECC Operations, March 20, 2001, Enron Corp. presentation............................. 396 i. GEnron Corp. email, March 2001, re: Requirements for Right of Offset accounting................................. 417 j. GEnron Corp./Blake, Cassels & Graydon LLP email, March 2001, re: Canadian Guaranty Issue with attached Enron Corp. handwritten notes re: Slapshot............................. 418 k. GBlake, Cassels & Graydon LLP Memorandum, March 2001, re: Warrant Arrangement........................................ 420 l. GJPMorgan Chase email, March 2001, re: enron............. 422 m. GFlagstaff Capital Corporation (Delaware), Assets and Liabilities, document produced by JPMorgan Chase........... 423 n. GEnron Corp./Blake, Cassels & Graydon LLP email, April 2001, re: Comments on drafts of April 12/01, attaching copy of April 2001 Blake, Cassels & Graydon LLP Memorandum...... 424 o. GBlake, Cassels & Graydon LLP Draft Memorandum, May 2001, re: Tax Issues............................................. 428 p. GEnron Corp./Blake, Cassels & Graydon LLP email, May 2001, re: Tax Benefit Analysis, attaching draft Tax Benefit Analysis................................................... 432 q. GHandwritten notes of Enron Corp., May 2001, re: Slapshot 435 r. GEnron Corp. email, May 2001, re: Journal Entries ([H]ere are accounting entries for the slapshot transaction.), attaching copy of Slapshot-Initial Purchase; Slapshot--Year 1-5 Balance Sheet; and Slapshot-Year 5 End Unwind.......... 436 s. GEnron Corp. Memorandum, May 2001, re: Project Slapshot-- Step-by-Step Description................................... 440 t. GHandwritten notes of Enron Corp., June 2001, re: Slapshot................................................... 443 u. GEnron Corp./Blake, Cassels & Graydon LLP email, June 2001, re: Blakes Second Set-off Opinion re: Hansen- Flagstaff, attaching Blake, Cassels & Graydon LLP correspondence concerning Project Slapshot................. 449 v. GFlagstaff Capital Corporation, Commitment Allocations as of September 24, 2001...................................... 453 w. GBlake, Cassels & Graydon LLP invoice for services rendered for the period ended June 21, 2001, re: Project Slapshot................................................... 454 x. GEnron Corp. Memorandum, October 2001, re: Campagnie Papiers Stadacona.......................................... 456 y. GVinson & Elkins invoice for services posted through June 27, 2001, re: Project Slapshot-Enron $400,000,000 Structured Financing....................................... 458 z. GProject Dasher, Preliminary Tax Disposition Structures To Maintain Project Slapshot, August 31, 2001, prepared by Enron Corp................................................. 459 aa. GEnron Corp. email, December 2001, re: Slapshot (. . . doug, pls call me asap since you are the most knowledgeable.)............................................ 463 bb. GHandwritten notes of Enron Corp., December 2001, re: Slapshot/CPS restructuring with attached copy of Enron Corp. Memorandum, December 2001, re: Proposed Sale of Stadacona Mill--Restructuring Steps........................ 464 cc. GBlake, Cassels & Graydon LLP Memorandum, December 2001, re: Slapshot Restructuring/CPS Sale........................ 468 dd. GEnron Corp. facsimile to Jeff McMahon, December 2001, re: Stadacona (Project Slapshot)........................... 481 ee. GBlake, Cassels & Graydon LLP Memorandum, January 2002, re: Slapshot Structure, Current Status Issues and Proposed Transactions............................................... 489 ff. GJPMorgan Chase email, January 2002, re: Flagstaff Commitment and Fee Letter (Given the sensitivity to the Enron name and this transaction in particular, I would suggest writing this up as an exception.).................. 494 gg. GEnron Corp. Memorandum, November 2002, re: Project Slapshot--Quarterly Payments............................... 495 hh. GPatton Boggs LLP correspondence, on behalf of JPMorgan Chase, to the Permanent Subcommittee on Investigations, December 2002, re: structuring fees paid to JPMC........... 497 ii. GCanadian Financing Strategy, A Presentation to Enron Corp., September 2000, National Australia Group............ 498 jj. GAdditional Points, JPMorgan Chase document regarding Project Slapshot........................................... 510 kk. GDaishowa Acquisition Structure Steps, Enron document regarding Project Slapshot................................. 511 384. GDocuments regarding Project Crane and Project Boomerang: a. GEnron Corp. email, December 2000, re: Project Crane-- Status Updated and Next Steps (I would to inform everyone that yesterday we had a meeting with Jeff Skilling to present Project Crane . . .)............................... 514 b. GEnron Corp. email, December 2000, re: Skilling presentation on EIM Pulp and Paper Market Making Strategy.. 515 c. GEnron Risk Assessment and Control Deal Approval Sheet, December 2000, re: Project Crane........................... 535 d. GProject Crane, Steps to Acquire SAT and DFPL and Post- Acquisition Undertakings, draft of presentation............ 542 e. GProject Boomerang, Transaction Overview, prepared by JPMorgan Chase............................................. 548 f. GJPMorgan Chase email, November 2000, re: Project Boomerang (I think what we would like to try to do is define fair market value in such a way that it always turns out to be equal to the value at which the SPE purchased the business.)................................................. 551 385. GAdditional documents relating to FAS 125/140 Transactions: a. GFASB Statement No. 125, Enron Corp. presentation........ 553 b. GUpdate on FASB 140, Transfers of Financial Assets & Extinguishment of Liabilities, June 2001, Enron Corp. presentation,.............................................. 571 c. GAndersen email, November 1999, re: Total Return Swaps... 584 d. GEnron Corp./Andersen email, September 2001, re: Background of Project Hawaii 125-O......................... 587 e. GEnron Corp. Memorandum, December 2001, re: Hawaii Structure Summary.......................................... 590 f. GEnron Corp., Pre-Tax Earnings Analysis of SFAS 140's 1998-2001.................................................. 593 g. GEnron Corp. email, May 2001, re: Offshore Double Lease Accounting Treatment....................................... 594 386. GDocuments relating to transactions involving Canadian Imperial Bank of Commerce (CIBC) and Enron Corp., November, 2002........................................................... 598 387. GAdditional documents regarding Enron Corp. structured finance deals generally: a. GGlobal Finance: Funding Vehicles, May 2000, Enron Corp. presentation............................................... 613 b. GFunds Flow Vehicles, Enron Corp. document............... 621 c. GStructured Finance Vehicle, August 24, 2001, Enron Corp. presentation............................................... 629 d. GEnron Corp., Structured Transactions Group Overview, June 2001.................................................. 652 e. GEnron Structured Finance List As of 11/16/2001.......... 659 388. GDocuments regarding Enron Bank Reviews: a. GEnron Corp. email, July 2000, re: Bank relationship review..................................................... 686 b. GDebt Investor Relationship Review, January 2001, Enron Corp. presentation......................................... 689 389. GDocuments regarding Enron Asset Valuations: a. GWhitewing Presentation, August 14, 2001, prepared by Enron Corp................................................. 741 b. GEnron Global Assets and Services, Equity Value Schedule, $(Millions), As of June 2001............................... 753 c. GEnron Global Assets & Services, Significant Exposures (InUS$MM's),............................................... 754 390. GAdditional documents regarding Enron Prepay Transactions: a. GCorrespondence between Citigroup and the Permanent Subcommittee on Investigations, July 2002-January 2003, regarding Delta Energy Corporation......................... 755 b. GCorrespondence between JPMorgan Chase and the Permanent Subcommittee on Investigations, July 2002-January 2003, regarding Mahonia, Ltd..................................... 812 c. GSummary of Proposed Transaction Approval Process (TAP) Policy Revisions, undated, from the ``H'' drive of the computer of Enron Corp. employee Rick Carson............... 952 d. GProposed Gas Storage Monetization Structure, undated, from the ``H'' drive of the computer of Enron Corp. employee Michael Garberding................................ 953 e. GEnron Corp. email, December 2000, re: New Prepay with Chase (In the prior transactions, we have received a prepayment from Mahonia on a forward delivery schedule of fixed volumes.)............................................ 959 f. GEnron Corp./JPMorgan Chase email, September 2001, re: Rep Letter for Mahonia, attaching draft Mahonia representation letter...................................... 960 g. GEnron Corp. email, June 2001, re: Sample Swap Co Letter (I am still trying to track down the original ``Delta/ Mahonia'' Letter. Everyone seems to have shredded their files, which is a little disturbing.)...................... 962 h. GEnron Corp. email, November 2001, re: Steps for $250mm Swap Assumption............................................ 963 i. GEnron Corp. email, September 2001, re: New Confirm...... 967 j. GEnron Corp. email, July 2001, re: Citibank/Delta Prepay (. . . the auditors would like to verify that the MMBtus involved in the trade are not inconsistent with normal trades that run through the financial book for gas.)....... 972 k. GEnron Corp. email, September 2001, re: Revised Pre Pay docs (This tracks language that is in the Guaranty and does not name Chase.)........................................... 973 l. GEnron Corp. email, October 2001, re: Comments on Prepaid Swaps...................................................... 975 m. GEnron Corp. email, September 2001, re: Mahonia Confirm... 990 n. GEnron Corp./JPMorgan Chase email, September 2001, re: Mahonia Limited............................................ 998 o. GEnron Corp. email, November 2000, re: Sale treatment for Prepayments with subsequent participation to an investor... 1001 p. GEnron Corp. email, September 2001, re: Chase Prepay..... 1003 q. GEnron Corp. email, November 2000, re: Prepay (Andy, Michael asked me to forward this structure to you in advance of his call.)...................................... 1004 r. GEnron Prepaid Oil Swap:................................. 1005 391. GSupplemental questions and answers for the record of Citibank, regarding December 11, 2002, hearing, dated February 27, 2003....................................................... 1006 392. GCorrespondence from the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Securities and Exchange Commission, to the Permanent Subcommittee on Investigations, regarding followup to questions posed in the Subcommittee's December 11th hearing and recommendations included in the Subcommittee report entitled Fishtail, Bacchus, Sundance, and Slapshot, Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions................................................... 1008 OVERSIGHT OF INVESTMENT BANKS' RESPONSE TO THE LESSONS OF ENRON ---------- WEDNESDAY, DECEMBER 11, 2002 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Governmental Affairs, Washington, DC. The Subcommittee met, pursuant to notice, at 9:37 a.m., in room SD-106, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin, Collins, and Bennett. Staff Present: Linda J. Gustitus, Chief of Staff; Elise J. Bean, Staff Director and Chief Counsel; Mary D. Robertson, Chief Clerk; Bob Roach, Counsel; Jamie Duckman, Professional Staff Member; Jessica Swartz, Intern; Beth Merrilat-Bianchi, Detailee/IRS; Jim Elliott, Detailee/Department of State; Kim Corthell, Republican Staff Director; Alec Roger, Counsel to the Minority; Claire Barnard, Investigator to the Minority; David Mount, Detailee/Secret Service; Jim Pittrizzi, Detailee/General Accounting Office; Meghan Foley, Staff Assistant; Marianne Upton (Senator Durbin); Tara Andringa (Senator Levin); Bob Klepp (Governmental Affairs/Senator Thompson); Mike Nelson (Senator Bennett); Holly Schmitt (Senator Bunning); Felicia Knight (Senator Collins); and Brooke Brewer (Senator Cochran). OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. One year ago, on December 2, 2001, Enron Corporation, then the seventh-largest company in the United States, declared bankruptcy. The follow- up to this financial disaster revealed a litany of Enron corporate abuses, from accounting fraud to price manipulation, insider dealing, and tax abuses. Yet it is still the case today, as it was a year ago, that most top Enron officials have walked away from the scandal that they created with tens of millions of dollars in their pockets while Enron employees, creditors, and shareholders have suffered substantial losses. As disturbing as Enron's own misconduct is the growing evidence that leading U.S. financial institutions not only took part in Enron's deceptive practices, but at times designed, advanced, and profited from them. This is the third in a series of hearings held by this Subcommittee focusing on the role of financial institutions in Enron's collapse. Our first hearing looked at the more than $8 billion in deceptive transactions referred to as prepays. Citigroup and J.P. Morgan Chase repeatedly used these deceptive prepays to issue Enron huge loans that were disguised as energy trades, which then enabled Enron to misstate the loan proceeds as cash flow from business operations. Investors and analysts were misled, along with the many employees who lost their life savings and jobs. Our second hearing looked in detail at a sham asset sale from Enron to Merrill Lynch just before the end of the year 2000 so that Enron could book the fake sale revenue and boost both its year-end earnings and cash flow from operations. This transaction didn't qualify as a true sale under accounting rules because Enron had eliminated risk from the deal by secretly promising Merrill Lynch to arrange a resale of the barges within 6 months, while guaranteeing a 15 percent profit. In both hearings, substantial evidence showed that the financial institutions involved in the deals knew exactly what was going on. They structured the transactions, signed the paperwork, and supplied the funds, knowing that Enron was using the deal to report that the company was in better financial condition than it really was. In the case of Citigroup and Chase, the banks not only assisted Enron, they developed the deceptive prepays as a financial product and sold it to other companies as so-called balance sheet-friendly financing, earning millions of fees for themselves in the process. Today's hearing will look at another set of deceptive transactions that took place over a 6-month period, from December 2000 to June 2001, involving Enron ventures in the pulp and paper business. These transactions were known as Fishtail, Bacchus, Sundance, and Slapshot. The evidence shows that Citigroup and Chase actively aided Enron in these transactions despite knowing that they employed deceptive accounting or tax strategies and were being used by Enron to manipulate its financial statements or deceptively reduce its tax obligations. Citigroup and Chase received substantial fees for their actions or favorable consideration from Enron in other business dealings. These four transactions required months of work by the Subcommittee staff to untangle. The complexity of the deals made the deceptions almost impossible for anyone to understand without a detailed road map. They also show how far our financial institutions have sunk in misusing structured finance. Instead of using structured deals to lower financing costs or spread risk, which are legitimate uses, they used structured finance to mislead investors, analysts, and regulators about a company's true activities and financial condition. I will place in the record at this time the Subcommittee staff report that describes the four transactions in detail, as well as charts and exhibits showing what happened.\1\ --------------------------------------------------------------------------- \1\ The staff report appears in the Appendix on page 150. --------------------------------------------------------------------------- Here are some of the highlights from that report and from our investigation. Enron constructed the first three transactions, Fishtail, Bacchus, and Sundance, as a sham asset sale of its new pulp and paper business venture in order to inflate its cash flow and earnings by hundreds of millions of dollars and to keep the substantial debts associated with this business venture off its balance sheet and out of the view of investors and analysts. The first two transactions took place in December 2000. Enron first pretended to move its pulp and paper trading business off its balance sheet to a new joint venture that it had set up called Fishtail. About 1 week later, in the Bacchus deal, Enron purportedly sold its Fishtail interest to another entity for $200 million. Enron then booked the $200 million as sale revenue and declared a profit and earnings of $112 million on its year-end financial statement, enabling the company to meet Wall Street expectations for its year 2000 earnings. In the Bacchus transaction, Enron allegedly sold its Fishtail ownership interest to a shell company that it had established earlier called the Caymus Trust, and Exhibit 301(a) \1\ shows how the transaction appeared on the surface, and that exhibit is on the screen. --------------------------------------------------------------------------- \1\ Exhibit No. 301(a) appears in the Appendix on page 185. --------------------------------------------------------------------------- The Caymus Trust came up with the $200 million purchase price by obtaining a $194 million loan from Citigroup and an apparent $6 million cash investment from Fleet Boston Financial that was also guaranteed by Citigroup. However, as Exhibit 301(b) \2\ demonstrates, the transaction was, in reality, a loan. The evidence shows that in addition to openly guaranteeing repayment of the $194 million Citigroup loan, which is permissible under accounting rules, Enron's Chief Financial Officer, Andrew Fastow, also made an undisclosed, oral agreement with Citigroup to ensure that Citigroup would not incur any loss connected with the so-called $6 million investment. --------------------------------------------------------------------------- \2\ Exhibit No. 301(b) appears in the Appendix on page 186. --------------------------------------------------------------------------- These two guarantees meant that Enron, in effect, had ensured repayment of the entire $200 million purchase price, and those two guarantees also meant that under accounting rules, Citigroup was, in reality, providing Enron a loan and using the Caymus Trust as a pass-through rather than financing a real sale to a real company. Six months later, Enron and Citigroup set up another joint venture called Sundance to take possession of all of Enron's pulp and paper assets, including the asset presumably just sold to the Caymus Trust, and to keep the debt associated with these assets off Enron's balance sheet. But this joint venture was also a sham. Enron's auditor, Andersen, had told Enron that it would approve off-balance sheet treatment of the Sundance joint venture only if at least 20 percent of Sundance's capital came from an independent investor and at least 3 percent of the total capital was placed at risk when the venture was formed and stayed at risk during the joint venture's operation. Exhibit 302(a) \3\ shows that Sundance appeared to meet these accounting requirements. Enron contributed approximately $750 million in assets and cash. Citigroup appeared to have contributed $188.5 million, or 20 percent of the joint venture's capital. Citigroup's contribution included $28.5 million in stock and cash, which supposedly met the requirement for 3 percent up-front capital at risk and $160 million in unfunded capital that supposedly would be provided on demand. --------------------------------------------------------------------------- \3\ Exhibit No. 302(a) appears in the Appendix on page 187. --------------------------------------------------------------------------- But as Exhibit 302(b) \1\ shows, the reality was that Citigroup's alleged investment was a sham because it was never intended to be at risk. As Exhibit 302(c) \2\ shows, the terms of the partnership included the following provisions. Citigroup could dissolve the partnership at any time. Enron needed to lose its entire $750 million before any of Citigroup's so- called investment could be touched, which meant Citigroup would have plenty of time to dissolve the partnership, if necessary, before it had to produce any funds. And Sundance had to keep the $28.5 million liquid, segregated, and earmarked for Citigroup so that Citigroup could recapture that part of its so-called investment at will. --------------------------------------------------------------------------- \1\ Exhibit No. 302(b) appears in the Appendix on page 188. \2\ Exhibit No. 302(c) appears in the Appendix on page 189. --------------------------------------------------------------------------- In summary and in reality, neither Citigroup's $28.5 million nor its unfunded $160 million were ever intended to be at risk. The Sundance joint venture was a sham and all of its assets should have been included in Enron's balance sheet. Indeed, just 2 days before the transaction closed, three senior Citigroup officials strongly urged the investment bank not to do the Sundance deal, with one warning the following: ``The GAAP accounting is aggressive and a franchise risk to us if there is publicity.'' Let me repeat that. Just before this deal was approved, this was the warning. It came from Citigroup people. ``The GAAP accounting is aggressive and a franchise risk to us if there is publicity.'' But Citigroup did the deal, earning $1.8 million in fees and preferred dividends and presumably got some good will from Enron. Citigroup also obtained full payment of the $200 million loan that it had provided earlier in the Bacchus deal, since one of Enron's contributions to Sundance was the $200 million needed to buy the Fishtail assets from the Caymus Trust and pay off the Citigroup loan. On paper, Fishtail, Bacchus, and Sundance seemed to bring new investment into Enron's pulp and paper business venture. In reality, these complex financial deals enabled Enron to use a $200 million Citigroup loan and a sham asset sale to boost its year-end cash flow and earnings and then quietly return the funds via Sundance. Without Citigroup's participation in supplying the lion's share of the funds, Enron would not have been able to pull off these deceptive transactions. Finally, the Slapshot transaction, another highly disturbing example of a major U.S. financial institution helping Enron engage in a deceptive transaction. It is particularly disturbing because Chase, the financial institution involved here, itself designed the deceptive transaction. That was even more than aiding and abetting. Chase designed the Slapshot deal and sold it to Enron for $5 million, enabling Enron to claim an estimated $60 million in Canadian tax savings and $65 million in financial statement benefits. The Slapshot sleight of hand took place on June 22, 2001. It was designed as a tax avoidance scheme, and as we can see from the next exhibit,\3\ it was a spaghetti bowl of structured finance arrangements using loans, funding transfers, and transactions involving Chase and Enron affiliates in two countries, many of which were established specifically to facilitate the deal. --------------------------------------------------------------------------- \3\ Exhibit No. 337 appears in the Appendix on page 347. --------------------------------------------------------------------------- In essence, Slapshot took a valid $375 million loan issued by a consortium of banks to an Enron affiliate and combined it with a $1 billion sham loan issued by a Chase-controlled shell company called Flagstaff. The sham $1 billion loan created the appearance, but not the reality, of a loan by using a shell game involving two different transfers of $1 billion through a maze of bank accounts belonging to Chase and Enron affiliates. Chase provided the alleged loan by issuing a $1 billion momentary overdraft to its shell company, Flagstaff. But Chase was unwilling to allow Flagstaff to release the funds to an Enron shell company called Hansen until Chase was sure that the $1 billion was fully protected and going to be returned the same day, indeed, almost at the same moment. So Chase required Enron to deposit a separate $1 billion in an escrow account controlled by Chase before Chase would release its $1 billion to Enron. Enron obtained its own $1 billion momentary overdraft on an account that it held at Citibank and transferred those funds into an escrow account at Chase. And then through a series of near-instantaneous transactions among Chase and Enron entities, the $1 billion sham loan was briefly commingled with the real $375 million loan to create the appearance of a combined $1.4 billion loan to an Enron affiliate. The sham $1 billion was then separated back out through a series of additional transfers and moved within hours back to the Enron account at Citibank. In the meantime, the $1 billion in Enron escrow funds was released to Chase. Now, the $1 billion loan that was supposedly supplied by Chase was a sham. It was issued and paid back within minutes without any of the credit risk that is the point of a loan, even during the few minutes that it moved from Chase's left pocket to its right pocket. It had no economic rationale or business purpose other than to circulate through multiple bank accounts to create the appearance of the larger $1.4 billion loan. Chase got more than $5 million for doing it. Enron got tax deductions and better financial statements. Enron's tax counsel warned that this transaction clearly involves a degree of risk and cautioned that, ``in our opinion, it is very likely that Revenue Canada will become aware of the Slapshot transactions and upon becoming aware of them will challenge them.'' Chase also knew that the Slapshot transaction was dubious. It worked with Enron to minimize the possibility that Canadian tax authorities would discover it, and they even developed contingency plans in the event that Canada disallowed the sham loan. When analyzing how to structure an interest rate swap that was a part of the transaction, for instance, Enron and Chase jointly considered three alternatives, two of which were described as disadvantageous, in part because they would produce a potential road map, in their words, of the transaction for Revenue Canada. So instead of following those two roads, Enron and Chase jointly chose the third alternative, which was explicitly described as providing no road map. In addition, Enron and Chase included in the transaction documents what was called a recharacterization rider, in which they agreed if they were caught by Revenue Canada to reclassify retroactively loan payments made by Enron to Chase to look like loans from Enron to Chase. How is that for a move? If Canada disallowed the Slapshot scheme and exposed Enron to additional taxes, Enron would try to make it look as though Enron was lending money to one of the world's largest banks. Slapshot was designed and intended to be a deceptive transaction. Chase set it up to pretend that a $375 million loan was really a $1.4 billion loan by, just for a moment, inserting an extra $1 billion in the transaction. The combined so-called loan then provided the cover for Enron's Canadian affiliate to claim for tax purposes that it had an outstanding loan obligation of $1.4 billion and claim its entire $22 million quarterly loan repayment as tax deductible interest payments on the fake $1.4 billion loan, instead of deducting only that portion of the payments that was the true interest payment on the $375 million loan. Enron could not have completed Slapshot without a major bank like Chase which had the resources to use $1 billion for a few brief moments and quickly move that $1 billion through multiple bank accounts across international lines. Chase charged Enron $5 million for its so-called tax technology. Chase has also shopped that same tax technology to other companies. The four transactions at issue today, together with the sham transactions examined at earlier hearings, all have deception at their core. All misuse structured finance, which has a legitimate purpose when used for real economic objectives, such as lowering financing costs or spreading risk. But here, there was no such legitimate economic objective. The goal was deception, and none of the transactions could have been executed without the complicity and financial resources of a major financial institution. Now, the purpose of today's hearing is not just to expose another set of deceptive transactions, but also to take the next step and to determine, 1 year after the Enron scandal broke, what is being done to prevent future deception. Citigroup and Chase have each announced new programs designed to prevent their employees from participating in deals that produce deceptive accounting. We need to learn more about those programs and whether they will prevent the type of deals that we are going to examine today. But we also are going to find out what our financial regulators are doing, what concrete steps they have taken to prevent U.S. financial institutions from designing, executing, and profiting from illegitimate structured financial transactions intended to help U.S. companies engage in misleading accounting or tax strategies. We want to learn what concrete steps the bank regulators and the SEC are taking, not only to punish wrongdoing on a case-by-case basis, which is important, but also to create a deterrence program to be part of regular bank examinations to stop future wrongdoing. There is a regulatory gap now. The Securities and Exchange Commission does not generally regulate banks, and bank regulators don't regulate accounting practices or ensure accurate financial statements. Two steps need to be taken, which together could close this gap. First, the SEC should issue a policy which states clearly that the SEC will take enforcement action against financial institutions which aid or abet a client's dishonest accounting by selling deceptive structured finance or tax products or by knowingly or recklessly participating in deceptive structured transactions. Second, the bank regulators, including the Federal Reserve that oversees our financial holding companies, need to state that violation of that SEC policy that I just described would constitute an unsafe and unsound banking practice, thereby enabling bank examiners to take regulatory action during bank examinations. We also need the SEC and the bank regulators to conduct a comprehensive joint review of the structured finance products being sold by or participated in by our financial institutions so that we can root out the ones that corrupt financial statements. One year after Enron's collapse, we need our regulators to tell our banks and our security firms that the deceptions and the era of self-regulation are over. Enron was an eye opener about the extent and the nature of corporate misconduct going on in the United States today and the role being played by our financial institutions. The question now is whether we have learned the Enron lessons and whether, in addition to punishing wrongdoers on a case-by-case basis, we have taken on the tougher task of building a new deterrence program to prevent future Enrons. Let me call on Senator Collins, my Ranking Member for a few more weeks and someone who has been such a great, not only supporter of efforts to protect consumers and to protect our economy, but whose staff has been so extraordinarily helpful in the production of this report and these documents. I want to thank her. I want to congratulate her on her new assignment as the Chair of our full Committee, the Governmental Affairs Committee, starting in January. But again, it has been a real pleasure serving with her, both as her Ranking Member here and then having her as my Ranking Member in the last few months. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Senator Levin. I want to thank you for your kind comments and your extraordinary leadership in this very important investigation. Our staffs have worked very closely together during the past year in what I believe has been an unprecedented level of cooperation to unravel these very complex transactions. It would not have happened without your leadership. I particularly want to take the opportunity to salute Linda Gustitus, who has been the leader of your staff since, I think, 1979, and will be retiring at the end of this year. Linda and I worked together on the Subcommittee many, many years ago and I know that her leadership will be sorely missed, as well. Senator Levin. Thank you. Thank you for mentioning Linda, who indeed has been absolutely at the forefront of over two decades of investigations by this Subcommittee and by a predecessor Subcommittee that we were also both associated with. Thank you very much for mentioning her. It is totally appropriate and, indeed, well founded. Senator Collins. Today's hearing represents a continuation of the Subcommittee's extensive investigation into the collapse of the Enron Corporation. It is our third hearing looking specifically at the role played by some of America's leading financial institutions in transactions that enabled Enron to paint a false picture of its financial health and that ultimately contributed to the bankruptcy of the company. Our earlier hearings documented that certain financial institutions, among them Merrill Lynch, J.P. Morgan Chase, and Citigroup, knowingly participated in and indeed facilitated transactions that Enron officials used to make the company's financial position appear to be more robust than it actually was. These complex transactions allowed Enron to deceive its investors, its customers, and its employees. Today's hearing will provide additional evidence of the complicity of certain financial institutions in Enron's deceptions. As Senator Levin indicated, we will closely examine four multi-million-dollar structured finance deals that enabled Enron to produce misleading financial statements, and in one case claim a highly questionable $125 million tax break. Citigroup funded two of the four transactions and J.P. Morgan Chase funded the other two. The first three transactions, known as Fishtail, Bacchus, and Sundance, involved Enron's so-called sale of certain assets at inflated values to special purpose entities that had been established by Enron, Citigroup, or Chase. In each case, the entities purchasing the assets were funded with equity commitments by Citigroup or Chase that did not truly place funds at risk or were supported by secret oral guarantees by Enron that invalidated the special purpose entity's independent status. Each of these transactions fabricated to look like an arm's length transaction and sale of a financial asset was, in fact, an artifice designed to enable Enron to obtain a Citicorp or a Chase loan or to sell an asset to itself. The evidence strongly suggests that Citigroup and Chase were not innocent pawns in these transactions. Warning flags were abundant. As Senator Levin noted, an internal memorandum from a senior Citicorp official strongly objected to the transactions, warning that the ``accounting is aggressive and a franchise risk to us if there is publicity.'' Citigroup's involvement in helping to disguise what were essentially phony loans as phony asset sales enabled Enron to inflate its sales revenues and produce misleading financial statements. The final transaction, known as Slapshot, involved a $1.4 billion loan and related transactions that were designed to produce Canadian tax benefits for Enron. This complex web of transactions was designed by J.P. Morgan Chase and used Enron affiliates or special purpose entities in the United States, Canada, and the Netherlands. In simplest terms, Slapshot involved a legitimate $375 million loan issued by a consortium of banks and a phony $1 billion loan issued by a J.P. Morgan Chase controlled SPE. The $1 billion loan was issued and repaid on the same day through a complex series of structured finance transactions. The $375 million loan was to be repaid over 5 years. Chase provided the $1 billion for the phony loan by approving a $1 billion daylight overdraft on an Enron account at Chase. The overdraft presented no risk, however, to Chase because the bank required Enron to deposit a separate $1 billion in an escrow account for the duration of the so-called loan. Chase then circulated the $1 billion through more than a dozen bank accounts held by Enron and Chase affiliates and SPEs, returning the $1 billion overdraft to the original Chase account by the end of the day. The end result of these transactions was that Enron was able to treat its quarterly $22 million loan repayments, each of which were, in fact, a payment of principal and interest on the $375 million loan, as purely interest payments on the $1 billion loan. By characterizing each $22 million loan payment as an interest payment on the larger loan, Enron claimed that it was entitled to deduct the entire $22 million from its Canadian taxes, for a total tax benefit of $125 million. In return for designing this phony loan structure and arranging the series of funding transfers, Chase received a fee of $5.25 million from Enron, and again, outside experts cautioned Chase about this transaction. The transactions that we are examining today once again demonstrate the extraordinary lengths to which investment banks went to keep Enron, an important client, happy. The checks and balances that were supposed to ensure the integrity of financial transactions apparently were compromised by conflicts of interest and the lure of big fees. It undermines the integrity of our capital markets when some of the most prestigious financial institutions in our country are involved in designing, marketing, executing, and profiting from financial transactions intended to enable public companies to engage in deceptive accounting and tax strategies. In earlier testimony, the financial institutions have generally denied any responsibility, claiming that it is simply not their fault if their clients choose to account for these transactions improperly. But the troubling fact remains that Enron could not have gotten away with what it did for so long without the active participation of its financial institutions. Numerous documents examined by the Subcommittee clearly demonstrate that the financial institutions that partnered with Enron knew of the company's intentions. In fact, in some cases, the financial institutions helped to design the transactions specifically so that Enron could cook its books. For example, Chase's own documents highlight a particular advantage of the deal as, ``[not providing] a `road map' for Revenue Canada.'' That has been explained to our staff as a selling point so that the deal would not be easily identified by Canadian tax authorities and audited. Today, we will also hear from the watchdogs, representatives of the Securities and Exchange Commission, the Federal Reserve, and the Office of the Comptroller of the Currency. There are a number of questions about the role of the regulators. To what extent do these regulatory agencies examine the type of transactions engaged in by J.P. Morgan Chase and Citigroup that enabled Enron to misrepresent its financial condition? What is their view of the legitimacy of the transactions we are examining today? Do the regulators have sufficient authority and expertise to oversee these complicated transactions? Has the current regulatory structure kept pace with changes in the financial markets and innovations in structured finance? The answers to these questions are critical to strengthening our free enterprise system and to restoring public confidence in our capital markets. It is important that we remember that the Enron debacle is more than just a tale of one company's greed. As a result of Enron's downward spiral and ultimate bankruptcy, shareholders large and small, individual and institutional, lost an estimated $60 billion. Moreover, the collapse of Enron caused thousands of Americans to lose jobs, to lose their savings, and to lose confidence in corporate America and U.S. financial institutions. When the individual investor does not have access to critical information to make wise investment decisions, information that is known only to corporate management and their financial partners, the playing field is far from level. We must ensure that our financial institutions act with integrity, and I want to acknowledge that the institutions before us today have taken several steps since our last hearings to put new safeguards in place. But we must ensure that investors, large and small, have access to complete and accurate information to guide their investment decisions. I look forward to hearing the testimony of our witnesses today. Thank you, Mr. Chairman. Senator Levin. Thank you, Senator Collins. Senator Bennett. OPENING STATEMENT OF SENATOR BENNETT Senator Bennett. Thank you very much, Mr. Chairman. I have not been as involved in this issue as you and Senator Collins have, and so I will be very brief in what opening statement I have and I will look forward to listening to the witnesses. I do sit on the Banking Committee, which has the legislative responsibility of coming up with changes in regulation and was involved in both the writing and in the conference report of the Sarbanes-Oxley bill that came almost exclusively as a result of the entire Enron experience. I think this hearing will be very useful, along with the other one which you previously held, in helping us in the Banking Committee's responsibility to provide oversight to both the SEC and to the bank regulators. The Banking Committee is the place where, if legislative changes have to be made, we are going to have to make them. This Permanent Subcommittee on Investigations has made a significant contribution to the institutional knowledge already available to the Banking Committee and I congratulate you for focusing on this in a way that, quite frankly, we on the Banking Committee could not. I do have one area of concern that I simply will raise for the record. As the previous hearing has gone forward and conducted investigations in a way that is very clearly within the purview and charge of the Permanent Subcommittee on Investigations, some lawyers have attempted to take statements made in that hearing, turn them into evidence with some kind of legal alchemy, and then make them part of a lawsuit that, unfortunate timing, is going on right now. Fortunately, the judge ruled them out of order and refused to allow statements made at the hearing to become part of evidence in a trial. I would hope that will not be attempted with anything that is said here today. This is an investigative Subcommittee. We are probing for information. We have not come up with a final report, and even when we do, I don't think our report constitutes evidence that can be used in a court of law to determine a fact. I think what it says is, here are facts. Now you lawyers for one side or another determine your own basis for these facts rather than simply quoting us. I wouldn't accuse any Member of this Committee of being given over to hyperbole in opening statements, but I do think there have been some members of the Senate who occasionally do that, and to take that hyperbole and try to turn it into evidence in a court of law, I think is a little bit like what we are finding out went on here, that is, a transaction that was intended for one purpose gets twisted into another purpose. There are some members of the trial bar who seem to be anxious to try to do that. They say I was glad the judge slapped them down and said they could not do that from previous statements that were made in these hearings and I would hope that no one in the audience would try to do that from anything that is said here today. With that, Mr. Chairman, again, I congratulate you for your persistence and your diligence in digging into these matters and I will sit back and learn as much as I can from today's witnesses. Senator Levin. Thank you so much, Senator Bennett, and thank you for your contributions in so many ways in the banking field and many other fields, including your contribution to that Sarbanes-Oxley bill and to this Subcommittee. Let me now turn to our witnesses. Our first panel of witnesses is from Citigroup. I thank you all for making it here today despite the challenging weather. We welcome Charles Prince, the Chairman and Chief Executive Officer of Citigroup Global Corporate and Investment Bank. We welcome also David Bushnell, Managing Director and Head of Global Risk Management at Citigroup/Salomon Smith Barney; Richard Caplan, the Managing Director and Co-Head of the Credit Derivatives Group at Salomon Smith Barney North America; and William Fox, who is the Managing Director of the Global Power and Energy Group at Citibank. Pursuant to Subcommittee Rule 6, all witnesses who testify before this Subcommittee are required to be sworn in, and so I would ask you at this time to please stand and to raise your right hand. Do you swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Prince. I do. Mr. Bushnell. I do. Mr. Caplan. I do. Mr. Fox. I do. Senator Levin. Thank you very much. We will be using our traditional timing system today. At about 1 minute before the 10-minute period for each of your testimony is up, the light will change from green to yellow, which will give you the opportunity to conclude your remarks. Your written testimony will be printed in the record in its entirety. Again, we thank you for your appearance here today and for your cooperation with this investigation. Mr. Prince. TESTIMONY OF CHARLES O. PRINCE III,\1\ CHAIRMAN AND CHIEF EXECUTIVE OFFICER, CITIGROUP GLOBAL CORPORATE AND INVESTMENT BANK, NEW YORK, NEW YORK Mr. Prince. Thank you, Mr. Chairman, Senator Collins, and Senator Bennett. Good morning. My name is Chuck Prince. Since September of this year, I have been Chief Executive Officer of Citigroup's Global Corporate and Investment Bank. I appreciate the opportunity to appear before you to discuss these important issues and I commend you on your determination to understand how and why a Fortune 10 company like Enron could unravel so quickly and to such devastating effect. The collapse of that company has been a disaster for thousands of people--employees, investors, and others--and making sure that similar events do not happen again is a critically important objective that we share. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Prince appears in the Appendix on page 91. --------------------------------------------------------------------------- The last year has been a challenging one on Wall Street. Industry practices that were standard operating procedure for years have come under sharp scrutiny by Congress, regulators, and investors. Many of these practices have been changed and others are in the process of changing. For our part at Citigroup, we want to be at the forefront of change, setting the standard for integrity and professionalism in our industry. This has become a guiding mission for the senior management of our entire organization. Part of our process has included the recognition that we have engaged in certain activities that do not reflect the way we believe business ought to be done going forward. Let me be clear, I believe that the Citigroup professionals involved with these transactions acted in good faith and understood these transactions to comply with the existing law and prevailing standards of the time. But let me be equally clear, good faith and legal compliance are no longer the issue as far as I am concerned. Even assuming that these transactions were entered into in good faith and were entirely lawful, they do not reflect our standards and they would not happen now at Citigroup. Recognizing the problems our industry faces, we have worked diligently to develop new practices and policies reflecting the lessons we have learned. When Sandy Weill asked me to take the helm at the Global Corporate and Investment Bank just 3 months ago, he gave me a mandate to accelerate the process of reform and change that was already underway. I have detailed a number of these reforms in my written statement, but in the interest of time, I will turn to the issue of structured transactions that is the focus of today's hearing and was the focus of the hearing you held, Mr. Chairman, on July 23 of this year. As I hope you will agree when I discuss the reform initiative we announced just 2 weeks after your hearing and a month before I became responsible for this business, at Citigroup, we heard you and we took appropriate action. First, though, let me say a few words about the specific transactions under review. While I believe our people acted in good faith, I think it is fair to say that we never anticipated that a financial intermediary like Citigroup would be criticized for the accuracy of the accounting treatment that a Fortune 10 company gave to its transactions with the express approval of a then-highly respected Big Five accounting firm. At the time we entered into these transactions, we never imagined that Arthur Andersen wouldn't even exist a year later or that a failure of ethics would have destroyed Enron, a company ranked in the top 20 on the list of most admired companies in the year 2001. But we have learned a hard and valuable lesson, that reliance on public accountants or a company's widely held excellent reputation has significant limits, particularly in the face of corporate malfeasance. To say that our professionals acted in good faith and in ways they believed to be appropriate is not to say that we consider a ``business as usual'' approach to be an acceptable prescription going forward. On the contrary, we concluded in the days and weeks following your July 23 hearing, Mr. Chairman, that we needed to act, even in the absence of industry action or regulatory action, and that the best way to protect both investors and our own reputation with regard to the kinds of transactions that appropriately concern this Committee was to insist on transparency. Accordingly, on August 7, Citigroup announced a new transparency policy, saying, in essence, that from that day forward, Citigroup would execute material financing transactions for companies that were not going to be recorded as debt on their balance sheet if, but only if, that company agreed to clearly disclose the net effect of the transaction on its financial condition. We announced this net effect rule for two reasons: First, to encourage companies to account for financing in a transparent manner so that investors can adequately assess the net effect of the transaction on the financial condition of the company; and second, because we simply did not wish to be a party to transactions that fail to meet a high standard of transparency. Under our net effect rule, the transactions at issue in today's hearing would not and could not have happened at Citigroup unless Enron had made clear detailed disclosure to investors. We simply would have refused, and today would refuse, to do those transactions without a commitment to make such disclosures. Our policy is based on a few key principles. First, it applies to any material structured or complex financing transaction of the sort this Subcommittee has been concerned about. In determining whether the policy applies to a given transaction, the economic reality, not the form of the transaction, is critical. Second, the required disclosures under our new policy include, among other things, management's analysis of the net effect of the transaction on the financial condition of their company, the nature and amount of the obligations, and a description of any events that may cause an obligation to arise, increase, or become accelerated. Third, Citigroup will obtain the client's written commitment that disclosure of such transactions in the client's relevant public filings will fairly present the transaction's financial impact. If we do not receive this commitment, we will not do the deal. Fourth, Citigroup will do these transactions only for clients that agree to provide the complete set of transaction documents to their chief financial officer, their chief legal officer, and their independent auditors. If there are any oral assurances from the client in connection with any transaction that Citigroup believes may give rise to accounting or disclosure issues, these will also have to be written down and those documents included with such transaction documents. Fifth, key decisions, such as whether the policy requires additional disclosures in a particular transaction, are made by senior management from our accounting, legal, and risk management control functions acting together. If the senior managers of our control functions do not approve a proposed transaction, then, very simply, that transaction will not go forward. Any concerns about accounting or similar matters must be fully resolved and must be written down, must be documented, if a transaction is to go forward. I am personally committed to making sure that our new procedures are fully observed. In order to do that, we are enhancing our decisionmaking process so that every step of decisions are documented, and importantly, our internal audit group will review and verify compliance with our procedures. Promptly after we announced this new transparency policy, we erected what amounted to a roadblock for each structured finance and related transaction to see whether it was the kind of transaction that would not be reflected as debt on a balance sheet and should, therefore, be specially disclosed to the company's investors. None of these transactions was permitted to go forward unless it was submitted to a rigorous examination process by a working group from our control functions. As we move forward, we are continually adjusting and fine tuning this process to allow for more efficient, but equally rigorous, review. We recognize, of course, that our execution will not be perfect. We are feeling our way, seeing what works, and discovering the challenges of applying a unilateral policy like this to an enormous range of complex transactions. Leaders, by definition, move in uncharted territory, and we will make some mistakes. But I am quite encouraged by what I have seen so far, by the seriousness and intensity with which Citigroup professionals are grappling with this new policy, from the transactional people on the front lines to the most senior managers of our company. It has already made a measurable difference in the kinds of deals we are doing or declining to do and in the nature of the disclosure that clients are making. Mr. Chairman, the world has changed a lot in the past year and is continuing to change. The collapse of Enron and the turmoil that followed on Wall Street has done tremendous damage to a great many people and businesses. We recognize that we must take real steps to change our ways of doing business and to get real results. We have done this and we are continuing to do more. This is not a time for half measures or foot dragging or public relations. We at Citigroup understand our role as a leader, our responsibility in that regard, and we embrace the mandate for change and subscribe to the goal of effective, far- reaching reform. We appreciate the seriousness and the vigor with which you and the Subcommittee approach these issues, and we look forward to working with you and your colleagues on these and other reforms. I thank you, sir, and I look forward to answering your questions. Senator Levin. Thank you so much, Mr. Prince. Mr. Bushnell. TESTIMONY OF DAVID C. BUSHNELL,\1\ MANAGING DIRECTOR, GLOBAL RISK MANAGEMENT, CITIGROUP/SALOMON SMITH BARNEY, NEW YORK, NEW YORK Mr. Bushnell. Thank you, Mr. Chairman and Members of the Subcommittee, for the opportunity to speak with you today. My name is David Bushnell. I am a Managing Director at Citicorp's Global and Investment Bank, and I am the head of its Risk Management Division. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Bushnell appears in the Appendix on page 101. --------------------------------------------------------------------------- The Global Risk Management Division functions as an independent control over our business units. It is the responsibility of my division to ensure that risks, including market risk, credit risk, and risk to the institution's reputation, are identified, measured, and evaluated. No extension of credit is permitted without risk management approval in accordance with our established policies and procedures. Positions that our traders take are subject to limits established by risk management. The firm's Risk Management Committee, including its Capital Markets Approval Committee, report to me. I am also charged with communicating and interpreting the risk views of senior-most management to our business units. I understand that the Subcommittee is interested in discussing my role in the Sundance transaction. I look forward to answering the Subcommittee's questions about that transaction. But before I do, I would like to take this opportunity to explain some of the very significant changes that Citigroup is making in the way we handle such transactions today. As you know, on August 7, Citigroup announced a new policy regarding transactions that raise significant accounting or disclosure issues. As its chief risk manager, I have been centrally involved in developing and implementing this policy. You have just heard Mr. Prince's testimony that describes the key elements of the policy and our implementation program. The message that I want to convey to you is that this new policy is having a real impact on the ground at Citigroup where transactions are done. Every material structured or complex financing of the sort this Subcommittee has been concerned with is being subject to a rigorous review process. The Capital Markets Approval Committee is thoroughly evaluating the transparency of transactions and is working with our business people to ensure that in any transaction we do, the client discloses fairly and appropriately the net effect of that transaction on the company's financial condition. If the client will not commit to these kinds of disclosures, the answer is simple: Citigroup will not execute the transaction. In the months since August 7, we have reviewed dozens of transactions and we are learning a great deal. This process is helping us to develop a uniform approach to assessing, routing, and where appropriate, approving and documenting transactions consistent with the principles of our new policy, and the policy has already had a real impact on the transactions we are declining or we are agreeing to do. One of the most significant objectives of the past few months has been to embed in our culture an understanding of the importance of this policy. I can tell you that our people are taking it seriously, from the front lines of our business units to our senior-most management. We are making this policy a living, breathing part of the way we do business. Thank you, and I look forward to answering your questions. Senator Levin. Thank you, Mr. Bushnell. Mr. Caplan. TESTIMONY OF RICHARD CAPLAN,\1\ MANAGING DIRECTOR AND CO-HEAD, CREDIT DERIVATIVES GROUP, SALOMON SMITH BARNEY NORTH AMERICAN CREDIT/CITIGROUP, NEW YORK, NEW YORK Mr. Caplan. Thank you, Mr. Chairman and Members of the Subcommittee. My name is Rick Caplan. I am a Managing Director of Citigroup's Global Corporate and Investment Bank and Co-Head of the North American Credit Derivatives Group. The Credit Derivatives Group is one of several business units at Citigroup that structures sophisticated financing for clients. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Caplan appears in the Appendix on page 103. --------------------------------------------------------------------------- I have worked in the derivatives business at Citigroup since 1997. I appreciate the opportunity to answer questions about Project Bacchus and Project Sundance. While I want to make clear that I understood these transactions to be appropriate under the prevailing laws and standards, I also want to reiterate the point that Mr. Prince made in his opening remarks. Under Citigroup's new structured finance policies, we will not do these transactions today unless the client agrees to provide clear, detailed disclosure to investors. Thank you, Mr. Chairman and Members of the Subcommittee. I look forward to answering your questions. Senator Levin. Thank you, Mr. Caplan. Mr. Fox. TESTIMONY OF WILLIAM T. FOX III,\2\ MANAGING DIRECTOR, GLOBAL POWER AND ENERGY GROUP, CITIBANK/CITI-GROUP, NEW YORK, NEW YORK Mr. Fox. Thank you, Mr. Chairman and Members of the Subcommittee. My name is William Fox. I have worked for Citibank since 1967. I am currently a Managing Director in the Global Relationship Bank and head of its Energy and Mining Department. I have overall responsibility for Citibank's relationship with clients in the energy and mining industries. --------------------------------------------------------------------------- \2\ The prepared statement of Mr. Fox appears in the Appendix on page 104. --------------------------------------------------------------------------- I have been invited here today to discuss two transactions that Citigroup executed for Enron, Project Bacchus and Project Sundance. While I am generally familiar with Project Bacchus, my familiarity with Project Sundance is more limited. I understand the Subcommittee has several questions about these transactions and Citibank's role in them. I look forward to helping the Subcommittee in any way that I can to answer questions about these transactions. While we believe these transactions met applicable legal standards, they are not transactions that Citigroup would undertake today without clear and detailed disclosure from our clients about the net effect of those transactions on a company's financial statements. Thank you, Mr. Chairman and Members of the Subcommittee. I look forward to answering your questions. Senator Levin. Thank you so much, Mr. Fox. Let me summarize the joint venture which we are going to start with called Fishtail and then ask my questions. At the end of the year 2000, Enron wanted to show a sale of the interest that it held in a joint venture called Fishtail. They wanted to show that sale in order to generate cash flow and earnings for its year-end financial statement, and Enron contrived a sale of its interest to an entity called the Caymus Trust for $200 million. The funding for Caymus was a $194 million loan from Citibank, which Enron in turn gave Citibank a guarantee on. The other $6 million was listed as being an equity investment by Fleet Boston which Citibank had guaranteed. Now, that $6 million had to be true equity for this to be a real sale by Enron, and Citibank understood this. If the $6 million was a loan instead of true equity at risk, then this could not be shown as a sale on Enron's books and the whole purpose of the transaction would have been defeated. But Citibank, on the other hand, wanted to reduce or eliminate its risk on this so-called equity investment, and so Citibank went to get an assurance from Enron's CFO, Andy Fastow, to, in the words of a memo, Exhibit 322 in these exhibits that are in front of you, this is Exhibit 322(c),\1\ Citi was looking to obtain the right comfort from Andy Fastow. --------------------------------------------------------------------------- \1\ Exhibit No. 322(c) appears in the Appendix on page 229. --------------------------------------------------------------------------- Mr. Fox, let me ask you these questions. You are the one who met with Mr. Fastow to obtain this comfort for your bank. At our staff interview, you indicated that Mr. Fastow said that Enron would take whatever steps were necessary to make certain that Citibank's equity interest in Bacchus would be bought out. This was an important transaction for Enron, according to that same Exhibit 322(c). On the second page, this transaction was said to be ``mission critical'' by them and ``a must'' for Enron, and the words that I have quoted were on page one of that Exhibit 322(c) when it was said that Enron has offered to have the CFO discuss this ``at whatever level of our organization we think necessary to obtain the right comfort.'' That is comfort now for Citibank. First of all, looking at that Exhibit 322--I am going to change the 322 now to Exhibit 322(h),\2\ if you would take a look at that. Exhibit 322(h) is a memo or e-mail from Lydia Junek to you, Mr. Fox, and it says that, ``the equity component,'' if you will look at page two at the top, that ``the equity component has been approved on the basis of verbal support verified by Enron CFO Andy Fastow.'' So they were promising you verbal support. --------------------------------------------------------------------------- \2\ Exhibit No. 322(h) appears in the Appendix on page 239. --------------------------------------------------------------------------- First of all, who is Lydia Junek, the woman who sent you the e-mail? Mr. Fox. Lydia Junek is a Managing Director in our Houston office and she reports to me and did at that time, as well. Senator Levin. So is it true, Mr. Fox, that Citi would not have provided the equity for this transaction unless it had this verbal support from Enron through Mr. Fastow? Mr. Fox. Senator, this transaction was an interim bridge financing that we were engaged in. Our firm typically does not engage in bridge financings unless we are involved in the take- out or providing the permanent financing. In this case, we were not. So for this reason, I went and visited with Mr. Fastow because he had control of the take-out of this transaction. He was working with another institution. So we wanted comfort from him that they were going to take all steps necessary in order to ensure that the take-out financing was accomplished and our entire transaction would be repaid within its terms. Senator Levin. So he gave you this assurance that your so- called investment would be repaid within that 6-month period? Mr. Fox. He gave me the assurance that he would take all steps necessary to make certain that the take-out financing was accomplished and, therefore, the entire Bacchus transaction would be repaid. Senator Levin. Now, would you have reassessed your participation in the deal had you not obtained that support? Mr. Fox. I believe we would have. That assurance was important to us. As I said, we were not involved in the take- out of the financing of Bacchus, and typically our firm would not be involved in a bridge financing that was dependent upon a take-out unless we were involved in the take-out, and we were not in this case. Senator Levin. Now, if you take a look at the top line of Exhibit 318,\1\ page three, it says the equity component that we provide--this was supposed to be equity, not a loan, supposed to be equity--will be based on verbal support committed by Andrew Fastow to Bill Fox. It is a commitment now. It says that the verbal support--and by the way, that verbal support was referred to a number of times in the memo--but is it not a fact, Mr. Fox, that the verbal support was an oral guarantee from Mr. Fastow and Enron that your equity interest would be returned to Citi one way or another? --------------------------------------------------------------------------- \1\ Exhibit No. 318 appears in the Appendix on page 219. --------------------------------------------------------------------------- Mr. Fox. Senator, no, I do not believe so. We did not view it as an oral guarantee. It was verbal support and assurance to us that he and Enron would take all steps necessary to ensure the take-out financing, the permanent financing was accomplished so that our entire transaction would, in fact, be repaid within its terms. Senator Levin. You did not consider the support, the oral assurance, the commitment, to be a guarantee? Mr. Fox. The oral assurance, we did not view that as a guarantee. We viewed ourselves as being at risk for that $6 million component of the transaction. Senator Levin. The bottom line is, you did not consider that to be an oral guarantee? Mr. Fox. We did not consider that to be an oral guarantee. Senator Levin. Now take a look at Exhibit 366.\2\ This is a Citibank credit approval document relating to Enron. It is dated December 2000, the month of the Bacchus transaction. At the top of page one, it lists Lydia Junek as the ``responsible officer.'' On the second-to-the-last page, she has signed the document. Citi's loan and so-called equity interest in the Bacchus transaction is referred to, if you will look at pages six and seven. --------------------------------------------------------------------------- \2\ Exhibit No. 366 appears in the Appendix on page 655. --------------------------------------------------------------------------- Now, the numbers are a little different, because at the time the document was written, it was expected that Bacchus would require a $242 million loan and $7.5 million in equity, so that is the numbers that are in there, but these amounts are the amounts that we are referring to here. They were reduced to the $194 million loan and $6 million in equity, but this is the same transaction, although the numbers were slightly reduced. Now, on page seven of this document, under the word ``support'' in the middle of that page, it says, ``verbal guarantees'' in capital letters. You said there were no verbal guarantees. You didn't consider them verbal guarantees. The lady who signed this document for the bank under your supervision, in fact, said in this document these were ``verbal guarantees'' in capital letters. Now, if they weren't guarantees, why did she say they were verbal guarantees? Mr. Fox. Senator, I would not--as I said, I was the one who had the conversation with Mr. Fastow. I was the one that understood exactly what he said. He did not give me a verbal guarantee. I did not seek a verbal guarantee. Senator Levin. Did you ever see this document that said there were verbal guarantees? Mr. Fox. I don't recall that I saw it. I may have. I probably did. Senator Levin. And Ms. Junek works under your supervision? Mr. Fox. Yes, she does, Senator. Senator Levin. But you are trying, then, to make the distinction--you are trying to make a distinction that what you got is a commitment, an assurance, that all steps necessary would be taken to repay that money. How is that different from a guarantee? All steps necessary means all steps necessary. Mr. Fox. Senator, as I said before, what I obtained from Mr. Fastow was his verbal assurance that they were going to take all steps necessary to make certain the take-out financing was done on a timely basis such that our entire transaction would be repaid. Senator Levin. How is that different from a verbal guarantee? ``All steps necessary'' sounds to me like a guarantee, and Ms. Junek was very straightforward under your supervision in saying it. Mr. Fox. Senator, this---- Senator Levin. How is ``all steps necessary'' different from a guarantee? Mr. Fox. This was not legally enforceable. It was a businessman's understanding with the company. They had control of the take-out, they and the other financial institution they were involved in. We had no knowledge, not detailed knowledge of what that take-out financing was going to be. So I was relying on his verbal assurances that they were going to take the steps and they had the wherewithal to take those steps to make certain that the take-out financing was accomplished. Senator Levin. You don't specifically remember seeing those words, ``verbal guarantees,'' in that document? Mr. Fox. I do not, Senator. Senator Levin. You knew that Enron was going to book this transaction as a sale, is that not correct? Mr. Fox. That is correct. Senator Levin. And you also knew that if Citibank did not truly have a 3 percent equity at risk, that it would be improper for Enron to book the transaction as a sale? Mr. Fox. We understood that we had to be at risk for the 3 percent of the transaction. Senator Levin. Well, it seems clear to me, Mr. Fox, that Citibank was aware that 3 percent had to be at risk. You just said so. You had to be assured that it would not be guaranteed in order for this to be booked as a sale. But to protect Citibank from loss, you went out and got a verbal assurance, a commitment, a statement that all steps necessary would be taken by Enron to pay you back. It was characterized properly by your assistant as a verbal guarantee. You are not a lawyer, are you, in terms of whether it is legally enforceable, or are you a lawyer? Mr. Fox. I am not a lawyer. Senator Levin. Did you receive an opinion that this was not legally enforceable? Mr. Fox. We did not receive an opinion with respect to this aspect of the transaction. As I said earlier, my view was I was there. What I got was assurances from Mr. Fastow that the take- out financing would be executed, and we would be paid out of the entire transaction within its terms. Senator Levin. It was clear that in doing this, you were trying to protect yourself from loss, isn't that correct? Mr. Fox. No, we understood we were at risk, but since we were not involved in the take-out and this was a short-term bridge financing, we wanted to make certain that that bridge financing was going to be executed and we would be out of this transaction within the terms. Senator Levin. Isn't that the same way of saying that you were trying to protect yourself from loss? Mr. Fox. We clearly understood we were at risk. Senator Levin. But weren't you trying to protect yourself from any loss from the transaction? Mr. Fox. We wanted to make certain that we were out of the transaction on a timely basis, that is correct. Senator Levin. And you were aware of the fact, I take it, that if this assurance, commitment was a guarantee, that that would queer the deal, is that correct? Mr. Fox. If we had obtained a guarantee, we understood that they could not achieve their accounting objective. Senator Levin. And that would queer the deal? The transaction would not have occurred, is that correct? Mr. Fox. I don't know what Enron would have done at the time, but we certainly knew that for them to achieve their objective, accounting objective, we had to be at risk on the $6 million. Senator Levin. Their financial statement, in showing this totally as a sale, with a sale of equity, not showing any guarantee, not showing any assurance to anybody, but just simply showing it as a sale, was clearly deceptive. You are not going to reach a judgment on the Enron books, I assume, or are you? Mr. Fox. No, Senator, I am not. Senator Levin. Others will and others have. It was clearly deceptive. By not showing on its books that oral guarantee that it made, in the words of Ms. Junek, it deceived the people who were reviewing its books, and you can split hairs and say that assurance, using all efforts, taking all the necessary steps, commitments, doesn't constitute a guarantee, but it is, one, hair splitting, and two, inconsistent with your own document which says, in fact, it was an oral guarantee. My final question to you is, under your current standards that Citibank has adopted, would this transaction occur? Mr. Fox. Senator, no, it would not occur under our current standards without complete and full disclosure of the net effect of the transaction on Enron's financial statements. Senator Levin. Well, now, would it occur knowing what you know? Mr. Fox. We would have not done the transaction unless they fully disclosed all aspects of the transaction and the net effect of it on their financial statements. Senator Levin. And had they done that in this case, based on what you know, would this transaction have taken place? Mr. Fox. Senator, I don't know what they would have done at the time, but---- Senator Levin. What would you do, knowing what you know? Mr. Fox. We would have gone to Enron and asked them, under our new standards, to have the complete, total disclosure of the net effect of the transaction. We would have had to make certain that their chief financial officer, general counsel were aware of the transaction, all aspects of it, not only the written documents, but also any oral understandings. Senator Levin. What is the net effect of this transaction on Enron? Was it in net effect a loan or net effect a sale? Mr. Fox. They booked---- Senator Levin. No, I know what they booked, but you are going to look at the net effect, right? Mr. Fox. Right. Senator Levin. Under your new standards. Mr. Fox. Yes. We would look at the net effect. Senator Levin. In your judgment, what was the net effect of this transaction on Enron, a sale or a loan? Mr. Fox. I think we would have required them to disclose the conversation with me. We would have required them to disclose all aspects of the transaction and the net impact on its financial statements. At that stage, I would assume they and their accountants would review the transaction with their legal people and determine how it would be booked. I am not in a position to determine how they would have booked it. I can only suggest and require them to have full and complete net effect exposure--disclosure. Senator Levin. I am not sure, Mr. Prince, what your new standards really mean if all you are going to say is if Enron discloses this on their books, it is OK with you, when it is so obvious, it seems to me, to anybody that when you give a guarantee, as they gave to you, that they would take all necessary steps to make sure that was repaid and that they gave assurances to that. If you can possibly then say, well, we would proceed the same way we did before providing they said that, I am not sure what your new standards really mean. Mr. Prince. Well, Senator, you have highlighted two key differences between what happened then and what would happen now. The first is that these oral assurances would be written down and would be included in the transaction documents that are forwarded to the chief financial officer, the chief legal officer, and the outside auditors, so everyone would have the same base of information. And second, the net effect rule would require that the net effect of the transaction, as I mentioned in my opening statement, on the assets, the liabilities, the balance sheet, the income statement, the net effect of all of the complicated moving around of assets would have to be disclosed. I think those are two very important differences between what happened then and what happened now. Senator Levin. And if they decided the net effect was a sale, that is OK with you? Mr. Prince. Well, Senator, it is not just a word, and it is not just a sentence. They wouldn't disclose the net effect was a sale. Senator Levin. Pardon. Mr. Prince. They would not, sir. They would not simply disclose a conclusory sentence that this was a sale or not a sale. As part of a sale, if it were a sale under the complicated accounting rules, they would have to disclose the net effect of that sale on their balance sheet, on their income statement. Senator Levin. And my question to you is, based on your study of this record and your judgment, would you conclude and agree that the net effect of this transaction was a sale? Mr. Prince. Senator---- Senator Levin. If they concluded that, would you accept their conclusion? Mr. Prince. Senator, again, I am trying to answer your question. It is more than the word ``sale.'' The net effect of the transaction, what happens to the balance sheet, what happens to the income statement is what our rule calls for, not the word ``sale'' or not sale. Senator Levin. The net effect on the Enron financial statement was $112 million in earnings from that transaction, but you cannot tell us today, based on all of these documents, that if they concluded again that that was a sale, that you would not proceed with that transaction, based on what you know? Mr. Prince. Senator, I---- Senator Levin. You know all the underlying facts. You can say it is not just the conclusion. I agree with you. You are going to look at the underlying facts and conclude whether or not it is a fair judgment that this is a sale. Otherwise, you said, it seems to me that you are not going to proceed. My question to you is, based on all these underlying facts which have been laid out in front of you, would you proceed if Enron again in this kind of a situation said, or Enron said in this kind of a situation that this was a sale? Would you proceed? Mr. Prince. Senator, if I understand your question correctly, if you are asking me, would I make the judgment that this was a sale or not a sale based on these various facts, I can't make that decision sitting here today. I would want to consult with my control people. I would want to have a much more rigorous review than the detail we have had here this morning. Senator Levin. Mr. Fox, you told the Subcommittee staff that Citi had a business policy that it would not engage in structural transactions that had a material impact on reported net income. That was the business policy that you had, and that Citi would look further at the project and assure itself that the project would not impact reported net income. That was your policy in place at the time. Yet, throughout the Bacchus transaction, you were notified that there was a possibility that Enron would use the transaction to report net income in its year 2000 financial statement. Exhibit 322(a) \1\ is an e-mail to you and it states the following: ``Enron's motivation in the deal now appears to be writing up the asset in question from a basis of about $100 million to as high as $250 million, thereby creating earnings.'' --------------------------------------------------------------------------- \1\ Exhibit No. 322(a) appears in the Appendix on page 226. --------------------------------------------------------------------------- Exhibit 322(c) \2\ is a November 28 e-mail which states, ``According to Enron, it is possible that there will be funds flow and/or earnings impacts. Although not certain at this time, we should assume that there will be funds flow from operations/earnings implications.'' That is what you said you were going to assume. --------------------------------------------------------------------------- \2\ Exhibit No. 322(c) appears in the Appendix on page 229. --------------------------------------------------------------------------- Finally, on December 6, there is an e-mail, Exhibit 322(d), \3\ which states, ``It is probable that the monetization will add to funds flow from operations as a portion of the assets will be from merchant pool. It is possible but not certain that there will be earnings impact.'' That was the last communication on the matter. --------------------------------------------------------------------------- \3\ Exhibit No. 322(d) appears in the Appendix on page 232. --------------------------------------------------------------------------- Now, did the Citibank policy then require further investigation at that time, since there was the possibility of an earnings impact which your policy would not permit? Mr. Fox. Senator, the series of e-mails you referred to, starting with the first one, certainly highlighted the potential of an earnings impact. We went back to the company. We went back to the treasurer of the company, who confirmed to us that there would not be significant material earnings impact. I was shocked when I learned from your staff, which was the first time I knew about it, that the impact of this transaction created $112 million of earnings. Quite frankly, Senator, in this particular case, we were lied to. We relied on Enron, who was the only one that could determine the impact of a transaction as to what the earnings impact would be. Senator Levin. So that you specifically contacted Enron after your decision that there could be an earnings impact to see whether there would be and they told you there would not be? Mr. Fox. I did not specifically contact them. Senator Levin. Who did? Mr. Fox. Jim Reilly, who is a Managing Director of our firm. If you go further into that last e-mail you made reference to, he reports that Enron has suggested, however, that because of their ongoing involvement in the business, it is unlikely there will be any material earnings benefit. Senator Levin. And you accepted that without further investigation? Mr. Fox. We relied on Enron's word. They were a highly respected company. They were a company we had a good relationship with at the time and that is something we would have relied on, yes, Senator. Senator Levin. And their word was ``unlikely''? Mr. Fox. Their word, it was unlikely that there will be any material--I don't know what their word was. That was Mr. Reilly's word. Senator Levin. But that was not enough, the fact that it was unlikely, still possible, investigation as your policy it seemed to me required you to do to assure yourself that there would not be an earnings impact. Mr. Fox. I believe that this would have sufficiently satisfied ourselves at the time. Senator Levin. You were not aware yourself of the conclusion? Mr. Fox. I was not aware. I did not have the conversations directly with the company, no, Senator. Senator Levin. You had earlier, in Exhibit 322(g),\1\ in a memo, you were aware of the fact that this highly reliable company, one of the largest in the country, significantly dresses up its balance sheets at year end. You were very much aware of Enron being someone who liked to and was willing to and typically did dress up their balance sheets, because you wrote in that memo that is at Exhibit 322(g) that, ``based on 1999 numbers, it would appear that Enron significantly dresses up its balance sheet for the year end. Suspect we can expect the same this year.'' --------------------------------------------------------------------------- \1\ Exhibit No. 322(g) appears in the Appendix on page 237. --------------------------------------------------------------------------- So you were expecting a dressing up, disguise, costume by Enron at the end of the year 2000. You had received strong suggestions from other Citi relationship managers that it was possible that Citi would claim earnings from the Bacchus transaction. You were told only apparently--you are supposed to be in a position here of some decisionmaking import--you were told that it was--you just took Enron's word that it was unlikely that there would be an earnings impact. Of course, if there was an earnings impact, that violated your policy. But knowing that this company put on a show at the end of its year, you nonetheless, or your bank nonetheless simply accepted their statement that it was likely that there would not be an earnings impact. How can you explain that? Mr. Fox. Let me comment and address that, Senator. My reference to dressing up the balance sheet is a slang reference that a number of companies will take certain steps at various points in their financial cycle to address balance sheet targets. They can stretch out payables to generate cash. They can monetize or securitize receivables to generate cash and pay down debt. They can borrow under their bank facilities and pay down short-term commercial paper. Many steps that large financial--I mean, large Fortune 500 companies take to impact their balance sheet. The context here was that I was looking at their September 1999 financial statements, reviewed them, and if I recall correctly, the debt-to-capital ratio appeared higher than it would at year end and that seemed to indicate to me that they would take certain steps as it impacts their balance sheet. That was a balance sheet comment and statement. It was not related to the income. Remember, at the time, Enron was an important relationship. Enron was a highly respected company. We had no reason to suspect or believe that we could not trust and accept their word. Senator Levin. Do you recall telling the Subcommittee staff that this unlikely earnings impact conclusion was an insufficient resolution as far as you were concerned of Citi's policy? Do you recall telling the staff that? Mr. Fox. No, I don't, Senator. Senator Levin. All right. Let me ask you, Mr. Prince, under your current policy, would this be a sufficient resolution? Mr. Prince. Indeed not, Senator. Senator Levin. This is my final question and then we will turn it over to Senator Collins, for this round, at least. Mr. Prince, let me first say that we all are hopeful that Citigroup's apparent willingness to change its practice will lead to the kind of results that you hope for and expressed in your opening statement, and I just want to ask you some questions about your new policy. Your new net effect rule is described as follows: Citigroup would execute material financing transactions for companies that were not going to be recorded as debt on their balance sheet if and only if, as you stated, the company agreed to disclose the net effect of the transaction on its financial condition. The first problem that I have with this policy, or question, is that it states that Citigroup will continue to provide financing in cases where it knows the company isn't going to record the debt on its balance sheet. Doesn't that mean that Citigroup still thinks it is OK to sell loans that aren't honestly reported as loans? Mr. Prince. No, Senator, it does not mean that. There are many things that are appropriately not recorded as debt on a balance sheet. The key for us is that even if they are appropriately not recorded as debt on a balance sheet, the effect of the transaction must be disclosed. It doesn't matter anymore whether you do just this much or just that much and you satisfy this little rule or that little rule and suddenly it shifts from one shoebox to another shoebox, or one pigeon hole to another pigeon hole. You are not done at that point. Even if you satisfy a test and it goes to the next category on the balance sheet, the effect of the transaction, separate from the accounting conclusion on the classification, has to be disclosed. That is the difference. Senator Levin. Are you going to make a judgment as to the fairness of the conclusion relative to net effect, or are you just going to accept the conclusion of the other company, of your client? Mr. Prince. Senator, I think one of the things that we have learned is that we have to make our own judgments in that regard. Senator Levin. Because Enron could argue, for instance, in those prepays that we made reference to and you are aware of from an earlier hearing, they did disclose the net effect of the transactions because it included the energy trades in its year 2000 financial statements. It recorded $4 billion worth of cash flow from operations, but no debt. Since Enron included the energy trades in its financial statements as cash flow from operations, would that meet your disclosure requirement, or would you look behind that and make sure that it is a fair and accurate disclosure? Mr. Prince. Senator, I think it is clearly the second. We would require that the effect of the transaction be disclosed. So we would require them to disclose it in a way where anyone could understand. One of the problems that we all face is that these matters are way too complex and getting to a simple decision shouldn't lead to opaqueness, shouldn't lead to, well, now that we have got the answer from an accounting standpoint, the effect of the transaction that goes one way or the other. Despite the accounting conclusion, the effect of the transaction has to be disclosed. Senator Levin. If I understand what you said a moment ago, not just disclosed, but that you would reach an independent judgment that the disclosure was a fair statement of the facts. Mr. Prince. Yes, sir. We would have to be comfortable ourselves with that disclosure. Senator Levin. And one last point. In Sundance, three senior Citigroup officials recognized the accounting problems with Sundance and said, don't do it. Citigroup did it anyway. What is the solution there? If there is no agreement among your top officials, will there be a requirement that whoever approves that at a higher level is going to have to put a stamp of approval on it? Mr. Prince. Senator, as I said in my opening statement, one of the key differences we have now is that every part of the process has to be documented. We have to be able to pull out a paper to put in this notebook which will say who finally and formally signed off and why they signed off once an issue has been raised. Senator Levin. Senator Collins. Senator Collins. Thank you, Mr. Chairman. Mr. Prince, I do recognize the steps that you have taken since our last hearings to put additional safeguards in place and I don't minimize those actions. I think they do represent progress. But in looking at the documents involved in these transactions, I find it very difficult to understand how these transactions were approved under your old procedures. There were warning flags galore, and I want to read you some of the comments by Citigroup's own employees, who it seems to me kept trying to raise red flags, kept trying to bring concerns to the attention of senior management. In one e-mail, for example, an Alan McDonald says, ``We, Bill Fox and I, share risk's view and if anything feel more strongly that the suitability issues and related risks, when coupled with returns, make it unattractive. It would also be an unfortunate precedent if both GRB management relationship and risk's views were ignored.'' Another e-mail describes one of these transaction as ``a funky deal accounting-wise,'' and characterizes another Citigroup employee's view as being ``amazed that they can get it off the balance sheet.'' Yet another e-mail, which Senator Levin has referred to, ``based on 1999 numbers would appear that Enron significantly dresses up its balance sheet for year end; suspect we can expect the same this year.'' Yet another from a memo, the ``accounting is aggressive and a franchise risk to us if there is publicity.'' Yet another e-mail, this one from Rick Caplan, ``Sounds like we've made a lot of exceptions to our standard policies. I'm sure we've gone out of our way to let them know that we are bending over backwards for them. Let's remember to collect this IOU when it really counts.'' How did this happen? Why would these transactions all be approved when you have Citigroup employees raising so many red flags, describing the accounting as ``funky,'' saying that they don't understand how this achieves Enron's objectives of getting off-the-books treatment for these transactions, saying that a lot of exceptions were made to standard policies? How could this have happened under your old procedures? Mr. Prince. Senator, I will tell you honestly, I have done a lot of soul searching about that. As the new CEO of this business, I am responsible for it now and I am responsible for what happens going ahead and I have to make sure that problems can't arise under my leadership of the business, and so I have thought a lot about how this could have happened when the issues that you have identified were raised. I think, honestly, that our people did spot some of those issues, did raise them. You have quoted the various documents. And I think that in hindsight, our people were too comfortable with the ability to rely on the outside auditors, on the law firms that structured and closed these transactions, and on the representations from Enron themselves. I think that at that time we did not view ourselves as being responsible for what Enron did with its own books and I think we have learned a very painful lesson in that regard. Senator Collins. But it wasn't as if the representations by Enron or Andersen or the legal team that Enron used didn't raise questions. Mr. Prince. That is correct, Senator. Senator Collins. And that is the part that is troubling. There are some cases where there was outright deception in the information and data that were provided to you. But in other cases, the information provided to Citigroup raised red flags and yet the transactions went through. Mr. Prince. And indeed, Senator, I think some of the language reflects our mental state at that time. The one you quoted that said we are surprised they can get it off their balance sheet, it is obvious that we are observing their decision process. We didn't view ourselves as a participant in that decision process. We were watching it. We were relying on what they told us. We were relying on what Arthur Andersen said was OK or not from an accounting standpoint. We have learned a painful lesson that we can't be a bystander and just watch that process. Senator Collins. Mr. Prince, how much was this driven by the fact that there was the lure of big fees? I come back to this e-mail, and it is Exhibit 322(i),\1\ where it says, ``Sounds like we made a lot of exceptions to our standard policies. I'm sure we've gone out of our way to let them know that we're bending over backwards for them. Let's remember to collect this IOU when it really counts.'' What does that mean to you? --------------------------------------------------------------------------- \1\ Exhibit No. 322(i) appears in the Appendix on page 242. --------------------------------------------------------------------------- Mr. Prince. Well, Senator, as you know, I was not managing this business and I wasn't intimately involved in these transactions, but in being briefed on these transactions, my understanding is that the exceptions to our policies involved things like choice of law, whether it is Texas law or New York law, things like that. But the short answer is, I can't put myself in the minds of the people who did these transactions. I don't believe that in a company like ours, an individual transaction would drive people to do bad things. Based on what I know, I believe that our people, acting under the rules as they understood them to be and with the clear mental state that I mentioned a moment ago about relying on others, that they acted in good faith. That is my belief. If I did not believe that, the people would not still be with the company. But I believe they did act in good faith under the rules as they understood them at the time, and I don't think that fees, whether on this transaction or others, corrupted our organization. Senator Collins. Mr. Fox, I want to follow up on your discussion with Senator Levin, which still leaves many questions in my mind. You traveled to Houston and met with Andrew Fastow, Enron's CFO at the time, because you wanted to discuss the verbal support or the support for Citigroup's investment in the Bacchus transaction, is that correct? Mr. Fox. Yes. I traveled to Houston to meet with Mr. Fastow to discuss the entire transaction and obtain his assurances that they were going to take the necessary steps to make certain that the take-out or permanent financing was put in place and that we would be repaid. Senator Collins. Yet in your testimony today in response to questions from Senator Levin, you indicated that it was never your understanding that Mr. Fastow provided you with any kind of guarantee, is that correct? Mr. Fox. That is correct. He did not provide me with any guarantee. Senator Collins. And you also testified, and this is obviously the critical point, that you considered Citigroup's investment to be at risk, is that correct? Mr. Fox. That is correct. Senator Collins. OK. Now, the reason I am having difficulties understanding that is a document that is the loan approval memorandum, which is Exhibit 318,\1\ where over and over again, in fact, I think four times in the document, there is reference to the verbal support, the verbal commitment that you received from Mr. Fastow. --------------------------------------------------------------------------- \1\ Exhibit No. 318 appears in the Appendix on page 219. --------------------------------------------------------------------------- For example, there is a sentence on page two of the memorandum in the first paragraph that says, ``From our perspective, the equity portion of the facility will be at risk and there is consequently a large element of trust and relationship rationale involved. However, this equity risk is largely mitigated by verbal support received from Enron Corporation as per its CFO.'' That is obviously referring to the conversation that you had with the CFO, is it not? Mr. Fox. Yes, it is. Senator Collins. Again in the memorandum, on page three, there is a statement saying, ``Enron's CFO has given his verbal commitment to Bill Fox that Enron Corporation will support the 3 percent equity piece of this transaction.'' At the top of that page, again, ``The equity component we provide will be based on verbal support as committed by Andrew Fastow to Bill Fox.'' It says over and over again in this document, which is the loan approval memorandum, that you had a verbal commitment. So I am trying to understand how you could view the funds as being truly at risk given the verbal support of the investment that you received from Enron. Mr. Fox. Senator, what we are doing here, I believe, in this document is trying to highlight to all that were involved in the transaction and approving it that a portion of the transaction was at risk as equity based solely on verbal support. It did not have a legal obligation from Enron. It did not have the faith and full faith and credit from Enron. It was simply that Enron through Mr. Fastow was going to make certain that the take-out transaction was going to be accomplished. Senator Collins. What did the verbal support mean and why was it so important that it appears four times in the loan approval memorandum? Mr. Fox. We, I believe I would say, we were trying to highlight the risk for all the approvers, that this was not a legal obligation by any stretch of Enron to pay us back the $6 million. It was verbal support. We were at risk, but we were dependent on them to make certain that the take-out financing, the permanent financing, was going to be accomplished. Senator Collins. I have to tell you that I read it exactly the opposite. If it was important enough for you to go and meet with Andrew Fastow to get that commitment, and if it appears four times in the approval memorandum, and when there is actually a statement in this memorandum saying that the equity risk is largely mitigated by the verbal support received from Enron, how can you continue to maintain that this commitment really had no meaning? Mr. Fox. I think that is just the point, Senator. It was mitigated, not eliminated. We had that risk, and I think that is what we were highlighting to everyone, so that everyone in our firm who was approving the transaction understood that this was an incremental risk we were undertaking. Senator Collins. On Exhibit 366,\1\ the phrase is used that it is a verbal guarantee and the percentage is 100 percent. What does that mean. --------------------------------------------------------------------------- \1\ Exhibit No. 366 appears in the Appendix on page 655. --------------------------------------------------------------------------- Mr. Fox. Senator, I am sorry. Where are you exactly in the exhibit? Senator Collins. It is Exhibit 366. It is under ``Support'' typed to the left. It says, ``verbal guarantees,'' ``Enron Corporation,'' ``percentage: 100.'' Mr. Fox. Yes, I am sorry. Senator Collins. Doesn't the word ``guarantee'' mean something? Mr. Fox. Senator, I don't know who completed that form, and it is a form that gets completed, but that was not what I obtained from Mr. Fastow, and I think what I obtained from Mr. Fastow was generally well articulated in some of the other written documentation. I obtained from him his verbal assurance that they would take all necessary steps to make certain that the take-out financing was accomplished and our entire financing, not just the equity piece but also the debt piece, would be repaid. Senator Collins. So are you saying that the word ``guarantee'' should not have been used on this document? Mr. Fox. That was not an accurate representation of my conversation with Mr. Fastow. Mr. Caplan. Senator, could I make one clarification, just looking at this for the first time? Senator Collins. Yes. Mr. Caplan. I am not certain that what Mr. Fox is inconsistent with--what he is saying is inconsistent with what this says, because if you note that this section of this memo is about the term loan, the $194 million term loan that we were providing as a bridge, and I think you could very easily conclude that the verbal guarantee is that Enron is going to work hard and get that take-out done at the termination of this loan. This doesn't actually refer to the equity at all. It seems just to refer to the term loan. Senator Collins. Let me ask one final question. Senator Levin. If you would yield to me on that point---- Senator Collins. Absolutely. Senator Levin [continuing]. Because you are inaccurate. Take a look at the prior page at the bottom. That is the term loan. Mr. Caplan. Well, it says in the middle of the page, ``Facility description, term loan,'' and then---- Senator Levin. I understand. I know exactly what you are saying. I am saying that the larger loan, the $242 million, which was then reduced, as I indicated in my opening statement, is on the previous page, and that is page six. This is, without any doubt, referring to the equity, which was listed as $7.5 million, but, in fact, as I indicated, was reduced to $6 million. But there is no doubt that this is the equity portion, so-called equity portion, called a term loan, by the way, in this document. I just want to--stated to be verbal guarantees, not just mitigated, 100 percent--but the point here is that you are wrong when you---- Mr. Caplan. I would agree. Senator Levin. OK. Mr. Caplan. But I think, though, if I might, I think this is the beauty of our new policy, because whether we called this thing--whether this thing turns out to be a sale or a loan, the effect of whatever the intent behind the transaction would be disclosed in the financials. We would require disclosure of that in the finances of the company. I think that is really the difference we are trying to articulate here today. Senator Collins. One final question, because my time has expired. Mr. Fox, had you not received the oral commitment, whether we are calling it a verbal guarantee or an oral commitment, from Enron, would you have proceeded with this transaction? Mr. Fox. Senator, today, I am not certain I can tell you one way or the other. If we had not received it, it would have certainly been a different risk, as the memo highlighted. The verbal support mitigated some of that risk. Without that, as I said earlier, it is unusual for us to engage in a bridge financing where we are not in control or involved in the take- out. So I can't say for certain today whether we would or would not have gone forward without it, but it clearly was important to us. Senator Levin. Thank you. Senator Bennett. Senator Bennett. Thank you, Mr. Chairman. Coming to this de novo, without the kind of research that both my Chairman and Ranking Member have done, I have a slightly different reaction. I think the first documents that refer to mitigation on the basis of verbal support pass the smell test. The second document clearly does not, the one that says verbal guarantee, 100 percent, and I think that is a bureaucratic slip-up that the people who had the conversation with Fastow--you, Mr. Fox--clearly understood you were at risk, and your first document makes it clear. We are at risk. Now, anybody on an approval basis reading that document says, well, what do we have to deal with the risk, and your answer is, I have had a conversation with Fastow and he says he is going to take it out. That is not legally binding, it is not something we can go to the bank with, but we are satisfied that they will make good on it and that mitigates the risk. I think that document passes the smell test. But as it got handled by the sausage machine down to the final drafting of the final loan document, that reference of a mitigation got turned into something more than a mitigation and it came out as a 100 percent guarantee and I think that is something you ought to look at in terms of the way documents get drafted within large bureaucracies. I am not surprised by it. I am not horrified by it. It happens all the time. But I think it is a clear message to you that when a deal is made at your level, Mr. Fox, it gets documented to the point that when it finally comes out in the final document that is done by an employee who is used to doing hundreds, if not thousands, of these in a very routine way, that the significant deal you made still retains its flavor when it comes out in the final wash. That is how I read what happened here. Now, if you want to challenge that and say, no, that is not where it is, looking at it strictly, as I say, de novo, that is what I see what happened here. So just to nail it down one last time, Mr. Fox, you were convinced, regardless of what the documents said, that Citibank really was at risk here? Mr. Fox. Yes, Senator, I was. Senator Bennett. And you were satisfied that it was a risk Citibank could afford to take because Andy Fastow had told you, ``We are going to be able to meet our obligation''? Mr. Fox. That is correct, Senator. Senator Bennett. OK. If that is all the farther it went, I think that is a legitimate position for you to have. The difficulty comes from what Enron did with this, and as Senator Collins said, you understood what they were doing with this was really, to use the catch-all term, very aggressive. ``Very aggressive'' usually means getting close to the edge of something that is improper. Now, Mr. Prince outlines the actions that Citibank is going to take, and this is what I really want to focus on, rather than the details of this particular situation. We are talking about a new role for banks. In the old world, banks did not view as their role--I interrupt myself here. Let me lay it out as I see it and then you agree or disagree. In the old world, banks did not view their role as being watchdogs of investors and borrowers. Banks viewed their role as being watchdogs for the investors in the bank. So as long as the bank was satisfied that it would get its money back, it really didn't care what the borrowers did with the money. Now we are saying the bank should have been part of the watchdog team that would blow the whistle and say, these guys are borrowing the money and they are going to do squirrelly things with it on their balance sheet, and unless they disclose the real effect on their balance sheet of taking on this loan, we are not going to give them the loan. Is that a fair characterization of the switch in the role of the bank that has occurred as a result of the Enron collapse? Mr. Bushnell. Mr. Bennett, perhaps I could take that one. Yes, I think that is a fair characterization of the new policy and the switch from where we were and the policies and independencies that we used to have versus the procedure going forward. Senator Bennett. It does represent a fairly significant change in policy, because up until now, we, the Federal Government, have assumed that the role of gaining transparency in financial statements is primarily, if not exclusively, the SEC, and as long as the SEC does its job, the banks don't have to worry about it. They can just make the loan as long as they are sure their shareholders will be taken care of and leave it up to the SEC to make sure the borrowers do the right thing with the money. Now we are saying, no, in addition to the SEC, the banks must play a role in disclosure to the shareholders of the borrower. Mr. Bushnell. I think that is right, Senator. I think our feeling is that, as Mr. Prince discussed in his opening remarks, this has been such a painful process for us, even if our depositors weren't hurt or the bank got its money back in this case, which it did, it has clearly been a damage to the financial system, to the trust in the development and establishment of the smooth flowing of our capital markets, and that in our own self-interest, if you will, we need to make that trust come back and be a party to it. Senator Bennett. This raises a number of very interesting possibilities. If the bank does assume a role and, therefore, a responsibility for the accuracy of financial statements on the part of the borrower, can the bank be sued if the borrower misstates the use of the funds it obtains from the bank? Mr. Bushnell. I understand that, Senator. I don't think we are looking to take on the legal responsibility or the accounting responsibility for this. We do think that there are regulatory agencies and that is others' jobs. We just think that when there are questions like this, the best policy as a risk manager, transparency, shedding the light on what the transaction is in plain English so that everybody can understand what happened, is the best policy for us. Senator Bennett. I think that is a very important point for you to make because I don't think you want to expose yourselves to lawsuits on the basis that you did not adequately require transparency on the part of the borrower. I think you want to keep the wall there that the lawsuits can go to the accounting firm that didn't adequately provide disclosure or require disclosure. The lawsuits obviously can go to the borrower themselves if they lied, as Enron clearly did. But that the lawsuits can't go to the deep pockets of a bank who, in their requirements for disclosure, fell short of the kinds of requirements. You want to make it clear, I think, that in the policies you are adopting, you are adopting these policies to protect the safety and soundness of the banks and the investment in the banks of the banks' shareholders. I think the case can be made that the kind of disclosures Mr. Prince has described here do, in fact, reduce the risk to shareholders of the bank, and by making these requirements on the part of the borrower, you are saying that the bank will ultimately have fewer bad debts and fewer write-offs. Let me ask the question that has not been answered here. Did you lose the $6 million? It was at risk. Did you lose it? Mr. Fox. No, Senator. The permanent financing was executed and the entire Bacchus financing was repaid. Senator Bennett. OK. Are there any other of the transactions we will be discussing here this morning where the bank had money at risk which you lost? Mr. Fox. Not in the transactions that we are discussing here today. Senator Bennett. OK. So the changes that Mr. Prince has talked about, if they had been in place, would not have changed the losses sustained by the bank. In other words, these changes would not have retrospectively benefitted the shareholders of the bank. Mr. Fox. I think they may have benefitted the shareholders because we wouldn't have been associated with these transactions, but---- Senator Bennett. That is fair, yes. They would have affected the shareholders in that they protect the reputation of the bank and the reputation of the bank is obviously something that is of value to the shareholders. So I will accept that, even if there was not a specific monetary loss. Mr. Fox. That is correct, but we did not lose money on these transactions. They were repaid within--to us. Senator Bennett. That is my point, Mr. Chairman, and I will stop there. I think the things we have heard from Mr. Prince are salutary and we should congratulate Citibank on its willingness to move forward. I think it should be pursued, but I think everybody should be a little careful about crossing the line and putting a liability on the bank, any bank, if they fail to do these kind of things, because traditionally, regulation of disclosure and achieving of transparency is something that should be accomplished by the SEC and by the independent accountants who are paid handsomely to make sure that there is transparency and that it should not be ultimately spilled over into a lender so that a lender could be liable for making a loan where the disclosure requirements of the lender were deemed to not be sufficient to protect the interests of the shareholders and the investor. That strikes me as very dangerous ground that would open the door for a huge number of lawsuits, to the detriment of everybody, if we are not very careful. Thank you, Mr. Chairman. Senator Levin. Thank you, Senator Bennett. What we are looking into is, in addition to the changes which Citibank is indicating it is making in the way its procedures operate, we are also looking at what it didn't do relative to the procedures that it had in place on these transactions. This is not just saying in hindsight that we have reached a conclusion. It is saying that the investigation discloses that at the time these transactions were inappropriate, that they aided and abetted deception, that there were major concerns raised internally that were overridden, set aside in order to please Enron or to make a fee. This isn't just a question of hindsight or under current rules these transactions wouldn't be approved. There were rules at the time about not aiding and abetting deceptive transactions. That is not a new rule for a bank. That is an old rule. There is an old accounting requirement that was in existence at the time that says there is no room for accounting representations that subordinate substance to form, and you cannot aid and abet a violation of that rule. So that is our major concern here, it is the way in which major institutions facilitated deceptive accounting and bent the rules or violated the rules that existed at the time. Senator Collins has made reference to this Exhibit 322(i),\1\ which says, ``it sounds like we made a lot of exceptions to our standard policy.'' Those are policies that existed at the time. Those aren't new policies. ``I am sure we have gone out of our way to let them know that we are bending over backwards for them,'' for Enron. ``Let's remember to collect this IOU when it really counts. Happy holidays to all.'' --------------------------------------------------------------------------- \1\ Exhibit No. 322(i) appears in the Appendix on page 242. --------------------------------------------------------------------------- Let us move to Sundance. A few months after Bacchus, Enron decided to create Sundance as a joint venture that would keep all of Enron's pulp and paper assets off its balance sheet. And, as I discussed in my opening statement, the joint venture was a sham because Citi really didn't have any investment at stake, and here are the facts. Citibank's $28.5 million that it was supposed to invest and have at risk, in fact, was set aside, kept segregated, available for Citibank. Seven-hundred-and-forty-seven million dollars of Enron's money would have had to have been lost before any of Citibank's money could be touched. Citibank could unilaterally dissolve this venture at any time, ensuring that it wouldn't lose anything on its investment. I want to go over this whole situation here with you, Mr. Caplan. Most auditors require that for a joint venture to be unconsolidated, the capital commitment must be split 50-50. Arthur Andersen was a lot weaker, a lot less conservative, and the second partner in the venture only had to put up 20 percent under Arthur Andersen's rules in order for the joint venture to be unconsolidated on the books of Enron, and that is, of course, what Enron was interested in. That was their goal. Now, even with the weaker approach, the 20 percent approach, Citi and Enron still went around it through all the ways that I discussed. Twenty-eight-point-five million dollars was segregated, couldn't be touched. Citibank could end this whole deal any time it wanted. Enron's $747 million had to all be spent before there was even any Citi money spent at all, whether it was the $28.5 million or the balance, which I believe was $160 million. Citibank also had a guaranteed return interest rate, and I would like you to look at one Citi e-mail, Exhibit 333(i),\1\ which appears to me to be an accurate summation of Citibank's so-called investment in Sundance. It is supposed to be an investment at risk. Principal is supposed to be at risk. --------------------------------------------------------------------------- \1\ Exhibit No. 333(i) appears in the Appendix on page 296. --------------------------------------------------------------------------- Here is what the e-mail from Citibank says. ``Still an equity investment of sorts, accounting and tax basis for partnership, but it is structured in such a way that the 670 basis points are guaranteed or we blow the deal. Also, our invest,'' I assume that means investment, ``is so subordinated and controlled,'' and now these are the key words, ``that it is unimaginable how our principal is not returned,'' Unimaginable how the principal could not be returned. This is supposed to be an investment at risk. Guaranteed return interest. Unimaginable, in your own words, how your principal would not be returned. Now, how does one realistically say that funds are at risk under those circumstances so that Enron could keep Sundance off its balance sheet? No one here is suggesting that you have got to go out and investigate the other guy's balance sheets, but my gosh, this is something that you knew. You knew that your investment was so subordinated, so unlikely to be reached, so much in your control--it was controlled by you. You could terminate that joint venture anytime you wanted. It was unimaginable that your principal was not going to be returned. Now, you tell me how that is an investment which is at risk. Mr. Caplan. Well, I would say a few things. First, I think it is important to note that this structure was presented to us by Enron in exactly this form, and our investment was absolutely in a preferred position. It was senior to Enron's investment. They absolutely had to lose $700 million. But my choice of words would not be ``unimaginable.'' There were many circumstances that we ran through---- Senator Levin. Whose choice of words were they? Mr. Caplan. Tim Leroux. Senator Levin. And who is he? Mr. Caplan. He is someone who works for me. Senator Levin. OK. So your employee described this as unimaginable. Mr. Caplan. But we spent a fair amount of time going through scenarios in which we could lose our money in this transaction. Now, I will submit to you that they are remote scenarios, but nevertheless, they are real. For example, one of the assets in this partnership was a paper mill in Canada sitting on the St. Lawrence River. If that paper mill blew up and caused significant environmental damage, we would have--our return would have been subordinated to the liability caused by that damage, and that was something we were very concerned with in this transaction. Senator Levin. Was there insurance on the paper mill, by the way? Mr. Caplan. I believe that there was insurance on the paper mill. Senator Levin. So the risk here was that the paper mill would blow up. That risk was covered by insurance. Get to some real risk here, will you? Mr. Caplan. In addition, the way that this transaction was structured was presented to us by Enron and it was a combination of things. It was a combination of this preferred equity investment, which had the full blessing of Arthur Andersen, and my understanding was the more important test was not just that we had an equity investment, but that we had voting rights in the structure, and we had 50 percent of the voting rights. We had the ability to control the destiny of the entity, and if we were a creditor of the entity, that would not be true. So I will absolutely submit to you that this is a preferred investment. It operates much like many other preferred investments out there, and it was not our accounting judgment as to how--as to whether this worked or not. This is an area of--I would call this joint venture accounting, is an area of accounting that there isn't a lot of literature on point and the way that our understanding is, that joint ventures are accounted for, is that the Big Five accounting--or Big Four now--accounting firms that give guidance, and this was Arthur Andersen's guidance on how to account for this transaction. Senator Levin. If you look at Exhibit 333(d),\1\ which is an e-mail to you, Perwein, who is a Citi tax attorney, is quoted as saying that ``Sundance was a funky deal accounting- wise, and was amazed that Enron can get it off the balance sheet.'' Do you remember getting this? --------------------------------------------------------------------------- \1\ Exhibit No. 333(d) appears in the Appendix on page 290. --------------------------------------------------------------------------- Mr. Caplan. I do. Senator Levin. Do you have any reason to disagree with that? Mr. Caplan. With--I am sorry. Senator Levin. With the statement that it is amazing that they could get this off the balance sheet. Mr. Caplan. I am not an accountant. Neither is Mr. Perwein---- Senator Levin. You were aware of this tax attorney's conclusion that it was a funky deal accounting-wise and amazing that Enron could get it off their balance sheet, is that right? You were aware of that? Mr. Caplan. Again, I think that is an accounting determination made by Arthur Andersen on how the structure should work. They were fully aware of all of the terms of the preferred investment. I think interestingly in this e-mail, you will see later on in it where, ``John C. called. He is most concerned about Garden State. I am trying to set up an environmental call.'' All this is indicative of our concerns about risks in this transaction, albeit remote risks, but real risk to our investment in the transaction. Senator Levin. And is this not your words, that in Exhibit 333(t),\1\ that this transaction is structured to safeguard against the possibility that we need to contribute our contingent equity and to ensure that there is sufficient liquidity at all times to repay our $28.5 million investment? That was ensured, wasn't it? --------------------------------------------------------------------------- \1\ Exhibit No. 333(t) appears in the Appendix on page 310. --------------------------------------------------------------------------- Mr. Caplan. Well, if you think about what this was, it was a collection of fairly illiquid assets, a couple paper mills, a trading business. We were trying to mitigate our risk to the extent possible, and to the extent we wanted to get out of the transaction, we didn't have creditor's rights to call in event of default and accelerate our debt, something like that. We only had the position of an equity holder who could force effectively a dissolution of the company, at which time the assets of the company would have needed to have been liquidated. We were concerned that the assets were extremely illiquid, so we put in steps to mitigate the illiquidity of the assets. Senator Levin. Well, it was way more than that, though, Mr. Caplan. You talk about liquidating assets. One of those assets was an account with $28.5 million in cash which was there to protect your $28 million, isn't that correct? Mr. Caplan. One of the assets when we closed the transaction was $28 million of Enron commercial paper, which is a liquid asset. It was absolutely designed to protect our ability to get out of the transaction in what I would call a timely and efficient manner. But again, all this was vetted fully with Enron's accountants, and I think this goes to the-- -- Senator Levin. I am talking about your accounts. I am talking about your advice. Your advice was funky transaction. You don't know how they can do it. And you knew the $28 million is there in an account. You insisted on it, for you. That is money to come back to you, guaranteed. This isn't something where you have to liquidate an asset. You don't liquidate something that is liquid. It is there, set aside, isolated, segregated for Citibank. That is supposed to be an investment at risk? You call that mitigating risk? That is not mitigating risk, it is eliminating risk on the $28.5 million. It is in a segregated account. Only you can touch it. You call that mitigation? I call that elimination. Mr. Caplan. With respect, Senator, originally, the money was in Enron commercial paper, and if they had defaulted the day after the transaction, if they had gone into bankruptcy the day after this transaction had closed, our $28 million would not have been---- Senator Levin. Was there any suggestion that Enron was going to go into bankruptcy at that time? Mr. Caplan. No, none at all. Senator Levin. You are talking about the possibility that they would go into bankruptcy the next day, and you had the $28 million there segregated for you. Mr. Caplan. I am not going to argue---- Senator Levin. Take a look at Exhibit 327,\2\ Project Sundance. Investment in the Sundance partnership is an equity investment. However--this is at the bottom of the page, number nine. ``However, based on the way the deal is structured, it is more like debt rather than equity.'' Would you agree with that? --------------------------------------------------------------------------- \2\ Exhibit No. 327 appears in the Appendix on page 255. --------------------------------------------------------------------------- Mr. Caplan. Well, I think I would agree in the context that Sundance as an entity had no debt, and we had a preferred position in effectively a liquidation scenario. So in that respect, it was debt-like because it was senior in the capital structure to Enron's interest in the transaction. Senator Levin. Senior doesn't make it debt. Mr. Caplan. Well, if the company were to liquidate and there were debt in the company, the debt, being senior in the capital structure, would be repaid first. Since there was no debt in the company, our interest was the most senior interest in the company and, therefore, any liquidation proceeds would go to pay off our investment prior to repaying Enron. Senator Levin. Whose document is this, Exhibit 327? Is that your document? I know it is a Citibank document. Mr. Caplan. It is--when we have a transaction that is unusual or the first of its kind, we have an approval committee called the Capital Markets Approval Committee at which we discuss the transaction. This transaction was discussed at the Capital Markets Approval Committee---- Senator Levin. Was that an accurate statement, that based on the way the deal was structured, it was more like debt rather than equity? Is that accurate? Mr. Caplan. It is accurate to the extent that Sundance as an entity had no debt. Yes, it is accurate. And understood by Enron and their accountants as to that was the structure. I think the key thing is, we had risk in the transaction and we had voting control, and that was the test laid out by Andersen. It was not that our risk was pari passu with Enron's. Senator Levin. No one is suggesting that. Let me go back to this $28.5 million. Is it correct that a couple days before bankruptcy, that you insisted that that $28 million come back to Citibank? Mr. Caplan. We had, under the transaction documents, as a partner in the partnership, a contractual right to call a board and dissolve the structure at any point in time, and as Enron moved towards bankruptcy, we effectively exercised that right. Senator Levin. So your statement a few moments ago that what would happen if Enron would go bankrupt the next day, as a matter of fact, it did go bankrupt the next 2 days after, many months down the road, and you were then able to protect that $28 million by terminating the deal, is that correct? Mr. Caplan. We were able to exit the transaction prior to the bankruptcy. Senator Levin. Exit the transaction. Mr. Caplan. If the bankruptcy had happened prior to our insistence on blowing this transaction up, we would have been at risk on that $28 million for---- Senator Levin. After you knew that it was on the verge of bankruptcy, you could get your $28 million just like that, couldn't you? Mr. Caplan. That was the structure of the transaction. Senator Levin. And that is what you call being at risk? Mr. Caplan. I will not dispute with you that this is a-- that the risk here was very contingent and remote. Nevertheless, it is risk and it was sufficient risk--I think the important point is that it was sufficient risk for Andersen to reach its conclusion that this joint venture would not consolidate on the balance sheet of Enron. And I think the paradigm shift that we have implemented in our business model now is this kind of transaction would not be--we would not execute this kind of transaction today unless we felt that there was clear, sufficient disclosure as to the net effect of it as to what really goes on here to investors, and I think that is the take-away from this. We have learned something from this transaction. Senator Levin. Well, I hope the world has learned something about this transaction, as well, and that is at the time, it was improper, not just now. At the time, it was improper. Exhibit 333(n),\1\ this is what you wrote. This is from Mr. Bushnell, he wrote to Michael Carpenter. This will be my last question of this panel in this round. Mr. Bushnell, you wrote to Michael Carpenter, who was the head of Global Corporate and Investment Bank at the time for Citibank, on May 30, 2001, 2 days before this deal went through, and here is what you told Mr. Carpenter. This is on page two of Exhibit 333(n). ``If you recall, this is a complex structured transaction which I have refused to sign off on.'' --------------------------------------------------------------------------- \1\ Exhibit No. 333(n) appears in the Appendix on page 302. --------------------------------------------------------------------------- And then you later said the following. ``The risk management has not approved this transaction for the following reasons,'' and then one of your reasons, which is the one, two, three, fourth bullet, is that ``the GAAP accounting is aggressive and a franchise risk to us if there is publicity, a la Xerox.'' This transaction was a franchise risk to Citibank if there was publicity, that is what you said in this document. Were you telling the truth? Mr. Bushnell. Yes, Senator. Senator Levin. And yet, you went ahead with this. This is what really is so troubling to me from Mr. Prince's testimony and otherwise and why the explanation that we have heard this morning is so unsatisfying. Well, this is all something in hindsight and we were following the rules at the time. Your own rules were bent. You made exceptions to them. You identified this transaction as one which would actually put the reputation of your bank at risk, and you proceeded anyway with this transaction. This isn't hindsight, folks. This is a lack of foresight on the part of Citibank as to what you were up to. How often do you write that a project or a transaction is a franchise risk? Is that a fairly common thing? Mr. Bushnell. Senator, perhaps I can give some context to this memo. First of all, I could have killed this deal and not let it go forward. I don't need to write a memo to kill a deal. If you read the entirety of the memo, most of this is an alert to Mike Carpenter about some process concerns and some internal differences between divisions about what to do with the transaction, and yes, I do express there are some concerns about what the GAAP accounting standard is. Senator Levin. If I could just interrupt your answer, that is not my question, about concerns over GAAP standards. My question to you was, how often do you write that a project or a transaction is a franchise risk to us if there is publicity? Is that a fairly common conclusion that you reach? Mr. Bushnell. I am sorry, Senator. I was trying to get to that point. I don't write it often. I sit about ten yards away from Mike Carpenter and he and I discussed lots of risk transactions, I would say three to five times a day. Some, and I will admit that it is not many, have an instance of reputational issues that could be there. It is not frequent. I normally don't write it down because I didn't--I just walked into Mike's room or I called him on the phone. In this particular instance, Mike was out of the country and I was trying to give him something to look at. That is the reason why I wrote it down. It is not frequent, but it is a risk issue that we talk about in some transactions. Senator Levin. A risk issue is a little bit different from saying there is a franchise risk to us if there is publicity. Is that something that you said about many transactions that have proceeded? Mr. Bushnell. Again, Senator, in terms of communications, not many, but this isn't the only one that we discussed reputational issues. Senator Levin. I am trying to go a little bit beyond reputational issues. This isn't quite that. This is your conclusion that this accounting is--it is not an issue, it is your conclusion that accounting is so aggressive it is a franchise risk to us. You concluded that---- Mr. Bushnell. Yes, Senator. Senator Levin [continuing]. If it is made public, and yet, it proceeded. Do you often proceed with loans, or forget that word, this wasn't a loan, really was a loan, but putting aside the loan-equity question, let me get to my question. Is it common that you have stated or concluded that accounting is so aggressive that it is a franchise risk to us if there is publicity, and yet the transaction nonetheless was concluded? Has that happened frequently? Mr. Bushnell. It has not, no. Senator Levin. Senator Collins. Senator Collins. Mr. Bushnell, what was Mr. Carpenter's response to your memo and your concerns about the Sundance deal? Mr. Bushnell. Senator, I wish I could recall those concerns. As I said, Mike was traveling at the time. He and I had hundreds of conversations about various risk issues. We have looked back at the record. It is clear, I think, that we had a conversation. I can't remember the specifics of those conversations, or indeed, how I might have paraphrased that concern about franchise or reputational risk or what the conversations might be. Senator Collins. Initially, you refused to sign off on the transaction. Did you ultimately approve it? Mr. Bushnell. Yes, I did, Senator. Senator Collins. And what caused you to change your mind? Mr. Bushnell. One of the very things that caused my mind is I wanted to talk to Mike Carpenter. As I said, I could have--I didn't need to write a memo to not do this deal. The reason why I sent the memo to Mike and the reason why I held up on approving the deal or declining the deal is I wanted to talk to him. I wanted to alert him about several issues that I had about the way this transaction came up, the way it was handled, and what some of the concerns about it were. Senator Collins. Did anyone at the bank direct you to approve the transaction? Mr. Bushnell. No, Senator. Senator Collins. Did Mr. Carpenter provide some sort of approval for the transaction? Mr. Bushnell. I can't recall it, but I am sure he must have. If he didn't want the transaction to go forward, we wouldn't have done it. Senator Collins. Are you aware that the Subcommittee has requested the paperwork authorizing the transaction, but that Citigroup to date has failed to locate and provide that paperwork? Mr. Bushnell. Yes, I am, Senator, and I think that is a breach of our policies and procedures. We do have--for an equity investment like this, at this size, it required a sign- off from both the Chief Financial Officer and Mike Carpenter. I believe we have provided the Subcommittee with the Chief Financial Officer's sign-off, but we don't have Mike Carpenter's sign-off in our files. Senator Collins. Thank you, Mr. Chairman. Senator Levin. You indicated that you remember today that you approved this deal? Mr. Bushnell. Yes, Senator. Senator Levin. Because you told our staff when you were interviewed by them that you did not recall approving the deal. Has something changed between that conversation and today? Mr. Bushnell. Yes, Senator. I have seen subsequently e-mail results that give me a conclusion--I can't recall verbally saying, ``I am OK with this deal,'' but there is an e-mail trail that says that I did talk with one of the transactors, a person in Mr. Caplan's division, and that we had agreed to go forward with the transaction. Senator Levin. According to this memo that I think you may be referring to, which you say refreshed your memory, I believe this is Exhibit 333(r),\1\ ``If you recall, Mike Carpenter was out of the country the day the transaction closed''--this is dated June 29, 2001. The approval memo was given to Mike's assistant and faxed to him. Mike then had a conversation with Dave Bushnell, who shared with us Mike's feedback. We proceeded to close the transaction that day, given the absence of instructions from Mike or Dave to the contrary.'' --------------------------------------------------------------------------- \1\ Exhibit No. 333(r) appears in the Appendix on page 308. --------------------------------------------------------------------------- Apparently, the transaction went through not because you approved it but because you didn't give any instructions to the contrary, is that true, or did you approve it actually? Mr. Bushnell. I can't recall verbally saying I approved it. I take this memo to mean that I had a conversation with the transactors and said that I had talked with Mike and that met the requirements or my criteria for going forward. Senator Levin. If you talked to Mike, what did he say? Mr. Bushnell. Senator, as I say, I wish I could recall that. I really do. It would make things a lot easier for all of us. And in our new policies, this is the type of thing that we want to have written down so that we can recall how we got to conclusions or overcame issues that are brought up about structured finance transactions. But I can't recall the nature of that conversation. Senator Levin. This is an unusual transaction. You just testified it is uncommon that there be a transaction where you would say there is a reputational risk serious to your bank, could actually risk your bank's reputation if made public. And yet, you went ahead and approved it. You can't remember the conversation with Carpenter. The approval document is missing. There are a number of very disturbing and unusual aspects to this transaction. It would seem to me that something which is this unusual should be remembered by you in terms of your conversation with Carpenter. Mr. Bushnell. Senator, I wish I could remember it, but as I said, I had three to five conversations a day on all significant risk transactions. This was 18 months ago, and I just can't recall having the conversation or, obviously, any specifics of the conversation if I had it. Senator Levin. If you look at the first page of Exhibit 333(n),\1\ which is an e-mail that Alan MacDonald, Head of the Global Relationship Bank, sent to Michael Carpenter the day after you wrote your memo, that previous memo we talked about. In it, he forwards Mr. Carpenter another copy of the memo and writes the following. ``We, Bill Fox and I, share risk's view and, if anything, feel more strongly that suitability issues and related risks, when coupled with the returns, make it unattractive. It would be an unfortunate precedent if both GRB relationship management and risk's views are ignored.'' --------------------------------------------------------------------------- \1\ Exhibit No. 333(n) appears in the Appendix on page 302. --------------------------------------------------------------------------- Mr. Fox, Mr. MacDonald writes that you shared the views of Mr. Bushnell. Did you have concerns about this project? Mr. Fox. I had some questions about the project, mostly surrounding the returns we were attempting to achieve. I was concerned that it was going to potentially disenfranchise another product area of ours called capital structuring. Initially, I had raised some issues concerning the fact that I didn't understand how the accounting was able to achieve Enron's objectives. Those were the areas of my concern. Senator Levin. Were you satisfied? Mr. Fox. With respect to the accounting question, I received an e-mail back from an individual that confirmed that Arthur Andersen had reviewed and utilized this type of structure elsewhere. Senator Levin. And what about the reference to the franchise risk if there is publicity? Mr. Fox. I had not seen Mr. Bushnell's memo until after the fact. My communication, though I don't recall it, must have been with Mr. MacDonald directly. Senator Levin. So here, we have got serious concerns raised by Mr. Bushnell and Mr. Fox about the accounting associated with it. You, at least, Mr. Bushnell, about the risk to the bank's reputation. You, Mr. Bushnell, as head of risk management, refused to sign off on the project because, in part, the aggressive accounting did create a franchise risk if it was made public, if it came to light. And yet, the deal went through, helped Enron to make its balance sheet look a lot better than it was entitled to look, and I am afraid that that story is a sad story. This is not just a story about should we make banks look at the books of clients. This is a story of how a bank with serious concerns, even to its reputation, was willing to proceed with a transaction which its own people thought was incredible in terms of its accounting techniques, and nonetheless, you went ahead and did it. You did it for a couple of reasons, I assume. One was there was money in it, and two, you wanted to keep a good client happy. But I do think it is important as we look at what our regulators are going to do about it and what your new procedures are to hopefully stop this from happening, that we recognize that these are problems that were raised at the time. This is not retroactive applying new standards. This is looking at how a bank of high reputation that should be a pillar in our economy stooped pretty low. We have got to learn from that lesson. The bank says it has. I am glad to hear you have. I hope you have. For the sake of our economy, I even pray you have, because this has got to stop. We are going to rely to some extent on self-regulation, but we cannot rely totally or even to a great degree on self- regulation because it hasn't worked in the past. There is too much temptation out there, to please customers and to make money, and I guess those are one and the same thing. And so we are going to need to talk to our regulators, and we will a little later on today, after we talk to Chase, as to how we, as a government, can be sure that these kind of activities are not repeated. I want to thank our witnesses. Again, I know this was a difficult day for you to get here. We also want to again repeat that Citibank as well as Chase has cooperated in our investigation. You have provided us with documents, obviously, and you have appeared. You have come and been interviewed by us, and those are important pluses on the ledger. We thank you and you are excused. Mr. Bushnell. Thank you, Senator. Mr. Caplan. Thank you, Senator. Mr. Fox. Thank you, Senator. Senator Levin. We are going to take a 5 minute recess. [Recess.] Senator Levin. We will come back to order. I would like to call now our second panel of witnesses. I want to thank all of you, as I did our first panel, for making it here in this weather. It was bad enough when you got here. I think it is worse now. I don't know if that is good news or bad news, but it is the fact, apparently. We want to welcome Michael Patterson, who is the Vice President of J.P. Morgan Chase and Company; Andrew Feldstein, the Managing Director and Co-Head of Structured Products and Derivatives Marketing at J.P. Morgan Chase; Robert Traband, Vice President of J.P. Morgan Chase in Houston; and Eric Peiffer, a Vice President of J.P. Morgan Chase in New York. Pursuant to Rule 6, witnesses who testify before the Subcommittee are required to be sworn and so I would ask you all to please stand and raise your right hand. Do you swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Patterson. I do. Mr. Feldstein. I do. Mr. Traband. I do. Mr. Peiffer. I do. Senator Levin. As I mentioned before, a minute before the red light comes on signaling that you should end your testimony, you will be given a green to yellow light, which will give you the opportunity to conclude your remarks. We will print testimony in its entirety in the record, so we would ask you to limit your oral testimony to no more than 10 minutes. Mr. Feldstein. Mr. Patterson. Mr. Chairman, with your permission, may I begin? Senator Levin. Sure. Do you want to start off? Mr. Patterson. Yes, sir. Senator Levin. Sure. Mr. Patterson. TESTIMONY OF MICHAEL E. PATTERSON,\1\ VICE CHAIRMAN, J.P. MORGAN CHASE AND COMPANY, NEW YORK, NEW YORK Mr. Patterson. Mr. Chairman and Members of the Subcommittee, my name is Michael Patterson. I am a Vice Chairman of J.P. Morgan Chase and head of the firm's Policy Review Office since August of this year. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Patterson appears in the Appendix on page 105. --------------------------------------------------------------------------- I am joined today by my colleagues Andrew Feldstein, a Managing Director and Co-Head of Structured Products and Derivatives Marketing since March of this year; Robert Traband, a Vice President of J.P. Morgan Chase; and Eric Peiffer, also a Vice President of the bank. After my statement, Mr. Traband will read a joint statement for himself and Mr. Peiffer, and with the permission of the Subcommittee, Mr. Feldstein will then give a brief opening statement. Senator Levin. That is fine. Mr. Patterson. I am pleased to be here to discuss the firm's policies and practices regarding transactions with publicly traded U.S. companies. As requested in your invitation letter, I will address policies and practices relating most particularly to structured finance, accounting, and tax matters. J.P. Morgan Chase and its predecessor firms have long had in place policies and procedures governing transactions with clients. These policies and procedures address, among many other subjects, compliance with external legal and regulatory requirements, as well as the aspects of the transaction that could raise reputation risk for the firm. These policies and procedures are periodically reviewed and updated to take account of our experience and external developments. Structured finance encompasses a wide variety of transactions and instruments designed to help clients achieve their risk management, financing liquidity, and other financial objectives within the framework of applicable and often complex legal, regulatory, tax, and accounting rules and principles. Securitization, special purpose vehicles, and derivatives are among the well-recognized techniques used to allocate risks, capital, and cash flows to meet client objectives. To make sure that our structured finance transactions comply in all respects with that framework, the business transaction approval process requires adherence to applicable policies, as well as review and sign-off from internal legal, conflicts, tax, and accounting policy groups, among others, such as credit and market risk management. Transactions involving a special purpose vehicle receive special scrutiny and must comply with a special purpose vehicle policy administered by a committee to ensure that every such entity is properly approved, documented, and monitored. The primary responsibility for adherence with all policies and procedures, including those designed to address reputation risk, lies with the business units conducting the transactions in question. But in addition to this framework, J.P. Morgan Chase in August of this year put in place a new set of procedures designed to reinforce our focus on reputation risk and provide a senior level of review of transactions with clients. Business units are required to submit to regional policy review committees proposed transactions that may raise reputation risks for any reason, but specifically including transactions where a material objective is to achieve a particular accounting treatment, those designed to achieve a particular tax treatment, those where there may be material uncertainty about legal or regulatory treatment, those with highly complex structures or cash flow profiles, and those which have as a significant purpose or effect the providing of financing, but which take the form of derivatives. The members of the regional policy review committees, including the Americas Committee, are senior representatives of the business and the support units, including tax and accounting policies, in the region. Transactions are reviewed from every angle that could affect reputation risk, but including specifically, where applicable, the intended financial disclosure of the transaction by the client, and the committee approves, rejects, or requires further clarification or changes in the transaction. These committees and their deliberations are overseen by a Policy Review Office, which I lead, and transactions can be formally escalated by the committees to me. We at J.P. Morgan Chase believe that one of the tests of our leadership in the financial marketplace is to learn from our experiences and to adjust our practices in light of these experiences and the changing environment. The core lessons we have learned are, one, that we cannot rely solely on our clients and their experts to determine that our transactions with them will be properly accounted for and disclosed; two, that we need to make sure that our transactions with clients are not misused to deceive investors or others; and three, that even where these tests are met, we need to consider carefully whether transactions could be viewed adversely in a way that would be harmful to our reputation for integrity, fair dealing, and doing first-class business in a first-class way. I believe that the policy review process we have put in place and which I have just outlined, together with our business transaction approval policies and procedures, are well designed and are already serving to enable us to meet these standards. As a final note, I would add that as the biggest corporate lender in America and as one of the largest investment managers, we have as much interest as anyone in increased transparency and disclosure and integrity in financial markets. We have our money and our investment management clients' money at risk in our belief that those financial statements are accurate. I would, of course, be happy to respond to any questions the Chairman or other Members of the Subcommittee may wish to put to me regarding the policy review process. Thank you, Senator. Senator Levin. Thank you very much, Mr. Patterson. Mr. Traband, I believe you were going to proceed next. TESTIMONY OF ROBERT W. TRABAND,\1\ VICE PRESIDENT, J.P. MORGAN CHASE AND COMPANY, HOUSTON, TEXAS; ACCOMPANIED BY ERIC N. PEIFFER, VICE PRESIDENT, J.P. MORGAN CHASE AND COMPANY, NEW YORK, NEW YORK Mr. Traband. Thank you, Mr. Chairman. My name is Robert Traband and I am currently a Vice President of J.P. Morgan Chase Bank. I am making a joint statement on behalf of myself and Eric Peiffer. --------------------------------------------------------------------------- \1\ The joint prepared statement of Mr. Traband, Mr. Peiffer, and Mr. Feldstein, appears in the Appendix on page 107. --------------------------------------------------------------------------- Let me say at the outset, Mr. Chairman, that while we believe that our participation in the Fishtail and Flagstaff transactions was perfectly legal and followed established rules, had we known then what we know now about Enron's practices, we would not have engaged in these transactions with Enron. We would not have accepted at face value, as we did in 2000 and 2001, Enron's statements that its requests to structure Fishtail or Flagstaff in particular ways were designed to properly achieve Enron's desired financial statement treatment of the transactions in accordance with Generally Accepted Accounting Principles. In addition, we would have wanted to know more about the aspects of the transactions in which the firm was not involved. But at that time, we, like many other parties, dealt with Enron in the belief that it was one of the most respected companies in America and that it was not our role to second guess our counterparties' accounting or other structuring determinations. In the case of Enron, the firm suffered substantial injury, not only by the loss of hundreds of millions of dollars from its own transactions with Enron, but also from the injury to its reputation from the erroneous suggestions of some that the firm was involved in Enron's wrongdoing. For these and many other reasons, we regret that we ever dealt with Enron. Let me now turn to the specific transactions with respect to which the Subcommittee has requested information from the firm. The first of these transactions has been referred to by the Subcommittee and others as Fishtail. This transaction was a $41.5 million loan commitment extended by the firm in December 2000 to a special purpose entity named Annapurna LLC, established by Enron. This commitment expired by its terms in June 2001 and was never funded. Enron informed the firm that in anticipation of its ultimate contribution of the existing pulp and paper business to a joint venture, Enron wanted to deconsolidate its pulp and paper business from the rest of its businesses. Enron also told us that in consultation with its accounting advisors, it had devised a structure to achieve this objective. Enron would contribute its economic interests in the present and future contracts of the pulp and paper business to a newly formed entity, Fishtail, which would be jointly owned by Enron and Annapurna. As I have said, the firm's participation in this transaction was limited to a 6-month commitment to make a bank loan to Annapurna. The firm had no other involvement in the transaction. The decision to make a commitment to Annapurna was a reasonable credit decision and it is not at all unusual, as banks often make loan commitments with the expectations that they will not be funded. The firm acted as a leader--a lender in this transaction and, consistent with industry practice, it did not make any determination whether completion of the transaction would achieve Enron's accounting objective, a deconsolidation of Enron's pulp and paper business. Such determinations were properly for Enron to make with the advice and assistance of its internal accountants and external auditors. In this connection, I note that the Subcommittee staff report states that Arthur Andersen actually did approve this transaction. In December 2000, when the Fishtail transaction was agreed to, the firm had no reason to believe that any such determinations were not being made by Enron and/or Arthur Andersen, which was then one of the Nation's premier accounting firms, in accordance with Generally Accepted Accounting Principles. There is one final point I would like to make about the Fishtail transaction. It appears that Fishtail included a broader set of transactions by Enron to effectuate not just the deconsolidation of Enron's pulp and paper trading business, but to recognize income in connection with the sale of those assets. The firm was not involved in these other transactions, and indeed was told very little about them by Enron or anyone else, for that matter. The Subcommittee has also asked for information concerning the firm's understanding of and participation in the Slapshot project, particularly with regard to the Flagstaff transaction. As I will explain in greater detail, Slapshot was the name given by the firm to a generic form of transaction intended to permit a loan by a U.S. lender to a Canadian borrower, to be structured in a manner that would provide advantageous tax treatment to the Canadian borrower under Canadian law. Flagstaff was the name under which a specific transaction with Enron was undertaken in June 2001 to provide long-term refinancing for the acquisition of a Canadian pulp and paper mill, Stadacona, acquired by a joint venture in which Enron was a equity participant. In short, Flagstaff was an actual transaction; Slapshot was not. As the Subcommittee is aware, there are substantial differences in tax codes of other countries that taxpayers, including both individuals and businesses, may lawfully and properly take advantage of. Such a situation existed under Canadian tax law, but before proposing the transaction to any client, the firm's structured finance group solicited and received a written opinion of an independent and highly regarded Canadian law firm setting forth the likely tax consequences of that structure under Canadian law. Ultimately, the firm obtained written opinions from two leading Canadian law firms that the structure and the Canadian tax benefits it provided were legal and valid. As I have indicated, the Flagstaff transaction had its genesis in the planned purchase of the Stadacona Canadian paper mill by CPS, a Canadian corporation owned by a joint venture, Sundance, between Enron and another party. The firm did not participate in the formation of the Sundance joint venture. Documents shown to employees by the firm by the Subcommittee staff during interviews in preparation for this hearing reveal that there were many aspects of the structure and funding of the joint venture that were completely unknown to us. Indeed, at the time of the Flagstaff transaction, the firm did not know the identity of Enron's partner in the joint venture. In January 2001, representatives of the firm met with Enron to present a proposal under which a group of banks would make a loan to finance the acquisition of the mill. During the meeting, the firm advised Enron that it had concluded, based on the opinion of counsel, that the loan transaction could be structured in a manner that would provide advantageous tax treatment to a Canadian borrower under Canadian law. Enron informed the firm's representatives that Enron was aware of and had itself already devoted substantial attention to analyzing a substantially similar Canadian tax structure. Enron ultimately selected the firm to lead the bank group, but opted to complete the acquisition of the Stadacona mill in March 2001 with a bridge loan of approximately $375 million provided by Enron. The Flagstaff transaction was thereafter completed in June 2001 in order to repay the bridge loan and provide the long-term debt financing. The Flagstaff loan transaction was structured in a manner intended to permit the realization of the Canadian tax benefits by the Canadian borrowers. To the best of the firm's knowledge, this structure did not provide otherwise unavailable U.S. tax benefits to any party. We understand that Enron obtained and relied upon its own written opinion from Canadian tax counsel and that the anticipated Canadian tax benefits could and should be realized under the structure. As the Subcommittee is aware, the Flagstaff structure is highly complex, and among the several transactions that comprise the structure was an intraday loan of approximately $1 billion provided by the firm to Flagstaff. It also involved two special purpose entities created by Enron or its affiliates. The complexity of the Flagstaff financing and the legal documentation required to implement it was necessitated by Canadian tax considerations and were undertaken in reliance of the opinions of Canadian tax counsel to facilitate realization of the Canadian tax benefits. As the Subcommittee also is aware, the credit support for the loan was provided by Enron, principally through a total return swap and certain supporting transactions, rather than as originally contemplated, a guarantee by Enron. This change was specifically requested by Enron. One or more members of our team understood at the time that a principal reason for Enron's position on this respect was that Enron had concluded that a guarantee might require consolidation of the entire Sundance joint venture, the assets of which included CPS and the Stadacona mill. The firm understood that the use of a total return swap to facilitate the continued deconsolidation of the joint venture had been vetted by Enron with its external auditors, Arthur Andersen, and had been approved by them. The firm did not attempt to second guess this accounting judgment. As I have noted earlier, under applicable law and practice, each party is properly responsible to ensure that it correctly accounts for the transactions to which it is a party. At the time, the firm had no reason to believe that any such determinations were not being made by Enron and its external auditors in accordance with Generally Accepted Accounting Principles. Consequently, from the firm's standpoint, the issue presented by Enron's decision not to provide a guarantee was whether the total return swap provided sufficient credit support for Flagstaff loans, that the new arrangement could prudently be accepted by the banks in lieu of a direct Enron guarantee. Ultimately, we and the other members of the bank group each concluded that the total return swap provided adequate credit support. This concludes my statement, Mr. Chairman. I am happy to answer any questions. Senator Levin. Mr. Peiffer, you are not going to give a statement at this point? Mr. Peiffer. It was a joint statement on behalf of both of us. Senator Levin. Mr. Feldstein. TESTIMONY OF ANDREW T. FELDSTEIN,\1\ MANAGING DIRECTOR, CO-HEAD STRUCTURED PRODUCTS AND DERIVATIVES MARKETING, J.P. MORGAN CHASE AND COMPANY, NEW YORK, NEW YORK Mr. Feldstein. Thank you, Mr. Chairman. My name is Andrew Feldstein. As Mr. Patterson said, I am a Managing Director at J.P. Morgan Chase, and since March of this year, I have been the Co-Head of our Structured Products and Derivatives Group in North America. In addition, I work closely with Mr. Patterson on the firm's Policy Review Office, designing and implementing the policies to guard against participation in transactions that don't comport with our standards for integrity and our commitment to transparent financial markets. --------------------------------------------------------------------------- \1\ The joint prepared statement of Mr. Traband, Mr. Peiffer, and Mr. Feldstein, appears in the Appendix on page 107. --------------------------------------------------------------------------- I would like to say four things. First, based on my review of the facts from this Subcommittee's report as well as from my internal inquiries, I am convinced that neither Mr. Traband nor Mr. Peiffer nor anyone else at J.P. Morgan Chase knowingly aided and abetted Enron's apparently deceptive activities. Second, Mr. Chairman, you mentioned earlier today the need to root out corruption in financial statement presentations. We agree with you 110 percent. We think it is incumbent upon all participants in our capital markets to combat that type of conduct at every turn. We are with you. Third, what has changed? The processes that our firm has implemented and the culture that we are endeavoring to create at all levels of the firm are meant to avoid our firm's participation in transactions contrary to the principles of integrity and transparency. One thing in particular bears noting here. We now insist not only everyone that works for me in structured finance, but everyone in the firm, to ask questions, more questions, and more specific questions than were commonly asked 1 year ago. We no longer rely on the assurances of clients or their outside advisors when the facts and circumstances of proposed transactions should give us pause. I like to think that senior management chose people like Mr. Patterson and me to play a big part in this cultural evolution because we have the ability to be real thought leaders and we can work with all professionals in the firm to identify the indicia of transactions that must be thoroughly questioned. Finally, let me end with this. The fact that things are changing, whether internally at firms like ours or with the accounting rules, that is evidence of what is good in the U.S. capital markets. Participants join together with the encouragement of committees like yours to help make the markets work even better. I appreciate being given the opportunity to appear before you today and I look forward to answering any questions. Thank you. Senator Levin. Thank you all. Mr. Peiffer, let me start with some questions to you. You worked, as I understand it, on the implementation of the Slapshot deal and the negotiations with Enron, is that correct? Mr. Peiffer. That is correct. Senator Levin. As I indicated in my opening statement, I believe the details of that structure show it to be a sham and I would like to go through the $1 billion so-called loan that Chase, through an SPE or special purpose entity that it created called Flagstaff, made to the Enron special purpose entity called Hansen. The $1 billion that Chase sent to Flagstaff, which again was under its control, was returned to it on the same day, as a matter of fact, within a period of a few hours or even a few minutes, and I want to look at some slides that show the general schematic of the transaction. First, step one. Chase provided a $1 billion so-called daylight overdraft loan to Flagstaff, its own special purpose entity. That is a loan which existed for just a few hours, if that long. This is, I believe, Exhibit 303(a),\1\ if you want to take a look in your book. It may be hard for you to see that far. So step one, at the bottom right, a $1 billion loan from Chase to Chase's special purpose entity, Flagstaff. That is the daylight overdraft loan for the few hours. --------------------------------------------------------------------------- \1\ Exhibit No. 303(a) appears in the Appendix on page 190. --------------------------------------------------------------------------- Step two, Enron gets the $1 billion daylight overdraft from Citibank, runs the money through a few of Enron's subsidiaries, and puts it in an escrow account at Chase, and that escrow account you will see there is called Newman and that is another Enron special purpose entity. Step three, Flagstaff at that time, and only then, releases the Chase $1 billion and it goes through a number of Enron entities to Citibank. So Citibank now has got its $1 billion back a few moments later. And then as soon as Flagstaff releases the Chase $1 billion, Newman releases the $1 billion from the escrow account to Flagstaff and then back to Chase. Now, all of these transactions occur within a matter of hours, some within a matter of minutes. One billion dollars this way, a billion dollars, that way. Exhibit 352 \1\ is the funds flow schedule that was attached to the opinion of Enron's tax counsel, who is also your tax counsel. Notations next to the funding steps show that certain steps will be completed by certain times, and it shows that the $1 billion would be returned to Chase between 10 a.m. and 12 noon the same day that it left Chase. --------------------------------------------------------------------------- \1\ Exhibit No. 352 appears in the Appendix on page 525. --------------------------------------------------------------------------- Chase released over $1 billion from its left hand, took the money back with its right hand, and you designed the structure so that even though $1 billion was returned almost instantaneously, at least on the same day, there would be an appearance to Canadian tax authorities that there was an outstanding loan of $1.4 billion. Now, Mr. Peiffer, isn't it the case that the amount of the $1 billion, $1.039 billion to be precise, was mathematically derived to ensure that interest payments made on the $1.4 billion apparent loan would equal the principal and interest payments on the $375 million loan? Mr. Peiffer. That is correct. Senator Levin. So the $1.03 billion amount wasn't derived from some independent business need, it was simply the number required to make the tax transaction work, is that correct? Mr. Peiffer. It was the number required to make the tax transaction work as it was intended. Senator Levin. Now, the company receiving the loan, the so- called loan, was Hansen, a Nova Scotia unlimited liability corporation which had been established by Enron. Do you know when Hansen was incorporated? Mr. Peiffer. Where it was incorporated? I am sorry. Senator Levin. When Hansen was incorporated. Mr. Peiffer. Nova Scotia, I believe. Senator Levin. No, when, not where. Mr. Peiffer. I don't know when it was incorporated. Senator Levin. Well, I will tell you when it was formed, less than 2 weeks before this transaction took place. That was also the same day that Newman, the company that formed the escrow account, was created. Given how new Hansen was, do you believe that it was a company with an identified business purpose that warranted a $1 billion loan? Mr. Peiffer. I think here, it depends on what context you are defining business purpose. Senator Levin. The normal. Mr. Peiffer. In my understanding---- Senator Levin. Just normal understanding. Mr. Peiffer. My understanding is that Enron set up both Hansen and Newman to help effect this transaction and that for Canadian tax purposes, based on advice we and they received from our Canadian tax counsel, that the contracts they entered into constituted a business purpose. Senator Levin. So these were set up for this transaction, these companies? Mr. Peiffer. That is my recollection, yes. Senator Levin. What was the commercial business purpose that was associated with this $1 billion loan to Hansen? Mr. Peiffer. The loan to Hansen was actually $1.4 billion, and as you---- Senator Levin. I want to talk about the $1 billion portion of it. What was the commercial business purpose associated with that $1 billion, which was the majority of the $1.4 billion? Mr. Peiffer. I think it is hard to talk about, with all due respect, just the $1 billion portion, since it was one $1.4 billion loan. I will acknowledge that, of course, as you did, that $1 billion came from J.P. Morgan into Flagstaff and that J.P. Morgan was repaid that same day, and so at the end of the day, there was $375 million remaining in this joint venture. Senator Levin. Which was the real loan, correct? Mr. Peiffer. Yes, the real loan, the economic loan is what I would prefer to call it. However, if you look at the actual contracts, there actually was a $1.4 billion loan. Those were actual contracts that continue to be respected from a legal perspective to this day, and in addition to that, from a Canadian tax perspective, which follows much more form over substance type of regime, my understanding, not being a Canadian tax lawyer, but given the advice that we are given, that the Canadian tax advisers would respect that as a $1.4 billion loan. To answer specifically your question as to what the business purpose is, the business purpose of this transaction as a whole was to provide financing to Enron in a tax advantageous way, and the $1 billion---- Senator Levin. Tax advantageous way---- Mr. Peiffer [continuing]. And the $1 billion helped with that. Senator Levin. That was the tax advantageous part of the $1.4 billion? Mr. Peiffer. I think the right way to say it is that it did help with the making, of course, of the $1.4 billion loan, and that, taken together with the other contracts, given the advice that we were given from Canadian tax counsel, helped to generate the Canadian tax benefits that were intended. Senator Levin. But the $1 billion was the tax advantage portion, was it not, of the $1.4 billion? That is what created the tax advantage. Mr. Peiffer. The $1 billion helped to create the tax advantage. Senator Levin. Was there any other tax advantage, other than what was created by the $1 billion? Mr. Peiffer. There were only Canadian tax advantages generated with respect to the full $1.4 billion loan interacting with the other contracts. Senator Levin. But I am saying, if it had just been the economic loan, as you put it, the business loan of $375 million, there would not have been any tax advantage from that, would there? Mr. Peiffer. Right. I think it is fair to say that if it were only a $375 million loan, that Enron would have received tax deductions on that $375 million loan and that is it. Senator Levin. The interest on it? Mr. Peiffer. Yes. Mr. Feldstein. May I add something, Mr. Chairman? Senator Levin. I would rather not. I want to just keep going with Mr. Peiffer and then you can come in a little later, if you like. Mr. Peiffer, would Chase have approved the $1 billion loan, that portion of the $1.4 billion loan to Hansen, if it had not been assured that it would receive the money back immediately from an escrow account held by Enron? Mr. Peiffer. I think it is fair to say it would not. From a credit perspective, Chase obviously would be concerned about getting paid back that amount of money, and so felt more comfortable if Enron was either paying to us $1 billion first via a separate transaction, and preferably through an escrow account, which I recall is what--where Newman had the money prior to paying to Chase under the subscription assumption agreement. Senator Levin. So is it fair to say, then, that the $1 billion portion of that loan to Hansen would not have been made by Chase unless you knew that there was money in escrow to immediately pay that money back to you, is that fair? Mr. Peiffer. That is fair. Senator Levin. Now, Mr. Peiffer, you are listed on the incorporation papers of Chase's special purpose entity Flagstaff as Flagstaff's Vice President, and Mr. Traband, you are listed as the Treasurer of Flagstaff. So as corporate officers of Flagstaff, both of you, with fiduciary duty to the company, I take it that you would not have felt comfortable loaning $1 billion to Hansen if you didn't know that the same amount of money was already in an established escrow physically located at Chase and that Chase would immediately receive the money back from Enron, is that a fair statement? You wouldn't possibly be handing $1 billion out to this new company without being darn sure that that $1 billion was coming right back to you, is that fair to say? Mr. Peiffer. I think it is fair to say we would go to measures to make sure that $1 billion was repaid. Senator Levin. Mr. Traband, do you agree with that? Mr. Traband. Yes. We understood the full scope of the transaction. Senator Levin. Now, even though the $1 billion, then, of the so-called $1.4 billion was already returned, you have asserted that the--Mr. Feldstein, did you want to interrupt at this point? Mr. Feldstein. No, I think I will wait. Senator Levin. OK. Even though the $1 billion was already returned, you nonetheless have asserted in your testimony that the tax deduction for interest on the entire $1.4 billion was allowed in Canada, and Chase has put a great deal of emphasis on that assertion in its statements. I am aware that a Canadian law firm informed Chase that Slapshot would be acceptable. However, that same law firm had provided services to Enron and told their client that Slapshot was likely to attract scrutiny by Revenue Canada. Were you aware of the fact that advice was given, by the same lawyer who advised you, to Enron that this transaction would attract scrutiny by Revenue Canada, Mr. Peiffer? Mr. Peiffer. At the time of this transaction, I was not aware. I have since become aware. But to comment on that, I don't think it necessarily would be surprising to say that this transaction or any necessarily complex transaction with tax advantages would--might invite some scrutiny. Senator Levin. But you designed the structure to be hidden from authorities, Canadian authorities. For example, Flagstaff, which is your special purpose entity, was concerned because the $375 million that it received from the bank consortium had a different interest rate than the so-called $1.4 billion loan, so Chase could lose money. And so Enron and Chase considered alternatives to avoid that risk, and Exhibit 344,\1\ if you will turn to that, contains a chart depicting various alternative strategies to alleviate Chase's interest rate risk. The chart on page 12 of that Exhibit 344 addresses alternative one under this section, entitled ``Advantages.'' Advantages--there were three alternatives you were looking at to address your interest rate risk, three alternatives. --------------------------------------------------------------------------- \1\ Exhibit No. 344 appears in the Appendix on page 396. --------------------------------------------------------------------------- Alternative one had the advantage of not having a road map for Revenue Canada, and to read the exact words there, ``No road map for Revenue Canada. No swap by Enron on economic interest.'' Now, a few pages later in Exhibit 344 is a chart that summarizes all three alternatives. One of the advantages of alternative two--excuse me, one of the disadvantages of alternative two is that it leaves a potential road map. Do you see that on page 15, under alternative two, disadvantages? Mr. Peiffer. Yes, I do. Senator Levin. Potential road map. Who does it leave a potential road map for? That same Revenue Canada. And then looking at the disadvantages listed for alternative three, it lists under disadvantages, possible road map for Revenue Canada with respect to these alternatives. So it clearly was your design and your joint decision with Enron, is it not correct, that you wanted to avoid providing a road map to Revenue Canada, is that a fair statement? Mr. Peiffer. Well, what I think is unfair is to say that the transaction was designed to avoid scrutiny. I think with any tax advantaged transaction that any company would do, there is an inherent desire to avoid highlighting the transaction. This, in particular, the interest rate swap, I don't think had on the margin very significant ability to highlight or not highlight the transaction. As you can see, there are a number of boxes and arrows, so to speak, with the transaction. I think that if the transaction was to be audited or not audited based on that, and to isolate it to the interest rate swap, I don't believe was the case. I mean, it was one of many advantages or disadvantages under each alternative that we considered and Enron ultimately ended up choosing the alternative based on whether it felt it could get comfortable with taking on additional fixed-rate interest rate exposure. There was very little discussion as to the road map, and when Enron actually chose that alternative, my recollection of the conversation was that it was based entirely on its ability to absorb additional fixed interest rate exposure and that there was no concern or discussion about this potential road map issue that we are looking at here. Senator Levin. Whether there was discussion of it or not, this is a document that you used to pitch this particular approach, did you not? Didn't you design this? Wasn't this a Chase design? Mr. Peiffer. I was not heavily involved at all in designing the structure, as I am not a tax expert. Senator Levin. Was it Chase's design, though? Mr. Peiffer. It was Chase's design, using a good deal of existing technology, tax technology, let us call it, that existed and other tax regimes where form took a great deal of place over substance. Senator Levin. So in the Chase design, or its tax technology, as you call it, you listed the advantages and disadvantages of each of three approaches, and Chase listed an advantage of there not being a road map to a potential customer, and listing alternatives two and three having disadvantages of having potential road map or possible road map. That is what you were pitching to a client here, is that not correct? Mr. Peiffer. Well, at this point---- Senator Levin. Whether there was discussion of it or not, this is your document, isn't it? Mr. Peiffer. Right. This was an organizational meeting. It was discussing the transaction, assuming that the transaction would go forward. It is our document, but, again, it naturally would have been this company's preference to not highlight a transaction. Senator Levin. Which company, yours or Enron's, when you say---- Mr. Peiffer. Enron's. Senator Levin. Why would you want to not have a transaction be apparent, or be transparent? Why would you want to try to sell an advantage of an option as not being transparent to the tax folks and to avoid giving them a road map? Why did you want to avoid that? Why did you think Enron wanted to avoid that? Mr. Peiffer. I think it is customary that any company would rather not highlight a transaction with tax advantages, given that I think that the transaction itself would more or less highlight itself were it to be looked at by Revenue Canada, and they certainly would. Senator Levin. Well, if they were going to look at it anyway, then you wouldn't have to pitch the absence of a road map as being an advantage, would you? Mr. Peiffer. In the end, there ended up being very little, if any, discussion around this particular aspect of choosing the interest rate swap precisely because of that. Senator Levin. I am not so interested in whether there was a discussion. I am much more interested in why Chase would design a structure and make a pitch for one of the options as having the advantage of being less transparent to the tax authorities. If you have nothing to hide, it would seem to me that Enron would be perfectly willing to share all the information with the tax authorities. They would not care if they gave it a road map or not. Something was being hidden here by Enron. They didn't want this to come to the attention of the tax authorities. They had an opinion, as a matter of fact, which you say you didn't know about, but they had an opinion from the tax lawyer who also gave you tax advice on this transaction. The opinion from their tax lawyer and yours, but you say only to Enron, was that this would be challenged, or might be challenged by tax authorities in Canada, and then you went and pitched this deal to them on something that you obviously thought would be attractive to them, which is that it would not give a road map to the people that would challenge this or might challenge this. Mr. Peiffer. With all due respect, the opinion that Blake Cassels wrote to Enron took place a good number of months after this was put together, and so based on the opinion that we had, we believed, given the strength of the opinion, that even if it were challenged, that it was a strong transaction and that the tax benefits inherent in it would stand. Again, the interest rate swap was a very small aspect of this transaction, and so to say whether it was not highlighted or not, I think it is very difficult to extrapolate and say we are trying to hide or even not highlight the entire transaction. Senator Levin. That is not extrapolation. I am reading your document.\1\ --------------------------------------------------------------------------- \1\ Exhibit No. 344 appears in the Appendix on page 396. --------------------------------------------------------------------------- Mr. Peiffer. But with all due respect, this is a very small part of the entire transaction, and to say---- Senator Levin. I am not extrapolating. Mr. Peiffer [continuing]. And to say on the margin that this is what is hiding the transaction---- Senator Levin. Advantage No. 1, no road map. Advantage No. 2, no swap fees. Advantage No. 3, most preferable alternative, Canadian tax perspective. Mr. Peiffer. That is--I am sorry. Senator Levin. That is listed by you as advantage No. 1 for alternative No. 1. I am not reading something into this. I am reading your words. That is advantage No. 1. Mr. Feldstein. May I say something that---- Senator Levin. Sure. Mr. Feldstein [continuing]. Maybe helps to make sense of this, and if you will give me permission, I wanted to say something more broadly. I will get to your questions about the swap transaction, at least my impressions of what went on. But, as well, I wanted to talk about the $1 billion which you mentioned previously. So I want to start maybe with just some general comments on--very brief, I promise--on transactions with big tax consequences like this. I want to give you my impressions of the Slapshot deal based, of course, on 20/20 hindsight, and I want to really briefly, I promise, talk about what is different at our institution relative to when this transaction was done. So first, unlike in the United States, tax principles in some jurisdictions elevate the importance of the form of a transaction. Sometimes that helps taxpayers and sometimes it works to their detriment. It is usually accepted in these jurisdictions that taxpayers are entitled to structure a business transaction in the most advantageous form for tax purposes. In fact, their shareholders might say that companies are obligated to do that. So that is just general observation. My second point, which is on this specific transaction, I, too, am not a Canadian tax expert, but from what I have gleaned, from what I have read, including the report and internal inquiries, I believe that the Canadian tax laws relevant to this transaction are very formalistic. The business transaction, you described correctly, was a $375 million borrowing. The form of the transaction, including the economic reality, what was an economic reality, the $1 billion flow of funds, if respected, including all the separate entities and the separate instruments that were created under some very formalistic Canadian tax laws, showed a $1.4 billion borrowing and it was tax advantageous to do that and it was very formalistic. My impressions of the swap, to get back to the questions you were asking, is that it was also important, being a very formalistic regime, to make the swap look like it was swapping the transactions that were trying to be respected as the form of the transaction, i.e., swapping the $1.4 billion transaction, not swapping what the underlying business transaction was, which was the $375 million loan. From the review I have done and from your report, I glean also that the structures on this transaction received advice from Canadian tax counsel that the form should be respected. Tax counsel didn't say it was 100 percent certain, and generally, that is not a condition for structuring deals with material tax consequences. We know now, after the fact, that Enron received an opinion from tax counsel, and you were right, it was the same tax counsel that had previously represented Morgan, but my understanding in talking with people is that it was at Enron's request that we stop using that counsel so they could because it was their regular tax counsel. They received an opinion from that counsel on the specific facts of this transaction that heavily caveated the advice. My understanding is that no one from J.P. Morgan Chase saw that caveated opinion. So that brings me to item No. three, which is what would we do differently now, because I think we would do things differently. First of all, we now insist on advice from our own internal corporate tax department, which is separate from the business unit, an independent third party tax counsel of their choosing to give us advice on the specific facts of any transaction. I presume that on the specific facts of this transaction, given what we learned after the fact about the opinion that Enron received, that we might have had new and different information that may have--I was not there, so I don't know for sure, but that may have caused us to act differently in this case. Senator Levin. Why would you have acted differently, only if you had access to the legal opinion? Mr. Feldstein. Again, let me try to maybe---- Senator Levin. You said you might have acted differently. I am trying to figure out why. Mr. Feldstein. Maybe I wasn't---- Senator Levin. What would you have now that you didn't have then? Mr. Feldstein. I guess I didn't explain it well enough. What we didn't do then, but we do now, is with respect to any transaction with material tax consequences or transactions which appear to us to have material tax consequences, we take that transaction and all the specific actual facts of that transaction to our corporate tax group, a completely separate group within the firm, not part of the business unit. Based on the facts that we provide to the corporate tax group, their review of them, but also the review of outside counsel selected by the corporate tax group reviewing the specific facts of the deal, we get advice on the strength of the tax consequences or the tax analysis of that specific transaction. That step was not part of our policy when this transaction was undertaken, so that as you pointed out, the opinion delivered to Enron, not seen by us, caveated the original advice that J.P. Morgan Chase had received about the certainty of the tax consequences. It caveated it heavily. I presume, I don't know for certain, but I presume that if we had engaged our corporate tax group, if the people working on the transaction had engaged the corporate tax group and the corporate tax group had engaged the outside counsel, independent outside counsel that they would today, that J.P. Morgan Chase, as well as Enron, based on the specific facts of the deal as it was structured, would have received very heavily caveated advice about it. And if that were the case, the fact that we received very heavily caveated advice may have caused us to walk away from this transaction. The big policy change, again, because maybe I didn't express myself clearly the first time, is that all transactions of this nature, and not just ones where we know explicitly there is a material tax consequence, but ones that have certain indicia that lead us to presume that there are material tax consequences, there is a rule that now everybody follows willingly to take that transaction, the specific facts of the transaction to the corporate tax group for independent advice. Senator Levin. You very much hedged your statement. I think the bottom line is, would Chase be pitching this deal today? This is your design. This is your structure. Mr. Feldstein. Let me first---- Senator Levin. This isn't something Enron cooked up. This is something Chase cooked up. Would you be pitching this deal today? Mr. Feldstein. I think that is an excellent question. Senator Levin. I appreciate your saying that, but let me just have a clear answer. Would you be pitching this today? Mr. Feldstein. Let me answer it in two ways, first, specifically. We don't pitch this transaction today. Second, more generally---- Senator Levin. How would you pitch it today, given what you know about it? Mr. Feldstein. We would not pitch it today, given what we learned are the--we would not enter into this transaction the way it was---- Senator Levin. Let us get to it. You designed this structure. It is not entered into it. Mr. Feldstein. Let me---- Senator Levin. You designed the structure. Would you design a structure like this today? Mr. Feldstein. I do not believe we would. I was not there at the time, so I don't know what went into designing this structure. Senator Levin. That is why I am saying today. Would you design this structure today? Mr. Feldstein. Let me talk more generally, then, about what we do today that is different from what we did then in the design of transactions and the marketing of transactions. I would characterize the way the firm approached the business last year as a product-out approach. That is, the firm would design products like this and they would go and market those products to clients. We have reoriented our approach. I would describe the approach today as a client-in approach. As opposed to designing generic transactions that we market to any number of clients who may or may not have the appropriate situation for those transactions, we start from a specific client situation, understand what makes the most sense for that client, and sometimes there are tax consequences to transactions where we advise clients to do things in a certain way to take--to create a transaction that most effectively-- with the most effective tax consequences. But that is different from what I think the old orientation was, which was to design a transaction generically and market it. So on your specific question, I don't think we would have done this transaction today given the policies we have in place to understand more about it, and more generally, I don't think we do business the way we did business then. As a business matter, we are much more client-in as opposed to product-out. Senator Levin. But putting that aside, generic change, client-in, client-out, this is a structure, whether you design it or whether it is designed by somebody else. Would you be using this structure today? Mr. Feldstein. We don't use this structure today, so it wouldn't---- Senator Levin. Based on what you know about this structure, I know you don't, but would you use it, given its $1 billion fake appearance of a loan? Would you participate in this thing---- Mr. Feldstein. Given the tax---- Mr. Patterson. Can I take a crack at that, Senator Levin? Senator Levin. You folks helped to create the appearance of a $1.4 billion loan. It wasn't. It was an economic loan of less than $400 million. The billion you handed with this hand got it back with this hand. You helped them create an appearance which then, as you knew it, allowed that--because you sold it-- allowed that company to claim an interest payment for the full amount of what was really a payment of interest and principal. You knew you were participating in that. Now, you also knew that it might be recharacterized by the tax authorities in Canada and you even took steps to what would happen if the jig was up, if they caught on, if they didn't allow the interest payment on the $1.4 billion and they took that payment as being payment of interest and principal. You even then went to the lengths of deciding what would you do if Revenue Canada said, hey, wait a minute. That is not a $1.4 billion loan. That is a $400 million loan and the repayments of it are payments of principal and interest, not all interest. We are not going to give you a tax deduction, Enron. You folks even worked with Enron on what you would do then. My question is, would you participate in this kind of a transaction now? I don't care whether you design it or someone else designs it. You know what this transaction was. You know the details of it. Would you participate in this transaction today? That is my question. Mr. Patterson. I think not. The result that you describe seems quirky, but as Mr. Feldstein explained, there are some tax jurisdictions where form seems to triumph over substance. That is why we rely on the advice of tax counsel in those jurisdictions before we go ahead. In this case, as Mr. Feldstein said, we didn't consult the tax counsel in the same way that we would today, and I won't repeat everything he described, but we would have our corporate tax department, which is charged with looking after the firm's reputation in these matters, get its own outside counsel and get an opinion based on all the facts. I do not know, because I am not a tax counsel, whether we would get as clean an opinion today as would be necessary for us to go forward. But even if we did, sir, as I mentioned in my opening statement, beyond assuring compliance with all external requirements, including tax laws, even if we thought this one might work, I personally, as head of the policy review function, would have to take into account how this would look to the world if, as we always have to assume, it would be publicly disclosed, and whether even if it met all the legal requirements and passed muster under Canadian tax law, it would be difficult to explain and might adversely affect our reputation. And on that basis, knowing what I know, I would not market this structure today. Senator Levin. Is this just a matter of how it looks to the world? Is this just a matter of that? Isn't there something rotten about something which looks like a $1.4 billion loan which is a $400 million loan? Doesn't that trouble you as a banker? Mr. Patterson. Well, the public perception of it troubles me. If you put the--what if we went to the Canadian tax authorities and got an opinion from the Canadian tax authorities that it worked? It would still look kind of quirky, but it would not be viewed in Canada as rotten. Senator Levin. Would you be willing to do what you did with Enron back then in terms of figuring out, what are we going to do if the Canadian tax authorities find out about this, despite your lack of a road map, that they track it anyway, that they spend as much time as this Subcommittee staff had to spend to figure out what was really going on here, Canadian tax authorities, if they did that, if they reached the same conclusion that this was more than quirky, this is just simply misleading because you are pretending that there was $1.4 billion which was lent, when in fact it was only $375 million, and if they reached that conclusion, you folks worked, and if you will take a look here at Exhibit 351,\1\ you folks even had a recharacterization rider. You had a fallback. You had a safety net here if they caught on and if they recharacterized this. --------------------------------------------------------------------------- \1\ Exhibit No. 351 appears in the Appendix on page 514. --------------------------------------------------------------------------- This is your document. The rider attempts to recast any principal paid in excess of 25 percent of the recharacterized loan as instead being a loan to Chase, instead of from Chase. Here you have got Enron. You are cooking up a deal. This is something you are pitching, you pitched. Mr. Patterson. I actually think that was added by Enron to the deal we pitched. Senator Levin. All right. You accepted it. Mr. Patterson. We accepted it, yes. Senator Levin. You agreed to this rider, which says if they decide, if the Canadian authorities find out about it despite your lack of a road map, if they find out about it, you agreed with Enron that you would then retroactively recast this as a loan to Chase instead of from Chase. One of the biggest banks in the world is being lent money by a client. That is what you agreed to. Does that trouble you, not just the appearance if it is made public, does that bother you as a person, as a banker? Mr. Patterson. Well, the fact that we borrow money from a client doesn't bother me. It seems to me not surprising that one would try to anticipate what we would do if the initially intended tax results were rejected by the Canadian tax authorities. I assume in that context, I don't know, but I assume that the whole transaction would be transparent to the Canadian tax authorities at that time, including the recharacterization, and they might accept it or not accept it. Senator Levin. Is there any way in just common sense understanding that that could accurately be characterized as a loan to you? Mr. Patterson. To be honest, I am not familiar enough with the transaction to be able to answer that question. Senator Levin. Well, think about it, would you, and give us an answer for the record.\2\ --------------------------------------------------------------------------- \2\ Exhibit No. 391 appears in the Appendix on page 1006. --------------------------------------------------------------------------- Mr. Patterson. Whether---- Senator Levin. Would you do that? Would you give it a little thought and give us an answer for the record? Mr. Patterson. Whether it would be possible to characterize---- Senator Levin. Whether you think---- Mr. Patterson [continuing]. Recharacterize a transaction as a loan to us? Senator Levin. Whether you think that in any way could be fairly described as a loan from Enron to Chase. Mr. Patterson. Happy to. Senator Levin. My understanding, by the way, is that opinion that came to Enron from the lawyers came within a couple days of, what, the completion of the transaction. It wasn't, as you indicated, Mr. Peiffer, months later. It was just right around the transaction. Mr. Peiffer. My understanding---- Senator Levin. It is obvious Chase knew that there was a question about this. We might as well cut to the chase. It is obvious that you knew that there could be a problem. Whether that same tax lawyer gave you that advice that they gave Enron or not, you knew it because you had worked out what would happen if the Canadian authorities decided that this wasn't right. You worked that out. So you knew that there could be a problem with this. To that extent that you had a retroactive recharacterization to turn something which was a loan from you into a loan to you, and it is that recharacterization document which seems to me to speak volumes.\1\ It may only be a page, but it speaks volumes. It speaks about what Chase really believed. Whether you saw that opinion that the Enron folks got from that same lawyer or not, you knew there could be a problem. --------------------------------------------------------------------------- \1\ Exhibit No. 351 appears in the Appendix on page 514. --------------------------------------------------------------------------- Mr. Peiffer. Could I make a comment on this? Senator Levin. Please. Mr. Peiffer. Again, Enron came to us with this. We are not sure why--actually, I can say I do know why Enron came to us with this. In the event that the Canadian tax authorities would recharacterize this, or choose---- Senator Levin. Disallow it. Mr. Peiffer. Disallow, yes, choose to disallow it by choosing to recharacterize it as a $375 million loan, Enron was concerned specifically in that situation, if that was, say, a 20, 25 percent chance of that happening, which would be consistent with a ``should'' level opinion, then they wanted to limit the specific downside with respect to withholding tax. They and their counsel thought that this provision would have a chance of success with that. It is not something we came up with, nor was it something we even thought made sense for Enron to put in that, and we voiced that opinion to them. Senator Levin. You agreed to it. Mr. Peiffer. We didn't think it was needed. Senator Levin. Did you agree to it? Mr. Peiffer. Because of our strong opinions and what we knew their opinion to be, or that we thought it was going to be, but yes, we agreed to it and it was something that Enron even amongst themselves was deliberating. And so I think it would be incorrect to mischaracterize this as saying this is a reflection of what everybody thought of the deal. I think this was a specific clause to recharacterize something specifically, withholding tax benefits, withholding tax that would need to be paid---- Senator Levin. Sure. Mr. Peiffer [continuing]. If the intended tax benefits were not achieved, and my understanding---- Senator Levin. You agree---- Mr. Peiffer [continuing]. With a lot of tax transactions, whether in the United States, Canada, anywhere, is that there are provisions to address certain things like that if the intended tax benefits aren't achieved. Senator Levin. But Chase agreed to recharacterize something as a loan to it instead of a loan from it in order to help Enron avoid taxes. Mr. Peiffer. I think in order to, under the Canadian tax rules, potentially avoid withholding taxes if the transaction were--if the tax benefits with respect to the transaction were disallowed. That doesn't take away the strength of the opinions or what we or Enron believed to be the high probability of the tax benefits. Senator Levin. There is nothing to take away from those opinions, because you knew--Chase knew that this loan was not $1.4 billion. That much, we know you knew. You have acknowledged that. You knew it was an economic loan of $400 million. Mr. Peiffer. It was an economic loan of $375 million---- Senator Levin. Three-hundred-and-seventy-five million. Mr. Peiffer [continuing]. For legal and Canadian tax purposes, the advice we received is that it was, indeed, a $1.4 billion loan. Senator Levin. And you also knew that it was going to be challenged or could be challenged, and you also then agreed with Enron that if it were challenged, you would retroactively change its nature. You would recharacterize it so that Enron wouldn't be hit with taxes by Canada. You helped to perpetrate a fiction. You helped them perpetrate a fiction, because there was no $1 billion loan. Mr. Peiffer. I am sorry, I take exception with that. Senator Levin. You might take exception---- Mr. Peiffer. I don't look at this as perpetrating a fiction. Senator Levin. That is a fiction. There was no $1 billion lent to them. Mr. Peiffer. We have opinions from Canadian tax counsel---- Senator Levin. Was $1 billion lent to them or not? Mr. Peiffer [continuing]. With that---- Senator Levin. Was $1 billion lent to them? I know there was $375 million. I am not talking about that. Was there $1 billion lent? Mr. Peiffer. There was a $1.4 billion loan made to the subsidiary of---- Senator Levin. Of which $1 billion was repaid within minutes, is that---- Mr. Peiffer. Under a separate contract, with money coming from elsewhere in Enron. Senator Levin. Separate contract, it was repaid within minutes, wasn't it? Mr. Peiffer. I think the distinction here again to make is that Canada follows a very form over substance---- Senator Levin. I am not talking Canada. I am talking Chase, your reputation, transparency. We hear lectures about transparency, that you are going to be transparent. I am not talking about Canada. Canada will take care of itself. I am talking about Chase. You knew that the $1 billion of the $1.4 billion came right back to you, did you not? You knew that much. Mr. Peiffer. I knew $1 billion was coming back to us, that is correct. Senator Levin. Of that $1.4 billion. Mr. Peiffer. Money is fungible and it was two separate transactions and we were advised that the transaction as a whole should be split up into two separate transactions, and yes, we did receive $1 billion back. Senator Levin. Did you get a legal opinion about this recharacterization? Mr. Peiffer. We did not---- Senator Levin. When you agreed to this---- Mr. Peiffer. There was no need for Chase to. Senator Levin. When you agreed to this, was there a legal opinion on this that Chase got? Mr. Peiffer. With respect to this, in the context of this, Chase did not need to receive a legal opinion, but my understanding is that Enron received advice from their Canadian tax counsel that it might be advantageous to put this in there in the event that this were audited and all the facts had become known and that there is the potential that this might do something for them. Senator Levin. You understood that Enron got an opinion from its lawyers about this? Mr. Peiffer. Yes, I do. Senator Levin. But you didn't? Mr. Peiffer. We had an opinion based on the generic transaction, the generic structure---- Senator Levin. No, I know that---- Mr. Peiffer [continuing]. But with respect to---- Senator Levin. The recharacterization. Mr. Feldstein. My understanding is J.P. Morgan Chase did not get an opinion on the specific details of the transaction. Mr. Peiffer. Right. Mr. Feldstein. Today, we certainly would. Senator Levin. Mr. Peiffer, you helped dream up Slapshot and helped develop it. Were you rewarded in any way by your supervisors for this, any special way? Mr. Peiffer. I think it is fair to say? Senator Levin. Was there a bonus, special bonus of any kind? Did you get---- Mr. Peiffer. There was no special bonus with respect to this. I think it is fair to say that it was one of many elements that, you know, played into the paying of a year-end bonus. We would all have been much better off, I think, also, if we had never made any of these loans to Enron and Enron had not gone bankrupt and the bank had more money to pay the bonuses. We all would have been better off if that were the case. Senator Levin. Let me conclude by just saying this. You have got some language on your website which says that banks were victims in fraud cases, not accomplices. All I can tell you is this, that this is a structure which you folks designed. You are not the victim here. You designed a structure. You sold a structure. Part of the sale was that it would not be providing a road map. You then agreed if, in fact, the Canadian tax authority would find that was not allowable, even agreed retroactively to recharacterize a loan from you into a loan to you. You folks aren't victims here. Mr. Feldstein. May I add something? Senator Levin. You folks helped a deceptive practice by Enron to be perpetrated, and it is--I am glad you are changing your approach. I can't tell you how glad I am. I will look forward, Mr. Patterson, to your answering the question for the record that you said you would think about.\1\ --------------------------------------------------------------------------- \1\ Exhibit No. 391 appears in the Appendix on page 1006. --------------------------------------------------------------------------- But it is important that we all worry about how things look, and that is important. But what is more important is how things really are. Mr. Feldstein. Could I just address your comments about the victim? My interpretation of that was that financial institutions were the victims of deceptive accounting practices and disclosure practices, or apparently deceptive practices at Enron. This transaction, and we have gone through the certainty or lack thereof in terms of the tax consequences, but this had nothing to do with the accounting presentation that Enron provided, but rather was a transaction which rested upon whether Canadian tax law would respect the form in which it was structured, and the victim comment, I think, is about the apparent accounting deception practiced by Enron, which is a different subject, I believe. Senator Levin. Your prepay pitch book back in 1998, if you look at Exhibit 128, says the following. This is what you were pitching. Prepayment received for a forward sale of inventory, fixed quantity, specific delivery locations. Your third dot says, balance sheet-friendly. Is that still the kind of pitch you would make, balance sheet-friendly, or balance sheet accurate? Which is more important? Mr. Feldstein. Balance sheet accurate. Senator Levin. Is it fair to say, Mr. Patterson, you wouldn't be making a pitch quite like that anymore? Mr. Patterson. I don't have it and can't see it, but---- Senator Levin. It is Exhibit 128. Mr. Patterson. I don't think we have No. 128 here. Senator Levin. I am sorry, I have got the wrong number. It is Exhibit 169. Mr. Patterson. I don't think we have that, either. Senator Levin. Let me try again, Exhibit 369.\2\ --------------------------------------------------------------------------- \2\ Exhibit No. 369 appears in the Appendix on page 687. --------------------------------------------------------------------------- Mr. Patterson. Three-sixty-nine. No, I think that we probably would not use that terminology today. That doesn't mean that accounting considerations are not relevant to our clients and to the transactions they enter into. They are structured in a way to comply with accounting rules. So accounting considerations continue to be an important part of structured finance. The key is that the accounting treatment be correct and not misleading. Senator Levin. Thank you. Thank you all for your appearance here today and we wish you good luck in greeting the weather on your return home, and we also wish you good luck in implementing fully and forcefully your new approach. It is important that our institutions, the ones we rely so heavily on, such as Chase and Citibank and others that have been such an important part of this economy, have the confidence and credibility of the public. I hope your new guidance has an impact in that regard, both internally and externally. Thank you all for coming. Mr. Patterson. Thank you, Senator. Mr. Peiffer. Thank you. Senator Levin. Ms. Siebert, we now welcome you, President and Chair of Muriel Siebert and Company of New York. Ms. Siebert gained fame as the first woman member of the New York Stock Exchange and Superintendent of Banks for the State of New York, now an owner of a discount stock brokerage firm, one of our wise elders--I hope you won't mind that description--when it comes to finance and the securities business. I want to thank you for your travels here today from New York, also fighting the elements. Pursuant to Rule 6, as I have mentioned to all of our witnesses, our witnesses need to be sworn because of that rule of the Subcommittee, and so I would ask you to please stand and raise your right hand. Do you swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Ms. Siebert. Yes, I do. Senator Levin. Ms. Siebert, I think you have a statement, which we would ask you now to proceed with. TESTIMONY OF MURIEL SIEBERT,\1\ PRESIDENT AND CHAIR, MURIEL SIEBERT AND COMPANY, INC., NEW YORK, NEW YORK Ms. Siebert. Yes. I submitted a written statement, but I have an abbreviated oral statement. I would like to thank you for inviting me. I am sorry I was late, but I came by way of LaGuardia Airport and then the train because they canceled our flights, so I apologize for being late. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Siebert appears in the Appendix on page 113. --------------------------------------------------------------------------- Senator Levin. Actually, you are right on time, except you missed some testimony. Ms. Siebert. Terrific. I commend your Subcommittee for tackling this very tough, nasty job. You know, it will be 35 years ago that I became the first woman member of the New York Stock Exchange, and at the time, while many people did not want me, I joined a group where your word was your bond and you would go broke before you broke your word. Things have changed when I look at the Enron transactions. The money became too vast and it was made too fast. I am sorry to say that greed became the creed. Enron, in my opinion, represents a total moral bankruptcy. It took more than the officers and the directors of the company. It required help from the accountants, the lawyers, and the investment and commercial banks. Many people profited from these transactions, except the investing public, many of whom will never be able to make their losses back. It has affected their future retirement and we have to make sure this does not happen again. My interest in Enron really began in February. I received a call from the man that runs our retail discount operations and he told me that he was seeing things that he never saw before. We had clients selling out their entire portfolios and requesting a check. We would not see that transaction if they sold their entire portfolios and went into a money market fund. That would be an automatic sweep. But when they requested a check, it took an action on their part and our part. I asked Peter, because we call every customer that leaves our firm, and if it is because their nephew has gone to work for Merrill Lynch, so be it. God bless them and good luck. If it is because of something we have done wrong, I want to know about it. So I started to get the reports every week, and the answer was, don't trust the integrity of the system. The system is against us. We can't let this happen. The reports have continued to come in that way, although very few people compared to what we had before. Our capital raising system is a national treasure. In the 1990's, the United States created tens of millions of new jobs. Every new technological development was made in the United States, and for most of the decade, at least the early part and middle part of the 1990's, the market was orderly and the public, the small investors, started to invest. First, they bought mutual funds. They wanted to own a piece of America. After I received the same answers for a few weeks, I realized the seriousness of the abrupt change in our investors' attitudes. Many of them, when we called them, specifically mentioned Enron. Sure, that was probably because there was a lot of publicity going on at that time, but they had been hurt in bond funds and other products. I will give you an example. When I gave a speech for the Miami Herald at their yearly investors' conference, a man in his 80's during the question and answer period told me, ``I lost a third of my money. Will they go to jail?'' This is serious. Enron could not have happened without two new financial products, derivatives and structured finance. These products in themselves are not bad. It was the purpose that was employed that was terribly wrong. They were used to deceive. The financial engineering permitted operations by legal loophole. Derivatives are not new. I testified in 1988, I have it here, after the 1987 market break. That was portfolio insurance. The regulators passed some laws and portfolio insurance is finished. I testified in 1998, 10 years later, after long-term capital market. Our country, frankly, lucked out in Long-Term Capital Management. Bob Rubin was our Secretary of Treasury and he was the only Secretary of Treasury that has ever come from the trading desks. He had helped invent derivatives. He knew what to do. Long-Term Capital Management had an equity, it is reported, of $4 to $5 billion and they were carrying, using derivatives, the notional value was over $1 trillion. When they made the wrong bet, major margin calls were threatened. The Federal Reserve called in the firms downtown. They called in the banks and they put together money and they took over the operations of Long-Term Capital Management and we liquidated it in a way that the public was not hurt. When I continued to see the attitude of our individual investors, in late spring, I said, well, I had better go down to Washington and tell some people what I am seeing, because I had never seen this before. So I had lunch with Larry Lindsey. I had a telephone appointment with Secretary O'Neill and I spent time with Mr. Pitt and his deputies. I recommended three things. Under Sarbanes-Oxley, officers of corporations must certify the authenticity of the earnings reports. I recommend that we add a statement to those reports that these figures represent economic reality. That would eliminate the sham transactions. That would have eliminated the phony energy trades. No officer would sign a statement that the transactions that your Subcommittee is examining represented economic reality. Enron was the leader in energy trading when it became deregulated. They used legal loopholes to create an illusion of activity. The trading practices of buying and selling on the same day, the same amount, at the same price, are illegal. They are considered to be wash sales in the listed markets. In the over-the-counter markets, they were legal. Other formerly solid conservative utilities participated in these trades, which are still being unraveled. As a result, some of these utilities have had to reduce or suspend their dividends. Most of these stocks are owned by individuals who count on the dividends for their livelihood. In some cases, the price of some of these utility stocks have been cut in half very fast, literally overnight. Now, when companies issue debt, they have an indenture which spell out the terms that these bonds are being issued under. It is their covenants, for example, the ratio of interest coverage, the ratio of asset coverage, the rating of bonds by rating agencies. If these covenants are violated, they have debt triggers in there whereby certain things are triggered. They can force a company to repay the bonds immediately. It is very difficult for individuals or institutional investors to get the terms of these bonds. They would not have owned a lot of these securities had these terms been readily available. I recommend that the debt triggers and terms of indentures on bonds, as well as covenants or terms in the preferred stocks, be made available easily and be listed on the corporation's website so that anyone who takes the effort, who wants to invest money, I do not care if it is 100 share of a Duke preferred stock or a Dominion preferred stock, can see the terms and see under what circumstances their income might be stopped or they will lose their protection. Finance is now global. It is almost impossible for regulators to keep up with the fast-moving technology. The SEC and Federal and State regulators, bank regulators, together could identify these transactions if the information was furnished. Otherwise, it is very hard for them to get into this. The SEC could have identified it. The Federal bank and the State bank regulators could have identified some of these transactions. It is difficult for U.S. regulators to act unilaterally. It will have the effect of driving the business offshore, but will not stop the business. We know we are going to have global bank regulations. We have some now. We will have global accounting standards. I suggest that our country be the leader to establish global securities regulations, that we include derivatives and margin requirements and other things that are used to get around the purpose of the laws. Certain laws and regulations have been passed which will stop the same practices from occurring again, but we must make sure that our focus is on the individual investor also, and that it is geared towards reinstating their faith in the system. Thank you for inviting me and allowing me to participate. Senator Levin. Thank you very much, Ms. Siebert, for your very thoughtful testimony. I don't know how much of the testimony this morning you were here to hear. I know you had to take a train when you expected to fly, but I think you have had an opportunity to look at the transactions which we were discussing here this morning in the report of our staff. What is your reaction to those transactions that you read about in our report? Ms. Siebert. They were designed to deceive. They were designed to create the illusion of certain economic events. I do not see the economic reality for it. Senator Levin. I think your testimony probably answered this question, but I will ask it, in effect, again. Are these the types of transactions that we want our major banks not only participating in, but designing and selling to public companies and to other clients? Ms. Siebert. No, they are not the kind of transactions, and I would also say that if they do participate in those kind of transactions, they should not have the benefit of FDIC insurance. Senator Levin. We are going to be hearing from our regulators in our next panel and we want to find out what is being done to stop this kind of deceptive practice, and I am wondering whether you would agree that our regulators need to not only take enforcement actions on a case-by-case basis to punish wrongdoers, but also to construct a regulatory deterrence program to deter future wrongdoing. Ms. Siebert. I believe they can do it. Our regulators are really a top quality group. The Federal Reserve and Federal bank regulators, the State bank regulators, the SEC, they have dedicated staff there. I mean, it is wonderful to see them. But I also believe that the information must be furnished them so they don't have to go hunting for it. Senator Levin. And if that information is furnished for them, or to them, excuse me, would it be useful if they can design, as you put it in your testimony, acting together with the SEC and the bank regulators acting together to regulate the kind of transactions which we have heard about and talked about here at this Subcommittee. Ms. Siebert. I believe it is. For a long time, I have said that we need regulation by function, because investment banks are doing the job previously done by banks and banks are doing the job previously done by investment firms. So they will have to work together. Normally, I don't like to see Uncle Sam and the regulators get too big, but it is probably the only way where we can effectively put our arms around this problem. Senator Levin. And in terms of the information that you say is so important for them to have so that they can act, would you feel it would be helpful if the SEC and the bank regulators conducted a comprehensive joint review of these structured finance products which are being sold by or used by our financial institutions so that they could identify the ones that are designed to deceive? Ms. Siebert. Yes, I believe that would be very welcome and necessary. Senator Levin. Our thanks again. You are a frequent visitor to committees of the Congress, to be providing the kind of testimony which comes from your experience and we are very grateful for that testimony and for your experience, for what you bring to the world in which you spend a great deal of your time. Ms. Siebert. I believe in the system. It has been very good to a lot of us. Senator Levin. It has, and we are going to do everything we can to make sure that system is strengthened and that credibility in it is restored, and it is going to take, I believe, at least, a combination of the entities, the institutions, the financial folks acting on their own to clean house, but it also is going to take a stronger regulatory arm, and we are going to talk to our regulators right now and see whether they are in agreement with that. Thank you again. Ms. Siebert. That is great. Thank you. Senator Levin. Let me now introduce our final panel of witnesses who represent one of the most important pieces to this puzzle and that is our regulators. We not only thank you for making it--I don't think you came quite as far as our other witnesses, but you have waited longer. I hope that it was worthwhile to you in terms of the testimony that you heard here. It is a very complicated subject that you live with and we are dealing with and we have spent a lot of time attempting to understand it and our staff has spent a huge amount of their time putting together a staff report, which I think has been made available to you. We have at our witness table today Richard Spillenkothen, Director of the Division of Banking Supervision and Regulation at the Federal Reserve. I think Ms. Annette Nazareth is on her way. She is the Director of the Division of Market Regulation at the Securities and Exchange Commission. And Douglas Roeder, Senior Deputy Comptroller for Large Bank Supervision at the Office of the Comptroller of the Currency. This is a very distinguished panel. We know that they are involved in a lot of things and had to sort out their schedule to make it possible to be here today. We look forward to hearing your views. As I have indicated, pursuant to Rule 6 of this Subcommittee, all witnesses who testify before us are required to be sworn, and at this time, then, I would ask you to stand and raise your right hand. Do you swear that the testimony that you will give before this Subcommittee today will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Spillenkothen. I do. Mr. Roeder. I do. Senator Levin. I think, Mr. Spillenkothen, we are going to call on you first. TESTIMONY OF RICHARD SPILLENKOTHEN,\1\ DIRECTOR, DIVISION OF BANKING SUPERVISION AND REGULATION, THE FEDERAL RESERVE, WASHINGTON, DC Mr. Spillenkothen. Thank you, Mr. Chairman, for the opportunity to testify on the continuing efforts of the Federal Reserve Supervisors to address issues emanating from the excesses of the recent credit cycle, including large corporate defaults and accounting irregularities. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Spillenkothen appears in the Appendix on page 117. --------------------------------------------------------------------------- The focus of today's hearing, on how complex structured financial products provided by banks and other financial institutions were used by their customers to obscure financial statements or to engage in questionable tax strategies, is timely. Events of the past year, such as the bankruptcy of Enron, have focused attention on the need for strong risk management, sound accounting, improved disclosures, and more active corporate governance oversight to avoid the kinds of losses that have been costly both in very real human and economic terms. The Federal Reserve has been reviewing bank participation in the types of structured financial activities that have raised significant legal and accounting questions and I will discuss the status of our efforts in a moment. I will also briefly discuss both our supervisory expectations for banks involved in transactions such as those that have been the focus of this Subcommittee, as well as how we are considering amending our procedures and refocusing our supervisory reviews. But first, I would like to say a word about the role of bank supervisors. The primary focus of the Federal Reserve's supervision is ensuring an institution's overall safety and soundness, as well as compliance with banking and consumer laws and regulations in a way that protects the Deposit Insurance Fund and the consumer while promoting stability of the financial system. As part of this risk-based approach to supervision, examiners focus primarily on areas posing the greatest risk to the institution, primarily credit risk, market liquidity, legal, and reputation. In carrying out our responsibilities, the Federal Reserve coordinates its supervisory activities with other Federal and State banking and securities agencies, such as my colleagues here from the OCC and the SEC, other functional regulators, and the bank regulatory agencies of other nations. If in the course of their review examiners have reason to believe that a bank is engaging in questionable activities that might relate to a possible violation of securities laws, then supervisors would refer those matters to the SEC as the primary interpreter and enforcer of those laws. I would say for an example, recently, Federal Reserve supervisors identified transactions by a banking organization, not one the subject of these discussions, but by a banking organization that raised concerns regarding the bank's accounting and public disclosure. In this case, we referred those potential securities law violations to the SEC, and in coordination with the SEC and the bank's primary regulator, took enforcement action and remedial action in a coordinated fashion. Now, some basic principles and expectations for banking organizations guide our work in examining complex financial transactions. First and most obviously, banks must obey the law. In particular, they must have policies and procedures in place to ensure that they are in compliance with all applicable laws and regulations with regard to a particular activity or product. Second, banks should perform thorough due diligence on the transactions they are engaged in or involved in and check with appropriate legal, accounting, and tax authorities within their own organizations, as well as their outside experts when appropriate, and also provide appropriate and relevant information to their customers. However, banks ordinarily should not be held legally responsible for the judgments and actions or malfeasance of their customers. Such an expectation would require, inappropriately, in my judgment, banking organizations to assume management responsibility for their customers and also could place undue significant costs on banking organizations to audit the activities of their customers. However, banks must not participate in activities of their customers that the banks know to be illegal or improper, nor should banks engage in borderline transactions that are likely to result in significant reputational or operational risks to the banks. Third, the role of banks is to assume and manage all the attendant risks related to their activities as financial intermediaries. In light of recent events, banking organizations should be, and indeed are, reevaluating the risks related to both their traditional as well as their new products, recognizing that as financial markets and practices change, legal and reputational risks may manifest themselves in new ways or in new magnitudes not previously recognized. As part of our supervisory review of complex structured transactions, we are assembling and evaluating the various findings and observations of our examiners, as well as the conclusions of other primary and functional regulators we work with, and identifying any necessary follow-up. While I am unable to discuss ongoing Federal Reserve supervisory reviews, as you know, there are several transactions that are currently under investigation by the SEC and other enforcement agencies with whom we have strong working relationships and with whom we have conferred on these matters. We are continuing to collaborate with them and receive their views and conclusions on various matters on an ongoing basis. As our fact finding is completed and our conclusions are drawn, we will provide institutions with feedback on any identified weaknesses, and if warranted, take appropriate supervisory corrective actions, including referrals to other authorities. More generally, in light of recent events, we have already modified our examination plans for larger banking organizations to focus more fully on evaluating the largest customer relationships, that is, the large relationship with the customers that they have and also looking at the overall customer relationship, not just a transaction-by-transaction basis. These plans or examinations cover the specific areas of concern in the structured finance business and an evaluation of the steps banks are taking to manage the credit, legal, and reputational risks in response to events of the past year. We will also be looking at the new product review process and how they manage the real and reputational risks in the new product review process. We have already begun the process of modifying our examination guidance and are considering additional supervisory guidance or regulatory changes, especially in the area of structured finance, and if we do this, we will obviously work with our colleagues from the other banking agencies and, as appropriate, the SEC. In this connection, we will also evaluate the range of reforms banking organizations are adopting, and once we are able to observe their performance and practice, consider whether there are some sound practices that should be adopted more widely within the industry. In closing, the fallout from the recent round of excesses and large corporate defaults appears to be resulting in some positive steps by corporations, banks, and capital markets. Supervisors should play a positive leadership role and work to ensure that these corrective actions, that their ongoing supervisory activities reinforce these corrective steps and help them to endure over the longer term. If banking organizations, corporations, and supervisors are attentive to the lessons learned over the past year and adopt appropriate policies and controls, the risk of repeating similar excesses in the coming years should be substantially reduced. Thank you. Senator Levin. Thank you very much, Mr. Spillenkothen. Mr. Roeder. TESTIMONY OF DOUGLAS W. ROEDER,\1\ SENIOR DEPUTY COMPTROLLER FOR LARGE BANK SUPERVISION, OFFICE OF THE COMPTROLLER OF THE CURRENCY, WASHINGTON, DC. Mr. Roeder. Thank you. Chairman Levin, thank you for inviting the OCC to participate in these important hearings. I am Douglas Roeder, Senior Deputy Comptroller for Large Bank Supervision. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Roeder appears in the Appendix on page 123. --------------------------------------------------------------------------- Let me begin by commending the Subcommittee for holding these hearings. Enron's failure has been nothing short of a national tragedy, especially for the thousands of Enron employees who lost their jobs and retirement savings. At its height, Enron was a multi-billion-dollar corporation whose influence was wide ranging and far reaching. Inevitably, some of its business involved national banks which operate under OCC supervision. In my statement, I would like to focus on the steps that national banks and the OCC as their supervisor are taking to help prevent Enrons from occurring, future Enrons. The OCC is responsible for supervising over 2,000 banks, some of which are the largest in the world. Resident examiners working in these large banks use a risk-based approach to supervision, an approach that takes into account the various sources of risk to a bank. Because credit risk has traditionally posed the greatest threat to safety and soundness of banks, much of our supervisory attention has traditionally focused on credit issues. However, the Enron situation demonstrates just how significant other types of risk can be. As a result, we have asked ourselves how our current approach could be enhanced. First, we intend to focus more intently on banks' procedures for authorizing new products. Our examiners will evaluate the bank's system to ensure that a comprehensive process exists for senior managers to review and approve new product offerings. Also, we believe it is important that the new product approval process is sufficiently robust to capture even seemingly small changes that could transform an existing product into one that poses an entirely different degree or type of risk. When in doubt as to whether a product requires vetting through the new product approval process, we encourage bank management to take a conservative approach and to apply the process to the proposed product or activity. Going forward, we will sample more extensively transactions going through the banks' new product approval process. In particular, we will check to see whether banks are complying with their own processes and whether proper review and authorization are received prior to engaging in complex structured transactions. In addition, we are in the midst of discussions with the other banking agencies to determine whether interagency guidelines should be revised to more specifically address board and senior management responsibilities for the approval and oversight of new products, such as complex structured products. Second, while banks' board and senior management may place their stamp of approval on a new product, the bank must also carefully consider the appropriateness of complex structured transactions from the standpoint of the bank's client. This represents a shift in our approach into supervising such transactions. In the past, our focus has been on how well the bank assesses the sophistication of the customer and that customer's ability to perform under the terms of the contract. We will now ask our examiners, in addition, to determine whether bank management understands the customer's disclosure and accounting intent. While it is not realistic for banks to be held responsible for how customers account for transactions on their own financial statements, it is incumbent on bank management to carefully consider the potential impact of their actions on the bank and to decline to participate in transactions that do not meet the standards of integrity that the bank has established. Third, we plan to review large relationships, even if credit risk is low, and flag structured products during our credit work for potential further review. We think it is important that bank management establishes controls that encompass the bank's total relationship with its large customers. Competitive pressures are a natural part of any business environment, but care must be taken to ensure that line managers eager to retain or expand business with important customers don't cross the line and jeopardize the trust and credibility that forms the foundation of a bank. It is encouraging to report that banks are studying and learning from the Enron experience, whether or not that experience was firsthand. Banks that offer complex structured transactions have come to realize that they stand to suffer great harm if they are implicated in questionable activities conducted by their customers. As a result, banks have taken steps to improve their internal controls of complex structured transactions and special purpose entities. Some banks have made changes to management, establishing new oversight committees, developing new policies and procedures, tightening controls, upgrading internal reporting to management and the board, and improving the quality and quantity of disclosures. Banks have also strengthened their review and approval processes for complex structured transactions. This includes expanding the definition of products to be approved and enhancing the approval process to provide for a broader range of senior-level management review. Also, banks are putting a greater focus on assessing customer motivation and appropriateness, including securing representations from customers regarding disclosures and accounting treatment. We believe that these are all positive steps toward strengthening internal processes. We are currently evaluating the responses of national banks and will assess these reforms as they are implemented. I also want to highlight another important facet of the supervisory process. That is the interaction among the Federal regulatory agencies. The ability to make and receive referrals ensures that the agency with the appropriate authority and expertise is involved. We are coordinating our reviews of national banks' previous involvement with Enron with the Federal Reserve and the SEC. Because this is an open matter, I am unable to comment institution specific details that pertain to the current reviews underway. Thank you once again for inviting OCC to testify at this important hearing. Senator Levin. Thank you very much, Mr. Roeder. Let me welcome Ms. Nazareth. We know that you were late, tied up somewhere, but we are going to need now to swear you in as we do all of our witnesses, so I would ask you to stand and raise your right hand. Do you solemnly swear that the testimony that you will give before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Ms. Nazareth. I do. Senator Levin. Thank you. Ms. Nazareth, thank you. TESTIMONY OF ANNETTE NAZARETH,\1\ DIRECTOR, DIVISION OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, DC Ms. Nazareth. Thank you, and I apologize for being late, Mr. Chairman. My name is Annette Nazareth and I am the Director of the Division of Market Regulation at the Securities and Exchange Commission. I would like to submit my written testimony for the record and briefly summarize, if I may. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Nazareth appears int he Appendix on page 134. --------------------------------------------------------------------------- Senator Levin. Thank you, and it will be made part of the record. Ms. Nazareth. Thank you. I will take just a few minutes to highlight a couple of key points. First, the SEC has significant powers to investigate possible violations of the Federal securities laws and to enforce those laws through civil and administrative actions. The Commission to date has charged two former Enron officers with fraud based on their participation in transactions designed to mislead investors about Enron's financial results. The Commission's investigation is ongoing and the Commission's Division of Enforcement continues to work diligently and vigorously with the Justice Department's Enron Task Force to ensure that all those responsible answer for their misdeeds. While I cannot speak publicly regarding the specifics of any ongoing investigation, several aspects of the Commission's general enforcement authority are particularly relevant to the issues of disclosure and transparency that are at the root of the problems you are examining today. The Commission has clear authority to proceed against public companies that file false information as part of their financial statements. Such conduct is potentially subject to various provisions of the Federal securities laws, including the requirement that companies' filings with the SEC be materially complete and accurate and the SEC's general anti- fraud authority. The Commission brings numerous actions, 163 this past fiscal year, based on false and fraudulent financial reporting and disclosures. Among these was an action the Commission recently brought against a public company for, among other things, using an undisclosed off-balance-sheet special purpose entity to dramatically overstate the company's cash flow from operations. Cases like this make clear that public companies using off-balance-sheet special purpose entities must ensure not only that their accounting treatment compiles with Generally Accepted Accounting Principles, known as GAAP, but also that they have accurately portrayed the economic realities of the transaction. The Commission also has explicit statutory authority not only to proceed against primary violators of the Federal securities laws, but also against aiders and abetters of those violations. The Commission aggressively employs this authority. In addition, the Commission may order any person who is or was a cause of a violation of any provision of the Exchange Act due to an act or omission the person knew or should have known would contribute to the violation, to cease and desist from causing such violations. Aggressive enforcement not only punishes wrongdoers, but also helps deter future illegal behavior, and in fulfilling this mission, the Commission cooperates with the Federal bank regulators, among others. The SEC obtains evidence of possible violations of the securities laws from many sources, including from other regulatory authorities, such as the Federal bank regulators. In addition, when appropriate, the Commission coordinates its investigations with Federal banking regulators, which can result in coordinated regulatory settlements. For example, in a recent case, the SEC took action with respect to accounting improprieties of the PNC Financial Services Group, Inc., a bank holding company. The Commission's order found, among other things, that PNC materially overstated its earnings by failing to consolidate into its financial statements three special purpose entities to which it transferred approximately $762 million of volatile, troubled, or under-performing loans and venture capital assets. Based in part on this conduct, the Commission found that PNC had violated the anti-fraud record keeping and reporting provisions of the securities laws. At the same time the Commission's order was issued, the Federal Reserve announced that PNC had entered into a written agreement to address bank supervisory matters. The Commission acknowledged the substantial cooperation provided by the board in this matter. The Commission has long recognized the need to consult and coordinate with the Federal banking agencies on matters involving financial institutions that are public companies. For example, the chief accountants of the Commission and the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision meet periodically to discuss matters of mutual interest. Similarly, key decision makers meet regularly to implement supervisory programs, work on international agreements, and guard against money laundering. While our enforcement activities are ongoing, there are numerous other efforts underway at the Commission to improve the quality of reported financial information, the reliability of that information, and the timeliness of that information. The fall of Enron, along with other corporate scandals, has crystallized the importance of efforts to strengthen the accountability of public company officers as well as other so- called gatekeepers of our financial markets, the lawyers, the accountants, the auditors who work with public companies as part of the financial reporting process. Enactment of the Sarbanes-Oxley law also will help ensure that regulation with regard to these parties is stronger. Some of these regulations are already final. For example, as of August of this year, the CEOs and CFOs are now required to certify the financial and other information in issuers' quarterly and annual reports. Other rules to implement the Act are proposed and are on track to be finalized in January. For example, in November, the Commission proposed rules regarding standards of professional conduct for attorneys, and in October, the Commission proposed rules that would significantly tighten the requirements for companies to disclose non-GAAP financial measures and for corporate management to disclose material off-balance-sheet arrangements. Individually and in their totality, these rules should have a significant effect on the quality and reliability of financial reporting and, thus, should serve to enhance investor confidence. At the same time that we are working to strengthen our own rules and regulations, we are also diligently exercising our oversight role through our Office of Chief Accountant to make sure that the private sector's standard-setting bodies, including the FASB and the AICPA, are making improvements in their auditing and accounting standards. You will find the details of these improvements outlined in my written testimony. To conclude, Mr. Chairman, there is no question that as we continue to unravel the improprieties of the Enron scandal and others, we will take away many more important lessons, and in response to these lessons, we will continue to refine our internal procedures, cooperate with other regulatory bodies, and hone our rules and regulations so that Enron-type disasters are less likely to occur in the future. Thank you. Senator Levin. Thank you, Ms. Nazareth. We have seen in a number of transactions financial institutions participating, aiding and abetting, contributing to deceptive prepays which were constructed to look like energy trades instead of debt, deceptive asset sales that are backed by secret guarantees, ensuring that the buyer will get its money back when the asset is sold a second time, deceptive joint ventures that are formed to move assets off balance sheets but ensure that the second investor never has any funds at risk, and deceptive tax products that include fake business transactions. I know that each of you, because you are leaders in your field, are troubled by those kinds of deceptive transactions and, indeed, spend your professional life in trying to see if we can't remove deceptive transactions or deceptive accounting from our financial world. It seems to me what we are facing is the following, that we have both our banking regulators and our SEC doing case-by-case enforcement, that when it comes to banks, we have a gap. We have a gap because, on the one hand, the SEC does not generally regulate banks, and we, on the other hand, don't have our banking regulators that do the work relative to banks that the SEC would do if it did regulate banks. I know you all work together, and that is really essential, that you do work together if we are going to overcome and to end some of the deceptive practices that we have both heard about and we have written about, our investigation has uncovered, and so forth, and I am not going to ask you to comment on any specific practice of any specific institution for obvious reasons. Is it possible that you could, working together, end that, or fill that gap in our regulatory regime, in the oversight that you carry out, because the SEC doesn't generally regulate banks and the bank regulators don't generally regulate accounting practices or ensure accounting financial statements, we have got that gap. Unless we have our regulators working together, we are not going to be able to deter. We may be able to, on a case-by-case basis, get to a problem in terms of punishment after the fact, but in terms of examining the books of financial institutions, we are not going to be able to do the deterrent work which is usually available in most regulatory bodies. We need a deterrence program. I would like you to react to the following approach. First, that the SEC issue a clear policy statement, that the SEC would take enforcement action against financial institutions which aid or abet a client's dishonest accounting, or, of course, if they participate in a deceptive structured transaction. We know the SEC has the authority to go after aiders and abetters, but what I am suggesting here is not just a case-by-case going after an aider or abetter, but issuing a clear policy statement that the SEC would take enforcement action against financial institutions if they aid or abet a client's dishonest accounting or participate in a deceptive structured transaction. Now, that would be the SEC side of the two-step action which I am suggesting. The second step would be by the bank regulators, here, informing the banks that violation of that SEC policy which I have just described would constitute an unsafe and unsound practice. That would enable bank examiners to take appropriate action during regular bank examinations. If the SEC issues a clear policy statement relative to aiding and abetting by the financial institutions and if then the banking regulators as part of their regular bank examination let the financial institutions understand that a violation of that SEC policy, in turn, would constitute an unsound and unsafe practice, we then will have addressed this gap which exists, which I think most people would agree should somehow or other be filled. So I am wondering whether or not I could get a reaction from our three witnesses today to that, and if that is something which needs to be looked at, fine. If there is a different approach where you can join together to fill this regulatory gap, then we would welcome your comments on it. Let me take you in the same order that I called on you before. Mr. Spillenkothen. Mr. Spillenkothen. Mr. Chairman, I think if the SEC had a requirement that said a certain activity was a violation of securities laws or a violation of the law or securities regulation, then I think it would be the responsibility of bank regulators, if they found a situation that was a violation of an SEC rule, to take action, to deal with that, take enforcement action or refer to the SEC. So I would, again, without having had a chance to work this through entirely--I am not a lawyer--but if an activity is clearly stated, if an activity is a violation of a securities law or regulation that the SEC has established or that is established, then I would think banking regulators would have no difficulty in taking steps when they found a violation. Obviously, you still have to make a judgment as to whether the organization is violating the law. But if the clear established rule is that a certain activity is a violation of the law, then the bank regulators would take an action it would be unsafe and unsound to violate securities law. Senator Levin. This would be part of their bank examination, or it could be part of their routine, regular bank examination? Mr. Spillenkothen. If we found a violation of a securities law, we should take action or refer to the SEC in the course of our ongoing supervisory process, yes. Senator Levin. You say law. My reference and my question was to either a law, regulation, or a policy clearly stated by the SEC as to what action they would take if they found certain activities. So I tried to identify the word ``policy.'' Now, it can't just be general and it can't just be oral. It would have to be a clearly stated enforcement policy of the SEC, obviously, but would that do it or does it have to be a regulation? Mr. Spillenkothen. I am not a lawyer, sir. Senator Levin. OK. If you could just take that back to your lawyers, I know they are waiting for work and will welcome the question. [Laughter.] Senator Levin. Mr. Roeder. Mr. Roeder. If the SEC issued a policy statement as you indicated, I think from our standpoint, a bank that would violate that statement, we would consider that an unsafe and unsound practice, because as Mr. Spillenkothen indicated, we expect banks to obey and comply with law. If we, in our examination process, detected noncompliance with that statement, in addition to referring that matter to our colleagues at the SEC, our own current enforcement authorities allow us to initiate action against an institution ourselves for unsafe and unsound practices. So I think what you propose is workable. Senator Levin. Thank you. Ms. Nazareth. Ms. Nazareth. I think to a large extent, what the Commission does is consistent with the spirit of, I think, what you are looking to achieve. Our enforcement actions are all settled pursuant to SEC orders that are very highly negotiated and contain, I think, very clear articulations of what is the Commission's position with respect to the activity, and as you know, we have a--one reason why people find it particularly painful to have had an enforcement action with the SEC is that we really name and shame. We are quite public in these actions in terms of making public what the activity was and what the Commission's articulation of the issue was. In the cases that you are discussing, those cases would be brought under our general anti-fraud authority. I think that, in general, our position is that we want it very clear--in other words, we would want to make it very clear to people, as we have in some of our recent aider and abetter cases, that there is aiding and abetting liability for this type of activity. You can see the specific examples in those cases as to what resulted in aider and abetter liability. But we, frankly, by not putting out a specific policy statement, we don't limit the context or the fact patterns in which we could find that activity to be violative, which I think is important. We are careful not to find ourselves in a position, I think, where ultimately someone could say, well, what I did was technically around the edges of your policy statement. Rather, I think we leave ourselves sufficient room so that regardless of how imaginative some of these schemes can become, that we will be on all fours in being able to bring a case against the parties. But again, that having been said, I think the language is quite clear in these enforcement orders and would provide sufficient guidance to other regulators to ascertain what we had found to be a legal activity, and I suspect as a result of all of this, all of us at this table and other regulators, as well, will be thinking through our own, as we have testified, our own examination procedures in terms of the kinds of activities that we will be looking for, the kinds of internal procedures that we will expect these entities to have in order to ensure that they are not engaging in these types of activities. Senator Levin. Would you take up with the SEC the suggestion that you adopt a policy statement relative to types of special purpose entities or structured transactions which you would consider to be improper? The advantage of that, obviously, is the one that I set out, that then the banking regulators would have not just the case-by-case results from your shop, but would have a policy statement which could appear prospectively. They wouldn't have to just interpret from a case or a finding in a specific case from a different agency, but they would have a policy statement of that agency. I think if you would be willing to take that back, that idea back, it also could contain within it a statement that your enforcement actions are not limited to those particular examples of practices which you would feel to be deceptive or not reflective of good accounting practices. You could make that clear that those are simply examples and don't represent the total universe of what your enforcement actions might be. But if you could at least consider taking that kind of action, it would, I believe, be an important step to filling what is a real gap, and that is the gap which I have identified, which is that SEC generally doesn't regulate banks and that banking examiners generally don't do--generally don't look for the kind of things that you look at in public corporations in terms of their financial statements. So would you be willing to do that? Ms. Nazareth. Yes, of course, I will take that back. Senator Levin. Let me turn now to Senator Bennett for a time. Senator Bennett. Thank you, Mr. Chairman. I apologize to the members of the other panels that I missed. I had a longstanding lunch engagement that I felt I had to keep, but you are still going forward, so I appreciate the opportunity to be back here. One of the things that has come out of all this is a recognition that contrary to general impressions, accounting is not an exact science. Indeed, accounting can be quite philosophical. My brother, who taught philosophy at the University of Utah, described getting acquainted with the new head of the accounting department at the University of Utah and the two of them would go to lunch together and discuss the philosophy of accounting, and interestingly enough, this fellow, whose name I do not know, was ultimately asked to leave the University of Utah because his philosophy of accounting was sufficiently upsetting to other members of the faculty, that even though his recruiting had been considered a great coup by the university at one time because he had something of an international reputation, it didn't mesh culturally with the other members of the faculty and he was ultimately asked to teach someplace else. I think the average person on the street thinks of accounting in the same terms as he does balancing his own checkbook or filling out his tax return and doesn't realize that there are all kinds of different ways that you can account for economic activity and all kinds of justifications that can be raised and defended for these different approaches. So the challenge that you face as regulators is not just one to make sure that the checkbook balances and all the numbers add up, but that the philosophy, if I can use that term, that is being applied will, in fact, be the clearest statement of what things really are. In the Banking Committee, we have had long and sometimes acrimonious debates about accounting in mergers and acquisitions, of whether you do it on a pooling basis or a purchase basis, and those that favor pooling insist that philosophy of accounting is responsible for the boom of the 1990's, and those that favor the purchase basis insist that pooling is a shell game that is hiding real value. The question that the Chairman of the Banking Committee, Senator Graham, raised, was is there really a depreciation of the value of some of the intangible assets? For example, does the reputation of Coca-Cola really go down to nothing over a 40-year period? Does the value of the Coca-Cola formula depreciate over time that can show up as a number on the income statement or in the balance sheet? And we debated that with all of the fervor of medieval theologians discussing how many angels can dance on the head of a pin. I would like your reaction to the following that has come to me as I have listened through all of this and contemplated the true disaster that Enron represents. It was a disaster for its employees and a disaster for its shareholders, but as I have reviewed the testimony of Muriel Siebert, it was also a disaster for the system as a whole and shook investor confidence in the entire American system in a way that we are still living with. You can manage earnings. That is a phrase that has come out of the whole Enron experience, that executives are managing earnings so that they will meet the numbers that the analysts have projected. I have been the CEO of a company and I know how, very rudimentarily, how to do some things to produce that result, how to put a particular loss in this quarter as opposed to next quarter, how to set up reserves that are perfectly legitimate, but you set them up in such a way as to manage how much money shows up on the bottom line. You can't manage cash flow. The cash is either in the bank or it is not. You can't fudge that one. As we are debating what to do about the economy in the next year, one of the proposals that is on the table has to do with the deductibility or tax treatment of dividends, and it has occurred to me that if we were to make dividends tax deductible or tax free to the individual investor who receives them, the investor would, therefore, have an incentive--economics is all about incentives--have an incentive to purchase a stock whose return could rival that of municipal bonds. Management would have a very difficult time managing the dividend flow, managing the cash flow that would make it possible to pay dividends. It would be much more difficult to try to manipulate market perceptions of your company if you had to come up with the cash every quarter to maintain your dividend payment in order to maintain your stock price, and that would change the incentive on the part of the CEO very dramatically. Instead of going into his CFO and saying, ``Find me an offshore special purpose entity that I can play with and pretend I have created earnings,'' the CEO would go to his operational leaders and say, ``Find me a place where I can get a little more cash so I can meet my dividend so that my stock price won't be hurt if the dividend is cut.'' In today's market, it is considered a sign of weakness if a company pays dividends. I remember speaking to a CEO of a company that was awash in cash and saying to him, why don't you pay some dividends, and he said, ``If we paid dividends, it would be an admission that we were not in a position to earn more money for our investors' dollars within the company than they could earn with after-tax dollars investing it themselves, and we don't want to admit that we are not good enough managers to do better with their dollars keeping them here as pre-tax dollars than we would be if we gave them the money and then they had to pay taxes on it and then they could get a still better rate of return.'' Now, I know this is economic policy. I know this is part of the tax debate. But thinking of it in terms of a corporate governance issue as opposed to a tax issue, do you see any change in corporate behavior if dividends were tax-free to the recipients and, therefore, corporations had a strong incentive in terms of the impact on their stock price to accumulate enough cash, not phony accounting activities, cash, to be able to pay out dividends? I would appreciate any reaction you might have. This is a little bit afield from what we have been talking about, but it is very current in what we will be talking about in January and it has come to my mind as I have tried to think my way through Enron and what could have been done to prevent it. If the Enron executives had had an incentive to meet genuine cash responsibilities, they would probably not have engaged in some of the very high-risk activities that they did engage in. I would like your reaction. I have caused all three of you to look at each other and smile. I won't interpret that as being, this Senator is completely out of his mind, but a more benign interpretation, but whoever might want to take it. Mr. Spillenkothen. Well, Senator, you are right, this question is beyond my bailiwick as a mere bank supervisor, so I don't have a good insight there. I think your point about accounting being not science certainly is a true one and I think that--but we would argue as a bank supervisor that banking organizations and private sector firms still have an obligation to get the accounting right. Senator Bennett. There is no question about that. Mr. Spillenkothen [continuing]. An obligation to get it right, and speaking as a bank supervisor, I am very strongly supportive of efforts by the Financial Accounting Standards Board, by the Congress in establishing reforms. We think the progress on getting the Auditor Oversight Board set up and getting that process working to provide more discipline to the accounting profession are all very good things and they are very critical for bank supervision. So I don't have an opinion on your original point, but getting the accounting right, bringing discipline to the accounting profession, bringing to bear some of the reforms that this Congress has established, the oversight board for accountants, the Auditor Oversight Board, the reforms that the FASB is trying to do, the steps that the SEC has been taking to improve disclosure and accounting are very critical to our role as bank supervisors. Ms. Nazareth. I feel like it is a trick law school question. Senator Bennett. Not at all. I am unburdened with a legal education---- Ms. Nazareth. Excellent. Senator Bennett [continuing]. So you can go in any direction you want. Ms. Nazareth. Well, I can assure you, a legal education doesn't necessarily bring you to the right answer. It is not clear to me as a lawyer and as a securities regulator what the consequences of that would be from a corporate governance perspective. I really haven't had time to think it through. I think what it is fair to say, though, is that I think we do need to continue to think creatively about ways that we can appropriately incent companies, incent boards of directors, to act in the best interests of shareholders, in the best interests of their corporations and their businesses, and to account for their activities in appropriate ways. And so, certainly, that is a creative idea that we could consider, as well as others, to get to that desired goal. Senator Bennett. As I say, economics is about incentives, and as I have gone through the Enron disaster, I realize there was a strong incentive in terms of the stock price to, again the phrase I mentioned this morning, be aggressive in reporting earnings, a strong incentive in terms of the stock price to find every possible way within the law, if you were determined to abide by the law, or outside the law if you were of that mind, to account for earnings in a way that would inflate them and hope that somehow the real business would catch up with that later on and you wouldn't get trapped. But I am old enough to have come from the school that says you manage the business properly and the earnings take care of themselves, and ultimately, they take care of themselves in the terms of money in the till. If you could share that money with your investors without their having to pay the double taxation on it, that becomes an incentive to move in the other direction. I won't berate that hobby horse any further. We will have debate about that. Mr. Chairman, I appreciate your indulgence. I noticed going through Mr. Spillenkothen's statement, his statement more clearly than I made it this morning on an issue that came out of this morning's comment, where he says banks should not be held legally responsible for the judgments, actions, or malfeasance of their customers, nor should they be required to second guess their customers' accountants, tax, or legal experts, or police their customers' activities. Such an expectation would require, inappropriately, banking organizations to assume management responsibility for their customers and place potential legal liability on banking organizations that would compromise their ability to perform their role as financial intermediaries or threaten their safety and soundness, and that is the point I was trying to make this morning, sir, and you have made it more eloquently. But you say in the next paragraph, as we all agree, that banks must not participate in activities of their customers that the banks know to be illegal or improper, and that is the area that the Chairman is looking into, very appropriately. Thank you very much for your testimony. Senator Levin. Thank you very much, Senator Bennett. We have all encountered some of the deceptive accounting practices since Enron in various forms and guises. In one instance that we discussed today, three senior officials of the investment bank told the head of the investment bank not to go forward with a transaction. They used words like it would put the reputation of the franchise at risk, but nonetheless, they proceeded because Enron had pressured the bank to go forward. So you have got client pressure, you have got competition pressure, and in the last few years, banks have begun competing for business on the basis of who can sell the product that makes the client's financial statement look the best, and that is the race to the bottom. So our banks and our security firms need accurate financial statements, but too often, instead of promoting honest accounting, they have been sold and are selling products that produce dishonest accounting. I just really need a good, clear statement from our regulators, because you are at the top of your professions, that this is unacceptable, that our financial institutions have got to stop facilitating accounting deceptions, they have got to stop helping clients manipulate their financial statements. I would ask you for a clear statement of that without commenting on any specific case. Mr. Spillenkothen. Mr. Chairman, I think in my statement I indicated that we do not think banks should engage in borderline transactions because they can pose operational and legal risks to the bank and they can also expose the bank to risks and ultimately risk to the depositors and the insurance funds. So we do not believe banks should engage in borderline transactions. Ms. Nazareth. I concur with that statement, as well. Mr. Roeder. And I take no disagreement with that. Senator Levin. Now, when it comes to the area of structured finance operations at banks and security firms, the question is how do you separate the legitimate from the illegitimate. There are obviously some legitimate purposes, as we have all indicated, for structured finance operations, but there are some clearly illegitimate uses to which they have been put, where there is no business purpose, where all they have been used for is to try to turn a loan into income or to try to pretend that there was an asset sale when there wasn't, there was a loan, where you have this kind of deceptive structure which is created. We have got to, if we are going to restore confidence in these financial statements, we have got to be able to identify, describe what separates the wheat from the chaff when it comes to these structured finance operations. Would you be willing to conduct, or take back to your agencies the suggestion that there be a joint review of structured finance operations at banks and security firms in order to identify the ones which are promoting deceptive accounting and to distinguish them from the legitimate uses of these structured finance operations? Would you be willing to take that suggestion back about such a joint review? Let me start with you, Mr. Roeder. Mr. Roeder. I think we have to absolutely work together, and, of course, do so around the ongoing matters under review or investigation within our agencies. One of the difficult things, as you mention, is separating good from bad, especially considering the large number of transactions that these banks conduct. Fortunately, the transactions that we have talked about today are, we believe, limited in banks. In addition, the life of some of these transactions is very short, so the scope and how you might go about conducting that review would clearly be something we would have to spend time talking about. We are all faced with limited resources, so I think you have to bear down on those things that are very complex and assess the reforms that the banks have adopted and try to determine how you could extract best practices in hopes that would lead us to maybe a better differentiation between what is appropriate and not appropriate. But I think a coordinated review, as long as it doesn't interfer with our current reviews, is sensible. Senator Levin. Ms. Nazareth. Ms. Nazareth. I think that there are a number of lessons that we are going to--that will ultimately emerge from this period and I think it would be incumbent on all the regulators to look back on this after we have completed all these enforcement investigations and see what the lessons learned are. Certainly, I think we will be much more knowledgeable about the types of transactions that were problematic. I think we could share information on that, and perhaps with assistance from the various auditing and accounting groups who assist us in these efforts, perhaps we could try to give some guidance for terms of what we saw that was problematic. Senator Levin. Thank you. Mr. Spillenkothen. Mr. Spillenkothen. Thank you, Mr. Chairman. As I said, the Federal Reserve is actually reviewing a handful of organizations that are engaging in these transactions, so we are involved now in a review of these transactions. We are consulting with our colleagues at the OCC and the SEC in this process, so we will continue that. As I indicated, we will, after this process is finished and we have had a chance to assess our results, consider the need for additional supervisory guidance to our examiners or to the industry. We will consider the need for additional sound practice guidance in some of these procedures that the banks are putting in place. I think the banking organizations themselves have recognized, as they have indicated to you, that they need to revise their internal controls and vetting processes. So we are engaged in a review and we will consider, after that review is done, whether we need to provide additional supervisory guidance or sound practice guidance in this area. Senator Levin. What is the time table for that review? Mr. Spillenkothen. Hopefully in the next weeks and months. I don't know exactly. We have got a lot of people doing a lot of things, but we are attempting to get this done. Senator Levin. Do you expect perhaps in a few months, it would be done? Mr. Spillenkothen. I would hope so. Senator Levin. Do you think it is likely that you will be issuing some guidance which we could, or you could label as being guidance that was contributed to by the other regulatory agencies? Mr. Spillenkothen. Well, we would certainly coordinate with the other agencies. We also need time to make our own assessments, and I think I should also point out that whatever we do, we would have to go to our oversight board and make an evaluation of all this. But we certainly would do this in coordination with the other regulators. Senator Levin. One of the recommendations we will be making in our report is that there be that kind of a joint review so that we can have that kind of guidance come from not just the Fed, but from all of our regulatory agencies working together. It would be, I think, a very important step in what we are trying to accomplish. Some time ago, if you could take a look, Mr. Spillenkothen, at the exhibits--let me see if I can find the number here-- Exhibit 370.\1\ I think we shared this with the folks at the Fed some time ago. This was an e-mail back in 1999 that is dated March 5, 1999, and it is entitled, ``Disguised Loans.'' It says that we are making disguised loans, usually buried in commodities or equities derivatives, and I am sure in other areas. With few exceptions, they are understood to be disguised loans and approved as such, but I am queasy about the process. --------------------------------------------------------------------------- \1\ Exhibit No. 370 appears in the Appendix on page 701. --------------------------------------------------------------------------- And then the employee of Chase listed a number of concerns, and one of which he said was he worried about loans that escape routine transparencies. The loan is buried in the trading books, and when we say we have X loans to Country Y, it is not included. And then he says further down, as a policy matter, I think we need a small task force to not eliminate disguised loans, but to make sure they are done right. I am wondering if your staff at the Fed has talked to you about it, are you aware of it, and whether anyone has talked to Chase about that. Mr. Spillenkothen. Mr. Chairman, I---- Senator Levin. It does address a safety and soundness problem. When a bank evaluates risk, how much of its money is tied up in a particular country or company or currency, how does it take into account all the loans disguised as energy trades or derivatives or asset sales and so forth? How do you do a risk analysis when you are missing important transactions? Are you familiar with this particular---- Mr. Spillenkothen. Not in detail. I think because we are reviewing these transactions, I really can't discuss specific questions. Senator Levin. All right, fair enough. Mr. Roeder, your office at the OCC oversees about 2,000 national banks, and you stated in your prepared testimony that complex structured transactions such as those entered into by Enron are generally offered at only a small number of large banking companies. About how many banks are we talking about? Mr. Roeder. Our review would indicate fewer than ten. Senator Levin. So that the banks that would require extra scrutiny on structured finance would be a small population? Mr. Roeder. There are a number of institutions that offer very standard structured finance products and services. The most complex products tend to be concentrated in fewer than ten institutions. So, yes, it is not something that we have found to date to be widespread. Senator Levin. Therefore, I presume that makes the regulatory burden a little narrower in terms of the targets? Mr. Roeder. It helps, yes. Senator Levin. One last document.\2\ This was a Chase document, too, in which it was back in 1998 selling or pitching prepays and used the term ``balance sheet-friendly.'' I take it you would all agree that our balance sheets should be accurate, neither friendly nor unfriendly, but accurate. Would that be a fair statement, Mr. Spillenkothen? --------------------------------------------------------------------------- \2\ Exhibit No. 369 appears in the Appendix on page 687. --------------------------------------------------------------------------- Mr. Spillenkothen. That is a fair statement. Senator Levin. Ms. Nazareth. Ms. Nazareth. Yes. Senator Levin. And Mr. Roeder. Mr. Roeder. Absolutely. Senator Levin. OK. Let me close by thanking you all. It has been a long day, but we have learned a lot. A lot of practices which we believe are deceptive have been analyzed. Some of our leading financial institutions, in our judgment, helped Enron cook the books, and the safety and the soundness and the vitality of our financial system depends on honest accounting and accurate financial reporting. So we need these banks that are the guardians and promoters of honest accounting to be that and not willing accomplices in accounting deceptions. We have heard testimony today which is extremely troubling about the extent of financial deceptions that Enron and its banks engaged in. The banks say that they recognize the problems now. They are changing the way in which they do business, and they say what was acceptable a year ago is not acceptable today. Hopefully, they will take the actions that are promised. But we simply cannot rely upon self-regulation and promises. We need our regulators to step in, ratchet up efforts to ensure honest accounting, and put an end to banks assisting their clients to produce deceptive financial statements. The gap now in the regulatory oversight area needs to be closed, the gap that exists because the SEC does not generally regulate banks and the bank regulators don't generally look at accounting practices or ensure accurate financial statements. We need to continue the effort to get regulators working together, of course, punishing wrongdoers on a case-by-case basis, but that is not enough. We need to design a new deterrence program. It needs a lot of work. Steps need to be taken together by our regulators, our watchdogs. I have outlined a couple steps that I thought would be useful, and we welcomed our witnesses' willingness to take those suggestions back to their agencies. We will make those suggestions, as I indicated, part of a Subcommittee report based on our staff investigation and our staff report. It would be very helpful if the SEC would issue a clear policy statement, that the SEC will take enforcement action against financial institutions that aid or abet dishonest accounting by a client. At the same time, we need bank regulators to tell banks that violation of such an SEC policy would constitute an unsafe and unsound practice, which would then enable bank examiners to take appropriate action during regular bank examinations. A comprehensive joint review, such as apparently is being undertaken by the Fed, would be very helpful if it is a joint review of the structured finance products that are being sold or participated in by our financial institutions so that we can clearly separate the products and the structured finance arrangements which are deceptive from the ones that serve a legitimate financial and economic purpose. The short story is that we need to send our financial firms, some of which are the most renowned firms in the world, much less in the country, we have got to send them an unmistakable message, that while we welcome their self- regulation and their growing awareness of what they participated in, willingly or unwillingly, wittingly or unwittingly, the message has got to be that touting balance sheet-friendly deals that allow clients to hide debt or to report deceptive amounts of cash flow or earnings are simply not going to be tolerated. Our financial institutions must be part of the restoration of credibility by helping us to return to that good old fashioned honest accounting. We all look forward to working with the banking industry and the regulators to get that message out and to establish that deterrence program that is needed to prevent future calamities, such as Enron. We again thank all of our witnesses here today. We thank our last panel for your patience, for your contributions, and most importantly, for the day-to-day work that you are engaged in and committed to, in which we place so much faith, that you will take aggressive actions against wrongdoers where you find them and that you will help us design a deterrence regime and a procedure so that we can deter wrongdoing in the future. With that, we stand in recess. 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