oversight

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

Published by the Government Accountability Office on 2003-03-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to the Senate Committee on
             Banking, Housing, and Urban Affairs
             and the House Committee on Financial
             Services

March 2003
             INVESTMENT BANKS

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




GAO-03-511
                                                March 2003


                                                INVESTMENT BANKS

                                                The Role of Firms and Their Analysts with
Highlights of GAO-03-511, a report to the
Senate Committee on Banking, Housing,
                                                Enron and Global Crossing
and Urban Affairs and the House
Committee on Financial Services.




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

                                                Although investment banks are not typically responsible for their client’s
                                                accounting, it is a violation of law to facilitate transactions that an
                                                investment bank knows will materially misstate the client’s financial
                                                statements. Since investment banks may be tempted to participate in
                                                profitable but questionable transactions, it is especially important that
www.gao.gov/cgi-bin/getrpt?GAO-03-511.
                                                regulators be alert to this and be ready to use their enforcement tools to
To view the full report, including the scope    deter such action. We are encouraged that investment banks and regulators
and methodology, click on the link above.       are strengthening their oversight of the appropriateness of transactions, but
For more information, contact Rick Hillman at
(202) 512-8678 or Jeanette Franzel at (202)
                                                it is too soon to evaluate the effectiveness of reforms.
512-9402.
Contents


Letter                                                                                 1
               Results in Brief                                                        4
               Background                                                              7
               The Role of Investment Banks in Enron’s Structured Finance
                 Transactions                                                         15
               Investment Banks and Federal Financial Regulators Have Begun
                 Strengthening Their Oversight of Structured Finance
                 Transactions Since Enron’s Collapse                                  23
               Conflicts of Interest Reportedly Affected Research Analysts’
                 Ratings of Enron and Global Crossing                                 33
               Observations                                                           37
               Agency Comments and Our Evaluation                                     39

Appendix I     Scope and Methodology                                                  41



Appendix II    Investment Bank Involvement With Enron In
               Five Structured Finance Transactions                                   44



Appendix III   GAO Contacts and Staff Acknowledgements                                59
               GAO Contacts                                                           59
               Staff Acknowledgements                                                 59


Tables
               Table 1: Services Investment Banks Provide Their Corporate
                        Clients                                                       8
               Table 2: Selected Types of Risks Faced by Financial Firms             28


Figures
               Figure 1: Simplified Nigerian Barge Transaction                        45
               Figure 2: Simplified Bacchus and Sundance Transactions                 47
               Figure 3: Simplified Slapshot Transaction                              51
               Figure 4: Detailed Slapshot Transaction                                52
               Figure 5: Mahonia Prepay Transaction                                   56
               Figure 6: Delta-Yosemite Prepay Transaction                            58



               Page i                                        GAO-03-511 Investment Banks
Abbreviations

AC                Analyst Certification
EITF              Emerging Issues Task Force
FAS               Financial Accounting Standards
LJM2              LJM2 Co-Investment, L.P.
NYSE              New York Stock Exchange
OCC               Office of the Comptroller of the Currency
PSI               Permanent Subcommittee on Investigations
SEC               Securities and Exchange Commission
SFAS              Statement of Financial Accounting Standards
SPE               special purpose entity



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Page ii                                                    GAO-03-511 Investment Banks
United States General Accounting Office
Washington, DC 20548



                                   March 17, 2003

                                   The Honorable Richard C. Shelby
                                   Chairman
                                   The Honorable Paul S. Sarbanes
                                   Ranking Minority Member
                                   Committee on Banking, Housing, and Urban Affairs
                                   United States Senate

                                   The Honorable Michael G. Oxley
                                   Chairman
                                   The Honorable Barney Frank
                                   Ranking Minority Member
                                   Committee on Financial Services
                                   House of Representatives

                                   The publicity surrounding Enron Corporation’s (Enron) bankruptcy and
                                   the effect on the company’s stockholders and employees has generated a
                                   debate on the activities of investment banks and their role in Enron’s
                                   collapse.1 Publicly available reports describe complex financial
                                   transactions among Enron, various investment banks,2 and a variety of
                                   special purpose entities3 (SPE) that have raised questions about whether
                                   investment banks knowingly4 and substantially assisted5 Enron in
                                   deceiving the public about Enron’s true financial condition.

                                   In the wake of this and other recent corporate scandals, the Congress
                                   passed the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act), which
                                   contains multiple accounting, corporate governance, and other reform
                                   requirements. Section 705 of that act requires GAO to study investment
                                   banks’ involvement in the failures of two particular public companies,


                                   1
                                       Enron Corporation is a global energy company.
                                   2
                                    In this report, the term “investment bank” includes not only securities firms but also those
                                   bank holding companies with securities affiliates or business divisions that assist clients in
                                   obtaining funds to finance investment projects.
                                   3
                                     An SPE is a separate entity that is created to carry out a specific purpose, activity, or
                                   transaction. An SPE is also known as a special purpose vehicle.
                                   4
                                    “Knowingly” has been defined by some courts as actual knowledge of a securities law
                                   violation or by others as a reckless disregard for the truth.
                                   5
                                    “Substantially” assisted has been interpreted by the courts as meaning significant
                                   assistance to the representations of others or to the fraud of others.



                                   Page 1                                                         GAO-03-511 Investment Banks
Enron and Global Crossing Ltd. (Global Crossing).6 This report presents
primarily publicly available information on the facts, allegations, and
rebuttals concerning selected investment banks’ involvement with Enron
and Global Crossing. It also presents observations on the issues raised by
the investment banks’ involvement with these companies and on the
actions Congress, regulators, and firms have taken or proposed in
response.

This report focuses primarily on five structured finance transactions
involving Enron and investment banks for the period 1992 through 2001.7
We found no publicly available documents on or references to investment
banks’ involvement in designing or implementing structured transactions
used by Global Crossing. Therefore, in this report we discuss other client
relationships that investment banks had with Global Crossing, primarily
through their research analysts. Through the transactions we describe in
this report, investment banks facilitated complex structured finance
transactions, despite allegedly knowing that Enron would use deceptive
accounting and tax strategies. Complaints filed by the Securities and
Exchange Commission (SEC) and individual investors also allege that,
through various transactions, Enron and its officers and directors engaged
in a scheme to defraud investors by inappropriately reporting the
transactions in Enron’s financial statements and consequently
misrepresenting Enron’s true financial condition.

Investigations and litigation are under way in connection with both Enron
and Global Crossing, and it was not our objective to assess, nor should this
report be construed as assessing, the potential culpability of the parties
involved in the transactions discussed in the report. In instances such as
these, if we have good cause to believe that any potential violations of
applicable laws or regulations have occurred, we refer such matters to the
appropriate governmental authorities for their consideration and possible
action.




6
    Global Crossing is a telecommunications company that operates worldwide.
7
  In this report, the use of the term “structured finance” is not limited to securitization,
which is the isolation of a defined group of assets that serve as the basis of a financing that
is intended to be remote, as a legal matter, from the bankruptcy risks of the former owner
of the assets. By isolating assets, structured financings can facilitate access to capital
markets, vastly expanding the sources of available funding.




Page 2                                                        GAO-03-511 Investment Banks
After taking the above concerns into consideration, we agreed with the
staffs of the Senate Committee on Banking, Housing and Urban Affairs and
the House Committee on Financial Services that the specific objectives of
this report were to (1) identify the roles investment banks played in
designing, executing, and participating in structured finance transactions
for Enron; (2) discuss investment banks’ and federal financial regulators’
oversight of products investment banks design and market to or for their
clients; and (3) discuss the role investment banks’ research analysts
played with Enron and Global Crossing.

To meet our objectives, we reviewed publicly available documents
pertaining to investment bank involvement with Enron in structured
finance transactions and other client relationships. The five transactions
we analyzed exemplify a variety of relationships that Enron had with
several different investment banks and were among those in which
investment bankers allegedly assisted Enron in manipulating its earnings,
but they were not those included in Enron’s restatement of its financials
for the period 1997 through the second quarter of 2001.8 Although the
investment banks described themselves as passive investors in the
restated transactions, we did not confirm or refute their assertions to that
effect. We did not conduct any evaluative analysis of the recent reforms
Congress, regulators, and some firms have initiated, as not enough time
has passed to allow for such analysis.

The five transactions we selected were discussed at hearings of the Senate
Committee on Governmental Affairs, Permanent Subcommittee on
Investigations (PSI), held in July and December 2002. In completing this
work, we spoke with PSI staff and relied primarily on witness statements,
hearing transcripts, and supporting documents published by the
subcommittee. Throughout this report, we cite several documents used in
the PSI hearings that were specifically relied on for allegations that
investment banks facilitated the transactions with knowledge of Enron’s
use of deceptive accounting and tax strategies. In addition, we interviewed
federal financial regulators9 and officials from the three investment banks


8
 We acknowledge that these do not cover all of the transactions these investment banks
undertook with Enron, nor do they represent transactions with all of the investment banks
with which Enron had relationships.
9
 For purposes of this report, we use the term “federal financial regulators” to refer to SEC
(securities regulator) and the Board of Governors of Federal Reserve System and the Office
of the Comptroller of the Currency (bank regulators) together. Separately, we may discuss
them by their name or type of regulator.




Page 3                                                     GAO-03-511 Investment Banks
                   involved in these transactions. We also reviewed available documents
                   provided by regulators and the investment banks. Appendix I contains a
                   full description of our scope and methodology.

                   We conducted our work in Washington, D.C. and New York, N.Y., between
                   September 2002 and March 2003 in accordance with generally accepted
                   government auditing standards.


                   It is alleged that certain investment banks knowingly and substantially
Results in Brief   assisted Enron in engaging in financial transactions that were intended to
                   manipulate and obscure Enron’s true financial condition, thereby
                   defrauding its investors, creditors, and others. If certain allegations are
                   proven true, SEC would have the authority to bring an action against the
                   investment banks for aiding and abetting securities laws violations. Some
                   have concluded that the transactions reportedly involved deceptive
                   accounting or tax strategies and were allegedly designed to help Enron
                   meet year-end revenue targets, inflate operating results, or evade taxes.
                   For example, in some transactions certain investment banks structured
                   transactions to purchase financial assets from Enron. Even though Enron
                   reported these transactions as sales, PSI and the bankruptcy examiner10
                   concluded that the substance of the transactions was not sales but secured
                   borrowings (i.e., loans). If this charge is true, they should have been
                   reported as debt on Enron’s financial statements. In another example, an
                   investment bank allegedly designed and orchestrated a transaction
                   intended to enable Enron to evade Canadian taxes. If this allegation is
                   true, the transaction ultimately would have improperly inflated Enron’s
                   reported after-tax earnings. Further, certain prepay transactions11
                   involving investment banks and Enron, which were reported by Enron as
                   energy trades, were allegedly disguised loans to Enron from the
                   investment banks. If these conclusions are proven, Enron’s accounting
                   could have misled investors and analysts about Enron’s financial
                   condition. The investment banks involved in the transactions we selected
                   for review contended that they had believed their role in assisting Enron



                   10
                     Enron filed for bankruptcy on December 2, 2001. On April 8, 2002, the Enron Bankruptcy
                   Court authorized the appointment of an examiner to inquire into certain transactions that
                   were not reported in accordance with generally accepted accounting principles and
                   requested that the examiner prepare reports regarding these transactions.
                   11
                     A prepay transaction involves paying in advance for a service or product to be delivered
                   at a later date.




                   Page 4                                                     GAO-03-511 Investment Banks
was proper and that Enron had not disclosed its true purpose in obtaining
their assistance. While investment banks are not responsible for the
financial reporting of their clients, if an investment bank knowingly and
substantially assisted Enron in engaging in violations of the securities
laws, SEC has the authority to bring legal action against the investment
bank for aiding and abetting a securities law violation. In February 2003,
one of the investment banks, Merrill Lynch & Co., Inc (Merrill Lynch), said
that it had agreed in principle to settle a civil complaint with SEC—
without admitting or denying any wrongdoing—charging that it aided
Enron in fraudulently overstating its earnings in 1999. As of March 14,
2003, this settlement agreement has not been approved by SEC.

Investment banks and federal financial regulators have oversight
processes for structured products and transactions that investment banks
offer their clients; however, the recent series of corporate scandals has
made both investment banks and federal financial regulators more
concerned about reputation and legal risks and they report taking steps to
strengthen their oversight processes.12 Investment bankers that we spoke
with told us that structured finance transactions are routinely vetted
internally through their risk management and internal controls systems.
Since Enron’s collapse, the investment banks have taken some steps to
increase their focus on reputation and legal risks, including making
managerial changes, establishing new oversight committees, and
strengthening their internal review and transaction approval processes.
Federal financial regulators believe that these are positive steps but noted
that it is too soon to evaluate how well the new policies and procedures
will work in practice. Federal financial regulators are responsible for
overseeing different segments of the large, complex financial institutions
that engage in structured finance transactions. Federal financial regulators
use a risk-focused approach to their examination processes for these
financial institutions, identifying the most significant risks to the
institution and then determining whether the financial institution has the
risk management systems and internal controls in place to identify,
measure, monitor, and manage them. Federal financial regulators noted
that exams prior to Enron’s collapse did not identify structured
transactions as a high-risk area that required attention because risk


12
   Reputation risk is the possibility that negative publicity regarding an entity’s business
practices, whether true or not, will cause costly litigation or a decline in the customer base
or revenues. Legal risk is the potential that unenforceable contracts, lawsuits, or adverse
judgments will disrupt or otherwise negatively affect the operations or financial condition
of a firm.




Page 5                                                       GAO-03-511 Investment Banks
assessments did not show that such deals posed a material risk of financial
loss. In the wake of Enron’s collapse, some regulatory officials said they
are refining their approach to supervising certain aspects of a financial
institution’s operations that may cause reputation, litigation, and other
operational risks in the area of complex structured transactions. For
example, bank regulators plan to more extensively sample transactions in
their future exams. Also, federal financial regulators are in the process of
performing targeted reviews of the few large investment banks that are
active in complex structured transactions and are planning to develop
guidance or best practices on ways to ensure the transactions are
appropriate.

Investment bankers of certain securities firms allegedly pressured their
research analysts covering Enron and Global Crossing to issue favorable
or misleading investment recommendations (i.e., buy ratings) in order to
keep or obtain lucrative investment banking work from the companies.
Conflicts of interest issues such as these have led the public to question
the independence and objectivity of favorable investment
recommendations research analysts make about public companies and
prospects for their equity securities. The primary issue here is the
adequacy and effectiveness of barriers between the research and
investment banking functions of securities firms that offer both services.
In response to these concerns, regulators have taken a number of actions.
For example, in May 2002, SEC approved changes to NASD and New York
Stock Exchange (NYSE) rules that seek to reestablish the separation
between the investment banking and research departments of a securities
firm. In December 2002, NASD and NYSE proposed additional analyst
rules and according to SEC officials will likely propose further rules this
spring in compliance with the directive in the Sarbanes-Oxley Act.13 During
the same month, SEC, the New York Attorney General’s office, NASD,
NYSE, and state securities regulators reached a “global settlement” in
principle with the top U.S. investment banking firms to resolve issues of
conflict of interest at these firms. As of March 14, 2003, SEC
commissioners have not approved this settlement. In February 2003 SEC
adopted a regulation on analysts’ conflicts of interest. Among other
requirements, the regulation requires brokers, dealers, or certain



13
  The Sarbanes-Oxley Act, which was signed into law in July 2002, among other things,
requires SEC or the self-regulatory organizations to adopt rules to address conflicts of
interest that can arise when research analysts recommend equity securities in research
reports and public appearances.




Page 6                                                      GAO-03-511 Investment Banks
                            associated persons of brokers or dealers14 to include certifications from
                            the research analyst that the views expressed in a research report
                            accurately reflect the analyst’s personal views and to disclose whether the
                            analyst received compensation or other payments in connection with any
                            recommendation or views. It is too soon to evaluate the adequacy of these
                            new rules.

                            This report makes no recommendations. We provided copies of a draft of
                            this report to the Board of Governors of the Federal Reserve (Federal
                            Reserve), the Office of the Comptroller of the Currency (OCC), SEC, and
                            the Department of Justice for their comment. The Federal Reserve, OCC,
                            and SEC provided technical comments, which we have incorporated
                            where appropriate. The Department of Justice had no comments.


                            Investment banks play an important role in maintaining the smooth
Background                  functioning of the U.S. economy. In that role, they provide many different
                            services to their clients. In addition to more traditional services such as
                            securities underwriting, investment banks provide advice on and
                            assistance in creating different types of structured finance transactions,
                            including SPE and prepay transactions that are designed to meet the needs
                            of specific corporate clients. Investment banks’ duties to their clients
                            depend on the activities in which the investment banks engage. In part
                            because of the complexity of the transactions investment banks engage in,
                            transparency in financial reporting is essential if stakeholders (such as
                            investors) and others are to understand these transactions.


Investment Banks Offer      Investment banks are an important means of allocating capital in the U.S.
Their Corporate Clients a   economy. In their traditional function of underwriting securities offerings,
Wide Variety of Services    according to securities industry data, investment banks arranged over half
                            of the total financing provided to U.S. nonfinancial businesses in 2001. The
                            wide variety of services today’s investment banks provide to their
                            corporate clients fall into two major categories—-securities/capital
                            markets and advisory services. Table 1 provides a description of services
                            investment banks provide their corporate clients.


                            14
                              Brokers effect securities transactions for the account of others. Dealers engage in buying
                            and selling securities for their own account. Associated persons of brokers or dealers are
                            partners, officers, directors, or branch managers of a broker or dealer or any person
                            controlling, controlled by, or under common control with a broker or dealer, or any
                            nonministerial employee of a broker or dealer.




                            Page 7                                                      GAO-03-511 Investment Banks
Table 1: Services Investment Banks Provide Their Corporate Clients

 Name of Service             Description of Service
 Underwriting                In this role, investment banks are financial intermediaries in securities offerings. They verify financial
                             data and business claims, facilitate pricing, and perform due diligence. Most underwritings are “firm
                             commitment” underwritings in which investment banks purchase the securities from the issuer and
                             distribute them to the public.
 Private placements          Investment banks may help corporate clients place securities privately. In these transactions, the banks
                             focus on the direct placement of corporate securities with investors—for example, by drafting the
                             private placement memorandum and contacting and negotiating with potential investors.
 Venture capital             Investment banks provide capital and strategic guidance to some companies and may manage
                             venture-capital pools or invest their own capital. They may also provide underwriting services or advice
                             on mergers and acquisitions.
 Asset-based financing       Investment banks help clients obtain financing using existing assets and assist with asset
                             securitizations. These transactions involve selling securities backed by cash flows from a pool of
                             financial assets, such as credit card receivables.
 Investment management       Investment management operations include managing mutual funds, hedge funds, unit investment
                             trusts, leveraged buyout funds, and private equity funds.
 Merchant banking            Merchant banking commits the investment bank’s own capital to facilitate a client transaction such as a
                             bridge (or temporary) loan.
 Research                    Research analysts at the investment banks analyze public companies and make investment
                             recommendations about the securities of those companies to investors through research reports and
                             other means, such as the media.
 Other transactions          Investment banks structure and implement transactions to allow clients to manage a variety of risks.
                             Such transactions may include a variety of derivatives.
 Corporate advisory services In addition to helping with mergers and acquisitions, investment banks assist with corporate
                             reorganizations and advising on other strategic matters. Services related to mergers and acquisitions
                             include conducting due diligence, preparing a valuation of the business, advising the client on the best
                             type of transaction, preparing a selling memorandum, participating in negotiations, and assisting the
                             client’s board of directors with discharge of their fiduciary duties. Investment banks may also facilitate
                             corporate reorganizations by recommending the sale of certain assets, issuing special securities such
                             as convertible stock and bonds, and even negotiating the sale of the entire company. Investment banks
                             may also provide corporate or financial advisory services on other strategic matters such as
                             divestitures, corporate defense strategies, joint ventures, privatizations, spin-offs, proxy and consent
                             solicitations, tender offers, exchange offers, and leveraged buyouts.
Source: J.P. Morgan & Co., SEC, and GAO analysis.

                                                    The three investment banks highlighted in this report, like other large
                                                    investment banks providing services to large companies, had various
                                                    relationships with Enron or Enron-related entities. The investment banks
                                                    provided an array of services and products to Enron, including acting as
                                                    advisors on mergers and acquisitions, lending money for loan
                                                    syndications,15 underwriting bond and stock offerings, providing research
                                                    on Enron securities, providing complex structured finance transactions,




                                                    15
                                                      Loan syndication is a form of financing involving a group of banks that agree to advance
                                                    a portion of the funding.




                                                    Page 8                                                     GAO-03-511 Investment Banks
                           acting as trading counterparties to derivatives transactions,16 participating
                           as passive investors (limited partners) in an SPE, and others.


Structured Financing       Structured finance is designed by investment bankers and others to help
Includes SPEs and Prepay   clients obtain funding on desirable terms and in some cases with favorable
Transactions               economic, accounting, and tax characteristics. It includes many variants,
                           including transactions that use SPEs and prepay transactions. An SEC
                           official has stated that structured finance plays an important role in the
                           modern business environment and, when used properly, can provide
                           needed liquidity, funding sources, and investment opportunities and
                           facilitate risk dispersion. The official also noted that structured finance
                           transactions have at times been used inappropriately to achieve a specific
                           accounting or tax result. Sometimes this inappropriate use has been
                           achieved by violating existing regulations or accounting standards.

Special Purpose Entities   In the ordinary course of business, many companies use a variety of
                           structured financings that involve SPEs to access capital or hedge risk.17
                           An SPE is a legal entity created by another entity (a sponsor) to carry out a
                           specified purpose or activity, such as to consummate a specific
                           transaction or series of transactions with a narrowly defined purpose.
                           SPEs are often used as a financing vehicle that allows a sponsor entity to
                           transfer assets to the SPE in exchange for cash or other assets the SPE
                           obtains by issuing debt, equity, or both, to third-party lenders or investors.
                           Originators of financial assets such as mortgages and consumer credit
                           have used SPEs extensively; at the end of 2001, such SPEs held over $2
                           trillion in assets. For example, a sponsor entity could transfer accounts
                           receivable from credit-card holders into an SPE in exchange for cash. In
                           this example, the SPE would obtain the cash by issuing securities backed
                           by the accounts receivable. SPEs may also be established to acquire,
                           construct, or manufacture assets the sponsor entity uses through leases,
                           management contracts, or other arrangements. For example, a sponsor
                           entity could establish an SPE to construct a power plant that was financed
                           through debt issued by the SPE.




                           16
                              Derivatives are financial products whose value is determined from an underlying
                           reference rate, index, or asset. The underlying includes stocks, bonds, commodities,
                           interest rates, foreign currency exchange rates, and indexes that reflect the collective value
                           of various financial products.
                           17
                                Hedging is a financial technique used to mitigate the risk of loss from price fluctuations.




                           Page 9                                                          GAO-03-511 Investment Banks
                          An SPE may take many different forms, including a corporation,
                          partnership, limited liability company, or trust.18 When the entity is
                          properly structured, an SPE’s assets may be legally separate from those of
                          its sponsor, protecting the SPE’s assets from the risk of the sponsor’s
                          bankruptcy. This arrangement often reduces credit or other risks for
                          lenders and investors and thus lowers financing costs for the sponsor.
                          SPEs may also create certain tax advantages for the participating parties.

                          Under generally accepted accounting principles and Financial Accounting
                          Standards Board guidance, SPEs meeting certain criteria do not appear on
                          the balance sheet of the sponsoring entity. Thus, transactions that provide
                          financing involving SPEs can be structured so that the assets and liabilities
                          transferred to an unconsolidated SPE can be removed from the sponsor’s
                          financial statements. Whether an SPE is consolidated with another entity
                          is a matter of judgment that involves an assessment of the risks and
                          rewards of ownership, as well as control over the SPE’s activities. This is
                          important, because an entity could materially misstate its own financial
                          statements by, for example, understating its debt or overstating its sales if
                          it does not properly account for ownership in an SPE. Even though a
                          sponsor of an SPE might not be required to consolidate the assets and
                          liabilities of an SPE in its financial statements, the sponsor is required to
                          either recognize in its financial statements or disclose in the footnotes to
                          its financial statements the nature of its involvement with the SPE; the
                          purpose, size, and activities of the SPE; and the maximum exposure to loss
                          as a result of its involvement with the SPE.

Accounting for Sales of   Ownership interests in an entity, including an SPE, are considered
Financial Assets          financial assets. When assets of this type are sold or transferred to another
                          entity, Financial Accounting Standards (FAS) 140, Accounting for
                          Transfers and Servicing of Financial Assets and Extinguishments of
                          Liabilities, provides the accounting guidance related to the transaction.19
                          In general, when an entity surrenders control of a transferred financial



                          18
                            SPEs generally do not include registered investment companies—an investment
                          company, such as a mutual fund, is registered with SEC under the Investment Company
                          Act of 1940.
                          19
                            FAS No. 140 became effective April 2001 and provides the accounting guidance used to
                          determine if a transfer “purported to be a sale” should be reported as a sale or a secured
                          borrowing. FAS 140 replaced FAS 125, which had the same name. FAS 140 revised some of
                          the accounting standards for securitizations and other financial assets and collateral and
                          requires certain disclosures, but it carries over most of FAS 125’s provisions without
                          reconsideration.




                          Page 10                                                    GAO-03-511 Investment Banks
                      asset, a sale can be recognized. For a sale to occur, the transferred asset
                      should be isolated from the transferring entity and its creditors, and the
                      entity receiving the asset has the right to pledge the asset as collateral or
                      to sell it. Further, the entity transferring the asset is not allowed to
                      maintain control of the asset through any agreement that entitles and
                      obligates it to repurchase the asset. If a transfer of financial assets in
                      exchange for cash or other consideration does not meet the criteria for a
                      sale, then the entity transferring the asset must account for the transaction
                      as a secured borrowing with a pledge of collateral, and the resulting
                      liability and the asset are reflected on the entity’s balance sheet.

Prepay Transactions   A prepay transaction involves a contractual agreement between two
                      parties that combines the economics of a debt obligation with those of a
                      forward contract, which is a contract for a service or product to be
                      delivered at a later date. Forward contracts, whether prepaid or not, can
                      be used to hedge against adverse price moves. For example, if two parties
                      enter into a forward contract to exchange 100 gallons of gas for $180
                      ($1.80 per gallon) in a month, the buyer of the gas is protected against a
                      price higher than $1.80 while the seller is protected against a price lower
                      than $1.80. In a prepaid forward contract, the payment for the gas is made
                      at the time of the contract but the gas is delivered in a month; this provides
                      immediate cash flow to the seller. If this prepay transaction is a loan in
                      substance and intent, its accounting treatment should be that of a loan.20

                      In the energy business, entities commonly enter into forward contracts for
                      the purchase or sale of a commodity. Such activities are generally settled
                      by the physical delivery of the commodity. The contracts are often entered
                      into based on an entity’s assessment of market movements either to hedge
                      its position or to speculate on price. Some entities enter into energy
                      contracts for trading purposes and often settle them with cash rather than
                      a commodity. In accounting guidance, “energy trading activities” refers to
                      energy contracts entered into with the objective of generating profits from
                      changes in market prices. The guidance states that determining whether
                      an entity is involved in energy trading activities is a matter of judgment
                      that depends not solely on the terms on the contracts, but also on an
                      assessment of relevant facts and circumstances related to the entity’s



                      20
                        To determine the accounting treatment, prepaid forward contracts must be evaluated
                      under the provisions of Financial Accounting Standards Board Statement of Financial
                      Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
                      Activities.




                      Page 11                                                  GAO-03-511 Investment Banks
                             activities. However, inherent in that assessment is an evaluation of the
                             entity’s intent in entering into an energy contract.21


Investment Banks’ Duties     Investment bankers are often retained to advise on a course of action that
to Their Clients Depend on   a board of directors has already determined to pursue. The banker’s role in
the Role the Banks Play      helping the board achieve those objectives is set forth in an agreement
                             known as an engagement letter, and the banker’s duties to the client are
                             limited to the terms of that letter. Moreover, the advice that investment
                             banks provide is largely subjective. However, in some cases courts have
                             found that an investment banker owes a fiduciary duty to a company if the
                             investment banker evaluated and considered the appropriateness of
                             unsuccessful financial transactions that caused the company’s
                             bankruptcy.22

                             Enron engaged investment bankers to provide advice on and at times to
                             participate in the creation of SPEs. The duties of the investment bankers
                             in such transactions depends on the role the investment bankers played. If
                             the SPE issues securities through a public offering that it sells to investors
                             in order to raise capital, and the investment bank acquires the securities
                             from the SPE with the intent to subsequently distribute them, then the
                             investment bank is acting as an underwriter. As an underwriter, the
                             investment banker would have duties of due diligence and disclosure.23



                             21
                                Energy trading activities also include dealing, the activity of standing ready to trade—
                             whether buying or selling—for the dealer’s own account, thereby providing liquidity to the
                             market. These contracts would have to be analyzed under the provisions of SFAS 133
                             (subsequent to its effective date) and Emerging Issues Task Force (EITF) 98-10. The EITF
                             sets forth a framework for concluding which energy contracts should be accounted for as
                             trading contracts. The model set forth generally focuses on an evaluation of the various
                             activities of an entity based on all available facts and circumstances. Further, the model
                             requires that in the event that a contract is entered into outside of a segregated energy
                             trading operation, an entity should analyze contracts at inception based on attendant facts
                             and circumstances and identify each contract as either trading or non-trading. See EITF 98-
                             10.
                             22
                               In re Daisy Corporation, 97 F.3d 1171 (9th Cir. 1996) (court refused to grant summary
                             judgment to investment banker when debtor relied upon banker’s advice and debtor
                             presented evidence that investment banker’s advice eventually led to debtor’s bankruptcy);
                             In re Healthco Intern, Inc., 195 B.R. 971 (Bankr. D. Mass. 1996).
                             23
                               Section 11 of the Securities Act of 1933 provides that signers of the registration
                             statements, including underwriters, may be held liable for materially misleading statements
                             or omissions in a registration statement and, therefore, have a duty to independently
                             investigate the statements—in other words, to conduct due diligence.




                             Page 12                                                    GAO-03-511 Investment Banks
    If investment bankers knowingly or substantially assisted a company—in
    this case, Enron—in violating the securities laws, SEC has the authority to
    bring an action for aiding and abetting a securities violation. The action
    depends on the involvement of the investment banker in the alleged
    conduct. SEC must prove three elements in an aiding and abetting a
    securities law violation: (1) that a principal committed a primary violation,
    (2) that the aider and abettor rendered such assistance knowingly or
    recklessly, and (3) that the aider and abettor provided substantial
    assistance to the primary violator. In other words:

•   The first legal element of aiding and abetting is the requirement that an
    independent, illegal act exists to which the aider and abettor can be
    attached. This independent illegal act or primary violation may be a
    misrepresentation, omission, scheme to defraud, or fraudulent course of
    business.
•   The second element of aider and abettor liability is either actual
    knowledge of the primary violation on the part of the aider and abettor or
    recklessness. However, the law is ambiguous with regard to the level of
    knowledge needed to prove aiding and abetting liability. Some courts have
    required SEC to prove that the entity aiding the primary violation had
    actual knowledge of the violation.24 However, other courts have found that
    recklessness is sufficient.25 In SEC administrative proceedings, liability
    may be based on less than actual knowledge of the violation.26
•   The third element of aiding and abetting, “substantial assistance by the
    aider and abettor in the achievement of the primary violation” has been
    interpreted as meaning significant assistance to the representations of
    others or to the fraud of others. Persons may assist primary violators in
    many ways—for example by repeating their misrepresentations, aiding in




    24
      SEC v. Fehn, 97 F.3d 1276, 1288 n. 11(9th Cir. 1996); Hauser v. Farrell, 14 F. 3d 1338 (9th
    Cir. 1994). Section 20(e) of the Securities Exchange Act of 1934 (the Exchange Act)
    provides for aiding and abetting liability against any person who “knowingly provides
    substantial assistance to another person” who violates the federal securities laws.
    25
         Aiken v. Q—L Investments, 959 F.2d 521, 526 (5th Cir. 1992).
    26
      SEC v. Graham, 222 F.3d 994 (D.C. Cir. 2000). SEC may bring administrative proceedings
    for aiding and abetting a securities law violation against certain regulated persons, such as
    broker-dealers. See Section 15(b)(4) of the Exchange Act. SEC may also bring an
    administrative cease-and-desist proceeding against any person who is “a cause of” another
    person’s violation due to an act or omission that the person knew or should have known
    would contribute to the primary violation. See Section 21C of the Exchange Act.




    Page 13                                                      GAO-03-511 Investment Banks
                            the preparation of misstatements, acting as conduits to accumulate or
                            distribute securities, executing transactions, or financing transactions.27

                            Thus, if SEC determines that there is evidence to allege that investment
                            bankers provided substantial assistance to Enron in violating the
                            securities laws and that the investment bankers rendered such assistance
                            knowingly, SEC could bring a civil action against the investment bankers
                            that engaged in such conduct. Depending on the forum where the action is
                            brought, reckless conduct on behalf of the investment banker may be
                            sufficient.

                            However, we have observed that some conflict exists among the courts
                            regarding the level of knowledge required for SEC to bring a claim in court
                            for aiding and abetting liability. Clearly, actual knowledge of the fraud is a
                            more difficult standard to prove. If this standard were to be the
                            requirement, SEC might not be able to successfully pursue all court cases
                            that could involve actions for aiding and abetting a securities law
                            violation.


Transparency in Financial   In part because of the complexity of many structured finance transactions,
Reporting Is Key to         transparency in financial reporting is essential to maintaining confidence
Maintaining Confidence in   in capital markets. Off-balance sheet transactions28 and other relationships
                            with off-balance sheet entities or other persons may have a significant
Capital Markets             effect on a company’s financial condition, revenue or expenses, results of
                            operations, and liquidity. Financial reporting should provide the
                            information that is useful to current and potential investors, creditors, and
                            others in making rational investment, credit, and similar decisions. The
                            information should be comprehensible to those who have a reasonable
                            understanding of business and economic activities and are willing to study
                            the information with reasonable diligence.

                            Financial reporting should also provide the information necessary to
                            assess the financial condition of an entity, including (1) the amount,
                            timing, and certainty of cash flows; (2) the assets, obligations, and equity;



                            27
                              Rolf. Blyth, Eastman, Dillon & Co., 570 F.2d 38, 48 (2d Cir. 1978); Cumis Ins. Soc’y v.
                            E.F. Hutton, 457 F. Supp. 1380, 1386 (S.D. N.Y. 1978).
                            28
                              An off-balance sheet item is a financial contract that can create gains or losses for an
                            entity but is not reported on the balance sheet under generally accepted accounting
                            standards.




                            Page 14                                                      GAO-03-511 Investment Banks
                       and (3) the financial performance during a specified period. Transparent
                       financial reporting depends on reliable information, sufficient disclosures,
                       and fundamental assertions about the information presented. For
                       example, assets are owned and are expected to provide future benefits to
                       an entity; all known obligations of an entity, as a result of prior events, are
                       recorded; an entity’s revenues are reported during the period earned; and
                       an entity’s sources and uses of cash flows are properly classified. If
                       investors and creditors lose confidence in the financial reporting of an
                       entity, the consequences to the entity and the marketplace can be
                       significant.

                       Both accounting and auditing standards recognize that an entity’s
                       management is responsible for an entity’s financial reporting, including the
                       fairness of its presentation in conformity with generally accepted
                       accounting principles. During an audit, audit standards require an auditor
                       to obtain written representations from management indicating, among
                       other things, management’s responsibility for the entity’s financial
                       reporting. The Sarbanes-Oxley Act reemphasized management’s
                       responsibility by requiring that an entity’s principal executive and financial
                       officers certify that the financial statements and other financial
                       information included in the report fairly present in all material respects
                       the financial condition and results of operations. The act also imposed
                       possible disgorgement of any ill-gotten gains on the part of principal
                       executive and financial officers when an entity is required to restate its
                       financial statements owing to noncompliance—that is, as a result of
                       misconduct with any financial reporting requirements under securities
                       laws.


                       Investment banks allegedly actively and substantially helped Enron
The Role of            deceive its investors and creditors by facilitating complex structured
Investment Banks in    finance transactions designed to result in misleading accounting and tax
                       outcomes that benefited the company. Enron used structured finance to
Enron’s Structured     generate recorded sales, decrease taxes, and facilitate prepay transactions
Finance Transactions   that bolstered operating results and cash flows. Investment banks played
                       key roles in each of the transactions discussed in this report. (See
                       appendix II for a detailed description of these transactions and the roles
                       played by investment banks.) It is alleged that these transactions enabled
                       Enron to manipulate and obscure its reported results or to avoid tax
                       obligations in various ways. If so, SEC can bring action against these
                       investment banks for aiding and abetting securities fraud.




                       Page 15                                             GAO-03-511 Investment Banks
Investment Banks Were      SPEs are often used for legitimate purposes as a financing vehicle, but
Involved in Transactions   they have also been used to inappropriately overstate net income and
That Enron Used to         understate total debt. For example, an entity that transfers control of an
                           asset, including the risks and rewards of ownership, to a properly
Generate Recorded Sales    structured, unconsolidated SPE for cash is generally expected to report
and Reduce Taxes           the transfer as a sale and record the gain or loss on the transaction. If an
                           entity transfers an asset but not all the risks of ownership to an SPE for
                           cash, then the cash received is generally accounted for as a secured
                           borrowing (i.e., a loan).

                           It has been alleged that Merrill Lynch knew that its participation in
                           Enron’s Nigerian barge transaction29 aided deceptive accounting by Enron.
                           The form of Merrill Lynch’s involvement was an equity investment that
                           would validate a sale by Enron, but it was reported that oral commitments
                           by Enron minimized Merrill Lynch’s risks and ensured a specified return,
                           meaning that Merrill Lynch’s investment was in substance a loan and that
                           therefore there was no valid sale. Publicly available reports describe a
                           transaction in which Enron reported a gain from selling an interest in
                           three power barges located in Nigeria to Ebarge, LLC (Ebarge), an SPE
                           Merrill Lynch created for this transaction. This transaction occurred 2
                           days before the year-end closing date for Enron’s 1999 financial
                           statements. It was asserted that Merrill Lynch was not at risk for the equity
                           investment in Enron’s barges because Enron officials made oral
                           guarantees to arrange for the resale of Merrill Lynch’s interest in the
                           barges within 6 months, with a specified return to Merrill Lynch for its
                           involvement in the transaction. A publicly available Merrill Lynch
                           document related to this transaction indicates that prior to entering into
                           the transaction, Merrill Lynch received assurance from Enron that Merrill
                           Lynch’s investment would be liquidated within 6 months.30 After attempts
                           by Enron to sell Merrill Lynch’s interest in the barges to an independent
                           third party failed, an Enron-related party purchased Ebarge from Merrill
                           Lynch. Based on the sale price and fees received for the transaction,
                           Merrill Lynch received the allegedly promised return on its equity
                           investment. If, as asserted, Merrill Lynch did not have an equity risk in the



                           29
                             In this transaction, Enron sold interest, or ownership, in Enron Nigeria Barge Limited an
                           entity whose sole assets were the three barges. Ownership interests are considered to be
                           financial assets under FAS 140.
                           30
                             Senate Committee on Governmental Affairs, Permanent Subcommittee on Investigations,
                           The Role of the Financial Institutions in Enron’s Collapse, Vol. 2, 107th Cong., 2nd sess.,
                           2002, Exhibit 207.




                           Page 16                                                     GAO-03-511 Investment Banks
barges through Ebarge but instead had a credit exposure to Enron, then
Enron should have reported this transaction as a secured borrowing
instead of a gain on the sale of an asset, reducing the company’s net
income and increasing its debt. If, as alleged, Merrill Lynch knowingly and
substantially assisted Enron in violating the securities laws by improperly
reporting its debt as net income, and if such reporting is a violation of the
securities laws, SEC has the authority to bring an action against Merrill
Lynch for aiding and abetting a securities law violation.

Merrill Lynch officials contended that Enron proposed and structured the
transaction and that Enron also assured Merrill Lynch that its outside
auditors had vetted and approved its accounting for the transaction.
Merrill Lynch officials also contended that the firm provided no
accounting advice to Enron and that Merrill Lynch in fact was at risk in the
transaction because, while Enron orally agreed to make a “best effort” to
find another buyer for the asset, this promise was not a legally binding
guarantee. Officials told us they undertook the transaction as an
accommodation to Enron in the hopes of receiving increased Enron
business in the future. In February 2003, Merrill Lynch said that it had
agreed in principle with SEC, without admitting or denying any
wrongdoing, to pay a fine to resolve civil charges that it aided Enron in
fraudulently overstating Enron’s earnings in 1999. One of the transactions
reportedly included in the settlement was this Nigerian barge transaction.

It has also been alleged that Citigroup Inc. (Citigroup) assisted Enron in
executing transactions, despite knowing that the transactions used
deceptive accounting strategies, in return for substantial fees or favorable
consideration in other business dealings. Publicly available documents
describe transactions referred to as Bacchus and Sundance that involved
Enron, Citigroup, and several SPEs and took place over a 6-month period
beginning in December 2000. PSI and the bankruptcy examiner concluded
that the substance of the transactions for Enron was borrowing, which
instead of being reported as debt was recorded as a sale with a gain that
increased Enron’s net income through deceptive accounting. In these
transactions, Enron sold its ownership in a pulp and paper trading
business to an Enron-created SPE, the Caymus Trust, a transaction for
which Enron recorded a gain. Through a variety of agreements, Citigroup
was to be at risk for $6 million of equity in the Caymus Trust. However, it
has been asserted that Citigroup did not have equity risk because Enron
verbally guaranteed that the $6 million equity investment would be repaid.




Page 17                                           GAO-03-511 Investment Banks
A publicly available Citigroup document indicates that “Bacchus is a part
of a program designed to ensure that Enron will meet its year-end
[targets].”31

Approximately 6 months after the Bacchus transaction, the Sundance
transaction returned Citigroup’s investment in the Caymus Trust by
redeeming its investment. The Sundance transactions involved the
creation of an Enron-Citigroup joint venture that was allegedly designed to
ensure that Citigroup had no equity at risk. If Citigroup never had equity at
risk in these transactions, then the substance of the transactions was
secured borrowing that Enron should have reported as debt rather than as
a sale. A publicly available document prepared by Citigroup’s Risk
Management Group indicates that the group initially did not approve the
Sundance transaction because, among other things, “the GAAP accounting
is aggressive and a franchise risk to [Citigroup] if there is publicity (a la
Xerox).”32 If Citigroup knew that Enron had improperly recorded these
transactions and that the reporting by Enron was a violation of the
securities laws, and Citigroup’s conduct substantially assisted Enron’s
violations, SEC would have the authority to bring an action against
Citigroup for aiding and abetting Enron’s securities law violations.

In response to these allegations, Citigroup officials testified at a December
11, 2002 congressional hearing that Citigroup employees had acted in good
faith and had understood that these transactions complied with existing
law and the prevailing standards at the time. Although Citigroup’s internal
review committee had reviewed the transactions, Citigroup officials said
that Citigroup had viewed the accounting decisions as decisions that
would be made by Enron and its accountants. Citigroup noted that Enron
was a Fortune 10 company and that Enron’s auditors from Arthur
Andersen LLP were presumed to know about the transactions and to have
approved their accounting treatment.

Companies such as Enron can use properly structured SPEs to minimize
taxes, but SPEs have also been used to create complex transactions




31
  Senate Committee on Governmental Affairs, Permanent Subcommittee on Investigations,
Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and
Facilitated by U.S. Financial Institutions, 107th Cong., 2nd sess., 2002, S. Prt. 107-82,
Exhibit 322d.
32
     Committee on Governmental Affairs, Four Enron Transactions, Exhibit 333n.




Page 18                                                   GAO-03-511 Investment Banks
                          designed to evade taxes. J.P. Morgan Chase & Co. (Chase)33 facilitated a
                          transaction for Enron (referred to as Slapshot), despite allegedly knowing
                          that the transaction used deceptive tax strategies. Chase designed the
                          Slapshot transaction, provided the funding, minimized its own risks, and
                          received substantial fees for facilitating the transaction. The Slapshot
                          transaction involved Enron, Chase, other lenders, a Chase SPE, and
                          several Enron affiliates and SPEs in order to refinance an Enron pulp and
                          paper mill and allegedly to evade Canadian taxes. Publicly available
                          reports describe Slapshot as a complex series of structured finance
                          arrangements that all took place during the same day and included a
                          $1.039 billion loan due later the same day and a $375 million loan due in 5
                          years and one day. In a publicly available Chase document related to the
                          design of the Slapshot transaction, Chase indicated that an advantage of
                          one aspect of the structure of the transaction was that it provided “no road
                          map for Revenue Canada.”34 If Chase knowingly and substantially assisted
                          Enron in evading taxes, resulting in the reporting of incorrect information
                          in Enron’s financial statements, and such reporting was a violation of the
                          securities laws, SEC would have the authority to bring an enforcement
                          action against Chase for aiding and abetting Enron’s securities fraud.

                          A Chase official testified at a congressional hearing that Chase’s
                          Structured Finance Group had developed the generic form of this
                          transaction and had received opinions from two leading Canadian law
                          firms that the structure and the Canadian tax benefits the transaction
                          provided were legal and valid.


Investment Banks Were     It has been alleged that Chase and Citigroup assisted Enron in its
Involved in Prepay        deceptive accounting over a period of years by facilitating several billion
Transactions Enron Used   dollars in loans disguised as energy trades and allowing Enron to use
                          offshore entities that the investment banks controlled as trading partners.
to Bolster Operating      Although prepay transactions are common in the energy industry in
Results                   general, the Enron prepay transactions were allegedly unique because they


                          33
                            J.P. Morgan Chase & Co. is the successor to J.P. Morgan & Co. Inc. and The Chase
                          Manhattan Corporation, which merged on December 31, 2000. Even though virtually all of
                          the Enron-related transactions were entered into with The Chase Manhattan Bank, the
                          successor assumes responsibility for those deals. Henceforth, for the purpose of the report,
                          GAO will use the name “Chase” to refer to the combined company.
                          34
                            Committee on Governmental Affairs, Four Enron Transactions, Exhibit 344. On
                          November 1, 1999, Revenue Canada became the Canada Customs and Revenue Agency.
                          Part of the agency’s mission is to promote compliance with Canada’s tax regulations.




                          Page 19                                                     GAO-03-511 Investment Banks
involved a circular cash flow arrangement among the three parties
involved in the transactions.

Publicly available reports describe several prepay transactions among
Enron, various investment banks, and usually a third-party SPE affiliated
with the investment bank. In these transactions, Enron received cash in
advance and promised to deliver a specific volume of oil or gas in the
future (or the cash value of the commodity). Enron accounted for these
transactions as energy trading activities and reported the prepay
transactions as liabilities from price risk management35 on its balance
sheet and as cash flows from operations on the statement of cash flows.
However, PSI and the bankruptcy examiner concluded that Enron’s
accounting for the transactions was inappropriate because the prepay
transactions were in substance and intent loans, not trading activities, and
should have been recorded by Enron as debt. Reporting them as debt,
however, would have weakened some of Enron’s key financial ratios, such
as its debt-to-equity ratio. Further, the cash Enron received would have
properly been reported as cash flows from financing activities on the
statement of cash flows and not as cash flows from operations. If it is
proven that the prepays were effectively loans, Enron’s accounting for the
prepay transactions as trading activities could have misled investors and
analysts about the scope of Enron’s trading activities and the nature of its
incoming cash flows.36 Publicly available Chase and Citigroup documents
indicate that the firms participated with other companies in prepay
transactions that, like Enron’s prepay transactions, often involved an SPE
and no price risk.37 However, we were not able to determine if these
transactions involved circular cash flows like Enron’s prepay transactions.
If the allegations that (1) the firms knowingly assisted Enron in engaging
in materially fraudulent transactions and (2) the firms’ conduct provided
substantial assistance to the fraud are proven true, SEC would have the
authority to bring an action against them for aiding and abetting securities
laws violations.




35
  Enron’s liability for price risk management was the balance sheet line item used to
account for trading liabilities. Enron also reported assets for price risk management
activities on its balance sheet.
36
     Committee on Governmental Affairs, Four Enron Transactions.
37
  Committee on Governmental Affairs, Role of the Financial Institutions, Vol. 1, Exhibits
134 and 161.




Page 20                                                     GAO-03-511 Investment Banks
Publicly available reports describe prepay transactions among Enron,
Chase, and an SPE (Mahonia, Ltd.) that was created to undertake
transactions for Chase. In these transactions, Enron’s accounting
treatment of the prepay transactions as trading activities was allegedly
improper because in substance and intent the transactions were actually
loans. One publicly available Chase document indicated that “Enron loves
these deals as they are able to hide funded debt from their equity analysts
because they (at the very least) book it as deferred revenue or (better yet)
bury it in their trading activities.”38 Between 1992 and 2001, Enron and
Chase entered into 12 prepay transactions with a combined value of over
$3.7 billion.

In testimony given at a congressional hearing, in an interview with us, and
in documents supplied to us, Chase officials said that they understood that
Enron, with Enron’s auditor’s approval, had treated the prepay
transactions as trading activities. The officials contended that Chase
mitigated risk, as required by banking law, and that the risks of the
different transactions and hedges involved in prepays were different from
those of a loan. Chase provided us with excerpts from other companies’
financial statements that described their prepays as a means of financing,
recorded as liabilities for price risk management. However, we have not
reviewed these transactions and cannot determine if they were similar to
Enron’s prepay transactions.

Another example of an Enron prepay transaction involved Enron,
Citigroup, and a Citigroup-created SPE, Delta Energy, that served as a
third party. The first of these Citigroup prepay transactions in 1993 was
similar in structure to the Chase prepay transactions. However, some of
the later Citigroup prepay transactions involving Delta Energy were
funded by bond offerings to qualified institutional buyers instead of by
Citigroup. By raising funds for the prepay transactions in this fashion, the
institutional investors rather than Citigroup were at risk if Enron should
go bankrupt or default. PSI and the bankruptcy examiner concluded that
Enron’s accounting for these prepay transactions as trading activities was
improper, because in substance and intent the transactions were actually
loans. One publicly available Citigroup document discussing the approval
of an Enron prepay transaction indicated that Citigroup’s “internal
approval for the transaction will acknowledge that [Citigroup] was



38
  Committee on Governmental Affairs, Role of the Financial Institutions, Vol. 1, Exhibit
123.




Page 21                                                   GAO-03-511 Investment Banks
                         basically making a loan.”39 PSI reported that between 1993 and 2001, Enron
                         and Citigroup entered into 14 prepay transactions with a combined value
                         of over $4.8 billion.

                         Citigroup officials contended the transactions were done in good faith,
                         complied with existing law and prevailing standards of the time, and had
                         been reviewed and approved by their internal review committee. Citigroup
                         officials contended that Enron assured them that its outside auditor had
                         fully vetted and approved its accounting treatment of prepays.


Other Enron and Global   The three investment banks highlighted in this report also participated as
Crossing Transactions    passive investors in other transactions involving SPEs with Enron.
                         However, we did not confirm or refute whether, as passive investors, these
                         financial institutions participated in the management of the SPE. For
                         example, Chase, Merrill Lynch, and Citigroup were investors as limited
                         partners in the SPE LJM2 Co-Investment, L.P. (LJM2), contributing a total
                         of about $40 million.40 Merrill Lynch also acted as the private placement
                         agent for LJM2 and in this capacity helped introduce sophisticated
                         (wealthy) investors to the LJM2 partnership. For its work, Merrill Lynch
                         testified that it received about $3 million in fees. Also, the investment bank
                         invested $5 million itself and permitted 96 of its executives to invest about
                         $16.6 million of their own money in LJM2.

                         Section 705 of the Sarbanes-Oxley Act mandates that we review
                         investment bank involvement in the failure of Global Crossing, “including
                         with respect to transactions involving swaps of fiber optic cable capacity.”
                         It has been reported in the press, and plaintiffs have alleged in civil
                         actions, that Global Crossing improperly reported as revenue the proceeds
                         it received from sales of fiber optic capacity and services in transactions
                         with counterparties; however, to our knowledge, no investment banks
                         were involved in these transactions. In these transactions, Global Crossing
                         and its counterparties entered into simultaneous agreements to purchase
                         and sell fiber optic capacity and services. In many of these transactions,
                         the aggregate purchase and sales prices were similar or the same. It also



                         39
                           Committee on Governmental Affairs, Role of the Financial Institutions, Vol. 1, Exhibit
                         188g.
                         40
                           LJM2 is a Delaware limited partnership organized and managed by the then chief
                         financial officer of Enron to make private equity investments in the energy and
                         telecommunications sectors.




                         Page 22                                                   GAO-03-511 Investment Banks
                         has been alleged by plaintiffs that these transactions lacked a legitimate
                         business justification and that, as a result, Global Crossing’s financial
                         statements were materially misleading to the investing public. In October
                         2002, Global Crossing announced that it would restate its financial
                         statements for prior periods based on advice from SEC staff that Global
                         Crossing’s previous accounting for these transactions did not comply with
                         generally accepted accounting principles and that the transactions should
                         be recorded on a historical carryover basis. Global Crossing’s
                         announcement stated that the company had relied on advice from its
                         independent advisors and an industry white paper in accounting for these
                         transactions.


                         According to the investment banks we spoke with, the transactions
Investment Banks and     discussed here were vetted through their internal risk management
Federal Financial        processes. In the aftermath of their experience with Enron, however, these
                         firms have become more concerned about possible reputation risk and
Regulators Have          thus have reported taking steps to strengthen their risk management
Begun Strengthening      processes. Federal financial regulators saw these steps as positive but
                         noted that it was too soon to evaluate how well the new policies and
Their Oversight of       procedures would work. Federal financial regulators also responded to the
Structured Finance       issues raised by the Enron collapse. These regulators use a risk-focused
Transactions Since       approach to oversight, identifying the most significant risks to a financial
                         institution and then determining whether appropriate risk management
Enron’s Collapse         systems and internal controls are in place. Federal financial regulators
                         noted that before Enron’s collapse, structured transactions did not pose
                         significant risks in traditional risk management areas. Since then the
                         regulators have been considering additional legal and reputation risk
                         reviews and are looking at ways to further enhance examination scopes
                         and procedures in this area. In addition, they have confirmed that they will
                         more extensively sample transactions in examinations that raise issues of
                         concern.


Investment Banks Use     In our market-based economy, market discipline and proper disclosure of
Risk Management and      risks are the primary means of controlling risk-taking behavior. When
Other Internal Control   investors respond to negative information about a company by selling (or
                         not buying) its securities, the company’s access to capital may be limited
Systems to Approve       or capital may become more costly to obtain. Investment banks have a
Structured Finance       similar but more extensive role: they not only make decisions on the
Transactions             provision and terms of capital, but also make decisions in other areas,
                         such as structured finance and whether to participate in and facilitate a
                         client’s activities.


                         Page 23                                          GAO-03-511 Investment Banks
Investment banks use a variety of control processes and policies—formal
and informal—for reviewing and evaluating whether to enter into a
particular transaction, to expand a business line, or enter into a new
business or product line. These policies and procedures are also used to
establish any conditions, procedures, or parameters applicable to the
transactions, new product or business line. The three investment banks
involved in the transactions discussed in this report all had internal review
and approval processes with independent control processes that were to
review transactions for their appropriateness.41 Control groups and
business unit representatives involved in the review process generally
operated by consensus. However, in circumstances where the business
unit wished to pursue a transaction despite concerns expressed by a
control group, senior management (management that is, at a minimum,
senior to the business unit directly interested in the transaction) could
exercise the discretion to approve the transaction.

In speaking for several large investment firms, a representative of the
securities industry told us that all investment firms recognized that the
various processes and policies they have adopted for transaction review
and approval are fallible. However, these processes and policies were
designed not to police compliance by clients with accounting or disclosure
obligations, but to ensure that the relevant risks and issues presented by a
transaction or new product or business line are identified and evaluated by
the appropriate control functions. In their view, an investment-banking
firm generally is not in a position to perform an effective policing function
vis-à-vis its client for a number of reasons. First, investment banks
generally (underwritings present a partial exception to this general
principle) will not have access to financial or transactional information
that, although unrelated to the specific transaction under consideration, is
relevant to determining whether the client’s disclosure for a transaction is
appropriate. Moreover, investment-banking firms are frequently not in a
position to make the relevant materiality determinations or to exercise
control over disclosure determinations. Indeed, these determinations are
made in many cases subsequent to the execution of the transactions. The
investment banks expressed the view that it is a client’s senior
management, audit committee, and independent auditors who are in
possession of the information and decisionmaking authority necessary to
exercise an effective gatekeeping role. Therefore, according to these



41
  These committees were usually made up of representatives of the accounting, legal, tax,
and compliance departments, among others.




Page 24                                                    GAO-03-511 Investment Banks
investment banks, as a policy matter, these are the groups who should be
viewed, and who should view themselves, as responsible for performing
that role.

The transactions that are the focus of this report were reportedly vetted
through the risk management processes of the investment banks involved.
For example, one investment bank told us that it had been engaging in
prepay transactions with Enron for about a decade and that it had closely
reviewed the initial transactions but not subsequent prepays, which were
not seen as a new type of transaction. The investment bank maintained
that because it had not reviewed the later transactions, it had not realized
the extent to which Enron had changed from an energy company to a
financial company over the years. Another investment bank told us that its
risk management reviews of the Enron transactions relied heavily on
Enron’s assurances that the outside auditor for Enron had reviewed the
transactions and considered them appropriate. Representatives of the
investment bank also said that, in their view, the decision to approve the
transactions was appropriate given the information they had at the time.
But they added that if they had known then what they know now about
Enron, they would not have done business with the company. A securities
industry official told us that risk management decisions regarding the
Enron transactions failed not because investment banks did not have
internal control processes but because Enron did not provide these firms
with the whole picture.

Representatives of some investment banks told us that after Enron’s
collapse, their firms became more sensitive to risk management issues,
such as the possibility that some transactions could involve fraudulent or
questionable financial reporting on a client’s part. Based on this
experience, some investment banks told us they had taken steps to
strengthen their risk management, although the processes themselves
remained essentially the same. For example, one investment bank created
a new policy review office to formalize and strengthen the firm’s process
for examining transactions and products. According to the investment
bank’s chief executive officer, the office is intended to help ensure that the
firm does not participate in transactions that its clients do not properly
disclose. The investment bank’s management told us that their risk
management process would not presume that transactions with highly
rated large U.S. corporations were appropriate without asking more
detailed questions. Instead, regardless of the corporation’s size and
reputation, the investment bank would require a closer look at all complex
transactions that could involve fraudulent or questionable financial



Page 25                                           GAO-03-511 Investment Banks
                            reporting. Investment bank representatives also said that accounting and
                            tax-driven transactions would now get a more thorough review.

                            Representatives from another investment bank told us that legal and
                            accounting representations on some transactions would now be obtained
                            from outside sources. Representatives from yet another investment bank
                            said that, based on their negative experiences with Enron, they were now
                            willing to ask more questions about specific transactions. In August 2002,
                            this investment bank announced a new initiative as one of a series of
                            enhancements to the controls it imposes on the execution of transactions
                            that raise legal, accounting, or other reputation issues. This new policy
                            states that if the transaction would be materially significant for the client,
                            the investment bank will proceed only if the client commits to disclosing
                            the transaction’s “net effect” on its financial position. Under this policy,
                            the focus will be on the economic reality of the transaction, not just its
                            form. Officials from this firm said that risk management processes do not
                            necessarily discover corporate accounting fraud on the part of clients.

                            According to bank regulators, since Enron’s collapse financial institutions
                            have taken some steps to deal with risk management issues in future
                            transactions. First, the financial institutions have centralized the process
                            for establishing, using, and managing SPEs and conducting separate audits
                            of SPEs’ activities. Second, they have strengthened their review and
                            approval processes for complex structured transactions in several ways.
                            For example, management reviews during the approval process now
                            include a broader range of senior managers from various areas of the
                            financial institution and focus more closely on assessing customer
                            motivation and appropriateness. In order to obtain a structured product,
                            customers are required not only to provide information on disclosures and
                            accounting treatment but also to comply with strict reporting standards.
                            Bank regulators said that these are positive steps toward strengthening
                            internal processes but noted that it is too early to evaluate how well the
                            changes will work.


Federal Banking and         The Federal Reserve, OCC, and SEC share responsibility for overseeing
Securities Regulators Use   the largest complex financial institutions. Each regulator is responsible for
a Risk-Focused Approach     specific activities. The Federal Reserve regulates bank holding companies
                            and state-chartered banks that are members of the Federal Reserve
to Overseeing Large         System; OCC regulates the activities of nationally chartered banks; and
Financial Institutions      SEC regulates activities involving securities and firms (broker-dealers)
                            that trade securities. Banking and securities regulators have different
                            regulatory missions and focus on different operational aspects of the


                            Page 26                                            GAO-03-511 Investment Banks
entities they oversee. Because commercial banks accept customer
deposits and use those funds to lend to borrowers, banking regulators
tend to focus on safety and soundness. Securities regulators focus on
protecting investors and ensuring that markets are fair. SEC aims to
ensure that public companies fully disclose material information, including
the risks associated with their transactions and their financial condition,
so investors can make informed investment decisions.

Because risks can manifest themselves in different parts of a large
financial institution, it is important for federal financial regulators to be
able to assess the overall risk management activities of the entire
organization. Most large financial institutions have a firm-wide risk
management framework in place to identify and control risk. These
institutions can have complex structures, including parent companies,
affiliates, and subsidiaries, all of which can be involved in different aspects
of risk assessment. The component entities may have one or more federal
financial regulators, or, in some cases, none. Banks and their holding
companies are regulated on a consolidated basis, but in the securities
sectors, SEC-registered broker-dealers are regulated by SEC, even if these
entities are part of a larger holding company. Although those parts of a
securities firm that are outside the broker-dealer may not be regulated by
SEC, SEC has authority to extend its oversight beyond the broker-dealer
to assure that activities in the affiliates do not threaten the soundness of
the regulated entity.42 SEC officials said that, when appropriate, they have
used this authority to examine the overall risks of affiliates.

The Federal Reserve, OCC, and SEC use a risk-focused exam approach
that concentrates on those products, transactions, and services that are
considered to pose the greatest risks to an individual firm’s overall
financial condition or the financial system as a whole. Risk is the potential
that expected or unanticipated events can cause a firm to suffer losses that
adversely affect its capital and earnings. Table 2 describes selected types
of risk.




42
 Although SEC has limited authority to oversee affiliates of broker-dealers, the Market
Reform Act of 1990 enables it to collect information about the activities and financial
condition of affiliates and parent firms to assess the risks they pose to the regulated entity.
Despite its supervisory role, SEC does not have legal regulatory authority to examine or set
regulatory capital requirements over the parents or affiliates of SEC-registered broker-
dealers.




Page 27                                                       GAO-03-511 Investment Banks
Table 2: Selected Types of Risks Faced by Financial Firms

 Type of Risk              Risk Definition
 Credit risk               The potential that a borrower or counterparty will fail to perform on
                           an obligation such as a loan or contract.
 Market risk               The risk that adverse movements in market rates or prices—for
                           example, interest rates, foreign exchanges rates, or equity prices—
                           can affect a firm’s financial position.
 Reputation risk           The possibility that negative publicity regarding an entity’s
                           business practices, whether true or not, will cause costly litigation
                           or a decline in the customer base or revenues.
 Operational risk          The potential that inadequate information systems, operational
                           problems, breaches in internal controls, or fraud will result in
                           unexpected losses.
 Legal risk                The potential that unenforceable contracts, lawsuits, or adverse
                           judgments will disrupt or otherwise negatively affect the operations
                           or conditions of a firm.
 Liquidity risk            Arises for the potential that an institution will be unable to meet its
                           obligations as they come due because of an inability to liquidate
                           assets or obtain adequate funding or that it cannot easily unwind or
                           offset specific exposures without significantly lowering market
                           prices because of inadequate market depth or market disruptions.
Source: Federal Reserve.



Under the risk-focused supervision approach, bank and securities
examiners identify the most significant risks to a financial institution and
then determine whether risk management and internal control systems are
in place to identify, measure, monitor, and manage those risks. Because of
the complexity of the largest financial institutions and the number of
transactions they conduct, bank and securities examiners focus on
assessing the integrity and effectiveness of the institutions’ overall risk
management and internal control systems. As deemed appropriate, bank
examiners also test selected transactions, and SEC reviews the policies
and procedures firms have in place.43 Federal financial regulators have an
array of tools at their disposal to ensure that regulated entities take
corrective steps when problems are identified. These tools range from
informal supervisory actions such as issuing a deficiency letter (SEC) or
issuing a memorandum of understanding (bank regulators) that details


43
  Transaction testing is used to validate examiners’ judgment on the reliability of an
institution’s internal controls. Transaction testing includes examination of underlying
support for transactions and the reconciliation of internal accounting records and financial
reports (to evaluate accuracy of account balances), the comparison of day-to-day practices
to the requirements of policies and procedures (to assess compliance with internal
systems), and all other supervisory testing procedures, such as quality reviews of individual
loans and investments.




Page 28                                                          GAO-03-511 Investment Banks
                               areas where corrective measures are appropriate to formal enforcement
                               actions such as cease and desist orders and referrals to other regulators or
                               law enforcement agencies for civil or criminal sanctions.

Federal Financial Regulators   According to federal financial regulatory officials, only a few large
Did Not Identify Structured    financial institutions offer complex structured transactions such as those
Finance As a High-Risk Area    involving Enron, although a variety of other financial institutions may
Before Enron’s Collapse        conduct isolated structured finance transactions. Federal financial
                               regulators noted that prior to Enron’s collapse they had not viewed
                               reputation risk from structured transactions as a high-risk area, primarily
                               because (1) the risk focus was on traditional market, credit, and
                               operational risks; (2) the size and volume of transactions were small
                               relative to the total capital of relevant financial institutions; (3) many such
                               transactions are conducted with investment-grade firms; and (4) with
                               respect to securities firms, many of the activities may have taken place in
                               affiliates outside of the SEC-regulated broker-dealer. Banking agency
                               officials told us that they had each reviewed the accounting for prepay
                               transactions conducted with Enron at one bank in their respective
                               jurisdictions and found it consistent with generally accepted accounting
                               principles. SEC officials noted that their focus is on the policies and
                               procedures the investment banks have in place for assessing risk and
                               approving these transactions and only review select transactions to
                               evaluate whether the policies and procedures have been effectively
                               implemented.

Federal Financial Regulators   Federal financial regulators said that since the Enron scandal they have
Have Made Changes to Their     refined their approach to supervising certain operational aspects of the
Oversight Processes As a       institutions that are involved in complex structured transactions. In a
Result of the Enron Scandal    February 10, 2003 response to questions posed to them by PSI, officials of
                               the Federal Reserve, OCC, and SEC said that staff at their agencies were
                               continuing to review investment banks’ participation in the complex
                               financial products, transactions, and practices that have raised significant
                               legal and accounting questions. Further, in carrying out these reviews, the
                               federal financial regulators said that they were collaborating on both
                               specific issues arising from the practices under review and broader issues
                               relating to the internal control and oversight mechanisms investment
                               banks need to oversee structured finance transactions. The agencies were
                               not planning an additional one-time joint review but said they would
                               continue conferring on the investigations and examinations that were
                               already under way. The federal financial regulators said that during 2003
                               they would review and evaluate the actions individual organizations were
                               taking to strengthen policies and practices in the structured finance
                               business. Based on the results of these reviews, the agencies intend to


                               Page 29                                            GAO-03-511 Investment Banks
                            develop consistent guidance and best practices for the entities within their
                            respective regulatory jurisdictions that they believe are necessary to
                            clarify their expectations for sound control and oversight mechanisms.

                            In addition, some of the federal financial regulators have altered their
                            policies and procedures examination manuals to improve oversight of
                            structured products and the institutions that use them. In the fall of 2002,
                            for example, the Federal Reserve issued additional examination guidance
                            on supervising structured products and SPEs. Further, SEC officials stated
                            that the agency is drafting a new examination module for structured
                            finance transactions to be used in examining the risk management and
                            internal control systems of broker-dealers. SEC has been conducting risk
                            management and internal control system examinations since 1995, but
                            limited resources have kept the agency from doing as many exams as it
                            considers necessary. An SEC official stated that an anticipated budget
                            increase should allow the agency to increase its staffing and conduct
                            additional examinations.


Recent Rules and            In light of Enron’s collapse, legislation and regulations have been adopted
Legislation Aim to Make     that attempt to restore investor confidence by requiring more disclosure
Off-Balance Sheet           and transparency in structured finance transactions. One area that has
                            received particular attention is the disclosure of off-balance sheet
Transaction Reporting and   transactions in registration statements and periodic filings. In addition,
Disclosures More            SEC is required to study this issue and to produce a report of its findings.
Transparent
                            Registration statements and periodic reports contain a “management
                            discussion and analysis” section for management to explain clearly a
                            company’s financial condition. According to SEC, as a response to
                            uncertainty over quality of earnings issues in general, including those
                            raised by the collapse of Enron, SEC issued a release cautioning company
                            management to report in this section full explanations of their “critical
                            accounting policies,” the judgments and uncertainties affecting the
                            application of these policies, and the likelihood that materially different
                            amounts could be reported under different conditions or using different
                            assumptions. Structured finance transactions frequently require the
                            application and selection of critical accounting policies.44 SEC issued a
                            follow-up release proposing rules to codify and expand upon this guidance



                            44
                             Cautionary Advice Regarding Disclosure About Critical Accounting Policies, Release
                            Nos. 33-8040; 34-45149; FR-60 (December 12, 2001).




                            Page 30                                                  GAO-03-511 Investment Banks
in May 2002. According to an SEC official, SEC staff are currently
reviewing the comment letters and developing recommendations for
future SEC action on this topic.45

In July 2002, Congress enacted Section 401(a) of the Sarbanes-Oxley Act,
which required that by January 2003 SEC issue final rules providing that
annual and quarterly financial reports filed with SEC disclose all material
off-balance sheet transactions, arrangements, and obligations. On January
22, 2003, SEC adopted rules to implement that section. These rules
stipulate that financial reports that public companies are required to file
with SEC after June 15, 2003 include an explanation of the company’s
financial condition disclosing material off-balance sheet transactions,
arrangements, obligations, and any relationships the issuer has with
unconsolidated entities.46

In August 2002, pursuant to Section 302(a) of the Sarbanes-Oxley Act, the
SEC adopted rules to require the certification of an issuer’s quarterly and
annual reports by its principal executive and financial officers. SEC also
adopted rules requiring issuers to maintain and regularly evaluate the
effectiveness of disclosure controls and procedures. Among other things,
the certifications state that the overall financial disclosure fairly presents,
in all material respects, the company’s financial condition, results of
operations and cash flows. A “fair representation” of an issuer’s financial
condition and results of operations and cash flows encompasses the
selection of appropriate accounting policies, proper application of
appropriate accounting policies, disclosure of financial information that is
informative and reasonably reflects the underlying transactions and
events, and any additional disclosure necessary to provide investors with a
materially accurate and complete picture of an issuer’s financial condition
and results of operations and cash flows. Such certification forces the
executive officers to not only certify whether the company’s financial
statements are prepared in compliance with generally accepted
accounting principles, but also whether the financial statements and other
financial information fairly present in all material respects the financial
condition and results of operations and cash flows of the company.



45
   Disclosure in Management’s Discussion and Analysis about the Application of Critical
Accounting Policies, Release No. 33-8098 (May 10, 2002).
46
  “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet
Arrangements and Aggregate Contractual Obligations,” Release No. 33-8182 (January 27,
2003).




Page 31                                                    GAO-03-511 Investment Banks
    In addition, Section 402 of the Sarbanes-Oxley Act requires that SEC
    complete a study by January 2004 to determine not only the extent of off-
    balance sheet transactions and the use of SPEs but also the degree to
    which the economics of such transactions are transparently conveyed to
    investors. The act also requires that SEC report to the President, the
    Committee on Banking, Housing, and Urban Affairs of the Senate, and the
    Committee on Financial Services of the House of Representatives 6
    months after the study is completed on the following:

•   public companies’ off-balance sheet transactions and use of SPEs,
•   the extent to which SPEs are used to facilitate off-balance sheet
    transactions,
•   the extent to which current rules and accounting principles result in
    financial statements that are transparent with respect to SPEs and off-
    balance sheet transactions,
•   the extent to which current accounting principles result in the
    consolidation of issuer-sponsored SPEs when the issuer carries most of
    the SPEs risks and receives most of its rewards, and
•   recommendations for improving the transparency of reporting off-balance
    sheet transactions in public companies’ financial statements.

    In response to controversies related to Enron’s use of SPEs, the
    accounting guidance related to SPE financial reporting was clarified in
    January 2003 when the Financial Accounting Standards Board released
    Interpretation No. 46, Consolidation of Variable Interest Entities.47 In
    general, this new guidance requires that an SPE be consolidated with
    another entity if that entity is the primary beneficiary48 of the SPE—that is,
    if it absorbs the majority of the risks and rewards of the SPE’s operations.
    Specifically, an SPE would be consolidated with its primary beneficiary if
    the outside equity investment was not at least 10 percent of its total
    assets49 and is not greater than its expected losses, or if the outside equity
    holders in the SPE lack (1) the ability to make decisions about the SPE’s


    47
         This guidance refers to an SPE subject to consolidation as a variable interest entity.
    48
      For purposes of determining whether an entity is the primary beneficiary, an entity with a
    variable interest (ownership or some other financial interests) shall treat variable interests
    held by its related parties as its own interest.
    49
       Prior to this guidance, 3 percent was used as a criterion to determine whether to
    consolidate an SPE with another entity. This 3-percent test did not originate in a Financial
    Accounting Standards Board standard but rather was contained in a supplement to an EITF
    issue related to leasing transactions involving SPEs and subsequently appears to have
    become the de facto test for all SPEs.




    Page 32                                                         GAO-03-511 Investment Banks
                           activities (control), (2) the obligation to absorb expected losses of the SPE
                           if they occur (risk), and (3) the right to receive residual returns of the SPE
                           if they occur (reward). Many SPEs that were previously unconsolidated
                           will be consolidated as a result of the interpretation, starting with their
                           first fiscal year or interim period beginning after June 15, 2003.


                           According to some allegations, some research analysts at investment
Conflicts of Interest      banks recommended Enron and Global Crossing securities to investors in
Reportedly Affected        order to get lucrative investment bank deals for their firms. Such analysts
                           are better trained and positioned than the average retail investor to assess
Research Analysts’         the value of a company’s securities. The value and credibility of their
Ratings of Enron and       recommendations depend on their maintaining unquestioned
                           independence and objectivity in their research and resulting investment
Global Crossing            recommendations. The issues surrounding research analysts’ actions in
                           recommending Enron raise a number of serious questions, primarily
                           concerning the effectiveness of barriers between the research and
                           investment banking functions of investment banks. In response to this
                           concern, regulators have introduced new rules designed to reduce such
                           conflicts of interest, and a number of other actions have been initiated.


Research Analysts          Research analysts study publicly traded companies and make
Allegedly Issued           recommendations about the securities of those companies, often by
Misleading Stock Reports   issuing research reports. Investors often see research analysts at
                           investment banks50 as important sources of information about securities.
                           However, many factors can adversely affect these analysts’ independence
                           and objectivity in their research reports, including investment banking
                           relationships and compensation arrangements tied to investment banking
                           revenues.

                           Conflicts of interest reportedly emerged at several investment banks that
                           made stock recommendations about Enron and Global Crossing. For
                           instance, research analysts with Merrill Lynch and Citigroup’s Salomon
                           Smith Barney Inc. (Salomon Smith Barney) who were covering Enron and
                           Global Crossing allegedly were pressured to issue misleading research
                           reports on these companies because the companies were current or
                           prospective investment banking clients. Although PSI did not examine the
                           research analyst issue, certain documents released at a PSI hearing


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




                           Page 33                                                            GAO-03-511 Investment Banks
                          suggest that Merrill Lynch terminated a research analyst because he did
                          not provide a sufficiently favorable rating on Enron that would have
                          improved the investment bank’s chances of being chosen by Enron to
                          participate in lucrative investment banking work. Merrill Lynch officials
                          contended that the analyst was terminated for other reasons and that he
                          actually raised his rating on Enron while working at another firm, one
                          month after he had left Merrill Lynch and before Merrill Lynch did so.

                          A number of class action securities lawsuits allege that a Salomon Smith
                          Barney research analyst covering Global Crossing Ltd. was pressured to
                          issue misleading research reports on this company because the company
                          was a current investment-banking client. The analyst reportedly issued
                          compromised or misleading research reports containing buy ratings for
                          the company that had no basis in fact. The complaints also allege that the
                          analyst provided strategic advice, essentially acting as an investment
                          banker as well as a research analyst. This relationship between Salomon
                          Smith Barney’s analyst and its investment bankers was allegedly not
                          disclosed. Citigroup officials told us that Salomon Smith Barney believed
                          that the analyst did in fact have a reasonable basis for his analysis and that
                          the company and the analyst are defending the lawsuits. The analyst in
                          question resigned in 2002. In addition, Citigroup officials informed us that
                          Salomon Smith Barney has created a new structure under new senior
                          management and implemented a number of other steps to strengthen the
                          independence of its analysts.


Regulators and Others     The role of research analysts and the potential conflicts of interest
Have Taken Some Actions   involving them raise a number of issues. The primary one is the adequacy
to Address Research       and effectiveness of barriers between the research and investment
                          banking functions of investment banks. In June 2001, the New York
Analysts’ Conflicts of    Attorney General opened an investigation into the practices of Merrill
Interest                  Lynch concerning analyst ratings and in May 2002 reached a settlement
                          with the firm. According to the terms of the settlement, Merrill agreed to
                          fines of $100 million and significant reforms, including severing the link
                          between analysts and investment banking.

                          In May 2002, both NYSE and NASD received SEC approval for rules
                          addressing conflicts of interest involving analysts at companies that have
                          an investment banking relationship with firms their analysts cover. The
                          new rules are intended to reestablish the separation between the
                          investment banking and research departments of large multiservice
                          brokerage firms and prevent investment banking personnel from
                          reviewing or approving research reports prior to publication. Similar


                          Page 34                                            GAO-03-511 Investment Banks
restrictions apply to communications between the research department
and the company being researched, with the additional restriction that the
company being researched is not to be provided with a research summary,
the research rating, or the price target. Further, the rules state that
companies cannot be offered, directly or indirectly, favorable research, a
specific rating, or a specific price target, nor can they be threatened with
changes to research, a rating, or a price target as consideration or
inducement for business or compensation. In addition, both NASD’s and
NYSE’s rule changes require disclosure of financial interests held by the
brokerage firm, analysts, and analysts’ family members and of any other
material conflict of interest associated with recommending a particular
security. Analysts are also subject to trading restrictions with respect to
securities in the subject company. In addition, the rules prohibit research
analysts from receiving compensation in any form—bonus, salary, or
otherwise—based on a specific investment banking services transaction.
According to NASD officials, NASD and NYSE have incorporated the new
rules into their examination programs and have already begun examining
firms for compliance with them. Soon after these rules were adopted,
NASD and NYSE began conducting joint examinations of multiservice
brokerage firms for compliance with the new NYSE and NASD analyst
rules on conflicts of interest.

NASD and NYSE proposed additional rules in December 2002 that are
intended to further manage analyst conflicts. The rules would, among
other things, further insolate analyst compensation from investment bank
pressures, prevent the issuance of “booster shot” research reports,51 and
require disclosure of a final research report when an analyst terminates




51
  A “booster shot” report refers to a favorable research report issued around the time of the
expiration, waiver, or termination of a “lock-up” agreement, which brokerage firms often
enter into with their clients to restrict the sale of a client’s securities for a defined period of
time. This proposed provision would prohibit managers and comanagers of a securities
offering from issuing research reports or making public appearances concerning a subject
company for 15 days prior to or after the expiration, waiver, or termination of a lock-up
agreement. This provision is intended to address situations in which research analysts may
issue positive research reports or reiterate “buy” recommendations shortly before or just
after the expiration of a lock-up agreement. Imposition of this 15-day blackout period is
intended to mitigate and/or eliminate the incentive for a research analyst to issue positive
research reports and to permit real market forces to determine the price at which such
securities can be sold after the expiration of such agreements.




Page 35                                                         GAO-03-511 Investment Banks
coverage of an issuer.52 We could not evaluate the overall effectiveness of
the rules because they are so new.

A number of other important steps have been taken to address research
analysts’ conflicts of interest. First, in the last year NASD has brought
many enforcement actions against broker-dealers that have issued
misleading analyst reports without having a reasonable basis for the
statements made in the reports. NASD brought most of these actions
under NASD Rule 2210, which requires broker-dealers to have a
reasonable basis for assertions they make in their research reports. In
April 2002, SEC announced that it had begun a formal inquiry into market
practices concerning research analysts and the potential conflicts in the
relationship between research and investment banking in brokerage firms.
According to SEC officials, as part of this inquiry SEC, NYSE, and NASD
conducted joint examinations of 12 multiservice brokerage firms. The
purpose of the examinations was to ascertain facts, conditions, practices,
and other matters relating to conflicts of interest associated with the work
of research analysts. In October 2002, SEC, NYSE, and NASD announced
that they would work jointly with the New York Attorney General’s office
and the North American Securities Administrators Association to bring to
a speedy and coordinated conclusion the investigations concerning
research analysts. NYSE and NASD conducted joint examinations of the
same firms53 separate from those examinations that they were conducting
for compliance with the new NYSE and NASD analyst rules on conflicts of
interest. SEC examination staff also participated in these examinations.

A settlement in principle to resolve issues of conflict of interest at
multiservice brokerage firms was announced in December 2002, with 10
large investment banks agreeing to pay over $1.4 billion in sanctions and
agreeing to certain reforms. Among the reforms were an agreement to
sever links between research and investment banking, a ban on allocating



52
  Self-Regulatory Organizations: Notice of Filing of Proposed Rule Changes by the New
York Stock Exchange, Inc. Relating to Exchange Rules 344 (“Supervisory Analysts”), 345A
(“Continuing Education for Registered Persons”), 351 (“Reporting Requirements”) and 472
(“Communications with the Public”) and by the National Association of Securities Dealers,
Inc. Relating to Research Analyst Conflicts of Interest, Release No. 34-47110, 68 Fed. Reg.
826 (January 7, 2003).
53
  The investment banks included Bear Stearns & Co. LLC;’ Credit Suisse First Boston
Corp.; Deutsche Bank; Goldman Sachs; J.P. Morgan Chase & Co.; Lehman Brothers, Inc.;
Merrill Lynch & Co. Inc.; Morgan Stanley; Salomon Smith Barney, Inc.; and UBS Warburg
LLC.




Page 36                                                    GAO-03-511 Investment Banks
               initial public offering shares to corporate executives and directors, an
               obligation to contract with at least three independent research firms to
               provide research to the brokerage firm’s customers for 5 years, and the
               hiring of an independent consultant (chosen by regulators) for each firm
               with final authority to procure independent research from independent
               providers. Additionally, the settlement would require each firm to make its
               ratings and price target forecasts publicly available. The settlement in
               principle is subject to approval by the SEC Commissioners.

               On February 6, 2003, SEC adopted Regulation AC (Analyst Certification),
               which requires that any research report disseminated by a broker, dealer,
               or certain associated persons of a broker-dealer include certifications by
               the research analyst that the views expressed in the research report
               accurately reflect the analyst’s personal views and disclose whether the
               analyst received compensation or other payments in connection with his
               or her specific recommendations or views.54 The regulation also requires
               analysts to provide certifications in connection with public appearances.
               By requiring these certifications and disclosures, according to SEC, the
               regulation should promote the integrity of research reports and investor
               confidence in the recommendations they contain.

               According to SEC officials, SEC examination staff will continue to
               examine for issues related to conflicts of interest involving research
               analysts in future examinations. SEC, NASD, and NYSE will examine
               investment banks for compliance with Regulation AC and self-regulatory
               organization rules on such conflicts of interest.

               Today structured finance transactions such as those Enron entered into
Observations   with various investment banks are very complex arrangements designed to
               achieve a variety of economic and tax purposes. With such creative
               financing, two financial transactions can, for example, have identical
               financial or economic outcomes but substantially different tax and
               accounting implications. The appropriateness and presentation of such
               transactions can hinge, among other things, on the actual purpose and
               intent of the transactions involved. Designing, advising on, or participating
               in such transactions can be lucrative for investment banks, which compete
               vigorously for the business. In the case of Enron, the incentives to
               participate in transactions to accommodate the client were strong: the
               prospect of handsome revenues and the perceived risk-mitigating factor


               54
                    SEC proposed Regulation AC prior to the Sarbanes-Oxley Act being signed into law.




               Page 37                                                     GAO-03-511 Investment Banks
that Enron was a large, prominent, investment-grade company whose
outside auditor had reportedly vetted the appropriateness of the
transactions. Given these incentives, the investment banks may have
reduced the weight attached to or overridden their risk-management
systems. These events illustrate that lapses in market discipline can create
significant reputation and legal risks and that adequate due diligence is
always necessary, regardless of the sophistication or prominence of the
counterparties.

Although investment banks have primary responsibility to practice
prudent risk management procedures, prudent procedures do not
guarantee prudent practices. The events surrounding Enron’s collapse
demonstrate the importance of regulatory oversight in identifying and
promptly correcting weaknesses in risk management practices. Prior to
Enron’s collapse, federal financial regulators had not identified the lapses
in investment banks’ risk management practices and the threats reputation
and legal risks posed to firms involved in complex structured transactions
with Enron. Federal financial regulators placed significantly more
emphasis on the regulated firms’ risk of material loss from traditional
risks, such as counterparty default, than they did on less quantifiable
factors such as reputation or legal risk. We are encouraged that investment
banks are beginning to strengthen their risk management practices by,
among other things, gaining additional assurances of the underlying intent
behind and the anticipated accounting treatment and presentation of
complex structured finance transactions they facilitate for their clients.
The purpose and intent behind these complex structured transactions
must be properly understood and transparent. Now, federal financial
regulators need to determine whether these safeguards will be sufficient
and develop a means not only to ensure that the safeguards are
implemented properly and swiftly but also to take steps to more regularly
consider the reputation and legal risks associated with complex structured
transactions in future examinations.

Accounting and auditing standards and securities laws recognize that an
entity’s management is responsible for the fair and accurate presentation
of the entity’s financial statements. Investment banks are not typically
responsible for their client’s accounting. However, it is a violation of the
federal securities laws for investment banks to aid and abet complex
structured financial transactions that will materially misstate a public
company’s financial statements, thereby deceiving investors and creditors.
SEC would have the authority to bring a legal action for aiding and
abetting a securities violation against an investment bank if the investment



Page 38                                          GAO-03-511 Investment Banks
                     bank knowingly gave substantial assistance to its client in carrying out a
                     violation of the securities laws.

                     However, we have observed that a conflict exists among the courts about
                     the level of knowledge that SEC must prove to successfully bring an aiding
                     and abetting case. As previously discussed, in some courts the level of
                     knowledge must be actual knowledge, a difficult element to prove. In
                     other jurisdictions, the proof of reckless disregard for the truth is
                     sufficient. Depending on where the fraudulent conduct occurred or the
                     location of potential parties to the suit, SEC may not be able to
                     successfully pursue all cases that may involve potential aiding and abetting
                     violations. Since investment banks might be tempted to participate in
                     profitable but questionable transactions when successful SEC prosecution
                     is in doubt, it is especially important that regulators be alert to this
                     possibility and be ready to use the rest of their enforcement tools to deter
                     such actions.

                     Another ongoing issue is the potential conflict of interest between
                     investment bankers and research analysts. The value and credibility of
                     research analysts’ recommendations depend on the analysts’ unquestioned
                     independence and objectivity in their research and resulting
                     recommendations. However, many factors can put pressure on an
                     analyst’s independence and objectivity, including investment banking
                     relationships and compensation arrangements tied to investment banking
                     revenues. SEC, NYSE, NASD, the New York Attorney General, and other
                     states have taken actions to promote the integrity of research reports and
                     investor confidence in the recommendations contained in those reports,
                     but it is too soon to assess the overall effectiveness of these steps. In
                     addition, SEC, NYSE, and NASD are required to take further actions to
                     promote the integrity of research reports in compliance with the directives
                     of The Sarbanes-Oxley Act. This issue will need to be monitored to ensure
                     that regulatory actions achieve the desired results.


                     We provided copies of a draft of this report to the Federal Reserve, OCC,
Agency Comments      SEC, and the Department of Justice for their comment. The Federal
and Our Evaluation   Reserve, OCC, and SEC provided technical comments, which we have
                     incorporated where appropriate. The Department of Justice had no
                     comment.


                     We are sending copies of this report to the Chairman and Ranking
                     Minority Member of the Permanent Subcommittee on Investigations,


                     Page 39                                          GAO-03-511 Investment Banks
Senate Committee on Governmental Affairs; the Chairman and Ranking
Minority Member of the Senate Committee on Governmental Affairs; and
the Chairman and Ranking Minority Member of the House Committee on
Energy and Commerce. We are also sending copies of this report to the
Chairman of the Federal Reserve, the Chairman of the SEC, the U.S.
Attorney General, the Comptroller of the Currency, and other interested
parties. This report will also be available at no cost on GAO’s Internet
homepage at http://www.gao.gov.

This report was prepared under the direction of Barbara I. Keller,
Assistant Director. Please contact her or us at (202) 512-8678 if you or your
staff have any questions concerning this work. Key contributors are
acknowledged in appendix III.




Richard J. Hillman
Director, Financial Markets and
 Community Investment




Jeanette M. Franzel
Director, Financial Management and
 Assurance




Page 40                                           GAO-03-511 Investment Banks
             Appendix I: Scope and Methodology
Appendix I: Scope and Methodology


             To determine the role investment banks played with Enron Corporation
             (Enron) in designing and executing structured finance transactions, we
             reviewed public reports and congressional testimony, interviewed private
             and public sector officials, and searched the Internet for relevant
             information. We selected five transactions involving primarily three
             investment banks for our analysis. The transactions do not cover all of the
             transactions these investment banks participated in with Enron, nor do
             they represent transactions with all of the investment banks with which
             Enron had relationships. They do, however, exemplify a variety of
             relationships Enron had with a number of different investment banks. The
             five transactions were discussed at hearings held by the Senate Committee
             on Governmental Affairs, Permanent Subcommittee on Investigations
             (PSI),in July and December 2002. These transactions are among those
             involving allegations that investment bankers assisted Enron in
             manipulating its earnings but are not those included in Enron’s
             restatement of its financials for the period 1997 through the second
             quarter of 2001. We did not have sufficient public information to determine
             the extent of investment bank involvement in the latter transactions. Given
             the short time frame and the ongoing agency investigations, we did not do
             an independent investigation into the involvement of these investment
             banks in possibly aiding and abetting Enron’s alleged securities fraud
             arising from these latter transactions. Moreover, the investment banks
             described themselves as passive investors, and we did not confirm or
             refute their assertions. We interviewed investment bank and federal
             financial regulatory officials1 to obtain their views on information (facts
             and issues) presented at congressional hearings regarding some of the
             above-mentioned transactions. We also spoke with PSI staff and compared
             PSI’s disclosures, such as descriptions of transactions, with information
             presented in other publicly available documentation, including the Powers
             Report,2 the bankruptcy court examiner reports,3 Securities and Exchange
             Commission (SEC) complaints, and complaints in private lawsuits.




             1
               For purposes of this report, we use the term “federal financial regulators” to refer to the
             Securities and Exchange Commission, (securities regulator) and the Board of Governors of
             the Federal Reserve System and the Office of the Comptroller of the Currency (both bank
             regulators).
             2
               William C. Powers, Jr., Raymond S. Troubh, and Herbert S. Winokur, Jr., Report of
             Investigation by the Special Committee of the Board of Directors of Enron Corporation,
             February 1, 2002. This report was produced by the Special Committee appointed by Enron
             and chaired by William Powers, Jr., to investigate transactions between Enron and entities
             connected to related parties.




             Page 41                                                     GAO-03-511 Investment Banks
Appendix I: Scope and Methodology




To determine regulatory oversight of structured financial products, we
interviewed relevant officials at the federal financial regulatory agencies
(SEC, Office of the Comptroller of the Currency [OCC], and the Federal
Reserve) about their oversight and examination processes for structured
finance transactions. We also reviewed examination guidance and relevant
GAO reports.4 To determine investment banks’ risk management and
internal controls processes, we interviewed members of the Securities
Industry Association as well as representatives of the investment banks
whose transactions we analyzed. We also reviewed companies’ annual
reports and literature on financial risk management.

To understand the role investment banks’ research analysts played with
Enron and Global Crossing Ltd. (Global Crossing), we focused on the
alleged conflicts of interest that affected the objectivity and independence
of Merrill Lynch & Co., Inc (Merrill Lynch) and Citigroup Inc.’s Salomon
Smith Barney Inc. research analysts. We relied on congressional
testimony, legal cases, law review articles, settlement agreements, press
releases, and bankruptcy filings for most of our information. To determine
the issues raised and responses taken, we reviewed SEC, New York Stock
Exchange, and NASD rules, proposals, releases, and documents about
their new policies and rules. To determine the standards for aiding and
abetting liability, we relied on case law, statutes, and law review articles.

We found no publicly available documents or references to investment
bank involvement with Global Crossing in its design or implementation of
structured transactions. We discuss other client relationships, primarily
those involving research analysts, that investment banks had with Global
Crossing. For this discussion, we relied on public documents, including
those obtained by the House Committee on Financial Services.



3
 Enron filed for bankruptcy on December 2, 2001. On April 8, 2002, the Enron Bankruptcy
Court authorized the appointment of an examiner to inquire into certain transactions that
were not reported in accordance with generally accepted accounting principles and
requested that the examiner prepare reports regarding these transactions.
4
 Risk-Focused Bank Examinations: Regulators of Large Banking Organizations Face
Challenges, (GAO/GGD-00-48, Jan. 24, 2000); Long-Term Capital Management: Regulators
Need to Focus Greater Attention on Systemic Risk, (GAO-GGD-00-3, Oct. 29, 1999); Rick-
Based Capital: Regulatory and Industry Approaches to Capital and Risk,
(GAO/GGD-98-153, July 20, 1998); Financial Statement Restatements: Trends, Market
Impacts, Regulatory Responses, and Remaining Challenges, (GAO-03-138, Oct. 4, 2002);
and Financial Derivatives: Actions Needed to Protect the Financial System,
(GAO/GGD-94-133, May 18, 1994).




Page 42                                                    GAO-03-511 Investment Banks
Appendix I: Scope and Methodology




Investigations and litigation are under way in connection with both Enron
and Global Crossing, and it was not our objective to assess, nor should this
report be construed as assessing, the potential culpability of the parties
involved in the transactions discussed in the report. In instances such as
these, if we have good cause to believe that any potential violations of
applicable laws or regulations have occurred, we refer such matters to the
appropriate governmental authorities for their consideration and possible
action. As noted, there are currently ongoing and extensive litigation and
investigations involving Enron and Global Crossing generally.

We conducted our work between September 2002 and March 2003 in
Washington, D.C. and New York, N.Y. in accordance with generally
accepted government auditing standards.




Page 43                                          GAO-03-511 Investment Banks
                         Appendix II: Investment Bank Involvement
Appendix II: Investment Bank Involvement
                         with Enron in Five Structured Finance
                         Transactions


with Enron in Five Structured Finance
Transactions
                         This appendix describes five transactions involving investment banks that
                         assisted Enron Corporation (Enron) in its use of structured finance to
                         generate recorded sales, decrease taxes, and facilitate prepay transactions
                         that resulted in beneficial operating results. It has been alleged that
                         Enron’s accounting for these transactions was deceptive and that
                         investment banks in various ways knowingly enabled Enron to manipulate
                         and obscure its reported results or to evade taxes.


Enron’s Nigerian Barge   Congressional hearing documents and an SEC complaint describe a
Transaction              transaction in which Enron reported a $12 million gain from selling
                         interest in three power barges1 located in Nigeria to Ebarge, LLC (Ebarge),
                         a special purpose entity (SPE) created for this transaction by Merrill
                         Lynch. This transaction occurred on December 29, 1999, 2 days before the
                         year-end closing date of Enron’s 1999 financial statements, reportedly to
                         allow Enron’s African Division to make its earnings target for the year. See
                         figure 1 for a diagram of this transaction.




                         1
                           In this transaction, Enron sold interest, or ownership, in Enron Nigeria Barge Limited, an
                         entity whose sole assets were the three barges. Ownership interests are considered to be
                         financial assets under FAS 140.




                         Page 44                                                     GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




Figure 1: Simplified Nigerian Barge Transaction


    M = million
                                                        LJM2
                                                 (Enron-related party)              LJM2 purchases
                                                                                     Ebarge from Merrill Lynch

                                                                                    E
                                                                          $7.525M



                                          D     $0.25M fee
               Enron                    Enron pays fee to Merrill Lynch

                                                                                              Merrill Lynch
        Enron Nigeria                                                                           $21 MM
      Power Holding, Ltd.                $21M
                                         cash (loan)
         Enron Nigeria
          Barge Ltd.             Note     B                                $7M cash
                                 $21M
                                                                                        A
                                                                                          100% equity
                  Ownership             $28M
                                 C      cash
                                                                                        ownership interest
                   interest in
                       barges                        Ebarge LLC
                                                (Merrill Lynch-created
                                                          SPE)



Source: GAO.

Note: Analysis based on information from the Senate Committee on Governmental Affairs,
Permanent Subcommittee on Investigations.


Merrill Lynch, through its SPE Ebarge, purchased an interest in the barges
for $28 million from a Nigerian Enron subsidiary. Merrill Lynch provided
$7 million in cash to Ebarge for equity ownership. The remaining $21
million was obtained as a loan from another Enron entity that received no
interest payments from Ebarge. It has been asserted that Merrill Lynch,
through its SPE, Ebarge, did not have equity from the purchase at risk
because Enron officials made oral guarantees to arrange for the resale of
Merrill Lynch’s interest in the barges by June 30, 2000, with a specified
return for Merrill Lynch for its involvement in the transaction. A publicly
available Merrill Lynch document related to this transaction indicates that
prior to entering into the transaction, Merrill Lynch received assurance
from Enron that its investment would be liquidated within 6 months.2 On


2
 Senate Committee on Governmental Affairs, Permanent Subcommittee on Investigations,
The Role of the Financial Institutions in Enron’s Collapse, Vol. 2, 107th Cong., 2nd sess.,
2002, Exhibit 207.




Page 45                                                                     GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




June 29, 2000, after Enron’s efforts failed to sell Merrill Lynch’s interest to
an independent third party, LJM2 Co-Investments, L.P., an Enron-related
party, purchased Ebarge from Merrill Lynch, which ended Merrill Lynch’s
ownership interest in the barges. Merrill Lynch received fees and a return
on its investment that totaled $775,000, equaling the allegedly promised
return to Merrill Lynch for its involvement in the transaction.3 If, as
asserted, Merrill Lynch through its SPE, Ebarge, did not have an equity
risk in the barges but instead had a credit exposure to Enron, then Enron
should have reported this transaction as a secured borrowing instead of a
$12 million gain on the $28 million sale of an asset. This accounting would
have reduced Enron’s net income and increased Enron’s debt.

Merrill Lynch officials contended that Enron proposed and structured the
transaction and also assured Merrill Lynch that its outside auditors had
vetted and approved its accounting for the transaction. Merrill Lynch
officials also contended that Merrill Lynch provided no accounting advice
to Enron and that Merrill Lynch in fact was at risk in the transaction
because, while Enron orally agreed to make a “best effort” to find another
buyer for the asset, this promise was not a legally binding guarantee and
there was no guarantee that Merrill Lynch would receive a certain rate of
return. Merrill Lynch officials told us they undertook the transaction to
accommodate Enron in the hope of receiving increased investment
banking business from Enron at a later time. In February 2003, Merrill
Lynch said that it had agreed in principle to pay a fine to resolve SEC civil
charges that it aided Enron in fraudulently overstating Enron’s earnings in
1999. The settlement in principle is subject to approval by the SEC. One of
the transactions reported to be included in the settlement was this
Nigerian barge transaction.




3
 It was reported that Merrill Lynch received fees of $250,000 from Enron and a $525,000
return on its 6-month investment.




Page 46                                                    GAO-03-511 Investment Banks
                                       Appendix II: Investment Bank Involvement
                                       with Enron in Five Structured Finance
                                       Transactions




Enron’s Bacchus and                    Publicly available documents describe another series of transactions,
Sundance Transactions                  which Enron recorded as a sale, that involved Enron, Citigroup Inc.
                                       (Citigroup), and several SPEs. These transactions, referred to as Bacchus
                                       and Sundance, took place over a 6-month period beginning in December
                                       2000.4 PSI and the bankruptcy examiner concluded that the substance of
                                       the transactions was borrowing (i.e., a loan), which instead of being
                                       reported as debt was recorded as a sale with a gain that increased Enron’s
                                       net income. See figure 2 for a diagram of these transactions.

Figure 2: Simplified Bacchus and Sundance Transactions




                                       Note: Analysis based on information from the Senate Committee on Governmental Affairs,
                                       Permanent Subcommittee on Investigations.




                                       4
                                        Senate Committee on Governmental Affairs, Permanent Subcommittee on Investigations,
                                       Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and
                                       Facilitated by U.S. Financial Institutions, 107th Cong., 2nd sess., 2002, S. Prt. 107-82.




                                       Page 47                                                        GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




The initial Bacchus transaction took place late in December 2000, just
prior to the year’s end. In this transaction, Enron sold ownership interest
in a pulp and paper trading business to an Enron-created SPE, the Caymus
Trust, for $200 million. The Caymus Trust purchase was funded by a $6
million cash equity investment by FleetBoston and a loan from Citigroup
for $194 million. Enron recorded a $112 million gain from the $200 million
sale of its ownership interest. It was reported that Citigroup assumed the
risks of FleetBoston’s ownership through a total return swap5 and that
Enron assumed Citigroup’s risk associated with the $194 million loan, also
through a total return swap. The effect of these agreements would indicate
that Citigroup held equity risk of $6 million, or 3 percent, of the $200
million purchase and that Enron retained the remaining risk associated
with the asset. However, it has been alleged that Citigroup, despite its
swap contract with FleetBoston, did not have equity risk for the $6 million
cash investment because Enron officials provided verbal guarantees to
Citigroup to ensure the repayment related to the $6 million investment.

If Enron was in fact the only entity with equity risk, the prescribed
accounting treatment would have been to consolidate the SPE into
Enron’s financial statements and to report the $200 million received as
debt, not a sale. This accounting treatment would not have allowed the
gain of $112 million that Enron recorded in its financial statements and
would have increased Enron’s reported debt by $200 million. The gain
recorded as a result of this transaction represented about 11 percent of
Enron’s total net income in 2000. A publicly available Citigroup document
indicates that “Bacchus is a part of a program designed to ensure that
Enron will meet its year-end [targets].”6 Another Citigroup document
indicates that technical issues “may make Bacchus unworkable—Enron
continues to try to resolve these unnamed issues.” In this event, a
Citigroup official noted that Enron would likely request a prepay
transaction, which is discussed later in this appendix, for $200 million
instead.7 It was reported that Citigroup received $500,000 in fees for its
participation in Bacchus, earned about $5 million in interest payments on
the loan, and obtained a $450,000 yield related to the $6 million equity
investment.


5
 A total return swap is a derivative transaction in which one party conveys to the other
party all the risks and rewards of owning an asset without transferring actual legal
ownership of the asset.
6
    Committee on Governmental Affairs, Four Enron Transactions, Exhibit 322d.
7
    Committee on Governmental Affairs, Four Enron Transactions, Exhibit 322e.




Page 48                                                     GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




The Sundance transaction, which took place about 6 months after the
Bacchus transaction, eliminated Citigroup’s risk from the Bacchus
transaction by redeeming Citigroup’s investment. The Sundance
transaction was initiated by the creation of an Enron and Citigroup joint
venture, referred to as Sundance. Enron reportedly contributed
approximately $750 million to Sundance in various financial assets,8 future
commitments, and $208 million in cash. Citigroup reportedly contributed
$188.5 million to Sundance, comprising $8.5 million in cash, $20 million of
shares in an Enron SPE, and $160 million in an “unfunded capital
commitment.” It was reported that Sundance immediately used the $208
million in cash to purchase the pulp and paper trading business interest
from the Caymus Trust. The Caymus Trust then paid off the $194 million
loan from Citigroup and returned the $6 million equity investment to
FleetBoston. This activity reportedly eliminated any possible risk to
Citigroup from the Bacchus transaction.

Citigroup agreed to participate in Sundance only after Enron had
structured the joint venture to ensure that Citigroup’s funds were virtually
not at risk; moreover, Citigroup’s returns would not depend on the
operating results of the joint venture. In addition, Citigroup arranged to
receive fees of $725,000 and a specified return of $1.1 million on its
investment in Sundance; Citigroup reportedly did not share in any profits
or increased value. A publicly available document prepared by Citigroup’s
Risk Management Group indicates that the group initially did not approve
the Sundance transaction because, among other things, “the GAAP
accounting is aggressive and a franchise risk to [Citigroup] if there is
publicity (a la Xerox).”9 This document also indicated the
“mismanagement of the process raises real questions about the discipline
and adherence to policies in the fixed income division [of Citigroup].”

At a congressional hearing that examined these transactions, Citigroup
officials testified that Citigroup employees acted in good faith and
understood these transactions to comply with existing law and the
prevailing standards of the time. These officials also testified that their
internal review committee at the time, the Capital Markets Approval
Committee, had reviewed and approved the transactions and that the Risk


8
 The financial assets were Enron’s ownership interests in various paper mills and real
property.
9
 Committee on Governmental Affairs, Four Enron Transactions, Exhibit 333n. The memo
refers to generally accepted accounting principles (GAAP).




Page 49                                                    GAO-03-511 Investment Banks
                   Appendix II: Investment Bank Involvement
                   with Enron in Five Structured Finance
                   Transactions




                   Management Group had ultimately approved it as well. Citigroup said it
                   viewed the accounting decisions as decisions to be made by Enron and its
                   accountants. Citigroup noted that Enron was a Fortune 10 company and
                   that Enron’s auditors from Arthur Andersen were presumed to know
                   about the transactions and to have approved their accounting treatment.10


Enron’s Slapshot   Publicly available reports describe a complex series of structured finance
Transaction        arrangements, referred to as the Slapshot transaction, which took place
                   during the same day and included a $1.039 billion loan due later that day.
                   These transactions involved Enron, J.P. Morgan Chase & Co. (Chase), a
                   Chase SPE, and several Enron affiliates and SPEs and were designed to
                   refinance an Enron paper mill and at the same time decrease Canadian
                   taxes. Since these transactions were so complicated, we have provided a
                   simplified diagram of the Slapshot transaction (fig. 3) and a more detailed
                   diagram (fig. 4).




                   10
                     The Fortune 500 list, compiled by Fortune magazine, ranks corporations by their
                   revenue. Prior to its bankruptcy, Enron was in the first 10 and was audited by Arthur
                   Anderson LLP, then a top five accounting firm.




                   Page 50                                                    GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




Figure 3: Simplified Slapshot Transaction




Note: Analysis based on information from the Senate Committee on Governmental Affairs,
Permanent Subcommittee on Investigations.




Page 51                                                        GAO-03-511 Investment Banks
                                          Appendix II: Investment Bank Involvement
                                          with Enron in Five Structured Finance
                                          Transactions




Figure 4: Detailed Slapshot Transaction




                                          Note: Chase officials and analysis based on information and original figure from the Senate
                                          Committee on Governmental Affairs, Permanent Subcommittee on Investigations.




                                          Page 52                                                           GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




Chase established a key entity in the transaction, Flagstaff Capital
Corporation (Flagstaff), as a wholly owned SPE and organized a bank
consortium that included three other large banks to issue a $375 million
loan (due in 5 years and 1 day) that would refinance an Enron paper mill.
The $375 million loan and a second loan for $1.039 billion from Chase
were provided to Flagstaff. Prior to Chase’s issuing the $1.039 billion loan
to Flagstaff, it was reported that Chase required Enron to provide $1.039
billion in an escrow account in order to ensure the repayment of the
$1.039 billion later the same day. After Flagstaff received the two loans
totaling about $1.4 billion, it reportedly then loaned the same amount to an
Enron affiliate. Subsequently, multiple loans and other contracts in the
amounts of $375 million, $1.039 billion, and $1.4 billion reportedly were
exchanged by various Enron-related entities. All of these transactions took
place during the same day. A publicly available Chase document indicated
that “only a $375 million net loan from Flagstaff was outstanding at the
end of day one.”11

The amounts involved in this transaction are key to understanding how
Enron could reduce its Canadian taxes, which like U.S. taxes may be
reduced by interest payments but not by loan principal repayments. It was
reported that the parties involved in the transactions calculated that $1.039
billion was the net present value of the $1.4 billion due in 5 years and 1
day. The difference between these two amounts equaled approximately
the $375 million loan. Thus, it was reported that Enron would treat the
principal and interest payments on the 5-year and 1 day $375 million net
economic obligation as interest payments on the $1.4 billion loan, reducing
Canadian taxes by about $60 million and providing Enron with additional
financial statement benefits totaling about $65 million over 5 years. In a
publicly available Chase document related to the design of the Slapshot
transaction, Chase indicated that an advantage of one aspect of the
structure was that it provided “no road map for Revenue Canada.”12 It was
reported that Chase was paid more than $5 million for designing and
orchestrating the Slapshot transaction.




11
     Committee on Governmental Affairs, Four Enron Transactions, Exhibit 338.
12
  Committee on Governmental Affairs, Four Enron Transactions, Exhibit 344. On
November 1, 1999, Revenue Canada became the Canada Customs and Revenue Agency
whose mission is to promote compliance with, among other things, Canada’s tax
regulations.




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                             Appendix II: Investment Bank Involvement
                             with Enron in Five Structured Finance
                             Transactions




                             At a congressional hearing that examined these transactions, a Chase
                             official testified that Chase believed that its participation in the
                             transactions was legal and followed established rules. He contended that
                             Chase’s Structured Finance Group had developed the generic form of this
                             transaction and had received opinions from two leading Canadian law
                             firms that the structure and the Canadian tax benefits the transaction
                             provided were legal and valid. Copies of these opinions were provided to
                             PSI. He went on to say that, with respect to the specific application of the
                             transaction structure, each party involved in the transactions is
                             responsible for ensuring that it correctly accounts for the transactions to
                             which it is a party. At the time, Chase had no reason to believe that Enron
                             and its external auditors were not doing so.


Enron’s Prepay               Although prepay transactions are common in the energy industry in
Transactions                 general, Enron’s prepay transactions were allegedly unique in that they
                             involved a circular cash flow arrangement among the three parties
                             involved. Enron entered into prepay transactions with various investment
                             banks, including Chase and Citigroup. Enron accounted for these prepay
                             transactions as trading activities, which were reported as liabilities from
                             price risk management on its balance sheet and as cash flows received
                             from operating activities on the statement of cash flows. However, PSI and
                             the bankruptcy examiner concluded that Enron’s accounting for the
                             transactions was inappropriate because the prepay transactions were in
                             substance and intent loans, not trading activities, and Enron should have
                             recorded them as debt and cash flows from financing activities. 13
                             Distinctions such as these are important to investors and creditors that
                             rely on financial reporting in deciding whether to invest in or lend to an
                             entity.

Mahonia Prepay Transaction   Publicly available reports describe prepay transactions among Enron,
                             Chase, and an SPE, Mahonia, Ltd. (Mahonia), that was created to
                             undertake transactions for Chase (fig. 5). In these transactions, Mahonia
                             received cash from Chase in exchange for a commitment to deliver a fixed
                             volume of gas at a specified future date. The purchase price was



                             13
                                Emerging Issues Task Force (EITF) 98-10, Accounting for Contracts Involved in Energy
                             Trading and Risk Management Activities, refers to energy trading activities as energy
                             contracts entered into with the objective of generating profits on or from changes in
                             market prices. Energy trading activities also include dealing, the activity of standing ready
                             to trade—whether buying or selling—for the dealer’s own account, thereby providing
                             liquidity to the market.




                             Page 54                                                      GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




reportedly based on the estimated future market price of gas on the
expected delivery date. At the same time, Mahonia and Enron entered into
an identical contract, with Enron receiving from Mahonia funds that had
originated with Chase. These two contracts resulted in cash for Enron and
a commitment for Chase for the future delivery of a fixed volume of gas.
Enron and Chase would both be at risk for changes in the price of gas.
However, at the same time the two prepay contracts were executed, Enron
and Chase entered into a commodity swap14 that essentially eliminated the
price risk from the transaction and ensured Chase a specified rate of
return. When Chase received the delivery of gas from Mahonia (which
Mahonia received from Enron) it sold the gas to the market, in some cases
back to another Enron entity.15 One publicly available Chase document
indicated that “Enron loves these deals as they are able to hide funded
debt from their equity analysts because they (at the very least) book it as
deferred revenue or (better yet) bury it in their trading activities.”16
Between 1992 and 2001, Enron and Chase entered into 12 prepay
transactions with a combined value of over $3.7 billion.




14
  Swaps can be used to reduce an entity’s risk to changes in prices, currency rates, and
other factors. The cash flows from swaps should be presented on the statement of cash
flows in the same category as the cash flows from the items being hedged, provided that
the accounting policy is disclosed.
15
  Not all of the Mahonia prepays ended with gas sales by Chase. On September 28, 2001,
Chase participated in a $350 million prepay with Enron in which Enron’s delivery at
maturity was not going to be gas, but cash in an amount equal to the spot value of the
specified quantity of gas. In this transaction, the money Chase received would come (via
Mahonia) from Enron instead of from sales of gas to the market or back to an Enron entity.
16
 Committee on Governmental Affairs, The Role of the Financial Institutions in Enron’s
Collapse, Vol. 1, Exhibit 123.




Page 55                                                    GAO-03-511 Investment Banks
Appendix II: Investment Bank Involvement
with Enron in Five Structured Finance
Transactions




Figure 5: Mahonia Prepay Transaction




Note: Analysis based on information and original figure from the Senate Committee on Governmental
Affairs, Permanent Subcommittee on Investigations.


According to testimony given at a congressional hearing, an interview with
us, and documents supplied to us, Chase officials said that they had
understood that Enron, with its auditor’s approval, had treated the prepay
transactions as trading activities. After discussion with its auditor, Chase
treated the prepays similarly and recorded them as trading assets on its
balance sheet. Chase officials said that the firm entered into swaps to
mitigate risk, as required by banking law, and that the risks of the different
transactions and hedges involved in the prepays differed from those of a
loan. In addition, the different components of the transaction received
separate credit approvals, and each transaction stood on its own—there
were no cross-default provisions and no netting of amounts, as alleged.17
Chase officials also maintained that each of the entities involved in the
transaction was legally independent of the others. Chase provided us with
excerpts from other companies’ financial statements describing those
companies' prepays as a means of financing, recorded as liabilities for



17
  Cross-default provisions included in contracts between two parties would, on default by
one of the parties, put that party in default in its other contract(s). Netting provisions in a
contract provide that mutual obligations are settled at the net, as opposed to the gross,
dollar value of the contracts.




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                        Appendix II: Investment Bank Involvement
                        with Enron in Five Structured Finance
                        Transactions




                        price risk management.18 Chase officials said that they believed Enron
                        officials’ assertion that Enron’s prepay transactions were being properly
                        accounted for as liabilities from price risk management in their financial
                        statements.

Delta-Yosemite Prepay   Another example of an Enron prepay transaction involved Enron,
Transaction             Citigroup, and a Citigroup-created SPE, Delta Energy (Delta), which
                        served as a third party. It was reported that the earliest of these Citigroup
                        prepay transactions, beginning in 1993, were similar in structure to the
                        Chase prepay transactions. However, some of the later Citigroup prepay
                        transactions involving Delta were funded by bond offerings to qualified
                        institutional buyers instead of by Citigroup (fig. 6). By raising funds for the
                        prepay transactions in this fashion, the institutional investors, rather than
                        Citigroup, were at risk in case of Enron’s bankruptcy or credit default. A
                        total of six Enron bond offerings were issued through trusts, raising $2.4
                        billion for the prepay transactions. The first such trust, Yosemite, loaned
                        the bond proceeds to Delta so Delta could initiate the prepay transactions
                        involving Enron and Citigroup. The series of transactions that followed
                        removed price risk, allegedly ensured a rate of return to Delta, and left
                        Delta with the same risk it would have had if it had loaned money to
                        Enron. One publicly available Citigroup document discussing the approval
                        of an Enron prepay transaction indicated that Citigroup’s “internal
                        approval for the transaction will acknowledge that [Citigroup] was
                        basically making a loan.”19 Between 1993 and 2001, Enron and Citigroup
                        reportedly entered into 14 prepay transactions with a combined value of
                        over $4.8 billion.




                        18
                         We have not reviewed these transactions and cannot determine if they were similar to
                        Enron’s prepay transactions.
                        19
                          Committee on Governmental Affairs, Role of the Financial Institutions, Vol. 1, Exhibit
                        188g.




                        Page 57                                                   GAO-03-511 Investment Banks
                                        Appendix II: Investment Bank Involvement
                                        with Enron in Five Structured Finance
                                        Transactions




Figure 6: Delta-Yosemite Prepay Transaction




                                        Note: Analysis based on information and original figure from the Senate Committee on Governmental
                                        Affairs, Permanent Subcommittee on Investigations.


                                        At a congressional hearing that examined these transactions and in an
                                        interview with us, Citigroup officials said that they had entered into the
                                        transactions in good faith and that their employees had understood that
                                        the transactions complied with existing law. The officials contended that
                                        Citigroup’s internal review committee had reviewed and approved the
                                        prepaid swaps and the Yosemite transactions. The officials also said no
                                        inherent connection existed between the notes from the Yosemite
                                        transactions, in which the risk to investors was Enron credit risk, and the
                                        prepays. The proceeds of the notes were used for the prepays, the officials
                                        noted, but could have been used for other transactions, and investors were
                                        not misled about the nature of the transactions. The ultimate problem that
                                        affected the notes, in the officials’ view, was that Enron had declared
                                        bankruptcy for reasons entirely unrelated to the prepaid transactions.




                                        Page 58                                                        GAO-03-511 Investment Banks
                   Appendix III: GAO Contacts and Staff
Appendix III: GAO Contacts and Staff
                   Acknowledgements



Acknowledgements

                   Richard J. Hillman (202) 512-8678
GAO Contacts       Jeanette M. Franzel (202) 512-9406


                   In addition to those named above, Marcia Carlsen, Emily Chalmers,
Staff              Orlando Copeland, Julia Duquette, Patrick Dynes, Joe Hunter, Barbara
Acknowledgements   Keller, Christine Kuduk, Marc Molino, John Treanor, and Sindy Udell made
                   key contributions to this report.




(250108)
                   Page 59                                       GAO-03-511 Investment Banks
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