David Duncan's E-Mail Exchange With Andersen Standards Group

The following e-mail was sent from Benjamin S. Neuhausen, a member of Andersen's Professional Standards Group, to David B. Duncan, then an Andersen partner, and cc-ed to John E. Stewart, also of the standards group, on May 28, 1999 at 03:50 PM, with a subject line of "Enron."

In case we don't hook up this afternoon, here are the results of discussion with John and further thinking on my part.

1.Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view. Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme? Plus, even if all the accounting obstacles below are overcome, it's a related party, which means FAS 57 disclosures of all transactions. Would Enron want these transactions disclosed every year as related party transactions in their financial statements?

2.Enron should view the new entity as a SPE for accounting purposes, and apply EITF Topic D-14 and Issue 90-15. This raises several issues:

a.CFO's capital is not capital from an independent party as that term is used in EITF 90-15. Therefore, CFO's capital is ignored in determining whether the entity has enough independent capital at risk to avoid consolidation by Enron.

b.If Enron makes a gift to the entity after formation, the value of the gift should be subtracted from the investors' equity at risk, including the independent investors. So, if CALPERS invests $10 million and their pro rata share of the gift from Enron is $50 million, CALPERS has no equity at risk. The result is that Enron will need to consolidate the SPE because the SPE has no outside equity at risk.

c.The outside investors need to own the residual class of equity. That is, the CFO can't be subordinated to the outside investors.

3.We would be very uncomfortable with Enron recording gains on sales of assets to the entity or immediate gains on any transactions. Subsequent mark to market gains are not troublesome, but immediate gains are.

4.If part of the gift goes to the CFO, that is compensation expense to Enron.

5.If Enron insulates the CFO from risk, then the CFO's capital and vote should be viewed as Enron's capital and vote. Same result if Enron has the upside on the CFO's investment.

Duncan's Reply

The following e-mail was sent by Mr. Duncan to Mr. Neuhausen and cc-ed to Mr. Stewart on June 1, 1999 at 11:07 AM with a subject line of "Re: Enron."

Ben -- I agree with all the points you and John raise except for two where I need some more help.

But first, on your point (i.e. the whole thing is a bad idea). I really couldn't agree more. Rest assured that I have already communicated and it has been agreed to by Andy that CEO, General council, and Board discussion and approval will be a requirement, on our part, for acceptance of a venture similar to what we have been discussing. Rick is insistent of such communication also. You should also know that none of this communication has yet to occur and this thing could get killed when it does. This thing is still very much in the brainstorming stage, but Andy wants to move through it very quickly to get all this done, if possible, this quarter. Andy is convinced that this is such a win-win that everyone will buy in. We'll see.

I have also discussed with Andy and Rick the formation and ongoing related party disclosures that will be necessary in the proxy and financials. This will also be a component of any discussion with those mentioned above.

Also, as usual, I am and will keep our local office mgmt. in the loop on this unusual potential transactions as it proceeds to ensure I'm getting appropriate practice advice.

On the accounting, I'd like to discuss further your points 2B (gift reduces equity at risk) and 3 (uncomfortable with transaction gains).

2b -- The purpose of the "gift" (obviously, Enron and Andy would dispute that characterization for the reasons I've mentioned to you previously) is to, no doubt, provide over-collateralization to the venture equity players. It will no longer enrich the equity holders as was a consequence of the original discussions (the deemed compensation issue took care of that). The current plan is to have any residual that may remain after some predetermined time to go to this charity trust idea that Andy had last Thursday (more about that later). It seems to me that the important consideration is whether the equity holders maintain original capital at risk sufficient to meet the SPE requirements throughout the life of the venture. If they were to receive a distribution of any "gift" capital or otherwise get a return of capital, I would agree with your conclusion. but if they do not and outside capital sufficient to meet the test remains in the venture, I don't understand why any other excess capital would make a difference. Please clarify.

In other ventures where Enron has employed an over-collateralization technique, we have looked to the 80/20 rule as a guide for excess. I have been thinking about how that may apply here, it would not seem to take much borrowed capital for the venture to pass the test I we wanted to apply it (assuming the "gift" as Enron capital for purposes of the test). Obviously, this structure is unusual in that Enron has no vote and no real ownership interest in the venture. It's like this gift equity is parked here for awhile to provide the over-collateralization, then will go away (to charity I'm told). Does it make sense to apply this test here? It does not seem that this will preclude the outside holders from truly controlling there important rights in the venture (i.e., to approve all investments). Your thoughts on this would be appreciated.

3 -- If we can clear the hurdle of Enron not consolidating this venture, help me to defeat gain accounting on Enron transactions where approval of the transaction is controlled by the nonrelated owners and fairness opinions will be obtained for all. I'm not saying I'm in love with this either, but I'll need all the ammo I can get to take that issue on.

Finally, the charitable trust idea. As I mentioned to you. Andy's latest idea to avoid the compensation issue and, in my view, make this all more saleable to top mgmt and the BOD, is to have any residual benefits from the forward transaction (the "gift") go to a charitable trust as opposed to the other venture parties. The notion that this does not create a residual interests to Enron as Enron would not control the trust (although Enron could suggest to the trustees where to direct gifts and the trust would probably be called the Enron Charity Trust). He says these are done all the time for tax purposes.

I'm still working with him to figure out how exactly this will work and accomplish his objectives. It seems if the gift is in the venture in general (as opposed to the trust only) it will attach to all the venture owners. It must be that the trust will hold a real but specifically defined residual interest in the venture but have no vote. If Enron will truly have no control over this trust and the funds could never return, how would you view this? Still no accounting by Enron (consolidation of trust and/or charitable donation expense)?

Thanks for your advice and patience as this thing unfolds. Let's talk as soon as possible.

Updated May 15, 2002 2:01 a.m. EDT