[Senate Prints 107-82]
[From the U.S. Government Publishing Office]
107th Congress
2d Session COMMITTEE PRINT S. Prt.
107-82
_______________________________________________________________________
FISHTAIL, BACCHUS, SUNDANCE, AND
SLAPSHOT: FOUR ENRON TRANSACTIONS
FUNDED AND FACILITATED BY
U.S. FINANCIAL INSTITUTIONS
__________
R E P O R T
prepared by the
PERMANENT SUBCOMMITTEE ON
INVESTIGATIONS
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
[GRAPHIC IS NOT AVAILABLE IN TIFF FORMAT]
January 2, 2003
U.S. GOVERNMENT PRINTING OFFICE
83-559 WASHINGTON : 2003
____________________________________________________________________________
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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
MARK DAYTON, Minnesota JIM BUNNING, Kentucky
PETER G. FITZGERALD, Illinois
Joyce A. Rechtschaffen, Staff Director and Counsel
Richard A. Hertling, Minority Staff Director
Darla D. Cassell, Chief Clerk
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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
MARK DAYTON, Minnesota JIM BUNNING, Kentucky
PETER G. FITZGERALD, Illinois
Elise J. Bean, Staff Director and Chief Counsel
Kim Corthell, Minority Staff Director
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Page
SUMMARY OF TRANSACTIONS.......................................... 3
Sham Asset Sale.............................................. 3
Sham Loan.................................................... 3
FISHTAIL......................................................... 5
The Facts.................................................... 5
Analysis..................................................... 9
BACCHUS.......................................................... 10
The Facts.................................................... 10
Analysis..................................................... 17
SUNDANCE......................................................... 18
The Facts.................................................... 18
Analysis..................................................... 25
SLAPSHOT......................................................... 26
The Facts.................................................... 26
Analysis..................................................... 33
SUBCOMMITTEE HEARING............................................. 34
SUBCOMMITTEE RECOMMENDATIONS..................................... 36
FISHTAIL, BACCHUS, SUNDANCE, AND
SLAPSHOT: FOUR ENRON TRANSACTIONS
FUNDED AND FACILITATED BY
U.S. FINANCIAL INSTITUTIONS
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On January 2, 2002, Senator Carl Levin, Chairman of the
U.S. Senate Permanent Subcommittee on Investigations of the
Committee on Governmental Affairs, and Senator Susan M.
Collins, the Ranking Minority Member of the Subcommittee,
announced that the Subcommittee would conduct an in-depth,
bipartisan investigation into the collapse of the Enron
Corporation. This investigation was initiated in response to
Enron's declaration of bankruptcy on December 2, 2001, ending
Enron's status as a leading energy company and the seventh
largest corporation in the United States.
In the year since Enron's declaration of bankruptcy,
Congressional hearings, including hearings held by this
Subcommittee and the full Governmental Affairs Committee, have
disclosed evidence of Enron's participation in accounting
deceptions, price manipulation, insider abuse, and unfair
dealing with employees, investors, and creditors. Law
enforcement agencies have indicted Enron's former chief
financial officer, Andrew Fastow, for fraud, money laundering,
and other misconduct. Mr. Fastow's former key assistant,
Michael Kopper, has pleaded guilty to fraud and money
laundering. Enron's former top Western energy trader, Timothy
Belden, has pleaded guilty to fraudulent conduct to manipulate
prices in the California energy market. Additional criminal and
civil investigations by the U.S. Department of Justice,
Securities and Exchange Commission, Federal Energy Regulatory
Commission, and other Federal, State, and local law enforcement
agencies are ongoing.
A key focus of the Subcommittee's investigation has been to
examine the role of major U.S. financial institutions in
Enron's collapse.\1\ In July, the Subcommittee held two days of
hearings examining transactions involving Enron and three
financial institutions, Citigroup, J.P. Morgan Chase & Co.
(``Chase''), and Merrill Lynch. Each of the transactions
examined in these hearings resulted in misleading information
in Enron's financial statements that made Enron appear to be in
better financial condition than it was.\2\ The first hearing
looked at more than $8 billion in deceptive transactions
referred to as ``prepays,'' which Citigroup and Chase used to
issue Enron huge loans disguised as energy trades. By
characterizing the transactions as energy trades rather than
loans, Citgroup and Chase enabled Enron to claim the loan
proceeds were cash flow from business operations rather than
cash flow from financing, thereby misleading investors and
analysts about the size of Enron's trading operations and the
nature of its incoming cash flow. The second hearing examined a
sham asset sale from Enron to Merrill Lynch just before the end
of the year 2000, which allowed Enron to claim the alleged
``sale'' revenue on its 2000 financial statements, boosting its
year-end earnings. The hearing showed that this transaction did
not qualify as a true sale under accounting rules, because
Enron had eliminated all risk from the deal by secretly
promising Merrill Lynch to arrange a resale of the assets
within six months and guaranteeing a 15 percent return on the
deal.
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\1\ The Subcommittee has also examined the conduct of Enron's Board
of Directors. See ``The Role of the Board of Directors in Enron's
Collapse,'' S. Prt. 107-70 (July 8, 2002).
\2\ See Subcommittee hearings, ``The Role of the Financial
Institutions in Enron's Collapse'' (July 23 and 30, 2002) (hereinafter
``July 23 hearing'' and ``July 30 hearing'').
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On December 11, 2002, the Subcommittee held a third hearing
examining four multi-million dollar structured finance
transactions known as Fishtail, Bacchus, Sundance, and
Slapshot, involving Enron, Citigroup, and Chase. These
transactions, which took place over a six-month period
beginning in December 2000 and ending in June 2001, are the
focus of this report. All four transactions related to Enron's
new business venture in pulp and paper trading. All four were
financed primarily by the Salomon Smith Barney unit of
Citigroup or by Chase. The evidence associated with the four
transactions demonstrates that Citigroup and Chase actively
aided Enron in executing them, despite knowing the transactions
utilized deceptive accounting or tax strategies, in return for
substantial fees or favorable consideration in other business
dealings. The evidence also indicates that Enron would not have
been able to complete any of these transactions without the
direct support and participation of a major financial
institution.
The cumulative evidence from the three Subcommittee
hearings demonstrates that some U.S. financial institutions
have been designing, participating in, and profiting from
complex financial transactions explicitly intended to help U.S.
public companies engage in deceptive accounting or tax
strategies. This evidence also shows that some U.S. financial
institutions and public companies have been misusing structured
finance vehicles, originally designed to lower financing costs
and spread investment risk, to carry out sham transactions that
have no legitimate business purpose and mislead investors,
analysts, and regulators about companies' activities, tax
obligations, and true financial condition.
The information and analysis provided in this report are
based upon a bipartisan investigation conducted jointly by the
Subcommittee's Democratic and Republican staffs. Overall, the
Subcommittee has issued more than 75 subpoenas and document
requests to Enron, Arthur Andersen, and a host of other
individuals, accounting firms, and financial institutions,
resulting in over two million pages of documents. The
Subcommittee has also conducted over 100 interviews.
To understand the four transactions examined in this
report, the Subcommittee staff reviewed hundreds of thousands
of pages of documents produced by Enron, Andersen, Citigroup,
Chase, and other parties; interviewed key personnel involved in
the transactions; consulted key Federal agencies including the
Securities and Exchange Commission, Federal Reserve System,
Office of the Comptroller of the Currency, the Internal Revenue
Service, and the Government of Canada; and consulted with a
number of finance, accounting, and tax experts. This report
presents the Subcommittee's findings with respect to those four
transactions, as well as bipartisan recommendations for actions
that can be taken to stop U.S. financial institutions from
continuing to design or participate in illegitimate structured
financial transactions that help U.S. companies engage in
misleading accounting.
SUMMARY OF TRANSACTIONS
All four of the transactions at issue in this report
involve Enron's fledgling electronic trading business in the
pulp and paper industry, a new business venture which Enron was
developing with the support of Citigroup, Chase, and others.
The assets involved in the transactions include Enron's trading
book of derivatives and forward contracts to deliver pulp and
paper products, electronic trading software, online trading
operations dedicated to pulp and paper trading activity, and
certain paper mills and timberlands in the United States and
Canada. All four transactions reflect efforts by Enron to keep
debt off its balance sheet or to manufacture immediate returns
on its pulp and paper trading business and use these returns to
report better financial results than the company actually
produced in 2000 and 2001.
The four transactions can be summarized as follows.
Sham Asset Sale. The first three transactions, Fishtail,
Bacchus, and Sundance, took place within an approximate six-
month period from December 2000 to June 2001. All three
involved the transfer of assets at inflated values from Enron
to special purpose entities (SPEs) or joint ventures that Enron
orchestrated and, among other problems, established with sham
outside investments that did not have the required independence
or did not truly place funds at risk. Moreover, when considered
as a whole, the three transactions resulted in a disguised,
six-month loan advanced by Citigroup to facilitate Enron's
deceptive accounting. In effect, Enron transferred its assets
to a sham joint venture, Fishtail; arranged, in the Bacchus
transaction, for a shell company to borrow $200 million from
Citigroup to ``purchase'' Enron's Fishtail interest, without
disclosing that Enron was guaranteeing the full purchase price;
used the sham sale revenue to inflate its year-end 2000
earnings by $112 million; and then quietly returned the $200
million to Citigroup six months later via another sham joint
venture, Sundance. The result was that the three transactions
enabled Enron to produce misleading financial statements that
made Enron's financial condition appear better than it was.
Senior Citigroup officials strongly objected to Citigroup's
participation in one of the transactions, warning: ``The GAAP
accounting is aggressive and a franchise risk to us if there is
publicity.'' Citigroup nevertheless proceeded and played a key
role in advancing this transaction, which could not have been
completed without the funding and active support of a large
financial institution.
Sham Loan. The final transaction, Slapshot, took place on
June 22, 2001. It involves a sham $1 billion loan and related
funding transfers and transactions that Chase designed and
presented to Enron to produce up to $60 million in Canadian tax
benefits and up to $65 million in financial statement benefits
for Enron.
In essence, the Slapshot transaction cloaked a legitimate
$375 million loan to Enron issued by a consortium of banks
inside a $1.4 billion sham loan to Enron issued by a Chase-
controlled SPE. Chase provided the extra money for the sham
loan by approving a $1 billion ``daylight overdraft'' on a
Chase bank account. To eliminate any risk associated with
providing the overdraft funds to Enron, Chase required Enron to
deposit a separate $1 billion in an escrow account at Chase
prior to Chase's issuing the sham loan to Enron. Enron obtained
the required escrow funds by drawing on its main corporate bank
account at Citigroup which issued Enron a separate $1 billion
daylight overdraft. Chase and Enron then circulated Chase's
$1.4 billion in ``loan'' proceeds and Enron's $1 billion in
escrow funds through a maze of U.S. and Canadian bank accounts
held by Enron and Chase affiliates, ending the transaction when
both Chase and Enron recovered their respective $1 billion
overdrafts by the end of the day.
The end result of the Slapshot transaction was that Enron
kept the $375 million provided by the bank consortium, and
Enron directed its Canadian affiliate to repay the $375 million
loan. But with Chase's assistance, Enron also used the Slapshot
transaction records to pretend that its affiliate had actually
received the larger $1.4 billion ``loan'' and to treat its $22
million loan repayments--each of which was actually a payment
of principal and interest on the $375 million loan--as pure
interest payments on the $1.4 billion ``loan.'' Canadian tax
law, like U.S. tax law, allows companies to deduct from their
taxable income all interest payments on a loan, but no payments
of loan principal. By characterizing each $22 million loan
payment as an interest payment on the $1.4 billion loan, Enron
claimed to be entitled to deduct the entire $22 million from
its Canadian taxes, as well as obtain related financial
statement benefits. Five months later, however, Enron declared
bankruptcy before all the projected benefits from Slapshot were
realized.\3\
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\3\ In response to Subcommittee inquiries, on the day before the
Subcommittee hearing, Enron's legal counsel provided a letter
forwarding information prepared by Enron on the current status of the
Slapshot-related loans, assets and entities. Letter from Skadden, Arps,
Slate, Meagher & Flom LLP, on behalf of Enron, to the Subcommittee (12/
10/02), included in the hearing record for December 11, 2002, as
Hearing Exhibit 368. (All exhibits from this hearing are hereinafter
referred to as ``Hearing Exhibit.'') Enron stated that it had taken
``[n]o United States federal income tax deductions . . . with respect
to the Slapshot transaction,'' and ``there were no tax-related benefits
reported in'' Enron's SEC filings. Enron also stated that its Canadian
affiliates had actually claimed ``gross interest [tax] deductions'' in
Canada totaling $124.9 million, but did not anticipate claiming any
future tax benefits related to the Slapshot transaction.
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Chase was paid fees and other remuneration totaling $5.6
million for allowing Enron to use its ``proprietary'' Slapshot
structure and for designing, coordinating, and completing the
complex transactions involved. A written tax opinion provided
to Enron by a Canadian law firm stated that the transaction
``clearly involves a degree of risk,'' and advocated proceeding
only after providing this warning: ``We would further caution
that in our opinion, it is very likely that Revenue Canada will
become aware of the proposed transactions . . . [and] will
challenge them.'' Chase sold similar tax structures to other
U.S. companies as well.
Each of the four transactions examined in this report
involved deceptive financial structures utilizing multiple SPEs
or joint ventures, asset or stock transfers, and exotic forms
of financing. All relied on a major financial institution to
provide funding, complex funds transfers, and intricate
structured finance deals. In the end, all four transactions
appear to have had no business purpose other than to enable
Enron to engage in deceptive accounting and tax strategies to
inflate its financial results or deceptively reduce its tax
obligations.
FISHTAIL
The Facts. The first transaction in the four-part series,
Fishtail, \4\ took place in December 2000. This transaction was
the first step in a larger plan by Enron to move its pulp and
paper trading business off its balance sheet into a separate
joint venture, sell its ownership interests in that venture,
and then declare the income from the sale on its 2000 financial
statements. The first step, Fishtail, called for Enron to
contribute its existing pulp and paper trading business--that
is, its electronic trading software, pulp and paper online
trading operation and personnel, and existing pulp and paper
trading book--to a joint venture with another investor in order
to convert the business into an equity investment and establish
its value.
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\4\ This report refers to transactions by the project names that
Enron chose. In some instances, the participating financial
institutions used different nomenclature. Fishtail, for example, was
known internally at Chase as project ``Grinch.''
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Enron, LJM2 Co-Investment, LP (``LJM2''), \5\ and Chase
participated in the Fishtail joint venture which was
established on December 19, 2000. To participate in Fishtail,
LJM2 (acting through an affiliate LJM2-Ampato LLC) formed a new
SPE called Annapurna LLC. Enron (acting through Enron North
America) and Annapurna each held 50 percent of Fishtail's
voting shares.\6\ Figure 1 illustrates the final structure of
the Fishtail joint venture.
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\5\ LJM2 is a Delaware limited partnership which was formed and
managed by Enron's chief financial officer, Andrew Fastow, and which
functioned as a private equity fund that dealt almost exclusively with
Enron. For more information on LJM2, its dealings with Enron, and the
conflicts of interest inherent in its relationship with Enron, see the
Subcommittee's report, ``The Role of the Board of Directors in Enron's
Collapse,'' S. Prt. 107-70 (July 8, 2002), at 23-35.
\6\ See ``Fishtail LLC Formation/Securitization,'' Andersen
memorandum by Thomas Bauer and Kate Agnew (12/29/00), Bates AASCGA
008673.1-4, Hearing Exhibit 324. Under generally accepted accounting
principles (GAAP), companies typically do not consolidate entities in
which they own 50 percent or less of the total outstanding voting
shares. Accounting Principles Board Opinion No. 18, ``The Equity Method
of Accounting for Investments in Common Stock'' (1971). Because the two
parties in Fishtail each owned 50 percent of the voting shares, the
joint venture did not appear on either Enron or Annapurna's financial
statements.
[GRAPHIC] [TIFF OMITTED] T3559.001
Arthur Andersen was Enron's auditor and evaluated the
Fishtail transaction to determine whether it complied with GAAP
accounting rules. The key Andersen guidelines for capitalizing
joint ventures stated that, in a 50-50 joint venture involving
two parties, the ratio of investment by the two parties may not
exceed a ratio of four to one.\7\ In other words, under the
Andersen 4:1 rule, a 50-50 joint venture may remain
unconsolidated only if the minority party to the joint venture
contributes a minimum of 20 percent of the total
capitalization. In addition, the Andersen guidelines require
that the contribution provided by the second investor must
include capital-at-risk equal to at least 3 percent of the
total capitalization. This 3 percent ``equity investment'' must
be funded at the time the joint venture is formed and remain at
risk throughout the venture.\8\
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\7\ See Andersen email, plus attachments, from Kate Agnew to
Andersen employees John Stewart and others (8/21/00), Bates AASCGA
007193.1-007195.11, Hearing Exhibit 336. Since authoritative accounting
literature on establishing, capitalizing and consolidating joint
ventures and distinguishing them from special purpose entities is
limited, Andersen developed internal policies and guidelines on how to
structure joint ventures to ensure their GAAP compliance and prevent
abuses such as deconsolidating a joint venture that was really funded
and controlled by a single party. The 4:1 rule, which was unique to
Andersen, was one of its key requirements for capitalizing 50-50 joint
ventures. The traditional approach to capitalizing 50-50 joint ventures
is to require each investor to provide 50 percent of the total
capitalization.
\8\ See ``Fishtail LLC Formation/Securitization,'' Andersen
memorandum by Thomas Bauer and Kate Agnew (12/29/00), Bates AASCGA
008673.1-4, Hearing Exhibit 324. When analyzing the minimum substantive
investment required for an unconsolidated joint venture like Fishtail,
Andersen analogized to the minimum 3 percent equity at risk requirement
already in place for SPEs. (``Specific authoritative guidance
surrounding the necessary amount of capital-at-risk to be considered a
substantive investment is available only in literature surrounding
SPE's. Although [Fishtail] appears to be a business/strategic joint
venture, and is not by definition an SPE, we believe the SPE guidance
(EITF 90-15) establishes a good reference point as a minimum standard
for our consideration.'')
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Enron's capital contribution to Fishtail was its pulp and
paper trading business. In order to place a dollar value on
this contribution, Chase and Enron relied on a November 2000
valuation analysis provided by Chase Securities, Inc. in
connection with an earlier effort by Enron and a third party to
form a joint venture that was not completed. The Chase
Securities analysis had concluded that the pulp and paper
trading business was worth $200 million.\9\ Chase Securities
issued this valuation, even though the key asset at the time,
Enron's pulp and paper trading book, was being carried on
Enron's books at less than half that amount, approximately $85
million.\10\ According to Enron and Chase officials interviewed
by the Subcommittee, the remaining $115 million in value came
from intangible or ``soft'' assets associated with the pulp and
paper trading business.\11\ Enron's own internal accounting
guidance, however, suggests that the most appropriate valuation
for such intangible or soft assets may be ``zero.'' \12\ To
justify the significant value assigned to Enron's soft assets
in Fishtail, Enron and Chase contend that the $115 million
figure is the product of an unbiased third-party analysis, but
this valuation is, in fact, the product of a Chase affiliate
supporting an Enron assessment of its own soft assets.\13\
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\9\ See ``Enron Network Partners: Valuation Analysis of Contributed
Assets,'' by Chase Securities, Inc. (11/20/00), Bates CITI-SPSI
0015996-0016017.
\10\ See ``Fishtail LLC,'' an Enron document summarizing the
Fishtail transaction (undated), Bates ECa000015282.
\11\ Subcommittee interview with Michael K. Patrick of Enron (11/
14/02) (hereinafter ``Patrick interview'') and Robert Traband of Chase
(11/19/02) (hereinafter ``Traband interview''). See also ``Enron
Network Partners: Valuation Analysis of Contributed Assets,'' by Chase
Securities, Inc., Bates CITI-SPSI 0016012. In the section entitled,
``Soft Assets,'' the Chase Securities analysis states: ``In addition to
`hard dollar' assets, Enron will contribute credit support, management
talent, a technology platform, internet experience (EOL), risk
management, and other assets to the partnership. . . . Enron believes
these assets add significant value to the partnership.'' EOL refers to
Enron Online, the electronic trading system Enron used to trade energy-
related contracts and derivatives. The Chase Securities analysis of
Enron's pulp and paper trading system apparently agreed with Enron's
valuation of its associated ``soft assets'' as worth another $115
million.
\12\ See ``Accounting for Investments in Limited Partnerships and
other Joint Ownership Entities,'' Enron accounting policy and guidance
(6/26/01), Bates AAHEC(2) 03172.6, Hearing Exhibit 335 (``[I]n all
cases the fair value of the contributions must be objectively
determined and verifiable. Certain contributed intangibles may be
difficult to objectively measure and therefore maybe [sic] deemed to be
valued at zero for the purposes of the economic assessment. The intent
is that the third party should not necessarily get `equity credit' for
`soft' contributions.'' (Emphasis in original.)). Evidence indicates
that Enron had vetted the policy statements in this memorandum with
Andersen, and they were consistent with Enron valuation principles in
place at the time of the Fishtail transaction.
\13\ When Enron ``sold'' its Fishtail ownership interests one week
later in the Bacchus transaction, Enron claimed a profit of $112
million on the ``sale.'' This outsized profit margin raises obvious
questions about whether Enron engineered an inflated asset valuation
and sales price to enable it to report a large sales gain on its 2000
financial statements. In addition, one year later, an internal,
preliminary asset inventory compiled by Enron in anticipation of
declaring bankruptcy estimated the total market value of its pulp and
paper trading business as of September 30, 2001, at $50 million.
``Enron Corporate Development Asset Inventory'' (11/25/01), Bates EC
001521856-57, Hearing Exhibit 313. This $50 million internal valuation
is dramatically less than the $200 million valuation Enron claimed in
the Fishtail transaction nine months earlier, and the $228.5 million
valuation claimed in the Sundance transaction just four months earlier.
See ``Sundance Structure,'' Citigroup document (undated), Bates CITI-
SPSI 0044992, Hearing Exhibit 331.
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In light of Enron's alleged $200 million contribution,
Annapurna was required to contribute at least $50 million to
Fishtail to meet the Andersen 4:1 guideline for capitalizing
joint ventures. In addition, Annapurna had to contribute at
least 3 percent of the total capitalization at the time the
joint venture was formed and ensure it remained at risk.\14\ To
provide the required contribution to Fishtail, Annapurna turned
to LJM2 and Chase. For its part, LJM2 transferred $8 million in
cash to Annapurna which, in turn, passed the funds to Fishtail.
Chase provided Annapurna with a $42 million ``commitment,'' set
out in a letter of credit, to fund Annapurna if called upon to
do so. Annapurna then passed on this funding commitment to
Fishtail. The parties referred to Chase's commitment as an
``unfunded capital'' investment.\15\ One Enron employee
referred to this novel approach of capitalizing a joint venture
with an ``unfunded capital'' commitment as a ``new accounting
technology'' developed by Enron.\16\
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\14\ See ``Fishtail LLC Formation/Securitization,'' Andersen
memorandum by Thomas Bauer and Kate Agnew (12/29/00), Bates AASCGA
008673.1-4, Hearing Exhibit 324. In addition to the joint venture
capitalization rules, under applicable accounting rules for SPEs,
Annapurna qualified as an independent entity, unconsolidated with any
party, only if, among other requirements, at least 3 percent of its
capital came from an independent equity investor and remained genuinely
at risk. See In Re The PNC Financial Services Group, Inc., SEC
Administrative Proceedings File No. 3-10838 (Order Making Findings and
Imposing Cease and Desist Order, 7/18/02); EITF Abstracts, Topic D-14,
``Transactions Involving Special Purpose Entities''; EITF Issue No. 90-
15, ``Impact of Nonsubstantive Lessors, Residual Value Guarantees, and
Other Provisions in Leasing Transactions,'' Response to Question No. 3.
\15\ Email by Enron employee Michael Patrick to Wes Colwell, (1/4/
01), Enron disk produced to the Subcommittee.
\16\ Id. Several finance and accounting experts told the
Subcommittee staff they had never heard of an ``unfunded capital''
commitment being used to capitalize a joint venture and expressed
skepticism over whether it qualified under current accounting rules as
a valid joint venture contribution. One expert also said that the
arrangement cast doubt on the arms-length nature of the transaction,
since it permitted one of the two parties to the joint venture to defer
any actual investment in the venture until a later time.
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According to the same Enron employee, the Fishtail
transaction was ``primarily accounting driven and the structure
was heavily negotiated with Arthur Andersen.'' \17\ Andersen
apparently approved ``the unfunded nature of the commitment''
made by Chase only after a clause was added to the joint
venture agreement giving Fishtail unilateral power to draw down
the Annapurna-Chase commitment in certain circumstances.\18\
Another aspect of the agreement, however, specified that the
first $200 million dollars of any loss experienced by Fishtail
would be allocated to Enron, thereby making it highly unlikely
that the Chase commitment would ever actually be drawn.\19\
Andersen nevertheless approved the transaction.
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\17\ Id. Mr. Patrick reaffirmed this information in his
Subcommittee interview. The key Andersen employee involved in the
Fishtail and Sundance transactions, Thomas Bauer, refused to be
interviewed by the Subcommittee prior to the hearing to explain either
his role or Andersen's understanding of the two transactions. His legal
counsel has since indicated, however, that Mr. Bauer has decided to
cooperate and submit to a Subcommittee interview in the near future.
\18\ ``Amended and Restated Limited Liability Company Agreement of
Fishtail LLC'' (12/19/00), Clause 4.02, Bates SENATE ANNA 00081. See
also ``Fishtail LLC Formation/Securitization,'' Andersen memorandum by
Tom Bauer and Kate Agnew (12/29/00), Bates AASCGA 008673.1, Hearing
Exhibit 324 (``Our preference would be to have the amount computed
pursuant to the 4 to 1 test to be fully funded upon formation but would
not insist since the 4 to 1 test is not mandatory in the
literature.''). Mr. Patrick substantiated this account in his
Subcommittee interview.
\19\ ``Amended and Restated Limited Liability Company Agreement of
Fishtail LLC'' (12/19/00), Clause 4.02, Bates SENATE ANNA 00081. See
also ``Project Grinch,'' summary memorandum by Chase (12/16/00), Bates
SENATE ANNA 00397-99, Hearing Exhibit 312 (The first paragraph of this
memorandum states in bold type: ``It is expected that the commitment
will be unfunded.'').
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Chase was paid $500,000 in fees for participating in the
Fishtail transaction.\20\ Its $42 million unfunded commitment
to the joint venture was never used, and Chase never actually
contributed any funds to Fishtail. LJM2 was paid an up-front
fee of $350,000 for participating in Fishtail. Approximately
six months later, LJM2 was paid $8.5 million to ``sell'' its
Annapurna ownership interest to Sundance. This payment meant
that LJM2 not only recouped its initial capital investment of
$8 million, but also, when combined with its earlier $350,000
fee, earned an overall 15 percent return on its Fishtail
investment.\21\
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\20\ See Chase Securities letter to Enron (12/20/00), Bates SENATE
ANNA 00360-61, Hearing Exhibit 315. This information was also confirmed
in the Traband interview and Subcommittee interview with Eric Peiffer
(12/4/02) (hereinafter ``Peiffer interview'').
\21\ LJM2 documents show that LJM2 had expected to receive a 15
percent return on its Annapurna investment and to be taken out of the
Fishtail transaction within six months. See, for example, ``LJM2
Investment Summary'' (12/20/00), Bates LJM 029881-4, Hearing Exhibit
306. While one Enron employee maintained in a Subcommittee interview
that the 15 percent return was the maximum that LJM2 was entitled to
receive on the joint venture, and not a guaranteed minimum return, the
LJM2 documentation and similar minimum fee arrangements between Enron
and LJM2 in other investments, suggest the final amount paid to LJM2
was more than coincidence. See, for example, 15 percent fee arrangement
in the Nigerian barge transaction examined at the Subcommittee's July
30 hearing; Patrick interview.
---------------------------------------------------------------------------
Analysis. The Fishtail transaction was, at its core, a sham
joint venture which pretended to have more than one investor,
but, in fact, relied solely on Enron. The primary goal of the
transaction was to create an appearance of Enron's moving its
pulp and paper trading business from an in-house operation to a
separate joint venture so that Enron could eliminate the assets
from its balance sheet. A secondary goal was to fix a market
value to the transferred assets in preparation for their
``sale'' a week later.
The evidence shows that Fishtail did not qualify for off-
balance sheet treatment and should have been consolidated with
Enron. Enron's counter party in the joint venture, Annapurna,
functioned as a shell operation designed to create the
appearance but not the reality of a second investor. Annapurna
had no employees, no bank account, and no purpose or activities
apart from its passive investment in Fishtail.
Annapurna was allegedly capitalized by LJM2 and Chase. But
LJM2's related party status, due to its close Enron ties and
the ownership and control exercised by Enron's chief financial
officer, Andrew Fastow, \22\ disqualified LJM2 from providing
the ``independent'' equity investment necessary to an
unconsolidated SPE or joint venture.\23\ In addition, Mr.
Fastow's pending criminal indictment alleges that Enron, on
more than one occasion, used LJM2 ``to manufacture earnings
through sham transactions'' and that Enron had an ``undisclosed
agreement'' with Mr. Fastow to ensure that LJM2 did ``not lose
money in its dealings with Enron.'' \24\ This undisclosed
agreement, if it existed, meant that LJM2's investment in
Annapurna was never truly at risk since, in essence, Enron had
guaranteed it would not suffer any loss from an Enron venture.
Chase's $42 million commitment also failed to place any funds
at risk, since it was never funded or drawn upon and functioned
under arrangements which made its use highly unlikely. As one
finance expert put it, ``Chase never really had any skin in the
game.''
---------------------------------------------------------------------------
\22\ See Subcommittee report, ``The Role of the Board of Directors
in Enron's Collapse,'' S. Prt. 107-70 (July 8, 2002), at 23-35.
\23\ See EITF Abstracts, Topic D-14, ``Transactions Involving
Special Purpose Entities.''
\24\ United States v. Fastow, (USDC SDTX, Cr. No. H-02-0665),
Indictment (10/31/02) at paragraphs 19 and 22.
---------------------------------------------------------------------------
If Chase's unfunded commitment were disregarded, then
Annapurna's capitalization and contribution to Fishtail totals
$8 million in cash, well short of the Andersen 4:1
capitalization guidelines for unconsolidated joint ventures. In
addition, if the $8 million was neither independent nor at risk
due to LJM2's related party status and undisclosed agreement
with Enron, Annapurna collapses as a SPE, and Fishtail fails to
meet its requirement for a minimum 3 percent at-risk
investment. In either situation, Fishtail should have been
consolidated with Enron.
Additional issues are raised by the $200 million valuation
placed on Enron's pulp and paper trading business when it was
contributed to Fishtail. This $200 million figure was more than
double the market value of the one ``hard asset'' carried on
Enron's own books, the remaining assets were ``soft assets''
that Enron itself was cautious about using to establish the
value of a joint venture contribution, and the only
``independent'' asset valuation was performed by a Chase
affiliate.
By participating in Fishtail, Chase helped Enron move its
pulp and paper trading business off-balance sheet and establish
a generous market value for the transferred assets. Chase never
actually invested any funds in Fishtail or took any active role
in the business, yet was paid half a million dollars for
pretending to provide the bulk of financing for this so-called
joint venture.
BACCHUS
The Facts. The second transaction, Bacchus, took place one
week after Fishtail, on or about December 26, 2000. Enron used
the Bacchus transaction to declare that a $200 million asset
``sale'' had taken place and record a $112 million ``gain'' on
its 2000 financial statements.
Enron's primary goal in Bacchus was to ``monetize'' its
interest in its pulp and paper trading business so that it
could record additional income and cash flow from the ``sale''
of this business venture on its financial statements.\25\ The
Fishtail transaction took the first step by purporting to move
Enron's pulp and paper trading business to a separate joint
venture off Enron's books. Once Fishtail was complete, Enron
took the next step, in Bacchus, to ``sell'' its Fishtail
investment to an allegedly independent third party so that it
could record the cash flow and income on its books.
---------------------------------------------------------------------------
\25\ See ``Transaction Descriptions,'' Enron document (undated),
Bates EC2 000009786-87, Hearing Exhibit 317; Patrick interview;
``Fishtail LLC Formation/Securitization,'' Andersen memorandum by
Thomas Bauer and Kate Agnew (12/29/00), Bates AASCGA 008673.1-4,
Hearing Exhibit 324.
---------------------------------------------------------------------------
Enron reasoned that its ownership interests in Fishtail
\26\ qualified as a ``financial asset'' that could be sold and
accounted for under Statement of Financial Accounting Standards
(SFAS) 140.\27\ SFAS 140 has typically been applied to the sale
of financial assets such as pools of mortgages or receivables
that have been securitized and transferred to an SPE.\28\ To
avoid consolidation, the SPE purchasing the financial assets
must have a minimum outside equity investment which represents
at least 3 percent of the SPE's total capital and which must
remain genuinely at risk.\29\
---------------------------------------------------------------------------
\26\ Enron and LJM2 had agreed on three classes of ownership
interests in the Fishtail joint venture. Class A interests, owned by
Enron, conveyed the right to exercise management control over the joint
venture and the right to 0.1 percent of the ``economic interests'' in
Fishtail. Class B interests, owned by Annapurna, conveyed the right to
20 percent of the ``economic interests'' in Fishtail. Class C
interests, owned by Enron, conveyed the right to 79.9 percent of the
``economic interests'' in Fishtail. See ``Fishtail,'' a summary of the
Fishtail transaction by Deloitte & Touche, LLP, executed in conjunction
with the Powers Report, Bates DT 000376-000403, Hearing Exhibit 305.
Presumably, by ``economic interests'' the parties meant the profits or
losses sustained by the joint venture.
\27\ SFAS 140, ``Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities,'' is a statement of
accounting standards issued by the Financial Accounting Standards Board
(FASB), an organization designated by the Securities and Exchange
Commission (SEC) to develop, promulgate, and interpret generally
accepted accounting principles for U.S. business. SFAS 140 superceded
and replaced SFAS 125. Enron's reliance on SFAS 140 in this transaction
is documented, for example, in a Citigroup draft analysis of the
transaction, ``Capital Markets Approval Committee: Enron Corp. Project
Bacchus FAS 125 Transaction'' (12/1/00), Bates CITI-SPSI 012895. Enron
engaged in numerous transactions under SFAS 140 and its predecessor
SFAS 125, collectively involving more than $1 billion. See ``Finance
Related Asset Sales: Prepays and 125 Sales'' (presentation to the
Finance Committee of the Enron Board of Directors, August 2001),
Exhibit 42 in the Subcommittee hearing, ``The Role of the Board of
Directors in Enron's Collapse'' (May 7, 2002). See also ``First Interim
Report of Neal Batson, Court-Appointed Examiner,'' In Re Enron Corp.,
Case No. 01-16034(AJG) (Bankr. SDNY, 9/21/02).
\28\ Unlike other asset sales, SFAS 140 has been interpreted to
allow the seller of the financial asset to retain a significant degree
of control over the asset, even after its securitization and transfer
to the SPE. For example, a financing company that routinely issues and
acquires car loans may continue to manage and collect payments on these
car loans even after pooling them and selling the rights to the cash
flow to an SPE in an SFAS 140 transaction. Enron analogized that, in an
SFAS 140 transaction, it could sell its Fishtail interests to an SPE,
while continuing to exercise control over its pulp and paper trading
business even after the sale.
\29\ See footnote 14. FASB is currently in the process of revising
certain SPE accounting standards and, among other changes, may increase
the required minimum outside equity for an unconsolidated SPE from 3 to
10 percent. See FASB Exposure Draft, ``Consolidation of Certain
Special-Purpose Entities'' (June 28, 2002).
---------------------------------------------------------------------------
Within one week of forming Fishtail, Enron ``sold'' its
Class C ownership interest in Fishtail for $200 million to an
SPE it had formed called the Caymus Trust. This transaction,
which Enron called Bacchus, is illustrated in the following
Figure 2.
[GRAPHIC] [TIFF OMITTED] T3559.002
The Caymus Trust was established by Enron as a Delaware
business trust.\30\ The Caymus Trust was capitalized with a
$194 million loan from Citigroup and a $6 million equity
``investment'' from FleetBoston Financial provided through an
off-balance sheet entity it had established called Long Lane
Master Trust IV.\31\ The $194 million represented 97 percent of
the Trust's total capitalization, while the $6 million
represented the required minimum 3 percent outside equity
investment. Although FleetBoston appeared to carry the risk
associated with the $6 million equity investment, in fact, the
risk had been conveyed to Citigroup through a total return
swap.\32\ This arrangement meant that Citigroup was responsible
not only for the $194 million loan it had issued to the Caymus
Trust, but also for the $6 million cash investment ostensibly
made by FleetBoston.\33\
---------------------------------------------------------------------------
\30\ See ``Data Sheet Reprint . . . Caymus Trust (c/o Wilmington
Trust)'' (2/22/02), Bates ECa 000009793.
\31\ Citigroup and FleetBoston worked together on at least one
other set of Enron transactions, the Yosemite prepays, which also made
use of Long Lane Master Trust IV. For more information, see the July 23
hearing, ``Testimony of Robert Roach, Chief Investigator, Permanent
Subcommittee on Investigations,'' Appendix D, at pages D-10 and D-11.
\32\ Email by Citigroup employee James Reilly (11/28/00), Bates
CITI-SPSI 0118432, Hearing Exhibit 322c; Subcommittee interview with
Citigroup employees Richard Caplan (11/21/02) and William Fox (11/22/
02). A total return swap is a derivative transaction in which one party
conveys to the other party all of the risks and rewards of owning an
asset without transferring actual legal ownership of that asset.
\33\ According to explanations provided by Citigroup employees
during their Subcommittee interviews, Citigroup used FleetBoston in the
Bacchus transaction because its initial analysis led it to believe that
owning both the debt and equity in Caymust Trust would raise regulatory
issues. By the time Citigroup realized that these issues would not
arise, the transaction was nearly completed and Citigroup decided not
to change the structure.
---------------------------------------------------------------------------
Enron, in turn, reduced Citigroup's risk in the Bacchus
transaction by entering into a total return swap with Citigroup
to provide credit support for the $194 million loan.\34\ Under
this total return swap, Enron effectively pledged to make
Citigroup whole for any decline in value of the Fishtail assets
should those assets be needed to repay the loan.\35\ In effect,
Enron had guaranteed the $194 million loan.\36\ In an
interview, Enron personnel explained to the Subcommittee that
Andersen had approved its interpreting SFAS 140 as allowing
Enron to guarantee the debt financing associated with the
Caymus Trust.\37\ Andersen instructed that similar credit
support could not be provided by Enron for the $6 million
outside equity investment, \38\ essentially because that
support would mean that Enron would, in effect, be guaranteeing
the entire purchase price, the purchaser of the assets would
assume no risk from participating in the transaction, and the
asset transfer would, therefore, no longer qualify as a
``sale'' under SFAS 140.
---------------------------------------------------------------------------
\34\ See ``Project Bacchus,'' diagram of Bacchus transaction
(undated), Bates ECa 000196027, Hearing Exhibit 316; ``Global Loans
Approval Memorandum,'' (12/11/00), Bates CITI-SPSI 0015991-95, Hearing
Exhibit 318.
\35\ Conversely, the total return swap also entitled Enron, in
effect, to retain any increase in value of the Fishtail assets, should
that occur.
\36\ By using a total return swap instead of a loan guarantee,
Enron avoided having to disclose the guarantee in its financial
statement footnotes.
\37\ Patrick interview.
\38\ See series of Andersen emails, (11/30/99), Bates AASCGA
001133.1-3, Hearing Exhibit 325.
---------------------------------------------------------------------------
Although Enron was barred by accounting standards from
doing so, the Subcommittee uncovered documentary evidence
indicating that Enron had also guaranteed the $6 million equity
``investment'' in the Caymus Trust. Enron provided this
guarantee by making an undisclosed oral agreement with
Citigroup to ensure repayment of the $6 million. The key
internal Citigroup memorandum seeking final approval of the
Bacchus transaction from the Citigroup Credit Committee makes
multiple references to the existence of this oral
agreement.\39\ The memorandum describes the Bacchus credit
``facility'' being requested as consisting of two parts: a
``loan'' and an ``equity'' contribution. The memorandum states:
``The equity component we provide will be based on verbal
support as committed by Andrew S. Fastow . . . to Bill Fox [of
Citigroup].'' It also states that the ``equity portion of the
facility'' involves ``a large element of trust and relationship
rationale'' but ``this equity risk is largely mitigated by
verbal support received from Enron Corp. as per its CFO, Andrew
S. Fastow.'' At another point, the memorandum states: ``Enron
Corp. will essentially support the entire facility, whether
through a guaranty or verbal support.'' \40\
---------------------------------------------------------------------------
\39\ ``Global Loans Approval Memorandum,'' (12/11/00), Bates CITI-
SPSI 0015991-95, Hearing Exhibit 318.
\40\ See also ``Executive Summary'' of certain Citigroup
transactions with Enron (undated), Bates CITI-SPSI 0128937, Hearing
Exhibit 320 (``Bacchus/Caymus Trust Facility--Citibank has been asked
to approve and hold this $250MM facility consisting of Notes and
Certificates. . . . The Notes ($242.5MM) will be supported by a total
return swap with Enron Corp as the credit risk. The Certificates are
supported by verbal support obtained by Bill Fox from Andy Fastow,
Enron Corp's Chief Financial Officer.'')
---------------------------------------------------------------------------
During an interview with Subcommittee staff, one senior
Citigroup official who played a key role in securing final
approval of the deal denied that Enron had verbally guaranteed
the equity ``investment.'' \41\ Yet he confirmed that, prior to
the closing of the deal, he traveled to Enron in Houston and
met with Mr. Fastow to obtain Enron's ``verbal support'' for
the equity investment. He also told the Subcommittee that Mr.
Fastow assured him that Enron would take ``whatever steps
necessary'' to ensure Citigroup would not suffer any loss
related to the $6 million.\42\ Later, the same senior official
sent an email to Citigroup's risk management team stating that
Citigroup had obtained a ``total return swap from Enron'' for
the debt financing and ``verbal support for the balance,''
meaning the $6 million.'' \43\
---------------------------------------------------------------------------
\41\ Fox interview.
\42\ Id. At the December 11 hearing, Mr. Fox testified that Mr.
Fastow promised to take ``all steps necessary'' to protect Citigroup
from any loss related to the $6 million.
\43\ Email from Mr. Fox to Citigroup employee Thomas Stott (4/18/
01), Bates CITI-SPSI 0085843, Hearing Exhibit 319. Still another
Citigroup email, written two days after the Bacchus deal closed,
stated: ``The equity component has been approved on the basis of verbal
support verified by Enron CFO, Andy Fastow.'' Email from Citigroup
employee Lydia Junek to Mr. Fox (12/21/00), Bates CITI-SPSI 0128944-45,
Hearing Exhibit 322h.
---------------------------------------------------------------------------
In addition, a key Citigroup document seeking approval of
multiple new credit facilities for Enron explicitly stated at
the time that, with respect to the Bacchus transaction,
Citigroup had obtained ``verbal guarantees'' from Enron for the
equity ``investment'' in the Caymus Trust.\44\ This document, a
Citigroup credit approval report signed by senior Citigroup
employees, listed 14 ``credit facilities'' Citigroup was
considering establishing for the benefit of Enron. Two
identified the Caymus Trust as the ``borrower.'' One of these
two described a proposed $7.5 million ``facility'' (later
reduced to $6 million) for the Caymus Trust, which represented
the required 3 percent outside equity ``investment'' in that
entity.\45\ The credit approval report states that Citigroup
had obtained the following ``Support'' for this equity
component:
---------------------------------------------------------------------------
\44\ Citibank Credit Approval (12/8/00), Bates CITI-SPSI 0128921,
Hearing Exhibit 320.
\45\ At the time the credit approval report was completed in early
December 2000, Enron and Citigroup expected the total purchase price in
the Bacchus transaction would be $250 million, instead of the $200
million amount ultimately decided upon; the credit approval report
reflected the initial, larger total. See email from Citigroup employee
Steve Baillie to other Citigroup employees (11/24/00), Bates CITI-SPSI
0119040, Hearing Exhibit 322a.
---------------------------------------------------------------------------
``Type: VERBAL GUARANTEES Percentage: 100.00''
The report lists the ``Support Provider'' as ``Enron Corp.''
\46\
---------------------------------------------------------------------------
\46\ Citibank Credit Approval (12/8/00), Bates CITI-SPSI 0128921,
Hearing Exhibit 320.
Together, the evidence establishes that Enron guaranteed
100 percent of the debt and equity ``investment'' in the Caymus
Trust, and both Enron and Citigroup knew it. Enron's 100
percent guarantee of the Caymus Trust investments meant that
the Caymus Trust had incurred no risk in transferring the $200
million to Enron to ``purchase'' the Fishtail assets, because
Enron itself had guaranteed repayment of the full amount. The
absence of risk meant the asset transfer did not qualify as a
``sale'' under SFAS 140, and Enron should not have booked
either cash flow from operations or a reportable gain from this
transaction. Instead, Enron should have treated the $200
million as a loan from Citigroup and booked the funds as debt
and cash flow from financing.
Nevertheless, immediately upon completing the December
``sale'' of its Class C Fishtail interests to the Caymus Trust,
Enron declared an additional $200 million in cash flow from
operations as well as a $112 million gain in income on its
year-end 2000 financial statements.\47\
---------------------------------------------------------------------------
\47\ See Enron's 10-K SEC filing for 2000. Enron apparently
calculated the $112 million gain by subtracting $88 million from the
$200 million ``sale'' price. This $88 million was apparently the
``basis'' Enron claimed for its Class C ownership interest in Fishtail.
See ``3% Test and Gain Calculation,'' Andersen document (11/17/01),
Bates AASCGA 002454.6, Hearing Exhibit 321. See also footnote 11.
---------------------------------------------------------------------------
Citigroup internal documentation shows that Citigroup
participated in the Bacchus transaction in part as an
accommodation to Enron. One email from November 2000 describes
the Bacchus transaction as follows: ``For Enron, this
transaction is `mission critical' (their label not mine) for
[year-end] and a `must' for us.'' \48\ Another email dated a
week after the deal closed states with respect to Bacchus:
``Sounds like we made a lot of exceptions to our standard
policies, I am sure we have 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.'' \49\
Another document advocating participating in several Enron
transactions states: ``Given the breadth of our relationship
with the company we have been told by Enron that it is
important that we participate in these strategic initiatives,''
including Bacchus.\50\ Another email a few months later
discussing Bacchus and other pending deals observes: ``Enron
generates substantial GCIB revenue ($50mm in 2000); any
decision to limit/reduce credit availability will significantly
reduce revenues going forward both at Cit and SSB and
permanently impair the relationship.'' \51\
---------------------------------------------------------------------------
\48\ Email from Citigroup employee James Reilly to other Citigroup
employees (11/28/00), Bates CITI-SPSI 0129017.
\49\ Email from Citigroup employee Steve Wagman to Citigroup
employee Amanda Angelini, with copies to Mr. Caplan and others (12/27/
00), Bates CITI-SPSI 0119009, Hearing Exhibit 322i.
\50\ ``Executive Summary,'' Citigroup document (undated), Bates
CITI-SPSI 0128937, Hearing Exhibit 320.
\51\ Email from Mr. Fox to Citigroup employee Thomas Stott (4/18/
01), Bates CITI-SPSI 0085843, Hearing Exhibit 319. GCIB refers to
Global Corporate & Investment Bank. Cit refers to Citigroup. SSB refers
to Salomon Smith Barney.
---------------------------------------------------------------------------
The evidence also indicates that, early on, Citigroup
became aware that Enron might use the Bacchus transaction to
improve its financial statements. Emails over time show
Citigroup personnel were aware, for example, that Enron might
use Bacchus to reduce debt and generate cash flow from
operations on its financial statements, but Citigroup asserts
its personnel were unaware that Bacchus would generate material
earnings for Enron. One Citigroup email in November 2000,
states that ``Enron's motivation'' in Bacchus ``now appears to
be writing up the asset in question from a [cost] basis of
about $100 [million] to as high as $250 [million], thereby
creating earnings.'' \52\ This email also states a ``concern''
about ``appropriateness since there is now an earnings
dimension to this deal, which was not there before.''
---------------------------------------------------------------------------
\52\ Email from Citigroup employee Steve Baillie to Mr. Fox (11/24/
00), Bates CITI-SPSI 0119040, Hearing Exhibit 322a.
---------------------------------------------------------------------------
Another Citigroup email a month later states that the
Bacchus transaction was ``designed'' in part to ``ensure that
Enron will meet its [year-end] debt/cap[iptalization]
targets''; it was ``probable'' the transaction would ``add to
[funds flow from operations]'' on Enron's financial statements;
and ``possible, but not certain, that there will be an earnings
impact.'' \53\ An email two days later calculates that the $200
million would represent more than ten percent of the cash flow
and net income Enron had reported in 1999 and was likely to
report in 2000.\54\ An email in response states: ``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.'' \55\ While two of the December emails predict any
earnings from the Bacchus transaction were likely to be
immaterial, Citigroup personnel agreed in Subcommittee
interviews that the $112 million in extra earnings finally
reported was material even to a company as large as Enron.\56\
Citigroup denied knowing at the time, however, that Enron had
actually recorded these additional earnings in its 2000
financial statements.
---------------------------------------------------------------------------
\53\ Email from Citigroup employee James Reilly to Mr. Caplan, Mr.
Fox, and others (12/6/00), Bates CITI-SPSI 0119046, Hearing Exhibit
322d.
\54\ Email from Citigroup employee Shirley Elliott to Mr. Fox (12/
13/00), Bates CITI-SPSI 011906, Hearing Exhibit 322f (``In terms of
total balance sheet size, it appears that Bacchus is immaterial;
however, the $200 million represents 16.3% and 22.4% of operating cash
flow and net income, respectively [for 1999, and] . . . 11.6% of cash
EBITDA . . . [for 2000].'') This analysis assumes a zero basis.
\55\ Email from Mr. Fox to Shirley Elliott (12/13/00), Bates CITI-
SPSI 0128912, Hearing Exhibit 322g.
\56\ Caplan interview; Fox interview.
---------------------------------------------------------------------------
In interviews with the Subcommittee staff, Citigroup
executives involved in the Bacchus transaction stated that when
a structured finance transaction has features suggesting that a
client might be using the transaction to manufacture earnings
on its financial statements, it creates an ``appropriateness
issue'' which generally requires a greater degree of review and
due diligence within the investment bank.\57\ When asked
whether the necessary appropriateness review took place in
Bacchus, one Citigroup official stated that ``further
investigation'' was warranted since the emails indicated that
Citigroup had not clarified whether Enron was, in fact, going
to claim earnings from the transaction and, if so, how much. He
also indicated that he was unaware of any additional action
taken to examine the earnings or other financial statement
implications of the transaction. The Subcommittee has not
found, and Citigroup has not provided, any evidence
establishing that Citigroup undertook any additional
appropriateness review to gauge Enron's potential use of
Bacchus to generate earnings.
---------------------------------------------------------------------------
\57\ Id. These Citigroup executives also indicated that Citigroup
typically does not get involved in structured transactions that have an
earnings impact, with the exception of transactions generating tax
benefits.
---------------------------------------------------------------------------
In fact, the Bacchus figures significantly improved Enron's
2000 financial statements. The $112 million gain represented
more than 11 percent of Enron's total net income for the fiscal
year, while the $200 million in cash flow represented about 6
percent of Enron's total cash flow from operations for the
year.\58\ These figures suggest that, had the Fishtail and
Bacchus transactions failed to close, Enron would likely have
failed to meet Wall Street's earnings projections for the year,
and the company's share price would have suffered.
---------------------------------------------------------------------------
\58\ According to its 10-K filing with the SEC, Enron's total net
income for 2000 was $979 million. Using this filing and other
information, the Subcommittee estimated Enron's total funds flow from
operations in 2000 at about $3.248 billion. See July 23 hearing,
``Testimony of Robert Roach, Chief Investigator, Permanent Subcommittee
on Investigations,'' Appendix A, at page A-4.
---------------------------------------------------------------------------
Citigroup was paid a $500,000 fee for its participation in
Bacchus, earned about $5 million in interest payments related
to the $200 million debt, and obtained another $450,000 yield
related to the $6 million ``equity investment.'' \59\
---------------------------------------------------------------------------
\59\ ``Global Loans Approval Memorandum,'' (12/11/00), Bates CITI-
SPSI 0015991-95, Hearing Exhibit 318; information supplied by Citigroup
to the Subcommittee.
---------------------------------------------------------------------------
Analysis. Even more than Fishtail, the Bacchus transaction
was steeped in deceptive accounting, if not outright accounting
fraud. The evidence shows that Enron guaranteed both the debt
and equity ``investment'' in the Caymus Trust, thereby
eliminating all risk associated with the ``sale'' of the
Fishtail assets to the Trust. Without risk, the transaction
fails to qualify as a sale under SFAS 140. The fact that
Enron's guarantee of the $6 million equity ``investment'' was
never placed in writing, but was kept as an oral side agreement
with Citigroup, demonstrates that both parties understood its
significance and potential for invalidating the entire
transaction. Citigroup nevertheless proceeded with the deal,
knowing that a key component, Enron's guarantee of the $6
million, rested on an unwritten and undisclosed oral agreement.
Citigroup was also aware that Enron was likely to use the
Bacchus transaction to improve its financial statements through
added cash flow and perhaps added earnings, but did not
sufficiently confront this issue either internally or by asking
Enron for more information. In the end, Citigroup not only
participated in the Bacchus deal, it supplied the funds needed
for Enron to book the $200 million in extra cash flow from
operations and $112 million in extra net income on its 2000
financial statements. Without Citigroup's complicity and
financial resources, Enron would not have been able to complete
the deal and manipulate its financial statements to meet Wall
Street expectations for its 2000 earnings.
SUNDANCE
The Facts. The third transaction, Sundance, took place six
months after Bacchus. Fishtail and Bacchus had been constructed
as short term arrangements \60\ intended to enable Enron to
move its pulp and paper trading business off-balance sheet and
recognize income and cash flow from this business venture prior
to the end of the fiscal year. Sundance Industrial Partners
(``Sundance'') was allegedly established to create a more long-
term off-balance sheet entity which Enron could use to hold and
manage all of its pulp and paper business assets. Like
Fishtail, however, Sundance provided the appearance but not the
reality of having more than one investor, and should have been
consolidated on Enron's balance sheet.
---------------------------------------------------------------------------
\60\ The $194 million loan in Bacchus, for example, had a one-year
maturity date. See ``Global Loans Approval Memorandum,'' (12/11/00),
Bates CITI-SPSI 0015991-95, Hearing Exhibit 318. LJM2's investment in
Fishtail was intended to end after six months or trigger higher costs.
``LJM2 Investment Summary'' (12/20/00), Bates LJM 029881-4, Hearing
Exhibit 306.
---------------------------------------------------------------------------
Sundance was constructed as a 50-50 joint venture between
Enron and Citigroup, to be capitalized at a 4:1 ratio in
accordance with Anderson's joint venture guidelines. Figure 3
is a diagram of the Sundance structure.
[GRAPHIC] [TIFF OMITTED] T3559.003
Enron contributed the following assets to the Sundance
joint venture: a Canadian paper mill known as Stadacona; a New
Jersey paper mill known as Garden State Paper; timberland
located in Maine and known as SATCO; a $25 million liquidity
reserve for ongoing administrative expenses; a $65 million
commitment to service debt and capital expenditures; and $208
million in cash.\61\ The total value of Enron's contribution
was approximately $750 million.
---------------------------------------------------------------------------
\61\ See ``Sundance Steps'' (6/1/01), Bates CITI-SPSI 0128886.
---------------------------------------------------------------------------
Citigroup, in turn, appeared to contribute $8.5 million in
cash, \62\ certain shares valued at $20 million, \63\ and $160
million in an ``unfunded capital commitment.'' Citigroup, thus,
appeared to contribute assets totaling approximately $188.5
million to meet the Andersen joint venture capitalization
guidelines.\64\
---------------------------------------------------------------------------
\62\ The $8.5 million was immediately used by Sundance to purchase
Annapurna's Class B 20-percent economic interest in Fishtail. All of
these monies were apparently paid to LJM2, enabling LJM2 to recoup its
$8 million capital contribution to Annapurna and, when combined with an
earlier $350,000 fee, earn an overall return of 15 percent on its
Fishtail investment. See ``Sundance Steps,'' Enron document (5/16/01),
Bates ECa 000022315, Hearing Exhibit 328a; ``Structuring Summary:
Project Grinch,'' Chase document (12/16/00), Bates JPM-1-00437, Hearing
Exhibit 311.
\63\ The shares conveyed ownership of an SPE called Sonoma, LLC
whose sole asset consisted of Enron's Class A interest in Fishtail,
which Enron had retained during the Bacchus transaction. The Class A
interest essentially conveyed management control over Enron's pulp and
paper trading business. Just prior to contributing the shares to
Sundance, Citigroup purchased them from Enron for $20 million. Enron
immediately reported the $20 million in ``sales'' revenue on its second
quarter 2001 financial statements. The evidence suggests that the $20
million transaction was executed solely to allow Enron to book the
additional $20 million. Initially, Enron's outside counsel, Vinson and
Elkins, had declined to issue a legal opinion characterizing the Sonoma
stock transfer to Citigroup as a ``true sale,'' since Citigroup had
avoided all risk associated with the shares by immediately contributing
them to Sundance. To satisfy Vinson and Elkins, Citigroup entered into
a derivative transaction with Sundance which, in part, allowed Sundance
to sell the shares back to Citigroup within a certain period of time.
After this derivative was put in place, Vinson and Elkins issued a
``last minute true sale opinion'' allowing Enron to book the sale. See
``Enron Industrial Markets Finance Presentation of Sundance Industrial
Partners,'' Enron document, (6/1/01), Bates ECa000169835, Hearing
Exhibit 329. An internal Citigroup email indicates that Citigroup
itself did not intend to take on any real risk by participating in the
derivative transaction: ``Spoke with the client. They intend and expect
to close tomorrow whether the put issue is resolved or not. They fully
understand that we will blow the deal up if we are at risk for the put.
. . .'' Email from Citigroup employee Doug Warren to Mr. Caplan (5/29/
01), Bates CITI-SPSI 0123901, Hearing Exhibit 333l.
\64\ The $188.5 million was intended to provide the minimum 20
percent capital contribution required by the Andersen 4:1
capitalization guidelines for 50-50 unconsolidated joint ventures. The
$28.5 million in cash and stock was intended to provide the minimum 3
percent capital-at-risk required by the Andersen guidelines.
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Although Vinson and Elkins viewed the derivative
transaction as sufficient to put Citigroup at risk for the
Sonoma shares, other terms in the Sundance partnership
agreement--which Vinson and Elkins helped draft--explicitly
authorized Citigroup to unilaterally dissolve the partnership
at any time, prior to incurring any loss. See email by Mr.
Caplan to Mr. Fox, with attachments (10/29/01), Bates CITI-SPSI
0127648, Hearing Exhibit 333t. Vinson and Elkins knew or should
have known that this partnership language insulated Citigroup
from any true risk of loss in its Sundance investments. Vinson
and Elkins nevertheless issued the true sale opinion allowing
Enron to record the $20 million gain from the Sonoma share
transfer.
Upon receiving the contributions from Enron and Citigroup,
Sundance immediately used the $208 million cash provided by
Enron to buy Enron's prior Fishtail interests from the Caymus
Trust.\65\ The Caymus Trust then used these funds to pay off
its $194 million loan from Citigroup and return the outstanding
$6 million equity ``investment,'' thereby eliminating all
remaining risk for Citigroup associated with the Bacchus
transaction.\66\ The $208 million payment also included a $1.5
million payment to the Caymus Trust that was apparently passed
along to Citigroup for alleged ``breakage costs,'' presumably
due to early repayment of the $194 million loan.\67\ In
essence, then, six months after receiving $200 million from the
Caymus Trust--all of which had been financed by Citigroup--and
using the money to book cash flow and earnings on its 2000
financial statements, Enron returned $200 million to Citigroup
via the Sundance joint venture.
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\65\ This $208 million ``purchase'' of the Class C Fishtail
interests, when considered in conjunction with Sundance's ``purchase''
of the Class B Fishtail interests for $8.5 million and Class A Fishtail
interests for $20 million, appears to mean that, as of June 2001, Enron
and Citigroup paid a total of $236.5 million for Enron's pulp and paper
trading business. But see ``Sundance Structure,'' Citigroup document
(undated), Bates CITI-SPSI 0044992, Hearing Exhibit 331 (valuing
Fishtail at $228.5 million). Both figures represent a significant
increase over the $200 million value assigned to this business just six
months earlier. This increased value was assigned to Enron's trading
business during a period in which many internet-based businesses were
falling in value.
\66\ ``Sundance Steps,'' Enron document (5/16/01), Bates
ECa000022315, Hearing Exhibit 328a.
\67\ Id.
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The evidence suggests that Citigroup agreed to participated
in Sundance only after, contrary to accounting principles, the
joint venture was structured to ensure that none of Citigroup's
funds was actually at risk and none of its expected returns
depended upon the risks and rewards of the joint venture.
Citigroup protected its ``investments'' from loss in several
ways. First, under the partnership agreement, Citigroup
obtained unilateral authority to dissolve the Sundance
partnership at any time and force its liquidation before Enron
could draw upon any Citigroup funds.\68\ This unilateral
authority meant, in effect, that as long as Citigroup monitored
the Sundance transaction and acted promptly to dissolve the
partnership, it could protect itself against any loss.
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\68\ The Sundance partnership agreement authorized Citigroup, at
its discretion, to invoke the creation of a board of directors and
appoint two of the four members. ``Sundance Partnership Agreement''
(06/01/01), at 52-53, Bates CITI-SPSI 0016044. If this board were to
``Deadlock,'' it would be considered a ``dissolution event'' and the
partnership would automatically dissolve. Id. at 6, 61; see also
``Description of the Sundance Transaction,'' Citigroup document, (10/
29/01), Bates CITI-SPSI 0127648, Hearing Exhibit 333t.
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In addition, the partnership agreement required Sundance to
maintain at all times $28.5 million in Enron notes or other
high quality, liquid financial instruments to which Citigroup
was given preferred access.\69\ These liquid financial
instruments were explicitly segregated and set aside to ensure
repayment, with a specified return, of Citigroup's $8.5 million
cash contribution and $20 million share contribution to the
partnership. In addition, the partnership agreement provided
that Enron had to exhaust its Sundance investments before any
of Citigroup's $28.5 million in cash and stock could be used.
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\69\ See ``Description of the Sundance Transaction,'' Citigroup
document (10/29/01), Bates CITI-SPSI 0127648, Hearing Exhibit 333t.
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Citigroup's $160 million ``unfunded'' capital commitment
also operated under multiple protections making it unlikely
ever to be used. Under the partnership agreement, Citigroup's
funding commitment could be called on only after the
partnership incurred GAAP losses in excess of $657 million,
Enron exhausted its $65 million debt and capital reserve and
$25 million liquidity reserve, and the $28.5 million in liquid
financial instruments were cashed in. Again, these arrangements
meant that Sundance would have to lose almost $750 million--
Enron's entire investment--before any loss could be repaid from
Citigroup's ``contributions.'' Enron highlighted these features
of the Sundance agreement in a September 2001 presentation to
Citigroup, describing it as ``SBHC's Cushion.'' \70\ Citigroup
was told that it could wait until the entire ``cushion'' was
absorbed before dissolving Sundance to avert any losses.
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\70\ ``Enron Industrial Markets Finance Presentation of Sundance
Industrial Partners to Salomon Smith Barney,'' (September 2001), Bates
CITI-SPSI 0044993, Hearing Exhibit 331. SBHC refers to Salomon Brothers
Holding Company. The presentation lists the risk mitigation mechanisms
point by point, including: ``Enron takes the first $747m in US GAAP
losses. . . . SBHC has the power to dissolve the partnership at will. .
. . SBHC has adequate information to assess ongoing risk. . . . Daily
trading loss cannot exceed $5.5mm (6.7 months to erode cushion through
trading losses). . . . Sundance has enough liquidity to repay SBHC
anytime.''
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Citigroup internal documents repeatedly described its
Sundance investment as protected from risk. One of Citigroup's
primary negotiators of Sundance put it this way:
``The transaction is structured to safeguard against
the possibility that we need to contribute our
contingency fund and to ensure that there is sufficient
liquidity at all times to repay our $28.5 million
investment.'' \71\
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\71\ Email from Mr. Caplan to Mr. Fox with attached Citigroup
memorandum, ``Description of the Sundance Transaction'' (10/29/01),
Bates CITI-SPSI 0127647-49, Hearing Exhibit 333t.
Another Citigroup email stated, ``our invest[ment] is so
subordinated and controlled that it is `unimaginable' how our
principal is not returned.'' \72\ In addition, Citigroup
arranged to receive fees and a specified return on its Sundance
``contributions,'' rather than share in any profits or
increased value in the partnership, which means that its
expected return was structured more like a return on debt than
on an equity investment. In fact, although Citigroup internally
classified its Sundance contribution as an ``equity
investment,'' minutes of a meeting of the Citigroup Capital
Markets Approval Committee (CMAC) considering the Sundance
structure noted that, ``based on the way the deal is
structured, it is more like debt rather than equity.'' \73\ The
final CMAC approval memorandum stated: ``The investment has
been structured to act like debt in form and substance.'' \74\
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\72\ Email between Citigroup employees Timothy Leroux and Andrew
Lee (5/25/01), Bates CITI-SPSI 0044874, Hearing Exhibit 333i. According
to a Subcommittee interview with Mr. Caplan, Citigroup was so convinced
of the security of its investment and the lack of any real risk, that
Citigroup decided not to purchase any default protection related to the
Sundance transaction.
\73\ ``Capital Markets Approval Committee (CMAC) Minutes to
Meeting'' (5/16/01), Bates CITI-SPSI 0016030-31, Hearing Exhibit 327.
See also email between Citigroup employees Amanda Angelini and Timothy
Leroux (4/27/01), Bates CITI-SPSI 0044852, Hearing Exhibit 333a
(listing reasons why Sundance ``is more like debt than equity'').
\74\ ``Capital Markets Approval Committee New Product/Complex
Transaction Description Guidelines Enron Corp. Project Sundance
Transaction'' (5/15/01), Bates CITI-SPSI 0044830, Hearing Exhibit 333c.
See also email from Citigroup employee Paul Gregg, ``Subject: Enron
Exposure on NA Credit Derivs,'' (10/22/01), Bates CITI-SPSI 0123218,
Hearing Exhibit 333u (``Note that these equity partnerships, are
designed to act as debt exposure due to numerous triggers built in
which allow us to terminate.'').
---------------------------------------------------------------------------
Given the lack of risk associated with Citigroup's Sundance
``investment,'' Citigroup personnel repeatedly questioned
Sundance's proposed off-balance sheet accounting. One Citigroup
e-mail two weeks before the deal's closing noted: ``[A
Citigroup tax attorney] wanted to say that this is a funky deal
(accounting-wise). He is amazed that they can get it off
balance sheet.'' \75\ Another email from Citigroup's Global
Energy and Mining group head in the Global Relationship Bank
questioning several aspects of the transaction stated: ``Also
not clear to me how this structure achieves Enron's off balance
sheet objectives. Do we have a full understanding of this
aspect of the transaction?'' A Citigroup official responded by
writing: ``On the accounting: [Andersen] has agreed that by
maintaining an 80/20 split on ownership with equal voting they
can achieve off b/s treatment. We have not advised nor opined
on the accuracy of that. However, according to Rick Caplan, it
is identical to what Dynegy did in the gas deal for abg gas.''
\76\
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\75\ Email from Citigroup employee Lynn Feintech to Mr. Caplan,
``RE: cmac memo'' (5/15/01), Bates CITI-SPSI 0122412, Hearing Exhibit
333d.
\76\ Email exchange between Citigroup employees Mr. Fox and Ms.
Feintech, ``RE: Sundance,'' (5/16/01), Bates CITI-SPSI 0119011, Hearing
Exhibit 333f. This email exchange may contain a reference to Dynegy and
an SPE it sponsored, ABS Gas Supply LLC. If so, the SEC has recently
determined that Dynegy violated certain securities laws and accounting
rules by failing to consolidate ABS Gas on its balance sheet. While not
admitting any of the SEC findings on this or other unrelated matters,
Dynegy agreed to entry of a cease and desist order in the case and paid
a $3 million penalty. See SEC v. Dynegy Inc., Civil Action No. H-02-
3623 (USDC SDTX), Complaint (9/23/02), paragraphs 42-53.
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Just prior to the closing for the Sundance transaction,
three senior Citigroup officials strongly warned against
proceeding with the deal, in part due to its ``aggressive''
accounting. The head of Citigroup's Risk Management team for
the Global Corporate and Investment Bank stated in a memorandum
sent to the head of the investment bank:
``This is a follow-up to our lunch conversation on the
transaction for Enron. If you recall, this is a complex
structured transaction, which I have refused to sign
off on.--Risk Management has not approved this
transaction for the following reasons: . . . The GAAP
accounting is aggressive and a franchise risk to us if
there is publicity (a la Xerox).'' \77\
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\77\ Citigroup memorandum by Mr. Bushnell, ``Enron--Project
Sundance Transaction,'' (5/30/01), Bates CITI-SPSI 0124615, Hearing
Exhibit 333n. The concerns expressed in the memorandum were raised
internally five days earlier in draft form. See email from Citigroup
employee Eleanor Wagner to Mr. Bushnell (5/25/01), Bates CITI-SPSI
0044872, Hearing Exhibit 333k.
In an accompanying email, the head of Citigroup's Global
---------------------------------------------------------------------------
Relationship Bank wrote:
``We ([the Global Energy and Mining group head] 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 were ignored.'' \78\
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\78\ Email from Alan MacDonald, head of Citigroup's Global
Relationship Bank, to Michael Carpenter, head of Citigroup's Global
Corporate & Investment Bank, ``FW: Memo on Enron--Project Sundance''
(5/31/01), Bates CITI-SPSI 0124614, Hearing Exhibit 333n.
Despite these strongly worded warnings from senior
personnel the transaction went forward on June 1, 2001. The
final go-ahead came on the day after a key Citigroup employee
working on the deal sent an email at 6 p.m. stating: ``Any
word? Am getting a significant amount of pressure from [E]nron
to execute.'' \79\ Another Citigroup email dated one month
later reported: ``[The head of the investment bank] was out of
the country the day that transaction closed. The approval memo
was . . . faxed to him. [He] then had a conversation with [the
Risk Management head], who shared with us [his] feedback. We
proceeded to close the transaction that day, given the absence
of in[s]tructions [from either person] to the contrary.'' \80\
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\79\ Email from Mr. Caplan to Shawn Feeny (5/31/01), Bates CITI-
SPSI 012894, Hearing Exhibit 333o.
\80\ Email from Shawn Feeney to Citigroup employee Andrew Lee (6/
29/01), Bates CITI-SPSI 0122944, Hearing Exhibit 333r.
---------------------------------------------------------------------------
Citigroup has been unable to tell the Subcommittee who
provided the final approval of the Sundance transaction.
Although Citigroup internal policy requires signed management
transaction approvals for transactions as large as Sundance,
Citigroup could not locate any of the normal signed
approvals.\81\ In his interview, Citigroup's Risk Management
head for the investment bank, who composed the strongly worded
memorandum warning against proceeding with Sundance, stated
that he was unable to recall virtually anything about his
objections to the transaction, how his concerns were resolved,
or who actually gave the final approval for the transaction.
For example, he stated that he could not recall the specifics
of his accounting concerns; whether he discussed his accounting
concerns with the investment bank head, although he assumes he
did; the reassurances he received on the accounting issues,
although he assumes he received reassurances; whether he ever
signed off on the transaction, although he assumes he did; or
whether the investment bank head ultimately approved the
project.\82\ At the hearing held one week after his interview,
this Citigroup official testified that his memory of the
transaction had been refreshed by reviewing certain emails and
recalled giving his approval to the Sundance transaction,
although he testified that he continued to be unable to recall
other specific information about the final approval process,
including whether the investment bank head finally approved the
deal.\83\
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\81\ See email exchange between Citigroup employees Timothy Leroux
and Andrew Lee, ``RE: Sundance Approvals,'' (6/6/01), Bates CITI-SPSI
0123806, Hearing Exhibit 333q (``Would you happen to have a copy of the
management approvals for the sundance trade (The Firm Investments group
needs it for their files.)'' Response: ``No . . . was given a verbal go
ahead. . . . Understand signed is to follow''). See also email from Mr.
Fox to Mr. MacDonald (6/04/01), Bates CITI-SPSI 0124617 (``[A]ny feed
back from Carpenter on Sundance; apparently the deal closed.'')
\82\ Bushnell interview (12/03/02).
\83\ Bushnell testimony at the Subcommittee hearing held on
December 11, 2002.
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In any event, the Sundance transaction did close. When
negative information about Enron began to emerge a few months
later and questions began to arise about Enron's solvency,
Citigroup invoked the Sundance agreement provisions protecting
it from loss and actually terminated the Sundance partnership
on or about November 30, 2001, five months after it was
established and two days before Enron filed for bankruptcy.\84\
At that time, Citigroup demanded that Enron buy out its
Sundance interest for the $28.5 million Citigroup had
``contributed'' in cash and stock, and recovered this entire
amount plus a return.\85\ Citigroup also terminated its $160
million funding commitment. Citigroup's actions showed that the
partnership features had worked as intended to insulate its
entire Sundance ``investment'' from loss.
---------------------------------------------------------------------------
\84\ Caplan interview.
\85\ Id. See also email from Mr. Caplan (11/30/01), Bates CITI-SPSI
0125273, Hearing Exhibit 333y. Although the Sonoma shares Citigroup had
contributed to Sundance had likely lost value in light of Enron's
bankruptcy and Citigroup had allegedly assumed any risk of loss,
Citigroup secured the full $20 million that the shares had supposedly
been worth when contributed five months earlier.
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For participating in Sundance, Citigroup was apparently
paid upfront fees of $725,000 as well as another $1.1 million
return on its $28.5 million ``investment.'' \86\ When Sundance
facilitated pre-payment of the $194 million loan in Bacchus,
Citigroup received another $1.5 million in ``breakage costs.''
---------------------------------------------------------------------------
\86\ Information provided to the Subcommittee by Citigroup.
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Analysis. Like Fishtail and Bacchus, the Sundance
transaction involves deceptive accounting and sham investments.
One key objective of the Sundance transaction was to keep
Enron's pulp and paper assets off its balance sheet by placing
them in a separate joint venture. But the lack of risk
associated with Citigroup's so-called ``investment'' in
Sundance indicates that this joint venture did not qualify for
off-balance sheet treatment and should have been consolidated
with Enron.
To qualify as an unconsolidated 50-50 joint venture,
Sundance needed two investors contributing capital in
accordance with the Andersen 4:1 joint venture capitalization
guidelines. In addition, a minimum three percent of the total
capitalization had to be an independent equity investment at
risk for the duration of the joint venture. The evidence
indicates, however, that none of Citigroup's Sundance
investment was ever truly at risk in light of Citigroup's right
to dissolve the partnership at will prior to any loss, and the
additional safeguards provided for each of its ``investments.''
In the case of its $160 million ``unfunded commitment,''
Citigroup funds could be used only after Enron's entire $750
million investment was exhausted. In the case of its $28.5
million contribution of cash and stock, Enron's investment not
only had to be exhausted beforehand, but the $28.5 million also
had to be kept in segregated, liquid financial instruments to
which Citigroup had preferred access. In the end, none of
Citigroup's funding commitment was actually used and all of its
cash and stock contributions were returned on short notice, in
cash, with interest. Without Citigroup's sham investment in
Sundance, Enron would have had to consolidate this partnership
on its balance sheet, include in its financial results all of
the Sundance pulp and paper assets, and disclose to investors
and financial analysts all of the debt associated with this
business venture.
Senior Citigroup officials opposed participating in
Sundance, calling its accounting ``aggressive'' and a
``franchise risk.'' Just prior to the transaction's closing,
three senior Citigroup officials warned against proceeding with
it. The final go-ahead on the transaction was provided verbally
by an unidentified Citigroup official. The final approval
documents cannot be located.
Sundance's aggressive accounting troubled senior Citigroup
officials who were analyzing the transaction on its own terms.
But its aggressive nature deepens when Sundance, Bacchus, and
Fishtail are analyzed as a whole. When viewed together, the
three transactions result in a disguised six-month loan
advanced by Citigroup to facilitate Enron's deceptive
accounting. In effect, Enron borrowed $200 million from
Citigroup in December 2000; arranged for a shell company, the
Caymus Trust, to use the funds to ``purchase'' the Fishtail
assets for $200 million, without disclosing that Enron was
guaranteeing the full purchase price; used this sham sale to
inflate its 2000 cash flow from operations by $200 million and
its earnings by $112 million; and then quietly returned the
$200 million to Citigroup six months later via Sundance.\87\
This view of the three transactions as a disguised $200 million
loan is further strengthened by evidence indicating that
Citigroup never truly placed any money at risk in the Bacchus
or Sundance transactions, it profited from the transactions by
obtaining fees and interest charges rather than equity rewards,
and the $200 million seems, in the end, to have been cycled
through all three transactions for the sole business purpose of
facilitating Enron's financial statement manipulation.
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\87\ In fact, when setting up the mechanics of the Sundance
transaction, Enron personnel cautioned Enron against muddying the
timing by reacquiring its old Fishtail assets too soon. One internal
Enron email instructed: ``Fishtail CANNOT touch Enron's Balance Sheet
before Sundance is deconsolidated.'' ``Sundance Steps,'' Enron document
(5/16/01), Bates ECa000022315, Hearing Exhibit 328a.
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SLAPSHOT
The Facts. The fourth and final transaction, Slapshot, took
place on June 22, 2001, soon after creation of the Sundance
joint venture. Undertaken in connection with a loan to
refinance a Canadian paper mill associated with Sundance,
Slapshot was designed as a tax avoidance scheme that centered
on utilizing a one-day, $1 billion ``loan'' from Chase to
generate approximately $60 million (U.S.) in Canadian tax
benefits, as well as $65 million in financial statement
benefits for Enron.\88\
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\88\ When Chase first presented the Slapshot structure to Enron, it
projected Canadian tax benefits totaling $125 million in U.S. dollars.
``Results and Cash Flows,'' Chase document (undated), Bates SENATE FL-
00939. When Enron performed its own analysis of potential tax savings
using more conservative assumptions, it calculated that, over five
years, Enron would obtain ``a tax savings NPV of US$60 million'' and
``net income improvement over the next five years of NPV US$65
million.'' ``Slapshot Savings,'' Enron document (undated), Bates
ECa000195947. NPV means net present value. Another Enron document
estimated that Slapshot would benefit Enron's Corp's ``earnings per
share computation'' by $120 million over the five-year life of the
project. Email from Enron tax expert Morris Clark to Enron North
America's chief financial officer Joseph Deffner (undated), Bates EC
003005056.
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Enron first purchased the Canadian paper mill in March 2001
for about $350 million.\89\ Three months later, in June, Enron
contributed the paper mill to the Sundance joint venture with
the explicit understanding that Enron would soon be refinancing
the purchase price.\90\
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\89\ Enron bought the mill, located in Quebec City, Canada, from
Daishowa, Inc. and provided the initial financing. When purchased by
Enron, the mill was named the Daishowa Forest Products paper mill;
Enron renamed it Stadacona. Enron also established a new company,
Campagnie Papiers Stadacona (``CPS''), as the immediate owner of the
mill. According to a tax opinion letter, CPS had originally borrowed
approximately $346 million from Enron to purchase the Stadacona paper
mill. The larger $375 million loan amount in the Slapshot transaction
was apparently provided not only to refinance the mill's purchase
price, but also to pay Enron a $29 million ``structuring fee.'' See tax
opinion letter from Skadden, Arps, Slate, Meagher & Flom LLP And
Affiliates (``Skadden Arps'') to Enron Wholesale Services, (8/15/01),
Bates EC2 000047056, Hearing Exhibit 352.
\90\ Since Stadacona was a key joint venture asset, Citigroup
demanded and was given the right to approve any refinancing arrangement
to ensure that Enron did not encumber the asset. Enron accordingly
informed Citigroup about the Slapshot structure, and Citicorp
apparently registered no objection to Enron's participation in it.
Enron also paid Citigroup a fee to reimburse it for the costs
associated with Citicorp's analyzing the Slapshot structure.
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Chase presented Enron with a refinancing proposal that
would not only provide Enron with a loan from a consortium of
banks to pay for the paper mill but also, at the same time,
provide an Enron affiliate with significant Canadian tax
benefits.\91\ In exchange for about $5.6 million in fees and
other remuneration, Chase provided Enron with access to its
``proprietary'' structured finance arrangement \92\ utilizing a
sham $1 billion ``loan'' intended to be issued and repaid
within a matter of hours. Although the $1 billion ``loan'' was
to be issued and repaid on the same day, the Slapshot structure
was designed to enable Enron's Canadian affiliate to claim tax
deductions and reap other Canadian tax benefits as if a real $1
billion loan had been issued and remained outstanding. See
Figure 4 for a diagram of the Slapshot structure.
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\91\ Since 2000, Enron had been working to design a tax structure
that would enable it to use Canadian tax laws to generate tax
deductions. Enron halted that effort when it decided to use the Chase
structure. See email, with attachments, between Enron employees Stephen
Douglas and Davis Maxey (12/11/00) (no Bates number), Hearing Exhibit
362, Enron disk produced to the Subcommittee; and Subcommittee
interview with Stephen Douglas (12/3/02).
\92\ A key Chase employee involved in Slapshot, Eric Peiffer,
referred to it as a new ``tax technology.'' Peiffer interview.
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Chase provided Enron with a step-by-step description of how
the Slapshot transaction was to be executed.\93\ These
instructions described a complex series of structured finance
arrangements using shell corporations, fake loans, and complex
funding transfers across international lines. They also showed
how the $1 billion in supposed loan proceeds would be repaid
later the same day. Chase personnel actively assisted in
planning and completing the specified steps in the Slapshot
deal. The transaction itself actually took place on June 22,
2001.
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\93\ See, for example, ``Structured Canadian Financing Transaction
Organizational Meeting,'' (2/8/01), Bates SENATE FL-00887, Hearing
Exhibit 344 (providing six-step description of Slapshot transaction);
``Transaction Summary,'' Chase document (undated), Bates SENATE FL-
00909-14, Hearing Exhibit 338 (providing seven-step description).
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The transaction involved multiple Chase and Enron
affiliates and SPEs, a number of which were established
specifically to facilitate the Slapshot deal. Chase established
its key entity in the transaction, Flagstaff Capital
Corporation (``Flagstaff''), as a wholly-owned SPE in Delaware.
Chase also organized a bank consortium made up of itself and
three other large banks to issue the $375 million loan to
refinance the paper mill.\94\ Enron established Compagnie
Papiers Stadacona (``CPS'') in Canada as the direct owner and
operator of the Stadacona paper mill.\95\
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\94\ The bank consortium members were Chase, Royal Bank of
Scotland, Industrial Bank of Japan, and Bank of Tokyo-Mitsubishi, each
of which was responsible for an equal share of the $375 million loan.
\95\ Enron then contributed CPS to the Sundance joint venture.
Enron established CPS as a Nova Scotia Unlimited Liability Company
(``NSULC''), which is a particular type of corporation in Canada. Enron
did not own CPS directly, but created a longer ownership chain which
included two Dutch corporations it had established, BV-1 and BV-2. As
indicated in the diagram, Sundance owned BV-1 which owned BV-2 which
directly owned CPS. Enron also created two additional NSULCs, Hansen
and Newman, that were both wholly-owned by CPS. Enron created this
complex maze of companies, CPS, BV-1, BV-2, Hansen, and Newman, as part
of the Slapshot tax avoidance structure in order to take advantage of
differences between U.S. and Canadian tax laws. For example, since
Hansen, Newman, and CPS were NSULCs, U.S. tax law would allow Enron to
treat them as pass-through entities for U.S. Federal income tax
purposes. Similarly, under U.S. tax law, BV-1 was a controlled foreign
corporation, while BV-2 could be treated as a disregarded entity for
tax purposes. A tax opinion letter issued to Enron by Skadden Arps
supporting the proposed structure explained, in part, that ``since CPS
itself [will be] treated as a branch of BV-2, which in turn [will be]
treated as branch of BV-1, Newman and Hansen will both be treated as
disregarded entities all of the assets and liabilities of which [will
be] owned by BV-1 for United States federal income tax purposes.'' At
the same time, Canadian law viewed CPS, Hansen, and Newman as separate
companies which would increase the amount of potential Canadian tax
benefits.
[GRAPHIC] [TIFF OMITTED] T3559.004
On June 22, Chase advanced the bank consortium's $375
million loan to Flagstaff to be repaid in five years and one
day.\96\ On the same day, Enron entered into a complex series
of derivatives with Flagstaff, in essence, to guarantee
repayment of the $375 million.\97\ According to one internal
Chase document, these derivatives gave Chase and the bank
consortium ``credit support equivalent to a guarantee . . .
that does not constitute a guarantee for GAAP accounting for
Enron's purposes, thus providing an accounting benefit to
Enron.'' \98\ In addition, by authorizing a ``daylight
overdraft'' on the Flagstaff account, Chase ``loaned'' its
affiliate, Flagstaff, another $1.039 billion.\99\
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\96\ The loan was structured to be in excess of five years in order
to qualify for certain withholding tax benefits under Canadian tax law.
\97\ Rather than a simple loan guarantee, Chase and Enron devised a
complex set of derivatives involving a warrant, put option, and total
return swap, which functioned together to support repayment of the $375
million loan. See email by Eric Peiffer (10/16/01), Bates SENATE FL
004540, Hearing Exhibit 357k.
\98\ ``(Flagstaff) Transaction Summary,'' Chase document (undated),
Bates FL-00910, Hearing Exhibit 375. An Enron employee indicated that
this transaction was structured so that Enron could avoid disclosure of
the guarantee in its financial statement footnotes. A Chase
representative indicated that Enron told Chase it wanted to structure
the transaction as a swap because it was concerned that a guarantee
would require Enron to carry the mill on its books.
\99\ According to a Skadden Arps opinion letter, despite the amount
involved, ``[n]o instrument was prepared to evidence the Day-Light
Loan'' from Chase to Flagstaff. Tax opinion letter from Skadden Arps to
Enron Wholesale Services, (8/15/01), Bates EC2 000047058, Hearing
Exhibit 354.
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At the conclusion of these initial steps, Flagstaff held
two loans totaling approximately $1.4 billion ($375 million
from the bank consortium and $1.039 billion from Chase).\100\
Flagstaff immediately loaned the entire amount to an Enron
affiliate, Hansen, in exchange for a note.\101\
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\100\ The total loan amount was $1,414,504,347, however, for ease
of reference, the figure $1.4 billion will be used in the following
analysis.
\101\ Hansen is a NSULC shell company established by Enron and
wholly owned by CPS. The Hansen note set up a so-called ``bullet loan''
of five years and one day, which required Hansen to pay only interest
on the loan for five years and then, on the last day of the loan, repay
the principal in its entirety.
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Upon receiving the $1.4 billion from Flagstaff, Hansen
immediately ``loaned'' the money to its parent, CPS, another
Enron affiliate.\102\ CPS then directed $375 million of the
$1.4 billion to Enron. CPS ``loaned'' the remaining $1.039
billion to an Enron subsidiary in Canada called Enron Canadian
Power Company (``ECPC'').
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\102\ Hansen ``loaned'' the funds to CPS on essentially the same
terms as the ``loan'' between Hansen and Flagstaff. Apparently in an
effort to make the two loans between Flagstaff and Hansen and between
Hansen and CPS technically different and to allow Hansen to assert that
its ``business purpose'' in entering into the transactions was to make
money off its loan to its parent CPS, the former loan had an interest
rate of 6.12 percent, and the latter an interest rate of 6.13 percent.
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At the same time this loan activity was occurring, Hansen
entered into an agreement with its fellow subsidiary,
Newman.\103\ This agreement obligated Newman to purchase 99.99
percent of Hansen's shares in five years and one day for $1.4
billion, the same amount Hansen already ``owed'' to Flagstaff.
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\103\ Newman is another NSULC shell company established by Enron
and, like Hansen, wholly owned by CPS.
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Newman and Flagstaff then entered into an agreement whereby
Newman immediately paid Flagstaff $1.039 billion in exchange
for Flagstaff's agreeing to assume Newman's obligation to pay
for Hansen's shares in five years and one day.\104\ The $1.039
billion Newman paid to Flagstaff had been provided to Newman by
Enron for placement in an escrow account.\105\ Chase had been
unwilling to release its $1.039 billion daylight overdraft
``loan'' to Enron until it was sure that there was $1.039
billion in an escrow account available to ensure Chase would
recover its money within the same day. To accommodate Chase,
Enron had secured its own $1.039 billion daylight overdraft
authorization on an account it held at Citibank. Once these
funds were wired from Citibank to an escrow account at Chase,
Chase released the $1.4 billion in Flagstaff that would go up
the chain to Hansen and CPS. Flagstaff also took possession of
the Enron escrow funds and forwarded the money to Chase which
used it to pay off the daylight overdraft it had issued at the
beginning of the day.
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\104\ The parties calculated that $1.039 billion was the net
present value of the $1.4 billion owed by Newman to Hansen in five
years and one day.
\105\ Enron sent the $1.039 billion to Newman in accordance with a
series of transactions involving ECPC and other Enron affiliates.
Enron's corporate bank account at Citigroup was, thus, both the
origination point and termination point for the two different chains of
transfers involving two separate amounts of $1.039 billion--Enron's
$1.039 billion in escrow funds and Chase's $1.039 billion in ``loan''
proceeds.
In the Newman-ECPC transaction, ECPC obtained Newman debenture
shares. These debenture shares were designed to provide monetary
distributions which exactly mirrored the interest payable to CPS under
the CPS-ECPC note. That meant ECPC was to pay interest on the note to
CPS in an amount exactly equal to the distributions that ECPC was to
receive from Newman, an entity wholly-owned by CPS. According to Enron,
Canadian tax lawyers advised it that the expected interest and
distributions needed to actually change hands among the parties,
notwithstanding the fact that from ECPC's perspective the net result
was a wash.
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The net result of the Slapshot transaction is as follows.
LIn two offsetting transfers of funds that
moved through multiple bank accounts of Chase, Enron,
and their affiliates, Chase issued a sham loan of
$1.039 billion to Enron and, on the same day, had Enron
send $1.039 billion in escrow funds to Chase which used
the escrow funds to satisfy the sham loan. Chase's
alleged ``loan'' was never at risk, however, since
Chase had required Enron to transfer the funds to an
escrow account at a Chase bank, before Chase released
any of the ``loan'' proceeds to Enron.
LHansen and Flagstaff exchanged obligations to
pay each other an identical amount, $1.4 billion, in
five years and one day. The legal documents explicitly
authorized them to set off the funds owed to each
other.\106\
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\106\ See ``Credit Agreement,'' (6/22/01), Bates JPM-14-00475,
Hearing Exhibit 350, Section 10.08 (``Right of Setoff'') at Bates JPM-
14-00512.
LCPS was left with a net outstanding loan of
$375 million, to be repaid with interest, to the bank
consortium through Hansen and Flagstaff over five years
and one day. The loan was guaranteed by Enron through a
complex set of derivatives that did not show up as a
loan guarantee on Enron's books.\107\
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\107\ The transaction was also structured to allow CPS to account
for the loan on its books by showing a net debt of $375 million, not
$1.4 billion. See, for example, ``Transaction Summary,'' (undated),
Bates SENATE FL-00912, Hearing Exhibit 338.
Notwithstanding the reality that only $375 million was
actually loaned to CPS, the transaction was structured in such
a way as to allow CPS, for tax purposes, to act as if it were
subject to a $1.4 billion ``loan'' obligation that remained
outstanding. The purpose was to circumvent the general
principle in U.S. and Canadian tax law which allows companies
to deduct only their loan interest payments, but not their loan
principal payments. The Chase structure was intended to enable
CPS to claim to be entitled to a Canadian tax deduction for its
entire amount of its payments on the $375 million loan.
The Chase-designed structure worked as follows. The
transaction documents required CPS to make quarterly loan
payments to Hansen in the amount of approximately $22 million.
Hansen was then to pay Flagstaff an identical amount, and
Flagstaff was to pay the same amount to the bank consortium.
The $22 million was equivalent to a payment of principal and
interest, using a fixed 6.12 percent interest rate, on the
existing $375 million loan. In five years and one day, these
payments would reduce the $375 million loan to zero.
At the same time, Chase and Enron had manipulated the size
of the loans between Flagstaff and Hansen and between Hansen
and CPS, as well as the interest rates on those loans, in such
a way that the $22 million quarterly payment was also
equivalent to an interest-only payment, using a fixed 6.13
percent interest rate, on the $1.4 billion loan. Under Canadian
tax law, if CPS were to characterize the $22 million as an
interest-only payment on an outstanding loan, it could deduct
the full $22 million from its Canadian taxes. Assuming
repayment of the loan in full, Enron calculated the total
deductions and related Canadian tax benefits from the Slapshot
transaction over five years to be in the range of $60
million.\108\ These Canadian tax benefits were also calculated
to convey additional financial statement benefits for Enron
totaling about $65 million.\109\ Another Enron document
calculated that Slapshot was going to ``positively [impact]
Enron's earnings per share computation by approximately $120
[million]'' over the life of the transaction.\110\
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\108\ ``Slapshot Savings,'' Enron document (undated), Bates
ECa000195947, Hearing Exhibit 339. Enron indicated that this $60
million represented the net present value of the total tax savings over
five years. See also Chase projection of tax and financial statement
benefits, ``Results and Cash Flows,'' Chase document (undated), Bates
SENATE FL-00939, Hearing Exhibit 343. In response to Subcommittee
inquiries, Enron stated that its Canadian affiliates actually claimed
``gross interest [tax] deductions'' in Canada related to Slapshot
totaling $124.9 million, but have since decided not to claim any
additional Slapshot tax benefits in the future. Letter from Enron legal
counsel, Skadden, Arps, Slate, Meagher & Flom LLP, to the Subcommittee
(12/10/02), Hearing Exhibit 368.
\109\ Id. Enron stated that a ``tax depreciation delay'' over five
years would create a ``deferred tax benefit, resulting in net income
improvement over the next five years of NPV US$65 million.'' (Emphasis
omitted.)
\110\ Email from Enron tax expert Morris Clark to Enron North
America's chief financial officer Joseph Deffner (undated), Bates EC
003005056.
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Prior to participating in Slapshot, Chase obtained a legal
opinion from a Canadian law firm, Blake, Cassels & Graydon, LLP
(``Blake Cassels''), supporting the Slapshot structure. Enron
apparently relied on that opinion and ultimately obtained its
own opinion from the same law firm.\111\ The opinion provided
to Enron, which included caveats and warnings that did not
appear in the law firm's earlier opinion to Chase, noted that
the Slapshot structure ``clearly involves a degree of risk''
and advocated proceeding only after providing this warning:
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\111\ See tax opinion letters from Blake Cassels to Chase
Securities Inc. (11/7/00) (no Bates number), Hearing Exhibit 353, and
from Blake Cassels to Enron North America Corp. (6/23/01), Bates EC2
000047037, Hearing Exhibit 352. The tax opinion Enron received from
Blake Cassels is dated one day after the transaction closed; Enron told
the Subcommittee it was informed orally of its substance prior to the
closing. Subcommittee interview of Stephen Douglas (12/3/02).
``We would further caution 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 under [the Canadian anti-tax
avoidance statute]. It is also, in our view, likely
that such a Revenue Canada challenge would not be
resolved in the Courts at a level below that of the
Federal Court of Appeal. It is therefore likely that
Enron will be faced with the decision as to whether to
pursue the matter through the Courts or to attempt to
reach a settlement with Revenue Canada pursuant to
which it would receive a reduced Canadian tax
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benefit.''
In short, Enron's own tax counsel warned that Slapshot would
likely result in litigation over Enron's tax liability and
Enron would have to determine whether to settle the expected
dispute with Revenue Canada.
Internal documentation indicates that both Enron and Chase
were concerned about the Canadian tax authorities disallowing
the Slapshot structure and so took steps to keep information
that would provide insights about the transaction to a minimum.
For example, in analyzing how to structure an interest rate
swap, Chase and Enron jointly considered three alternatives,
two of which were described as disadvantageous, in part,
because they would produce a ``potential road map'' of the
transaction for Revenue Canada. Chase and Enron chose the third
alternative which was explicitly described as advantageous, in
part, because it provided ``no road map'' for Revenue
Canada.\112\
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\112\ ``Structured Canadian Financing Transaction Organizational
Meeting,'' (2/8/01), Bates SENATE FL-00897, Hearing Exhibit 344.
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In another document, an Enron tax attorney cautioned
against Enron's repatriating into the United States in 2001,
certain funds associated with certain ``preferred shares'' that
had been exchanged in the Slapshot transaction in 2001, because
this same-year transaction would undermine Slapshot's alleged
business purpose. An email written by the Enron tax attorney
states that the Slapshot tax analysis ``is predicated on two
significant factors'': (1) demonstrating a business purpose for
why Enron's Canadian affiliates received $1 billion from Enron
and CPS; and (2) demonstrating that ``Enron Canada did not have
a tax-avoidance motive for entering into Project Slapshot.''
\113\ The email goes on to state:
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\113\ Email from Enron tax expert Morris Clark to Enron North
America's chief financial officer Joseph Deffner (undated), Bates EC
003005056.
``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. .
. . [I]t is certainly our position that the greater
period of time that we can interpose before repaying
any of the Preferred Shares, the greater the likelihood
of withstanding an attack by Revenue Canada on audit.''
\114\
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\114\ Id.
This analysis shows, again, Enron's ongoing concerns that
Revenue Canada would ``attack'' Slapshot and that the Slapshot
structure itself would not withstand legal challenge.
Chase and Enron also included in the Slapshot legal
documents a ``recharacterization rider'' to take effect only if
Canadian tax authorities successfully challenged the underlying
tax structure and reclassified the payments from Hansen to
Flagstaff as payments of principal and interest on the $375
million loan. Should such an event occur, Chase and Enron
agreed to ``recast any principal paid in excess of 25% of the
recharacterized loan as instead being a loan from [Hansen] to
Flagstaff.'' \115\ This rider was designed to avoid payment of
certain Canadian withholding taxes that would be triggered if
Hansen's loan principal payments were to exceed a specified 25
percent limit. The rider's solution was to reclassify the
Hansen loan payments to Flagstaff as the reverse--as the
extension of loans by Hansen to Flagstaff--the exact opposite
of what was intended under the Slapshot structure. This rider's
existence is additional evidence, not only that Chase and Enron
had real concerns that Revenue Canada would overturn Slapshot,
but also that both were willing to continue to use deceptive
strategies to avoid payment of Canadian taxes.
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\115\ ``5/25 Recharacterization Rider,'' (undated), Bates SENATE
FL-00075, Hearing Exhibit 351.
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Analysis. Chase constructed and sold Slapshot as a tax
avoidance structure whose core transaction was a deception--a
sham $1 billion loan that had no economic rationale or business
purpose apart from generating deceptively large tax
deductions.\116\ The funds never performed any function other
than to transverse multiple bank accounts in a single day to
create the appearance of a loan that was, in fact, an illusion.
The funds were issued without the paperwork that normally
accompanies a billion-dollar borrowing. Chase's $1 billion was
never even truly at risk since Chase had required Enron to
place the same amount in a Chase escrow account before Chase
issued the original ``loan'' to Enron.
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\116\ In one interview, Enron contended that one of the purported
business purposes of the transactions was that the various Chase and
Enron affiliates were profiting from the loans they exchanged. Douglas
interview. However, the interest rate difference in the loans between
Flagstaff and Hansen and between Hansen and CPS differed by only 0.01
percent. In addition, Hansen and CPS were both Enron affiliates,
contradicting any business rational for them to profit from each other.
Moreover, the loan activity among these entities had no function apart
from the $1.039 billion loan. All of the loans and related transactions
were engineered by Chase and Enron to function together.
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The deceptive nature of the Slapshot transaction is clear
from its component parts. Serial billion-dollar-plus loans were
issued to newly created shell companies such as Flagstaff and
Hansen which had virtually no capitalization, assets, or
business operations to justify the lending. Another key
transaction was a complex stock agreement between Hansen and
Newman, two companies that were incapable of negotiating at
arms-length because both were Enron-sponsored SPEs, wholly
owned by the same Enron affiliate, CPS, with identical company
officers. With respect to another key series of transactions,
Flagstaff and Hansen clearly intended to set-off their
identical $1.4 billion obligations to each other, but this
intent to set-off is never mentioned in the transaction
documents due to legal advice that it would undercut the
supposed arms-length nature of the transaction.\117\ Still
another decision on interest rates appears to have been made
not to rationalize or maximize the benefits to any one party
but to avoid providing Revenue Canada with a useful ``road
map'' to the transaction. Chase and Enron even agreed to recast
the very nature of key transactions to salvage limited Canadian
tax benefits in the event Canadian tax authorities refused to
recognize Hansen as paying off a $1.4 billion ``loan.''
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\117\ A Chase email stated: ``As Flagstaff's payment to [Hansen] is
conditional on [Hansen's] repaying, Chase can just choose to invoke
set-off which is Chase's full intention--to direct [Hansen] to keep its
money rather than repay the loan, in return for Flagstaff not having to
pay cash for the [Hansen] shares. Clearly there is no benefit to Chase/
Flagstaff to have the money move. As discussed, the lawyers (especially
the tax lawyers) are hesitant to state explicitly Chase's intent to
set-off or to require this set off, as they wish to keep the documents
as `arm's length' as possible rather than tie them together (which
additional `intent to set-off' language would do).'' Email between
Chase employees Eric Peiffer and Kathryn Ryan (date illegible but
possibly 2/28/01), Bates SENATE FL-02335, Hearing Exhibit 357c.
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Many features of Slapshot--the sham billion-dollar loan
that had no business purpose apart from generating tax
benefits, the contrived set offs between key parties, and the
involvement of multiple shell companies lacking ongoing
business operations--raised the possibility that the entire
Slapshot transaction would be invalidated under Canada's
statutory general anti-avoidance rule. Despite the legal risks
associated with Slapshot, Chase and Enron proceeded with the
transaction.\118\ If Enron had not gone bankrupt, the large tax
deductions generated by Slapshot would likely have been used to
shelter the paper mill's income from the payment of Canadian
corporate income tax. Lower tax liabilities would have then
translated into stronger Enron financial statements. Enron's
bankruptcy, however, interrupted Slapshot just five months
after it began producing the promised benefits.
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\118\ In fact, one Chase employee informed the Subcommittee that it
has marketed the Slapshot structure to at least 15 to 20 other
companies in addition to Enron.
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Chase was paid more than $5 million for designing and
orchestrating Slapshot. Enron could not have completed this
transaction without the initiative and enthusiastic backing of
a major financial institution with the resources to issue and
move a $1 billion daylight overdraft through multiple bank
accounts across international lines in a single day. Without
Chase's willing efforts to design, fund, and execute the
incredibly complex transactions involved, whose details had to
be carefully planned and coordinated, Enron would not have been
able to make use of this deceptive tax strategy.
SUBCOMMITTEE HEARING
On December 11, 2002, the Subcommittee held a hearing
examining Fishtail, Bacchus, Sundance, and Slapshot. The
Subcommittee heard from four panels of witnesses, including
Citigroup and Chase officials, a banking and securities expert,
and key Federal agencies.
The first panel consisted of Citigroup officials who were
directly involved in the Bacchus and Sundance transactions, as
well as a senior Citigroup official responsible for setting
corporate policy. The Citigroup witnesses were Charles O.
Prince III, Chairman and Chief Executive Officer of Citigroup's
Global Corporate and Investment Bank; David C. Bushnell,
Managing Director and head of Global Risk Management for the
Global Corporate and Investment Bank; Richard Caplan, Managing
Director and Co-Head of the Credit Derivatives Group at Salomon
Smith Barney North American Credit; and William T. Fox III,
Managing Director of the Global Power & Energy Group at
Citibank. Mr. Caplan participated directly in both the Bacchus
and Sundance transactions. Mr. Fox was directly involved in the
Bacchus transaction and was the key Citigroup official who
communicated with Mr. Fastow regarding the verbal guarantee of
the ``equity investment'' in the Caymus Trust. Mr. Bushnell, as
head of risk management, was directly involved in the Sundance
transaction. At the hearing, Mr. Bushnell disclosed that,
although he had strongly urged Citigroup not to participate in
Sundance, he may have provided the final oral approval that
allowed this project to proceed. Mr. Prince, who was not
directly involved in either transaction, described a number of
Citigroup's post-Enron reforms, including a new corporate
policy to prevent Citigroup's participation in any transaction
in which the transaction's net effect is not accurately
disclosed to a company's investors and analysts.
The second panel consisted of Chase officials who were
directly involved in the Slapshot transaction, as well as
senior officials responsible for setting Chase's corporate
policy. The Chase officials were Michael E. Patterson, Vice
Chairman of J.P. Morgan Chase & Co.; Andrew T. Feldstein,
Managing Director and Co-Head of Structured Products and
Derivatives Marketing at J.P. Morgan Chase & Co.; Robert W.
Traband, Vice President of Chase in Houston; and Eric N.
Peiffer, Vice President of Chase in New York. Mr. Peiffer
played a key role in developing and marketing the Slapshot tax
structure. Mr. Peiffer and Mr. Traband dealt directly with
Enron to design and carry out the Slapshot transaction examined
in this report. Mr. Feldstein, who was not directly involved in
Slapshot and is the new head of the Chase division carrying out
structured finance and derivatives transactions, described
Chase's renewed commitment to the principles of integrity and
transparency in its structured finance and derivative
transactions. Mr. Patterson, who was also not directly involved
in Slapshot, described a number of Chase's post-Enron reforms,
including a new transaction review committee, which he heads,
to prevent Chase's participation in transactions that
facilitate deceptive accounting or carry other reputational
risks. The Chase witnesses also testified at the hearing that
Chase would no longer market the Slapshot tax structure or
participate in transactions similar to Slapshot.
The third panel at the hearing consisted of testimony from
Muriel Siebert, who was the first woman member of the New York
Stock Exchange, the first woman Supervisor of Banking for the
State of New York, and the current owner and president of a
brokerage house. Ms. Siebert testified that, since Enron's
collapse, her business had seen individual investors leave the
stock market altogether because ``they did not trust the
system.'' She expressed great concern about the deceptive
transactions discussed in the hearing and the need to initiate
reforms to prevent U.S. financial institutions from
facilitating deceptive accounting or tax transactions.
The fourth and final panel consisted of top Federal
regulators at the Federal Reserve, Securities and Exchange
Commission (``SEC''), and Office of the Comptroller of the
Currency (``OCC''). The witnesses were Richard Spillenkothen,
Director of the Division of Banking Supervision and Regulation
at the Federal Reserve; Annette Nazareth, Director of the
Division of Market Regulation at the SEC; and Douglas W.
Roeder, Senior Deputy Comptroller for Large Bank Supervision at
the OCC. These witnesses indicated that a relatively small
universe of financial institutions--for example, less than ten
of the national banks overseen by the OCC--engage in the type
of complex structured finance transactions examined in this
report. They also acknowledged a regulatory gap that now exists
in overseeing these transactions, since the SEC does not
generally regulate banks, and the bank regulators do not
generally oversee accounting practices. All three witnesses
agreed with the testimony of the Federal Reserve that banks
should not ``engage in borderline transactions that are likely
to result in significant reputational or operational risks to
the banks.'' The witnesses also described their existing
regulatory efforts to address the issues raised in the hearing
and their plans for additional actions in the future. Among
other measures, the Federal Reserve has begun a review of
structured finance products which it plans to complete within a
few months. All three witnesses expressed a readiness to
consider joint efforts to prevent U.S. financial institutions
from aiding or abetting accounting fraud by their clients.
SUBCOMMITTEE RECOMMENDATIONS
The four transactions discussed in this report, Fishtail,
Bacchus, Sundance, and Slapshot, are examples of the complex,
deceptive transactions that have become Enron's signature. None
of the four could have been completed without the backing and
active participation of a major financial institution willing
to facilitate a client's deceptive accounting or tax
transactions. The evidence compiled in this report and the
December hearing, as well as in the two earlier Subcommittee
hearings in July, show that some major U.S. financial
institutions deliberately misused structured finance techniques
to help Enron engage in deceptive accounting or tax strategies,
and were rewarded with millions of dollars in fees or favorable
consideration in other business dealings. The resulting loss of
investor confidence in the honesty and integrity of U.S.
companies and financial institutions is an ongoing problem that
requires additional attention and action.
Based upon the evidence before it, including more than two
million pages of subpoenaed documents; numerous interviews with
Enron, Andersen, Citigroup, Chase, Merrill Lynch, and other
parties; consultations with multiple finance, accounting, and
tax experts; and the records associated with the Subcommittee
hearings on July 23, July 30, and December 11, 2002, the U.S.
Senate Permanent Subcommittee on Investigations makes the
following recommendations.
L(1) Joint Review of Structured Finance Products and
Transactions. The Federal Reserve, OCC, and SEC should
immediately initiate a one-time, joint review of banks and
securities firms participating in complex structured finance
products with U.S. public companies to identify those
structured finance products, transactions, or practices which
facilitate a U.S. public company's use of deceptive accounting
in its financial statements or reports. By June 2003, these
agencies should issue joint guidance on acceptable and
unacceptable structured finance products, transactions and
practices. By the end of 2003, the Federal Reserve, OCC and SEC
should each take all necessary steps to ensure the financial
institutions they oversee have stopped participating in
unacceptable structured finance products, transactions, or
practices.
L(2) SEC Policy Statement: The SEC should issue a
regulation, guidance, or other policy document stating that it
is the SEC's policy to take enforcement action against a
financial institution that offers a deceptive financial product
to, or participates in a deceptive financial transaction with,
a U.S. publicly traded company, thereby aiding or abetting that
company's inclusion of material false or misleading information
in its financial statements or reports.
L(3) Unsafe and Unsound Practice: Upon issuance of an SEC
regulation, guidance or other policy statement under
Recommendation (2), the Federal Reserve and OCC should promptly
instruct their bank examiners, as part of their routine bank
examinations, to evaluate a bank's structured finance
activities to determine whether such activity appears to
constitute a violation of the SEC policy and, if so, to declare
that activity also constitutes an unsafe and unsound banking
practice. In addition, the Federal Reserve and OCC should
instruct their bank examiners to utilize the agency's full
panoply of regulatory and enforcement tools to require any such
bank to cease engaging in any such unsafe and unsound practice.
In this way, for the first time, Federal bank regulators will
be able to exercise regulatory authority within their
jurisdiction to deter banks from aiding or abetting deceptive
accounting, because such activities will constitute an unsafe
and unsound banking practice. In addition, such Federal Reserve
and OCC actions will help ensure that a meaningful mechanism is
introduced into routine Federal bank examinations to deter
banks' future misuse of structured finance transactions that
aid or abet deceptive accounting.
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