WEST'S DEFENCES / CAUSES OF ACTION
West contends that it is entitled not to pay the demand made under the L/C or is entitled to cross-claim against Mahonia and Chase because it has six defences or causes of action:
i) Mahonia and Chase were party to a conspiracy with Enron to devise a transaction to enable Enron wrongfully to account for the transaction in breach of US Securities law. The transaction involving the Three Swaps and the L/C was part of this conspiracy enabling Enron to account wrongfully for the proceeds of the transaction and thereby commit a breach of US Securities law. The bank asked to issue the L/C in support of one leg of the swaps would inevitably suffer loss by relying on the apparent financial strength of Enron and the apparent legality of the purpose behind the ENAC/Mahonia Swap.
ii) Mahonia and Chase were party to a conspiracy to obtain the L/C. The allegation is that Enron/Chase conspired to obtain the L/C (which secured the disguised loan from Chase to Enron) by misleading the bank issuing the L/C (West) as to the underlying transaction, the true purpose behind the L/C and the real obligation that the L/C would secure.
iii) West contends that in the course of a conversation on 4th October 2001 Mr Levy of Chase expressly or impliedly represented to West that the underlying transaction was a Swap transaction and that the real obligation secured by the L/C was the ENAC/Mahonia Swap, whereas in fact the transaction secured a disguised loan between Enron and Chase.
iv) West contends that the transaction involving the Three Swaps and the L/C is illegal, whether directly or pursuant to the doctrine of taint, as the purpose behind it was to enable Enron to wrongly account for such a transaction in its accounts and thereby commit a breach of US Securities law.
v) West originally contended that Chase/ Mahonia procured Enron to obtain the L/C in breach of the Facility Agreement between West and Enron, the terms of which it must be taken to know or of which it ought to have known. This allegation was abandoned in closing submissions.
vi) West also originally contended that as a matter of law Mahonia (as beneficiary under the L/C) impliedly represented that the underlying transaction was genuine and concluded for a lawful purpose. West contended it was not. This allegation was also abandoned in closing submissions.
THE NATURE OF CHASE XII
I have described in outline the three interrelated swaps transactions that constitute the arrangements made in September 2001. Expert evidence was adduced by Chase and Mahonia from Professor Tufano, a financial economist and Professor of Financial Management at Harvard Business School whilst West adduced evidence from Mr. Stanton who was the head of Structured Finance and Chief Operating Officer of Global Capital Markets at Robert Fleming & Co. until April 2001. These experts sought respectively to define the transactions in Chase XII as "structured finance" or as a "loan". Professor Tufano took the view that, whether the ENAC/Mahonia Swap and the ENAC/Chase Swap were each seen in isolation, or viewed together with one another, with or without reference to the Mahonia/Chase Swap, there were characteristics of these transactions which meant that they could not properly be characterised as a loan. They were, he said, a typical example of what is commonly referred to as "structured finance" since, on any definition of those words, a transaction involving the use of a SPV, credit support arrangements (posting of margin and external third party credit support) and ancillary transactions which modify the price risk of the underlying asset, would qualify. Mr. Stanton's view however was that, although there were characteristics of these transactions which were dissimilar to the conventional loan, the term "structured finance" was not a meaningful one, since it was so loosely used in banking and financial circles, and none of those characteristics to which Professor Tufano referred were such as to affect the substance of the matter, which on his analysis was that of a loan.
In my judgment, the question of nomenclature of the transactions is of little importance. The issue between the parties is the proper way to account for these transactions, which is a matter of accounting principle and practice, not one of usage of words in the jargon of banks, financial markets or economists. The reports of the experts did nonetheless draw attention to the features of the transactions which could affect their accounting treatment and Chase's view of it as bankers, and it is to those that I now turn.
The ENAC/Mahonia Swap is a forward prepay under which Mahonia was required to pay to ENAC the sum of $350 million on September 28th 2001 (the "initial fixed payment amount") and $0 on March 26th 2002 ("the second fixed payment amount") in exchange for the payment by ENAC to Mahonia of a floating payment on March 26th 2002 representing a notional quantity of natural gas at a market index price on March 25th 2002 for the April 2002 delivery month.
Mahonia had additional protection in the shape of a parent company guarantee from Enron Corp. in respect of ENAC's obligation, which was also supported by standby letters of credit from West and Chase, each of which was syndicated. The total of these amounted to $315 million, thereby leaving $35 million uncovered. Under the terms of the ISDA agreement operating between them, ENAC was obliged, in the event of an increase in the market price of gas which would have the effect of increasing its liability in respect of the floating payment, to provide collateral/ margin on a daily basis, in the shape of cash and/or US Securities or "other eligible support". If the market price of gas then dropped, the collateral required would equally be reduced so that there remained $35 million uncovered at all times in respect of ENAC's obligation to pay Mahonia for the market price for the gas. No collateral was required from Mahonia in the ENAC/Mahonia transaction, as Mahonia had no further payment obligations.
Under the Chase/Mahonia Swap, Chase was required to make a fixed payment to Mahonia and Mahonia was required to make a floating payment to Chase, in identical terms to the respective obligations of Mahonia and ENAC under the ENAC/Mahonia Swap. No collateral was required from Mahonia in respect of movements in the market price but the agreement between Mahonia and Chase gave Chase a security interest in the assets which Mahonia would receive under the ENAC/Mahonia Swap. Moreover Mahonia appointed Chase as its agent in relation to the ENAC/Mahonia Swap and there was a limited recourse agreement between them, albeit not written.
Under the ENAC/Chase Swap, ENAC was required to pay Chase the fixed sum of $355,961.258 on March 26th 2002 in exchange for the floating payment by Chase on the same date in respect of the same notional quantity of natural gas and at the same price as that to which the other two swap agreements referred. ENAC and Chase had entered into an ISDA Master Agreement on 5th April 1994 under which either party could be required to put up collateral in respect of market movements of the gas price. The amount of collateral to be posted depended upon the current market value of the gas involved in the transaction less a threshold amount which was dependent on the parties' S & P ratings. (The threshold applied to the totality of dealings between ENAC and Chase under ISDA terms, which included a large number of transactions apart from Chase XII.) Enron's rating at September 28th was BBB+, which meant that the threshold amount for it was $10 million whilst, as Chase's rating stood at AA - or higher, its applicable threshold was $50 million. If the market movements resulted in net sums which exceeded the relevant threshold for the party in question, collateral was required. Additionally ENAC's parent company Enron Corp. guaranteed ENAC's obligations to Chase up to an aggregate of $50 million.
These three transactions were entered into contemporaneously and in contemplation of one another. They were however legally distinct in that there was no cross referencing between them. There were no cross default provisions and no cross collateralisation provisions. A default by a party in one transaction would therefore not impact upon the rights and obligations of the parties in the other transactions. There were three distinct parties to the transactions as a matter of law and the contracts between them imposed distinct rights and obligations upon each of them.
It is accepted by Chase that the ENAC/Mahonia Swap transaction, as a prepay, inevitably involved financing, in as much as Mahonia gave six months credit to ENAC. It is also accepted that when the three transactions are looked at in the round, there was a financing to ENAC, achieved by the three transactions. Whilst on the ENAC/Mahonia transaction alone, there was a clear market risk for both ENAC and Mahonia, the effect of the other two transactions would be to eliminate this price risk for all parties at 26th March 2002, provided that all performed their obligations in accordance with the terms of the contracts between them.
On this footing West maintained that the economic substance of the transactions constituted a loan because the only payments which would ultimately be made, in the event of full performance, were the initial payments of $350 million from Chase to Mahonia and from Mahonia to ENAC followed by the payment by ENAC to Chase of almost $356 million six months later, the difference being a figure which reflected a calculation of current interest rates which amounted to about 3.4 per cent pa.
Mr Stanton seemed slightly reluctant to admit that there were forms of finance that were not loans, but it is obvious that, as a matter of law this is so and he said he had been involved in such transactions. Sale and leaseback arrangements, sales and repurchases ("repos"), aircraft leasing, bonds, gold swaps and various forms of commodity finance exist as pointed out by Prof Tufano. The way they are viewed by a banker or by accountants or the taxman may differ, but the characteristics of a transaction which provides financing are not always such as to make the instrument a loan and customers of banks have reasons for wanting financing that does not take the form of a loan. Mr Stanton agreed that there would be nothing unusual about a customer structuring financing transactions for the tax or accounting treatment they would receive and that it would not be surprising to hear of a bank that participated in (and marketed to other banks) a financing which was designed by the customer to be accounted for as "non debt" financing.
The fact is that the Chase XII transactions involved not two parties but three and that the form of each transaction was that of a swap transaction involving fixed and floating payments and other financial obligations which were directly linked to the movement in the market price of natural gas.
Thus Chase and Mahonia point out that: -
i) The three swap contracts are real contracts on standard form swap terms (ISDA terms) with requirements for posting additional margin on a daily basis. Each of the three parties was bound to fulfil their obligations under these contracts.
ii) Because of the terms of the ENAC/Chase Swap, the final net payment to be made could be either a payment by ENAC or a payment by Chase, depending upon the price of gas on the relevant date. If the payment was to be made by Chase, ENAC would have credit exposure to the entity which West regarded as ENAC's "lender".
iii) If either Chase or ENAC defaulted, the absence of cross default provisions meant that the effect of market movement on the extant floating price payment obligations would result in a loss to one or other party which varied in accordance with the price of the gas.
This last point was exemplified in evidence and argument by a series of different illustrations as to what would occur in the event of default of one party with the market price of the gas moving over the 6 month period.
i) If Chase became insolvent soon after the inception of the transaction and the Chase/ENAC Swap was terminated, the net sum owed under that Swap would be fixed as at the early termination date. The ENAC/Mahonia Swap would however continue to maturity and ENAC would have to put up further margin if the price moved against it on a rising market. On maturity of the ENAC/Mahonia Swap, the amounts due under the ENAC/Mahonia Swap and the ENAC/Chase Swap would no longer match. (When ENAC defaulted, arrangements were made between Mahonia and Chase to fix Mahonia's obligation to Chase at the same level as ENAC's obligation to Mahonia, in order to avoid this problem.) West says that the possibility of a Chase default and insolvency is so remote as not to be taken into account, but Prof Tufano pointed out that the yields on Chase bonds in September 2001 indicated a market assessment of the possibility of default as compared with Treasury bonds (a 30% differential) and Chase pointed to the collapse of entities such as Enron as a warning against an assessment of invulnerability. Nonetheless the likelihood of such a default was undoubtedly remote.
ii) If however ENAC became insolvent prior to 8th October when it was bound to provide security in the form of letters of credit, and the ENAC/Mahonia swap then terminated and if the price of gas had gone up, Mahonia would be owed a payment of something in excess of the sum advanced on the ENAC/ Mahonia swap which could have no reference to any notion of "interest". Because the ENAC/ Chase swap was separate, Chase would also still be bound to pay ENAC on 26th March 2002, any net sum owing on that swap by reference to market prices.
iii) In fact the price of gas went up by about 9 cents in the period prior to October 8th 2001 which meant that ENAC had to post about $11 million collateral on that date. Thus within 10 days, ENAC, having received $350 million had to post some of that as collateral so that it no longer had the use of it, whilst it would receive only $1 million in collateral from Chase on ENAC /Chase swap, because of the different thresholds for posting of collateral. Thus the amount of money available to ENAC varies with the market price of the gas- each cent in market value equating to about $1.3 million in collateral.
iv) If ENAC later became insolvent and failed to pay Mahonia the floating payment due under the ENAC/Mahonia Swap, the obligations of Chase to ENAC under the Chase/ENAC Swap would not be affected. Thus if the market price went up so that on the ENAC/Chase Swap, Chase owed ENAC money because the market price on the floating payment exceeded the fixed payment due from ENAC, Chase would then be obliged to pay ENAC a sum in excess of the original advance payment it had made to Mahonia and Mahonia had made to ENAC. At $3.50/MMBtu (which is close to the approximate actual price on March 25th 2002 of $3.46), ENAC would owe $447.73 million under the ENAC/Mahonia Swap. ENAC would however be owed approximately $91.77 million on the ENAC/Chase net Swap. In those circumstances (leaving out of account additional collateral provided for margin) if ENAC could pay nothing in insolvency, Mahonia would be $35 million short of the sum it had prepaid, if it enforced the letters of credit, whilst Chase would have to pay $91.77 million to ENAC in respect of this transaction.
v) If collateral was provided in accordance with the ISDA Agreements however right up to the point of non payment on 26th March 2002, the net effect for Chase/Mahonia should never exceed the $35 million hold because on the ENAC/Mahonia transaction, collateral would be available (save in respect of that amount) however high the price went and that collateral would match Chase's obligation to ENAC under the Chase/ENAC Swap.
vi) If in the same circumstances (leaving out of account any collateral provided for margin), with the price at $3.50, Chase was to default, ENAC would pay Mahonia $447.73 million on the ENAC/Mahonia Swap and if Chase was unable to pay anything in insolvency, ENAC would be out of pocket by approximately $91.77 million on the ENAC/Chase swap.
vii) If collateral was provided however in accordance with the ISDA Agreements right up to March 26th 2002 and the same circumstances otherwise obtained, ENAC would suffer a loss of $50 million representing the Chase threshold for margin.
Thus if collateral had not been posted then, assuming a gas price of $3.50, in the event of ENAC's default, Chase/Mahonia, even if taken together would receive $223.23 million net whilst, if Chase defaulted, Chase/Mahonia, if taken together would receive $447.73 million net.
With rising prices, if ENAC defaults and is unable to pay, Chase's loss exceeds the sum originally "advanced" and, if the price rises to over $5.25 Chase/Mahonia actually have to pay a net sum to ENAC, as shown on Prof Tufano's modified Figure 8 and Figure 9. If Chase defaults and is unable to pay, ENAC has to pay more than the fixed payment sum originally envisaged under the Chase/ENAC Swap. The effect of the independence of the three transactions is that the defaulting party gains at the expense of the innocent parties because of the substantive obligations owed as between Chase, Mahonia and ENAC. It is clear that there is credit exposure of each party which is related to price movement.
The position is of course affected and mitigated by the collateral obligations for which the ENAC/ Mahonia and the Chase/ENAC swap agreements provide, if fulfilled, whether the price goes up or down.
Whilst the position with regard to the upward movement is illustrated in the preceding paragraphs, that of downward movement is simpler. If the market price was to go down, there would be adequate collateral on the ENAC/Mahonia Swap (subject to the $35 million hold) and collateral on the ENAC/Chase Swap (subject to the $10 million ENAC threshold). West are therefore right in saying that the net loss for Chase and Mahonia together should never exceed $45 million if collateral is provided as it should be up to the last possible moment before 26th March.
In practice however, if there was default on that date, it is likely that there would be a shortfall in relation to collateral due prior to that, since it is highly likely that a party going into liquidation will fail to put up margin in the period preceding its declaration of insolvency. If its credit rating slips in the period prior to insolvency, which is also a real possibility, there will be requirement for increased margin, but whether or not that would be met must be doubtful.
In general however, if the collateral obligations are met, it is only when the transactions are looked at individually, rather than as a whole, that the independent obligations are seen to give rise to substantial variable losses for individual parties.
Examples can be multiplied by reference to different gas prices which reveal nonetheless that the nature of the obligations undertaken by the parties differ significantly from those which would be undertaken in a conventional loan situation. The substance of the three transactions, when taken compositely, is affected by the fact that there are three independent transactions between three parties with fixed and floating payments in each which are not in any way dependent upon one another as a matter of law. Moreover the requirement for the provision of margin, which not only operates asymmetrically as between Chase, Mahonia and ENAC, but operates by reference to the price of gas, differs from any conventional provisions for security, where additional security is required when the collateral provided drops in value. Here where the price of gas goes up, additional margin is required both from ENAC to Mahonia and from Chase to ENAC, because that is what swap contracts subject to ISDA require.
Whether or not a bank would assess the overall structure as it would a loan, the effect of default in the Chase XII transaction is different, as appears from the preceding paragraphs. Whilst the economic effect of full performance is the same as a conventional loan in the final outcome, there are differences in the obligations and economic effect on the way, because of the asymmetrical margin provisions, which depend on price movement and their effect on liquidity.
Price risk is eliminated on the floating payments due on March 26th 2002, if all are made but price risk remains in relation to the provision of margin in the interim period. In the event of default losses are clearly price risk related.
Mr Stanton was content to accept that, viewed individually, the parties to the swaps in Chase XII were taking trading positions, but when taken together, their effect was, he said, a loan and none of the characteristics referred to, nor the consequences which occurred in the scenarios posited by Chase (which he considered for the most part unrealistic and unlikely) affected that view. To Prof Tufano these elements were critical in analysing the nature of the three instruments in Chase XII and their individual and collective impact.
These therefore are the matters which fall to be considered and taken into account in assessing the proper accounting treatment to be given to Chase XII, Enron's actual accounting for it and any involvement of Chase itself in any such accounting. In my judgment, the characterisation of the Three Swaps in Chase XII as a matter of law, business economics or banking only serves as the background to the critical question of proper accounting treatment.
THE WEST FACILITY AGREEMENT
The $165 million Letter of Credit was provided by West under the terms of a Facility Agreement dated 10th September 2001. The heading to this agreement read as follows:
"Trade Finance and Reimbursement Agreement
(for the primary purpose of supporting the general corporate business of the European subsidiaries of Enron Corp)".
This was a committed facility in the sense that West, as the Issuing Bank, agreed that it would, following its receipt of an Instrument Request (as defined in the Facility Agreement) issue Instruments in accordance with its terms. Issues arise with regard to the construction of the terms of the agreement and in connection with an ancillary agreement allegedly reached in August or September 2001 by the terms of which, West contends, it was agreed that Instruments should not be provided to secure financing from other Banks. Whether the point is framed as a collateral agreement or as a form of estoppel, in order to make this point good, West has to establish that there was such an agreement or mutual assumption as a result of communications between it and Enron.
The Facility Agreement was made between Enron Corp (the Enron parent company and defined in the Facility Agreement as "the company"), West as Issuing Bank and the other syndicate banks. It contained the following provisions:
"WHEREAS
(A) The Company requires from time to time the issue of letters of credit, bid bonds, performance bonds, guarantees and other instruments, primarily (but not exclusively) in support of the European business and operations of itself and its Subsidiaries and Related Entities including Enron Europe Limited and Enron Metals Limited.
(B) The issuing Bank shall issue such letters of credit, bid bonds, performance bonds, guarantees and other instruments on the terms and subject to the conditions set out in this Agreement. …………
"Instrument" means a letter of credit, guarantee indemnity, performance bond or bid bond or such other form of instrument as the Company and issuing Bank may from time to time agree, each such Instrument to be substantially in a form agreed by the Company and the Issuing Bank on or prior to the date of this Agreement or in such other form as the Issuing Bank may from time to time approve, such approval not to be unreasonably withheld or delayed.
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"Related Entity" means, in relation to the Company, any person in which the Company holds, directly or indirectly, any shares, voting rights or other ownership interests.
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"Subsidiary" of any Person means any corporation, partnership, joint venture, or other entity of which more than 50% of the outstanding capital stock or other equity interests having ordinary voting power (irrespective of whether or not at the time capital stock or other equity interest of any other class or classes occurrence of any contingency) is at the time owned directly or indirectly by such Person; provided, however, that no such corporation, partnership, joint venture or other entity shall (a) constitute a Subsidiary of the Company, unless such entity of a Consolidated Subsidiary of the Company, or (b) constitute a Subsidiary of any other Person, unless such entity would appear as a consolidated subsidiary of such person on a consolidated balance sheet of such Person prepared in accordance with GAAP. Unless otherwise provided or the context otherwise requires, the term "Subsidiary" when used herein shall refer to a Subsidiary of the Company.
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2. INSTRUMENTS
2.1 Instrument Request
Subject to the terms and conditions set forth herein, the Company may request (a) the issuance of an Instrument by delivering an "Instrument Issuance Request" substantially in the form attached as Exhibit A-1 properly completed, or (b) the amendment of an outstanding Instrument (including an amendment that extends the term of an Instrument), by delivering an "Instrument Amendment Request" substantially in the form attached as Exhibit A-2 properly completed (each of the Instrument Issuance Request and the Instrument Amendment Request, an "Instrument Request") to the Issuing Bank at any time and from time to time from the date of this Agreement until the Final Instrument Issuance Date (subject to the provision of Clause 2.2(c) below) by facsimile transmission. Each Instrument Request shall, when issued, be irrevocable. The Issuing Bank shall not be required to issue or amend any Instrument where, if issued or amended, there would be outstanding more than ten (10) Instruments, each with a principal amount of less than $200,000 (or its equivalent).
2.2 Instruments
(a) Subject to the terms and conditions set forth herein, and provided that no Default or Event of Default has occurred and is continuing, the Issuing Bank agrees that it will, following its receipt of an Instrument Request prepared in accordance with the terms and conditions of this Agreement, issue one or more Instruments:
(i) on the day specified for each issue in any Instrument Request received by the Issuing Bank in accordance with Clause 2.1 not later than 12.00 (noon) (or such later time as the Company and the Issuing Bank m ay agree from time to time) on the date specified in such Instrument Request for the issue of such Instrument; or
(ii) on the next following Business Day where such Instrument Request is received by the Issuing Bank after 12.00 (noon) (or such later time as the Company and the Issuing Bank may agree from time to time) on the date specified in such Instrument Request as the date for the issue of such Instrument.
(b) Each Instrument will be denominated in Dollars, Sterling, euros or, with the consent of the Banks and the Issuing Bank which shall not be unreasonably withheld or delayed, any other currency which is freely convertible into Dollars, and will be extended for the general corporate purposes of the Company (including such purposes of Enron Europe Limited, Enron Metals Limited and/or any other Related Entity of the Company). Without in any way affecting the obligations of the Company under this Agreement, neither the Issuing Bank nor any Bank shall be obliged to monitor or verify the purpose of any Instrument.
(c) The Issuing Bank shall not be required to issue or amend any Instrument under this Agreement where:
(i) following the issue of such Instrument, the Total Instrument Disbursement Exposure would exceed the Total Commitments (and upon issuance of amendment of each Instrument, the Company shall be deemed to represent and warrant to that effect.
(ii) in the case of an Instrument Amendment Request, the Issuing Bank, acting reasonably and in accordance with good international banking practice, is not reasonably satisfied that such amendment will be acceptable to, or has been accepted by, the beneficiary of the Instrument to which such Instrument Amendment Request relates; or
(iii) such Instrument would, if issued in accordance with the Instrument Request, expire at its counters at any time after the close of business on the Final Instrument Expiry Date.
The Issuing Bank will notify the Banks promptly following the issuance by the Issuing Bank of an Instrument and may, at its sole discretion, notify the Banks of any material amendment of an Instrument.
(d) The Issuing Bank shall not be required to issue any Instrument to the extent that it is aware that the issue of such Instrument would be contrary to any law, regulation, regulatory requirement or directive which is legally binding on or applicable to any Bank in its place of incorporation or in the jurisdiction in which its Funding Office is located at the date of this Agreement or which would be contrary to any official directive, guideline or code of practice, issued by any governmental or regulatory body, applicable to any Bank in any such jurisdiction which, although not having the force of law, is of a type with which institutions of a similar nature to such Bank generally are accustomed to comply, until such Bank is replaced in accordance with Clause 2.14 or until the issue of such Instrument otherwise ceases to be so contrary; provided that the Issuing Bank shall promptly notify the Company of its intention not to issue such Insurance pursuant to this Clause 2.2(d).
(e) Subject to Clause 2.2(f), each Instrument will be governed by the laws of England and Wales and, in the case of letters of credit, to the extent not inconsistent with such laws, will incorporate the terms of the UCP 500.
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2.6 Fees
The Company agrees to pay to the Issuing Bank such fees as are set forth in a separate fee agreement between the Company and the Issuing Bank. In addition, the Company agrees to pay the fees listed in this Clause 2.6 (collectively, "the Fees"). ……………..
(a) Commitment Fee. The Company shall pay to the Issuing Bank (for the account of each Bank) a fee in Dollars calculated at the rate of zero decimal four per cent (0.4%) per annum on the undrawn, unutilized and uncancelled amount of such Bank's Commitment and which shall accrue on a daily basis ……………..
(b) Instrument Fees
(i) The Company shall pay to the Issuing Bank (for the account of each Bank) a risk weighting fee (the "Instrument Fee") in respect of each Instrument issued ……….
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3.2 Additional Conditions Precedent to issuance of Each Instrument
The obligation of the Issuing Bank to issue or amend any Instrument shall be subject to the additional conditions precedent that on the date of such issuance or amendment, as the case may be, (a) the following statements shall be true (and the giving of the applicable Instrument Request shall constitute a representation and warranty by the Company that on the date of such issuance or amendment, as the case may be such statements are true):
(a) The representations and warranties contained in Clause 4.1 of this Agreement are correct on and as if the date of issuance of amendment as the case may be, of such Instrument (other than those set out in Clause 4.1(d) and (e) and other than those representations and warranties that expressly relate solely to a specific earlier date, which shall remain correct as of such earlier date), before and after giving effect to the issuance or amendment as the case may be, of such Instrument and to the application of the proceeds therefrom, as though made on and as of such date, and
(b) No event has occurred and is continuing, or would result from such issuance or amendment, as the case may be, of such Instrument which constitutes a Default, an Event of Default or both.
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4. REPRESENTATIONS AND WARRANTIES
4.1 Representations and Warranties of the Company
The Company represents and warrants on the date hereof and (other than in relation to those representations and warranties contained in Clause 4.1(d) and (e) on the dates falling at three-monthly intervals thereafter, as follows:
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(d) The audited consolidated balance sheet of the Company and its Subsidiaries as of December 31, 2000 and the related audited consolidated statements of income, cash flows and changes in stockholders' equity accounts for the fiscal year then ended and the unaudited consolidated balance sheet of the Company and it Subsidiaries as of March 21, 2001 and the related unaudited consolidated statements of income, cash flows and changes in stockholders' equity accounts for the three months then ended, certified by the chief financial or accounting officer of the Company, copies of which have been delivered to each of the Banks, fairly present, in conformity with GAAP except as otherwise expressly noted therein, the consolidated financial position of the Company and its Subsidiaries as of such dates and their consolidated results of operations and changes in financial position for such fiscal periods, subject (in the case of the unaudited balance sheet and statements) to changes resulting from audit and normal year end adjustments.
(e) Since December 31, 2000 through the date hereof, there has been no material adverse change in the business, consolidated financial position or consolidated results of operations of the company and its Subsidiaries considered as a whole.
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5.1 Affirmative Covenants
The Company covenants agree that so long as any Instrument shall remain outstanding, any Instrument Obligation shall remain unpaid or any Bank shall have any Commitment hereunder, the Company will, unless the Majority Banks shall otherwise consent in writing:
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(b) Compliance with Laws, Etc
Comply, and cause each of its Subsidiaries to comply with all applicable laws, rules, regulations and orders to the extent non-compliance therewith would have a material adverse effect on the Company and its Subsidiaries taken as a whole, such compliance to include, without limitation, compliance with environmental laws and the paying before the same become delinquent of all taxes, assessments and governmental charges imposed upon it or upon its property except to the extent contests in good faith.
(c) Use of proceeds:
Request the issuance of an instrument only of general corporate purposes of the company (including such purposes of any Related Entity of the Company) not in violation of Clause 5.2 (f).
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5.2 Negative Covenants
So long as any Instrument shall remain outstanding, any Instrument Obligation shall remain unpaid or any Bank shall have any Commitment hereunder, the Company will not at any time, without the written consent of the Majority Banks:
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(f) Use of Proceeds
Use any Instrument or the proceeds of any Instrument for any purpose other than for general corporate purposes of the Company (including such payment of any Related Entity of the Company), or use any Instrument or such proceed (i) in a manner which violates or results in a violation of any law or regulation, (ii) to purchase or carry any margin stock (as defined in Regulation 11 issued by the Federal Reserve Board) or to extend credit to others for that purpose or (iii) to make nay investment in any person if such investment is opposed by the board of directors, general partner or other governing body of such Person.
6. EVENTS OF DEFAULT
6.1 Events of Default
If any of the following events ("Events of Default") shall occur and be continuing:
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(b) Any representation or warranty made by the Company (or any of its officers) (including representations and warranties deemed made pursuant to Clause 3.2), under or in connection with any Facility Document shall prove to have been incorrect in any material respect when made or deemed made and such materiality is continuing; or
(c) The Company shall fail to perform or observe any terms, covenant or agreement contained in Clause 5.2 or shall fail to perform or observe any other term, covenant or agreement contained in any Facility Document on its part to be performed or observed if, in the case of such other term, covenant or agreement, such failure shall remain unremedied for 30 days after written notice thereof shall have been given to the Company by the Issuing Bank at the request of any Bank; or
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then, and in any event, the Issuing Bank (i) shall at the request, or may with the consent, of the Majority Bank, by notice to the Company declare the obligation of the Issuing Bank to issue further Instruments, or amend Instruments already issued to be terminated, whereupon such obligation and all of the Commitments shall forthwith terminate, except for obligations to the Issuing Bank in respect of then outstanding Instrument and Instrument Obligations, …………..
8.7 Governing Law: Service: Entire Agreement
(a) This Agreement shall be governed by, and construed in accordance with, the laws of England and Wales.
(b) Each of the Company, the Issuing Bank and the Banks irrevocable submits to the non-exclusive jurisdiction of the courts of England in respect of any claim or matter arising out of or in connection with this Agreement.
………..
(d) This Agreement and the other Facility Documents accepted by the Company constitute the entire understanding among the parties hereto with respect to the subject matter hereof and supersede any prior agreements, written or oral, with respect thereto."
The form of Instrument Request to which the Facility Agreement referred constituted Exhibit A-1 to that Agreement. It provided boxes for completion in which details of the Instrument sought were to be set out but it contained no scope for setting out the purpose for which the Instrument was required. Enron was required to certify that no Event had occurred and was continuing, or would result from the issue or amendment of the Instrument sought, which constituted a default or an event of default within the meaning of the Facility Agreement.
ENAC'S ACCOUNTING AND US G.A.A.P.
West contends that Enron's and ENAC's accounting for the swaps to which it was party was not in accordance with US Generally Accepted Accounting Principles (GAAP) and was therefore unlawful. West maintains that it was improper for Enron to classify the ENAC/ Mahonia Swap and the ENAC/ Chase Swap in Chase XII as trading instruments which took their place in the "Price Risk Management Activities" line of its balance sheet and to classify the cash inflows at inception and subsequent outflows on those Swaps as "operating" cash flow. West, in accordance with the views of their expert Mr. Turner, the former chief accountant of the SEC, maintains that the substance of the three Swap transactions, when taken together, constitutes a loan from Chase via Mahonia to Enron and that the sum of $350 million should be represented on Enron's balance sheet as "debt", whilst the cash inflows and outflows from the transactions should be represented as "financing" cash flow.
Unlike other areas of its business where Enron failed to make entries in its balance sheet for transactions (off balance sheet transactions), which have been the subject of considerable criticism elsewhere, Enron always accounted for the prepaid transactions on its balance sheet. The issue is whether it should have done so as "debt" or as "price risk management activities". Because the transactions took the form of prepaid forward sales or swaps, they featured in the same way as trading contracts which were not concluded for financing purposes. It is common ground between the parties that the Three Swaps (Chase XII) and Chase I – XI were all concluded as a form of financing, as a way of Enron raising cash.
Whilst the expert reports from Mr. Turner (West's expert) on the one hand and Professor Ryan (Chase's expert) on the other were extensive, the issues were ultimately limited in scope. The key issue is the manner in which the ENAC/Mahonia Swap falls to be accounted, since, in his second report, Mr. Turner accepted that the ENAC/ Chase Swap should be treated as a derivative on the balance sheet, as Professor Ryan had stated in his first report. Further, once the form of the balance sheet entry in respect of the ENAC/ Mahonia swap is resolved, then the form of the entry in the cash flow statement automatically follows. If the ENAC/ Mahonia Swap is to be treated as an "energy trading contract" as Professor Ryan opined and as part of Enron's "price risk management activities", then it is accepted that the cash flow entries would form part of "operating" cash flows, whereas if it is to be treated as a loan or debt in the Balance Sheet, whether in part or in whole, then the cash flows would require at least an element to appear as "financing" cash flows. If Enron was entitled to classify the prepays as price risk management activities then a fair presentation was made in its financial statements.
Equally, issues between the parties about Enron's disclosure in its Accounts and accompanying statements add little to the question of classification of the transactions in the balance sheet since, if they were properly classified, there is no need for any further disclosure and, if they were not properly and lawfully classified, West does not need to point to any inadequacy of disclosure in addition to the unlawful accounting. Mr. Turner, West's expert, accepted that disclosure issues followed from the decision whether the prepaid Swaps were to be treated as trading instruments or as a loan. Although West sought, in its closing submissions to raise a freestanding case in respect of inadequate disclosure in Enron's Financial Statements and public disclosure documents, apart from the issue of the balance sheet, both Mr Turner and Leading Counsel had previously accepted that the point was determined by the issue of proper treatment on the balance sheet. In the notes to Enron's form 10K for 2000, Enron referred to its "price risk management activities" in notes one and three. It stated that: -
"The cash flow impact of financial instruments is reflected as cash flows from operating activities in the Consolidated Statement of Cash Flows."
"Enron engages in price risk management activities for both trading and non-trading purposes. Instruments utilised in connection with trading activities are accounted for using the mark to market method. Under the mark to market method of accounting, forwards, Swaps, options, energy transportation contracts utilised for activities and other instruments with third parties are reflected at fair value and are shown as "Assets and Liabilities from Price Risk Management Activities in the Consolidated Balance Sheet"."
If the transactions at issue could properly be accounted for as "price risk management activities", then this reveals that there were non-trading elements involved, which to the trained eye might indicate financing whilst the cash flow note speaks for itself. If Enron was not entitled to account for the prepays as price risk management activities, then the absence of specific disclosure of the transactions as financing transactions adds nothing. Notwithstanding West's attempts to suggest that this was not the effect of Mr. Turner's evidence, it is in my judgment clear that he did concede this at the outset of his cross-examination. The effect of his concession and of Professor Ryan's evidence was that if proper accounting allowed these transactions to be represented as liabilities on the balance sheet, in the shape of price risk management activities, no further breakdown of the component parts of those liabilities was required in the accounts or in any separate form of disclosure and there was no unfair presentation.
The disclosures required are at the aggregate level, not at the individual transaction level, where liquidity is concerned. Thus, when Enron's overall liquidity was in doubt, appropriate disclosure should have been made but this was not disclosure which related to the prepay transactions as such.
West's freestanding case on disclosure was based on rule 240.12B-20 under the Securities Exchange Act which requires that "in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading". It is said that even if the accounting was correct and in accordance with GAAP there should have been specific disclosure of the Mahonia prepaid transactions (including Chase XII), revealing the economic substance of them. Such disclosure should have taken place in the financial statements and/or in the Management Discussion and Analysis of Financial Condition and Results of Operations. If however the substance of the transactions was properly accounted for, how can additional disclosure be required? Enron made numerous statements in its financial reports and its other public disclosures about its policy of monetising assets whenever possible to generate financing for its growth. Thus page 23 of Enron's annual report for the year 2000 indicated that the segment which included Enron's energy trading business monetised its price risk management assets: -
"Wholesale Services (the relevant segment) manages its portfolio of contracts and assets in order to maximise value, minimise the associated risks and provide overall liquidity. In doing so, Wholesale Services uses portfolio and risk management disciplines, including off setting or hedging transactions to manage exposures to market price movements… Wholesale Services manages its liquidity and exposure to third party credit risk through monetization of its contract portfolio."
Further, in note 1 on its annual report for 2000, Enron stated that financial instruments were represented in the cash flow statement as arising from operating activities, as opposed to financing activities.
Quite apart therefore from the question whether an educated reader of accounts would evaluate not just the debt line in the balance sheet but the overall liabilities (which might well be expected) the real issue is the correctness of the classification in the balance sheet. The prepay liabilities were shown in the balance sheet and were therefore disclosed in a manner to which the notes referred. A reader could see this and therefore the issue is ultimately one of classification under GAAP for balance sheet purposes.
West's case involves criticism not only of the Three Swaps in September 2001 but Enron's accounting for the six previous prepaid transactions from Chase VI to Chase XI, which were effected from 1997 onwards (and possibly Chase I – V also). West maintains that the flaw in the accounting was the same in relation to the ENAC/Mahonia transaction in each prepay. West needs to make this point good in order to establish that Chase knew in September and October 2001 that Enron would wrongly account for the Three Swaps because it knew that Enron had wrongly accounted for the six previous prepaid transactions.
In this connection it is necessary to note that there were changes in GAAP, during the relevant period, to which the experts referred. The effect and significance of the new standards and guidance appears later in this judgment. FAS 133 and DIG K1 both took effect in respect of Enron for its 2001 reporting year and did not apply to any earlier years. EITF 98-10 and 98-15 were effective for fiscal years beginning after 1998. The experts differed as to the meaning, effect or relevance of these standards in the context of the dispute.
Despite suggestions to the contrary, it is clear from Mr. Turner's first report that he initially took the view that the Three Swap transactions had to be viewed as a composite transaction and should be accounted for together as a loan. No details appeared in his first report as to the actual journal entries to be made but, in accordance with his evidence to the PSI, which he endorsed in his oral evidence to this court, his view as expressed there and in his first report was that the three transactions should be "collapsed" and represented as a unity, namely a loan from Chase to Enron, ignoring the presence of Mahonia. The inevitable conclusion to be reached from his first report was that Chase and Mahonia's accounts should be consolidated and that the accounting entries to be made in Enron's accounts were to reflect a direct loan from Chase to Enron. This is borne out by his expressed view that there was no applicable GAAP and the absence of reference in that report to FAS 133 upon which he later relied in his second report as the basis for accounting for the ENAC/ Mahonia swap in Chase XII. He opined that "no specific comprehensive accounting guidance for prepay forward transactions exists whether the three legs are viewed individually or (as they should be) as a composite transaction".
By the time the matter came before the court, it was common ground that:
i) The presence of Mahonia did not alter the accounting question to be decided. It did not matter if the swaps were made directly between Chase and ENAC or whether there was an oil trader of substance in the place of Mahonia or whether Mahonia was involved in the way it was.
ii) The question whether Mahonia's accounts should be consolidated with those of Chase was also irrelevant to the accounting issue.
iii) The accounting treatment for physically settled transactions and financially settled transactions was the same under GAAP.
iv) The ENAC/ Mahonia and ENAC/Chase Swap had to be accounted for separately under US GAAP, in the sense of having separate accounting entries in ENAC's books.
v) The ENAC/Chase Swaps was a derivative for this purpose.
So far as the ENAC/Mahonia Swap is concerned, Mr. Turner, having initially denied that there was any GAAP specifically on point, in his second report accepted that EITF 98-10 was relevant when making the primary decision as to whether or not this transaction was to be treated as an "energy trading contract" or, as he put it in his second report, a "host loan with an embedded derivative" which fell to be accounted for under FAS133. The essence of his position at the trial was that, regardless of the apparent applicability of any standard set out in GAAP, there was an overarching question which had to be considered first, namely what was the economic substance of the Three Swaps, when considered together? If the economic substance of these Three Swaps differed from their legal form, then the GAAP standards applicable to each swap had to yield to that substance and once the true nature of the combined transaction had been identified, accounting entries could then be formulated for each leg of it.
Mr. Turner's view was that not only did proper accounting require regard to be had to the economic substance of the transactions, but also that regard should be had to the subjective "intent" of ENAC in entering into them. In his view not only was there a principle of GAAP accounting inherent in the DNA of GAAP which could conveniently be expressed as "substance over form", but the subjective intent of ENAC in concluding the transactions was relevant (which he tended to equate with "substance over form"). In addition he referred to the specific terms of EITF 98-10 which required the accountant to have regard to the intention which underlay any contract before it could be classified as an energy trading transaction.
The form that the swaps took was considered by Prof Ryan to be of significance and their economic substance fell to be assessed by reference to the obligations and risks involved. They were legally entirely independent of one another. There were no cross-default provisions between any of the Three Swaps nor any provision for off setting liabilities under one transaction against liabilities under another. Thus if there was a failure by ENAC to pay Mahonia on 26th March 2002, Mahonia was still obliged to pay Chase and if the price of gas had increased between 28th September 2001 and 26th March 2002, Chase would still be obliged to pay ENAC, under their net settled swap, the difference between that value and the fixed figure due from ENAC. Thus each swap settled entirely independently one of the other and gave rise to entirely independent rights and obligations. In Professor Ryan's view this feature of the transactions was one which had to be reflected in the accounting treatment of them, quite apart from the fact that they were Swap contracts with all the obligations that such transactions entail.
The accounting treatment utilised by Enron for these transactions meant that at any time Enron's accounting for the Three Swaps would show liabilities of at least $350 million in its balance sheet for Chase XII. More could be shown, depending on the price movement of gas which affected the floating sum due from ENAC to Mahonia, although this would be balanced by an asset of equal size reflecting the floating sum payable to it by Chase on 26th March 2002. Under loan accounting, there would never be a liability greater than $350 million (plus entries reflecting a sum representing "interest") because there would be no mark to market valuation in respect of a floating payment due at a later date as occurred for the Swaps. Loan accounting would reflect the cash obligation alone. Professor Ryan took the view that this would represent an inadequate representation of the three transactions, both as a matter of form and substance.
Before embarking on the questions of form and substance and the relevant accounting principles, it is necessary to record briefly the hierarchy of GAAP. The SEC was created by the Securities Exchange Act of 1934 as a Governmental agency designated to regulate public securities markets and the companies that participate in them. The SEC is authorised to specify the form and content of public financial reports that must be issued by companies with traded securities. Throughout its history, the SEC has relied upon a series of private sector accounting standards setting bodies, currently the Financial Accounting Standards Board (FASB), to develop GAAP. The SEC staff periodically issue staff accounting bulletins that interpret GAAP. It is also involved in the FASB's processes, including participation in meetings of the Emerging Issues Task Force (EITF).
The FASB issues GAAP in two main forms, namely Statements of Financial Accounting Standards (FAS's) which typically provide accounting rules for specified classes of transactions and FASB Interpretations (FIN's) that seek to clarify the position. There are in existence some 150 FAS's and some 46 FIN's. In addition the FASB periodically issues Concepts Statements (CON's) which are not intended to function as accounting rules but as a guide for the FASB in its standard setting decisions.
In 1984 the FASB established the EITF so that it could provide timely guidance on emerging financial reporting issues. If consensus is reached by the EITF on an issue, the FASB will usually take no action and those consensus positions form part of authorised GAAP. FAS 133, Accounting for derivative instruments and hedging activities was issued in June 1998 and effective for fiscal years beginning after June 15th 2000. This constituted a major change in accounting for a complex class of transactions and, anticipating a number of difficult issues in implementing it, the FASB established the Derivatives Implementation Group (DIG) as a temporary task force to help resolve those issues. The DIG functioned much like the EITF, meeting publicly but not exposing its documents for public comments. The FASB staff wrote up DIG issues based on their understanding of DIG's discussion so that the DIG provided support for FASB staff rather than being an accounting standard setting body in its own right. DIG issues which are ratified by the FASB are authorised GAAP.
GAAS (Generally Accepted Auditing Standards) is the body of requirements for audits of financial statements and associated notes. GAAS was, until recently, set by the Auditing Standards Board and its primary auditing rules were issued in the form of Statements of Auditing Standards (SAS's). Following the Sarbanes-Oxley Act 2002, the responsibility for developing GAAS moved to the Public Companies Accounting Oversight Board but in April 2002 that board ruled that the previously established GAAS could be relied upon on an interim basis. Whilst GAAS applies to auditing, I find that its principles must also be applicable to the preparation of financial statements.
Applying GAAP or GAAS requires significant professional judgement on the part of those preparing financial reports and on the part of the auditors. For many transactions GAAP provides a single acceptable way to account but it does not and cannot realistically provide unambiguous answers in respect of all transactions. Where it does not provide a single acceptable way to account for a transaction, preparers and auditors have to study and understand the GAAP rules that might apply and exercise professional judgement in seeking to apply those rules to the transaction in question. The judgment involves both the selection of accounting principles and the evaluation of any parameters necessary to apply those principles. As a consequence, for many transactions, various possible accounting treatments could be considered to conform to GAAP, it being solely a matter of professional judgement as to the appropriateness of the accounting adopted.
The hierarchy of GAAP is set out in a GAAS standard, SAS69 as follows: -
i) At the highest level there are accounting standards issued by the FASB and its predecessors which include FAS's and FIN's and also APB's.
ii) Underneath this there are FASB technical bulletins and AICPA statements of position.
iii) Underneath this there are EITF consensuses and other standards which are not exposed for public comment.
iv) Underneath this there are other standards and widely recognised practices such as DIG issues.
v) At a non-authoritative level there are FASB Concepts Statements (CONs), accounting textbooks and various other sources.
SAS69 treats the highest level GAAP with more reverence than any other level and in looking for appropriate accounting treatment, SAS 69 requires auditors to start at the top of the hierarchy in looking for guidance. The highest level of GAAP is the most general, the conceptually strongest, the most publicly debated and the most widely and best understood. The rules become progressively narrower, conceptually weaker, less publicly debated and less well understood through the descent in the hierarchy.
It is common ground between the experts that the main circumstances where judgment has to be applied in the selection of accounting principles is where there is no accounting rule directly in point. In such cases the characteristics of the transaction have to be identified and accounting has to be determined by analogy to other rules, in an attempt to identify the most relevant and reliable accounting treatment.
The principle of "substance over form" is not one which is enshrined in any authorised GAAP rule nor is it to be found in any leading Accounting or auditing text book. The purpose of FASB guidance in the shape of FAS and lower hierarchy GAAP is to set out the accounting treatment to be given to particular types of transactions. In a SEC Study pursuant to Section 108(d) of the Sarbanes-Oxley Act 2002 on the adoption by the US Financial Reporting System of a Principles-based Accounting System, the following appears in relation to the idea that a necessary component of principles-based standards is the inclusion of the "true and fair override": -
"We do not believe that a "true and fair override" is a necessary component of a principles-based or objectives-oriented standard setting system. In fact, we would expect that an objectives-oriented standard setting regime should reduce legitimate concerns about the established standards not providing appropriate guidance, as the standards should be based on objectives that would almost certainly not be met by a presentation that was not "true and fair". While this view might seem, on the surface, to be inflexible, it is, in fact, grounded in the objectives-orientated standard setting model. There are various ways that the economics of an arrangement can be viewed and evaluated. Reasonable people can reasonably disagree on the economics of an arrangement. It is, however, precisely the role of the standard setter to define the class of transactions included within the economic arrangement and to then establish the appropriate accounting for that class of transactions. While not everyone will agree with the standard setter's conclusions, making the determination of the underlying economics of an arrangement and the appropriate accounting for that arrangement are integral to the standard setter's role. Thus, we believe that when the standard setter establishes standards under an objectives-orientated regime, the accounting should, in virtually all cases, be consistent with the standard setter's view of the nature of the economic arrangement".
This excerpt from the study reflects the overall approach of the FASB. The whole point of accounting standards is to ensure uniformity in accounting so that comparable transactions are treated in the same way in accordance with the standard setter's view of the economic arrangement.
SAS 69, which is an auditing standard includes the following at paragraph 6: -
"Generally accepted accounting principles recognise the importance of reporting transactions and events in accordance with their substance. The auditor should consider whether the substance of transactions or events differs materially from their form."
It also includes at paragraph 9: -
"Because of developments such as new legislation or the evolution of a new type of business transaction, there sometimes are no established accounting principles for reporting a specific transaction or event. In those instances it might be possible to report the event or transaction on the basis of its substance by selecting an accounting principle that appears appropriate when applied in a manner similar to the application of an established principle to an analogous transaction or event."
SAS 82 considers fraud in a financial statement audit and refers to risk factors relating to mis-statements arising from fraudulent financial reporting. An example of a risk factor relating to operating characteristics and financial stability is given as "significant, unusual or highly complex transactions, especially those close to year-end, that pose difficult "substance over form" questions".
Paragraph 5(a) of SAS 69 states this: -
"Rule 203 implies that application of official established accounting principles almost always results in the fair presentation of financial position, results of operation and cash flows, in conformity with generally accepted accounting principles. Nevertheless rule 203 provides for the possibility that literal application of such a pronouncement might, in unusual circumstances, result in misleading financial statements".
Paragraph 7of SAS 69 however refers to accounting treatment of a transaction which is not specified by a pronouncement covered by rule 203. Rule 203 requires highest-level GAAP to be followed regardless. Where lower level GAAP is relevant however, it should be applied unless the auditor can justify a conclusion that another treatment is generally accepted. If there is conflict between accounting principles relevant to the circumstances from one or more sources of lower level GAAP, the auditor should follow the treatment specified by the source in the higher category or be prepared to justify a conclusion that a treatment specified by a source in the lower category better represents the substance of the transaction in the circumstances. FIN39, to which this judgment refers later is highest-level GAAP and would, under the terms of rule 203, have to be followed if applicable.
Concept statement 2 (CON 2) at paragraph 160 reads as follow: -
"Substance over form is an idea that also has proponents, but is not included because it would be redundant. The quality of reliability and, in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form. Substance over form is, in any case, a rather vague idea that defies precise definition".
Representational faithfulness is defined in CON 2 as
"Correspondence or agreement between a measure or description and the phenomenon that it purports to represent (sometimes called validity). In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations."
Paragraph 33 of CON 2 provides that "to be reliable information must have representational faithfulness and it must be verifiable and neutral". Verifiability involves the replication of accounting treatment by independent accountants using the same methods.
The experts differed as to what was meant by the terms of CON 2 but it is clear that the concept paper (which is not authoritative GAAP) considers that "representational faithfulness" is what is required and that "substance over form" is not an appropriate criterion because of its vagueness. As Professor Ryan pointed out, the form of a transaction will almost invariably shape its substance. If a label is given to a transaction which does not represent the terms of the transaction, accounting must proceed on the basis of the terms and not the label. If however a transaction is a repurchase transaction, a leasing transaction or a sale transaction, the substance of the transaction is constituted by its form and "representational faithfulness" requires correspondence between the accounting treatment accorded to it and the rights and obligations (assets and liabilities) inherent within it. If one transaction contains different rights and obligations from another, representational faithfulness requires accounting treatment which distinguishes between the two and the concepts of comparability and verifiability which GAAP enshrines mean that transactions with real rights and liabilities of a similar nature should be accounted for in similar fashion. Whilst not all elements of a transaction may necessarily be capable of being captured in accounting treatment, that treatment must adequately reflect the substance of the transaction in question with due regard for all elements of it. This plainly involves a judgment in seeking to capture the substance of a transaction, particularly if it is a novel form of transaction or one where there is no direct accounting guidance.
FIN 39
FIN 39 was issued in March 1992 and was effective for periods beginning after December 15th 1993. It is concerned with the offsetting of amounts relating to certain contracts and interprets APB Opinion No. 10 and FASB Statement No. 105. As FIN, it is highest level GAAP. In the summary of FIN 39, the following appears: -
"APB Opinion No. 10, Omnibus Opinion – 1966, paragraph 7, states that "it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists." This Interpretation defines right of setoff and specifies what conditions must be met to have that right. It also addresses the applicability of that general principle to forward, interest rate swap, currency swap, option, and other conditional or exchange contracts and clarifies the circumstances in which it is appropriate to offset amounts recognised for those contract in the statement of financial position. In addition, it permits offsetting of fair value amounts recognised for multiple forward, swap, option, and other conditional or exchange contracts executed with the same counter party under a master netting arrangement."
The general principle is expressed in paragraph 5 in the following manner:-
"Opinion 10, paragraph 7, states that "it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists." A right of setoff is a debtor's legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying against the debt an amount that the other party owes to the debtor. 2(3). A right of setoff exists when all of the following conditions are met:
Each of two parties owes the other determinable amounts.
The reporting party has the right to set off the amount owed with the amount owed by the other party.
The reporting party intends to set off.
The right of setoff is enforceable at law.
A debtor having a valid right of setoff may offset the related asset and liability and report the net amount."
The effect of this is clear, as Professor Ryan pointed out. If there is no right of setoff, as a matter of law, between liabilities in differing transactions, those transactions must be accounted for separately. There can be no "netting" of the liabilities in independent transactions whether there are two or three transactions involved. To treat individual transactions as composite is to engage in "synthetic accounting" which is impermissible. Three transactions cannot be collapsed into one transaction where, as a matter of law, the rights and obligations are separate and can be individually enforced. Proper accounting must reflect the individual rights and obligations in the transactions which are a matter of substance and not merely of form. The fact that, if various transactions are fully performed, they may negate one another and the fact that the transactions may have been entered into in contemplation of the others does not effect their legal substance, quite apart from their legal form. Economic substance must reflect legal substance.
Furthermore paragraph 20 of FIN 39 reads as follows:
"FASB Concepts Statement No.1, Objectives of Financial Reporting by Business Enterprises, paragraph 37, states that "…financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise". The amount of credit risk exposure – the amount of accounting loss the entity would incur if the counterparties to forward, interest rate swap, currency swap, option, or other conditional or exchange contracts failed to perform in accordance with the terms of those contracts – is one indicator of the uncertainty of future cash flows from those instruments.
Con 1 Objectives of Financial Reporting by Business Enterprises also makes clear that it is a fundamental objective of financial reporting that it should provide investors with information purposes about the uncertainty of future cash flows.
The necessity of providing information which reflects the uncertainty of prospective net cash inflows, of credit risk exposure and potential failure of counterparties to perform provides an additional reason for accounting for transactions with differing parties on an individual basis.
Once it is accepted that the transactions must be reflected in the accounts on an individual basis as Mr. Turner agreed in his second report, FIN39 comes into play. It is only if the three transactions can be seen as one transaction because of rights of set off, that it is possible to look for the substance or economic substance of the three transactions compositely as opposed to the substance or economic substance of the individual transactions. It is crucial in this respect that the three transactions are independent without offsetting, netting or cross-default provisions between them. The obligations in each and the possibility of failure to perform in any one transaction should be represented in the accounting treatment of the three transactions.
When regard is had to the individual transactions themselves it can be seen that there are other individual characteristics which are inconsistent with characterisation as a loan. In a footnote in his second report Mr. Turner accepted that credit risk was borne to a greater or lesser degree by all three parties in Chase XII because the three transactions existed without any legal right of setoff between any of them. If ENAC defaulted on its obligation under the ENAC/Mahonia Swap which in turn would cause Mahonia to default on its obligations to Chase under the Chase/Mahonia Swap, and the market price of gas increased, Chase, despite the defaults which had occurred on the other two Swaps would be required to pay its net obligation to ENAC. In these circumstances, Chase would suffer an economic loss in excess of the aggregate amount which it had originally advanced to Mahonia and which Mahonia had advanced to ENAC ($350 million). Similarly, if Chase became insolvent and the price of gas went up, ENAC would have to pay a sum in excess of $350 million to Mahonia under the ENAC/Mahonia transaction whilst receiving nothing from Chase under the net settled Swap with Chase. There is no suggestion that the contracts were in any sense of the word a sham, so these rights and obligations were enforceable in accordance with the terms of the transactions with results which are very different from an ordinary loan.
Both the ENAC/Mahonia Swap and the ENAC/Chase Swap were subject to ISDA terms which gave rise to liability to provide collateral. In the case of the ENAC/Chase Swap, collateral was to be provided in respect of movements in the market price and the exposure of each party to the other as a result. There was an agreed threshold for each party which meant that Chase had to provide collateral when the market differential exceeded $50 million whilst ENAC had to provide collateral when the margin exceeded $10 million. The position of collateral was therefore not symmetrical as between the parties and the obligations were those which applied to sale transactions which would not have applied to a loan transaction. In the case of the ENAC/Mahonia Swap, ENAC had to provide collateral in respect of market movements by reference to the floating payment it had agreed to make to Mahonia. In the case of the ENAC/Chase Swap, Chase had to provide collateral for its obligations, an anomaly if Chase is seen as a lender.
The different obligations which arise as a result of structuring the transactions as three separate Swap transactions rather than as a bipartite loan transaction are matters of substance and not merely matters of form. As Professor Ryan said, the form of the transaction shapes the substance of the legal obligations and the economic substance which depends upon it. The point is illustrated by ENAC's insolvency in this case. Whereas, if all the obligations of the parties are performed, the ultimate economic effect at the end of the day is identical or virtually identical to that of a loan with interest payable, the obligations undertaken by the parties have an altogether different effect during the six month period of the transactions and ultimately if there is default.
Mr. Turner accepted that each Swap was intended to operate in accordance with its own terms, that each was legally independent of the other with no cross default or setoff provisions and that there were default characteristics which were dissimilar from a loan and could, if Chase or ENAC became insolvent, result in payments which differed from that for a standard loan. He considered the hypothetical case of Chase's insolvency to be so remote as not to be taken into account but the fact of ENAC's insolvency illustrates the point as a matter of practicality. As a matter of analysis the likelihood or unlikelihood of performance does not affect the true nature of the rights and obligations agreed, but as set out earlier, the element of uncertainty of receipt is a matter which should be reflected in accounting treatment. It is the existence of distinct obligations and rights which should be represented in the accounting treatment, rather than some composite synthesised view of all the obligations, should they be fulfilled.
Whilst at one point in his evidence Mr. Turner said that there was no other legitimate view of the Three Swaps and its accounting treatment than the one he had expressed, elsewhere in cross-examination he accepted that there were matters of accounting judgment involved in characterising the transactions and selecting the facts which were significant for the purpose of that characterisation. He accepted that it was not all black and white and, because the accounting rules were not clear, that there was room for disagreement between accountants on the subject.
He maintained his view however that the three transactions had to been seen together collectively as a loan before deciding upon the accounting treatment to be granted to each swap for the purpose of journal entries and that such composite analysis was required where there was manipulation of "the accounting model to achieve a desired accounting result".
DIG K1 & EITF 98-15
As mentioned earlier, DIGK1 only came into force in 2001 and therefore applies only to Chase XII and not to the earlier transactions. It came in with FAS133, which also only applies to Chase XII. EITF 98-15 came into force in 1998 but both of these are low-level GAAP as compared with FIN 39 which is highest level GAAP. DIG K1 relates to specific situations in which there are two instruments which separately do not meet the definition of a derivative but, when combined, would do so. This provides for a specific instance where parties have attempted to circumvent the accounting literature for derivatives which requires fair value accounting. It sets out three specific criteria to be applied in considering whether or not the transactions should be viewed together rather than separately. This is of no direct application to the three Swap transactions, nor to the two which ENAC accounted for on a fair value basis in any event.
EITF 98-15 applies to two structured notes with exactly opposite risk characteristics that are accounted for at amortized cost on (at least) the income statement, thus providing an ability to manage earnings by subsequently selling one of the structured notes and realising a gain or loss. It requires that the two notes be accounted for on a composite basis. It too has no application to the Three Swaps, but Mr. Turner relied on it by way of analogy.
Neither of these low-level GAAP rules however sets out any general principle for general application elsewhere. Each provides for a specific situation. Neither qualifies FIN 39 in any other situation and as the highest-level standard, FIN39 remains applicable to those situations.
Nonetheless Mr. Turner relied on these provisions as looking to the intention of the transaction in situations where two transactions were entered into contemporaneously and in contemplation of one another, where they were executed by same party and/or counter party and where the desired accounting result was the only object of the structure. These, he said supported his view of EITF 98-10.
EITF 98-10
The terms of EITF98-10 are of importance in relation to classification of the ENAC/Mahonia Swap. In so far as relevant it provides as follows: -
"EITF 98-10: Accounting for Contracts Involved in Energy Trading and Risk Management Activities [Superseded by issue No. 02-3]
"2. For purposes of this Issue, energy contracts refers to contracts entered into for (or indexed to) the purchase or sale of electricity, natural gas, natural gas liquids, crude oil, refined products, coal, and other hydrocarbons (collectively, energy). Energy contracts also includes energy-related contracts (for example, capacity contracts, requirements contracts, and transportation contracts 1(1)). Energy trading activities or energy trading contracts refers to energy contracts entered into with the objective of generating profits on or from exposure to shifts or changes in market prices. Consistent with the way in which trading activities are defined in Statement 119, trading activities also include dealing (the activity of standing ready to trade – whether buying or selling – for the dealer's own account, thereby providing liquidity to the market)."
"6. The issue is how energy trading contracts should be accounted for."
EITF 98-10 DISCUSSION
"7. At the November 18-19, 1998 meeting, the Task Force discussed the working group's recommended approach to accounting for contracts involved in energy trading and risk management activities. The Task Force reached a consensus that energy trading contracts should be marked to market (that is, measured at fair value (2) determined as of the balance sheet date) with the gains and losses included in earnings and separately disclosed in the financial statements or footnotes thereto……."
"8. The Task Force reached a consensus that determining whether or when an entity is involved in energy trading activities is a matter of judgment that depends on the relevant facts and circumstances………."
"The Task Force agreed that the framework in which such facts and circumstances are assessed should be based on an evaluation of the various activities of an entity rather than solely on the terms of the contracts. Inherent in that framework is an evaluation of the entity's intent into an energy contract. The Task Force reached a consensus that the factors or indicators identified in Exhibit 98-10A should be considered in evaluating whether an operation's energy contracts are entered into for trading purposes….."
"As used in Exhibit 98-10A, operation refers to any identifiable activity of an entity (for example, a subsidiary, a division, or a unit) that enters into the types of energy contracts that are within the scope of this issue."
"9. The Task Force acknowledged that it is easier to evaluate the trading activities of an entity when such activities are segregated organisationally or by legal entity. However, the Task Force observed that if an operation's trading activities are not segregated in either of those ways and an evaluation of the indicators identified in Exhibit 98-10A would conclude that a portion of the operation's activities are trading, then only that portion of the operation's activities would be considered trading and all energy trading contracts entered into by that portion of the operation's activities should be marked to market. Task Force members noted that when an operation conducts both trading activities and non-trading activities and those activities are not segregated organisationally or by legal entity, it is essential that the entity analyse contracts at inception based on the factors in Exhibit 98-10A and identify each contract either as trading or non-trading."
Exhibit 98-10A set out the factors to be considered for determining trading activities. The opening paragraph reads as follows: -
"FACTORS TO CONSIDER FOR DETERMINING TRADING ACTIVITIES
For purposes of identifying energy trading activities, the following groups of indicators should be considered for each identifiable operation (activity) of an entity that enters into energy contracts that are within the scope of this Issue. The absence of any or all of the indicators in any category, by itself, would not preclude the operation's activities from being considered trading. 3(3) Categories A and B represent the fundamentals of the operation's activities. Accordingly, the presence of indicators in both Categories A and B, in combination, may be a strong indication that such activities are trading. The presence of indicators in any one of the other categories (C-F), by itself, may indicate that the operation's activities are trading. Nevertheless, all available evidence should be considered to determine whether, based on the weight of that evidence, an operation is involved in energy trading activities."
Of the thirty factors which followed in groups A-F, twenty-six were concerned with the nature of the entity's business whilst four (F2-F5) were concerned specifically with the energy contracts in which that entity was involved. By virtue of paragraph 9 of EITF 98-10, those factors were to be used to analyse contracts to ascertain whether or not a contract was to be considered as an energy trading contract or a non energy trading contract, where an operation's energy trading contracts were not conducted by an organisationally segregated body.
Despite considerable argument about the necessity for a two-stage approach, upon which the experts differed, it is clear in my judgment that "energy trading activities" and "energy trading contracts" are essentially equated by paragraph 2 of EITF 98-10 and that the objective referred to in that paragraph of "generating profits on or from exposure to shifts or changes in market prices" falls to be assessed within the framework of the entity's business as a whole. This is made clear by paragraph 8 which focuses attention upon the various activities of an entity rather than solely on the terms of its contracts and the reference to what is meant by an "operation". It is expressly said to be a matter of judgment whether and when an entity is involved in energy trading activities and the evaluation of an entity's intent in entering into an energy trading contract is tied up with the evaluation of its activities as a whole. Thus the factors identified in Exhibit 98-10A are to be taken into account in evaluating whether an operation's energy contracts are entered into for trading purpose and in particular so under paragraph 9 if the trading and non-trading activities are not organisationally segregated. As Professor Ryan put it, the objective referred to in paragraph 2 is to be assessed on a portfolio or total business level rather than by reference to individual contracts per se. Energy traders enter into multiple contracts with a view to generation of profits. Some of those contracts may effectively hedge other contracts but, taken as a whole, the contracts are concluded with a view to generating profits as a result of movement in market prices.
West's skeleton argument at paragraph 31 appears to recognise that a contract designed to protect against exposures to shifts or changes in market prices, would be an energy trading contract although Mr. Turner maintained that only a contract with a speculative element in it was a contract entered into with the objective of generating profits on or from exposure to changes in market prices.
It was common ground that the ENAC/Mahonia swap was an "energy contract" within EITF 98-10 but the question was whether or not it was an "energy trading contract" within EITF 98-10.
i) Mr. Turner accepted that the ENAC/Mahonia Swap was an energy trading contract if the ENAC/Chase Swap was not taken into account. It was the elimination of the market price risk through circular contracts which, in his view, stopped the ENAC/Mahonia Swap from being an energy trading contract. Mr. Turner's view was based on the meaning of the text of EITF 98-10 which he said required an analysis of the intention of the accounting party in entering into a contract and the need to allow substance to prevail over form. He maintained that contracts with price risk management would qualify as energy trading contracts but without that they would not be energy trading contracts at all. In consequence, it would not seem to matter whether or not the entity was involved in energy trading, when considering the issue.
ii) Professor Ryan took the view that if an entity was involved in energy trading in a segregated manner, whether organisationally or by legal entity (see paragraphs 8 and 9 of EITF 98-10), that created a strong presumption that contracts entered into by that organisation, or that part of the organisation which concluded energy trading contracts, would qualify as energy trading contracts. That was why so many of the factors in Exhibit 98-10A focused on the nature of the organisation as opposed to the specific contract in question.
The ENAC/Mahonia Swap, when viewed on its own is, as Mr. Turner agreed plainly an energy trading contract within EITF 98-10. In order to escape the conclusion that it should be accounted for in this way, it is necessary to look at the objective which lies behind the two Swaps in which ENAC was involved and the third Swap between Chase and Mahonia. The objective to which Mr. Turner therefore wished to refer is the objective of the Three Swaps when taken as a composite whole, not the objective of any individual contract, despite maintaining that it was each individual contract to which regard had to be paid in assessing intent. In my judgment it does not appear to be a legitimate approach to look at a group of contracts compositely, as Professor Ryan opined, because of the terms of FIN 39 and the independence of each of the transactions from the other.
When considered as an independent contract, there is no doubt that the ENAC/Mahonia Swap has price risk in it and would qualify as an energy trading contract. Moreover, even if the Three Swaps are taken collectively, there remains a price risk in the event of default by the parties as set out by Mr. Turner himself in the footnote to his second report to which I have already referred. Whilst there was much discussion about whether default should be taken into account and the difference between credit risk and price risk, the fact is that, bound up with the credit risk in transacting business with each of the other two parties, was a price risk which would result in a greater or lesser sum being payable by reference to the price of gas at 26th March 2002 in the event that one or other entity failed to perform in an independent transaction. Moreover there was an element of price risk in both ENAC swaps throughout their duration because of the requirement for collateral to be put up in respect of market movements, albeit that this does not per se reflect a profit objective for the individual contract. Whether or not performance risk is only to be accounted for as it becomes apparent that there may be failure as Mr. Turner maintained, there is price risk involved in the transaction, whether taken individually or as a composite, which Mr. Turner advanced as the key issue.
As paragraph 8 of EITF 98-10 makes plain, there is an element of judgment depending on the relevant facts and circumstances in determining whether or when an entity is involved in energy trading activities by reference to the factors in Exhibit 98-10A. All the available evidence has to be considered for that purpose as the Exhibit makes clear and there is clearly some room for different views on the subject. Whether or not the underlying purpose of a forward prepay is financing, if there is price risk management involved, on Mr Turner's criterion, the contract must be an energy trading contract.
Professor Ryan pointed out that ENAC was an entity whose business was energy trading and that the objective of ENAC in Chase XII was no doubt to raise financing, but to do so in a form that was compatible with the other instruments in its trading portfolio. Many of the positions taken in a normal energy trading portfolio are not themselves speculative as the last sentence of paragraph 2 of EITF 98-10 recognises. Reference must be made to paragraphs 8 and 9 of EITF 98-10 and not merely to paragraph 2. If a contract is of a similar kind to another in the trading portfolio, why is it to be distinguished from the others because its purpose is financing, which is intended to render the portfolio as a whole profitable? Even if regard was to be had to other independent contracts, there would be no reason to draw a box round these two ENAC contracts and to treat them separately from the rest (with or without reference to the Mahonia/Chase Swap). Individual contracts in any energy trading portfolio may perform a number of roles other than directly generating profits by themselves. The question is whether or not the portfolio as a whole is aimed at profit and a financing contract which allows the portfolio to be profitable and which takes a form similar to other contracts within the portfolio should be accounted for in the same manner.
Professor Ryan pointed out that if Chase and ENAC had not hedged with each other in the ENAC/Chase Swap but had hedged with other counterparties, the position would be no different economically and all the contracts would clearly be energy trading contracts because of the price risk management inherent in each, even if that risk was perfectly hedged by another similar contract. The fact that Chase and ENAC chose to hedge with each other does not have significant effect on the substance of each transaction. In energy trading portfolios there are often contracts which are fully hedged from a price risk point of view if the counterparties perform, but they all fall to be accounted for as energy trading contracts. Here there is both individual price risk in each transaction and even should a box be put round the two contracts in question and the Chase/Mahonia Swap taken into account, there was a collectively price risk linked to credit or default risk.
When Mr. Turner was asked whether Chase I - Chase V (or IV) were energy trading contracts because these were hedged out into the market and were not the subject of a net settled swap constituting a third leg between ENAC and Chase, he said he did not know the answer. Proceeding from his view that it was the elimination of price risk which prevented a contract from being an energy trading contract his answer should have been negative. Proceeding from his view that it was the circularity of the Three Swaps transactions and the requirement to treat them compositely which prevented the transactions from being energy trading contracts, his answer should have been affirmative. He insisted that it was the composite analysis of these transactions which showed that price risk was eliminated and meant that the Three Swaps together constituted a loan, so, on that basis, it was inevitable that the logical answer to the question posed in relation to Chase I – IV would be as effectively eliminated in both situations. This highlights the point that, because of the independence of the Three Swaps one from the other, it can make no difference whether ENAC and Chase hedge their risks in the market generally or with one another. It can be said that each transaction takes effect as an energy trading contract with an inbuilt price risk and profit objective, notwithstanding any underlying financing purpose which is achieved if all three independent contracts are fully performed and the profits or losses are cancelled out.
West maintained that Professor Ryan's approach was contrived because the subjective aim of Enron and ENAC was to obtain financing by means of the Three Swaps taken together so that there was no objective of generating a profit in any individual transaction. West argued that Mahonia was introduced simply as a conduit to transfer the price risk round in a circle. ENAC had however two contracts only with Mahonia and Chase for which it had to account with price risk in each and an inbuilt profit or loss depending on market movement. Looked at individually, on an objective basis, they were speculative and clearly energy trading contracts. If they were considered as part of an overall trading portfolio, they could also be considered energy trading contracts since the objective of the portfolio was plainly to make profit and these contracts were intended to contribute thereto by providing financing.
In these circumstances, whether ENAC's transactions are looked at individually or looked at on a collective basis by reference to the whole of its trading activity, I cannot say that Professor Ryan's approach in treating them as energy trading contracts under EITF 98-10 was not a legitimate approach to adopt.
In my judgment it is simply not possible to focus on the "round tripping" or "circularity" of the three transactions and state that this is so much the dominant characteristic of the two ENAC transactions that nothing else matters besides, so that it is imperative to ignore the overall portfolio and the price risk characteristics of each transaction which, as is common ground, has to be accorded individual entries in the accounts.
FAS 133
In his second report, Mr. Turner said that the ENAC/Chase Swap was to be treated as a derivative whilst the ENAC/Mahonia Swap was to be treated as a loan host with an embedded derivative. The $350 million figure would be entered as a debt in the balance sheet whilst the derivative element relating to the floating sum would be accounted for separately. The effect of Mr. Turner's view, as set out in his second report was that the objective, for the purposes of paragraph 2 of EITF 98-10 was to be assessed on a composite basis in respect of the Three Swaps, whilst the accounting entries were to be made on an individual basis. The effect would then be to treat the ENAC/Mahonia Swap in accounting entries, not as a single instrument but as two instruments and to treat it differently from other contracts in the portfolio of a similar kind.
Mr. Turner took the view that paragraph 12 of FAS 133 applied to the accounting entries to be made for the ENAC/Mahonia Swap. FAS 133 which is headed "Accounting for derivative instruments and hedging activities" was effective for ENAC for the 2001 year and therefore could apply to Chase XII alone, not to Chase I – XI. It was recognised as easily the most single complex standard that FASB have ever issued. Mr. Turner accepted that it was difficult to understand and implement and that paragraph 12 was entirely new in the sense that GAAP had nothing similar prior to it. Paragraph 12 was an anti-avoidance provision to stop people trading derivatives in composite instruments but accounting for them on an accrual or historic cost basis and to ensure that fair value accounting was applied instead. Thus paragraph 293 of FAS 133 refers to the Board's view that it was important that an entity should not be able to avoid the recognition and measurement requirements merely by embedding a derivative instrument in a non-derivative financial instrument or other contract. What is envisaged is a contract with separate elements in it, one of which is a derivative and one of which is not, and a situation where the accounting entity chooses to account for the instrument as a whole on a non-derivative basis. As Professor Ryan pointed out however, the ENAC/Mahonia transaction settles as a single instrument and not as two instruments. Moreover fair value accounting was applied by ENAC to this transaction so that the objective which underlies FAS 133 paragraph 12 does not apply in any event. It would be odd to use FAS 133 to justify historic cost accounting as opposed to mark to market treatment. It is clear and common ground that the ENAC/Mahonia Swap, if treated as one instrument is not a derivative because of the substantial advance payment of $350 million, so that a characterisation as a loan and a derivative does not seem apt.
It is accepted that there is no provision in GAAP as to how to account for energy contracts which are not energy trading contracts. There was an issue between the parties as to whether or not there was a practice of accounting for such contracts as if they were energy trading contracts but the evidence on this was not sufficient for me to come to any clear conclusion about it. Suffice it to say that Mr. Turner recognises that most, if not all entities involved in energy trading activities accounted for these contracts (energy contracts) as energy trading assets and liabilities, whilst Professor Ryan's research from studying the filings of the 15 main energy trading companies revealed that they accounted for all their energy contracts as energy trading contracts or as hedging instruments, but not in any other way. The issue summary for EITF 98-10 referred to the prior practice as "diverse".
CONCLUSION ON US GAAP ACCOUNTING ISSUES.
I found Professor Ryan's evidence more persuasive than that of Mr. Turner, despite the latter's experience as chief accounting officer for the SEC. The latter's analysis of the position changed significantly and fundamentally between his first and second report and the matters relied on by him when giving evidence to the PSI were different from those upon which he relied in his evidence before me. Insofar as he sought to say that there was only one legitimate way to account for the prepays, whether Chase VI – XI or Chase XII, namely as a loan, I reject his evidence. As appears from the above discussion, in my judgment, Professor Ryan's view that ENAC was bound to account for the ENAC/Mahonia Swap and the ENAC/Chase Swap as separate transactions (because that is what they were) on the basis of the rights and liabilities contained in each was a justifiable view. A faithful representation of those contracts required them to be treated as the contracts they were and not on some composite basis, as if they constituted a single loan, simply because the economic effect of them, if they and the Mahonia/Chase Swap were fully performed, was similar or identical to that of a loan. They contained provisions which made them swap contracts with margin obligations and obligations to make payments which depended on the market movement of gas prices. There was price risk in each both on a performance basis and on a default basis.
I also take the view that ENAC was justified in treating the ENAC/Mahonia Swap as an energy trading contract and the ENAC/Chase Swap as a derivative so that both were accounted for on ENAC's balance sheet as price risk management assets or liabilities. Prior to the introduction of FAS 133, I do not see how this could be criticised or thought impermissible under GAAP and thereafter, although alternative accounting treatment was available, in the manner put forward by Mr Turner, it cannot be said that Prof Ryan's approach was impermissible. Thus ENAC was justified in giving the prepays "non debt" treatment on its Balance Sheet and accounting for them as Price Risk Management Activities, both in respect of Chase I – XI and Chase XII.
It follows from this conclusion that ENAC was entitled also to account for cash flows resulting from these Swaps as "operating cash flows" rather than "financing cash flows". Whilst ENAC was seeking to raise cash through the Three Swaps, both the form and substance of the transactions were forward swaps so that cash flows resulting from them do not constitute "investment" or "financing" cash flows and therefore fall into the remaining category of "operating" cash flows.
I am conscious of what West refers to as "the US Investigations", namely the report of the chief investigator of the US Senate's Permanent Subcommittee on Investigations (the PSI), the report of Mr. Batson, the Enron Bankruptcy Courts Appointed Examiner, the SEC complaint and settlement and the DA settlement. West points out that conclusions were reached about Enron's wrongful accounting for the Mahonia prepay transactions and that Mr. Turner's evidence played some part in this. On the 28th July 2003 the SEC filed a complaint against Chase in respect of the Mahonia prepay transactions including Chase XII, contending that Chase had aided and abetted Enron's breach of US Securities laws. On the same day as the SEC complaint was issued against Chase, Chase entered into the SEC settlement and consented to judgment in respect of the complaint. Chase agreed to pay a disgorgement in the sum of $65 million plus interest in the sum of $5 million, to pay a civil penalty in the sum of $65 million under S(2)(1)d of the Securities Exchange Act 1934 and to be permanently restrained and enjoined from a violation of S10(b) of that Act. Chase consented to judgment without admitting or denying the allegations in the SEC complaint but also declared that it understood and agreed to comply with the SEC's policy "not to permit Chase to consent to a judgment or order that imposes a sanction whilst denying an allegation in the complaint or order for proceedings". Additionally, on the same day, Chase entered into a settlement with the Manhattan District Attorneys Office pursuant to which the Manhattan DA agreed not to prosecute Chase in respect of its conduct in relation to the Mahonia prepay transactions. Pursuant to that settlement Chase agreed to pay without any reservations or denials $12.5 million to the State of New York, $12.5 million to the City of New York and $2.5 million to the Manhattan DA's office for the costs of its investigations.
West has placed reliance upon these matters as showing that not only was Enron's accounting obviously wrongful but that Chase recognised that it was so and that the settlements can be treated as admissions.
I have had to proceed on the evidence before me which plainly differs from that put forward to the PSI by Mr. Turner in his capacity as an expert witness called by the investigating committee. As is usual for such investigations, there was questioning by the PSI itself but no cross-examination of Mr Turner by others. Mr Turner had taken a stance before the PSI which he upheld in this Court, but on a different basis. His view appears to have evolved between the time he gave evidence to the PSI and made his first report (which accorded with one another) and the time when he made his second report, as set out earlier in this judgment. Mr. Turner's initial view was that the prepay transactions were collapsible into loans and should have been accounted for as such. In his second report to this Court he changed his analysis, arguing that the transaction comprised a freestanding derivative and an embedded derivative and a debt host. This latter accounting treatment is one which West had described in its statement of case as "wrong and misleading". Before the PSI and in his first report, Mr. Turner considered that the Swaps should together be reported as a loan whereas in his second report he accepted that they had to be accounted for individually under FAS 133–12, of which no mention was previously made. He also grappled with APB10, FIN 39 and EITF 98.10 for the first time in that second report, each of these having been raised in the sequential report of Prof Ryan. Equally, in his first report Mr. Turner placed great reliance upon the involvement of Mahonia and the GAAP guidance relating to SPV's, whereas in his second report Mahonia scarcely merits a mention and under cross-examination he accepted that the accounting issues would be exactly the same whether or not Mahonia had been involved in the transaction at all or whether Mahonia had been a company of substance. Once again this ran counter to West's pleaded case that "Chase knew that the proposed accounting treatment could not be justified not least because Chase and Mahonia were not unrelated entities".
The change in Mr. Turner's stance, as the former chief accountant of the SEC, is significant not only in respect of the substance of his evidence and the reliability of it but also because it shows that there is considerable room for divergence of view as to the proper accounting treatment of these prepays. Mr. Turners' second report could only criticise the accounting for Chase XII because there he relied upon FAS 133, which was inapplicable to Chase I – XI, whereas in his first report, where he maintained that the transactions were collapsible, Chase VI – XI or possibly all twelve transactions were attacked. I am bound to say that I did not find Mr Turner's evidence to be satisfactory, and whilst I had reservations about some of Prof Ryan's views on rating agencies, his approach was much more considered and balanced on the accounting issues. It was suggested that Prof Ryan was partisan, but it seemed to me that Mr Turner had taken a stance before the PSI which he felt he had to justify on new and different grounds and I preferred the evidence of Professor Ryan on all the accounting points that matter where there was an issue between him and Mr Turner.
It can fairly be said that this area of accounting is not one without difficulty, in particular in the application of EITF98-10 and FAS 133. Whilst the overall structure of the prepays from Chase I – Chase XII remained essentially the same and the accounting treatment given to it by Enron, with advice from Andersens, also remained the same, not only did the standards change over the period of accounting but the difficulty in applying them is self evident.
Whilst therefore there may be other ways in which the transactions could properly be accounted, on the evidence before me, I cannot conclude that the accounting treatment actually adopted was contrary to GAAP.
CHASE'S KNOWLEDGE
In paragraph 48 J of the re-amended defence and counter-claim, West alleges that because Chase VI – Chase XI were "disguised loans", Chase knew that Enron overstated its cash flow from operating activities and understated debt on its balance sheet in respect of these transactions and that as a result it knew that third parties such as actual or potential creditors, analysts and credit agencies were being misled. In particular in paragraph 48K, West alleges that Chase knew in respect of Chase VI – XI that: -
i) In economic substance, Chase VI – XI were loans to Enron.
ii) Enron entered into Chase VI – XI for the purpose of reporting its obligations under them as price risk management liabilities rather than debt and in order to report the proceeds it received as cash from operating activities rather than as cash from financing activities.
iii) Enron's accounting was not in accordance with the economic substance of the transaction and/or US GAAP.
iv) Enron's accounting was not fairly presented and Enron would not provide disclosures in its financial statements or related securities law disclosures that would enable a reader of its financial statements to determine the economic substance of Chase VI – Chase XI.
v) Enron's failure to provide adequate disclosure of Chase VI – Chase XI was material to Enron's financial statements and critical to the maintenance of Enron's credit rating. In consequence Chase knew that Enron's failure properly to disclose the nature of Chase VI – Chase XI did not permit the users of Enron's financial statements to understand the effect of Chase VI – Chase XI on those financial statements.
West alleges in paragraph 108 A of its statement of case that Chase knew or ought to have known that Enron's proposed accounting treatment for the Three Swaps would not be fairly presented or in accordance with GAAP and would be in breach of US Securities laws. Chase was thus complicit in such conduct. Since the Three Swaps were concluded on 28th September 2001, there would be no figures filed publicly, in which this transaction fell to be included, until the quarterly filing on 16th October 2001. West relies upon Chase's alleged knowledge of Enron's wrongful accounting treatment of Chase VI – XI and its knowledge that, since the Three Swaps were "in effect a loan to Enron", Enron's purpose in concluding the Three Swaps was to report its obligations under them as price risk management liabilities and its proceeds as cash from operating activities. Chase therefore is alleged to know that Enron would not account for the Three Swaps in accordance with the economic substance of the transaction or in accordance with GAAP, nor make proper disclosure of those transactions in its financial statements nor elsewhere, as required by law.
West also placed reliance upon Chase's continued maintenance of "the illusion of Mahonia's independence" but in the light of the expert accountancy evidence, which was to the effect that the presence of Mahonia had no impact upon the proper accounting treatment of the transaction, this must be based on the premise that Chase wrongly understood that there was a need for Mahonia to be involved.
In their closing submissions West maintained that Chase not only knew of Enron's improper accounting objectives but also actively participated in enabling Enron to achieve these objectives by structuring the Mahonia prepay transactions to appear as if they were genuine trading contracts rather than in reality a loan from Chase to Enron. It is said that the inclusion of Mahonia in the transactions for no substantive business purpose was nothing more than a device to seek to enable Enron to pass these transactions off as trading contracts which could be accounted for as trading liabilities under the heading "price risk management activities".
West contends that Chase's knowledge and participation in Enron's improper accounting can be established by the following: -
i) Chase knew that the Mahonia prepay transactions were in reality loans/debt.
ii) Chase knew that Enron accounted for the Mahonia prepay transactions as trading liabilities under the heading price risk management activities.
iii) Chase knew that the Mahonia prepay transactions were hiding debt and burying the liabilities in the balance sheet as trading liabilities.
iv) Chase knew that Mahonia had no substantive role to play in the transactions and it was necessary for it to seem independent in order to make the transactions appear commercial transactions between three independent parties.
v) Chase knew that the Mahonia prepay transactions involved no trading or price risk management as the price risk had been eliminated.
vi) Chase knew that there had not been adequate disclosure in Enron's accounts and that readers/users were being misled (i.e. that the transactions were not fairly presented).
I have already held that the prepay transactions were financing transactions which could properly be accounted for on the balance sheet as trading liabilities or price risk management activities rather than loans or debt. I have also found that there was price risk management in the transactions even thought the intention was that, on final performance, the price risks in the individual transactions would be cancelled out. In such circumstances, what Chase personnel thought, assumed or knew is of no significance but I now set out my findings on this aspect of the matter.
I heard evidence from a number of Chase witnesses, some of whom were cross-examined about their knowledge of some of these matters. West asked the four members of the deal team, Messrs. Traband, Walker, Serice and Dellapina, as well as Mr Ballentine, about their knowledge of Enron's accounting, but the latter's knowledge was derived from the members of the deal team, so that the focus was on the first four individuals. Mr. Levy was scarcely questioned on this aspect but his evidence was that he knew there was a perceived accounting benefit for Enron in the prepays but did not know what it was.
Mr. Traband was, from about March 1999 onwards, the Corporate Banker or Lending Officer at Chase with responsibility for Enron. His job involved the assessment of extensions of credit to Enron and liaison with Credit in relation to this. He said that, so far as he was concerned, the prepay transactions in which he was involved, namely Chase IX – Chase XII were all concluded by Enron with a view to "monetising" Enron's net assets in its trading book. This was an understanding he gained from Enron in particular at a meeting in May 1999 and perhaps one later meeting. The need to raise finance was what drove the transactions. He understood them to be financing, thought that there could be small losses from the transactions but that if both parties performed there would be no profit and no loss, whilst recognising risks in respect of the physical delivery of commodity where this occurred and risks associated with the individual contracts.
On May 11th 1999 he, together with Mr. Walker who was Chase's client relationship manager for Enron, wrote a letter to Enron about a projected meeting which, whilst planned for the 14th May, took place a little later. The letter and the enclosure were drafted by Mr. Traband. The opening sentence of the letter read thus: -
"We appreciate your consideration in taking time to review the Enron capital structure, both on and off balance sheet with us. While we believe Chase understands the Enron corporate financing structure as well as anyone outside of your firm, we are equally sure that our understanding is incomplete. Your willingness to walk us through these issues will only help us in the process of adding value to your financing process and decisions."
The letter went on to describe some of the key issues which they hoped to address but which no-one suggested were directly relevant to the issues before the court. The last paragraph however read as follows: -
"As you can see from the above areas of focus, an underlying theme is both the level and structure of consolidated and non-consolidated cash flows used to support the varying on and off balance sheet debt structures. Attached is our understanding of how ENE's financial statements might be impacted by various project structures…"
Attached to the letter was a document headed "overview" which set out Enron's capital structure including consolidated debt, unconsolidated affiliated debt, other items and prepays. In addition a consolidated income statement, a consolidated balance sheet and a consolidated statement of cash flows were included, encompassing the years ending December 31st 1996, 1997 and 1998. In the margin of these financial statements Mr. Traband had added the types of financing arrangements alongside what he thought to be the entries in which those transactions would be included, with an arrow pointing to the relevant entry. In relation to the balance sheet, he identified prepays with "liabilities from price risk management activities", whilst on the cash flows he identified prepays with "net assets from price risk management activities".
The meeting was due to be attended, according to an attachment to this letter by, inter alia, Mr. Walker, Mr. Traband, Mr. Biello, the head of Credit for North America and Mr. Serice, who was in the syndications department of Chase.
Mr. Traband's evidence was that, at the meeting, his belief in relation to the balance sheet was confirmed but that nothing was ever said to confirm his assumption with regard to the treatment of prepays in the cash flow statements. In a memorandum shortly before Chase IX, Mr. Walker told others, including Mr. Dellapina and Mr. Traband of a "business purpose" discussion in which he had been involved "a couple of times recently". He referred to a high level meeting in late May with Enron's treasurer Mr. McMahon in which the latter articulated the business purpose as "efficiently priced funding" and as monetization of the positive excess of assets for price risk management over liabilities for price risk management. I find that Enron made these purposes plain to Chase at the meeting. Mr. Traband's assumption with regard to the balance sheet was expressly confirmed but not his assumption with regard to the treatment of cash flows, although it was the logical consequence of the balance sheet treatment.
Mr. Walker who was Enron's client relationship manager at Chase from about April 1994 onwards, said that he appreciated from around November 1994 as a result of an interim review, or possibly earlier, that Enron booked the prepay transactions in its accounts as liabilities for price risk management on its balance sheet. The review referred to the background of utilisation of prepays as "a mechanism to address a number of needs including refreshment of section 29 credits and sourcing of funds (classified as liabilities from price risk management assets as opposed to long-term debt)". That remained his understanding throughout and he had some recollection of a discussion at the meeting following Mr. Traband's 11th May 1999 memorandum, about prepay transactions and the benefits that Enron enjoyed from utilising them as a funding structure. At no stage did he know how Enron accounted for the matter on their cash flow statements.
Mr. Serice was a syndications officer from 1996 onwards whose job was to sell or syndicate bank business. He was involved in syndicating the performance letters of credit which were credit support for Chase V and Chase VI but played little part in Chase VII – XI because syndicated letters of credit were replaced in the transaction structure by surety bonds. He remained someone who was consulted on issues of pricing and bank market capacity for any extension of the Enron credit and was considered part of the "deal team" for the purposes of Chase XII. He had been involved in arranging the syndicated facility for Enron which Chase led in May 2001 in the amount of $500 million. He, like Mr. Traband and Mr. Walker said he knew of the accounting treatment given by Enron to prepay transactions on its balance sheet but did not know of its treatment of prepay liabilities in its cash flow statement. In an earlier deposition on which he was not cross-examined at the trial, he had said that he had been told by Mr. Traband at the time of Chase XII that the prepays appeared in the cash flow statements as cash from operations. Mr. Traband was not asked about this either.
Mr. Dellapina, after a short spell in London returned to the New York branch of Chase in the summer of 1997 and joined the global commodities division there. He became the effective coordinator of the prepays which took place from December 1997 onwards (Chase VI – Chase XII). So far as he was concerned, he said, although he did not have any specific discussions on the point, the purpose of the prepay transactions was to raise finance for Enron. His knowledge of how Enron accounted for the prepays was gleaned from internal discussions at Chase with Mr. Walker and Mr. Traband. He therefore understood that they were included on Enron's balance sheet as liabilities from price risk management. He did not enquire nor did he know how the prepays were shown on Enron's statement of cash flows.
Mr Ballentine, the first level credit officer involved in discussions with the "deal team" on Chase XII shared the same understanding on balance sheet treatment as the members of that team as a result of being told this by Mr Dellapina and Mr Traband.
These individuals when cross examined about their understanding of the prepay structures, gave evidence that they perceived the Swaps as having an element of price risk management.
The Chase structure summaries which were produced in respect of the prepays referred to them as meeting Enron's objectives of (amongst others) "sourcing funds (classified as liabilities from price risk management as opposed to long term debt)." These structure summaries were widely circulated and the essential contents of them must have been known to each member of the deal team, who was aware of the balance sheet accounting treatment that Enron had given and proposed to give to prepays.
Emails and documents, in combination with evidence from the deal team members show that they were conscious of Enron's desire to raise finance on a 'non-debt' basis, driven in part, so Enron personnel said, by Rating Agencies' desire for Enron to get more cash out of its trading book. The idea was to "monetise" Enron's assets which, after being used to refer to forward sales or Volumetric Production Payments (VPP) came ultimately to mean no more than raising cash on the basis of a surplus of net assets, which reflected perceived credit worthiness.
There are various documents on Chase's files which show that the prepay transactions were regarded at Chase as being "balance sheet friendly" or "balance sheet advantaged". Despite reluctance on the part of some of the Chase witnesses to accept the point, I find that each of the four members of the deal team, namely Messrs Traband, Walker, Serice and Dellapina, all shared this view. The reason why the transactions were so viewed was because these persons considered that if appropriately structured, they enabled the figures for a financing operation to be accounted for in the balance sheet as something other than debt. Whilst the liability was represented in the balance sheet, it was represented as price risk management activity which reflected trading activity. This, I find on the evidence, was considered by companies to be advantageous because, rightly or wrongly, it was thought that this improved their financial standing in the perception of some readers of their financial statements, including possibly the rating agencies. This perception was shared by the deal team and used to "sell" the prepay structure to customers.
Evidence was adduced under the Civil Evidence Act of the testimony given to the PSI by Mr. Barrone and Ms. Stumpp of the rating agencies S & P and Moodys. Both had positions to defend in relation to their analysis of Enron's financial statements. It was said that Moodys had no knowledge of Enron's prepaid forward and related Swap transactions whilst S & P did know of the prepays and sought to characterise them appropriately. S & P considered that Enron was engaged in prepaid forward transactions to actively manage its trading and marketing positions and cash flow and because its price risk management account was largely in balance, it considered it as operational cash flow. Both rating agencies maintained that they had been misled by Enron and its financial statements. Ms. Stumpp referred to this as "financial engineering gone a little too far" where "the disclosure element was particularly problematic". Both agencies said that their rating of Enron would have been reduced if the prepays had been booked as loans.
Chase adduced some hearsay evidence to the contrary from Mr. De Spain of Enron who was responsible for Enron's relationships with the rating agencies but this was not of great weight. On the evidence before me I cannot find that the rating agencies were actually misled, whether by the accounts or in meetings with Enron personnel: nor can I make any findings as to how the rating agencies made their assessments of corporations such as Enron, whether by reference to their publicly available manuals which are apparently used for the purpose of analysis or otherwise. What is however relatively clear is that the notion of "prepays" was known to many in accounting and financial circles and that a number of banks and customers had utilised financing structures to which this name was applied. Exactly what these structures were did not appear in evidence before the court, nor the accounting treatment they attracted, but plainly their attractiveness was the accounting treatment they were thought to engender. Whether or not the rating agencies did know about them or understood them or should have had such knowledge or understanding or whether they were misled are matters beyond the scope of this judgment. I find however that individuals of Chase, such as Mr. Walker, thought that they did not properly understand them.
The documents revealed that Chase developed forms of "pitch" or presentation for their customers on prepaid financing. These documentary presentations set out the structure of a prepay transaction involving Mahonia with diagrammatic illustration. Whilst the forms of presentation in the documents differed from one transaction to another, reference was made to the accounting treatment in terms such as "treated as a commercial obligation", "non-debt treatment", "price risk management", "diversification of finance" "balance sheet friendly", "rating agency friendly" and, in one case the following: -
"Accounted for as a commercial obligation. Could reduce…total consolidated financial debt and receive favourable treatment from accounting and rating viewpoints. (Should provide insight as to the impact on debt/EBITDA ratios)."
The footnote to this last entry was a disclaimer saying that
"J. P. Morgan Chase makes no representation with regard to tax or accounting treatment of the transaction."
In an internal document "for discussion purposes only" a junior employee at Chase sent Mr. Dellapina and Mr. Serice, amongst others, what appears to be a draft of a presentation to be made to a potential prepay customer. In this document a comparison was made between prepaid forward sales, volumetric production payments and royalty trusts (in terms of improvement or reduction) with regard to "EBITDA", "total debt", "leverage ratios" and "Net Present Value of O & G assets/ total debt", in the context of liquidity whilst a similar comparison was made in relation to the balance sheet treatment of these items. In dealing with a production company the latter comparison referred to "reduction of bank debt" and "Deferred Revenue Liability" (the equivalent for a production company of "price risk management activity" for a trader).
It is clear, despite the reluctance of some of the Chase witnesses to accept it, that they all had a broad understanding of the prospective advantages of "non-debt" financing, inasmuch as some readers of the financial statements of the customer concerned might make a more favourable analysis of the company by focusing on debt rather than focusing on liabilities as a whole and by using debt/assets ratios or debt/earnings ratios as a measure of the company's well-being, instead of applying the liabilities of the company to assess leverage or earnings ratios.
Whilst it seems that Enron was renowned for off balance sheet financing and innovative financing using prepay structures and the like, it is unclear whether or not credit analysts and rating agencies were or were not sufficiently alive to these points to appreciate the extent of financing in which Enron was involved. Mr. Traband said that he understood that the level of debt was something which might affect a company's credit rating but he thought that an increase in the trading liability on the balance sheet should have a comparable effect to an increase in debt, so far as equity analysts were concerned. It seems to me however to be clear that Chase personnel involved in the prepays knew that Enron wanted a structure that obtained non-debt treatment in accountancy terms and that this was a key reason for effecting the prepay, as opposed to other forms of financing. The desire for "non-debt financing" on the balance sheet was founded upon the supposition that avoidance of "debt" on the balance sheet would lead to a more favourable view of the company concerned. Chase personnel involved in prepays, such as Mr Dellapina used this accounting benefit as a selling point to other customers, but, it appears, subject to the reservation that it was a matter for each customer, with its own accountants, to ascertain whether or not the proposed transaction was suitable for it in accounting terms and achieved what it wanted to achieve.
Mr. Serice recognised that there was an attractiveness to Enron in recording the liability as a non-debt liability on the balance sheet, which was an option presented by a prepay and he knew of Enron's preference prior to September 2001 of raising cash in this way, whilst saying that it was normal for Enron to have numerous transactions upon which it was working, some of which would raise cash as debt, some of which would be totally off balance sheet and some of which, like prepays were on the balance sheet but not recorded as debt.
In an e-mail in November 1998, Mr. Serice, in referring to prepays, said that:
"Enron loves these deals as they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred rev or (better yet) bury it in their trading liabilities. There are however tax attributes to the structure that can 'freshen' NOL's. (Net operating losses) …sale can accelerate gains to the year in which the prepay is consummated which gains can be offset by expiring NOLs."
In Mr. Walker's call report referring to a meeting with Enron on 18th December 1998, it is suggested that the Rating Agencies did not have full knowledge of all Enron's financings and Enron might "suffer heartburn" if they did. This appears to have been primarily referable to off balance sheet financing, to which the call report refers but may also encompass prepays. Similarly, in an e-mail in October 2001 Mr. Walker expressed his belief that "agencies had not yet figured out prepays". I am left in no doubt that all the members of the "deal team" considered that there were balance sheet advantages to be gained by Enron and other customers in effecting prepay transactions which were not recorded as debt on the balance sheet, because not only was it good for a company to have diverse means of financing, but the perceptions of others (including rating agencies) of the company's financial standing would, might well be, or could be, improved thereby.
Historically, as already mentioned, Structure Summaries were prepared for each proposed prepay transaction. These described the transactions as "a series of commodities and interest rate Swaps which result in a known cash flow stream". In the first draft structure summary for Chase XII, (as with previous structure summaries), the Enron credit statistics in it did not include the prepays. As a result of a conversation between Mr. Ballentine, Mr. Traband and Mr. Dellapina on 20th September 2001, subsequent structure summaries did include the prepays in the debt figures in the credit statistics. In that telephone conversation, a transcript of which was available to the court, it was explained to Mr. Ballentine that this was a structured financing transaction and a monetization of assets from price risk management. Mr Ballentine, who was relatively new to Credit, after referring to it as "amortised debt" and being told it was "monetization", insisted that it was nonetheless a liability and, in the same way as he had required prepays to be included as a notation in the Aquila statistics for their prepay in order to calculate leverage, he required the previous prepay liabilities to be included in the credit statistics for Enron for any consideration by Credit as to whether to grant more financing in the shape of what became Chase XII. Thereafter they were included by Mr. Traband in the debt figures in those credit statistics and the leverage figures then reflected that addition.
In a few Chase documents, there are references to Enron "hiding the debt" or burying it in other liabilities. There are also many occasions in the documents where Chase personnel referred to the transactions as "loans" or "debt". West drew attention to all kinds of documents which took the matter no further. Correspondence with bank regulators when seeking permission to conduct prepays proceeded on the basis that they were analogous to loans and that the assessment of credit risk was the same as for loans. They are many internal references to the effect of prepays being similar to that of loans, to the result of a "known cash flow stream" and documents showing treatments of prepays in the same way as a loan for a number of different purposes including, specifically, pricing. The deal team members themselves often referred to the prepays either as loans or in loan-like terms. Occasional references appear to the economics working like a loan, to prepays counting as debt for financial covenant purposes and even to a "term loan embedded in a commodity Swap". The calculation of the figures for use in assessing the discount on the prepayment was done by reference to interest rates also.
In this latter connection where Chase XII is concerned, there is a series of exchanges between Mr. Garberding of Enron and Mr. Sabloff of Chase in which they refer to it throughout as being a loan, for the purpose of effecting the calculations necessary to arrive at the figures for the amount of gas for the floating payment and for the purpose of calculating the fixed payments. Whilst the exchanges also relate to additional interest rate risk and whether or not Enron wanted additional interest rate management (which they did not) and some of the language used ("bullet loan" "borrowing" "no amortisation") relate to this, there is no doubt that for those involved in calculating the figures, the prepays were treated as if they were loans.
Nonetheless when using terms appropriate for loans, these individuals were not speaking technically. There is no doubt that bank personnel regarded the prepay transactions as similar to a loan or debt, referred to it in such terms and frequently treated the transactions as if they were debt. From a banking perspective, and the judgement to be made as to whether to finance Enron or not, little depended on the form of the financing adopted- it was a matter for the lawyers to draft the appropriate structure and a matter of legal analysis to say what the transactions represented. Whether or not Chase personnel regarded the prepays as loans or referred to them in language which referred to them as such or reflected a view of them as loans is beside the point however. It has no relevance, in my judgement to the question of their knowledge of Enron's accounting treatment, its justifiability or unjustifiability nor to their own view as to whether or not the structures devised did carry with them the accounting benefits to which they referred nor their knowledge of Andersens' approval of Enron's accounting treatment of them.
West drew attention to the expression "efficiently priced funding". West said that pricing was not efficient because, as was accepted by Mr. Serice, a premium was payable in respect of prepayments as opposed to conventional "vanilla" loans. Indeed the evidence from all those involved in banking, from both sides, was that banks (including West) generally charged more for structured finance than for vanilla loans. Equally there was a premium for end of year deals when many companies were seeking financing. West drew attention to a reference in a Mr. Dellapina telephone conversation where he suggested that Chase XII was an opportunity to "charge the shit out of them" but this was said in a telephone conversation immediately following the events of September 11th when the market was in turmoil and options for raising finance were limited. It does not appear to me that this point takes West any distance since it is plain that Enron had said at a meeting that it regarded its prepays with Chase as "efficiently priced funding" and it may be that it was indeed efficiently priced in comparison with other possible options for raising money available to Enron from other banks. The fact that it was funding is not an issue and there was no evidence to suggest that the pricing was exorbitant because there was some known unlawfulness in the transactions.
Although the accounting experts agreed that there was no significance in the presence of Mahonia in the transaction for accounting purposes, West made much in its arguments of that and of Chase's knowledge of the lack of a substantive role for Mahonia in the transactions as a basis for imputing guilty knowledge of some kind. Attention was drawn to many of the factors set out earlier in this judgment in relation to Mahonia, its status and its activities as well as to the lack of any apparent tax or regulatory reason for its use after 1996/7. Documents show that in October 1997 consideration was certainly being given to the abandonment of Mahonia's use but I find on the evidence that a decision was taken to retain Mahonia because Enron requested it because of the perceived benefit to Enron of dealing with an SPV which was legally independent. Chase was content to continue in the same way as the documents were essentially drafted with an available template. There was a view shared by some at Enron (and Chase) that there was benefit in having a three party transaction on a prepay where the prepayment was not made by a bank. This could be described as "optics" as it was by Mr. Serice in a deposition, on the basis that the outside world might regard a transaction with a bank as more likely to be a loan than a transaction with another company. Mr. Dellapina accepted that the need to use an SPV was driven by the treatment that Enron wanted on its balance sheet and that the question of legal independence of that entity was an important requirement so far as Enron was concerned.
Thus it seems that there was a perceived accounting benefit in making use of Mahonia, although the experts at trial indicated that there was none in reality. Moreover, Andersens who advised upon prepay transactions, appeared to have advised both on two leg and three leg transactions and had been told back in 1993 of Mahonia's status as an SPV. Mr. Dellapina's evidence was that prepays were done by Chase with other companies without the use of SPV's in the years 1998 – 2000 but that he knew that Enron wanted non-debt funding and a structure which had an independent SPV which worked for Enron to accomplish this objective.
Moreover it is right to note that Chase, in its marketing of prepays to its customer, marketed them on the basis of using Mahonia as part of the structure. Whilst this did provide an additional option in facilitating syndication of the funding, it appears that it was part of the structure which was thought to achieve the accounting benefits envisaged. There was moreover some evidence that Mr. Dellapina wished to add to the "commerciality" of Mahonia's activities by involving it in investment in speculative gas contracts which Mr. James was not prepared to countenance at the time of the suggestion. Whilst West regards all this as suspicious, if the reality was that Mahonia was an independent company but that questions might be raised, there was nothing devious about seeking to involve it in other business activity.
West refers also to the hedging strategy letters which were, it said calculated to give an impression of independence. These were exchanged between Mahonia and Enron and it is hard to see how they take the matter further since it was not suggested that Andersens was misled.
Contrary to West's contentions, the limited recourse agreement which formed part of the transactional documents is a strong pointer to Mahonia's independence from Chase and the autonomy of its decision making process so far as concluding any prepay transaction is concerned. Mahonia needed such an agreement to protect its own position in the event of a default by Enron and to enable it justifiably to conclude the transaction for the small fee available. The letters showing that neither party relied on the other's advice also reinforce this point. It was in fact the limited recourse agreement which meant that it was sensible for both Mahonia and Chase to enter into the agreement of 26th November 2001 to ensure that Mahonia's obligation to Chase were fixed at the same level as those of ENAC to Mahonia.
Mr. James's evidence, which I have accepted, was entirely accurate and apt in describing Mahonia as being independent in deciding whether or not to conclude any given transaction. The existence of "perfect hedging", Agency Agreements, Security Agreements giving Chase a lien on Mahonia's contractual rights against ENAC and the other documents and representations reflect Mahonia's independence in that decision making process, whilst handing over control of the transactions it had concluded to Chase, as its agent and as the arranger required because of its security interests. It matters not how the point is put, it cannot be said that Chase controlled Mahonia – only that Chase, by agreement with Mahonia controlled the transactions which Mahonia had voluntarily and independently concluded with Chase, at Chase's request, following upon Chase's presentation of a virtually concluded deal to it for consideration.
West's propositions which are put forward as supporting the allegation of Chase's knowledge and participation in Enron's improper accounting purposes do not get to the root of the real issue which is whether or not Chase understood that Enron's past accounting and proposed accounting for prepay transactions was wrongful, that the prepays were in accounting terms "debt" and that US GAAP required a different treatment from that which Enron had given and proposed to adopt in the future. To say that Chase knew that the Mahonia prepay transactions were in reality loans/debt, that it knew that Enron was "hiding" debt and burying the liabilities in the balance sheet as trading liabilities begs the question. West accepted that it had to show that Chase knew of misaccounting, mischaracterization of the transactions in accounting terms and that the accounting was wrongful. If Chase personnel considered that prepays could properly be accounted for in the manner which Enron adopted, its knowledge of the manner in which Enron did account for them and its knowledge of the presence or absence of risk management in them are not significant. The question is whether or not Chase did know that the accounting was improper and there had been inadequate disclosure in Enron's accounts with the result that readers or users were being misled in a manner that was wrongful.
Although the four individuals in the Chase deal team to whom I have referred all had financial experience and some had accounting qualifications, none were current practising accountants and all were entitled to take the view that Enron was taking its own accountancy advice and would properly account for the transactions in accordance with that advice, unless there was some indication to the contrary.
In July 2000, the documents show that Mr. Dellapina had a meeting with Price Waterhouse Coopers who were Chase's auditors "to review the final rulings on VPP/prepay accounting". An e-mail from Mr. Dellapina to Mr. Serice reveals that a "standard prepay pitch" had been given to Mr. Keehan of that firm at his request. Mr. Dellapina described his objective "to have a coherent argument to maintain deferred revenue treatment even if we must separate the embedded commodity forward". Mr. Serice was invited to the meeting which was scheduled to take place, where Mr. Dellapina said that the VPP accounting issues had been the focus by FASB and that it was hard to imagine that this could affect the off balance sheet product. He said he did not recall any final rulings on the issues of VPP or prepays. Mr. Serice did not attend the meeting. Following the meeting Mr. Keehan sent Mr. Dellapina a copy of DIG B11 relating to volumetric production payments and embedded derivatives and a copy of FAS 138 which amounted to an amendment of FAS 133, dealing with "accounting for certain derivative instruments and certain hedging activities". FAS 133, as already discussed in the context of the accountancy expert evidence was a document of considerable size and complexity and when Mr Dellapina says that he did not grapple with its complexities, that may not be surprising. That was presumably why he was seeing Mr. Keehan, but I find that he was taking trouble to understand the accounting issues because, if Chase was to continue to sell structured financing to its customers, he had to be aware of the general rules surrounding their accounting treatment.
Mr. Dellapina's evidence under cross-examination was that he understood that FAS 133 was to come into effect and he was seeking to ascertain the impact on the transactions upon which the bank worked. He had a limited understanding of FAS 133, gained by being part of a large trading business at the bank but did not know whether a prepay could or could not simply be treated as a derivative obligation. It seemed that he had picked up that separating the embedded commodity forward was one of the issues raised by FAS 133 in derivatives but he did not know whether that applied specifically to prepays. Whilst this matter was not explored in any great detail in cross-examination, I conclude that Mr. Dellapina did consult Price Waterhouse on accounting questions with regard to prepays and FAS 133 and that Mr. Dellapina must have had some understanding of FAS 133 to talk in the terms in which he did in the e-mail to Mr Serice.
In a telephone conversation between Mr. Dellapina and Mr. Serice on 14th September 2001 there is discussion about the prospective Chase XII. Part of the conversation included reference to Enron's desire for the transaction for "accounting reasons" because "they don't want to just keep rolling this into debt". The conversation continued by reference to the Royal Bank of Canada who had done some pure prepayments of financial Swaps, to whom Enron might go direct. The exchange then included the following: -
DELLAPINA: "So they could go to them direct. I wouldn't be surprised if they did. Literally, they do like an ISDA Swap and just prepay it. "
SERICE "Uh-huh".
DELLAPINA "Which I don't know how the fxxx they've ever gotten accounting treatment, but I think the accountants are getting tougher. I think they need this. I think you should. I think you go back we could do it together"
SERICE "Uh-huh".
It was unclear exactly to what Mr. Dellapina was referring in relation to the past accounting treatment but, far from demonstrating that Mr. Dellapina was involved in putting up schemes which were unlawful, it demonstrates that he knew that accountants were involved and deciding on the appropriate accounting treatment for Enron whether in relation to Royal Bank of Canada deal or otherwise. It does show that he had a greater understanding of accounting matters than he was prepared to concede but I have no doubt that he was not prepared to second-guess Enron's accountants and, as with all the other witnesses, it was never suggested to him that he was in any way trying to deceive Andersens into giving advice to Enron on a wrong basis about appropriate accounting treatment for their transactions.
Whilst the evidence of the Chase witnesses was well rehearsed and some of the deal team had a propensity for avoiding questions on documents on the basis of not reading them at the time, on the fundamental points which matter, I accept their evidence. What is plain from the evidence of each of the four members of the deal team is that they considered that Enron's own accountants, Andersens were fully involved in the issue of accounting treatment of the prepay transactions by Enron and that the structure of the transactions was vetted by Andersens in order to give it "non-debt" classification on the balance sheet.
i) Mr. Traband had analysed Enron's publicly filed financial statements in order to reach the conclusions which he did in May 1999, which were recorded in the Annexure to the letter of May 11th 1999. His evidence was that he never had any indication or reason to think that the prepays were accounted for in a strange manner and that he assumed throughout that Enron, on the advice of Andersens, would account for and disclose the prepays properly, in accordance with GAAP.
ii) Mr. Walker knew that prepays were treated by Enron and other marketing and trading companies as liabilities from price risk management as a result of an accounting determination which, in Enron's case, was effected in consultation with Andersens. His evidence was that on numerous occasions Enron told him that prepays (and the other forms of structured finance that it adopted) were vetted by Andersens which tendered its advice to book the prepays as liabilities for price risk management.
iii) Similarly, Mr. Serice referred to Mr. Deffner telling him that Enron's perception was that analysts focused in particular on the debt line in the balance sheet. Mr Deffner complained that Enron did not get proper credit for its substantial and valuable trading assets and said that the prepays enabled Enron to raise cash by monetising its trading book, rather than issuing debt. He was told that these prepays were reviewed and approved by Andersens to be recorded as a liability for price risk management on the balance sheet, rather than as debt.
iv) Mr. Dellapina's evidence was that he had a general understanding that the prepay transactions which Enron had concluded on many occasions were acceptable in form to accomplish the treatment of financing in a manner that was non-debt. He did not know what Andersens' requirements were because he had never talked to them but he understood that Andersens had been involved and that the structure worked for Enron. He fully believed that Enron as advised by Andersens and their lawyers would account for the Enron prepays in a manner which was wholly in accordance with US GAAP.
The fact that Chase sought to interest its customers in prepay transactions by referring to the beneficial accounting treatment they were thought to receive is a clear indication that Chase did not consider that to account for them as "non debt" in the Balance Sheet was unlawful. The forms of "pitch" revealed in the documents are straightforward in their attribution of potential accounting benefits. Chase required customers to make their own enquiries of their accountants by disclaiming liability for any representation or accounting advice but if Chase had considered the accounting treatment to be in breach of GAAP it is, in my judgement, virtually inconceivable that it would have issued presentations in the form it did.
Despite reservations about some of their evidence, as set out above, I have no hesitation in finding that all the relevant Chase personnel, throughout the relevant period, not only considered that Enron had accounted for prior prepays in accordance with the advice of their well known accountants, Andersens, but that future accounting of such prepays would be vetted by those accountants also. Whilst these individuals were entitled to take the view that the manner of accounting for the prepays was a matter for Enron and Andersens, it is in my judgement clear from the attempts made by Chase to sell the structure to others that the general view amongst Chase personnel at all times was that prepays did carry with them legitimate non debt accounting treatment on the balance sheet in compliance with GAAP. Treatment as operating cash flow would follow. To the extent that the individuals involved in the Enron prepay transactions were party to such promotions, or were cross examined on the issue (as they were when asked if they considered the prepays to be loans, disguised loans or debt) I find that they considered the structure of the prepays to merit non debt accounting treatment, as Enron had told them that their accountants had advised.
Each of the members of the deal team at Chase, in their statements set out their understanding that Enron was advised by Andersens on accounting issues and their belief that Enron, as advised by Andersens and Vinson & Elkins would account for and disclose the prepays in a proper wholly lawful manner consistent with all relevant policies and regulations. There was no direct challenge to this in cross-examination, nor was any witness asked whether he regarded Enron's accounting as unlawful.
There is no basis therefore for contending that Chase knew that Enron's accounting for Chase VI – XI or I –XI was contrary to GAAP, constituted misaccounting or was wrongful. Indeed, Mr Turner's final view as to the correct accounting treatment of prepays appeared to depend on FAS 133 which was not operative prior to Chase XII. How Chase personnel were meant to conclude that Andersens was wrongly advising Enron prior to that is hard to fathom. I reject any such suggestion.
With the introduction of FAS 133, which would apply to Chase XII, there was the possibility of accounting in accordance with Mr Turner's view, but there is no evidence (other than the passing reference in Mr Dellapina's email to Mr Serice concerning FAS 133) that the Chase personnel considered this in any detail or took the view that this, as opposed to Andersens' and Professor Ryan's view, constituted the correct accounting treatment.
The shape of Chase XII was the subject of some discussion between Enron and Chase following the granting of approval for the transaction by Credit. Despite approval being given for a 3 year deal, the length of the prepay was reduced initially to enable it to go through in two separate stages. In the first stage Chase was to fund the financing itself with credit support for $315 million but the idea was to replace the structure by a joint funding structure in due course. The short duration of stage one meant that there was no room for physical delivery so that the structure adopted was one involving financially settled swaps. For tax reasons connected with withholding tax, on Enron's request, 6 months was agreed as the swaps period. In addition, Andersens specifically sought and obtained from Mahonia the four representations in writing in connection with Chase XII to which I have referred earlier in this judgment. The drafting of the documents was effected by Vinson & Elkins for Enron and agreed with Mr Levy of Chase's legal department. It is clear therefore, and I find, that the Chase personnel knew of the involvement of Andersens (and Enron's lawyers) in advising Enron on the form of the Three Swaps and therefore rightly considered that Enron would account for Chase XII in accordance with the advice they were given by those who had undoubted expertise in this area.
In my judgment West cannot succeed in showing that Chase knew that Enron's accounting of Chase I – XI nor its prospective accounting for Chase XII was or would be wrongful or contrary to GAAP, nor that its financial statements had not or would not contain proper accounting treatment of the prepays or disclosure in accordance with GAAP. Whatever the "economic substance" of the prepays, a term which is best avoided in accountancy for the reasons expressed earlier, and whatever the views of the relevant Chase personnel as to that substance, none of them can be shown to have appreciated that there was or was to be any misaccounting nor any breach by Enron of GAAP, whether in relation to its financial statements or in relation to its disclosure obligations.
i) When the letter of credit is opened, although the beneficiary may not know of its existence.
ii) When the letter of credit is notified to the beneficiary.
iii) When the beneficiary makes a demand under the letter of credit.
In the present case Mr. Levy of Chase had contact with West on 4th October and the L/C was opened and notified on 5th October 2001.
