Transcript Long-Term Capital Management

American College of Bankruptcy
October 2, 2002
The Implications of Enron
Douglas G. Baird
Randal C. Picker
Harry Bigelow
Distinguished Service
Professor of Law
Paul & Theo Leffmann
Professor of Commercial Law
The Law School, The University of Chicago
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Four Issues
Corporate Information, Disclosure and
Governance
 Entity Fragility and Liquid Markets
 Understanding Enron’s Transactions
 The Law of Deodands and SPEs

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Corporate Information,
Disclosure and Governance
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Ann Report 2000: Page 1
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Ann Report 2000: Page 2
Enron has built unique and strong businesses that
have tremendous opportunities for growth. These
businesses — wholesale services, retail energy
services, broadband services and transportation
services — can be significantly expanded within
their very large existing markets and extended to
new markets with enormous growth potential. At a
minimum, we see our market opportunities
company-wide tripling over the next five years.
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Ann Report 2000: Page 2
Enron is laser-focused on earnings per share, and
we expect to continue strong earnings
performance. We will leverage our extensive
business networks, market knowledge and
logistical expertise to produce high-value bundled
products for an increasing number of global
customers.
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Ann Report 2000: Page 39
Guarantees of liabilities of unconsolidated
entities and residual value guarantees have no
carrying value and fair values which are not
readily determinable (see Note 15).
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4/17/01: 1st Quarter Earnings
Report
“Enron’s wholesale business continues to generate
outstanding results. Transaction and volume
growth are translating into increased profitability,”
said Jeff Skilling, Enron’s president and CEO. “In
addition, our retail energy services and broadband
intermediation activities are rapidly accelerating.”
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5/15/01: Files 1Q ‘01 10-Q:
Related Deals Discussion

“During the first quarter of 2001, Enron entered into
transactions with limited partnerships (the Related
Party), whose general partner is a senior officer of
Enron. The limited partners of the Related Party are
unrelated to Enron. All transactions with the Related
Party are approved by Enron’s senior risk officers as
well as reviewed annually by the Board of Directors.
Management believes that the terms of the
transactions with the Related Party were reasonable
compared to those which could have been negotiated
with unrelated third parties.”
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7/12/01: 2nd Quarter Earnings
Report
“Enron completed another quarter of exceptional
performance. Our wholesale and retail energy
businesses continue to dramatically expand
business activity and increase profitability. In
addition, Enron is distinct in developing a leading
role in the European energy markets and in other
high potential wholesale markets,” said Jeff
Skilling, Enron president and CEO.
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8/14/01: Skilling Resigns
“I am resigning for personal reasons. I want to
thank Ken Lay for his understanding of this purely
personal decision, and I want to thank the board
and all of my colleagues at Enron,” said Skilling.
“We regret Jeff’s decision to resign, as he has been
a big part of our success for over eleven years,”
said Lay. “But, we have the strongest and deepest
talent we have ever had in the organization, our
business is extremely strong, and our growth
prospects have never been better.”
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8/14/01: Files 2Q ‘01 10-Q

“During the second quarter of 2001, Enron did not
recognize any material revenues or income from
transactions with the limited partnerships
discussed below. Additionally, the senior officer,
who previously was the general partner of these
partnerships, sold all of his financial interests as of
July 31, 2001, and no longer has any management
responsibilities for these entities. Accordingly,
such partnerships are no longer related parties to
Enron.”
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8/14/01: Files 2Q ‘01 10-Q


“All transactions with these partnerships (the
Partnerships) have been approved by Enron’s
senior risk officers as well as reviewed annually
by the Board of Directors. Management believes
that the terms of the transactions were reasonable
compared to those which could have been
negotiated with unrelated third parties.”
“In the first quarter of 2001, Enron entered into
transactions with the Partnerships, now unrelated,
to hedge certain merchant investments and other
assets.”
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8/15/01: Watkins Letter to Ken Lay
Has Enron become a risky place to work? For
those of us who didn’t get rich over the last
few years, can we afford to stay?
Skilling’s abrupt departure will raise suspicions
of accounting improprieties and valuation
issues. Enron has been very aggressive in its
accounting—most notably the Raptor
transactions and the Condor vehicle.
The spotlight will be on us, the market just
can’t accept that Skilling is leaving his dream
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job.
8/15/01: Watkins Letter to Ken Lay
I am incredibly nervous that we will implode in
a wave of accounting scandals. My eight years
of Enron work history will be worth nothing on
my resume, the business world will consider
the past successes as nothing but an elaborate
accounting hoax. Skilling is resigning now for
“personal reasons” but I would think he wasn’t
having fun, looked down the road and knew
this stuff was unfixable and would rather
abandon ship now than resign in shame in two
years.
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10/16/01: 3rd Quarter Earnings
Report
ENRON REPORTS RECURRING THIRD
QUARTER EARNINGS OF $0.43 PER
DILUTED SHARE; REPORTS NONRECURRING CHARGES OF $1.01 BILLION
AFTER-TAX; REAFFIRMS RECURRING
EARNINGS ESTIMATES OF $1.80 FOR
2001 AND $2.15 FOR 2002; AND EXPANDS
FINANCIAL REPORTING
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10/16/01: 3rd Quarter Earnings
Report
“Our 26 percent increase in recurring earnings per
diluted share shows the very strong results of our
core wholesale and retail energy businesses and
our natural gas pipelines,” said Kenneth L. Lay,
Enron chairman and CEO. “The continued
excellent prospects in these businesses and Enron’s
leading market position make us very confident in
our strong earnings outlook.”
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10/16/01: 3rd Quarter Earnings
Report
“$544 million related to losses associated with
certain investments, principally Enron’s interest in
The New Power Company, broadband and
technology investments, and early termination
during the third quarter of certain structured
finance arrangements with a previously disclosed
entity.”
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Timeline
10/24/01: Fastow, Enron CFO, placed on
leave
 11/8/01: 8-K Filing with SEC

– A required restatement of prior period financial
statements to reflect the previously disclosed
$1.2 billion reduction to shareholders’ equity, as
well as various income statement and balance
sheet adjustments required as the result of a
determination by Enron and its auditors, based
on current information, that certain off-balance
sheet entities should have been included in
Enron’s consolidated financial statements
pursuant to generally
accepted accounting
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principles;
Timeline
– the restatement of its financial statements for
1997 through 2000 and the first two quarters of
2001. As a result, financial statements for these
periods and the audit reports relating to the
year-end financial statements for 1997 through
2000 should not be relied upon;

11/19/01: Files 3Q 2001 10-Q with SEC
– Extensive follow-on discussion to 11/8 8-K
regarding LJM transactions
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12/2/01: Enron Files for Chapter
11
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Sarbanes-Oxley
P.L. 107-204, July 30, 2002: Sarbanes-Oxley Act
of 2002
Creates new Public Company Accounting
Oversight Board, with broad authority to set
accounting standards for public companies and
their auditors
Mandatory lead audit partner rotation after 5 years
New requirement for signing officer liability for
reported financial information
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Andy Grove, CEO of Intel,
Fortune, 9/16/02

What's your view of the new regulations
coming out of Washington?
– Well, one part--attestation of financial reports-is a real pain in the ass. At Intel, we had an 11hour financial meeting. I sat through it and
learned a bunch of things about how we put
together a statement. I met a bunch of the
people responsible for the actual work; not the
comptrollers, whom we normally deal with. It
was very useful. Would we have done that
without the SEC regulations? No. Should we
have done it? Yes.
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Entity Fragility and
Liquid Markets
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Fragility and Liquidity

“Liquidating” An Entity
– “Our most important assets walk out the door
each day.”
– Human capital is highly mobile on its own
– Physical capital is increasing mobile with liquid
asset markets

Entities Are Fragile
– Trademarks can depreciate quickly
– People can leave, assets can be sold
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Fragile Enron

Much of what has occupied the first part of
Enron’s Chapter 11 has been a sale of assets
– Enron’s trading operation and many of its gas
pipelines and other businesses have been sold.
– Any firm that emerges will have little in
common with the firm that was seventh on the
list of the Fortune 500

This is typical of large, modern Chapter 11s
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Fragile Andersen

12/12/01: Berardino testifies in Congress
– “If there is one thing you take away from my
testimony, I hope it is this: Andersen will not hide
from its responsibilities. That’s why I’m here today.
The public’s confidence is of paramount
importance. If my firm has made errors of
judgment, we will acknowledge them. We will
make the changes needed to restore confidence.”


1/10/02: AA announces “significant but
undetermined number of Enron-related documents
were disposed of”
1/15/02: AA fires David Duncan
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3/14/02: Andersen Indictment
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Fragile Andersen

Law Can Limit Human Capital Mobility
– Status of covenants not to compete
– Fears of acquired liability as large chunks of
Andersen move to new firms

Trademark Implosion
– From valuable brand to The Tonight Show
monologue in 60 seconds

Receivables
– Collect quickly or vanish
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18 USC 1512(b)(2)

§ 1512. Tampering with a witness, victim, or an
informant
– (b) Whoever knowingly uses intimidation or physical
force, threatens, or corruptly persuades another person,
or attempts to do so, or engages in misleading conduct
toward another person, with intent to—
»…
» (2) cause or induce any person to—



(A) withhold testimony, or withhold a record, document, or other
object, from an official proceeding;
(B) alter, destroy, mutilate, or conceal an object with intent to
impair the object’s integrity or availability for use in an official
proceeding;
…
– shall be fined under this title or imprisoned not more
than ten years, or both.
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10/12/01: Andersen Emails:
Temple to Odom to Duncan
To: David Duncan
From: Michael C. Odom
Forwarding email from Nancy Temple
MikeIt might be useful to consider reminding the
engagement team of our document and retention
policy. It will be helpful to make sure that we have
complied with the policy. Let me know if you have
any questions.
Nancy
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Duncan’s Draft Memo to File
(10-15-01)
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Temple’s Email (10-16-01)
Dave – Here are a few suggested comments for
consideration.
I recommend deleting reference to consultation
with the legal group and deleting my name on the
memo. Reference to the legal group consultation
arguably is a waiver of attorney-client privileged
advice and if my name is mentioned it increases
the chances that I might be a witness, which I
prefer to avoid.
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Temple’s Email (10-16-01)
I suggested deleting some language that might
suggest that we have concluded that the release is
misleading.
In light o the “non-recurring” characterization, the
lack of any suggestion that this characterization is
not in accordance with GAAP, and the lack of
income statements in accordance with GAAP, I
will consult further within the legal group as to
whether we should do anything more to protect
ourselves from potential Section 10A issues.
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Understanding Enron’s
Transactions
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Enron’s Place in the Pantheon

Two notable bankruptcies provide a good baseline
– Crazy Eddie
– Equity Funding

Basic Lessons
– Don’t obsess too much about who did and did not
engage in fraud
– Those who commit frauds are usually judgmentproof
– You often can recover from others, even if they knew
nothing about the fraud
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Crazy Eddie

Crazy Eddie’s prices were insane
– But he also inflated the stock price, sold stock,
and took the cash with him—in suitcases
– He went to jail, and the investors were left
unpaid
– He is now back in business
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Lessons of Crazy Eddie
The litigation was largely over bringing
securities and other actions against those
(such as accountants) with money
 Willie Sutton principle (and its corollary)

– You go to where the money is
– But there is usually an inverse corollation
between the amount of money and the strength
of your cause of action
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Crazy Eddie and Enron


In chasing after solvent third parties,
nonbankruptcy law is what matters
Recently, we’ve narrowed third-party liability
– Central Bank of Denver v. First Interstate Bank of
Denver, 511 U.S. 164 (1994)
– Private plaintiffs cannot bring Rule 10b-5 actions
against those who merely aided and abetted violations
of the securities law
– But there are lots of other theories that may be
sufficient to get past a motion for summary judgment
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Bankruptcy and Third-Party
Liability

When can the bankruptcy trustee bring the cause
of action?
– If the firm could bring the action outside of bankruptcy,
the cause of action is property of the estate under §541
– The trustee has the power to avoid liens and recover
transfers under §544 and the other avoiding powers

But the trustee cannot bring ordinary damage
actions, even if the creditors as a group could
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The Caplin Principle


Caplin v. Marine Midland Grace Trust Company,
406 U.S. 416 (1972), sharply limits the trustee’s
freedom of movement here
Warning!
– The case law here about what is “property of
the estate” is unreliable and confused
– Be cautious about taking appellate opinions at
face value
– E.g., they can be reversed by subsequent state
court decisions
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Equity Funding’s Business Plan
We are in the 1960s, and we have learned
that bull markets last forever
 Investors get the tax benefits of life
insurance and the growth potential of a
mutual fund

– Investors buy our mutual fund, and we lend
them the money (with their shares as collateral)
to buy insurance
– They pay off the loan with the appreciated
mutual fund shares
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Equity Funding’s Problem
The 1960s bull market ends
 Investors start to withdraw their funds and
are less inclined to invest in the first place

– How do we maintain our stock price?
– We turn to aggressive accounting
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Aggressive Accounting

Treat as cash received
– revenues that will come when an identified
person makes the first payment on a policy
already issued
– revenues that will come if an identified person
we have solicited agrees to buy a policy, passes
the medical test, etc.
– revenues that would come if a fictitious person
actually existed, was solicited by us, agreed to
buy our policy, passed the medical test, etc.
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Equity Funding’s Problem
Reinsurers expect us to turn over premiums
from all living insureds, even if they are
fictitious
 Fictitous people don’t pay premiums

– Some can die young
– But reinsurers get suspicious if too many
people die young

Proving fictitious people both lived and
died is hard work
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Equity Funding Lessons
Sliding slowly from corner-cutting to
outright fraud is commonplace in
bankruptcy, especially in small Chapter 11s
 Many of the Equity Funding people who
end up engaging in outright fraud (forging
medical histories) aren’t even getting paid a
lot of money

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Equity Funding Lessons
Uncovering fraud after the fact is easy, but
beforehand it’s hard
 WARNING!

– Be alert to departures from past practice
– Be aware of slippery slopes
– Don’t sign off on transactions you don’t
understand
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What happens in Enron now?
Enron is harder than Crazy Eddie, Equity
Funding, or WorldCom
 The complex structure hid the extent of the
failure of the business

– Outright fraud and self-dealing is a problem,
but the law is easy and recoveries small
– What remedies do creditors have against those
who help a debtor keep them in the dark?
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What happens in Enron now?
Can the estate recover Enron assets parked
in various SPEs and transferred out of SPEs
to investors?
 The challenge is to filter out what doesn’t
matter

– Identify the basic transaction behind the SPEs
– Don’t get hung up on whether the transaction
complied with GAAP or securities regulations
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Office
Co
$800
White Elephant
Plaza
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Limited
Partners
Office
Co
$198
$800
CFO Partners
GP
White Elephant
Plaza
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$2
CFO
51
Office
Co
CFO Partners
$200 cash & $800 note
White Elephant Co.
White Elephant
Plaza
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CFO Partners
Office
Co
$800 note
White Elephant Co.
White Elephant
Plaza
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$250
Office
Co
Bank
$800 note
Elephant Co.
Security Interest
White Elephant
Plaza
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CFOPartners
Bank
$250 dividend
Office
Co
$800 note
Elephant Co.
Security Interest
White Elephant
Plaza
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What’s Really Going On?
OfficeCo is spending real resources
merely to give outsiders the illusion of
financial stability
 CFOPartners is the big winner

– It put nothing at risk, and ended up with
$50 in cash
– All the upside in the event that Plaza ever is
worth more than $1000
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White Elephant Plaza and Willie
Sutton

Potential Assets
– White Elephant Plaza no longer belongs to
OfficeCo, but it has value
– Funds were transferred out of White Elephant to
CFOPartners

Possible Recoveries
– Bring White Elephant back into the estate, stripped
of Bank’s liens and CFOPartners claims
– Recover transfers made to CFOPartners
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Recovering White Elephant Plaza

Potential Theories of Recovery
– Veil-piercing and alter ego actions
– Substantive consolidation
– Absence of a “true sale”

Problems
– Each of these theories has serious weaknesses
– In any event, they don’t rid us of Bank’s security
interest or allow us to recover from CFOPartners
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Fraudulent Conveyance
Recovery from CFOPartners

Step-transaction doctrine applies
– Multiple layers of entities irrelevant
– Orr v. Kinderhill Corp., 991 F.2d 31 (2d Cir. 1993)

We may be able to show insolvency and lack
of reasonably equivalent value
– Dividends of insolvent firm are fraudulent
conveyances
– Insolvency can be defined broadly. See In re W.R.
Grace & Co., 2002 WL 1767221 (Bankr. D. Del.
2002)
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Fraudulent Conveyance
Recovery from CFOPartners

“Badges of fraud” fraudulent conveyance
– Proving actual fraud is unnecessary
– Proving GAAP or violation of securities laws is
irrelevant

Potential Badges
–
–
–
–
Closeness of relationship
Retention of control
Concealment
No business justification
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Fraudulent Conveyance
Recovery from Bank


If a fraudulent conveyance theory can be made
out against CFOPartners, history suggests that
Bank is similarly at risk
Mere knowledge of the transaction may be
enough and giving reasonably equivalent
value isn’t a defense
– We can recharacterize as a transaction in which
Debtor gave Bank a security interest in White
Elephant and received nothing in return
– Form of the transaction may be a one-way ratchet.
See In re W.R. Grace
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The Law of Deodands
and SPEs
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Exodus 21:28

“If a bull gores a man or a woman to death,
the bull must be stoned to death, and its
meat must not be eaten. But the owner of
the bull will not be held responsible.”
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Blackstone on Deodand


“By this is meant whatever personal chattel is the
immediate occasion of the death of any reasonable
creature: which is forfeited to the king, to be applied to
pious uses, and distributed in alms by his high almoner;
though formerly destined to a more superstitious purpose.
* * * Wherever the thing is in motion, not only that part
which immediately gives the wounds (as the wheel which
runs over his body,) but all things which move with it and
help to make the wound more dangerous, (as the cart and
loading, which increase the pressure of the wheel) are
forfeited.” Blackstone, Book 1, Chap. 8, XVI.
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HR 833 (July 17, 2001)
Sec. 912. Asset-Backed Securitizations.
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Transferred?

‘‘(5) the term ‘transferred’ means the debtor, under a
written agreement, represented and warranted that
eligible assets were sold, contributed, or otherwise
conveyed with the intention of removing them from the
estate of the debtor pursuant to subsection (b)(8) (whether
or not reference is made to this title or any section hereof),
irrespective and without limitation of—
– (A) whether the debtor directly or indirectly obtained or held
an interest in the issuer or in any securities issued by the
issuer;
– (B) whether the debtor had an obligation to repurchase or to
service or supervise the servicing of all or any portion of
such eligible assets; or
– (C) the characterization of such sale, contribution, or other
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conveyance for tax,
accounting,
regulatory reporting, or 66
other purposes.’’
Commentary

Respect True Sales
– True sales that are not otherwise subject to
avoidance under the fraudulent transfer
provisions should be respected in bankruptcy.
– This is true whether the sold asset is real estate
or a car, securities or accounts receivable.
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Commentary

Assessing Whether a True Sale Has Taken
Place
– The problem that arises—and here is where
asset securitization comes in—is that for some
assets, the basic notion of sale can be quite
tricky.
– In some versions, true sales take place, in
others, this is much less obvious, and the
essential point here is that the basic notion of
sale in these contexts is quite difficult to apply.
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Commentary

Managing Uncertainty
– How should we deal with that uncertainty, that
is, the uncertainty about whether the structure
of a particular asset securitization is or is not a
true sale?
– Current law appropriately leaves these
questions to judges, to be resolved under state
law, if and when a particular transaction is
challenged.
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HR 333 Conf Rep (7-26-02)
Sec. 912 Completely gone.
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S. 2798/H.R. 5221 (7-25-02)
Employee Abuse Prevention Act of 2002
To protect employees from corporate practices that
deprive them of their earnings and retirement
savings when a business files for bankruptcy under
title 11
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Securitization
New Sec. 105(e)(1): “Notwithstanding any
otherwise applicable provision of law, the court
may recharacterize as a secured loan, a sale, lease,
or transaction if the material characteristics of the
sale, lease, or transaction are substantially similar
to the characteristics of a secured loan.”
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