[Senate Hearing 107-871]
[From the U.S. Government Publishing Office]
S. Hrg. 107-871
OVERSIGHT OF INVESTMENT BANKS' RESPONSE TO THE LESSONS OF ENRON--VOL. I
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE OF INVESTIGATIONS
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
DECEMBER 11, 2002
__________
Printed for the use of the Committee on Governmental Affairs
U. S. GOVERNMENT PRINTING OFFICE
83-485 WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky
MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois
Joyce A. Rechtschaffen, Staff Director and Counsel
Richard A. Hertling, Minority Staff Director
Darla D. Cassell, Chief Clerk
------
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan, Chairman
DANIEL K. AKAKA, Hawaii, SUSAN M. COLLINS, Maine
RICHARD J. DURBIN, Illinois TED STEVENS, Alaska
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia THAD COCHRAN, Mississippi
THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah
JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky
MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois
Elise J. Bean, Acting Staff Director and Chief Counsel
Robert L. Roach, Counsel and Chief Investigator
Kim Corthell, Minority Staff Director
Mary D. Robertson, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Levin................................................ 1
Senator Collins.............................................. 7
Senator Bennett.............................................. 10
WITNESSES
Wednesday, December 11, 2002
Charles O. Prince III, Chairman and Chief Executive Officer,
Citigroup Global Corporate and Investment Bank, New York, New
York........................................................... 12
David C. Bushnell, Managing Director, Global Risk Management,
Citigroup/Salomon Smith Barney, New York, New York............. 15
Richard Caplan, Managing Director and Co-Head, Credit Derivatives
Group, Salomon Smith Barney North American Credit/Citigroup,
New York, New York............................................. 16
William T. Fox III, Managing Director, Global Power and Energy
Group, Citibank/Citigroup, New York, New York.................. 16
Michael E. Patterson, Vice Chairman, J.P. Morgan Chase and
Company, New York, New York.................................... 44
Robert W. Traband, Vice President, J.P. Morgan Chase and Company,
Houston, Texas, accompanied by Eric N. Peiffer, Vice President,
J.P. Morgan Chase and Company, New York, New York.............. 46
Andrew T. Feldstein, Managing Director, Co-Head Structured
Products and Derivatives Marketing, J.P. Morgan Chase and
Company, New York, New York.................................... 49
Muriel Siebert, President and Chair, Muriel Siebert and Company,
Inc., New York, New York....................................... 66
Richard Spillenkothen, Director, Division of Banking Supervision
and Regulation, The Federal Reserve, Washington, DC............ 71
Douglas W. Roeder, Senior Deputy Comptroller for Large Bank
Supervision, Office of the Comptroller of the Currency,
Washington, DC................................................. 73
Annette Nazareth, Director, Division of Market Regulation, U.S.
Securities and Exchange Commission, Washington, DC............. 75
.................................................................
Alphabetical List of Witnesses
Bushnell, David C.:
Testimony.................................................... 15
Prepared statement........................................... 101
Caplan, Richard:
Testimony.................................................... 16
Prepared statement........................................... 103
Feldstein, Andrew T.:
Testimony.................................................... 49
Joint prepared statement..................................... 107
Fox, William T. III:
Testimony.................................................... 16
Prepared statement........................................... 104
Nazareth, Annette:
Testimony.................................................... 75
Prepared statement........................................... 134
Patterson, Michael E.:
Testimony.................................................... 44
Prepared statement........................................... 105
Peiffer, Eric N.:
Testimony.................................................... 46
Joint prepared statement..................................... 107
Prince, Charles O. III:
Testimony.................................................... 12
Prepared statement........................................... 91
Roeder, Douglas W.:
Testimony.................................................... 73
Prepared statement........................................... 123
Siebert, Muriel:
Testimony.................................................... 66
Prepared statement........................................... 113
Spillenkothen, Richard:
Testimony.................................................... 71
Prepared statement........................................... 117
Traband, Robert W.:
Testimony.................................................... 46
Joint prepared statement..................................... 107
APPENDIX
Permanent Subcommittee on Investigations Staff Report on
``Fishtail, Bacchus, Sundance, and Slapshot: Four Enron
Transactions Funded and Facilitated by U.S. Financial
Institutions,'' December 11, 2002.............................. 150
EXHIBITS
VOLUME I
301. a. GBacchus, The appearance is a sale, chart prepared by the
Permanent Subcommittee on Investigations....................... 185
b. GBacchus, The reality is a loan, chart prepared by the
Permanent Subcommittee on Investigations................... 186
302. a. GSundance, The appearance is a joint investment, chart
prepared by the Permanent Subcommittee on Investigations....... 187
b. GSundance, [The appearance is a joint investment,] The
reality is a sham investment by Citigroup, chart prepared
by the Permanent Subcommittee on Investigations............ 188
c. GSundance, The agreement included these provisions, chart
prepared by the Permanent Subcommittee on Investigations... 189
303. a. G$1 Billion Cash Flow, June 22, 2001, chart prepared by
the Permanent Subcommittee on Investigations................... 190
b. G$1 Billion Cash Flow, June 22, 2001, chart prepared by
the Permanent Subcommittee on Investigations............... 191
c. GFlagstaff-Hansen $1.4 Billion, Share Subscription/
Assumption/Payment Set Off, chart prepared by the Permanent
Subcommittee on Investigations............................. 192
d. G$1 Billion Cash Flow, June 22, 2001, chart prepared by
the Permanent Subcommittee on Investigations............... 193
304. GEnron Guarantees Citigroup's ``Equity'' Investment In
Bacchus, chart prepared by the Permanent Subcommittee on
Investigations................................................. 194
Project Fishtail Transaction:
305. GFishtail deal structure, dated January 21, 2002, prepared
by Deloitte & Touche........................................... 195
306. GLJM2 Investment Summary for Fishtail, dated December 20,
2000........................................................... 196
307. GInvestment Return Summary for Fishtail prepared by LJM2.... 199
308. GBenefits to Enron Summary, Deal Name: Ampato (Fishtail),
dated December 20, 2000, prepared by LJM2...................... 200
309. GEnron's LJM2 Approval Sheet for Fishtail, dated December
18, 2000....................................................... 201
310. GProject Fishtail/125 Structure............................. 205
311. GStructuring Summary, Project Grinch, dated December 18,
2000, prepared by Chase........................................ 206
312. GProject Grinch LP, summary memorandum prepared by Chase,
December 16, 2000.............................................. 208
313. GEnron Corporate Development Asset Inventory, Tentative and
Preliminary, EIM, updated 11/25/01............................. 211
314. GEnron Corp. email, December 2000/January 2001, re: 2000
Accomplishments, attaching document, Mike Patrick 2000
Accomplishments................................................ 212
315. GChase fee letter to Enron Corp. signed by both parties,
December 20, 2000, re: Fishtail (. . . an advisory fee in an
amount equal to $500,000. . . .)............................... 214
Project Bacchus Transaction:
316. GProject Bacchus, deal structure chart prepared by Enron
Corp........................................................... 216
317. GTransaction Descriptions: Project Bacchus, Summary and
Structure Description, prepared by Enron Corp.................. 217
318. GGlobal Loans Approval Memorandum, December 6, 2000,
prepared by Citibank, re: Project Bacchus...................... 219
319. GCitibank email, April 2001, re: Enron Credit Approval
($200mm--Bacchus: SPV where we have a total return swap from
Enron for $180 mm and verbal support for the balance . . .).... 223
320. GExecutive Summary, including Bacchus/Caymus Trust Facility,
prepared by Citibank........................................... 224
321. GProject Bacchus, 3% Test and Gain Calculation, prepared by
Enron Corp..................................................... 225
322. a. GCitibank email, November 2000, re: Enron update (Enron's
motivation in the deal now appears to be writing up the asset
in question from a basis of about $100MM to as high as $250MM,
thereby creating earnings.).................................... 226
b. GCitibank email, November 2000, re: Enron update (. . .
but it will be major appropriateness issue as will the
first two)................................................. 228
c. GCitibank email, November 2000, re: Enron/Bacchus Summary
(They [Enron] have offered to have the CFO discuss this at
whatever level of our [Citibank] organization we think
necessary to obtain the right comfort)..................... 229
d. GCitibank email, December 2000, re: ENE/Bacchus Update
(It is possible, but not certain, that there will be an
earnings impact. . . .).................................... 232
e. GCitibank email, December 2000, re: ENE/Bacchus (There
are ``technical'' issues with NetWorks which MAY make
Bacchus unworkable. . . .)................................. 233
f. GCitibank email, December 2000, re: Enron ([H]owever, the
$200 million represents 16.3% and 22.4% of operating cash
flow and net income . . .), attaching estimated Enron
figures.................................................... 234
g. GCitibank email, December 2000, re: Enron (Based on 1999
numbers would appear that Enron significantly dresses up
its balance sheet for year end; . . .)..................... 237
h. GCitibank email, December 2000, re: Enron/Bacchus (The
equity component has been approved on the basis of verbal
support verified by Enron CFO, Andy Fastow.)............... 239
i. GCitibank email, December 2000, re: Enron/Bacchus (Sounds
like we made a lot of exceptions to our standard policies.
. . .)..................................................... 242
j. GCitibank email, May 2001, re: Bacchus Unwind (. . .
sufficient for the Trust to prepay the notes in full plus
break costs.).............................................. 243
323. GCapital Markets Approval Committee, New Project/Complex
Transaction Description Guidelines, Enron Corp., Project
Bacchus FAS 125 Transaction, 12/11/00 draft, prepared by
Citibank....................................................... 244
324. GArthur Andersen LLC Memorandum, December 2000, re: Fishtail
LLC Formation/Securitization................................... 246
325. GArthur Andersen email, November 1999, re: Total Return
Swaps.......................................................... 250
Project Sundance Transaction:
326. GDescription of the Sundance Transaction, 10/29/01, prepared
by Citibank.................................................... 253
327. GCapital Markets Approval Committee (CMAC), Minutes to
Meeting, May 16, 2001, Project Sundance (Enron Corp.), prepared
by Citibank.................................................... 255
328. a. GChart prepared by Enron Corp., Sundance Steps, Updated
May 16, 2001, 5pm.............................................. 257
b. GSundance Steps, Updated May 11, 2001, 5:44 pm........... 259
c. GSundance Steps, Updated June 1, 2001.................... 260
329. GEnron Corp. Presentation, Enron Industrial Markets Finance
Presentation of Sundance Industrial Partners, June 1, 2001..... 261
330. GEnron Corp. Presentation, Enron Industrial Markets--
Finance, Presentation of Sundance Industrial Partners to
Salomon Smith Barney, NY, August 2001.......................... 264
331. GEnron Corp. Presentation, Enron Industrial Markets--
Finance, Potential paper mill acquisition presentation to
Salomon Smith Barney, September 2001........................... 271
332. GFirst cut at questions re Sundance, prepared by Citibank... 280
333. a. GCitibank email, April 2001, re: sundance ([T]he argument
for why it is debt even if we take a partnership interest that
it is more debt like than equity.)............................. 282
b. GCitibank email, May 2001, re: Enron Slapshot Structure.. 283
c. GCitibank email, May 2001, re: Materials for CMAC
meeting, attaching copy of Capital Markets Approval
Committee, New Project/Complex Transaction Description
Guidelines, Enron Corp., Project Sundance Transaction,
prepared by Citibank....................................... 285
d. GCitibank email, May 2001, re: cmac memo ([P]erwein
wanted to say that this is a funky deal (accounting-wise.)) 290
e. GCitibank email, May 2001, re: sundance (. . . is a
structure that insures, insofar as possible, that it will
never get drawn.).......................................... 291
f. GCitibank email, May 2001, re: sundance (. . . I do not
understand why we are proposing to do this transaction.)... 292
g. GCitibank email, May 2001, re: Sundance.................. 294
h. GCitibank email, May 2001, re: Treatment for Project
Sundance, includes a handwritten comment that contingent
capital commitment cannot be drawn since SBHC will dissolve
partnership if draws triggers are being approached.)....... 295
i. GCitibank email, May 2001, re: Enron/Sundance (Still an
equity investment of sorts (acctg and tax basis for
partnership) but is structured in such a way that the 670
bps is guaranteed or we blow the deal. Also our ``invest''
is so subordinated and controlled that it is
``unimaginable'' how our principal is not returned.)....... 296
j. GCitibank email, May 2001, re: Sundance/Firm Investment
(. . . it does appear that we will need to have approval at
some point from Mike Carpenter . . .)...................... 297
k. GCitibank (Eleanor Wagner) email, May 2001, re: Project
Sundance, including draft memo for Michael Carpenter,
expressing Risk Management's Concerns...................... 298
l. GCitibank email, May 2001, re: sundance (We do still need
Barbara Yastine and Mike Carpenter to approve before we
close?).................................................... 300
m. GCitibank email, May 2001, re: Sundance (Approval sits in
front of Carpenter waiting for signature.)................. 301
n. GCitibank email, May 2001, re: Memo on Enron-Project
Sundance (We (Bill Fox and I) share Risk's view and if
anything, feel more strongly that suitability issues and
related risks when coupled with the returns, make it
unattractive.), attaching May 2001 Dave Bushnell Memorandum
to Mike Carpenter.......................................... 302
o. GCitibank email, May 2001, re: sundance ([A]ny word? am
getting a significant amount of pressure from enron to
execute.).................................................. 305
p. GCitibank email, June 2001, re: Sundance Closing......... 306
q. GCitibank email, June 2001, re: Sundance Approvals (No .
. . was given a verbal go ahead . . . Understand signed is
to follow.)................................................ 307
r. GCitibank email, June 2001, re: Sundance (Mike then had a
conversation with Dave Bushnell, who shared with us Mike's
feedback.)................................................. 308
s. GCitibank email, October 2001, re: Sundance Revenues..... 309
t. GCitibank email, October 2001, re: sundance redux,
attaching Description of the Sundance Transaction.......... 310
u. GCitibank email, October 2001, re: Enron Exposure on NA
Credit Derivs (Note that these equity partnerships, are
designed to act as debt exposure . . .).................... 313
v. GCitibank email, October 2001, re: ene transactions
(Sundance . . . allows Enron to manage its paper and pulp
physical assets and trading business off-balance sheet.)... 315
w. GCitibank email, October 2001, re: sundance (According to
Enron, our $28.5MM is being held in bank deposits.)........ 316
x. GCitibank email, November 2001, re: Sundance Paper (ENE
wants to ``discuss'' I have not reiterated the imperative
nature of request, did NOT waive the BoD stick. . . .)..... 317
y. GCitibank email, November 2001, re: Enron Sundance--the
paper trading partnership (Last night we came to terms with
Enron for the purchase of our interest in the Sundance
partnership.).............................................. 318
334. GCitibank/SolomonSmithBarney Interoffice Memo, May 2001, re:
Enron Corp.--Project Sundance (Transactions Overview,
Description of the Assets, Economics).......................... 319
335. GAccounting for Investments in Limited Partnerships and
Other Joint Ownership Entities, prepared by Enron Corp......... 324
336. GArthur Andersen email, August 2000, re: 4 to 1 test........ 334
Project Slapshot Transaction:
337. GFlagstaff Funding Flows, diagram prepared by Enron Corp.... 347
338. GTransaction Summary, Flagstaff/Enron Transaction, prepared
by JPMorgan Chase.............................................. 348
339. GSlapshot Savings, diagram prepared by Enron Corp........... 354
340. GProject Slapshot, Transaction Diagram--@ Closing, June
2001, prepared by Enron Corp................................... 355
341. GStructuring Summary, Flagstaff Capital Corporation,
February 2001, (partial) prepared by JPMorgan Chase............ 356
342. GEnron Corp. Stadacona, JPMorgan Chase presentation......... 362
343. GProposal to Enron Industrial Markets, Structured Canadian
Financing Transaction (Project ``Slapshot''), January 11, 2001,
JPMorgan Chase presentation.................................... 379
344. GStructured Canadian Financing Transaction, Organizational
Meeting, February 8, 2001, JPMorgan Chase presentation......... 396
345. GSlapshot Transaction Diagram............................... 416
346. GProject Slapshot, Transaction Components, June 2001, Enron
Corp. presentation............................................. 422
347. GJ.P. Morgan Securities Inc./Enron Corp. correspondence,
June 2001, re: Tax Comfort Letter--Enron Structured Financing.. 426
348. GJ.P. Morgan Securities Inc./Enron Corp. correspondence,
June 2001, re: U.S. Tax Matters--Enron Structured Financing.... 428
349. G206.(f) Agreement between Flagstaff Capital Corporation and
Hanson Investments Co., June 2001.............................. 431
350. GCredit Agreement between Hansen Investments Co., Flagstaff
Capitol Corporation and The Chase Manhattan Bank, June 2001.... 434
351. GProject Slapshot, Discussion Session, March 2001,
presentation prepared by JPMorgan Chase........................ 514
352. GTax opinion letter from Blake, Cassels & Graydon LLP to
Enron Corp., June 2001, re: Canadian Tax Consequences of
Proposed Financing............................................. 525
353. GTax opinion letter from Blake, Cassels & Graydon LLP to
Chase Securities, Inc., November 2000, re: Canadian Tax
Consequences of Proposed Financing............................. 544
354. GTax opinion memorandum from Skadden, Arps, Slate, Meagher &
Flom LLP to Enron Wholesale Services, August 2001, re: Project
Slapshot....................................................... 565
355. GProject Slapshot Structured Financing Fee Letter
(Arranger), June 2001.......................................... 593
356. GFee Agreement, between J.P. Morgan Securities Inc. and
Compagnie Papiers Stadacona, June 2001......................... 596
357. a. GJPMorgan Chase email, February 2001, re: Some Good News
(Slapshot) (Bruce and Eric run the Slapshot product.).......... 600
b. GJPMorgan Chase email, February 2001, re: Project
Slapshot (The lawyers have slammed on the brakes until we
confirm that the net accounting for the twist we're
contemplating will work.).................................. 601
c. GJPMorgan Chase email, February 2001, re: Slapshot (As
discussed, the lawyers (especially the tax lawyers) are
hesitant to state explicitly Chase's intention to set-off .
. . as they wish to keep the documents as ``arm's length''
as possible . . .)......................................... 607
d. GJPMorgan Chase email, May 2001, re: Wed conf call--
discussion points, attaching Enron Discussion Points (May
9, 2001)................................................... 608
e. GJPMorgan Chase emails, February and May 2001, re:
Project Rio Grande (a.k.a. Flagstaff Capital Corporation)--
HEADS UP MEMO (Club Bank Target Hold: $60MM . . ).......... 611
f. GJPMorgan Chase email, June 2001, re: Flagstaff I.D. #'s
(The $1.1 billion will be repaid same day.)................ 613
g. GCitibank email, June 2001, re: Additional Daylight
Overdraft Request from Enron (Enron will require additional
daylight overdraft protection on Friday 6/22/2001 . . .)... 614
h. GJPMorgan Chase email, October 2001, re: Flagstaff
Syndication Update ([L]ets make sure we lock up Citi and
Boa on confidentiality agreements, for what they're worth.) 621
i. GJPMorgan Chase email, October 2001, re: Enron Flagstaff
(The message from Enron to them is ``you have to do
this.'')................................................... 622
j. GJPMorgan Chase email, November 2001, re: Enron--
Flagstaff (The papers were signed with a $56.25MM target
hold to be achieved by 9/30.).............................. 623
k. GEric Peiffer/JPMorgan Chase email, October 2001, re:
enron responsibilities (Eric did an outstanding job and
took on serious responsibilities.)......................... 624
358. GBill W. Brown, Accomplishments for the First Half of 2001.. 626
359. GDoug McDowell resume....................................... 627
360. GProject Slapshot brief, Project Slapshot Scores!, prepared
by Enron Corp.................................................. 629
361. GSundance Transaction, Slapshot Financing, prepared by
Citigroup...................................................... 630
362. GEnron Corp. email, December 2000, re: Canadian Financing
Proposal (. . . it is a similar version of an arrangement that
Morris and I have independently been developing with our
Canadian counsel . . .)........................................ 632
363. GEnron Corporation Closing Funds Flows for Slapshot, Closing
Date: Friday, 6/22/00, Final................................... 633
364. GMemorandum prepared by Tim Edgar, Faculty of Law, The
University of Western Ontario, to the Permanent Subcommittee on
Investigations, December 9, 2002, re: Canadian Income Tax
Consequences of Flagstaff/Enron Transaction.................... 638
365. GEnron Industrial Markets Finance Presentation of Sundance
and Slapshot, March 21, 2001, prepared by Enron Corp........... 646
366. GCiticorp/Citibank Credit Approval, Enron Corporation,
December 2000, indicating ``verbal guarantees'' of Project
Bacchus ``equity'' (see page Bates #CITI-SPSI 0128921)......... 655
367. GAccounting Schedules for Projects Fishtail and Sundance,
prepared by Enron Corp......................................... 680
368. GLetter from Skadden, Arps, Slate, Meagher & Flom LLP
(attorneys for Enron Corp.) to the Permanent Subcommittee on
Investigations, December 10, 2002, regarding status of the
loans, assets, and entities involved in the Slapshot
transaction.................................................... 684
369. GJPMorgan Chase email, July 1998, attaching copy of Prepay
pitch presentation............................................. 687
370. GJPMorgan Chase email, March-July 1999, re: Prepaid Forwards
and Disguised Loans............................................ 701
VOLUME II
371. GEnron Net Works Partners: Valuation Analysis of Contributed
Assets, Chase Securities Inc., November 20, 2000............... 1
372. GFishtail LLC, Enron Corp. draft document summarizing
Project Fishtail (undated)..................................... 19
373. GAmended and Restated Limited Liability Company Agreement of
Fishtail LLC, December 19, 2000................................ 22
374. GSummary of Project Fishtail, prepared by Deloitte & Touche,
LLP, for the Powers Report, dated January 21, 2002............. 74
375. GData Sheet Report, Caymus Trust (c/o Wilmington Trust) as
of February 22, 2002........................................... 102
376. GAmended and Restated Limited Partnership Agreement of
Sundance Industrial Partners, L.P., June 1, 2001............... 103
377. GCitibank email, June 2001, re: Apache Opportunity (Any
feedback from Carpenter on Sundance; apparently the deal
closed.)....................................................... 175
378. GSenior Bank Contacts, document prepared by Enron Corp...... 176
379. GEnron status as of November 26, 2001 in terms of directors,
officers, stock outstanding, and direct subsidiaries........... 177
380. GEnron Corp. Memorandum, October 1, 2000, re: Accounting
Enron's Investment in Fishtail LLC............................. 191
381. GAdditional documents regarding Project Bacchus:
a. GEnron Corp. Memorandum, December 31, 2000, re: Project
Bacchus Transaction Memorandum............................. 196
b. GFishtail Total Costs.................................... 202
c. GCitibank email, October 2000, re: Enron/Project Bacchus
(Dan sees NO chance that this deal will not go ahead . . .) 203
d. GCitibank email, December 2000, re: Bacchus Equity (As
you know we are looking for a balance sheet provider for
the new Enron trade.)...................................... 204
e. GCitibank email, December 2000, re: Enron Bacchus
(Citibank GRB have agreed to provide a 9-month facility for
the 194 M and also to take the credit risk on the equity
portion.).................................................. 205
f. GCitibank fax, December 12, 2000, attaching copy with
comments of Global Loans Approval Memorandum, December 6,
2000, re: Project Bacchus (from section on page 3 entitled,
Enron Corporate Credit Risk: Enron Corp. will essentially
support the entire facility, whether through a guaranty or
verbal support.)........................................... 206
g. GCitibank email, December 2000, re: Enron follow-up
(Having this source of liquidity during this nanosecond is
important in providing certain legal opinions . . .)....... 211
h. GCitibank email, December 2000, re: Enron/Bacchus (. . .
the RAP treatment should be that the Banking Book will view
the Certificates as if it made a loan in the face amount of
the Certificates.)......................................... 212
i. GEnron Corp. email, January 2001, re: Fishtail in EIM
Partners (In talking to Jeff, he does not like the way I
was proposing that Fishtail went into EIM Ptrs . . .)...... 213
j. GCitibank email, February 2001, re: Bacchus (I had an
Enron question regarding the Enron gty provided for
Baccus(sp?).).............................................. 214
k. GCitibank email, May 2001, re: phone call with bill brown 215
l. GCitibank email, November 2001, re: Enron Exposure (For
Bushnell), attaching Enron exposure table.................. 216
382. GAdditional documents regarding Project Sundance:
a. GSundance Earnings (Still Under Negotiation), document
prepared by Enron Corp..................................... 218
b. GAdministrative Agent Fee Calculation, document prepared
by Enron Corp.............................................. 219
c. GAmended and Restated Sundance Limited Partnership
Agreement, June 1, 2001.................................... 220
d. GFinal Sundance Numbers, document prepared by Enron Corp. 293
e. GCitibank email, May 2001, re: Sundance (Re fleet: we shd
approach these guys by saying we are rolling the trs they
have on bacchus but also adding to it.).................... 295
f. GCitibank email, May 2001, re: Sundance (Thoughts or
concerns I had as I read the revised Sundance LP
Agreement:)................................................ 296
g. GCitibank email, May 2001, re: sundance (. . . I do not
understand why we are proposing to do this transaction. . .
.), attaching copy of First cut at questions re Sundance... 298
h. GCitibank email, May 2001, re: Second Sundance question
set, attaching copy of Second Set of Sundance Questions.... 301
i. GCitibank email, May 2001, re: Sundance Partnership...... 304
j. GEnron email, May 2001, re: Updated Step by Step Sundance
structure Chart--03/22/01.................................. 306
k. GEnron Corp. Presentation, Enron Industrial Markets
Finance Presentation of Sundance Industrial Partners, June
1, 2001.................................................... 311
383. GAdditional documents regarding Project Slapshot:
a. GFlagstaff Capital Corporation, $375,000,000, Senior
Credit Facility, JPMorgan Confidential Information
Memorandum, May 2001....................................... 316
b. GEnron Corp. (Morris Clark to Joseph Deffner) email,
undated, re: Repatriation of Cash from Enron Canada (It
should be noted that repaying the Preferred Shares within
the same year as entering into Project Slapshot puts
pressure on both of the above factors and, as such, puts
the integrity of the transaction at risk.)................. 352
c. GDaishowa Acquisition Structure Steps, charts prepared by
Enron Corp................................................. 353
d. GJPMorgan Chase email, February 2000, re: Slapshot--
Frazer Milner Tax Opinion, attaching copy of draft opinion
on Re: Canadian Structured Finance Proposal................ 360
e. GHandwritten notes of Enron Corp. re: Project Slapshot... 379
f. GBlake, Cassels & Graydon LLP Memorandum to Enron Corp.,
January 2001, re: Prepaid Forward Structure................ 387
g. GEnron Corp./Blake, Cassels & Graydon LLP email, February
2001, re: Rider, attaching draft recharacterization rider.. 394
h. GProject Slapshot, Canadian Tax Advantaged Financing
Structure for Project Crane & ECC Operations, March 20,
2001, Enron Corp. presentation............................. 396
i. GEnron Corp. email, March 2001, re: Requirements for
Right of Offset accounting................................. 417
j. GEnron Corp./Blake, Cassels & Graydon LLP email, March
2001, re: Canadian Guaranty Issue with attached Enron Corp.
handwritten notes re: Slapshot............................. 418
k. GBlake, Cassels & Graydon LLP Memorandum, March 2001, re:
Warrant Arrangement........................................ 420
l. GJPMorgan Chase email, March 2001, re: enron............. 422
m. GFlagstaff Capital Corporation (Delaware), Assets and
Liabilities, document produced by JPMorgan Chase........... 423
n. GEnron Corp./Blake, Cassels & Graydon LLP email, April
2001, re: Comments on drafts of April 12/01, attaching copy
of April 2001 Blake, Cassels & Graydon LLP Memorandum...... 424
o. GBlake, Cassels & Graydon LLP Draft Memorandum, May 2001,
re: Tax Issues............................................. 428
p. GEnron Corp./Blake, Cassels & Graydon LLP email, May
2001, re: Tax Benefit Analysis, attaching draft Tax Benefit
Analysis................................................... 432
q. GHandwritten notes of Enron Corp., May 2001, re: Slapshot 435
r. GEnron Corp. email, May 2001, re: Journal Entries ([H]ere
are accounting entries for the slapshot transaction.),
attaching copy of Slapshot-Initial Purchase; Slapshot--Year
1-5 Balance Sheet; and Slapshot-Year 5 End Unwind.......... 436
s. GEnron Corp. Memorandum, May 2001, re: Project Slapshot--
Step-by-Step Description................................... 440
t. GHandwritten notes of Enron Corp., June 2001, re:
Slapshot................................................... 443
u. GEnron Corp./Blake, Cassels & Graydon LLP email, June
2001, re: Blakes Second Set-off Opinion re: Hansen-
Flagstaff, attaching Blake, Cassels & Graydon LLP
correspondence concerning Project Slapshot................. 449
v. GFlagstaff Capital Corporation, Commitment Allocations as
of September 24, 2001...................................... 453
w. GBlake, Cassels & Graydon LLP invoice for services
rendered for the period ended June 21, 2001, re: Project
Slapshot................................................... 454
x. GEnron Corp. Memorandum, October 2001, re: Campagnie
Papiers Stadacona.......................................... 456
y. GVinson & Elkins invoice for services posted through June
27, 2001, re: Project Slapshot-Enron $400,000,000
Structured Financing....................................... 458
z. GProject Dasher, Preliminary Tax Disposition Structures
To Maintain Project Slapshot, August 31, 2001, prepared by
Enron Corp................................................. 459
aa. GEnron Corp. email, December 2001, re: Slapshot (. . .
doug, pls call me asap since you are the most
knowledgeable.)............................................ 463
bb. GHandwritten notes of Enron Corp., December 2001, re:
Slapshot/CPS restructuring with attached copy of Enron
Corp. Memorandum, December 2001, re: Proposed Sale of
Stadacona Mill--Restructuring Steps........................ 464
cc. GBlake, Cassels & Graydon LLP Memorandum, December 2001,
re: Slapshot Restructuring/CPS Sale........................ 468
dd. GEnron Corp. facsimile to Jeff McMahon, December 2001,
re: Stadacona (Project Slapshot)........................... 481
ee. GBlake, Cassels & Graydon LLP Memorandum, January 2002,
re: Slapshot Structure, Current Status Issues and Proposed
Transactions............................................... 489
ff. GJPMorgan Chase email, January 2002, re: Flagstaff
Commitment and Fee Letter (Given the sensitivity to the
Enron name and this transaction in particular, I would
suggest writing this up as an exception.).................. 494
gg. GEnron Corp. Memorandum, November 2002, re: Project
Slapshot--Quarterly Payments............................... 495
hh. GPatton Boggs LLP correspondence, on behalf of JPMorgan
Chase, to the Permanent Subcommittee on Investigations,
December 2002, re: structuring fees paid to JPMC........... 497
ii. GCanadian Financing Strategy, A Presentation to Enron
Corp., September 2000, National Australia Group............ 498
jj. GAdditional Points, JPMorgan Chase document regarding
Project Slapshot........................................... 510
kk. GDaishowa Acquisition Structure Steps, Enron document
regarding Project Slapshot................................. 511
384. GDocuments regarding Project Crane and Project Boomerang:
a. GEnron Corp. email, December 2000, re: Project Crane--
Status Updated and Next Steps (I would to inform everyone
that yesterday we had a meeting with Jeff Skilling to
present Project Crane . . .)............................... 514
b. GEnron Corp. email, December 2000, re: Skilling
presentation on EIM Pulp and Paper Market Making Strategy.. 515
c. GEnron Risk Assessment and Control Deal Approval Sheet,
December 2000, re: Project Crane........................... 535
d. GProject Crane, Steps to Acquire SAT and DFPL and Post-
Acquisition Undertakings, draft of presentation............ 542
e. GProject Boomerang, Transaction Overview, prepared by
JPMorgan Chase............................................. 548
f. GJPMorgan Chase email, November 2000, re: Project
Boomerang (I think what we would like to try to do is
define fair market value in such a way that it always turns
out to be equal to the value at which the SPE purchased the
business.)................................................. 551
385. GAdditional documents relating to FAS 125/140 Transactions:
a. GFASB Statement No. 125, Enron Corp. presentation........ 553
b. GUpdate on FASB 140, Transfers of Financial Assets &
Extinguishment of Liabilities, June 2001, Enron Corp.
presentation,.............................................. 571
c. GAndersen email, November 1999, re: Total Return Swaps... 584
d. GEnron Corp./Andersen email, September 2001, re:
Background of Project Hawaii 125-O......................... 587
e. GEnron Corp. Memorandum, December 2001, re: Hawaii
Structure Summary.......................................... 590
f. GEnron Corp., Pre-Tax Earnings Analysis of SFAS 140's
1998-2001.................................................. 593
g. GEnron Corp. email, May 2001, re: Offshore Double Lease
Accounting Treatment....................................... 594
386. GDocuments relating to transactions involving Canadian
Imperial Bank of Commerce (CIBC) and Enron Corp., November,
2002........................................................... 598
387. GAdditional documents regarding Enron Corp. structured
finance deals generally:
a. GGlobal Finance: Funding Vehicles, May 2000, Enron Corp.
presentation............................................... 613
b. GFunds Flow Vehicles, Enron Corp. document............... 621
c. GStructured Finance Vehicle, August 24, 2001, Enron Corp.
presentation............................................... 629
d. GEnron Corp., Structured Transactions Group Overview,
June 2001.................................................. 652
e. GEnron Structured Finance List As of 11/16/2001.......... 659
388. GDocuments regarding Enron Bank Reviews:
a. GEnron Corp. email, July 2000, re: Bank relationship
review..................................................... 686
b. GDebt Investor Relationship Review, January 2001, Enron
Corp. presentation......................................... 689
389. GDocuments regarding Enron Asset Valuations:
a. GWhitewing Presentation, August 14, 2001, prepared by
Enron Corp................................................. 741
b. GEnron Global Assets and Services, Equity Value Schedule,
$(Millions), As of June 2001............................... 753
c. GEnron Global Assets & Services, Significant Exposures
(InUS$MM's),............................................... 754
390. GAdditional documents regarding Enron Prepay Transactions:
a. GCorrespondence between Citigroup and the Permanent
Subcommittee on Investigations, July 2002-January 2003,
regarding Delta Energy Corporation......................... 755
b. GCorrespondence between JPMorgan Chase and the Permanent
Subcommittee on Investigations, July 2002-January 2003,
regarding Mahonia, Ltd..................................... 812
c. GSummary of Proposed Transaction Approval Process (TAP)
Policy Revisions, undated, from the ``H'' drive of the
computer of Enron Corp. employee Rick Carson............... 952
d. GProposed Gas Storage Monetization Structure, undated,
from the ``H'' drive of the computer of Enron Corp.
employee Michael Garberding................................ 953
e. GEnron Corp. email, December 2000, re: New Prepay with
Chase (In the prior transactions, we have received a
prepayment from Mahonia on a forward delivery schedule of
fixed volumes.)............................................ 959
f. GEnron Corp./JPMorgan Chase email, September 2001, re:
Rep Letter for Mahonia, attaching draft Mahonia
representation letter...................................... 960
g. GEnron Corp. email, June 2001, re: Sample Swap Co Letter
(I am still trying to track down the original ``Delta/
Mahonia'' Letter. Everyone seems to have shredded their
files, which is a little disturbing.)...................... 962
h. GEnron Corp. email, November 2001, re: Steps for $250mm
Swap Assumption............................................ 963
i. GEnron Corp. email, September 2001, re: New Confirm...... 967
j. GEnron Corp. email, July 2001, re: Citibank/Delta Prepay
(. . . the auditors would like to verify that the MMBtus
involved in the trade are not inconsistent with normal
trades that run through the financial book for gas.)....... 972
k. GEnron Corp. email, September 2001, re: Revised Pre Pay
docs (This tracks language that is in the Guaranty and does
not name Chase.)........................................... 973
l. GEnron Corp. email, October 2001, re: Comments on Prepaid
Swaps...................................................... 975
m. GEnron Corp. email, September 2001, re: Mahonia Confirm... 990
n. GEnron Corp./JPMorgan Chase email, September 2001, re:
Mahonia Limited............................................ 998
o. GEnron Corp. email, November 2000, re: Sale treatment for
Prepayments with subsequent participation to an investor... 1001
p. GEnron Corp. email, September 2001, re: Chase Prepay..... 1003
q. GEnron Corp. email, November 2000, re: Prepay (Andy,
Michael asked me to forward this structure to you in
advance of his call.)...................................... 1004
r. GEnron Prepaid Oil Swap:................................. 1005
391. GSupplemental questions and answers for the record of
Citibank, regarding December 11, 2002, hearing, dated February
27, 2003....................................................... 1006
392. GCorrespondence from the Board of Governors of the Federal
Reserve System, Office of the Comptroller of the Currency,
Securities and Exchange Commission, to the Permanent
Subcommittee on Investigations, regarding followup to questions
posed in the Subcommittee's December 11th hearing and
recommendations included in the Subcommittee report entitled
Fishtail, Bacchus, Sundance, and Slapshot, Four Enron
Transactions Funded and Facilitated by U.S. Financial
Institutions................................................... 1008
OVERSIGHT OF INVESTMENT BANKS'
RESPONSE TO THE LESSONS OF ENRON
----------
WEDNESDAY, DECEMBER 11, 2002
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:37 a.m., in
room SD-106, Dirksen Senate Office Building, Hon. Carl Levin,
Chairman of the Subcommittee, presiding.
Present: Senators Levin, Collins, and Bennett.
Staff Present: Linda J. Gustitus, Chief of Staff; Elise J.
Bean, Staff Director and Chief Counsel; Mary D. Robertson,
Chief Clerk; Bob Roach, Counsel; Jamie Duckman, Professional
Staff Member; Jessica Swartz, Intern; Beth Merrilat-Bianchi,
Detailee/IRS; Jim Elliott, Detailee/Department of State; Kim
Corthell, Republican Staff Director; Alec Roger, Counsel to the
Minority; Claire Barnard, Investigator to the Minority; David
Mount, Detailee/Secret Service; Jim Pittrizzi, Detailee/General
Accounting Office; Meghan Foley, Staff Assistant; Marianne
Upton (Senator Durbin); Tara Andringa (Senator Levin); Bob
Klepp (Governmental Affairs/Senator Thompson); Mike Nelson
(Senator Bennett); Holly Schmitt (Senator Bunning); Felicia
Knight (Senator Collins); and Brooke Brewer (Senator Cochran).
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Good morning, everybody. One year ago, on
December 2, 2001, Enron Corporation, then the seventh-largest
company in the United States, declared bankruptcy. The follow-
up to this financial disaster revealed a litany of Enron
corporate abuses, from accounting fraud to price manipulation,
insider dealing, and tax abuses. Yet it is still the case
today, as it was a year ago, that most top Enron officials have
walked away from the scandal that they created with tens of
millions of dollars in their pockets while Enron employees,
creditors, and shareholders have suffered substantial losses.
As disturbing as Enron's own misconduct is the growing
evidence that leading U.S. financial institutions not only took
part in Enron's deceptive practices, but at times designed,
advanced, and profited from them. This is the third in a series
of hearings held by this Subcommittee focusing on the role of
financial institutions in Enron's collapse.
Our first hearing looked at the more than $8 billion in
deceptive transactions referred to as prepays. Citigroup and
J.P. Morgan Chase repeatedly used these deceptive prepays to
issue Enron huge loans that were disguised as energy trades,
which then enabled Enron to misstate the loan proceeds as cash
flow from business operations. Investors and analysts were
misled, along with the many employees who lost their life
savings and jobs.
Our second hearing looked in detail at a sham asset sale
from Enron to Merrill Lynch just before the end of the year
2000 so that Enron could book the fake sale revenue and boost
both its year-end earnings and cash flow from operations. This
transaction didn't qualify as a true sale under accounting
rules because Enron had eliminated risk from the deal by
secretly promising Merrill Lynch to arrange a resale of the
barges within 6 months, while guaranteeing a 15 percent profit.
In both hearings, substantial evidence showed that the
financial institutions involved in the deals knew exactly what
was going on. They structured the transactions, signed the
paperwork, and supplied the funds, knowing that Enron was using
the deal to report that the company was in better financial
condition than it really was. In the case of Citigroup and
Chase, the banks not only assisted Enron, they developed the
deceptive prepays as a financial product and sold it to other
companies as so-called balance sheet-friendly financing,
earning millions of fees for themselves in the process.
Today's hearing will look at another set of deceptive
transactions that took place over a 6-month period, from
December 2000 to June 2001, involving Enron ventures in the
pulp and paper business. These transactions were known as
Fishtail, Bacchus, Sundance, and Slapshot. The evidence shows
that Citigroup and Chase actively aided Enron in these
transactions despite knowing that they employed deceptive
accounting or tax strategies and were being used by Enron to
manipulate its financial statements or deceptively reduce its
tax obligations. Citigroup and Chase received substantial fees
for their actions or favorable consideration from Enron in
other business dealings.
These four transactions required months of work by the
Subcommittee staff to untangle. The complexity of the deals
made the deceptions almost impossible for anyone to understand
without a detailed road map. They also show how far our
financial institutions have sunk in misusing structured
finance. Instead of using structured deals to lower financing
costs or spread risk, which are legitimate uses, they used
structured finance to mislead investors, analysts, and
regulators about a company's true activities and financial
condition.
I will place in the record at this time the Subcommittee
staff report that describes the four transactions in detail, as
well as charts and exhibits showing what happened.\1\
---------------------------------------------------------------------------
\1\ The staff report appears in the Appendix on page 150.
---------------------------------------------------------------------------
Here are some of the highlights from that report and from
our investigation. Enron constructed the first three
transactions, Fishtail, Bacchus, and Sundance, as a sham asset
sale of its new pulp and paper business venture in order to
inflate its cash flow and earnings by hundreds of millions of
dollars and to keep the substantial debts associated with this
business venture off its balance sheet and out of the view of
investors and analysts.
The first two transactions took place in December 2000.
Enron first pretended to move its pulp and paper trading
business off its balance sheet to a new joint venture that it
had set up called Fishtail. About 1 week later, in the Bacchus
deal, Enron purportedly sold its Fishtail interest to another
entity for $200 million. Enron then booked the $200 million as
sale revenue and declared a profit and earnings of $112 million
on its year-end financial statement, enabling the company to
meet Wall Street expectations for its year 2000 earnings.
In the Bacchus transaction, Enron allegedly sold its
Fishtail ownership interest to a shell company that it had
established earlier called the Caymus Trust, and Exhibit 301(a)
\1\ shows how the transaction appeared on the surface, and that
exhibit is on the screen.
---------------------------------------------------------------------------
\1\ Exhibit No. 301(a) appears in the Appendix on page 185.
---------------------------------------------------------------------------
The Caymus Trust came up with the $200 million purchase
price by obtaining a $194 million loan from Citigroup and an
apparent $6 million cash investment from Fleet Boston Financial
that was also guaranteed by Citigroup. However, as Exhibit
301(b) \2\ demonstrates, the transaction was, in reality, a
loan. The evidence shows that in addition to openly
guaranteeing repayment of the $194 million Citigroup loan,
which is permissible under accounting rules, Enron's Chief
Financial Officer, Andrew Fastow, also made an undisclosed,
oral agreement with Citigroup to ensure that Citigroup would
not incur any loss connected with the so-called $6 million
investment.
---------------------------------------------------------------------------
\2\ Exhibit No. 301(b) appears in the Appendix on page 186.
---------------------------------------------------------------------------
These two guarantees meant that Enron, in effect, had
ensured repayment of the entire $200 million purchase price,
and those two guarantees also meant that under accounting
rules, Citigroup was, in reality, providing Enron a loan and
using the Caymus Trust as a pass-through rather than financing
a real sale to a real company.
Six months later, Enron and Citigroup set up another joint
venture called Sundance to take possession of all of Enron's
pulp and paper assets, including the asset presumably just sold
to the Caymus Trust, and to keep the debt associated with these
assets off Enron's balance sheet. But this joint venture was
also a sham. Enron's auditor, Andersen, had told Enron that it
would approve off-balance sheet treatment of the Sundance joint
venture only if at least 20 percent of Sundance's capital came
from an independent investor and at least 3 percent of the
total capital was placed at risk when the venture was formed
and stayed at risk during the joint venture's operation.
Exhibit 302(a) \3\ shows that Sundance appeared to meet
these accounting requirements. Enron contributed approximately
$750 million in assets and cash. Citigroup appeared to have
contributed $188.5 million, or 20 percent of the joint
venture's capital. Citigroup's contribution included $28.5
million in stock and cash, which supposedly met the requirement
for 3 percent up-front capital at risk and $160 million in
unfunded capital that supposedly would be provided on demand.
---------------------------------------------------------------------------
\3\ Exhibit No. 302(a) appears in the Appendix on page 187.
---------------------------------------------------------------------------
But as Exhibit 302(b) \1\ shows, the reality was that
Citigroup's alleged investment was a sham because it was never
intended to be at risk. As Exhibit 302(c) \2\ shows, the terms
of the partnership included the following provisions. Citigroup
could dissolve the partnership at any time. Enron needed to
lose its entire $750 million before any of Citigroup's so-
called investment could be touched, which meant Citigroup would
have plenty of time to dissolve the partnership, if necessary,
before it had to produce any funds. And Sundance had to keep
the $28.5 million liquid, segregated, and earmarked for
Citigroup so that Citigroup could recapture that part of its
so-called investment at will.
---------------------------------------------------------------------------
\1\ Exhibit No. 302(b) appears in the Appendix on page 188.
\2\ Exhibit No. 302(c) appears in the Appendix on page 189.
---------------------------------------------------------------------------
In summary and in reality, neither Citigroup's $28.5
million nor its unfunded $160 million were ever intended to be
at risk.
The Sundance joint venture was a sham and all of its assets
should have been included in Enron's balance sheet. Indeed,
just 2 days before the transaction closed, three senior
Citigroup officials strongly urged the investment bank not to
do the Sundance deal, with one warning the following: ``The
GAAP accounting is aggressive and a franchise risk to us if
there is publicity.'' Let me repeat that. Just before this deal
was approved, this was the warning. It came from Citigroup
people. ``The GAAP accounting is aggressive and a franchise
risk to us if there is publicity.''
But Citigroup did the deal, earning $1.8 million in fees
and preferred dividends and presumably got some good will from
Enron. Citigroup also obtained full payment of the $200 million
loan that it had provided earlier in the Bacchus deal, since
one of Enron's contributions to Sundance was the $200 million
needed to buy the Fishtail assets from the Caymus Trust and pay
off the Citigroup loan.
On paper, Fishtail, Bacchus, and Sundance seemed to bring
new investment into Enron's pulp and paper business venture. In
reality, these complex financial deals enabled Enron to use a
$200 million Citigroup loan and a sham asset sale to boost its
year-end cash flow and earnings and then quietly return the
funds via Sundance. Without Citigroup's participation in
supplying the lion's share of the funds, Enron would not have
been able to pull off these deceptive transactions.
Finally, the Slapshot transaction, another highly
disturbing example of a major U.S. financial institution
helping Enron engage in a deceptive transaction. It is
particularly disturbing because Chase, the financial
institution involved here, itself designed the deceptive
transaction. That was even more than aiding and abetting. Chase
designed the Slapshot deal and sold it to Enron for $5 million,
enabling Enron to claim an estimated $60 million in Canadian
tax savings and $65 million in financial statement benefits.
The Slapshot sleight of hand took place on June 22, 2001.
It was designed as a tax avoidance scheme, and as we can see
from the next exhibit,\3\ it was a spaghetti bowl of structured
finance arrangements using loans, funding transfers, and
transactions involving Chase and Enron affiliates in two
countries, many of which were established specifically to
facilitate the deal.
---------------------------------------------------------------------------
\3\ Exhibit No. 337 appears in the Appendix on page 347.
---------------------------------------------------------------------------
In essence, Slapshot took a valid $375 million loan issued
by a consortium of banks to an Enron affiliate and combined it
with a $1 billion sham loan issued by a Chase-controlled shell
company called Flagstaff. The sham $1 billion loan created the
appearance, but not the reality, of a loan by using a shell
game involving two different transfers of $1 billion through a
maze of bank accounts belonging to Chase and Enron affiliates.
Chase provided the alleged loan by issuing a $1 billion
momentary overdraft to its shell company, Flagstaff. But Chase
was unwilling to allow Flagstaff to release the funds to an
Enron shell company called Hansen until Chase was sure that the
$1 billion was fully protected and going to be returned the
same day, indeed, almost at the same moment. So Chase required
Enron to deposit a separate $1 billion in an escrow account
controlled by Chase before Chase would release its $1 billion
to Enron. Enron obtained its own $1 billion momentary overdraft
on an account that it held at Citibank and transferred those
funds into an escrow account at Chase.
And then through a series of near-instantaneous
transactions among Chase and Enron entities, the $1 billion
sham loan was briefly commingled with the real $375 million
loan to create the appearance of a combined $1.4 billion loan
to an Enron affiliate. The sham $1 billion was then separated
back out through a series of additional transfers and moved
within hours back to the Enron account at Citibank. In the
meantime, the $1 billion in Enron escrow funds was released to
Chase.
Now, the $1 billion loan that was supposedly supplied by
Chase was a sham. It was issued and paid back within minutes
without any of the credit risk that is the point of a loan,
even during the few minutes that it moved from Chase's left
pocket to its right pocket. It had no economic rationale or
business purpose other than to circulate through multiple bank
accounts to create the appearance of the larger $1.4 billion
loan. Chase got more than $5 million for doing it. Enron got
tax deductions and better financial statements.
Enron's tax counsel warned that this transaction clearly
involves a degree of risk and cautioned that, ``in our opinion,
it is very likely that Revenue Canada will become aware of the
Slapshot transactions and upon becoming aware of them will
challenge them.''
Chase also knew that the Slapshot transaction was dubious.
It worked with Enron to minimize the possibility that Canadian
tax authorities would discover it, and they even developed
contingency plans in the event that Canada disallowed the sham
loan. When analyzing how to structure an interest rate swap
that was a part of the transaction, for instance, Enron and
Chase jointly considered three alternatives, two of which were
described as disadvantageous, in part because they would
produce a potential road map, in their words, of the
transaction for Revenue Canada. So instead of following those
two roads, Enron and Chase jointly chose the third alternative,
which was explicitly described as providing no road map.
In addition, Enron and Chase included in the transaction
documents what was called a recharacterization rider, in which
they agreed if they were caught by Revenue Canada to reclassify
retroactively loan payments made by Enron to Chase to look like
loans from Enron to Chase. How is that for a move? If Canada
disallowed the Slapshot scheme and exposed Enron to additional
taxes, Enron would try to make it look as though Enron was
lending money to one of the world's largest banks.
Slapshot was designed and intended to be a deceptive
transaction. Chase set it up to pretend that a $375 million
loan was really a $1.4 billion loan by, just for a moment,
inserting an extra $1 billion in the transaction. The combined
so-called loan then provided the cover for Enron's Canadian
affiliate to claim for tax purposes that it had an outstanding
loan obligation of $1.4 billion and claim its entire $22
million quarterly loan repayment as tax deductible interest
payments on the fake $1.4 billion loan, instead of deducting
only that portion of the payments that was the true interest
payment on the $375 million loan.
Enron could not have completed Slapshot without a major
bank like Chase which had the resources to use $1 billion for a
few brief moments and quickly move that $1 billion through
multiple bank accounts across international lines. Chase
charged Enron $5 million for its so-called tax technology.
Chase has also shopped that same tax technology to other
companies.
The four transactions at issue today, together with the
sham transactions examined at earlier hearings, all have
deception at their core. All misuse structured finance, which
has a legitimate purpose when used for real economic
objectives, such as lowering financing costs or spreading risk.
But here, there was no such legitimate economic objective. The
goal was deception, and none of the transactions could have
been executed without the complicity and financial resources of
a major financial institution.
Now, the purpose of today's hearing is not just to expose
another set of deceptive transactions, but also to take the
next step and to determine, 1 year after the Enron scandal
broke, what is being done to prevent future deception.
Citigroup and Chase have each announced new programs designed
to prevent their employees from participating in deals that
produce deceptive accounting. We need to learn more about those
programs and whether they will prevent the type of deals that
we are going to examine today.
But we also are going to find out what our financial
regulators are doing, what concrete steps they have taken to
prevent U.S. financial institutions from designing, executing,
and profiting from illegitimate structured financial
transactions intended to help U.S. companies engage in
misleading accounting or tax strategies. We want to learn what
concrete steps the bank regulators and the SEC are taking, not
only to punish wrongdoing on a case-by-case basis, which is
important, but also to create a deterrence program to be part
of regular bank examinations to stop future wrongdoing.
There is a regulatory gap now. The Securities and Exchange
Commission does not generally regulate banks, and bank
regulators don't regulate accounting practices or ensure
accurate financial statements. Two steps need to be taken,
which together could close this gap.
First, the SEC should issue a policy which states clearly
that the SEC will take enforcement action against financial
institutions which aid or abet a client's dishonest accounting
by selling deceptive structured finance or tax products or by
knowingly or recklessly participating in deceptive structured
transactions.
Second, the bank regulators, including the Federal Reserve
that oversees our financial holding companies, need to state
that violation of that SEC policy that I just described would
constitute an unsafe and unsound banking practice, thereby
enabling bank examiners to take regulatory action during bank
examinations.
We also need the SEC and the bank regulators to conduct a
comprehensive joint review of the structured finance products
being sold by or participated in by our financial institutions
so that we can root out the ones that corrupt financial
statements.
One year after Enron's collapse, we need our regulators to
tell our banks and our security firms that the deceptions and
the era of self-regulation are over. Enron was an eye opener
about the extent and the nature of corporate misconduct going
on in the United States today and the role being played by our
financial institutions. The question now is whether we have
learned the Enron lessons and whether, in addition to punishing
wrongdoers on a case-by-case basis, we have taken on the
tougher task of building a new deterrence program to prevent
future Enrons.
Let me call on Senator Collins, my Ranking Member for a few
more weeks and someone who has been such a great, not only
supporter of efforts to protect consumers and to protect our
economy, but whose staff has been so extraordinarily helpful in
the production of this report and these documents. I want to
thank her. I want to congratulate her on her new assignment as
the Chair of our full Committee, the Governmental Affairs
Committee, starting in January. But again, it has been a real
pleasure serving with her, both as her Ranking Member here and
then having her as my Ranking Member in the last few months.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Senator Levin. I want to thank
you for your kind comments and your extraordinary leadership in
this very important investigation. Our staffs have worked very
closely together during the past year in what I believe has
been an unprecedented level of cooperation to unravel these
very complex transactions. It would not have happened without
your leadership.
I particularly want to take the opportunity to salute Linda
Gustitus, who has been the leader of your staff since, I think,
1979, and will be retiring at the end of this year. Linda and I
worked together on the Subcommittee many, many years ago and I
know that her leadership will be sorely missed, as well.
Senator Levin. Thank you. Thank you for mentioning Linda,
who indeed has been absolutely at the forefront of over two
decades of investigations by this Subcommittee and by a
predecessor Subcommittee that we were also both associated
with. Thank you very much for mentioning her. It is totally
appropriate and, indeed, well founded.
Senator Collins. Today's hearing represents a continuation
of the Subcommittee's extensive investigation into the collapse
of the Enron Corporation. It is our third hearing looking
specifically at the role played by some of America's leading
financial institutions in transactions that enabled Enron to
paint a false picture of its financial health and that
ultimately contributed to the bankruptcy of the company.
Our earlier hearings documented that certain financial
institutions, among them Merrill Lynch, J.P. Morgan Chase, and
Citigroup, knowingly participated in and indeed facilitated
transactions that Enron officials used to make the company's
financial position appear to be more robust than it actually
was. These complex transactions allowed Enron to deceive its
investors, its customers, and its employees.
Today's hearing will provide additional evidence of the
complicity of certain financial institutions in Enron's
deceptions. As Senator Levin indicated, we will closely examine
four multi-million-dollar structured finance deals that enabled
Enron to produce misleading financial statements, and in one
case claim a highly questionable $125 million tax break.
Citigroup funded two of the four transactions and J.P. Morgan
Chase funded the other two.
The first three transactions, known as Fishtail, Bacchus,
and Sundance, involved Enron's so-called sale of certain assets
at inflated values to special purpose entities that had been
established by Enron, Citigroup, or Chase. In each case, the
entities purchasing the assets were funded with equity
commitments by Citigroup or Chase that did not truly place
funds at risk or were supported by secret oral guarantees by
Enron that invalidated the special purpose entity's independent
status.
Each of these transactions fabricated to look like an arm's
length transaction and sale of a financial asset was, in fact,
an artifice designed to enable Enron to obtain a Citicorp or a
Chase loan or to sell an asset to itself. The evidence strongly
suggests that Citigroup and Chase were not innocent pawns in
these transactions. Warning flags were abundant. As Senator
Levin noted, an internal memorandum from a senior Citicorp
official strongly objected to the transactions, warning that
the ``accounting is aggressive and a franchise risk to us if
there is publicity.'' Citigroup's involvement in helping to
disguise what were essentially phony loans as phony asset sales
enabled Enron to inflate its sales revenues and produce
misleading financial statements.
The final transaction, known as Slapshot, involved a $1.4
billion loan and related transactions that were designed to
produce Canadian tax benefits for Enron. This complex web of
transactions was designed by J.P. Morgan Chase and used Enron
affiliates or special purpose entities in the United States,
Canada, and the Netherlands. In simplest terms, Slapshot
involved a legitimate $375 million loan issued by a consortium
of banks and a phony $1 billion loan issued by a J.P. Morgan
Chase controlled SPE. The $1 billion loan was issued and repaid
on the same day through a complex series of structured finance
transactions. The $375 million loan was to be repaid over 5
years.
Chase provided the $1 billion for the phony loan by
approving a $1 billion daylight overdraft on an Enron account
at Chase. The overdraft presented no risk, however, to Chase
because the bank required Enron to deposit a separate $1
billion in an escrow account for the duration of the so-called
loan. Chase then circulated the $1 billion through more than a
dozen bank accounts held by Enron and Chase affiliates and
SPEs, returning the $1 billion overdraft to the original Chase
account by the end of the day.
The end result of these transactions was that Enron was
able to treat its quarterly $22 million loan repayments, each
of which were, in fact, a payment of principal and interest on
the $375 million loan, as purely interest payments on the $1
billion loan. By characterizing each $22 million loan payment
as an interest payment on the larger loan, Enron claimed that
it was entitled to deduct the entire $22 million from its
Canadian taxes, for a total tax benefit of $125 million. In
return for designing this phony loan structure and arranging
the series of funding transfers, Chase received a fee of $5.25
million from Enron, and again, outside experts cautioned Chase
about this transaction.
The transactions that we are examining today once again
demonstrate the extraordinary lengths to which investment banks
went to keep Enron, an important client, happy. The checks and
balances that were supposed to ensure the integrity of
financial transactions apparently were compromised by conflicts
of interest and the lure of big fees.
It undermines the integrity of our capital markets when
some of the most prestigious financial institutions in our
country are involved in designing, marketing, executing, and
profiting from financial transactions intended to enable public
companies to engage in deceptive accounting and tax strategies.
In earlier testimony, the financial institutions have
generally denied any responsibility, claiming that it is simply
not their fault if their clients choose to account for these
transactions improperly. But the troubling fact remains that
Enron could not have gotten away with what it did for so long
without the active participation of its financial institutions.
Numerous documents examined by the Subcommittee clearly
demonstrate that the financial institutions that partnered with
Enron knew of the company's intentions. In fact, in some cases,
the financial institutions helped to design the transactions
specifically so that Enron could cook its books.
For example, Chase's own documents highlight a particular
advantage of the deal as, ``[not providing] a `road map' for
Revenue Canada.'' That has been explained to our staff as a
selling point so that the deal would not be easily identified
by Canadian tax authorities and audited.
Today, we will also hear from the watchdogs,
representatives of the Securities and Exchange Commission, the
Federal Reserve, and the Office of the Comptroller of the
Currency. There are a number of questions about the role of the
regulators. To what extent do these regulatory agencies examine
the type of transactions engaged in by J.P. Morgan Chase and
Citigroup that enabled Enron to misrepresent its financial
condition? What is their view of the legitimacy of the
transactions we are examining today? Do the regulators have
sufficient authority and expertise to oversee these complicated
transactions? Has the current regulatory structure kept pace
with changes in the financial markets and innovations in
structured finance? The answers to these questions are critical
to strengthening our free enterprise system and to restoring
public confidence in our capital markets.
It is important that we remember that the Enron debacle is
more than just a tale of one company's greed. As a result of
Enron's downward spiral and ultimate bankruptcy, shareholders
large and small, individual and institutional, lost an
estimated $60 billion. Moreover, the collapse of Enron caused
thousands of Americans to lose jobs, to lose their savings, and
to lose confidence in corporate America and U.S. financial
institutions.
When the individual investor does not have access to
critical information to make wise investment decisions,
information that is known only to corporate management and
their financial partners, the playing field is far from level.
We must ensure that our financial institutions act with
integrity, and I want to acknowledge that the institutions
before us today have taken several steps since our last
hearings to put new safeguards in place. But we must ensure
that investors, large and small, have access to complete and
accurate information to guide their investment decisions.
I look forward to hearing the testimony of our witnesses
today. Thank you, Mr. Chairman.
Senator Levin. Thank you, Senator Collins. Senator Bennett.
OPENING STATEMENT OF SENATOR BENNETT
Senator Bennett. Thank you very much, Mr. Chairman. I have
not been as involved in this issue as you and Senator Collins
have, and so I will be very brief in what opening statement I
have and I will look forward to listening to the witnesses.
I do sit on the Banking Committee, which has the
legislative responsibility of coming up with changes in
regulation and was involved in both the writing and in the
conference report of the Sarbanes-Oxley bill that came almost
exclusively as a result of the entire Enron experience. I think
this hearing will be very useful, along with the other one
which you previously held, in helping us in the Banking
Committee's responsibility to provide oversight to both the SEC
and to the bank regulators. The Banking Committee is the place
where, if legislative changes have to be made, we are going to
have to make them. This Permanent Subcommittee on
Investigations has made a significant contribution to the
institutional knowledge already available to the Banking
Committee and I congratulate you for focusing on this in a way
that, quite frankly, we on the Banking Committee could not.
I do have one area of concern that I simply will raise for
the record. As the previous hearing has gone forward and
conducted investigations in a way that is very clearly within
the purview and charge of the Permanent Subcommittee on
Investigations, some lawyers have attempted to take statements
made in that hearing, turn them into evidence with some kind of
legal alchemy, and then make them part of a lawsuit that,
unfortunate timing, is going on right now. Fortunately, the
judge ruled them out of order and refused to allow statements
made at the hearing to become part of evidence in a trial.
I would hope that will not be attempted with anything that
is said here today. This is an investigative Subcommittee. We
are probing for information. We have not come up with a final
report, and even when we do, I don't think our report
constitutes evidence that can be used in a court of law to
determine a fact. I think what it says is, here are facts. Now
you lawyers for one side or another determine your own basis
for these facts rather than simply quoting us.
I wouldn't accuse any Member of this Committee of being
given over to hyperbole in opening statements, but I do think
there have been some members of the Senate who occasionally do
that, and to take that hyperbole and try to turn it into
evidence in a court of law, I think is a little bit like what
we are finding out went on here, that is, a transaction that
was intended for one purpose gets twisted into another purpose.
There are some members of the trial bar who seem to be anxious
to try to do that. They say I was glad the judge slapped them
down and said they could not do that from previous statements
that were made in these hearings and I would hope that no one
in the audience would try to do that from anything that is said
here today.
With that, Mr. Chairman, again, I congratulate you for your
persistence and your diligence in digging into these matters
and I will sit back and learn as much as I can from today's
witnesses.
Senator Levin. Thank you so much, Senator Bennett, and
thank you for your contributions in so many ways in the banking
field and many other fields, including your contribution to
that Sarbanes-Oxley bill and to this Subcommittee.
Let me now turn to our witnesses. Our first panel of
witnesses is from Citigroup. I thank you all for making it here
today despite the challenging weather. We welcome Charles
Prince, the Chairman and Chief Executive Officer of Citigroup
Global Corporate and Investment Bank. We welcome also David
Bushnell, Managing Director and Head of Global Risk Management
at Citigroup/Salomon Smith Barney; Richard Caplan, the Managing
Director and Co-Head of the Credit Derivatives Group at Salomon
Smith Barney North America; and William Fox, who is the
Managing Director of the Global Power and Energy Group at
Citibank.
Pursuant to Subcommittee Rule 6, all witnesses who testify
before this Subcommittee are required to be sworn in, and so I
would ask you at this time to please stand and to raise your
right hand.
Do you swear that the testimony that you will give before
this Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Prince. I do.
Mr. Bushnell. I do.
Mr. Caplan. I do.
Mr. Fox. I do.
Senator Levin. Thank you very much. We will be using our
traditional timing system today. At about 1 minute before the
10-minute period for each of your testimony is up, the light
will change from green to yellow, which will give you the
opportunity to conclude your remarks. Your written testimony
will be printed in the record in its entirety. Again, we thank
you for your appearance here today and for your cooperation
with this investigation.
Mr. Prince.
TESTIMONY OF CHARLES O. PRINCE III,\1\ CHAIRMAN AND CHIEF
EXECUTIVE OFFICER, CITIGROUP GLOBAL CORPORATE AND INVESTMENT
BANK, NEW YORK, NEW YORK
Mr. Prince. Thank you, Mr. Chairman, Senator Collins, and
Senator Bennett. Good morning. My name is Chuck Prince. Since
September of this year, I have been Chief Executive Officer of
Citigroup's Global Corporate and Investment Bank. I appreciate
the opportunity to appear before you to discuss these important
issues and I commend you on your determination to understand
how and why a Fortune 10 company like Enron could unravel so
quickly and to such devastating effect. The collapse of that
company has been a disaster for thousands of people--employees,
investors, and others--and making sure that similar events do
not happen again is a critically important objective that we
share.
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\1\ The prepared statement of Mr. Prince appears in the Appendix on
page 91.
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The last year has been a challenging one on Wall Street.
Industry practices that were standard operating procedure for
years have come under sharp scrutiny by Congress, regulators,
and investors. Many of these practices have been changed and
others are in the process of changing. For our part at
Citigroup, we want to be at the forefront of change, setting
the standard for integrity and professionalism in our industry.
This has become a guiding mission for the senior management of
our entire organization.
Part of our process has included the recognition that we
have engaged in certain activities that do not reflect the way
we believe business ought to be done going forward. Let me be
clear, I believe that the Citigroup professionals involved with
these transactions acted in good faith and understood these
transactions to comply with the existing law and prevailing
standards of the time. But let me be equally clear, good faith
and legal compliance are no longer the issue as far as I am
concerned. Even assuming that these transactions were entered
into in good faith and were entirely lawful, they do not
reflect our standards and they would not happen now at
Citigroup.
Recognizing the problems our industry faces, we have worked
diligently to develop new practices and policies reflecting the
lessons we have learned. When Sandy Weill asked me to take the
helm at the Global Corporate and Investment Bank just 3 months
ago, he gave me a mandate to accelerate the process of reform
and change that was already underway. I have detailed a number
of these reforms in my written statement, but in the interest
of time, I will turn to the issue of structured transactions
that is the focus of today's hearing and was the focus of the
hearing you held, Mr. Chairman, on July 23 of this year. As I
hope you will agree when I discuss the reform initiative we
announced just 2 weeks after your hearing and a month before I
became responsible for this business, at Citigroup, we heard
you and we took appropriate action.
First, though, let me say a few words about the specific
transactions under review. While I believe our people acted in
good faith, I think it is fair to say that we never anticipated
that a financial intermediary like Citigroup would be
criticized for the accuracy of the accounting treatment that a
Fortune 10 company gave to its transactions with the express
approval of a then-highly respected Big Five accounting firm.
At the time we entered into these transactions, we never
imagined that Arthur Andersen wouldn't even exist a year later
or that a failure of ethics would have destroyed Enron, a
company ranked in the top 20 on the list of most admired
companies in the year 2001. But we have learned a hard and
valuable lesson, that reliance on public accountants or a
company's widely held excellent reputation has significant
limits, particularly in the face of corporate malfeasance.
To say that our professionals acted in good faith and in
ways they believed to be appropriate is not to say that we
consider a ``business as usual'' approach to be an acceptable
prescription going forward. On the contrary, we concluded in
the days and weeks following your July 23 hearing, Mr.
Chairman, that we needed to act, even in the absence of
industry action or regulatory action, and that the best way to
protect both investors and our own reputation with regard to
the kinds of transactions that appropriately concern this
Committee was to insist on transparency.
Accordingly, on August 7, Citigroup announced a new
transparency policy, saying, in essence, that from that day
forward, Citigroup would execute material financing
transactions for companies that were not going to be recorded
as debt on their balance sheet if, but only if, that company
agreed to clearly disclose the net effect of the transaction on
its financial condition.
We announced this net effect rule for two reasons: First,
to encourage companies to account for financing in a
transparent manner so that investors can adequately assess the
net effect of the transaction on the financial condition of the
company; and second, because we simply did not wish to be a
party to transactions that fail to meet a high standard of
transparency.
Under our net effect rule, the transactions at issue in
today's hearing would not and could not have happened at
Citigroup unless Enron had made clear detailed disclosure to
investors. We simply would have refused, and today would
refuse, to do those transactions without a commitment to make
such disclosures.
Our policy is based on a few key principles. First, it
applies to any material structured or complex financing
transaction of the sort this Subcommittee has been concerned
about. In determining whether the policy applies to a given
transaction, the economic reality, not the form of the
transaction, is critical.
Second, the required disclosures under our new policy
include, among other things, management's analysis of the net
effect of the transaction on the financial condition of their
company, the nature and amount of the obligations, and a
description of any events that may cause an obligation to
arise, increase, or become accelerated.
Third, Citigroup will obtain the client's written
commitment that disclosure of such transactions in the client's
relevant public filings will fairly present the transaction's
financial impact. If we do not receive this commitment, we will
not do the deal.
Fourth, Citigroup will do these transactions only for
clients that agree to provide the complete set of transaction
documents to their chief financial officer, their chief legal
officer, and their independent auditors. If there are any oral
assurances from the client in connection with any transaction
that Citigroup believes may give rise to accounting or
disclosure issues, these will also have to be written down and
those documents included with such transaction documents.
Fifth, key decisions, such as whether the policy requires
additional disclosures in a particular transaction, are made by
senior management from our accounting, legal, and risk
management control functions acting together. If the senior
managers of our control functions do not approve a proposed
transaction, then, very simply, that transaction will not go
forward. Any concerns about accounting or similar matters must
be fully resolved and must be written down, must be documented,
if a transaction is to go forward.
I am personally committed to making sure that our new
procedures are fully observed. In order to do that, we are
enhancing our decisionmaking process so that every step of
decisions are documented, and importantly, our internal audit
group will review and verify compliance with our procedures.
Promptly after we announced this new transparency policy,
we erected what amounted to a roadblock for each structured
finance and related transaction to see whether it was the kind
of transaction that would not be reflected as debt on a balance
sheet and should, therefore, be specially disclosed to the
company's investors. None of these transactions was permitted
to go forward unless it was submitted to a rigorous examination
process by a working group from our control functions. As we
move forward, we are continually adjusting and fine tuning this
process to allow for more efficient, but equally rigorous,
review.
We recognize, of course, that our execution will not be
perfect. We are feeling our way, seeing what works, and
discovering the challenges of applying a unilateral policy like
this to an enormous range of complex transactions. Leaders, by
definition, move in uncharted territory, and we will make some
mistakes.
But I am quite encouraged by what I have seen so far, by
the seriousness and intensity with which Citigroup
professionals are grappling with this new policy, from the
transactional people on the front lines to the most senior
managers of our company. It has already made a measurable
difference in the kinds of deals we are doing or declining to
do and in the nature of the disclosure that clients are making.
Mr. Chairman, the world has changed a lot in the past year
and is continuing to change. The collapse of Enron and the
turmoil that followed on Wall Street has done tremendous damage
to a great many people and businesses. We recognize that we
must take real steps to change our ways of doing business and
to get real results. We have done this and we are continuing to
do more. This is not a time for half measures or foot dragging
or public relations. We at Citigroup understand our role as a
leader, our responsibility in that regard, and we embrace the
mandate for change and subscribe to the goal of effective, far-
reaching reform.
We appreciate the seriousness and the vigor with which you
and the Subcommittee approach these issues, and we look forward
to working with you and your colleagues on these and other
reforms.
I thank you, sir, and I look forward to answering your
questions.
Senator Levin. Thank you so much, Mr. Prince. Mr. Bushnell.
TESTIMONY OF DAVID C. BUSHNELL,\1\ MANAGING DIRECTOR, GLOBAL
RISK MANAGEMENT, CITIGROUP/SALOMON SMITH BARNEY, NEW YORK, NEW
YORK
Mr. Bushnell. Thank you, Mr. Chairman and Members of the
Subcommittee, for the opportunity to speak with you today. My
name is David Bushnell. I am a Managing Director at Citicorp's
Global and Investment Bank, and I am the head of its Risk
Management Division.
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\1\ The prepared statement of Mr. Bushnell appears in the Appendix
on page 101.
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The Global Risk Management Division functions as an
independent control over our business units. It is the
responsibility of my division to ensure that risks, including
market risk, credit risk, and risk to the institution's
reputation, are identified, measured, and evaluated. No
extension of credit is permitted without risk management
approval in accordance with our established policies and
procedures. Positions that our traders take are subject to
limits established by risk management. The firm's Risk
Management Committee, including its Capital Markets Approval
Committee, report to me. I am also charged with communicating
and interpreting the risk views of senior-most management to
our business units.
I understand that the Subcommittee is interested in
discussing my role in the Sundance transaction. I look forward
to answering the Subcommittee's questions about that
transaction. But before I do, I would like to take this
opportunity to explain some of the very significant changes
that Citigroup is making in the way we handle such transactions
today.
As you know, on August 7, Citigroup announced a new policy
regarding transactions that raise significant accounting or
disclosure issues. As its chief risk manager, I have been
centrally involved in developing and implementing this policy.
You have just heard Mr. Prince's testimony that describes the
key elements of the policy and our implementation program.
The message that I want to convey to you is that this new
policy is having a real impact on the ground at Citigroup where
transactions are done. Every material structured or complex
financing of the sort this Subcommittee has been concerned with
is being subject to a rigorous review process. The Capital
Markets Approval Committee is thoroughly evaluating the
transparency of transactions and is working with our business
people to ensure that in any transaction we do, the client
discloses fairly and appropriately the net effect of that
transaction on the company's financial condition. If the client
will not commit to these kinds of disclosures, the answer is
simple: Citigroup will not execute the transaction.
In the months since August 7, we have reviewed dozens of
transactions and we are learning a great deal. This process is
helping us to develop a uniform approach to assessing, routing,
and where appropriate, approving and documenting transactions
consistent with the principles of our new policy, and the
policy has already had a real impact on the transactions we are
declining or we are agreeing to do.
One of the most significant objectives of the past few
months has been to embed in our culture an understanding of the
importance of this policy. I can tell you that our people are
taking it seriously, from the front lines of our business units
to our senior-most management. We are making this policy a
living, breathing part of the way we do business.
Thank you, and I look forward to answering your questions.
Senator Levin. Thank you, Mr. Bushnell. Mr. Caplan.
TESTIMONY OF RICHARD CAPLAN,\1\ MANAGING DIRECTOR AND CO-HEAD,
CREDIT DERIVATIVES GROUP, SALOMON SMITH BARNEY NORTH AMERICAN
CREDIT/CITIGROUP, NEW YORK, NEW YORK
Mr. Caplan. Thank you, Mr. Chairman and Members of the
Subcommittee. My name is Rick Caplan. I am a Managing Director
of Citigroup's Global Corporate and Investment Bank and Co-Head
of the North American Credit Derivatives Group. The Credit
Derivatives Group is one of several business units at Citigroup
that structures sophisticated financing for clients.
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\1\ The prepared statement of Mr. Caplan appears in the Appendix on
page 103.
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I have worked in the derivatives business at Citigroup
since 1997. I appreciate the opportunity to answer questions
about Project Bacchus and Project Sundance. While I want to
make clear that I understood these transactions to be
appropriate under the prevailing laws and standards, I also
want to reiterate the point that Mr. Prince made in his opening
remarks. Under Citigroup's new structured finance policies, we
will not do these transactions today unless the client agrees
to provide clear, detailed disclosure to investors.
Thank you, Mr. Chairman and Members of the Subcommittee. I
look forward to answering your questions.
Senator Levin. Thank you, Mr. Caplan. Mr. Fox.
TESTIMONY OF WILLIAM T. FOX III,\2\ MANAGING DIRECTOR, GLOBAL
POWER AND ENERGY GROUP, CITIBANK/CITI-GROUP, NEW YORK, NEW YORK
Mr. Fox. Thank you, Mr. Chairman and Members of the
Subcommittee. My name is William Fox. I have worked for
Citibank since 1967. I am currently a Managing Director in the
Global Relationship Bank and head of its Energy and Mining
Department. I have overall responsibility for Citibank's
relationship with clients in the energy and mining industries.
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\2\ The prepared statement of Mr. Fox appears in the Appendix on
page 104.
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I have been invited here today to discuss two transactions
that Citigroup executed for Enron, Project Bacchus and Project
Sundance. While I am generally familiar with Project Bacchus,
my familiarity with Project Sundance is more limited. I
understand the Subcommittee has several questions about these
transactions and Citibank's role in them. I look forward to
helping the Subcommittee in any way that I can to answer
questions about these transactions.
While we believe these transactions met applicable legal
standards, they are not transactions that Citigroup would
undertake today without clear and detailed disclosure from our
clients about the net effect of those transactions on a
company's financial statements.
Thank you, Mr. Chairman and Members of the Subcommittee. I
look forward to answering your questions.
Senator Levin. Thank you so much, Mr. Fox.
Let me summarize the joint venture which we are going to
start with called Fishtail and then ask my questions.
At the end of the year 2000, Enron wanted to show a sale of
the interest that it held in a joint venture called Fishtail.
They wanted to show that sale in order to generate cash flow
and earnings for its year-end financial statement, and Enron
contrived a sale of its interest to an entity called the Caymus
Trust for $200 million. The funding for Caymus was a $194
million loan from Citibank, which Enron in turn gave Citibank a
guarantee on. The other $6 million was listed as being an
equity investment by Fleet Boston which Citibank had
guaranteed.
Now, that $6 million had to be true equity for this to be a
real sale by Enron, and Citibank understood this. If the $6
million was a loan instead of true equity at risk, then this
could not be shown as a sale on Enron's books and the whole
purpose of the transaction would have been defeated.
But Citibank, on the other hand, wanted to reduce or
eliminate its risk on this so-called equity investment, and so
Citibank went to get an assurance from Enron's CFO, Andy
Fastow, to, in the words of a memo, Exhibit 322 in these
exhibits that are in front of you, this is Exhibit 322(c),\1\
Citi was looking to obtain the right comfort from Andy Fastow.
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\1\ Exhibit No. 322(c) appears in the Appendix on page 229.
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Mr. Fox, let me ask you these questions. You are the one
who met with Mr. Fastow to obtain this comfort for your bank.
At our staff interview, you indicated that Mr. Fastow said that
Enron would take whatever steps were necessary to make certain
that Citibank's equity interest in Bacchus would be bought out.
This was an important transaction for Enron, according to that
same Exhibit 322(c). On the second page, this transaction was
said to be ``mission critical'' by them and ``a must'' for
Enron, and the words that I have quoted were on page one of
that Exhibit 322(c) when it was said that Enron has offered to
have the CFO discuss this ``at whatever level of our
organization we think necessary to obtain the right comfort.''
That is comfort now for Citibank.
First of all, looking at that Exhibit 322--I am going to
change the 322 now to Exhibit 322(h),\2\ if you would take a
look at that. Exhibit 322(h) is a memo or e-mail from Lydia
Junek to you, Mr. Fox, and it says that, ``the equity
component,'' if you will look at page two at the top, that
``the equity component has been approved on the basis of verbal
support verified by Enron CFO Andy Fastow.'' So they were
promising you verbal support.
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\2\ Exhibit No. 322(h) appears in the Appendix on page 239.
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First of all, who is Lydia Junek, the woman who sent you
the e-mail?
Mr. Fox. Lydia Junek is a Managing Director in our Houston
office and she reports to me and did at that time, as well.
Senator Levin. So is it true, Mr. Fox, that Citi would not
have provided the equity for this transaction unless it had
this verbal support from Enron through Mr. Fastow?
Mr. Fox. Senator, this transaction was an interim bridge
financing that we were engaged in. Our firm typically does not
engage in bridge financings unless we are involved in the take-
out or providing the permanent financing. In this case, we were
not. So for this reason, I went and visited with Mr. Fastow
because he had control of the take-out of this transaction. He
was working with another institution. So we wanted comfort from
him that they were going to take all steps necessary in order
to ensure that the take-out financing was accomplished and our
entire transaction would be repaid within its terms.
Senator Levin. So he gave you this assurance that your so-
called investment would be repaid within that 6-month period?
Mr. Fox. He gave me the assurance that he would take all
steps necessary to make certain that the take-out financing was
accomplished and, therefore, the entire Bacchus transaction
would be repaid.
Senator Levin. Now, would you have reassessed your
participation in the deal had you not obtained that support?
Mr. Fox. I believe we would have. That assurance was
important to us. As I said, we were not involved in the take-
out of the financing of Bacchus, and typically our firm would
not be involved in a bridge financing that was dependent upon a
take-out unless we were involved in the take-out, and we were
not in this case.
Senator Levin. Now, if you take a look at the top line of
Exhibit 318,\1\ page three, it says the equity component that
we provide--this was supposed to be equity, not a loan,
supposed to be equity--will be based on verbal support
committed by Andrew Fastow to Bill Fox. It is a commitment now.
It says that the verbal support--and by the way, that verbal
support was referred to a number of times in the memo--but is
it not a fact, Mr. Fox, that the verbal support was an oral
guarantee from Mr. Fastow and Enron that your equity interest
would be returned to Citi one way or another?
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\1\ Exhibit No. 318 appears in the Appendix on page 219.
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Mr. Fox. Senator, no, I do not believe so. We did not view
it as an oral guarantee. It was verbal support and assurance to
us that he and Enron would take all steps necessary to ensure
the take-out financing, the permanent financing was
accomplished so that our entire transaction would, in fact, be
repaid within its terms.
Senator Levin. You did not consider the support, the oral
assurance, the commitment, to be a guarantee?
Mr. Fox. The oral assurance, we did not view that as a
guarantee. We viewed ourselves as being at risk for that $6
million component of the transaction.
Senator Levin. The bottom line is, you did not consider
that to be an oral guarantee?
Mr. Fox. We did not consider that to be an oral guarantee.
Senator Levin. Now take a look at Exhibit 366.\2\ This is a
Citibank credit approval document relating to Enron. It is
dated December 2000, the month of the Bacchus transaction. At
the top of page one, it lists Lydia Junek as the ``responsible
officer.'' On the second-to-the-last page, she has signed the
document. Citi's loan and so-called equity interest in the
Bacchus transaction is referred to, if you will look at pages
six and seven.
---------------------------------------------------------------------------
\2\ Exhibit No. 366 appears in the Appendix on page 655.
---------------------------------------------------------------------------
Now, the numbers are a little different, because at the
time the document was written, it was expected that Bacchus
would require a $242 million loan and $7.5 million in equity,
so that is the numbers that are in there, but these amounts are
the amounts that we are referring to here. They were reduced to
the $194 million loan and $6 million in equity, but this is the
same transaction, although the numbers were slightly reduced.
Now, on page seven of this document, under the word
``support'' in the middle of that page, it says, ``verbal
guarantees'' in capital letters. You said there were no verbal
guarantees. You didn't consider them verbal guarantees. The
lady who signed this document for the bank under your
supervision, in fact, said in this document these were ``verbal
guarantees'' in capital letters. Now, if they weren't
guarantees, why did she say they were verbal guarantees?
Mr. Fox. Senator, I would not--as I said, I was the one who
had the conversation with Mr. Fastow. I was the one that
understood exactly what he said. He did not give me a verbal
guarantee. I did not seek a verbal guarantee.
Senator Levin. Did you ever see this document that said
there were verbal guarantees?
Mr. Fox. I don't recall that I saw it. I may have. I
probably did.
Senator Levin. And Ms. Junek works under your supervision?
Mr. Fox. Yes, she does, Senator.
Senator Levin. But you are trying, then, to make the
distinction--you are trying to make a distinction that what you
got is a commitment, an assurance, that all steps necessary
would be taken to repay that money. How is that different from
a guarantee? All steps necessary means all steps necessary.
Mr. Fox. Senator, as I said before, what I obtained from
Mr. Fastow was his verbal assurance that they were going to
take all steps necessary to make certain the take-out financing
was done on a timely basis such that our entire transaction
would be repaid.
Senator Levin. How is that different from a verbal
guarantee? ``All steps necessary'' sounds to me like a
guarantee, and Ms. Junek was very straightforward under your
supervision in saying it.
Mr. Fox. Senator, this----
Senator Levin. How is ``all steps necessary'' different
from a guarantee?
Mr. Fox. This was not legally enforceable. It was a
businessman's understanding with the company. They had control
of the take-out, they and the other financial institution they
were involved in. We had no knowledge, not detailed knowledge
of what that take-out financing was going to be. So I was
relying on his verbal assurances that they were going to take
the steps and they had the wherewithal to take those steps to
make certain that the take-out financing was accomplished.
Senator Levin. You don't specifically remember seeing those
words, ``verbal guarantees,'' in that document?
Mr. Fox. I do not, Senator.
Senator Levin. You knew that Enron was going to book this
transaction as a sale, is that not correct?
Mr. Fox. That is correct.
Senator Levin. And you also knew that if Citibank did not
truly have a 3 percent equity at risk, that it would be
improper for Enron to book the transaction as a sale?
Mr. Fox. We understood that we had to be at risk for the 3
percent of the transaction.
Senator Levin. Well, it seems clear to me, Mr. Fox, that
Citibank was aware that 3 percent had to be at risk. You just
said so. You had to be assured that it would not be guaranteed
in order for this to be booked as a sale. But to protect
Citibank from loss, you went out and got a verbal assurance, a
commitment, a statement that all steps necessary would be taken
by Enron to pay you back. It was characterized properly by your
assistant as a verbal guarantee. You are not a lawyer, are you,
in terms of whether it is legally enforceable, or are you a
lawyer?
Mr. Fox. I am not a lawyer.
Senator Levin. Did you receive an opinion that this was not
legally enforceable?
Mr. Fox. We did not receive an opinion with respect to this
aspect of the transaction. As I said earlier, my view was I was
there. What I got was assurances from Mr. Fastow that the take-
out financing would be executed, and we would be paid out of
the entire transaction within its terms.
Senator Levin. It was clear that in doing this, you were
trying to protect yourself from loss, isn't that correct?
Mr. Fox. No, we understood we were at risk, but since we
were not involved in the take-out and this was a short-term
bridge financing, we wanted to make certain that that bridge
financing was going to be executed and we would be out of this
transaction within the terms.
Senator Levin. Isn't that the same way of saying that you
were trying to protect yourself from loss?
Mr. Fox. We clearly understood we were at risk.
Senator Levin. But weren't you trying to protect yourself
from any loss from the transaction?
Mr. Fox. We wanted to make certain that we were out of the
transaction on a timely basis, that is correct.
Senator Levin. And you were aware of the fact, I take it,
that if this assurance, commitment was a guarantee, that that
would queer the deal, is that correct?
Mr. Fox. If we had obtained a guarantee, we understood that
they could not achieve their accounting objective.
Senator Levin. And that would queer the deal? The
transaction would not have occurred, is that correct?
Mr. Fox. I don't know what Enron would have done at the
time, but we certainly knew that for them to achieve their
objective, accounting objective, we had to be at risk on the $6
million.
Senator Levin. Their financial statement, in showing this
totally as a sale, with a sale of equity, not showing any
guarantee, not showing any assurance to anybody, but just
simply showing it as a sale, was clearly deceptive. You are not
going to reach a judgment on the Enron books, I assume, or are
you?
Mr. Fox. No, Senator, I am not.
Senator Levin. Others will and others have. It was clearly
deceptive. By not showing on its books that oral guarantee that
it made, in the words of Ms. Junek, it deceived the people who
were reviewing its books, and you can split hairs and say that
assurance, using all efforts, taking all the necessary steps,
commitments, doesn't constitute a guarantee, but it is, one,
hair splitting, and two, inconsistent with your own document
which says, in fact, it was an oral guarantee.
My final question to you is, under your current standards
that Citibank has adopted, would this transaction occur?
Mr. Fox. Senator, no, it would not occur under our current
standards without complete and full disclosure of the net
effect of the transaction on Enron's financial statements.
Senator Levin. Well, now, would it occur knowing what you
know?
Mr. Fox. We would have not done the transaction unless they
fully disclosed all aspects of the transaction and the net
effect of it on their financial statements.
Senator Levin. And had they done that in this case, based
on what you know, would this transaction have taken place?
Mr. Fox. Senator, I don't know what they would have done at
the time, but----
Senator Levin. What would you do, knowing what you know?
Mr. Fox. We would have gone to Enron and asked them, under
our new standards, to have the complete, total disclosure of
the net effect of the transaction. We would have had to make
certain that their chief financial officer, general counsel
were aware of the transaction, all aspects of it, not only the
written documents, but also any oral understandings.
Senator Levin. What is the net effect of this transaction
on Enron? Was it in net effect a loan or net effect a sale?
Mr. Fox. They booked----
Senator Levin. No, I know what they booked, but you are
going to look at the net effect, right?
Mr. Fox. Right.
Senator Levin. Under your new standards.
Mr. Fox. Yes. We would look at the net effect.
Senator Levin. In your judgment, what was the net effect of
this transaction on Enron, a sale or a loan?
Mr. Fox. I think we would have required them to disclose
the conversation with me. We would have required them to
disclose all aspects of the transaction and the net impact on
its financial statements. At that stage, I would assume they
and their accountants would review the transaction with their
legal people and determine how it would be booked. I am not in
a position to determine how they would have booked it. I can
only suggest and require them to have full and complete net
effect exposure--disclosure.
Senator Levin. I am not sure, Mr. Prince, what your new
standards really mean if all you are going to say is if Enron
discloses this on their books, it is OK with you, when it is so
obvious, it seems to me, to anybody that when you give a
guarantee, as they gave to you, that they would take all
necessary steps to make sure that was repaid and that they gave
assurances to that. If you can possibly then say, well, we
would proceed the same way we did before providing they said
that, I am not sure what your new standards really mean.
Mr. Prince. Well, Senator, you have highlighted two key
differences between what happened then and what would happen
now. The first is that these oral assurances would be written
down and would be included in the transaction documents that
are forwarded to the chief financial officer, the chief legal
officer, and the outside auditors, so everyone would have the
same base of information.
And second, the net effect rule would require that the net
effect of the transaction, as I mentioned in my opening
statement, on the assets, the liabilities, the balance sheet,
the income statement, the net effect of all of the complicated
moving around of assets would have to be disclosed.
I think those are two very important differences between
what happened then and what happened now.
Senator Levin. And if they decided the net effect was a
sale, that is OK with you?
Mr. Prince. Well, Senator, it is not just a word, and it is
not just a sentence. They wouldn't disclose the net effect was
a sale.
Senator Levin. Pardon.
Mr. Prince. They would not, sir. They would not simply
disclose a conclusory sentence that this was a sale or not a
sale. As part of a sale, if it were a sale under the
complicated accounting rules, they would have to disclose the
net effect of that sale on their balance sheet, on their income
statement.
Senator Levin. And my question to you is, based on your
study of this record and your judgment, would you conclude and
agree that the net effect of this transaction was a sale?
Mr. Prince. Senator----
Senator Levin. If they concluded that, would you accept
their conclusion?
Mr. Prince. Senator, again, I am trying to answer your
question. It is more than the word ``sale.'' The net effect of
the transaction, what happens to the balance sheet, what
happens to the income statement is what our rule calls for, not
the word ``sale'' or not sale.
Senator Levin. The net effect on the Enron financial
statement was $112 million in earnings from that transaction,
but you cannot tell us today, based on all of these documents,
that if they concluded again that that was a sale, that you
would not proceed with that transaction, based on what you
know?
Mr. Prince. Senator, I----
Senator Levin. You know all the underlying facts. You can
say it is not just the conclusion. I agree with you. You are
going to look at the underlying facts and conclude whether or
not it is a fair judgment that this is a sale. Otherwise, you
said, it seems to me that you are not going to proceed. My
question to you is, based on all these underlying facts which
have been laid out in front of you, would you proceed if Enron
again in this kind of a situation said, or Enron said in this
kind of a situation that this was a sale? Would you proceed?
Mr. Prince. Senator, if I understand your question
correctly, if you are asking me, would I make the judgment that
this was a sale or not a sale based on these various facts, I
can't make that decision sitting here today. I would want to
consult with my control people. I would want to have a much
more rigorous review than the detail we have had here this
morning.
Senator Levin. Mr. Fox, you told the Subcommittee staff
that Citi had a business policy that it would not engage in
structural transactions that had a material impact on reported
net income. That was the business policy that you had, and that
Citi would look further at the project and assure itself that
the project would not impact reported net income. That was your
policy in place at the time.
Yet, throughout the Bacchus transaction, you were notified
that there was a possibility that Enron would use the
transaction to report net income in its year 2000 financial
statement. Exhibit 322(a) \1\ is an e-mail to you and it states
the following: ``Enron's motivation in the deal now appears to
be writing up the asset in question from a basis of about $100
million to as high as $250 million, thereby creating
earnings.''
---------------------------------------------------------------------------
\1\ Exhibit No. 322(a) appears in the Appendix on page 226.
---------------------------------------------------------------------------
Exhibit 322(c) \2\ is a November 28 e-mail which states,
``According to Enron, it is possible that there will be funds
flow and/or earnings impacts. Although not certain at this
time, we should assume that there will be funds flow from
operations/earnings implications.'' That is what you said you
were going to assume.
---------------------------------------------------------------------------
\2\ Exhibit No. 322(c) appears in the Appendix on page 229.
---------------------------------------------------------------------------
Finally, on December 6, there is an e-mail, Exhibit 322(d),
\3\ which states, ``It is probable that the monetization will
add to funds flow from operations as a portion of the assets
will be from merchant pool. It is possible but not certain that
there will be earnings impact.'' That was the last
communication on the matter.
---------------------------------------------------------------------------
\3\ Exhibit No. 322(d) appears in the Appendix on page 232.
---------------------------------------------------------------------------
Now, did the Citibank policy then require further
investigation at that time, since there was the possibility of
an earnings impact which your policy would not permit?
Mr. Fox. Senator, the series of e-mails you referred to,
starting with the first one, certainly highlighted the
potential of an earnings impact. We went back to the company.
We went back to the treasurer of the company, who confirmed to
us that there would not be significant material earnings
impact.
I was shocked when I learned from your staff, which was the
first time I knew about it, that the impact of this transaction
created $112 million of earnings. Quite frankly, Senator, in
this particular case, we were lied to. We relied on Enron, who
was the only one that could determine the impact of a
transaction as to what the earnings impact would be.
Senator Levin. So that you specifically contacted Enron
after your decision that there could be an earnings impact to
see whether there would be and they told you there would not
be?
Mr. Fox. I did not specifically contact them.
Senator Levin. Who did?
Mr. Fox. Jim Reilly, who is a Managing Director of our
firm. If you go further into that last e-mail you made
reference to, he reports that Enron has suggested, however,
that because of their ongoing involvement in the business, it
is unlikely there will be any material earnings benefit.
Senator Levin. And you accepted that without further
investigation?
Mr. Fox. We relied on Enron's word. They were a highly
respected company. They were a company we had a good
relationship with at the time and that is something we would
have relied on, yes, Senator.
Senator Levin. And their word was ``unlikely''?
Mr. Fox. Their word, it was unlikely that there will be any
material--I don't know what their word was. That was Mr.
Reilly's word.
Senator Levin. But that was not enough, the fact that it
was unlikely, still possible, investigation as your policy it
seemed to me required you to do to assure yourself that there
would not be an earnings impact.
Mr. Fox. I believe that this would have sufficiently
satisfied ourselves at the time.
Senator Levin. You were not aware yourself of the
conclusion?
Mr. Fox. I was not aware. I did not have the conversations
directly with the company, no, Senator.
Senator Levin. You had earlier, in Exhibit 322(g),\1\ in a
memo, you were aware of the fact that this highly reliable
company, one of the largest in the country, significantly
dresses up its balance sheets at year end. You were very much
aware of Enron being someone who liked to and was willing to
and typically did dress up their balance sheets, because you
wrote in that memo that is at Exhibit 322(g) that, ``based on
1999 numbers, it would appear that Enron significantly dresses
up its balance sheet for the year end. Suspect we can expect
the same this year.''
---------------------------------------------------------------------------
\1\ Exhibit No. 322(g) appears in the Appendix on page 237.
---------------------------------------------------------------------------
So you were expecting a dressing up, disguise, costume by
Enron at the end of the year 2000. You had received strong
suggestions from other Citi relationship managers that it was
possible that Citi would claim earnings from the Bacchus
transaction. You were told only apparently--you are supposed to
be in a position here of some decisionmaking import--you were
told that it was--you just took Enron's word that it was
unlikely that there would be an earnings impact. Of course, if
there was an earnings impact, that violated your policy. But
knowing that this company put on a show at the end of its year,
you nonetheless, or your bank nonetheless simply accepted their
statement that it was likely that there would not be an
earnings impact. How can you explain that?
Mr. Fox. Let me comment and address that, Senator. My
reference to dressing up the balance sheet is a slang reference
that a number of companies will take certain steps at various
points in their financial cycle to address balance sheet
targets. They can stretch out payables to generate cash. They
can monetize or securitize receivables to generate cash and pay
down debt. They can borrow under their bank facilities and pay
down short-term commercial paper. Many steps that large
financial--I mean, large Fortune 500 companies take to impact
their balance sheet.
The context here was that I was looking at their September
1999 financial statements, reviewed them, and if I recall
correctly, the debt-to-capital ratio appeared higher than it
would at year end and that seemed to indicate to me that they
would take certain steps as it impacts their balance sheet.
That was a balance sheet comment and statement. It was not
related to the income.
Remember, at the time, Enron was an important relationship.
Enron was a highly respected company. We had no reason to
suspect or believe that we could not trust and accept their
word.
Senator Levin. Do you recall telling the Subcommittee staff
that this unlikely earnings impact conclusion was an
insufficient resolution as far as you were concerned of Citi's
policy? Do you recall telling the staff that?
Mr. Fox. No, I don't, Senator.
Senator Levin. All right. Let me ask you, Mr. Prince, under
your current policy, would this be a sufficient resolution?
Mr. Prince. Indeed not, Senator.
Senator Levin. This is my final question and then we will
turn it over to Senator Collins, for this round, at least. Mr.
Prince, let me first say that we all are hopeful that
Citigroup's apparent willingness to change its practice will
lead to the kind of results that you hope for and expressed in
your opening statement, and I just want to ask you some
questions about your new policy.
Your new net effect rule is described as follows: Citigroup
would execute material financing transactions for companies
that were not going to be recorded as debt on their balance
sheet if and only if, as you stated, the company agreed to
disclose the net effect of the transaction on its financial
condition.
The first problem that I have with this policy, or
question, is that it states that Citigroup will continue to
provide financing in cases where it knows the company isn't
going to record the debt on its balance sheet. Doesn't that
mean that Citigroup still thinks it is OK to sell loans that
aren't honestly reported as loans?
Mr. Prince. No, Senator, it does not mean that. There are
many things that are appropriately not recorded as debt on a
balance sheet. The key for us is that even if they are
appropriately not recorded as debt on a balance sheet, the
effect of the transaction must be disclosed. It doesn't matter
anymore whether you do just this much or just that much and you
satisfy this little rule or that little rule and suddenly it
shifts from one shoebox to another shoebox, or one pigeon hole
to another pigeon hole. You are not done at that point. Even if
you satisfy a test and it goes to the next category on the
balance sheet, the effect of the transaction, separate from the
accounting conclusion on the classification, has to be
disclosed. That is the difference.
Senator Levin. Are you going to make a judgment as to the
fairness of the conclusion relative to net effect, or are you
just going to accept the conclusion of the other company, of
your client?
Mr. Prince. Senator, I think one of the things that we have
learned is that we have to make our own judgments in that
regard.
Senator Levin. Because Enron could argue, for instance, in
those prepays that we made reference to and you are aware of
from an earlier hearing, they did disclose the net effect of
the transactions because it included the energy trades in its
year 2000 financial statements. It recorded $4 billion worth of
cash flow from operations, but no debt. Since Enron included
the energy trades in its financial statements as cash flow from
operations, would that meet your disclosure requirement, or
would you look behind that and make sure that it is a fair and
accurate disclosure?
Mr. Prince. Senator, I think it is clearly the second. We
would require that the effect of the transaction be disclosed.
So we would require them to disclose it in a way where anyone
could understand.
One of the problems that we all face is that these matters
are way too complex and getting to a simple decision shouldn't
lead to opaqueness, shouldn't lead to, well, now that we have
got the answer from an accounting standpoint, the effect of the
transaction that goes one way or the other. Despite the
accounting conclusion, the effect of the transaction has to be
disclosed.
Senator Levin. If I understand what you said a moment ago,
not just disclosed, but that you would reach an independent
judgment that the disclosure was a fair statement of the facts.
Mr. Prince. Yes, sir. We would have to be comfortable
ourselves with that disclosure.
Senator Levin. And one last point. In Sundance, three
senior Citigroup officials recognized the accounting problems
with Sundance and said, don't do it. Citigroup did it anyway.
What is the solution there? If there is no agreement among your
top officials, will there be a requirement that whoever
approves that at a higher level is going to have to put a stamp
of approval on it?
Mr. Prince. Senator, as I said in my opening statement, one
of the key differences we have now is that every part of the
process has to be documented. We have to be able to pull out a
paper to put in this notebook which will say who finally and
formally signed off and why they signed off once an issue has
been raised.
Senator Levin. Senator Collins.
Senator Collins. Thank you, Mr. Chairman.
Mr. Prince, I do recognize the steps that you have taken
since our last hearings to put additional safeguards in place
and I don't minimize those actions. I think they do represent
progress. But in looking at the documents involved in these
transactions, I find it very difficult to understand how these
transactions were approved under your old procedures. There
were warning flags galore, and I want to read you some of the
comments by Citigroup's own employees, who it seems to me kept
trying to raise red flags, kept trying to bring concerns to the
attention of senior management.
In one e-mail, for example, an Alan McDonald says, ``We,
Bill Fox and I, share risk's view and if anything feel more
strongly that the suitability issues and related risks, when
coupled with returns, make it unattractive. It would also be an
unfortunate precedent if both GRB management relationship and
risk's views were ignored.''
Another e-mail describes one of these transaction as ``a
funky deal accounting-wise,'' and characterizes another
Citigroup employee's view as being ``amazed that they can get
it off the balance sheet.''
Yet another e-mail, which Senator Levin has referred to,
``based on 1999 numbers would appear that Enron significantly
dresses up its balance sheet for year end; suspect we can
expect the same this year.''
Yet another from a memo, the ``accounting is aggressive and
a franchise risk to us if there is publicity.''
Yet another e-mail, this one from Rick Caplan, ``Sounds
like we've made a lot of exceptions to our standard policies.
I'm sure we've gone out of our way to let them know that we are
bending over backwards for them. Let's remember to collect this
IOU when it really counts.''
How did this happen? Why would these transactions all be
approved when you have Citigroup employees raising so many red
flags, describing the accounting as ``funky,'' saying that they
don't understand how this achieves Enron's objectives of
getting off-the-books treatment for these transactions, saying
that a lot of exceptions were made to standard policies? How
could this have happened under your old procedures?
Mr. Prince. Senator, I will tell you honestly, I have done
a lot of soul searching about that. As the new CEO of this
business, I am responsible for it now and I am responsible for
what happens going ahead and I have to make sure that problems
can't arise under my leadership of the business, and so I have
thought a lot about how this could have happened when the
issues that you have identified were raised.
I think, honestly, that our people did spot some of those
issues, did raise them. You have quoted the various documents.
And I think that in hindsight, our people were too comfortable
with the ability to rely on the outside auditors, on the law
firms that structured and closed these transactions, and on the
representations from Enron themselves. I think that at that
time we did not view ourselves as being responsible for what
Enron did with its own books and I think we have learned a very
painful lesson in that regard.
Senator Collins. But it wasn't as if the representations by
Enron or Andersen or the legal team that Enron used didn't
raise questions.
Mr. Prince. That is correct, Senator.
Senator Collins. And that is the part that is troubling.
There are some cases where there was outright deception in the
information and data that were provided to you. But in other
cases, the information provided to Citigroup raised red flags
and yet the transactions went through.
Mr. Prince. And indeed, Senator, I think some of the
language reflects our mental state at that time. The one you
quoted that said we are surprised they can get it off their
balance sheet, it is obvious that we are observing their
decision process. We didn't view ourselves as a participant in
that decision process. We were watching it. We were relying on
what they told us. We were relying on what Arthur Andersen said
was OK or not from an accounting standpoint. We have learned a
painful lesson that we can't be a bystander and just watch that
process.
Senator Collins. Mr. Prince, how much was this driven by
the fact that there was the lure of big fees? I come back to
this e-mail, and it is Exhibit 322(i),\1\ where it says,
``Sounds like we made a lot of exceptions to our standard
policies. I'm sure we've gone out of our way to let them know
that we're bending over backwards for them. Let's remember to
collect this IOU when it really counts.'' What does that mean
to you?
---------------------------------------------------------------------------
\1\ Exhibit No. 322(i) appears in the Appendix on page 242.
---------------------------------------------------------------------------
Mr. Prince. Well, Senator, as you know, I was not managing
this business and I wasn't intimately involved in these
transactions, but in being briefed on these transactions, my
understanding is that the exceptions to our policies involved
things like choice of law, whether it is Texas law or New York
law, things like that.
But the short answer is, I can't put myself in the minds of
the people who did these transactions. I don't believe that in
a company like ours, an individual transaction would drive
people to do bad things. Based on what I know, I believe that
our people, acting under the rules as they understood them to
be and with the clear mental state that I mentioned a moment
ago about relying on others, that they acted in good faith.
That is my belief. If I did not believe that, the people would
not still be with the company. But I believe they did act in
good faith under the rules as they understood them at the time,
and I don't think that fees, whether on this transaction or
others, corrupted our organization.
Senator Collins. Mr. Fox, I want to follow up on your
discussion with Senator Levin, which still leaves many
questions in my mind. You traveled to Houston and met with
Andrew Fastow, Enron's CFO at the time, because you wanted to
discuss the verbal support or the support for Citigroup's
investment in the Bacchus transaction, is that correct?
Mr. Fox. Yes. I traveled to Houston to meet with Mr. Fastow
to discuss the entire transaction and obtain his assurances
that they were going to take the necessary steps to make
certain that the take-out or permanent financing was put in
place and that we would be repaid.
Senator Collins. Yet in your testimony today in response to
questions from Senator Levin, you indicated that it was never
your understanding that Mr. Fastow provided you with any kind
of guarantee, is that correct?
Mr. Fox. That is correct. He did not provide me with any
guarantee.
Senator Collins. And you also testified, and this is
obviously the critical point, that you considered Citigroup's
investment to be at risk, is that correct?
Mr. Fox. That is correct.
Senator Collins. OK. Now, the reason I am having
difficulties understanding that is a document that is the loan
approval memorandum, which is Exhibit 318,\1\ where over and
over again, in fact, I think four times in the document, there
is reference to the verbal support, the verbal commitment that
you received from Mr. Fastow.
---------------------------------------------------------------------------
\1\ Exhibit No. 318 appears in the Appendix on page 219.
---------------------------------------------------------------------------
For example, there is a sentence on page two of the
memorandum in the first paragraph that says, ``From our
perspective, the equity portion of the facility will be at risk
and there is consequently a large element of trust and
relationship rationale involved. However, this equity risk is
largely mitigated by verbal support received from Enron
Corporation as per its CFO.'' That is obviously referring to
the conversation that you had with the CFO, is it not?
Mr. Fox. Yes, it is.
Senator Collins. Again in the memorandum, on page three,
there is a statement saying, ``Enron's CFO has given his verbal
commitment to Bill Fox that Enron Corporation will support the
3 percent equity piece of this transaction.'' At the top of
that page, again, ``The equity component we provide will be
based on verbal support as committed by Andrew Fastow to Bill
Fox.'' It says over and over again in this document, which is
the loan approval memorandum, that you had a verbal commitment.
So I am trying to understand how you could view the funds as
being truly at risk given the verbal support of the investment
that you received from Enron.
Mr. Fox. Senator, what we are doing here, I believe, in
this document is trying to highlight to all that were involved
in the transaction and approving it that a portion of the
transaction was at risk as equity based solely on verbal
support. It did not have a legal obligation from Enron. It did
not have the faith and full faith and credit from Enron. It was
simply that Enron through Mr. Fastow was going to make certain
that the take-out transaction was going to be accomplished.
Senator Collins. What did the verbal support mean and why
was it so important that it appears four times in the loan
approval memorandum?
Mr. Fox. We, I believe I would say, we were trying to
highlight the risk for all the approvers, that this was not a
legal obligation by any stretch of Enron to pay us back the $6
million. It was verbal support. We were at risk, but we were
dependent on them to make certain that the take-out financing,
the permanent financing, was going to be accomplished.
Senator Collins. I have to tell you that I read it exactly
the opposite. If it was important enough for you to go and meet
with Andrew Fastow to get that commitment, and if it appears
four times in the approval memorandum, and when there is
actually a statement in this memorandum saying that the equity
risk is largely mitigated by the verbal support received from
Enron, how can you continue to maintain that this commitment
really had no meaning?
Mr. Fox. I think that is just the point, Senator. It was
mitigated, not eliminated. We had that risk, and I think that
is what we were highlighting to everyone, so that everyone in
our firm who was approving the transaction understood that this
was an incremental risk we were undertaking.
Senator Collins. On Exhibit 366,\1\ the phrase is used that
it is a verbal guarantee and the percentage is 100 percent.
What does that mean.
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\1\ Exhibit No. 366 appears in the Appendix on page 655.
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Mr. Fox. Senator, I am sorry. Where are you exactly in the
exhibit?
Senator Collins. It is Exhibit 366. It is under ``Support''
typed to the left. It says, ``verbal guarantees,'' ``Enron
Corporation,'' ``percentage: 100.''
Mr. Fox. Yes, I am sorry.
Senator Collins. Doesn't the word ``guarantee'' mean
something?
Mr. Fox. Senator, I don't know who completed that form, and
it is a form that gets completed, but that was not what I
obtained from Mr. Fastow, and I think what I obtained from Mr.
Fastow was generally well articulated in some of the other
written documentation. I obtained from him his verbal assurance
that they would take all necessary steps to make certain that
the take-out financing was accomplished and our entire
financing, not just the equity piece but also the debt piece,
would be repaid.
Senator Collins. So are you saying that the word
``guarantee'' should not have been used on this document?
Mr. Fox. That was not an accurate representation of my
conversation with Mr. Fastow.
Mr. Caplan. Senator, could I make one clarification, just
looking at this for the first time?
Senator Collins. Yes.
Mr. Caplan. I am not certain that what Mr. Fox is
inconsistent with--what he is saying is inconsistent with what
this says, because if you note that this section of this memo
is about the term loan, the $194 million term loan that we were
providing as a bridge, and I think you could very easily
conclude that the verbal guarantee is that Enron is going to
work hard and get that take-out done at the termination of this
loan. This doesn't actually refer to the equity at all. It
seems just to refer to the term loan.
Senator Collins. Let me ask one final question.
Senator Levin. If you would yield to me on that point----
Senator Collins. Absolutely.
Senator Levin [continuing]. Because you are inaccurate.
Take a look at the prior page at the bottom. That is the term
loan.
Mr. Caplan. Well, it says in the middle of the page,
``Facility description, term loan,'' and then----
Senator Levin. I understand. I know exactly what you are
saying. I am saying that the larger loan, the $242 million,
which was then reduced, as I indicated in my opening statement,
is on the previous page, and that is page six. This is, without
any doubt, referring to the equity, which was listed as $7.5
million, but, in fact, as I indicated, was reduced to $6
million. But there is no doubt that this is the equity portion,
so-called equity portion, called a term loan, by the way, in
this document. I just want to--stated to be verbal guarantees,
not just mitigated, 100 percent--but the point here is that you
are wrong when you----
Mr. Caplan. I would agree.
Senator Levin. OK.
Mr. Caplan. But I think, though, if I might, I think this
is the beauty of our new policy, because whether we called this
thing--whether this thing turns out to be a sale or a loan, the
effect of whatever the intent behind the transaction would be
disclosed in the financials. We would require disclosure of
that in the finances of the company. I think that is really the
difference we are trying to articulate here today.
Senator Collins. One final question, because my time has
expired. Mr. Fox, had you not received the oral commitment,
whether we are calling it a verbal guarantee or an oral
commitment, from Enron, would you have proceeded with this
transaction?
Mr. Fox. Senator, today, I am not certain I can tell you
one way or the other. If we had not received it, it would have
certainly been a different risk, as the memo highlighted. The
verbal support mitigated some of that risk. Without that, as I
said earlier, it is unusual for us to engage in a bridge
financing where we are not in control or involved in the take-
out. So I can't say for certain today whether we would or would
not have gone forward without it, but it clearly was important
to us.
Senator Levin. Thank you. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
Coming to this de novo, without the kind of research that
both my Chairman and Ranking Member have done, I have a
slightly different reaction. I think the first documents that
refer to mitigation on the basis of verbal support pass the
smell test. The second document clearly does not, the one that
says verbal guarantee, 100 percent, and I think that is a
bureaucratic slip-up that the people who had the conversation
with Fastow--you, Mr. Fox--clearly understood you were at risk,
and your first document makes it clear. We are at risk.
Now, anybody on an approval basis reading that document
says, well, what do we have to deal with the risk, and your
answer is, I have had a conversation with Fastow and he says he
is going to take it out. That is not legally binding, it is not
something we can go to the bank with, but we are satisfied that
they will make good on it and that mitigates the risk. I think
that document passes the smell test.
But as it got handled by the sausage machine down to the
final drafting of the final loan document, that reference of a
mitigation got turned into something more than a mitigation and
it came out as a 100 percent guarantee and I think that is
something you ought to look at in terms of the way documents
get drafted within large bureaucracies. I am not surprised by
it. I am not horrified by it. It happens all the time.
But I think it is a clear message to you that when a deal
is made at your level, Mr. Fox, it gets documented to the point
that when it finally comes out in the final document that is
done by an employee who is used to doing hundreds, if not
thousands, of these in a very routine way, that the significant
deal you made still retains its flavor when it comes out in the
final wash. That is how I read what happened here. Now, if you
want to challenge that and say, no, that is not where it is,
looking at it strictly, as I say, de novo, that is what I see
what happened here.
So just to nail it down one last time, Mr. Fox, you were
convinced, regardless of what the documents said, that Citibank
really was at risk here?
Mr. Fox. Yes, Senator, I was.
Senator Bennett. And you were satisfied that it was a risk
Citibank could afford to take because Andy Fastow had told you,
``We are going to be able to meet our obligation''?
Mr. Fox. That is correct, Senator.
Senator Bennett. OK. If that is all the farther it went, I
think that is a legitimate position for you to have. The
difficulty comes from what Enron did with this, and as Senator
Collins said, you understood what they were doing with this was
really, to use the catch-all term, very aggressive. ``Very
aggressive'' usually means getting close to the edge of
something that is improper.
Now, Mr. Prince outlines the actions that Citibank is going
to take, and this is what I really want to focus on, rather
than the details of this particular situation. We are talking
about a new role for banks. In the old world, banks did not
view as their role--I interrupt myself here. Let me lay it out
as I see it and then you agree or disagree.
In the old world, banks did not view their role as being
watchdogs of investors and borrowers. Banks viewed their role
as being watchdogs for the investors in the bank. So as long as
the bank was satisfied that it would get its money back, it
really didn't care what the borrowers did with the money.
Now we are saying the bank should have been part of the
watchdog team that would blow the whistle and say, these guys
are borrowing the money and they are going to do squirrelly
things with it on their balance sheet, and unless they disclose
the real effect on their balance sheet of taking on this loan,
we are not going to give them the loan. Is that a fair
characterization of the switch in the role of the bank that has
occurred as a result of the Enron collapse?
Mr. Bushnell. Mr. Bennett, perhaps I could take that one.
Yes, I think that is a fair characterization of the new policy
and the switch from where we were and the policies and
independencies that we used to have versus the procedure going
forward.
Senator Bennett. It does represent a fairly significant
change in policy, because up until now, we, the Federal
Government, have assumed that the role of gaining transparency
in financial statements is primarily, if not exclusively, the
SEC, and as long as the SEC does its job, the banks don't have
to worry about it. They can just make the loan as long as they
are sure their shareholders will be taken care of and leave it
up to the SEC to make sure the borrowers do the right thing
with the money. Now we are saying, no, in addition to the SEC,
the banks must play a role in disclosure to the shareholders of
the borrower.
Mr. Bushnell. I think that is right, Senator. I think our
feeling is that, as Mr. Prince discussed in his opening
remarks, this has been such a painful process for us, even if
our depositors weren't hurt or the bank got its money back in
this case, which it did, it has clearly been a damage to the
financial system, to the trust in the development and
establishment of the smooth flowing of our capital markets, and
that in our own self-interest, if you will, we need to make
that trust come back and be a party to it.
Senator Bennett. This raises a number of very interesting
possibilities. If the bank does assume a role and, therefore, a
responsibility for the accuracy of financial statements on the
part of the borrower, can the bank be sued if the borrower
misstates the use of the funds it obtains from the bank?
Mr. Bushnell. I understand that, Senator. I don't think we
are looking to take on the legal responsibility or the
accounting responsibility for this. We do think that there are
regulatory agencies and that is others' jobs. We just think
that when there are questions like this, the best policy as a
risk manager, transparency, shedding the light on what the
transaction is in plain English so that everybody can
understand what happened, is the best policy for us.
Senator Bennett. I think that is a very important point for
you to make because I don't think you want to expose yourselves
to lawsuits on the basis that you did not adequately require
transparency on the part of the borrower. I think you want to
keep the wall there that the lawsuits can go to the accounting
firm that didn't adequately provide disclosure or require
disclosure. The lawsuits obviously can go to the borrower
themselves if they lied, as Enron clearly did. But that the
lawsuits can't go to the deep pockets of a bank who, in their
requirements for disclosure, fell short of the kinds of
requirements.
You want to make it clear, I think, that in the policies
you are adopting, you are adopting these policies to protect
the safety and soundness of the banks and the investment in the
banks of the banks' shareholders. I think the case can be made
that the kind of disclosures Mr. Prince has described here do,
in fact, reduce the risk to shareholders of the bank, and by
making these requirements on the part of the borrower, you are
saying that the bank will ultimately have fewer bad debts and
fewer write-offs.
Let me ask the question that has not been answered here.
Did you lose the $6 million? It was at risk. Did you lose it?
Mr. Fox. No, Senator. The permanent financing was executed
and the entire Bacchus financing was repaid.
Senator Bennett. OK. Are there any other of the
transactions we will be discussing here this morning where the
bank had money at risk which you lost?
Mr. Fox. Not in the transactions that we are discussing
here today.
Senator Bennett. OK. So the changes that Mr. Prince has
talked about, if they had been in place, would not have changed
the losses sustained by the bank. In other words, these changes
would not have retrospectively benefitted the shareholders of
the bank.
Mr. Fox. I think they may have benefitted the shareholders
because we wouldn't have been associated with these
transactions, but----
Senator Bennett. That is fair, yes. They would have
affected the shareholders in that they protect the reputation
of the bank and the reputation of the bank is obviously
something that is of value to the shareholders. So I will
accept that, even if there was not a specific monetary loss.
Mr. Fox. That is correct, but we did not lose money on
these transactions. They were repaid within--to us.
Senator Bennett. That is my point, Mr. Chairman, and I will
stop there. I think the things we have heard from Mr. Prince
are salutary and we should congratulate Citibank on its
willingness to move forward.
I think it should be pursued, but I think everybody should
be a little careful about crossing the line and putting a
liability on the bank, any bank, if they fail to do these kind
of things, because traditionally, regulation of disclosure and
achieving of transparency is something that should be
accomplished by the SEC and by the independent accountants who
are paid handsomely to make sure that there is transparency and
that it should not be ultimately spilled over into a lender so
that a lender could be liable for making a loan where the
disclosure requirements of the lender were deemed to not be
sufficient to protect the interests of the shareholders and the
investor. That strikes me as very dangerous ground that would
open the door for a huge number of lawsuits, to the detriment
of everybody, if we are not very careful.
Thank you, Mr. Chairman.
Senator Levin. Thank you, Senator Bennett.
What we are looking into is, in addition to the changes
which Citibank is indicating it is making in the way its
procedures operate, we are also looking at what it didn't do
relative to the procedures that it had in place on these
transactions. This is not just saying in hindsight that we have
reached a conclusion. It is saying that the investigation
discloses that at the time these transactions were
inappropriate, that they aided and abetted deception, that
there were major concerns raised internally that were
overridden, set aside in order to please Enron or to make a
fee.
This isn't just a question of hindsight or under current
rules these transactions wouldn't be approved. There were rules
at the time about not aiding and abetting deceptive
transactions. That is not a new rule for a bank. That is an old
rule.
There is an old accounting requirement that was in
existence at the time that says there is no room for accounting
representations that subordinate substance to form, and you
cannot aid and abet a violation of that rule.
So that is our major concern here, it is the way in which
major institutions facilitated deceptive accounting and bent
the rules or violated the rules that existed at the time.
Senator Collins has made reference to this Exhibit 322(i),\1\
which says, ``it sounds like we made a lot of exceptions to our
standard policy.'' Those are policies that existed at the time.
Those aren't new policies. ``I am sure we have gone out of our
way to let them know that we are bending over backwards for
them,'' for Enron. ``Let's remember to collect this IOU when it
really counts. Happy holidays to all.''
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\1\ Exhibit No. 322(i) appears in the Appendix on page 242.
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Let us move to Sundance. A few months after Bacchus, Enron
decided to create Sundance as a joint venture that would keep
all of Enron's pulp and paper assets off its balance sheet.
And, as I discussed in my opening statement, the joint venture
was a sham because Citi really didn't have any investment at
stake, and here are the facts.
Citibank's $28.5 million that it was supposed to invest and
have at risk, in fact, was set aside, kept segregated,
available for Citibank. Seven-hundred-and-forty-seven million
dollars of Enron's money would have had to have been lost
before any of Citibank's money could be touched. Citibank could
unilaterally dissolve this venture at any time, ensuring that
it wouldn't lose anything on its investment.
I want to go over this whole situation here with you, Mr.
Caplan. Most auditors require that for a joint venture to be
unconsolidated, the capital commitment must be split 50-50.
Arthur Andersen was a lot weaker, a lot less conservative, and
the second partner in the venture only had to put up 20 percent
under Arthur Andersen's rules in order for the joint venture to
be unconsolidated on the books of Enron, and that is, of
course, what Enron was interested in. That was their goal.
Now, even with the weaker approach, the 20 percent
approach, Citi and Enron still went around it through all the
ways that I discussed. Twenty-eight-point-five million dollars
was segregated, couldn't be touched. Citibank could end this
whole deal any time it wanted. Enron's $747 million had to all
be spent before there was even any Citi money spent at all,
whether it was the $28.5 million or the balance, which I
believe was $160 million.
Citibank also had a guaranteed return interest rate, and I
would like you to look at one Citi e-mail, Exhibit 333(i),\1\
which appears to me to be an accurate summation of Citibank's
so-called investment in Sundance. It is supposed to be an
investment at risk. Principal is supposed to be at risk.
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\1\ Exhibit No. 333(i) appears in the Appendix on page 296.
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Here is what the e-mail from Citibank says. ``Still an
equity investment of sorts, accounting and tax basis for
partnership, but it is structured in such a way that the 670
basis points are guaranteed or we blow the deal. Also, our
invest,'' I assume that means investment, ``is so subordinated
and controlled,'' and now these are the key words, ``that it is
unimaginable how our principal is not returned,'' Unimaginable
how the principal could not be returned.
This is supposed to be an investment at risk. Guaranteed
return interest. Unimaginable, in your own words, how your
principal would not be returned. Now, how does one
realistically say that funds are at risk under those
circumstances so that Enron could keep Sundance off its balance
sheet?
No one here is suggesting that you have got to go out and
investigate the other guy's balance sheets, but my gosh, this
is something that you knew. You knew that your investment was
so subordinated, so unlikely to be reached, so much in your
control--it was controlled by you. You could terminate that
joint venture anytime you wanted. It was unimaginable that your
principal was not going to be returned. Now, you tell me how
that is an investment which is at risk.
Mr. Caplan. Well, I would say a few things. First, I think
it is important to note that this structure was presented to us
by Enron in exactly this form, and our investment was
absolutely in a preferred position. It was senior to Enron's
investment. They absolutely had to lose $700 million. But my
choice of words would not be ``unimaginable.'' There were many
circumstances that we ran through----
Senator Levin. Whose choice of words were they?
Mr. Caplan. Tim Leroux.
Senator Levin. And who is he?
Mr. Caplan. He is someone who works for me.
Senator Levin. OK. So your employee described this as
unimaginable.
Mr. Caplan. But we spent a fair amount of time going
through scenarios in which we could lose our money in this
transaction. Now, I will submit to you that they are remote
scenarios, but nevertheless, they are real. For example, one of
the assets in this partnership was a paper mill in Canada
sitting on the St. Lawrence River. If that paper mill blew up
and caused significant environmental damage, we would have--our
return would have been subordinated to the liability caused by
that damage, and that was something we were very concerned with
in this transaction.
Senator Levin. Was there insurance on the paper mill, by
the way?
Mr. Caplan. I believe that there was insurance on the paper
mill.
Senator Levin. So the risk here was that the paper mill
would blow up. That risk was covered by insurance. Get to some
real risk here, will you?
Mr. Caplan. In addition, the way that this transaction was
structured was presented to us by Enron and it was a
combination of things. It was a combination of this preferred
equity investment, which had the full blessing of Arthur
Andersen, and my understanding was the more important test was
not just that we had an equity investment, but that we had
voting rights in the structure, and we had 50 percent of the
voting rights. We had the ability to control the destiny of the
entity, and if we were a creditor of the entity, that would not
be true.
So I will absolutely submit to you that this is a preferred
investment. It operates much like many other preferred
investments out there, and it was not our accounting judgment
as to how--as to whether this worked or not. This is an area
of--I would call this joint venture accounting, is an area of
accounting that there isn't a lot of literature on point and
the way that our understanding is, that joint ventures are
accounted for, is that the Big Five accounting--or Big Four
now--accounting firms that give guidance, and this was Arthur
Andersen's guidance on how to account for this transaction.
Senator Levin. If you look at Exhibit 333(d),\1\ which is
an e-mail to you, Perwein, who is a Citi tax attorney, is
quoted as saying that ``Sundance was a funky deal accounting-
wise, and was amazed that Enron can get it off the balance
sheet.'' Do you remember getting this?
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\1\ Exhibit No. 333(d) appears in the Appendix on page 290.
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Mr. Caplan. I do.
Senator Levin. Do you have any reason to disagree with
that?
Mr. Caplan. With--I am sorry.
Senator Levin. With the statement that it is amazing that
they could get this off the balance sheet.
Mr. Caplan. I am not an accountant. Neither is Mr.
Perwein----
Senator Levin. You were aware of this tax attorney's
conclusion that it was a funky deal accounting-wise and amazing
that Enron could get it off their balance sheet, is that right?
You were aware of that?
Mr. Caplan. Again, I think that is an accounting
determination made by Arthur Andersen on how the structure
should work. They were fully aware of all of the terms of the
preferred investment. I think interestingly in this e-mail, you
will see later on in it where, ``John C. called. He is most
concerned about Garden State. I am trying to set up an
environmental call.'' All this is indicative of our concerns
about risks in this transaction, albeit remote risks, but real
risk to our investment in the transaction.
Senator Levin. And is this not your words, that in Exhibit
333(t),\1\ that this transaction is structured to safeguard
against the possibility that we need to contribute our
contingent equity and to ensure that there is sufficient
liquidity at all times to repay our $28.5 million investment?
That was ensured, wasn't it?
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\1\ Exhibit No. 333(t) appears in the Appendix on page 310.
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Mr. Caplan. Well, if you think about what this was, it was
a collection of fairly illiquid assets, a couple paper mills, a
trading business. We were trying to mitigate our risk to the
extent possible, and to the extent we wanted to get out of the
transaction, we didn't have creditor's rights to call in event
of default and accelerate our debt, something like that. We
only had the position of an equity holder who could force
effectively a dissolution of the company, at which time the
assets of the company would have needed to have been
liquidated. We were concerned that the assets were extremely
illiquid, so we put in steps to mitigate the illiquidity of the
assets.
Senator Levin. Well, it was way more than that, though, Mr.
Caplan. You talk about liquidating assets. One of those assets
was an account with $28.5 million in cash which was there to
protect your $28 million, isn't that correct?
Mr. Caplan. One of the assets when we closed the
transaction was $28 million of Enron commercial paper, which is
a liquid asset. It was absolutely designed to protect our
ability to get out of the transaction in what I would call a
timely and efficient manner. But again, all this was vetted
fully with Enron's accountants, and I think this goes to the--
--
Senator Levin. I am talking about your accounts. I am
talking about your advice. Your advice was funky transaction.
You don't know how they can do it. And you knew the $28 million
is there in an account. You insisted on it, for you. That is
money to come back to you, guaranteed. This isn't something
where you have to liquidate an asset. You don't liquidate
something that is liquid. It is there, set aside, isolated,
segregated for Citibank. That is supposed to be an investment
at risk? You call that mitigating risk? That is not mitigating
risk, it is eliminating risk on the $28.5 million. It is in a
segregated account. Only you can touch it. You call that
mitigation? I call that elimination.
Mr. Caplan. With respect, Senator, originally, the money
was in Enron commercial paper, and if they had defaulted the
day after the transaction, if they had gone into bankruptcy the
day after this transaction had closed, our $28 million would
not have been----
Senator Levin. Was there any suggestion that Enron was
going to go into bankruptcy at that time?
Mr. Caplan. No, none at all.
Senator Levin. You are talking about the possibility that
they would go into bankruptcy the next day, and you had the $28
million there segregated for you.
Mr. Caplan. I am not going to argue----
Senator Levin. Take a look at Exhibit 327,\2\ Project
Sundance. Investment in the Sundance partnership is an equity
investment. However--this is at the bottom of the page, number
nine. ``However, based on the way the deal is structured, it is
more like debt rather than equity.'' Would you agree with that?
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\2\ Exhibit No. 327 appears in the Appendix on page 255.
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Mr. Caplan. Well, I think I would agree in the context that
Sundance as an entity had no debt, and we had a preferred
position in effectively a liquidation scenario. So in that
respect, it was debt-like because it was senior in the capital
structure to Enron's interest in the transaction.
Senator Levin. Senior doesn't make it debt.
Mr. Caplan. Well, if the company were to liquidate and
there were debt in the company, the debt, being senior in the
capital structure, would be repaid first. Since there was no
debt in the company, our interest was the most senior interest
in the company and, therefore, any liquidation proceeds would
go to pay off our investment prior to repaying Enron.
Senator Levin. Whose document is this, Exhibit 327? Is that
your document? I know it is a Citibank document.
Mr. Caplan. It is--when we have a transaction that is
unusual or the first of its kind, we have an approval committee
called the Capital Markets Approval Committee at which we
discuss the transaction. This transaction was discussed at the
Capital Markets Approval Committee----
Senator Levin. Was that an accurate statement, that based
on the way the deal was structured, it was more like debt
rather than equity? Is that accurate?
Mr. Caplan. It is accurate to the extent that Sundance as
an entity had no debt. Yes, it is accurate. And understood by
Enron and their accountants as to that was the structure. I
think the key thing is, we had risk in the transaction and we
had voting control, and that was the test laid out by Andersen.
It was not that our risk was pari passu with Enron's.
Senator Levin. No one is suggesting that. Let me go back to
this $28.5 million. Is it correct that a couple days before
bankruptcy, that you insisted that that $28 million come back
to Citibank?
Mr. Caplan. We had, under the transaction documents, as a
partner in the partnership, a contractual right to call a board
and dissolve the structure at any point in time, and as Enron
moved towards bankruptcy, we effectively exercised that right.
Senator Levin. So your statement a few moments ago that
what would happen if Enron would go bankrupt the next day, as a
matter of fact, it did go bankrupt the next 2 days after, many
months down the road, and you were then able to protect that
$28 million by terminating the deal, is that correct?
Mr. Caplan. We were able to exit the transaction prior to
the bankruptcy.
Senator Levin. Exit the transaction.
Mr. Caplan. If the bankruptcy had happened prior to our
insistence on blowing this transaction up, we would have been
at risk on that $28 million for----
Senator Levin. After you knew that it was on the verge of
bankruptcy, you could get your $28 million just like that,
couldn't you?
Mr. Caplan. That was the structure of the transaction.
Senator Levin. And that is what you call being at risk?
Mr. Caplan. I will not dispute with you that this is a--
that the risk here was very contingent and remote.
Nevertheless, it is risk and it was sufficient risk--I think
the important point is that it was sufficient risk for Andersen
to reach its conclusion that this joint venture would not
consolidate on the balance sheet of Enron.
And I think the paradigm shift that we have implemented in
our business model now is this kind of transaction would not
be--we would not execute this kind of transaction today unless
we felt that there was clear, sufficient disclosure as to the
net effect of it as to what really goes on here to investors,
and I think that is the take-away from this. We have learned
something from this transaction.
Senator Levin. Well, I hope the world has learned something
about this transaction, as well, and that is at the time, it
was improper, not just now. At the time, it was improper.
Exhibit 333(n),\1\ this is what you wrote. This is from Mr.
Bushnell, he wrote to Michael Carpenter. This will be my last
question of this panel in this round. Mr. Bushnell, you wrote
to Michael Carpenter, who was the head of Global Corporate and
Investment Bank at the time for Citibank, on May 30, 2001, 2
days before this deal went through, and here is what you told
Mr. Carpenter. This is on page two of Exhibit 333(n). ``If you
recall, this is a complex structured transaction which I have
refused to sign off on.''
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\1\ Exhibit No. 333(n) appears in the Appendix on page 302.
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And then you later said the following. ``The risk
management has not approved this transaction for the following
reasons,'' and then one of your reasons, which is the one, two,
three, fourth bullet, is that ``the GAAP accounting is
aggressive and a franchise risk to us if there is publicity, a
la Xerox.''
This transaction was a franchise risk to Citibank if there
was publicity, that is what you said in this document. Were you
telling the truth?
Mr. Bushnell. Yes, Senator.
Senator Levin. And yet, you went ahead with this. This is
what really is so troubling to me from Mr. Prince's testimony
and otherwise and why the explanation that we have heard this
morning is so unsatisfying. Well, this is all something in
hindsight and we were following the rules at the time. Your own
rules were bent. You made exceptions to them. You identified
this transaction as one which would actually put the reputation
of your bank at risk, and you proceeded anyway with this
transaction. This isn't hindsight, folks. This is a lack of
foresight on the part of Citibank as to what you were up to.
How often do you write that a project or a transaction is a
franchise risk? Is that a fairly common thing?
Mr. Bushnell. Senator, perhaps I can give some context to
this memo. First of all, I could have killed this deal and not
let it go forward. I don't need to write a memo to kill a deal.
If you read the entirety of the memo, most of this is an alert
to Mike Carpenter about some process concerns and some internal
differences between divisions about what to do with the
transaction, and yes, I do express there are some concerns
about what the GAAP accounting standard is.
Senator Levin. If I could just interrupt your answer, that
is not my question, about concerns over GAAP standards. My
question to you was, how often do you write that a project or a
transaction is a franchise risk to us if there is publicity? Is
that a fairly common conclusion that you reach?
Mr. Bushnell. I am sorry, Senator. I was trying to get to
that point. I don't write it often. I sit about ten yards away
from Mike Carpenter and he and I discussed lots of risk
transactions, I would say three to five times a day. Some, and
I will admit that it is not many, have an instance of
reputational issues that could be there. It is not frequent. I
normally don't write it down because I didn't--I just walked
into Mike's room or I called him on the phone.
In this particular instance, Mike was out of the country
and I was trying to give him something to look at. That is the
reason why I wrote it down. It is not frequent, but it is a
risk issue that we talk about in some transactions.
Senator Levin. A risk issue is a little bit different from
saying there is a franchise risk to us if there is publicity.
Is that something that you said about many transactions that
have proceeded?
Mr. Bushnell. Again, Senator, in terms of communications,
not many, but this isn't the only one that we discussed
reputational issues.
Senator Levin. I am trying to go a little bit beyond
reputational issues. This isn't quite that. This is your
conclusion that this accounting is--it is not an issue, it is
your conclusion that accounting is so aggressive it is a
franchise risk to us. You concluded that----
Mr. Bushnell. Yes, Senator.
Senator Levin [continuing]. If it is made public, and yet,
it proceeded. Do you often proceed with loans, or forget that
word, this wasn't a loan, really was a loan, but putting aside
the loan-equity question, let me get to my question. Is it
common that you have stated or concluded that accounting is so
aggressive that it is a franchise risk to us if there is
publicity, and yet the transaction nonetheless was concluded?
Has that happened frequently?
Mr. Bushnell. It has not, no.
Senator Levin. Senator Collins.
Senator Collins. Mr. Bushnell, what was Mr. Carpenter's
response to your memo and your concerns about the Sundance
deal?
Mr. Bushnell. Senator, I wish I could recall those
concerns. As I said, Mike was traveling at the time. He and I
had hundreds of conversations about various risk issues. We
have looked back at the record. It is clear, I think, that we
had a conversation. I can't remember the specifics of those
conversations, or indeed, how I might have paraphrased that
concern about franchise or reputational risk or what the
conversations might be.
Senator Collins. Initially, you refused to sign off on the
transaction. Did you ultimately approve it?
Mr. Bushnell. Yes, I did, Senator.
Senator Collins. And what caused you to change your mind?
Mr. Bushnell. One of the very things that caused my mind is
I wanted to talk to Mike Carpenter. As I said, I could have--I
didn't need to write a memo to not do this deal. The reason why
I sent the memo to Mike and the reason why I held up on
approving the deal or declining the deal is I wanted to talk to
him. I wanted to alert him about several issues that I had
about the way this transaction came up, the way it was handled,
and what some of the concerns about it were.
Senator Collins. Did anyone at the bank direct you to
approve the transaction?
Mr. Bushnell. No, Senator.
Senator Collins. Did Mr. Carpenter provide some sort of
approval for the transaction?
Mr. Bushnell. I can't recall it, but I am sure he must
have. If he didn't want the transaction to go forward, we
wouldn't have done it.
Senator Collins. Are you aware that the Subcommittee has
requested the paperwork authorizing the transaction, but that
Citigroup to date has failed to locate and provide that
paperwork?
Mr. Bushnell. Yes, I am, Senator, and I think that is a
breach of our policies and procedures. We do have--for an
equity investment like this, at this size, it required a sign-
off from both the Chief Financial Officer and Mike Carpenter. I
believe we have provided the Subcommittee with the Chief
Financial Officer's sign-off, but we don't have Mike
Carpenter's sign-off in our files.
Senator Collins. Thank you, Mr. Chairman.
Senator Levin. You indicated that you remember today that
you approved this deal?
Mr. Bushnell. Yes, Senator.
Senator Levin. Because you told our staff when you were
interviewed by them that you did not recall approving the deal.
Has something changed between that conversation and today?
Mr. Bushnell. Yes, Senator. I have seen subsequently e-mail
results that give me a conclusion--I can't recall verbally
saying, ``I am OK with this deal,'' but there is an e-mail
trail that says that I did talk with one of the transactors, a
person in Mr. Caplan's division, and that we had agreed to go
forward with the transaction.
Senator Levin. According to this memo that I think you may
be referring to, which you say refreshed your memory, I believe
this is Exhibit 333(r),\1\ ``If you recall, Mike Carpenter was
out of the country the day the transaction closed''--this is
dated June 29, 2001. The approval memo was given to Mike's
assistant and faxed to him. Mike then had a conversation with
Dave Bushnell, who shared with us Mike's feedback. We proceeded
to close the transaction that day, given the absence of
instructions from Mike or Dave to the contrary.''
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\1\ Exhibit No. 333(r) appears in the Appendix on page 308.
---------------------------------------------------------------------------
Apparently, the transaction went through not because you
approved it but because you didn't give any instructions to the
contrary, is that true, or did you approve it actually?
Mr. Bushnell. I can't recall verbally saying I approved it.
I take this memo to mean that I had a conversation with the
transactors and said that I had talked with Mike and that met
the requirements or my criteria for going forward.
Senator Levin. If you talked to Mike, what did he say?
Mr. Bushnell. Senator, as I say, I wish I could recall
that. I really do. It would make things a lot easier for all of
us. And in our new policies, this is the type of thing that we
want to have written down so that we can recall how we got to
conclusions or overcame issues that are brought up about
structured finance transactions. But I can't recall the nature
of that conversation.
Senator Levin. This is an unusual transaction. You just
testified it is uncommon that there be a transaction where you
would say there is a reputational risk serious to your bank,
could actually risk your bank's reputation if made public. And
yet, you went ahead and approved it. You can't remember the
conversation with Carpenter. The approval document is missing.
There are a number of very disturbing and unusual aspects to
this transaction. It would seem to me that something which is
this unusual should be remembered by you in terms of your
conversation with Carpenter.
Mr. Bushnell. Senator, I wish I could remember it, but as I
said, I had three to five conversations a day on all
significant risk transactions. This was 18 months ago, and I
just can't recall having the conversation or, obviously, any
specifics of the conversation if I had it.
Senator Levin. If you look at the first page of Exhibit
333(n),\1\ which is an e-mail that Alan MacDonald, Head of the
Global Relationship Bank, sent to Michael Carpenter the day
after you wrote your memo, that previous memo we talked about.
In it, he forwards Mr. Carpenter another copy of the memo and
writes the following. ``We, Bill Fox and I, share risk's view
and, if anything, feel more strongly that suitability issues
and related risks, when coupled with the returns, make it
unattractive. It would be an unfortunate precedent if both GRB
relationship management and risk's views are ignored.''
---------------------------------------------------------------------------
\1\ Exhibit No. 333(n) appears in the Appendix on page 302.
---------------------------------------------------------------------------
Mr. Fox, Mr. MacDonald writes that you shared the views of
Mr. Bushnell. Did you have concerns about this project?
Mr. Fox. I had some questions about the project, mostly
surrounding the returns we were attempting to achieve. I was
concerned that it was going to potentially disenfranchise
another product area of ours called capital structuring.
Initially, I had raised some issues concerning the fact that I
didn't understand how the accounting was able to achieve
Enron's objectives. Those were the areas of my concern.
Senator Levin. Were you satisfied?
Mr. Fox. With respect to the accounting question, I
received an e-mail back from an individual that confirmed that
Arthur Andersen had reviewed and utilized this type of
structure elsewhere.
Senator Levin. And what about the reference to the
franchise risk if there is publicity?
Mr. Fox. I had not seen Mr. Bushnell's memo until after the
fact. My communication, though I don't recall it, must have
been with Mr. MacDonald directly.
Senator Levin. So here, we have got serious concerns raised
by Mr. Bushnell and Mr. Fox about the accounting associated
with it. You, at least, Mr. Bushnell, about the risk to the
bank's reputation. You, Mr. Bushnell, as head of risk
management, refused to sign off on the project because, in
part, the aggressive accounting did create a franchise risk if
it was made public, if it came to light. And yet, the deal went
through, helped Enron to make its balance sheet look a lot
better than it was entitled to look, and I am afraid that that
story is a sad story.
This is not just a story about should we make banks look at
the books of clients. This is a story of how a bank with
serious concerns, even to its reputation, was willing to
proceed with a transaction which its own people thought was
incredible in terms of its accounting techniques, and
nonetheless, you went ahead and did it. You did it for a couple
of reasons, I assume. One was there was money in it, and two,
you wanted to keep a good client happy.
But I do think it is important as we look at what our
regulators are going to do about it and what your new
procedures are to hopefully stop this from happening, that we
recognize that these are problems that were raised at the time.
This is not retroactive applying new standards. This is looking
at how a bank of high reputation that should be a pillar in our
economy stooped pretty low. We have got to learn from that
lesson. The bank says it has. I am glad to hear you have. I
hope you have. For the sake of our economy, I even pray you
have, because this has got to stop.
We are going to rely to some extent on self-regulation, but
we cannot rely totally or even to a great degree on self-
regulation because it hasn't worked in the past. There is too
much temptation out there, to please customers and to make
money, and I guess those are one and the same thing. And so we
are going to need to talk to our regulators, and we will a
little later on today, after we talk to Chase, as to how we, as
a government, can be sure that these kind of activities are not
repeated.
I want to thank our witnesses. Again, I know this was a
difficult day for you to get here. We also want to again repeat
that Citibank as well as Chase has cooperated in our
investigation. You have provided us with documents, obviously,
and you have appeared. You have come and been interviewed by
us, and those are important pluses on the ledger. We thank you
and you are excused.
Mr. Bushnell. Thank you, Senator.
Mr. Caplan. Thank you, Senator.
Mr. Fox. Thank you, Senator.
Senator Levin. We are going to take a 5 minute recess.
[Recess.]
Senator Levin. We will come back to order. I would like to
call now our second panel of witnesses. I want to thank all of
you, as I did our first panel, for making it here in this
weather. It was bad enough when you got here. I think it is
worse now. I don't know if that is good news or bad news, but
it is the fact, apparently.
We want to welcome Michael Patterson, who is the Vice
President of J.P. Morgan Chase and Company; Andrew Feldstein,
the Managing Director and Co-Head of Structured Products and
Derivatives Marketing at J.P. Morgan Chase; Robert Traband,
Vice President of J.P. Morgan Chase in Houston; and Eric
Peiffer, a Vice President of J.P. Morgan Chase in New York.
Pursuant to Rule 6, witnesses who testify before the
Subcommittee are required to be sworn and so I would ask you
all to please stand and raise your right hand.
Do you swear that the testimony that you will give before
this Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Patterson. I do.
Mr. Feldstein. I do.
Mr. Traband. I do.
Mr. Peiffer. I do.
Senator Levin. As I mentioned before, a minute before the
red light comes on signaling that you should end your
testimony, you will be given a green to yellow light, which
will give you the opportunity to conclude your remarks. We will
print testimony in its entirety in the record, so we would ask
you to limit your oral testimony to no more than 10 minutes.
Mr. Feldstein.
Mr. Patterson. Mr. Chairman, with your permission, may I
begin?
Senator Levin. Sure. Do you want to start off?
Mr. Patterson. Yes, sir.
Senator Levin. Sure. Mr. Patterson.
TESTIMONY OF MICHAEL E. PATTERSON,\1\ VICE CHAIRMAN, J.P.
MORGAN CHASE AND COMPANY, NEW YORK, NEW YORK
Mr. Patterson. Mr. Chairman and Members of the
Subcommittee, my name is Michael Patterson. I am a Vice
Chairman of J.P. Morgan Chase and head of the firm's Policy
Review Office since August of this year.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Patterson appears in the Appendix
on page 105.
---------------------------------------------------------------------------
I am joined today by my colleagues Andrew Feldstein, a
Managing Director and Co-Head of Structured Products and
Derivatives Marketing since March of this year; Robert Traband,
a Vice President of J.P. Morgan Chase; and Eric Peiffer, also a
Vice President of the bank. After my statement, Mr. Traband
will read a joint statement for himself and Mr. Peiffer, and
with the permission of the Subcommittee, Mr. Feldstein will
then give a brief opening statement.
Senator Levin. That is fine.
Mr. Patterson. I am pleased to be here to discuss the
firm's policies and practices regarding transactions with
publicly traded U.S. companies. As requested in your invitation
letter, I will address policies and practices relating most
particularly to structured finance, accounting, and tax
matters.
J.P. Morgan Chase and its predecessor firms have long had
in place policies and procedures governing transactions with
clients. These policies and procedures address, among many
other subjects, compliance with external legal and regulatory
requirements, as well as the aspects of the transaction that
could raise reputation risk for the firm. These policies and
procedures are periodically reviewed and updated to take
account of our experience and external developments.
Structured finance encompasses a wide variety of
transactions and instruments designed to help clients achieve
their risk management, financing liquidity, and other financial
objectives within the framework of applicable and often complex
legal, regulatory, tax, and accounting rules and principles.
Securitization, special purpose vehicles, and derivatives are
among the well-recognized techniques used to allocate risks,
capital, and cash flows to meet client objectives.
To make sure that our structured finance transactions
comply in all respects with that framework, the business
transaction approval process requires adherence to applicable
policies, as well as review and sign-off from internal legal,
conflicts, tax, and accounting policy groups, among others,
such as credit and market risk management. Transactions
involving a special purpose vehicle receive special scrutiny
and must comply with a special purpose vehicle policy
administered by a committee to ensure that every such entity is
properly approved, documented, and monitored.
The primary responsibility for adherence with all policies
and procedures, including those designed to address reputation
risk, lies with the business units conducting the transactions
in question. But in addition to this framework, J.P. Morgan
Chase in August of this year put in place a new set of
procedures designed to reinforce our focus on reputation risk
and provide a senior level of review of transactions with
clients.
Business units are required to submit to regional policy
review committees proposed transactions that may raise
reputation risks for any reason, but specifically including
transactions where a material objective is to achieve a
particular accounting treatment, those designed to achieve a
particular tax treatment, those where there may be material
uncertainty about legal or regulatory treatment, those with
highly complex structures or cash flow profiles, and those
which have as a significant purpose or effect the providing of
financing, but which take the form of derivatives.
The members of the regional policy review committees,
including the Americas Committee, are senior representatives of
the business and the support units, including tax and
accounting policies, in the region. Transactions are reviewed
from every angle that could affect reputation risk, but
including specifically, where applicable, the intended
financial disclosure of the transaction by the client, and the
committee approves, rejects, or requires further clarification
or changes in the transaction. These committees and their
deliberations are overseen by a Policy Review Office, which I
lead, and transactions can be formally escalated by the
committees to me.
We at J.P. Morgan Chase believe that one of the tests of
our leadership in the financial marketplace is to learn from
our experiences and to adjust our practices in light of these
experiences and the changing environment. The core lessons we
have learned are, one, that we cannot rely solely on our
clients and their experts to determine that our transactions
with them will be properly accounted for and disclosed; two,
that we need to make sure that our transactions with clients
are not misused to deceive investors or others; and three, that
even where these tests are met, we need to consider carefully
whether transactions could be viewed adversely in a way that
would be harmful to our reputation for integrity, fair dealing,
and doing first-class business in a first-class way.
I believe that the policy review process we have put in
place and which I have just outlined, together with our
business transaction approval policies and procedures, are well
designed and are already serving to enable us to meet these
standards.
As a final note, I would add that as the biggest corporate
lender in America and as one of the largest investment
managers, we have as much interest as anyone in increased
transparency and disclosure and integrity in financial markets.
We have our money and our investment management clients' money
at risk in our belief that those financial statements are
accurate.
I would, of course, be happy to respond to any questions
the Chairman or other Members of the Subcommittee may wish to
put to me regarding the policy review process. Thank you,
Senator.
Senator Levin. Thank you very much, Mr. Patterson.
Mr. Traband, I believe you were going to proceed next.
TESTIMONY OF ROBERT W. TRABAND,\1\ VICE PRESIDENT, J.P. MORGAN
CHASE AND COMPANY, HOUSTON, TEXAS; ACCOMPANIED BY ERIC N.
PEIFFER, VICE PRESIDENT, J.P. MORGAN CHASE AND COMPANY, NEW
YORK, NEW YORK
Mr. Traband. Thank you, Mr. Chairman. My name is Robert
Traband and I am currently a Vice President of J.P. Morgan
Chase Bank. I am making a joint statement on behalf of myself
and Eric Peiffer.
---------------------------------------------------------------------------
\1\ The joint prepared statement of Mr. Traband, Mr. Peiffer, and
Mr. Feldstein, appears in the Appendix on page 107.
---------------------------------------------------------------------------
Let me say at the outset, Mr. Chairman, that while we
believe that our participation in the Fishtail and Flagstaff
transactions was perfectly legal and followed established
rules, had we known then what we know now about Enron's
practices, we would not have engaged in these transactions with
Enron. We would not have accepted at face value, as we did in
2000 and 2001, Enron's statements that its requests to
structure Fishtail or Flagstaff in particular ways were
designed to properly achieve Enron's desired financial
statement treatment of the transactions in accordance with
Generally Accepted Accounting Principles.
In addition, we would have wanted to know more about the
aspects of the transactions in which the firm was not involved.
But at that time, we, like many other parties, dealt with Enron
in the belief that it was one of the most respected companies
in America and that it was not our role to second guess our
counterparties' accounting or other structuring determinations.
In the case of Enron, the firm suffered substantial injury,
not only by the loss of hundreds of millions of dollars from
its own transactions with Enron, but also from the injury to
its reputation from the erroneous suggestions of some that the
firm was involved in Enron's wrongdoing. For these and many
other reasons, we regret that we ever dealt with Enron.
Let me now turn to the specific transactions with respect
to which the Subcommittee has requested information from the
firm. The first of these transactions has been referred to by
the Subcommittee and others as Fishtail. This transaction was a
$41.5 million loan commitment extended by the firm in December
2000 to a special purpose entity named Annapurna LLC,
established by Enron. This commitment expired by its terms in
June 2001 and was never funded.
Enron informed the firm that in anticipation of its
ultimate contribution of the existing pulp and paper business
to a joint venture, Enron wanted to deconsolidate its pulp and
paper business from the rest of its businesses. Enron also told
us that in consultation with its accounting advisors, it had
devised a structure to achieve this objective. Enron would
contribute its economic interests in the present and future
contracts of the pulp and paper business to a newly formed
entity, Fishtail, which would be jointly owned by Enron and
Annapurna.
As I have said, the firm's participation in this
transaction was limited to a 6-month commitment to make a bank
loan to Annapurna. The firm had no other involvement in the
transaction. The decision to make a commitment to Annapurna was
a reasonable credit decision and it is not at all unusual, as
banks often make loan commitments with the expectations that
they will not be funded.
The firm acted as a leader--a lender in this transaction
and, consistent with industry practice, it did not make any
determination whether completion of the transaction would
achieve Enron's accounting objective, a deconsolidation of
Enron's pulp and paper business. Such determinations were
properly for Enron to make with the advice and assistance of
its internal accountants and external auditors. In this
connection, I note that the Subcommittee staff report states
that Arthur Andersen actually did approve this transaction.
In December 2000, when the Fishtail transaction was agreed
to, the firm had no reason to believe that any such
determinations were not being made by Enron and/or Arthur
Andersen, which was then one of the Nation's premier accounting
firms, in accordance with Generally Accepted Accounting
Principles.
There is one final point I would like to make about the
Fishtail transaction. It appears that Fishtail included a
broader set of transactions by Enron to effectuate not just the
deconsolidation of Enron's pulp and paper trading business, but
to recognize income in connection with the sale of those
assets. The firm was not involved in these other transactions,
and indeed was told very little about them by Enron or anyone
else, for that matter.
The Subcommittee has also asked for information concerning
the firm's understanding of and participation in the Slapshot
project, particularly with regard to the Flagstaff transaction.
As I will explain in greater detail, Slapshot was the name
given by the firm to a generic form of transaction intended to
permit a loan by a U.S. lender to a Canadian borrower, to be
structured in a manner that would provide advantageous tax
treatment to the Canadian borrower under Canadian law.
Flagstaff was the name under which a specific transaction
with Enron was undertaken in June 2001 to provide long-term
refinancing for the acquisition of a Canadian pulp and paper
mill, Stadacona, acquired by a joint venture in which Enron was
a equity participant. In short, Flagstaff was an actual
transaction; Slapshot was not.
As the Subcommittee is aware, there are substantial
differences in tax codes of other countries that taxpayers,
including both individuals and businesses, may lawfully and
properly take advantage of. Such a situation existed under
Canadian tax law, but before proposing the transaction to any
client, the firm's structured finance group solicited and
received a written opinion of an independent and highly
regarded Canadian law firm setting forth the likely tax
consequences of that structure under Canadian law. Ultimately,
the firm obtained written opinions from two leading Canadian
law firms that the structure and the Canadian tax benefits it
provided were legal and valid.
As I have indicated, the Flagstaff transaction had its
genesis in the planned purchase of the Stadacona Canadian paper
mill by CPS, a Canadian corporation owned by a joint venture,
Sundance, between Enron and another party. The firm did not
participate in the formation of the Sundance joint venture.
Documents shown to employees by the firm by the Subcommittee
staff during interviews in preparation for this hearing reveal
that there were many aspects of the structure and funding of
the joint venture that were completely unknown to us. Indeed,
at the time of the Flagstaff transaction, the firm did not know
the identity of Enron's partner in the joint venture.
In January 2001, representatives of the firm met with Enron
to present a proposal under which a group of banks would make a
loan to finance the acquisition of the mill. During the
meeting, the firm advised Enron that it had concluded, based on
the opinion of counsel, that the loan transaction could be
structured in a manner that would provide advantageous tax
treatment to a Canadian borrower under Canadian law. Enron
informed the firm's representatives that Enron was aware of and
had itself already devoted substantial attention to analyzing a
substantially similar Canadian tax structure.
Enron ultimately selected the firm to lead the bank group,
but opted to complete the acquisition of the Stadacona mill in
March 2001 with a bridge loan of approximately $375 million
provided by Enron. The Flagstaff transaction was thereafter
completed in June 2001 in order to repay the bridge loan and
provide the long-term debt financing. The Flagstaff loan
transaction was structured in a manner intended to permit the
realization of the Canadian tax benefits by the Canadian
borrowers. To the best of the firm's knowledge, this structure
did not provide otherwise unavailable U.S. tax benefits to any
party. We understand that Enron obtained and relied upon its
own written opinion from Canadian tax counsel and that the
anticipated Canadian tax benefits could and should be realized
under the structure.
As the Subcommittee is aware, the Flagstaff structure is
highly complex, and among the several transactions that
comprise the structure was an intraday loan of approximately $1
billion provided by the firm to Flagstaff. It also involved two
special purpose entities created by Enron or its affiliates.
The complexity of the Flagstaff financing and the legal
documentation required to implement it was necessitated by
Canadian tax considerations and were undertaken in reliance of
the opinions of Canadian tax counsel to facilitate realization
of the Canadian tax benefits.
As the Subcommittee also is aware, the credit support for
the loan was provided by Enron, principally through a total
return swap and certain supporting transactions, rather than as
originally contemplated, a guarantee by Enron. This change was
specifically requested by Enron. One or more members of our
team understood at the time that a principal reason for Enron's
position on this respect was that Enron had concluded that a
guarantee might require consolidation of the entire Sundance
joint venture, the assets of which included CPS and the
Stadacona mill.
The firm understood that the use of a total return swap to
facilitate the continued deconsolidation of the joint venture
had been vetted by Enron with its external auditors, Arthur
Andersen, and had been approved by them. The firm did not
attempt to second guess this accounting judgment. As I have
noted earlier, under applicable law and practice, each party is
properly responsible to ensure that it correctly accounts for
the transactions to which it is a party. At the time, the firm
had no reason to believe that any such determinations were not
being made by Enron and its external auditors in accordance
with Generally Accepted Accounting Principles.
Consequently, from the firm's standpoint, the issue
presented by Enron's decision not to provide a guarantee was
whether the total return swap provided sufficient credit
support for Flagstaff loans, that the new arrangement could
prudently be accepted by the banks in lieu of a direct Enron
guarantee. Ultimately, we and the other members of the bank
group each concluded that the total return swap provided
adequate credit support.
This concludes my statement, Mr. Chairman. I am happy to
answer any questions.
Senator Levin. Mr. Peiffer, you are not going to give a
statement at this point?
Mr. Peiffer. It was a joint statement on behalf of both of
us.
Senator Levin. Mr. Feldstein.
TESTIMONY OF ANDREW T. FELDSTEIN,\1\ MANAGING DIRECTOR, CO-HEAD
STRUCTURED PRODUCTS AND DERIVATIVES MARKETING, J.P. MORGAN
CHASE AND COMPANY, NEW YORK, NEW YORK
Mr. Feldstein. Thank you, Mr. Chairman. My name is Andrew
Feldstein. As Mr. Patterson said, I am a Managing Director at
J.P. Morgan Chase, and since March of this year, I have been
the Co-Head of our Structured Products and Derivatives Group in
North America. In addition, I work closely with Mr. Patterson
on the firm's Policy Review Office, designing and implementing
the policies to guard against participation in transactions
that don't comport with our standards for integrity and our
commitment to transparent financial markets.
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\1\ The joint prepared statement of Mr. Traband, Mr. Peiffer, and
Mr. Feldstein, appears in the Appendix on page 107.
---------------------------------------------------------------------------
I would like to say four things. First, based on my review
of the facts from this Subcommittee's report as well as from my
internal inquiries, I am convinced that neither Mr. Traband nor
Mr. Peiffer nor anyone else at J.P. Morgan Chase knowingly
aided and abetted Enron's apparently deceptive activities.
Second, Mr. Chairman, you mentioned earlier today the need
to root out corruption in financial statement presentations. We
agree with you 110 percent. We think it is incumbent upon all
participants in our capital markets to combat that type of
conduct at every turn. We are with you.
Third, what has changed? The processes that our firm has
implemented and the culture that we are endeavoring to create
at all levels of the firm are meant to avoid our firm's
participation in transactions contrary to the principles of
integrity and transparency.
One thing in particular bears noting here. We now insist
not only everyone that works for me in structured finance, but
everyone in the firm, to ask questions, more questions, and
more specific questions than were commonly asked 1 year ago. We
no longer rely on the assurances of clients or their outside
advisors when the facts and circumstances of proposed
transactions should give us pause.
I like to think that senior management chose people like
Mr. Patterson and me to play a big part in this cultural
evolution because we have the ability to be real thought
leaders and we can work with all professionals in the firm to
identify the indicia of transactions that must be thoroughly
questioned.
Finally, let me end with this. The fact that things are
changing, whether internally at firms like ours or with the
accounting rules, that is evidence of what is good in the U.S.
capital markets. Participants join together with the
encouragement of committees like yours to help make the markets
work even better.
I appreciate being given the opportunity to appear before
you today and I look forward to answering any questions. Thank
you.
Senator Levin. Thank you all.
Mr. Peiffer, let me start with some questions to you. You
worked, as I understand it, on the implementation of the
Slapshot deal and the negotiations with Enron, is that correct?
Mr. Peiffer. That is correct.
Senator Levin. As I indicated in my opening statement, I
believe the details of that structure show it to be a sham and
I would like to go through the $1 billion so-called loan that
Chase, through an SPE or special purpose entity that it created
called Flagstaff, made to the Enron special purpose entity
called Hansen.
The $1 billion that Chase sent to Flagstaff, which again
was under its control, was returned to it on the same day, as a
matter of fact, within a period of a few hours or even a few
minutes, and I want to look at some slides that show the
general schematic of the transaction.
First, step one. Chase provided a $1 billion so-called
daylight overdraft loan to Flagstaff, its own special purpose
entity. That is a loan which existed for just a few hours, if
that long.
This is, I believe, Exhibit 303(a),\1\ if you want to take
a look in your book. It may be hard for you to see that far. So
step one, at the bottom right, a $1 billion loan from Chase to
Chase's special purpose entity, Flagstaff. That is the daylight
overdraft loan for the few hours.
---------------------------------------------------------------------------
\1\ Exhibit No. 303(a) appears in the Appendix on page 190.
---------------------------------------------------------------------------
Step two, Enron gets the $1 billion daylight overdraft from
Citibank, runs the money through a few of Enron's subsidiaries,
and puts it in an escrow account at Chase, and that escrow
account you will see there is called Newman and that is another
Enron special purpose entity.
Step three, Flagstaff at that time, and only then, releases
the Chase $1 billion and it goes through a number of Enron
entities to Citibank. So Citibank now has got its $1 billion
back a few moments later. And then as soon as Flagstaff
releases the Chase $1 billion, Newman releases the $1 billion
from the escrow account to Flagstaff and then back to Chase.
Now, all of these transactions occur within a matter of hours,
some within a matter of minutes. One billion dollars this way,
a billion dollars, that way.
Exhibit 352 \1\ is the funds flow schedule that was
attached to the opinion of Enron's tax counsel, who is also
your tax counsel. Notations next to the funding steps show that
certain steps will be completed by certain times, and it shows
that the $1 billion would be returned to Chase between 10 a.m.
and 12 noon the same day that it left Chase.
---------------------------------------------------------------------------
\1\ Exhibit No. 352 appears in the Appendix on page 525.
---------------------------------------------------------------------------
Chase released over $1 billion from its left hand, took the
money back with its right hand, and you designed the structure
so that even though $1 billion was returned almost
instantaneously, at least on the same day, there would be an
appearance to Canadian tax authorities that there was an
outstanding loan of $1.4 billion.
Now, Mr. Peiffer, isn't it the case that the amount of the
$1 billion, $1.039 billion to be precise, was mathematically
derived to ensure that interest payments made on the $1.4
billion apparent loan would equal the principal and interest
payments on the $375 million loan?
Mr. Peiffer. That is correct.
Senator Levin. So the $1.03 billion amount wasn't derived
from some independent business need, it was simply the number
required to make the tax transaction work, is that correct?
Mr. Peiffer. It was the number required to make the tax
transaction work as it was intended.
Senator Levin. Now, the company receiving the loan, the so-
called loan, was Hansen, a Nova Scotia unlimited liability
corporation which had been established by Enron. Do you know
when Hansen was incorporated?
Mr. Peiffer. Where it was incorporated? I am sorry.
Senator Levin. When Hansen was incorporated.
Mr. Peiffer. Nova Scotia, I believe.
Senator Levin. No, when, not where.
Mr. Peiffer. I don't know when it was incorporated.
Senator Levin. Well, I will tell you when it was formed,
less than 2 weeks before this transaction took place. That was
also the same day that Newman, the company that formed the
escrow account, was created.
Given how new Hansen was, do you believe that it was a
company with an identified business purpose that warranted a $1
billion loan?
Mr. Peiffer. I think here, it depends on what context you
are defining business purpose.
Senator Levin. The normal.
Mr. Peiffer. In my understanding----
Senator Levin. Just normal understanding.
Mr. Peiffer. My understanding is that Enron set up both
Hansen and Newman to help effect this transaction and that for
Canadian tax purposes, based on advice we and they received
from our Canadian tax counsel, that the contracts they entered
into constituted a business purpose.
Senator Levin. So these were set up for this transaction,
these companies?
Mr. Peiffer. That is my recollection, yes.
Senator Levin. What was the commercial business purpose
that was associated with this $1 billion loan to Hansen?
Mr. Peiffer. The loan to Hansen was actually $1.4 billion,
and as you----
Senator Levin. I want to talk about the $1 billion portion
of it. What was the commercial business purpose associated with
that $1 billion, which was the majority of the $1.4 billion?
Mr. Peiffer. I think it is hard to talk about, with all due
respect, just the $1 billion portion, since it was one $1.4
billion loan. I will acknowledge that, of course, as you did,
that $1 billion came from J.P. Morgan into Flagstaff and that
J.P. Morgan was repaid that same day, and so at the end of the
day, there was $375 million remaining in this joint venture.
Senator Levin. Which was the real loan, correct?
Mr. Peiffer. Yes, the real loan, the economic loan is what
I would prefer to call it. However, if you look at the actual
contracts, there actually was a $1.4 billion loan. Those were
actual contracts that continue to be respected from a legal
perspective to this day, and in addition to that, from a
Canadian tax perspective, which follows much more form over
substance type of regime, my understanding, not being a
Canadian tax lawyer, but given the advice that we are given,
that the Canadian tax advisers would respect that as a $1.4
billion loan.
To answer specifically your question as to what the
business purpose is, the business purpose of this transaction
as a whole was to provide financing to Enron in a tax
advantageous way, and the $1 billion----
Senator Levin. Tax advantageous way----
Mr. Peiffer [continuing]. And the $1 billion helped with
that.
Senator Levin. That was the tax advantageous part of the
$1.4 billion?
Mr. Peiffer. I think the right way to say it is that it did
help with the making, of course, of the $1.4 billion loan, and
that, taken together with the other contracts, given the advice
that we were given from Canadian tax counsel, helped to
generate the Canadian tax benefits that were intended.
Senator Levin. But the $1 billion was the tax advantage
portion, was it not, of the $1.4 billion? That is what created
the tax advantage.
Mr. Peiffer. The $1 billion helped to create the tax
advantage.
Senator Levin. Was there any other tax advantage, other
than what was created by the $1 billion?
Mr. Peiffer. There were only Canadian tax advantages
generated with respect to the full $1.4 billion loan
interacting with the other contracts.
Senator Levin. But I am saying, if it had just been the
economic loan, as you put it, the business loan of $375
million, there would not have been any tax advantage from that,
would there?
Mr. Peiffer. Right. I think it is fair to say that if it
were only a $375 million loan, that Enron would have received
tax deductions on that $375 million loan and that is it.
Senator Levin. The interest on it?
Mr. Peiffer. Yes.
Mr. Feldstein. May I add something, Mr. Chairman?
Senator Levin. I would rather not. I want to just keep
going with Mr. Peiffer and then you can come in a little later,
if you like.
Mr. Peiffer, would Chase have approved the $1 billion loan,
that portion of the $1.4 billion loan to Hansen, if it had not
been assured that it would receive the money back immediately
from an escrow account held by Enron?
Mr. Peiffer. I think it is fair to say it would not. From a
credit perspective, Chase obviously would be concerned about
getting paid back that amount of money, and so felt more
comfortable if Enron was either paying to us $1 billion first
via a separate transaction, and preferably through an escrow
account, which I recall is what--where Newman had the money
prior to paying to Chase under the subscription assumption
agreement.
Senator Levin. So is it fair to say, then, that the $1
billion portion of that loan to Hansen would not have been made
by Chase unless you knew that there was money in escrow to
immediately pay that money back to you, is that fair?
Mr. Peiffer. That is fair.
Senator Levin. Now, Mr. Peiffer, you are listed on the
incorporation papers of Chase's special purpose entity
Flagstaff as Flagstaff's Vice President, and Mr. Traband, you
are listed as the Treasurer of Flagstaff. So as corporate
officers of Flagstaff, both of you, with fiduciary duty to the
company, I take it that you would not have felt comfortable
loaning $1 billion to Hansen if you didn't know that the same
amount of money was already in an established escrow physically
located at Chase and that Chase would immediately receive the
money back from Enron, is that a fair statement? You wouldn't
possibly be handing $1 billion out to this new company without
being darn sure that that $1 billion was coming right back to
you, is that fair to say?
Mr. Peiffer. I think it is fair to say we would go to
measures to make sure that $1 billion was repaid.
Senator Levin. Mr. Traband, do you agree with that?
Mr. Traband. Yes. We understood the full scope of the
transaction.
Senator Levin. Now, even though the $1 billion, then, of
the so-called $1.4 billion was already returned, you have
asserted that the--Mr. Feldstein, did you want to interrupt at
this point?
Mr. Feldstein. No, I think I will wait.
Senator Levin. OK. Even though the $1 billion was already
returned, you nonetheless have asserted in your testimony that
the tax deduction for interest on the entire $1.4 billion was
allowed in Canada, and Chase has put a great deal of emphasis
on that assertion in its statements. I am aware that a Canadian
law firm informed Chase that Slapshot would be acceptable.
However, that same law firm had provided services to Enron and
told their client that Slapshot was likely to attract scrutiny
by Revenue Canada.
Were you aware of the fact that advice was given, by the
same lawyer who advised you, to Enron that this transaction
would attract scrutiny by Revenue Canada, Mr. Peiffer?
Mr. Peiffer. At the time of this transaction, I was not
aware. I have since become aware. But to comment on that, I
don't think it necessarily would be surprising to say that this
transaction or any necessarily complex transaction with tax
advantages would--might invite some scrutiny.
Senator Levin. But you designed the structure to be hidden
from authorities, Canadian authorities. For example, Flagstaff,
which is your special purpose entity, was concerned because the
$375 million that it received from the bank consortium had a
different interest rate than the so-called $1.4 billion loan,
so Chase could lose money.
And so Enron and Chase considered alternatives to avoid
that risk, and Exhibit 344,\1\ if you will turn to that,
contains a chart depicting various alternative strategies to
alleviate Chase's interest rate risk. The chart on page 12 of
that Exhibit 344 addresses alternative one under this section,
entitled ``Advantages.'' Advantages--there were three
alternatives you were looking at to address your interest rate
risk, three alternatives.
---------------------------------------------------------------------------
\1\ Exhibit No. 344 appears in the Appendix on page 396.
---------------------------------------------------------------------------
Alternative one had the advantage of not having a road map
for Revenue Canada, and to read the exact words there, ``No
road map for Revenue Canada. No swap by Enron on economic
interest.''
Now, a few pages later in Exhibit 344 is a chart that
summarizes all three alternatives. One of the advantages of
alternative two--excuse me, one of the disadvantages of
alternative two is that it leaves a potential road map. Do you
see that on page 15, under alternative two, disadvantages?
Mr. Peiffer. Yes, I do.
Senator Levin. Potential road map. Who does it leave a
potential road map for? That same Revenue Canada.
And then looking at the disadvantages listed for
alternative three, it lists under disadvantages, possible road
map for Revenue Canada with respect to these alternatives. So
it clearly was your design and your joint decision with Enron,
is it not correct, that you wanted to avoid providing a road
map to Revenue Canada, is that a fair statement?
Mr. Peiffer. Well, what I think is unfair is to say that
the transaction was designed to avoid scrutiny. I think with
any tax advantaged transaction that any company would do, there
is an inherent desire to avoid highlighting the transaction.
This, in particular, the interest rate swap, I don't think had
on the margin very significant ability to highlight or not
highlight the transaction.
As you can see, there are a number of boxes and arrows, so
to speak, with the transaction. I think that if the transaction
was to be audited or not audited based on that, and to isolate
it to the interest rate swap, I don't believe was the case.
I mean, it was one of many advantages or disadvantages
under each alternative that we considered and Enron ultimately
ended up choosing the alternative based on whether it felt it
could get comfortable with taking on additional fixed-rate
interest rate exposure. There was very little discussion as to
the road map, and when Enron actually chose that alternative,
my recollection of the conversation was that it was based
entirely on its ability to absorb additional fixed interest
rate exposure and that there was no concern or discussion about
this potential road map issue that we are looking at here.
Senator Levin. Whether there was discussion of it or not,
this is a document that you used to pitch this particular
approach, did you not? Didn't you design this? Wasn't this a
Chase design?
Mr. Peiffer. I was not heavily involved at all in designing
the structure, as I am not a tax expert.
Senator Levin. Was it Chase's design, though?
Mr. Peiffer. It was Chase's design, using a good deal of
existing technology, tax technology, let us call it, that
existed and other tax regimes where form took a great deal of
place over substance.
Senator Levin. So in the Chase design, or its tax
technology, as you call it, you listed the advantages and
disadvantages of each of three approaches, and Chase listed an
advantage of there not being a road map to a potential
customer, and listing alternatives two and three having
disadvantages of having potential road map or possible road
map. That is what you were pitching to a client here, is that
not correct?
Mr. Peiffer. Well, at this point----
Senator Levin. Whether there was discussion of it or not,
this is your document, isn't it?
Mr. Peiffer. Right. This was an organizational meeting. It
was discussing the transaction, assuming that the transaction
would go forward. It is our document, but, again, it naturally
would have been this company's preference to not highlight a
transaction.
Senator Levin. Which company, yours or Enron's, when you
say----
Mr. Peiffer. Enron's.
Senator Levin. Why would you want to not have a transaction
be apparent, or be transparent? Why would you want to try to
sell an advantage of an option as not being transparent to the
tax folks and to avoid giving them a road map? Why did you want
to avoid that? Why did you think Enron wanted to avoid that?
Mr. Peiffer. I think it is customary that any company would
rather not highlight a transaction with tax advantages, given
that I think that the transaction itself would more or less
highlight itself were it to be looked at by Revenue Canada, and
they certainly would.
Senator Levin. Well, if they were going to look at it
anyway, then you wouldn't have to pitch the absence of a road
map as being an advantage, would you?
Mr. Peiffer. In the end, there ended up being very little,
if any, discussion around this particular aspect of choosing
the interest rate swap precisely because of that.
Senator Levin. I am not so interested in whether there was
a discussion. I am much more interested in why Chase would
design a structure and make a pitch for one of the options as
having the advantage of being less transparent to the tax
authorities. If you have nothing to hide, it would seem to me
that Enron would be perfectly willing to share all the
information with the tax authorities. They would not care if
they gave it a road map or not.
Something was being hidden here by Enron. They didn't want
this to come to the attention of the tax authorities. They had
an opinion, as a matter of fact, which you say you didn't know
about, but they had an opinion from the tax lawyer who also
gave you tax advice on this transaction. The opinion from their
tax lawyer and yours, but you say only to Enron, was that this
would be challenged, or might be challenged by tax authorities
in Canada, and then you went and pitched this deal to them on
something that you obviously thought would be attractive to
them, which is that it would not give a road map to the people
that would challenge this or might challenge this.
Mr. Peiffer. With all due respect, the opinion that Blake
Cassels wrote to Enron took place a good number of months after
this was put together, and so based on the opinion that we had,
we believed, given the strength of the opinion, that even if it
were challenged, that it was a strong transaction and that the
tax benefits inherent in it would stand.
Again, the interest rate swap was a very small aspect of
this transaction, and so to say whether it was not highlighted
or not, I think it is very difficult to extrapolate and say we
are trying to hide or even not highlight the entire
transaction.
Senator Levin. That is not extrapolation. I am reading your
document.\1\
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\1\ Exhibit No. 344 appears in the Appendix on page 396.
---------------------------------------------------------------------------
Mr. Peiffer. But with all due respect, this is a very small
part of the entire transaction, and to say----
Senator Levin. I am not extrapolating.
Mr. Peiffer [continuing]. And to say on the margin that
this is what is hiding the transaction----
Senator Levin. Advantage No. 1, no road map. Advantage No.
2, no swap fees. Advantage No. 3, most preferable alternative,
Canadian tax perspective.
Mr. Peiffer. That is--I am sorry.
Senator Levin. That is listed by you as advantage No. 1 for
alternative No. 1. I am not reading something into this. I am
reading your words. That is advantage No. 1.
Mr. Feldstein. May I say something that----
Senator Levin. Sure.
Mr. Feldstein [continuing]. Maybe helps to make sense of
this, and if you will give me permission, I wanted to say
something more broadly. I will get to your questions about the
swap transaction, at least my impressions of what went on. But,
as well, I wanted to talk about the $1 billion which you
mentioned previously.
So I want to start maybe with just some general comments
on--very brief, I promise--on transactions with big tax
consequences like this. I want to give you my impressions of
the Slapshot deal based, of course, on 20/20 hindsight, and I
want to really briefly, I promise, talk about what is different
at our institution relative to when this transaction was done.
So first, unlike in the United States, tax principles in
some jurisdictions elevate the importance of the form of a
transaction. Sometimes that helps taxpayers and sometimes it
works to their detriment. It is usually accepted in these
jurisdictions that taxpayers are entitled to structure a
business transaction in the most advantageous form for tax
purposes. In fact, their shareholders might say that companies
are obligated to do that. So that is just general observation.
My second point, which is on this specific transaction, I,
too, am not a Canadian tax expert, but from what I have
gleaned, from what I have read, including the report and
internal inquiries, I believe that the Canadian tax laws
relevant to this transaction are very formalistic. The business
transaction, you described correctly, was a $375 million
borrowing. The form of the transaction, including the economic
reality, what was an economic reality, the $1 billion flow of
funds, if respected, including all the separate entities and
the separate instruments that were created under some very
formalistic Canadian tax laws, showed a $1.4 billion borrowing
and it was tax advantageous to do that and it was very
formalistic.
My impressions of the swap, to get back to the questions
you were asking, is that it was also important, being a very
formalistic regime, to make the swap look like it was swapping
the transactions that were trying to be respected as the form
of the transaction, i.e., swapping the $1.4 billion
transaction, not swapping what the underlying business
transaction was, which was the $375 million loan.
From the review I have done and from your report, I glean
also that the structures on this transaction received advice
from Canadian tax counsel that the form should be respected.
Tax counsel didn't say it was 100 percent certain, and
generally, that is not a condition for structuring deals with
material tax consequences.
We know now, after the fact, that Enron received an opinion
from tax counsel, and you were right, it was the same tax
counsel that had previously represented Morgan, but my
understanding in talking with people is that it was at Enron's
request that we stop using that counsel so they could because
it was their regular tax counsel. They received an opinion from
that counsel on the specific facts of this transaction that
heavily caveated the advice. My understanding is that no one
from J.P. Morgan Chase saw that caveated opinion.
So that brings me to item No. three, which is what would we
do differently now, because I think we would do things
differently. First of all, we now insist on advice from our own
internal corporate tax department, which is separate from the
business unit, an independent third party tax counsel of their
choosing to give us advice on the specific facts of any
transaction. I presume that on the specific facts of this
transaction, given what we learned after the fact about the
opinion that Enron received, that we might have had new and
different information that may have--I was not there, so I
don't know for sure, but that may have caused us to act
differently in this case.
Senator Levin. Why would you have acted differently, only
if you had access to the legal opinion?
Mr. Feldstein. Again, let me try to maybe----
Senator Levin. You said you might have acted differently. I
am trying to figure out why.
Mr. Feldstein. Maybe I wasn't----
Senator Levin. What would you have now that you didn't have
then?
Mr. Feldstein. I guess I didn't explain it well enough.
What we didn't do then, but we do now, is with respect to any
transaction with material tax consequences or transactions
which appear to us to have material tax consequences, we take
that transaction and all the specific actual facts of that
transaction to our corporate tax group, a completely separate
group within the firm, not part of the business unit. Based on
the facts that we provide to the corporate tax group, their
review of them, but also the review of outside counsel selected
by the corporate tax group reviewing the specific facts of the
deal, we get advice on the strength of the tax consequences or
the tax analysis of that specific transaction.
That step was not part of our policy when this transaction
was undertaken, so that as you pointed out, the opinion
delivered to Enron, not seen by us, caveated the original
advice that J.P. Morgan Chase had received about the certainty
of the tax consequences. It caveated it heavily.
I presume, I don't know for certain, but I presume that if
we had engaged our corporate tax group, if the people working
on the transaction had engaged the corporate tax group and the
corporate tax group had engaged the outside counsel,
independent outside counsel that they would today, that J.P.
Morgan Chase, as well as Enron, based on the specific facts of
the deal as it was structured, would have received very heavily
caveated advice about it. And if that were the case, the fact
that we received very heavily caveated advice may have caused
us to walk away from this transaction.
The big policy change, again, because maybe I didn't
express myself clearly the first time, is that all transactions
of this nature, and not just ones where we know explicitly
there is a material tax consequence, but ones that have certain
indicia that lead us to presume that there are material tax
consequences, there is a rule that now everybody follows
willingly to take that transaction, the specific facts of the
transaction to the corporate tax group for independent advice.
Senator Levin. You very much hedged your statement. I think
the bottom line is, would Chase be pitching this deal today?
This is your design. This is your structure.
Mr. Feldstein. Let me first----
Senator Levin. This isn't something Enron cooked up. This
is something Chase cooked up. Would you be pitching this deal
today?
Mr. Feldstein. I think that is an excellent question.
Senator Levin. I appreciate your saying that, but let me
just have a clear answer. Would you be pitching this today?
Mr. Feldstein. Let me answer it in two ways, first,
specifically. We don't pitch this transaction today. Second,
more generally----
Senator Levin. How would you pitch it today, given what you
know about it?
Mr. Feldstein. We would not pitch it today, given what we
learned are the--we would not enter into this transaction the
way it was----
Senator Levin. Let us get to it. You designed this
structure. It is not entered into it.
Mr. Feldstein. Let me----
Senator Levin. You designed the structure. Would you design
a structure like this today?
Mr. Feldstein. I do not believe we would. I was not there
at the time, so I don't know what went into designing this
structure.
Senator Levin. That is why I am saying today. Would you
design this structure today?
Mr. Feldstein. Let me talk more generally, then, about what
we do today that is different from what we did then in the
design of transactions and the marketing of transactions.
I would characterize the way the firm approached the
business last year as a product-out approach. That is, the firm
would design products like this and they would go and market
those products to clients. We have reoriented our approach. I
would describe the approach today as a client-in approach.
As opposed to designing generic transactions that we market
to any number of clients who may or may not have the
appropriate situation for those transactions, we start from a
specific client situation, understand what makes the most sense
for that client, and sometimes there are tax consequences to
transactions where we advise clients to do things in a certain
way to take--to create a transaction that most effectively--
with the most effective tax consequences. But that is different
from what I think the old orientation was, which was to design
a transaction generically and market it.
So on your specific question, I don't think we would have
done this transaction today given the policies we have in place
to understand more about it, and more generally, I don't think
we do business the way we did business then. As a business
matter, we are much more client-in as opposed to product-out.
Senator Levin. But putting that aside, generic change,
client-in, client-out, this is a structure, whether you design
it or whether it is designed by somebody else. Would you be
using this structure today?
Mr. Feldstein. We don't use this structure today, so it
wouldn't----
Senator Levin. Based on what you know about this structure,
I know you don't, but would you use it, given its $1 billion
fake appearance of a loan? Would you participate in this
thing----
Mr. Feldstein. Given the tax----
Mr. Patterson. Can I take a crack at that, Senator Levin?
Senator Levin. You folks helped to create the appearance of
a $1.4 billion loan. It wasn't. It was an economic loan of less
than $400 million. The billion you handed with this hand got it
back with this hand. You helped them create an appearance which
then, as you knew it, allowed that--because you sold it--
allowed that company to claim an interest payment for the full
amount of what was really a payment of interest and principal.
You knew you were participating in that.
Now, you also knew that it might be recharacterized by the
tax authorities in Canada and you even took steps to what would
happen if the jig was up, if they caught on, if they didn't
allow the interest payment on the $1.4 billion and they took
that payment as being payment of interest and principal. You
even then went to the lengths of deciding what would you do if
Revenue Canada said, hey, wait a minute. That is not a $1.4
billion loan. That is a $400 million loan and the repayments of
it are payments of principal and interest, not all interest. We
are not going to give you a tax deduction, Enron. You folks
even worked with Enron on what you would do then.
My question is, would you participate in this kind of a
transaction now? I don't care whether you design it or someone
else designs it. You know what this transaction was. You know
the details of it. Would you participate in this transaction
today? That is my question.
Mr. Patterson. I think not. The result that you describe
seems quirky, but as Mr. Feldstein explained, there are some
tax jurisdictions where form seems to triumph over substance.
That is why we rely on the advice of tax counsel in those
jurisdictions before we go ahead.
In this case, as Mr. Feldstein said, we didn't consult the
tax counsel in the same way that we would today, and I won't
repeat everything he described, but we would have our corporate
tax department, which is charged with looking after the firm's
reputation in these matters, get its own outside counsel and
get an opinion based on all the facts.
I do not know, because I am not a tax counsel, whether we
would get as clean an opinion today as would be necessary for
us to go forward. But even if we did, sir, as I mentioned in my
opening statement, beyond assuring compliance with all external
requirements, including tax laws, even if we thought this one
might work, I personally, as head of the policy review
function, would have to take into account how this would look
to the world if, as we always have to assume, it would be
publicly disclosed, and whether even if it met all the legal
requirements and passed muster under Canadian tax law, it would
be difficult to explain and might adversely affect our
reputation. And on that basis, knowing what I know, I would not
market this structure today.
Senator Levin. Is this just a matter of how it looks to the
world? Is this just a matter of that? Isn't there something
rotten about something which looks like a $1.4 billion loan
which is a $400 million loan? Doesn't that trouble you as a
banker?
Mr. Patterson. Well, the public perception of it troubles
me. If you put the--what if we went to the Canadian tax
authorities and got an opinion from the Canadian tax
authorities that it worked? It would still look kind of quirky,
but it would not be viewed in Canada as rotten.
Senator Levin. Would you be willing to do what you did with
Enron back then in terms of figuring out, what are we going to
do if the Canadian tax authorities find out about this, despite
your lack of a road map, that they track it anyway, that they
spend as much time as this Subcommittee staff had to spend to
figure out what was really going on here, Canadian tax
authorities, if they did that, if they reached the same
conclusion that this was more than quirky, this is just simply
misleading because you are pretending that there was $1.4
billion which was lent, when in fact it was only $375 million,
and if they reached that conclusion, you folks worked, and if
you will take a look here at Exhibit 351,\1\ you folks even had
a recharacterization rider. You had a fallback. You had a
safety net here if they caught on and if they recharacterized
this.
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\1\ Exhibit No. 351 appears in the Appendix on page 514.
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This is your document. The rider attempts to recast any
principal paid in excess of 25 percent of the recharacterized
loan as instead being a loan to Chase, instead of from Chase.
Here you have got Enron. You are cooking up a deal. This is
something you are pitching, you pitched.
Mr. Patterson. I actually think that was added by Enron to
the deal we pitched.
Senator Levin. All right. You accepted it.
Mr. Patterson. We accepted it, yes.
Senator Levin. You agreed to this rider, which says if they
decide, if the Canadian authorities find out about it despite
your lack of a road map, if they find out about it, you agreed
with Enron that you would then retroactively recast this as a
loan to Chase instead of from Chase. One of the biggest banks
in the world is being lent money by a client. That is what you
agreed to. Does that trouble you, not just the appearance if it
is made public, does that bother you as a person, as a banker?
Mr. Patterson. Well, the fact that we borrow money from a
client doesn't bother me. It seems to me not surprising that
one would try to anticipate what we would do if the initially
intended tax results were rejected by the Canadian tax
authorities. I assume in that context, I don't know, but I
assume that the whole transaction would be transparent to the
Canadian tax authorities at that time, including the
recharacterization, and they might accept it or not accept it.
Senator Levin. Is there any way in just common sense
understanding that that could accurately be characterized as a
loan to you?
Mr. Patterson. To be honest, I am not familiar enough with
the transaction to be able to answer that question.
Senator Levin. Well, think about it, would you, and give us
an answer for the record.\2\
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\2\ Exhibit No. 391 appears in the Appendix on page 1006.
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Mr. Patterson. Whether----
Senator Levin. Would you do that? Would you give it a
little thought and give us an answer for the record?
Mr. Patterson. Whether it would be possible to
characterize----
Senator Levin. Whether you think----
Mr. Patterson [continuing]. Recharacterize a transaction as
a loan to us?
Senator Levin. Whether you think that in any way could be
fairly described as a loan from Enron to Chase.
Mr. Patterson. Happy to.
Senator Levin. My understanding, by the way, is that
opinion that came to Enron from the lawyers came within a
couple days of, what, the completion of the transaction. It
wasn't, as you indicated, Mr. Peiffer, months later. It was
just right around the transaction.
Mr. Peiffer. My understanding----
Senator Levin. It is obvious Chase knew that there was a
question about this. We might as well cut to the chase. It is
obvious that you knew that there could be a problem. Whether
that same tax lawyer gave you that advice that they gave Enron
or not, you knew it because you had worked out what would
happen if the Canadian authorities decided that this wasn't
right. You worked that out. So you knew that there could be a
problem with this.
To that extent that you had a retroactive
recharacterization to turn something which was a loan from you
into a loan to you, and it is that recharacterization document
which seems to me to speak volumes.\1\ It may only be a page,
but it speaks volumes. It speaks about what Chase really
believed. Whether you saw that opinion that the Enron folks got
from that same lawyer or not, you knew there could be a
problem.
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\1\ Exhibit No. 351 appears in the Appendix on page 514.
---------------------------------------------------------------------------
Mr. Peiffer. Could I make a comment on this?
Senator Levin. Please.
Mr. Peiffer. Again, Enron came to us with this. We are not
sure why--actually, I can say I do know why Enron came to us
with this. In the event that the Canadian tax authorities would
recharacterize this, or choose----
Senator Levin. Disallow it.
Mr. Peiffer. Disallow, yes, choose to disallow it by
choosing to recharacterize it as a $375 million loan, Enron was
concerned specifically in that situation, if that was, say, a
20, 25 percent chance of that happening, which would be
consistent with a ``should'' level opinion, then they wanted to
limit the specific downside with respect to withholding tax.
They and their counsel thought that this provision would have a
chance of success with that. It is not something we came up
with, nor was it something we even thought made sense for Enron
to put in that, and we voiced that opinion to them.
Senator Levin. You agreed to it.
Mr. Peiffer. We didn't think it was needed.
Senator Levin. Did you agree to it?
Mr. Peiffer. Because of our strong opinions and what we
knew their opinion to be, or that we thought it was going to
be, but yes, we agreed to it and it was something that Enron
even amongst themselves was deliberating. And so I think it
would be incorrect to mischaracterize this as saying this is a
reflection of what everybody thought of the deal. I think this
was a specific clause to recharacterize something specifically,
withholding tax benefits, withholding tax that would need to be
paid----
Senator Levin. Sure.
Mr. Peiffer [continuing]. If the intended tax benefits were
not achieved, and my understanding----
Senator Levin. You agree----
Mr. Peiffer [continuing]. With a lot of tax transactions,
whether in the United States, Canada, anywhere, is that there
are provisions to address certain things like that if the
intended tax benefits aren't achieved.
Senator Levin. But Chase agreed to recharacterize something
as a loan to it instead of a loan from it in order to help
Enron avoid taxes.
Mr. Peiffer. I think in order to, under the Canadian tax
rules, potentially avoid withholding taxes if the transaction
were--if the tax benefits with respect to the transaction were
disallowed. That doesn't take away the strength of the opinions
or what we or Enron believed to be the high probability of the
tax benefits.
Senator Levin. There is nothing to take away from those
opinions, because you knew--Chase knew that this loan was not
$1.4 billion. That much, we know you knew. You have
acknowledged that. You knew it was an economic loan of $400
million.
Mr. Peiffer. It was an economic loan of $375 million----
Senator Levin. Three-hundred-and-seventy-five million.
Mr. Peiffer [continuing]. For legal and Canadian tax
purposes, the advice we received is that it was, indeed, a $1.4
billion loan.
Senator Levin. And you also knew that it was going to be
challenged or could be challenged, and you also then agreed
with Enron that if it were challenged, you would retroactively
change its nature. You would recharacterize it so that Enron
wouldn't be hit with taxes by Canada. You helped to perpetrate
a fiction. You helped them perpetrate a fiction, because there
was no $1 billion loan.
Mr. Peiffer. I am sorry, I take exception with that.
Senator Levin. You might take exception----
Mr. Peiffer. I don't look at this as perpetrating a
fiction.
Senator Levin. That is a fiction. There was no $1 billion
lent to them.
Mr. Peiffer. We have opinions from Canadian tax counsel----
Senator Levin. Was $1 billion lent to them or not?
Mr. Peiffer [continuing]. With that----
Senator Levin. Was $1 billion lent to them? I know there
was $375 million. I am not talking about that. Was there $1
billion lent?
Mr. Peiffer. There was a $1.4 billion loan made to the
subsidiary of----
Senator Levin. Of which $1 billion was repaid within
minutes, is that----
Mr. Peiffer. Under a separate contract, with money coming
from elsewhere in Enron.
Senator Levin. Separate contract, it was repaid within
minutes, wasn't it?
Mr. Peiffer. I think the distinction here again to make is
that Canada follows a very form over substance----
Senator Levin. I am not talking Canada. I am talking Chase,
your reputation, transparency. We hear lectures about
transparency, that you are going to be transparent. I am not
talking about Canada. Canada will take care of itself. I am
talking about Chase. You knew that the $1 billion of the $1.4
billion came right back to you, did you not? You knew that
much.
Mr. Peiffer. I knew $1 billion was coming back to us, that
is correct.
Senator Levin. Of that $1.4 billion.
Mr. Peiffer. Money is fungible and it was two separate
transactions and we were advised that the transaction as a
whole should be split up into two separate transactions, and
yes, we did receive $1 billion back.
Senator Levin. Did you get a legal opinion about this
recharacterization?
Mr. Peiffer. We did not----
Senator Levin. When you agreed to this----
Mr. Peiffer. There was no need for Chase to.
Senator Levin. When you agreed to this, was there a legal
opinion on this that Chase got?
Mr. Peiffer. With respect to this, in the context of this,
Chase did not need to receive a legal opinion, but my
understanding is that Enron received advice from their Canadian
tax counsel that it might be advantageous to put this in there
in the event that this were audited and all the facts had
become known and that there is the potential that this might do
something for them.
Senator Levin. You understood that Enron got an opinion
from its lawyers about this?
Mr. Peiffer. Yes, I do.
Senator Levin. But you didn't?
Mr. Peiffer. We had an opinion based on the generic
transaction, the generic structure----
Senator Levin. No, I know that----
Mr. Peiffer [continuing]. But with respect to----
Senator Levin. The recharacterization.
Mr. Feldstein. My understanding is J.P. Morgan Chase did
not get an opinion on the specific details of the transaction.
Mr. Peiffer. Right.
Mr. Feldstein. Today, we certainly would.
Senator Levin. Mr. Peiffer, you helped dream up Slapshot
and helped develop it. Were you rewarded in any way by your
supervisors for this, any special way?
Mr. Peiffer. I think it is fair to say?
Senator Levin. Was there a bonus, special bonus of any
kind? Did you get----
Mr. Peiffer. There was no special bonus with respect to
this. I think it is fair to say that it was one of many
elements that, you know, played into the paying of a year-end
bonus. We would all have been much better off, I think, also,
if we had never made any of these loans to Enron and Enron had
not gone bankrupt and the bank had more money to pay the
bonuses. We all would have been better off if that were the
case.
Senator Levin. Let me conclude by just saying this. You
have got some language on your website which says that banks
were victims in fraud cases, not accomplices. All I can tell
you is this, that this is a structure which you folks designed.
You are not the victim here. You designed a structure. You sold
a structure. Part of the sale was that it would not be
providing a road map. You then agreed if, in fact, the Canadian
tax authority would find that was not allowable, even agreed
retroactively to recharacterize a loan from you into a loan to
you. You folks aren't victims here.
Mr. Feldstein. May I add something?
Senator Levin. You folks helped a deceptive practice by
Enron to be perpetrated, and it is--I am glad you are changing
your approach. I can't tell you how glad I am. I will look
forward, Mr. Patterson, to your answering the question for the
record that you said you would think about.\1\
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\1\ Exhibit No. 391 appears in the Appendix on page 1006.
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But it is important that we all worry about how things
look, and that is important. But what is more important is how
things really are.
Mr. Feldstein. Could I just address your comments about the
victim? My interpretation of that was that financial
institutions were the victims of deceptive accounting practices
and disclosure practices, or apparently deceptive practices at
Enron. This transaction, and we have gone through the certainty
or lack thereof in terms of the tax consequences, but this had
nothing to do with the accounting presentation that Enron
provided, but rather was a transaction which rested upon
whether Canadian tax law would respect the form in which it was
structured, and the victim comment, I think, is about the
apparent accounting deception practiced by Enron, which is a
different subject, I believe.
Senator Levin. Your prepay pitch book back in 1998, if you
look at Exhibit 128, says the following. This is what you were
pitching. Prepayment received for a forward sale of inventory,
fixed quantity, specific delivery locations. Your third dot
says, balance sheet-friendly. Is that still the kind of pitch
you would make, balance sheet-friendly, or balance sheet
accurate? Which is more important?
Mr. Feldstein. Balance sheet accurate.
Senator Levin. Is it fair to say, Mr. Patterson, you
wouldn't be making a pitch quite like that anymore?
Mr. Patterson. I don't have it and can't see it, but----
Senator Levin. It is Exhibit 128.
Mr. Patterson. I don't think we have No. 128 here.
Senator Levin. I am sorry, I have got the wrong number. It
is Exhibit 169.
Mr. Patterson. I don't think we have that, either.
Senator Levin. Let me try again, Exhibit 369.\2\
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\2\ Exhibit No. 369 appears in the Appendix on page 687.
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Mr. Patterson. Three-sixty-nine. No, I think that we
probably would not use that terminology today. That doesn't
mean that accounting considerations are not relevant to our
clients and to the transactions they enter into. They are
structured in a way to comply with accounting rules. So
accounting considerations continue to be an important part of
structured finance. The key is that the accounting treatment be
correct and not misleading.
Senator Levin. Thank you. Thank you all for your appearance
here today and we wish you good luck in greeting the weather on
your return home, and we also wish you good luck in
implementing fully and forcefully your new approach. It is
important that our institutions, the ones we rely so heavily
on, such as Chase and Citibank and others that have been such
an important part of this economy, have the confidence and
credibility of the public. I hope your new guidance has an
impact in that regard, both internally and externally. Thank
you all for coming.
Mr. Patterson. Thank you, Senator.
Mr. Peiffer. Thank you.
Senator Levin. Ms. Siebert, we now welcome you, President
and Chair of Muriel Siebert and Company of New York. Ms.
Siebert gained fame as the first woman member of the New York
Stock Exchange and Superintendent of Banks for the State of New
York, now an owner of a discount stock brokerage firm, one of
our wise elders--I hope you won't mind that description--when
it comes to finance and the securities business. I want to
thank you for your travels here today from New York, also
fighting the elements.
Pursuant to Rule 6, as I have mentioned to all of our
witnesses, our witnesses need to be sworn because of that rule
of the Subcommittee, and so I would ask you to please stand and
raise your right hand.
Do you swear that the testimony that you will give before
this Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Ms. Siebert. Yes, I do.
Senator Levin. Ms. Siebert, I think you have a statement,
which we would ask you now to proceed with.
TESTIMONY OF MURIEL SIEBERT,\1\ PRESIDENT AND CHAIR, MURIEL
SIEBERT AND COMPANY, INC., NEW YORK, NEW YORK
Ms. Siebert. Yes. I submitted a written statement, but I
have an abbreviated oral statement. I would like to thank you
for inviting me. I am sorry I was late, but I came by way of
LaGuardia Airport and then the train because they canceled our
flights, so I apologize for being late.
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\1\ The prepared statement of Ms. Siebert appears in the Appendix
on page 113.
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Senator Levin. Actually, you are right on time, except you
missed some testimony.
Ms. Siebert. Terrific. I commend your Subcommittee for
tackling this very tough, nasty job. You know, it will be 35
years ago that I became the first woman member of the New York
Stock Exchange, and at the time, while many people did not want
me, I joined a group where your word was your bond and you
would go broke before you broke your word. Things have changed
when I look at the Enron transactions. The money became too
vast and it was made too fast. I am sorry to say that greed
became the creed.
Enron, in my opinion, represents a total moral bankruptcy.
It took more than the officers and the directors of the
company. It required help from the accountants, the lawyers,
and the investment and commercial banks. Many people profited
from these transactions, except the investing public, many of
whom will never be able to make their losses back. It has
affected their future retirement and we have to make sure this
does not happen again.
My interest in Enron really began in February. I received a
call from the man that runs our retail discount operations and
he told me that he was seeing things that he never saw before.
We had clients selling out their entire portfolios and
requesting a check. We would not see that transaction if they
sold their entire portfolios and went into a money market fund.
That would be an automatic sweep. But when they requested a
check, it took an action on their part and our part.
I asked Peter, because we call every customer that leaves
our firm, and if it is because their nephew has gone to work
for Merrill Lynch, so be it. God bless them and good luck. If
it is because of something we have done wrong, I want to know
about it.
So I started to get the reports every week, and the answer
was, don't trust the integrity of the system. The system is
against us. We can't let this happen. The reports have
continued to come in that way, although very few people
compared to what we had before.
Our capital raising system is a national treasure. In the
1990's, the United States created tens of millions of new jobs.
Every new technological development was made in the United
States, and for most of the decade, at least the early part and
middle part of the 1990's, the market was orderly and the
public, the small investors, started to invest. First, they
bought mutual funds. They wanted to own a piece of America.
After I received the same answers for a few weeks, I
realized the seriousness of the abrupt change in our investors'
attitudes. Many of them, when we called them, specifically
mentioned Enron. Sure, that was probably because there was a
lot of publicity going on at that time, but they had been hurt
in bond funds and other products.
I will give you an example. When I gave a speech for the
Miami Herald at their yearly investors' conference, a man in
his 80's during the question and answer period told me, ``I
lost a third of my money. Will they go to jail?'' This is
serious.
Enron could not have happened without two new financial
products, derivatives and structured finance. These products in
themselves are not bad. It was the purpose that was employed
that was terribly wrong. They were used to deceive. The
financial engineering permitted operations by legal loophole.
Derivatives are not new. I testified in 1988, I have it
here, after the 1987 market break. That was portfolio
insurance. The regulators passed some laws and portfolio
insurance is finished.
I testified in 1998, 10 years later, after long-term
capital market. Our country, frankly, lucked out in Long-Term
Capital Management. Bob Rubin was our Secretary of Treasury and
he was the only Secretary of Treasury that has ever come from
the trading desks. He had helped invent derivatives. He knew
what to do. Long-Term Capital Management had an equity, it is
reported, of $4 to $5 billion and they were carrying, using
derivatives, the notional value was over $1 trillion. When they
made the wrong bet, major margin calls were threatened. The
Federal Reserve called in the firms downtown. They called in
the banks and they put together money and they took over the
operations of Long-Term Capital Management and we liquidated it
in a way that the public was not hurt.
When I continued to see the attitude of our individual
investors, in late spring, I said, well, I had better go down
to Washington and tell some people what I am seeing, because I
had never seen this before. So I had lunch with Larry Lindsey.
I had a telephone appointment with Secretary O'Neill and I
spent time with Mr. Pitt and his deputies. I recommended three
things.
Under Sarbanes-Oxley, officers of corporations must certify
the authenticity of the earnings reports. I recommend that we
add a statement to those reports that these figures represent
economic reality. That would eliminate the sham transactions.
That would have eliminated the phony energy trades. No officer
would sign a statement that the transactions that your
Subcommittee is examining represented economic reality.
Enron was the leader in energy trading when it became
deregulated. They used legal loopholes to create an illusion of
activity. The trading practices of buying and selling on the
same day, the same amount, at the same price, are illegal. They
are considered to be wash sales in the listed markets. In the
over-the-counter markets, they were legal. Other formerly solid
conservative utilities participated in these trades, which are
still being unraveled. As a result, some of these utilities
have had to reduce or suspend their dividends. Most of these
stocks are owned by individuals who count on the dividends for
their livelihood.
In some cases, the price of some of these utility stocks
have been cut in half very fast, literally overnight.
Now, when companies issue debt, they have an indenture
which spell out the terms that these bonds are being issued
under. It is their covenants, for example, the ratio of
interest coverage, the ratio of asset coverage, the rating of
bonds by rating agencies. If these covenants are violated, they
have debt triggers in there whereby certain things are
triggered. They can force a company to repay the bonds
immediately. It is very difficult for individuals or
institutional investors to get the terms of these bonds. They
would not have owned a lot of these securities had these terms
been readily available.
I recommend that the debt triggers and terms of indentures
on bonds, as well as covenants or terms in the preferred
stocks, be made available easily and be listed on the
corporation's website so that anyone who takes the effort, who
wants to invest money, I do not care if it is 100 share of a
Duke preferred stock or a Dominion preferred stock, can see the
terms and see under what circumstances their income might be
stopped or they will lose their protection.
Finance is now global. It is almost impossible for
regulators to keep up with the fast-moving technology. The SEC
and Federal and State regulators, bank regulators, together
could identify these transactions if the information was
furnished. Otherwise, it is very hard for them to get into
this. The SEC could have identified it. The Federal bank and
the State bank regulators could have identified some of these
transactions. It is difficult for U.S. regulators to act
unilaterally. It will have the effect of driving the business
offshore, but will not stop the business.
We know we are going to have global bank regulations. We
have some now. We will have global accounting standards. I
suggest that our country be the leader to establish global
securities regulations, that we include derivatives and margin
requirements and other things that are used to get around the
purpose of the laws.
Certain laws and regulations have been passed which will
stop the same practices from occurring again, but we must make
sure that our focus is on the individual investor also, and
that it is geared towards reinstating their faith in the
system.
Thank you for inviting me and allowing me to participate.
Senator Levin. Thank you very much, Ms. Siebert, for your
very thoughtful testimony.
I don't know how much of the testimony this morning you
were here to hear. I know you had to take a train when you
expected to fly, but I think you have had an opportunity to
look at the transactions which we were discussing here this
morning in the report of our staff. What is your reaction to
those transactions that you read about in our report?
Ms. Siebert. They were designed to deceive. They were
designed to create the illusion of certain economic events. I
do not see the economic reality for it.
Senator Levin. I think your testimony probably answered
this question, but I will ask it, in effect, again. Are these
the types of transactions that we want our major banks not only
participating in, but designing and selling to public companies
and to other clients?
Ms. Siebert. No, they are not the kind of transactions, and
I would also say that if they do participate in those kind of
transactions, they should not have the benefit of FDIC
insurance.
Senator Levin. We are going to be hearing from our
regulators in our next panel and we want to find out what is
being done to stop this kind of deceptive practice, and I am
wondering whether you would agree that our regulators need to
not only take enforcement actions on a case-by-case basis to
punish wrongdoers, but also to construct a regulatory
deterrence program to deter future wrongdoing.
Ms. Siebert. I believe they can do it. Our regulators are
really a top quality group. The Federal Reserve and Federal
bank regulators, the State bank regulators, the SEC, they have
dedicated staff there. I mean, it is wonderful to see them. But
I also believe that the information must be furnished them so
they don't have to go hunting for it.
Senator Levin. And if that information is furnished for
them, or to them, excuse me, would it be useful if they can
design, as you put it in your testimony, acting together with
the SEC and the bank regulators acting together to regulate the
kind of transactions which we have heard about and talked about
here at this Subcommittee.
Ms. Siebert. I believe it is. For a long time, I have said
that we need regulation by function, because investment banks
are doing the job previously done by banks and banks are doing
the job previously done by investment firms. So they will have
to work together. Normally, I don't like to see Uncle Sam and
the regulators get too big, but it is probably the only way
where we can effectively put our arms around this problem.
Senator Levin. And in terms of the information that you say
is so important for them to have so that they can act, would
you feel it would be helpful if the SEC and the bank regulators
conducted a comprehensive joint review of these structured
finance products which are being sold by or used by our
financial institutions so that they could identify the ones
that are designed to deceive?
Ms. Siebert. Yes, I believe that would be very welcome and
necessary.
Senator Levin. Our thanks again. You are a frequent visitor
to committees of the Congress, to be providing the kind of
testimony which comes from your experience and we are very
grateful for that testimony and for your experience, for what
you bring to the world in which you spend a great deal of your
time.
Ms. Siebert. I believe in the system. It has been very good
to a lot of us.
Senator Levin. It has, and we are going to do everything we
can to make sure that system is strengthened and that
credibility in it is restored, and it is going to take, I
believe, at least, a combination of the entities, the
institutions, the financial folks acting on their own to clean
house, but it also is going to take a stronger regulatory arm,
and we are going to talk to our regulators right now and see
whether they are in agreement with that. Thank you again.
Ms. Siebert. That is great. Thank you.
Senator Levin. Let me now introduce our final panel of
witnesses who represent one of the most important pieces to
this puzzle and that is our regulators. We not only thank you
for making it--I don't think you came quite as far as our other
witnesses, but you have waited longer. I hope that it was
worthwhile to you in terms of the testimony that you heard
here. It is a very complicated subject that you live with and
we are dealing with and we have spent a lot of time attempting
to understand it and our staff has spent a huge amount of their
time putting together a staff report, which I think has been
made available to you.
We have at our witness table today Richard Spillenkothen,
Director of the Division of Banking Supervision and Regulation
at the Federal Reserve. I think Ms. Annette Nazareth is on her
way. She is the Director of the Division of Market Regulation
at the Securities and Exchange Commission. And Douglas Roeder,
Senior Deputy Comptroller for Large Bank Supervision at the
Office of the Comptroller of the Currency.
This is a very distinguished panel. We know that they are
involved in a lot of things and had to sort out their schedule
to make it possible to be here today. We look forward to
hearing your views.
As I have indicated, pursuant to Rule 6 of this
Subcommittee, all witnesses who testify before us are required
to be sworn, and at this time, then, I would ask you to stand
and raise your right hand.
Do you swear that the testimony that you will give before
this Subcommittee today will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Spillenkothen. I do.
Mr. Roeder. I do.
Senator Levin. I think, Mr. Spillenkothen, we are going to
call on you first.
TESTIMONY OF RICHARD SPILLENKOTHEN,\1\ DIRECTOR, DIVISION OF
BANKING SUPERVISION AND REGULATION, THE FEDERAL RESERVE,
WASHINGTON, DC
Mr. Spillenkothen. Thank you, Mr. Chairman, for the
opportunity to testify on the continuing efforts of the Federal
Reserve Supervisors to address issues emanating from the
excesses of the recent credit cycle, including large corporate
defaults and accounting irregularities.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Spillenkothen appears in the
Appendix on page 117.
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The focus of today's hearing, on how complex structured
financial products provided by banks and other financial
institutions were used by their customers to obscure financial
statements or to engage in questionable tax strategies, is
timely. Events of the past year, such as the bankruptcy of
Enron, have focused attention on the need for strong risk
management, sound accounting, improved disclosures, and more
active corporate governance oversight to avoid the kinds of
losses that have been costly both in very real human and
economic terms.
The Federal Reserve has been reviewing bank participation
in the types of structured financial activities that have
raised significant legal and accounting questions and I will
discuss the status of our efforts in a moment. I will also
briefly discuss both our supervisory expectations for banks
involved in transactions such as those that have been the focus
of this Subcommittee, as well as how we are considering
amending our procedures and refocusing our supervisory reviews.
But first, I would like to say a word about the role of
bank supervisors. The primary focus of the Federal Reserve's
supervision is ensuring an institution's overall safety and
soundness, as well as compliance with banking and consumer laws
and regulations in a way that protects the Deposit Insurance
Fund and the consumer while promoting stability of the
financial system. As part of this risk-based approach to
supervision, examiners focus primarily on areas posing the
greatest risk to the institution, primarily credit risk, market
liquidity, legal, and reputation.
In carrying out our responsibilities, the Federal Reserve
coordinates its supervisory activities with other Federal and
State banking and securities agencies, such as my colleagues
here from the OCC and the SEC, other functional regulators, and
the bank regulatory agencies of other nations. If in the course
of their review examiners have reason to believe that a bank is
engaging in questionable activities that might relate to a
possible violation of securities laws, then supervisors would
refer those matters to the SEC as the primary interpreter and
enforcer of those laws.
I would say for an example, recently, Federal Reserve
supervisors identified transactions by a banking organization,
not one the subject of these discussions, but by a banking
organization that raised concerns regarding the bank's
accounting and public disclosure. In this case, we referred
those potential securities law violations to the SEC, and in
coordination with the SEC and the bank's primary regulator,
took enforcement action and remedial action in a coordinated
fashion.
Now, some basic principles and expectations for banking
organizations guide our work in examining complex financial
transactions. First and most obviously, banks must obey the
law. In particular, they must have policies and procedures in
place to ensure that they are in compliance with all applicable
laws and regulations with regard to a particular activity or
product.
Second, banks should perform thorough due diligence on the
transactions they are engaged in or involved in and check with
appropriate legal, accounting, and tax authorities within their
own organizations, as well as their outside experts when
appropriate, and also provide appropriate and relevant
information to their customers. However, banks ordinarily
should not be held legally responsible for the judgments and
actions or malfeasance of their customers. Such an expectation
would require, inappropriately, in my judgment, banking
organizations to assume management responsibility for their
customers and also could place undue significant costs on
banking organizations to audit the activities of their
customers. However, banks must not participate in activities of
their customers that the banks know to be illegal or improper,
nor should banks engage in borderline transactions that are
likely to result in significant reputational or operational
risks to the banks.
Third, the role of banks is to assume and manage all the
attendant risks related to their activities as financial
intermediaries. In light of recent events, banking
organizations should be, and indeed are, reevaluating the risks
related to both their traditional as well as their new
products, recognizing that as financial markets and practices
change, legal and reputational risks may manifest themselves in
new ways or in new magnitudes not previously recognized.
As part of our supervisory review of complex structured
transactions, we are assembling and evaluating the various
findings and observations of our examiners, as well as the
conclusions of other primary and functional regulators we work
with, and identifying any necessary follow-up. While I am
unable to discuss ongoing Federal Reserve supervisory reviews,
as you know, there are several transactions that are currently
under investigation by the SEC and other enforcement agencies
with whom we have strong working relationships and with whom we
have conferred on these matters. We are continuing to
collaborate with them and receive their views and conclusions
on various matters on an ongoing basis. As our fact finding is
completed and our conclusions are drawn, we will provide
institutions with feedback on any identified weaknesses, and if
warranted, take appropriate supervisory corrective actions,
including referrals to other authorities.
More generally, in light of recent events, we have already
modified our examination plans for larger banking organizations
to focus more fully on evaluating the largest customer
relationships, that is, the large relationship with the
customers that they have and also looking at the overall
customer relationship, not just a transaction-by-transaction
basis. These plans or examinations cover the specific areas of
concern in the structured finance business and an evaluation of
the steps banks are taking to manage the credit, legal, and
reputational risks in response to events of the past year. We
will also be looking at the new product review process and how
they manage the real and reputational risks in the new product
review process.
We have already begun the process of modifying our
examination guidance and are considering additional supervisory
guidance or regulatory changes, especially in the area of
structured finance, and if we do this, we will obviously work
with our colleagues from the other banking agencies and, as
appropriate, the SEC.
In this connection, we will also evaluate the range of
reforms banking organizations are adopting, and once we are
able to observe their performance and practice, consider
whether there are some sound practices that should be adopted
more widely within the industry.
In closing, the fallout from the recent round of excesses
and large corporate defaults appears to be resulting in some
positive steps by corporations, banks, and capital markets.
Supervisors should play a positive leadership role and work to
ensure that these corrective actions, that their ongoing
supervisory activities reinforce these corrective steps and
help them to endure over the longer term. If banking
organizations, corporations, and supervisors are attentive to
the lessons learned over the past year and adopt appropriate
policies and controls, the risk of repeating similar excesses
in the coming years should be substantially reduced. Thank you.
Senator Levin. Thank you very much, Mr. Spillenkothen. Mr.
Roeder.
TESTIMONY OF DOUGLAS W. ROEDER,\1\ SENIOR DEPUTY COMPTROLLER
FOR LARGE BANK SUPERVISION, OFFICE OF THE COMPTROLLER OF THE
CURRENCY, WASHINGTON, DC.
Mr. Roeder. Thank you. Chairman Levin, thank you for
inviting the OCC to participate in these important hearings. I
am Douglas Roeder, Senior Deputy Comptroller for Large Bank
Supervision.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Roeder appears in the Appendix on
page 123.
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Let me begin by commending the Subcommittee for holding
these hearings. Enron's failure has been nothing short of a
national tragedy, especially for the thousands of Enron
employees who lost their jobs and retirement savings. At its
height, Enron was a multi-billion-dollar corporation whose
influence was wide ranging and far reaching. Inevitably, some
of its business involved national banks which operate under OCC
supervision. In my statement, I would like to focus on the
steps that national banks and the OCC as their supervisor are
taking to help prevent Enrons from occurring, future Enrons.
The OCC is responsible for supervising over 2,000 banks,
some of which are the largest in the world. Resident examiners
working in these large banks use a risk-based approach to
supervision, an approach that takes into account the various
sources of risk to a bank. Because credit risk has
traditionally posed the greatest threat to safety and soundness
of banks, much of our supervisory attention has traditionally
focused on credit issues. However, the Enron situation
demonstrates just how significant other types of risk can be.
As a result, we have asked ourselves how our current approach
could be enhanced.
First, we intend to focus more intently on banks'
procedures for authorizing new products. Our examiners will
evaluate the bank's system to ensure that a comprehensive
process exists for senior managers to review and approve new
product offerings. Also, we believe it is important that the
new product approval process is sufficiently robust to capture
even seemingly small changes that could transform an existing
product into one that poses an entirely different degree or
type of risk. When in doubt as to whether a product requires
vetting through the new product approval process, we encourage
bank management to take a conservative approach and to apply
the process to the proposed product or activity.
Going forward, we will sample more extensively transactions
going through the banks' new product approval process. In
particular, we will check to see whether banks are complying
with their own processes and whether proper review and
authorization are received prior to engaging in complex
structured transactions.
In addition, we are in the midst of discussions with the
other banking agencies to determine whether interagency
guidelines should be revised to more specifically address board
and senior management responsibilities for the approval and
oversight of new products, such as complex structured products.
Second, while banks' board and senior management may place
their stamp of approval on a new product, the bank must also
carefully consider the appropriateness of complex structured
transactions from the standpoint of the bank's client. This
represents a shift in our approach into supervising such
transactions. In the past, our focus has been on how well the
bank assesses the sophistication of the customer and that
customer's ability to perform under the terms of the contract.
We will now ask our examiners, in addition, to determine
whether bank management understands the customer's disclosure
and accounting intent.
While it is not realistic for banks to be held responsible
for how customers account for transactions on their own
financial statements, it is incumbent on bank management to
carefully consider the potential impact of their actions on the
bank and to decline to participate in transactions that do not
meet the standards of integrity that the bank has established.
Third, we plan to review large relationships, even if
credit risk is low, and flag structured products during our
credit work for potential further review. We think it is
important that bank management establishes controls that
encompass the bank's total relationship with its large
customers. Competitive pressures are a natural part of any
business environment, but care must be taken to ensure that
line managers eager to retain or expand business with important
customers don't cross the line and jeopardize the trust and
credibility that forms the foundation of a bank.
It is encouraging to report that banks are studying and
learning from the Enron experience, whether or not that
experience was firsthand. Banks that offer complex structured
transactions have come to realize that they stand to suffer
great harm if they are implicated in questionable activities
conducted by their customers. As a result, banks have taken
steps to improve their internal controls of complex structured
transactions and special purpose entities.
Some banks have made changes to management, establishing
new oversight committees, developing new policies and
procedures, tightening controls, upgrading internal reporting
to management and the board, and improving the quality and
quantity of disclosures. Banks have also strengthened their
review and approval processes for complex structured
transactions. This includes expanding the definition of
products to be approved and enhancing the approval process to
provide for a broader range of senior-level management review.
Also, banks are putting a greater focus on assessing customer
motivation and appropriateness, including securing
representations from customers regarding disclosures and
accounting treatment.
We believe that these are all positive steps toward
strengthening internal processes. We are currently evaluating
the responses of national banks and will assess these reforms
as they are implemented.
I also want to highlight another important facet of the
supervisory process. That is the interaction among the Federal
regulatory agencies. The ability to make and receive referrals
ensures that the agency with the appropriate authority and
expertise is involved. We are coordinating our reviews of
national banks' previous involvement with Enron with the
Federal Reserve and the SEC. Because this is an open matter, I
am unable to comment institution specific details that pertain
to the current reviews underway.
Thank you once again for inviting OCC to testify at this
important hearing.
Senator Levin. Thank you very much, Mr. Roeder.
Let me welcome Ms. Nazareth. We know that you were late,
tied up somewhere, but we are going to need now to swear you in
as we do all of our witnesses, so I would ask you to stand and
raise your right hand.
Do you solemnly swear that the testimony that you will give
before this Subcommittee will be the truth, the whole truth,
and nothing but the truth, so help you, God?
Ms. Nazareth. I do.
Senator Levin. Thank you. Ms. Nazareth, thank you.
TESTIMONY OF ANNETTE NAZARETH,\1\ DIRECTOR, DIVISION OF MARKET
REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION,
WASHINGTON, DC
Ms. Nazareth. Thank you, and I apologize for being late,
Mr. Chairman. My name is Annette Nazareth and I am the Director
of the Division of Market Regulation at the Securities and
Exchange Commission. I would like to submit my written
testimony for the record and briefly summarize, if I may.
---------------------------------------------------------------------------
\1\ The prepared statement of Ms. Nazareth appears int he Appendix
on page 134.
---------------------------------------------------------------------------
Senator Levin. Thank you, and it will be made part of the
record.
Ms. Nazareth. Thank you. I will take just a few minutes to
highlight a couple of key points. First, the SEC has
significant powers to investigate possible violations of the
Federal securities laws and to enforce those laws through civil
and administrative actions. The Commission to date has charged
two former Enron officers with fraud based on their
participation in transactions designed to mislead investors
about Enron's financial results. The Commission's investigation
is ongoing and the Commission's Division of Enforcement
continues to work diligently and vigorously with the Justice
Department's Enron Task Force to ensure that all those
responsible answer for their misdeeds.
While I cannot speak publicly regarding the specifics of
any ongoing investigation, several aspects of the Commission's
general enforcement authority are particularly relevant to the
issues of disclosure and transparency that are at the root of
the problems you are examining today.
The Commission has clear authority to proceed against
public companies that file false information as part of their
financial statements. Such conduct is potentially subject to
various provisions of the Federal securities laws, including
the requirement that companies' filings with the SEC be
materially complete and accurate and the SEC's general anti-
fraud authority.
The Commission brings numerous actions, 163 this past
fiscal year, based on false and fraudulent financial reporting
and disclosures. Among these was an action the Commission
recently brought against a public company for, among other
things, using an undisclosed off-balance-sheet special purpose
entity to dramatically overstate the company's cash flow from
operations. Cases like this make clear that public companies
using off-balance-sheet special purpose entities must ensure
not only that their accounting treatment compiles with
Generally Accepted Accounting Principles, known as GAAP, but
also that they have accurately portrayed the economic realities
of the transaction.
The Commission also has explicit statutory authority not
only to proceed against primary violators of the Federal
securities laws, but also against aiders and abetters of those
violations. The Commission aggressively employs this authority.
In addition, the Commission may order any person who is or was
a cause of a violation of any provision of the Exchange Act due
to an act or omission the person knew or should have known
would contribute to the violation, to cease and desist from
causing such violations.
Aggressive enforcement not only punishes wrongdoers, but
also helps deter future illegal behavior, and in fulfilling
this mission, the Commission cooperates with the Federal bank
regulators, among others. The SEC obtains evidence of possible
violations of the securities laws from many sources, including
from other regulatory authorities, such as the Federal bank
regulators. In addition, when appropriate, the Commission
coordinates its investigations with Federal banking regulators,
which can result in coordinated regulatory settlements.
For example, in a recent case, the SEC took action with
respect to accounting improprieties of the PNC Financial
Services Group, Inc., a bank holding company. The Commission's
order found, among other things, that PNC materially overstated
its earnings by failing to consolidate into its financial
statements three special purpose entities to which it
transferred approximately $762 million of volatile, troubled,
or under-performing loans and venture capital assets. Based in
part on this conduct, the Commission found that PNC had
violated the anti-fraud record keeping and reporting provisions
of the securities laws.
At the same time the Commission's order was issued, the
Federal Reserve announced that PNC had entered into a written
agreement to address bank supervisory matters. The Commission
acknowledged the substantial cooperation provided by the board
in this matter.
The Commission has long recognized the need to consult and
coordinate with the Federal banking agencies on matters
involving financial institutions that are public companies. For
example, the chief accountants of the Commission and the
Federal Deposit Insurance Corporation, the Federal Reserve
Board, the Office of the Comptroller of the Currency, and the
Office of Thrift Supervision meet periodically to discuss
matters of mutual interest. Similarly, key decision makers meet
regularly to implement supervisory programs, work on
international agreements, and guard against money laundering.
While our enforcement activities are ongoing, there are
numerous other efforts underway at the Commission to improve
the quality of reported financial information, the reliability
of that information, and the timeliness of that information.
The fall of Enron, along with other corporate scandals, has
crystallized the importance of efforts to strengthen the
accountability of public company officers as well as other so-
called gatekeepers of our financial markets, the lawyers, the
accountants, the auditors who work with public companies as
part of the financial reporting process. Enactment of the
Sarbanes-Oxley law also will help ensure that regulation with
regard to these parties is stronger.
Some of these regulations are already final. For example,
as of August of this year, the CEOs and CFOs are now required
to certify the financial and other information in issuers'
quarterly and annual reports. Other rules to implement the Act
are proposed and are on track to be finalized in January. For
example, in November, the Commission proposed rules regarding
standards of professional conduct for attorneys, and in
October, the Commission proposed rules that would significantly
tighten the requirements for companies to disclose non-GAAP
financial measures and for corporate management to disclose
material off-balance-sheet arrangements. Individually and in
their totality, these rules should have a significant effect on
the quality and reliability of financial reporting and, thus,
should serve to enhance investor confidence.
At the same time that we are working to strengthen our own
rules and regulations, we are also diligently exercising our
oversight role through our Office of Chief Accountant to make
sure that the private sector's standard-setting bodies,
including the FASB and the AICPA, are making improvements in
their auditing and accounting standards. You will find the
details of these improvements outlined in my written testimony.
To conclude, Mr. Chairman, there is no question that as we
continue to unravel the improprieties of the Enron scandal and
others, we will take away many more important lessons, and in
response to these lessons, we will continue to refine our
internal procedures, cooperate with other regulatory bodies,
and hone our rules and regulations so that Enron-type disasters
are less likely to occur in the future. Thank you.
Senator Levin. Thank you, Ms. Nazareth.
We have seen in a number of transactions financial
institutions participating, aiding and abetting, contributing
to deceptive prepays which were constructed to look like energy
trades instead of debt, deceptive asset sales that are backed
by secret guarantees, ensuring that the buyer will get its
money back when the asset is sold a second time, deceptive
joint ventures that are formed to move assets off balance
sheets but ensure that the second investor never has any funds
at risk, and deceptive tax products that include fake business
transactions.
I know that each of you, because you are leaders in your
field, are troubled by those kinds of deceptive transactions
and, indeed, spend your professional life in trying to see if
we can't remove deceptive transactions or deceptive accounting
from our financial world.
It seems to me what we are facing is the following, that we
have both our banking regulators and our SEC doing case-by-case
enforcement, that when it comes to banks, we have a gap. We
have a gap because, on the one hand, the SEC does not generally
regulate banks, and we, on the other hand, don't have our
banking regulators that do the work relative to banks that the
SEC would do if it did regulate banks.
I know you all work together, and that is really essential,
that you do work together if we are going to overcome and to
end some of the deceptive practices that we have both heard
about and we have written about, our investigation has
uncovered, and so forth, and I am not going to ask you to
comment on any specific practice of any specific institution
for obvious reasons.
Is it possible that you could, working together, end that,
or fill that gap in our regulatory regime, in the oversight
that you carry out, because the SEC doesn't generally regulate
banks and the bank regulators don't generally regulate
accounting practices or ensure accounting financial statements,
we have got that gap. Unless we have our regulators working
together, we are not going to be able to deter. We may be able
to, on a case-by-case basis, get to a problem in terms of
punishment after the fact, but in terms of examining the books
of financial institutions, we are not going to be able to do
the deterrent work which is usually available in most
regulatory bodies. We need a deterrence program.
I would like you to react to the following approach. First,
that the SEC issue a clear policy statement, that the SEC would
take enforcement action against financial institutions which
aid or abet a client's dishonest accounting, or, of course, if
they participate in a deceptive structured transaction. We know
the SEC has the authority to go after aiders and abetters, but
what I am suggesting here is not just a case-by-case going
after an aider or abetter, but issuing a clear policy statement
that the SEC would take enforcement action against financial
institutions if they aid or abet a client's dishonest
accounting or participate in a deceptive structured
transaction. Now, that would be the SEC side of the two-step
action which I am suggesting.
The second step would be by the bank regulators, here,
informing the banks that violation of that SEC policy which I
have just described would constitute an unsafe and unsound
practice. That would enable bank examiners to take appropriate
action during regular bank examinations.
If the SEC issues a clear policy statement relative to
aiding and abetting by the financial institutions and if then
the banking regulators as part of their regular bank
examination let the financial institutions understand that a
violation of that SEC policy, in turn, would constitute an
unsound and unsafe practice, we then will have addressed this
gap which exists, which I think most people would agree should
somehow or other be filled.
So I am wondering whether or not I could get a reaction
from our three witnesses today to that, and if that is
something which needs to be looked at, fine. If there is a
different approach where you can join together to fill this
regulatory gap, then we would welcome your comments on it. Let
me take you in the same order that I called on you before. Mr.
Spillenkothen.
Mr. Spillenkothen. Mr. Chairman, I think if the SEC had a
requirement that said a certain activity was a violation of
securities laws or a violation of the law or securities
regulation, then I think it would be the responsibility of bank
regulators, if they found a situation that was a violation of
an SEC rule, to take action, to deal with that, take
enforcement action or refer to the SEC.
So I would, again, without having had a chance to work this
through entirely--I am not a lawyer--but if an activity is
clearly stated, if an activity is a violation of a securities
law or regulation that the SEC has established or that is
established, then I would think banking regulators would have
no difficulty in taking steps when they found a violation.
Obviously, you still have to make a judgment as to whether the
organization is violating the law. But if the clear established
rule is that a certain activity is a violation of the law, then
the bank regulators would take an action it would be unsafe and
unsound to violate securities law.
Senator Levin. This would be part of their bank
examination, or it could be part of their routine, regular bank
examination?
Mr. Spillenkothen. If we found a violation of a securities
law, we should take action or refer to the SEC in the course of
our ongoing supervisory process, yes.
Senator Levin. You say law. My reference and my question
was to either a law, regulation, or a policy clearly stated by
the SEC as to what action they would take if they found certain
activities. So I tried to identify the word ``policy.'' Now, it
can't just be general and it can't just be oral. It would have
to be a clearly stated enforcement policy of the SEC,
obviously, but would that do it or does it have to be a
regulation?
Mr. Spillenkothen. I am not a lawyer, sir.
Senator Levin. OK. If you could just take that back to your
lawyers, I know they are waiting for work and will welcome the
question. [Laughter.]
Senator Levin. Mr. Roeder.
Mr. Roeder. If the SEC issued a policy statement as you
indicated, I think from our standpoint, a bank that would
violate that statement, we would consider that an unsafe and
unsound practice, because as Mr. Spillenkothen indicated, we
expect banks to obey and comply with law.
If we, in our examination process, detected noncompliance
with that statement, in addition to referring that matter to
our colleagues at the SEC, our own current enforcement
authorities allow us to initiate action against an institution
ourselves for unsafe and unsound practices. So I think what you
propose is workable.
Senator Levin. Thank you. Ms. Nazareth.
Ms. Nazareth. I think to a large extent, what the
Commission does is consistent with the spirit of, I think, what
you are looking to achieve. Our enforcement actions are all
settled pursuant to SEC orders that are very highly negotiated
and contain, I think, very clear articulations of what is the
Commission's position with respect to the activity, and as you
know, we have a--one reason why people find it particularly
painful to have had an enforcement action with the SEC is that
we really name and shame. We are quite public in these actions
in terms of making public what the activity was and what the
Commission's articulation of the issue was.
In the cases that you are discussing, those cases would be
brought under our general anti-fraud authority. I think that,
in general, our position is that we want it very clear--in
other words, we would want to make it very clear to people, as
we have in some of our recent aider and abetter cases, that
there is aiding and abetting liability for this type of
activity. You can see the specific examples in those cases as
to what resulted in aider and abetter liability.
But we, frankly, by not putting out a specific policy
statement, we don't limit the context or the fact patterns in
which we could find that activity to be violative, which I
think is important. We are careful not to find ourselves in a
position, I think, where ultimately someone could say, well,
what I did was technically around the edges of your policy
statement. Rather, I think we leave ourselves sufficient room
so that regardless of how imaginative some of these schemes can
become, that we will be on all fours in being able to bring a
case against the parties.
But again, that having been said, I think the language is
quite clear in these enforcement orders and would provide
sufficient guidance to other regulators to ascertain what we
had found to be a legal activity, and I suspect as a result of
all of this, all of us at this table and other regulators, as
well, will be thinking through our own, as we have testified,
our own examination procedures in terms of the kinds of
activities that we will be looking for, the kinds of internal
procedures that we will expect these entities to have in order
to ensure that they are not engaging in these types of
activities.
Senator Levin. Would you take up with the SEC the
suggestion that you adopt a policy statement relative to types
of special purpose entities or structured transactions which
you would consider to be improper? The advantage of that,
obviously, is the one that I set out, that then the banking
regulators would have not just the case-by-case results from
your shop, but would have a policy statement which could appear
prospectively. They wouldn't have to just interpret from a case
or a finding in a specific case from a different agency, but
they would have a policy statement of that agency.
I think if you would be willing to take that back, that
idea back, it also could contain within it a statement that
your enforcement actions are not limited to those particular
examples of practices which you would feel to be deceptive or
not reflective of good accounting practices. You could make
that clear that those are simply examples and don't represent
the total universe of what your enforcement actions might be.
But if you could at least consider taking that kind of
action, it would, I believe, be an important step to filling
what is a real gap, and that is the gap which I have
identified, which is that SEC generally doesn't regulate banks
and that banking examiners generally don't do--generally don't
look for the kind of things that you look at in public
corporations in terms of their financial statements. So would
you be willing to do that?
Ms. Nazareth. Yes, of course, I will take that back.
Senator Levin. Let me turn now to Senator Bennett for a
time.
Senator Bennett. Thank you, Mr. Chairman. I apologize to
the members of the other panels that I missed. I had a
longstanding lunch engagement that I felt I had to keep, but
you are still going forward, so I appreciate the opportunity to
be back here.
One of the things that has come out of all this is a
recognition that contrary to general impressions, accounting is
not an exact science. Indeed, accounting can be quite
philosophical.
My brother, who taught philosophy at the University of
Utah, described getting acquainted with the new head of the
accounting department at the University of Utah and the two of
them would go to lunch together and discuss the philosophy of
accounting, and interestingly enough, this fellow, whose name I
do not know, was ultimately asked to leave the University of
Utah because his philosophy of accounting was sufficiently
upsetting to other members of the faculty, that even though his
recruiting had been considered a great coup by the university
at one time because he had something of an international
reputation, it didn't mesh culturally with the other members of
the faculty and he was ultimately asked to teach someplace
else.
I think the average person on the street thinks of
accounting in the same terms as he does balancing his own
checkbook or filling out his tax return and doesn't realize
that there are all kinds of different ways that you can account
for economic activity and all kinds of justifications that can
be raised and defended for these different approaches.
So the challenge that you face as regulators is not just
one to make sure that the checkbook balances and all the
numbers add up, but that the philosophy, if I can use that
term, that is being applied will, in fact, be the clearest
statement of what things really are.
In the Banking Committee, we have had long and sometimes
acrimonious debates about accounting in mergers and
acquisitions, of whether you do it on a pooling basis or a
purchase basis, and those that favor pooling insist that
philosophy of accounting is responsible for the boom of the
1990's, and those that favor the purchase basis insist that
pooling is a shell game that is hiding real value.
The question that the Chairman of the Banking Committee,
Senator Graham, raised, was is there really a depreciation of
the value of some of the intangible assets? For example, does
the reputation of Coca-Cola really go down to nothing over a
40-year period? Does the value of the Coca-Cola formula
depreciate over time that can show up as a number on the income
statement or in the balance sheet? And we debated that with all
of the fervor of medieval theologians discussing how many
angels can dance on the head of a pin.
I would like your reaction to the following that has come
to me as I have listened through all of this and contemplated
the true disaster that Enron represents. It was a disaster for
its employees and a disaster for its shareholders, but as I
have reviewed the testimony of Muriel Siebert, it was also a
disaster for the system as a whole and shook investor
confidence in the entire American system in a way that we are
still living with.
You can manage earnings. That is a phrase that has come out
of the whole Enron experience, that executives are managing
earnings so that they will meet the numbers that the analysts
have projected. I have been the CEO of a company and I know
how, very rudimentarily, how to do some things to produce that
result, how to put a particular loss in this quarter as opposed
to next quarter, how to set up reserves that are perfectly
legitimate, but you set them up in such a way as to manage how
much money shows up on the bottom line. You can't manage cash
flow. The cash is either in the bank or it is not. You can't
fudge that one.
As we are debating what to do about the economy in the next
year, one of the proposals that is on the table has to do with
the deductibility or tax treatment of dividends, and it has
occurred to me that if we were to make dividends tax deductible
or tax free to the individual investor who receives them, the
investor would, therefore, have an incentive--economics is all
about incentives--have an incentive to purchase a stock whose
return could rival that of municipal bonds.
Management would have a very difficult time managing the
dividend flow, managing the cash flow that would make it
possible to pay dividends. It would be much more difficult to
try to manipulate market perceptions of your company if you had
to come up with the cash every quarter to maintain your
dividend payment in order to maintain your stock price, and
that would change the incentive on the part of the CEO very
dramatically.
Instead of going into his CFO and saying, ``Find me an
offshore special purpose entity that I can play with and
pretend I have created earnings,'' the CEO would go to his
operational leaders and say, ``Find me a place where I can get
a little more cash so I can meet my dividend so that my stock
price won't be hurt if the dividend is cut.''
In today's market, it is considered a sign of weakness if a
company pays dividends. I remember speaking to a CEO of a
company that was awash in cash and saying to him, why don't you
pay some dividends, and he said, ``If we paid dividends, it
would be an admission that we were not in a position to earn
more money for our investors' dollars within the company than
they could earn with after-tax dollars investing it themselves,
and we don't want to admit that we are not good enough managers
to do better with their dollars keeping them here as pre-tax
dollars than we would be if we gave them the money and then
they had to pay taxes on it and then they could get a still
better rate of return.''
Now, I know this is economic policy. I know this is part of
the tax debate. But thinking of it in terms of a corporate
governance issue as opposed to a tax issue, do you see any
change in corporate behavior if dividends were tax-free to the
recipients and, therefore, corporations had a strong incentive
in terms of the impact on their stock price to accumulate
enough cash, not phony accounting activities, cash, to be able
to pay out dividends?
I would appreciate any reaction you might have. This is a
little bit afield from what we have been talking about, but it
is very current in what we will be talking about in January and
it has come to my mind as I have tried to think my way through
Enron and what could have been done to prevent it. If the Enron
executives had had an incentive to meet genuine cash
responsibilities, they would probably not have engaged in some
of the very high-risk activities that they did engage in. I
would like your reaction.
I have caused all three of you to look at each other and
smile. I won't interpret that as being, this Senator is
completely out of his mind, but a more benign interpretation,
but whoever might want to take it.
Mr. Spillenkothen. Well, Senator, you are right, this
question is beyond my bailiwick as a mere bank supervisor, so I
don't have a good insight there. I think your point about
accounting being not science certainly is a true one and I
think that--but we would argue as a bank supervisor that
banking organizations and private sector firms still have an
obligation to get the accounting right.
Senator Bennett. There is no question about that.
Mr. Spillenkothen [continuing]. An obligation to get it
right, and speaking as a bank supervisor, I am very strongly
supportive of efforts by the Financial Accounting Standards
Board, by the Congress in establishing reforms. We think the
progress on getting the Auditor Oversight Board set up and
getting that process working to provide more discipline to the
accounting profession are all very good things and they are
very critical for bank supervision.
So I don't have an opinion on your original point, but
getting the accounting right, bringing discipline to the
accounting profession, bringing to bear some of the reforms
that this Congress has established, the oversight board for
accountants, the Auditor Oversight Board, the reforms that the
FASB is trying to do, the steps that the SEC has been taking to
improve disclosure and accounting are very critical to our role
as bank supervisors.
Ms. Nazareth. I feel like it is a trick law school
question.
Senator Bennett. Not at all. I am unburdened with a legal
education----
Ms. Nazareth. Excellent.
Senator Bennett [continuing]. So you can go in any
direction you want.
Ms. Nazareth. Well, I can assure you, a legal education
doesn't necessarily bring you to the right answer.
It is not clear to me as a lawyer and as a securities
regulator what the consequences of that would be from a
corporate governance perspective. I really haven't had time to
think it through.
I think what it is fair to say, though, is that I think we
do need to continue to think creatively about ways that we can
appropriately incent companies, incent boards of directors, to
act in the best interests of shareholders, in the best
interests of their corporations and their businesses, and to
account for their activities in appropriate ways. And so,
certainly, that is a creative idea that we could consider, as
well as others, to get to that desired goal.
Senator Bennett. As I say, economics is about incentives,
and as I have gone through the Enron disaster, I realize there
was a strong incentive in terms of the stock price to, again
the phrase I mentioned this morning, be aggressive in reporting
earnings, a strong incentive in terms of the stock price to
find every possible way within the law, if you were determined
to abide by the law, or outside the law if you were of that
mind, to account for earnings in a way that would inflate them
and hope that somehow the real business would catch up with
that later on and you wouldn't get trapped.
But I am old enough to have come from the school that says
you manage the business properly and the earnings take care of
themselves, and ultimately, they take care of themselves in the
terms of money in the till. If you could share that money with
your investors without their having to pay the double taxation
on it, that becomes an incentive to move in the other
direction. I won't berate that hobby horse any further. We will
have debate about that.
Mr. Chairman, I appreciate your indulgence. I noticed going
through Mr. Spillenkothen's statement, his statement more
clearly than I made it this morning on an issue that came out
of this morning's comment, where he says banks should not be
held legally responsible for the judgments, actions, or
malfeasance of their customers, nor should they be required to
second guess their customers' accountants, tax, or legal
experts, or police their customers' activities. Such an
expectation would require, inappropriately, banking
organizations to assume management responsibility for their
customers and place potential legal liability on banking
organizations that would compromise their ability to perform
their role as financial intermediaries or threaten their safety
and soundness, and that is the point I was trying to make this
morning, sir, and you have made it more eloquently.
But you say in the next paragraph, as we all agree, that
banks must not participate in activities of their customers
that the banks know to be illegal or improper, and that is the
area that the Chairman is looking into, very appropriately.
Thank you very much for your testimony.
Senator Levin. Thank you very much, Senator Bennett.
We have all encountered some of the deceptive accounting
practices since Enron in various forms and guises. In one
instance that we discussed today, three senior officials of the
investment bank told the head of the investment bank not to go
forward with a transaction. They used words like it would put
the reputation of the franchise at risk, but nonetheless, they
proceeded because Enron had pressured the bank to go forward.
So you have got client pressure, you have got competition
pressure, and in the last few years, banks have begun competing
for business on the basis of who can sell the product that
makes the client's financial statement look the best, and that
is the race to the bottom. So our banks and our security firms
need accurate financial statements, but too often, instead of
promoting honest accounting, they have been sold and are
selling products that produce dishonest accounting.
I just really need a good, clear statement from our
regulators, because you are at the top of your professions,
that this is unacceptable, that our financial institutions have
got to stop facilitating accounting deceptions, they have got
to stop helping clients manipulate their financial statements.
I would ask you for a clear statement of that without
commenting on any specific case.
Mr. Spillenkothen. Mr. Chairman, I think in my statement I
indicated that we do not think banks should engage in
borderline transactions because they can pose operational and
legal risks to the bank and they can also expose the bank to
risks and ultimately risk to the depositors and the insurance
funds. So we do not believe banks should engage in borderline
transactions.
Ms. Nazareth. I concur with that statement, as well.
Mr. Roeder. And I take no disagreement with that.
Senator Levin. Now, when it comes to the area of structured
finance operations at banks and security firms, the question is
how do you separate the legitimate from the illegitimate. There
are obviously some legitimate purposes, as we have all
indicated, for structured finance operations, but there are
some clearly illegitimate uses to which they have been put,
where there is no business purpose, where all they have been
used for is to try to turn a loan into income or to try to
pretend that there was an asset sale when there wasn't, there
was a loan, where you have this kind of deceptive structure
which is created.
We have got to, if we are going to restore confidence in
these financial statements, we have got to be able to identify,
describe what separates the wheat from the chaff when it comes
to these structured finance operations. Would you be willing to
conduct, or take back to your agencies the suggestion that
there be a joint review of structured finance operations at
banks and security firms in order to identify the ones which
are promoting deceptive accounting and to distinguish them from
the legitimate uses of these structured finance operations?
Would you be willing to take that suggestion back about such a
joint review? Let me start with you, Mr. Roeder.
Mr. Roeder. I think we have to absolutely work together,
and, of course, do so around the ongoing matters under review
or investigation within our agencies.
One of the difficult things, as you mention, is separating
good from bad, especially considering the large number of
transactions that these banks conduct. Fortunately, the
transactions that we have talked about today are, we believe,
limited in banks.
In addition, the life of some of these transactions is very
short, so the scope and how you might go about conducting that
review would clearly be something we would have to spend time
talking about. We are all faced with limited resources, so I
think you have to bear down on those things that are very
complex and assess the reforms that the banks have adopted and
try to determine how you could extract best practices in hopes
that would lead us to maybe a better differentiation between
what is appropriate and not appropriate. But I think a
coordinated review, as long as it doesn't interfer with our
current reviews, is sensible.
Senator Levin. Ms. Nazareth.
Ms. Nazareth. I think that there are a number of lessons
that we are going to--that will ultimately emerge from this
period and I think it would be incumbent on all the regulators
to look back on this after we have completed all these
enforcement investigations and see what the lessons learned
are.
Certainly, I think we will be much more knowledgeable about
the types of transactions that were problematic. I think we
could share information on that, and perhaps with assistance
from the various auditing and accounting groups who assist us
in these efforts, perhaps we could try to give some guidance
for terms of what we saw that was problematic.
Senator Levin. Thank you. Mr. Spillenkothen.
Mr. Spillenkothen. Thank you, Mr. Chairman. As I said, the
Federal Reserve is actually reviewing a handful of
organizations that are engaging in these transactions, so we
are involved now in a review of these transactions. We are
consulting with our colleagues at the OCC and the SEC in this
process, so we will continue that.
As I indicated, we will, after this process is finished and
we have had a chance to assess our results, consider the need
for additional supervisory guidance to our examiners or to the
industry. We will consider the need for additional sound
practice guidance in some of these procedures that the banks
are putting in place. I think the banking organizations
themselves have recognized, as they have indicated to you, that
they need to revise their internal controls and vetting
processes.
So we are engaged in a review and we will consider, after
that review is done, whether we need to provide additional
supervisory guidance or sound practice guidance in this area.
Senator Levin. What is the time table for that review?
Mr. Spillenkothen. Hopefully in the next weeks and months.
I don't know exactly. We have got a lot of people doing a lot
of things, but we are attempting to get this done.
Senator Levin. Do you expect perhaps in a few months, it
would be done?
Mr. Spillenkothen. I would hope so.
Senator Levin. Do you think it is likely that you will be
issuing some guidance which we could, or you could label as
being guidance that was contributed to by the other regulatory
agencies?
Mr. Spillenkothen. Well, we would certainly coordinate with
the other agencies. We also need time to make our own
assessments, and I think I should also point out that whatever
we do, we would have to go to our oversight board and make an
evaluation of all this. But we certainly would do this in
coordination with the other regulators.
Senator Levin. One of the recommendations we will be making
in our report is that there be that kind of a joint review so
that we can have that kind of guidance come from not just the
Fed, but from all of our regulatory agencies working together.
It would be, I think, a very important step in what we are
trying to accomplish.
Some time ago, if you could take a look, Mr. Spillenkothen,
at the exhibits--let me see if I can find the number here--
Exhibit 370.\1\ I think we shared this with the folks at the
Fed some time ago. This was an e-mail back in 1999 that is
dated March 5, 1999, and it is entitled, ``Disguised Loans.''
It says that we are making disguised loans, usually buried in
commodities or equities derivatives, and I am sure in other
areas. With few exceptions, they are understood to be disguised
loans and approved as such, but I am queasy about the process.
---------------------------------------------------------------------------
\1\ Exhibit No. 370 appears in the Appendix on page 701.
---------------------------------------------------------------------------
And then the employee of Chase listed a number of concerns,
and one of which he said was he worried about loans that escape
routine transparencies. The loan is buried in the trading
books, and when we say we have X loans to Country Y, it is not
included. And then he says further down, as a policy matter, I
think we need a small task force to not eliminate disguised
loans, but to make sure they are done right.
I am wondering if your staff at the Fed has talked to you
about it, are you aware of it, and whether anyone has talked to
Chase about that.
Mr. Spillenkothen. Mr. Chairman, I----
Senator Levin. It does address a safety and soundness
problem. When a bank evaluates risk, how much of its money is
tied up in a particular country or company or currency, how
does it take into account all the loans disguised as energy
trades or derivatives or asset sales and so forth? How do you
do a risk analysis when you are missing important transactions?
Are you familiar with this particular----
Mr. Spillenkothen. Not in detail. I think because we are
reviewing these transactions, I really can't discuss specific
questions.
Senator Levin. All right, fair enough.
Mr. Roeder, your office at the OCC oversees about 2,000
national banks, and you stated in your prepared testimony that
complex structured transactions such as those entered into by
Enron are generally offered at only a small number of large
banking companies. About how many banks are we talking about?
Mr. Roeder. Our review would indicate fewer than ten.
Senator Levin. So that the banks that would require extra
scrutiny on structured finance would be a small population?
Mr. Roeder. There are a number of institutions that offer
very standard structured finance products and services. The
most complex products tend to be concentrated in fewer than ten
institutions. So, yes, it is not something that we have found
to date to be widespread.
Senator Levin. Therefore, I presume that makes the
regulatory burden a little narrower in terms of the targets?
Mr. Roeder. It helps, yes.
Senator Levin. One last document.\2\ This was a Chase
document, too, in which it was back in 1998 selling or pitching
prepays and used the term ``balance sheet-friendly.'' I take it
you would all agree that our balance sheets should be accurate,
neither friendly nor unfriendly, but accurate. Would that be a
fair statement, Mr. Spillenkothen?
---------------------------------------------------------------------------
\2\ Exhibit No. 369 appears in the Appendix on page 687.
---------------------------------------------------------------------------
Mr. Spillenkothen. That is a fair statement.
Senator Levin. Ms. Nazareth.
Ms. Nazareth. Yes.
Senator Levin. And Mr. Roeder.
Mr. Roeder. Absolutely.
Senator Levin. OK. Let me close by thanking you all. It has
been a long day, but we have learned a lot. A lot of practices
which we believe are deceptive have been analyzed. Some of our
leading financial institutions, in our judgment, helped Enron
cook the books, and the safety and the soundness and the
vitality of our financial system depends on honest accounting
and accurate financial reporting. So we need these banks that
are the guardians and promoters of honest accounting to be that
and not willing accomplices in accounting deceptions.
We have heard testimony today which is extremely troubling
about the extent of financial deceptions that Enron and its
banks engaged in. The banks say that they recognize the
problems now. They are changing the way in which they do
business, and they say what was acceptable a year ago is not
acceptable today. Hopefully, they will take the actions that
are promised.
But we simply cannot rely upon self-regulation and
promises. We need our regulators to step in, ratchet up efforts
to ensure honest accounting, and put an end to banks assisting
their clients to produce deceptive financial statements.
The gap now in the regulatory oversight area needs to be
closed, the gap that exists because the SEC does not generally
regulate banks and the bank regulators don't generally look at
accounting practices or ensure accurate financial statements.
We need to continue the effort to get regulators working
together, of course, punishing wrongdoers on a case-by-case
basis, but that is not enough. We need to design a new
deterrence program.
It needs a lot of work. Steps need to be taken together by
our regulators, our watchdogs. I have outlined a couple steps
that I thought would be useful, and we welcomed our witnesses'
willingness to take those suggestions back to their agencies.
We will make those suggestions, as I indicated, part of a
Subcommittee report based on our staff investigation and our
staff report.
It would be very helpful if the SEC would issue a clear
policy statement, that the SEC will take enforcement action
against financial institutions that aid or abet dishonest
accounting by a client. At the same time, we need bank
regulators to tell banks that violation of such an SEC policy
would constitute an unsafe and unsound practice, which would
then enable bank examiners to take appropriate action during
regular bank examinations.
A comprehensive joint review, such as apparently is being
undertaken by the Fed, would be very helpful if it is a joint
review of the structured finance products that are being sold
or participated in by our financial institutions so that we can
clearly separate the products and the structured finance
arrangements which are deceptive from the ones that serve a
legitimate financial and economic purpose.
The short story is that we need to send our financial
firms, some of which are the most renowned firms in the world,
much less in the country, we have got to send them an
unmistakable message, that while we welcome their self-
regulation and their growing awareness of what they
participated in, willingly or unwillingly, wittingly or
unwittingly, the message has got to be that touting balance
sheet-friendly deals that allow clients to hide debt or to
report deceptive amounts of cash flow or earnings are simply
not going to be tolerated. Our financial institutions must be
part of the restoration of credibility by helping us to return
to that good old fashioned honest accounting.
We all look forward to working with the banking industry
and the regulators to get that message out and to establish
that deterrence program that is needed to prevent future
calamities, such as Enron.
We again thank all of our witnesses here today. We thank
our last panel for your patience, for your contributions, and
most importantly, for the day-to-day work that you are engaged
in and committed to, in which we place so much faith, that you
will take aggressive actions against wrongdoers where you find
them and that you will help us design a deterrence regime and a
procedure so that we can deter wrongdoing in the future.
With that, we stand in recess.
[Whereupon, at 3:17 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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