E.         Typical Enron FAS 140 Transactions

Purpose of a Typical Enron FAS 140 Transaction

Through numerous transactions that were intended by Enron to comply with FAS

140, Enron "monetized" a variety of otherwise illiquid assets, removing those assets from

its balance sheet while at the same time retaining control over them with a view to time

better the final sale of those assets. 141 Enron began engaging in FAS 140 transactions as

early as 1998 and completed its last FAS 140 transactions in the months immediately preceding the filing of the Bankruptcy Case. t⁴²

When Enron monetized an asset in a FAS 140 Transaction, the Sponsor that transferred the asset received a payment equal to the amount financed through the structure, 143 and Enron recognized as income on its financial statements all, or its share of, the difference between those cash proceeds and the carrying value of the asset. 144 Despite the "sale" of these assets, Enron continued to treat them as part of its own holdings. 145 Then, through the Total Return Swaps entered into in connection with many of the transactions, Enron, though purportedly engaging in a sale by an affiliate to an unrelated third party, obligated itself to repay amounts equal to both the principal amount of, and the interest payable on, the loans used to fund the purchase, thereby retaining the

141 See Enron Hawaii Presentation, supra note 129.

142 For example, the Nikita Transaction was completed in September 2001. See infra Section III.G.

143 See, e.g., Section 5.03, Amended and Restated Limited Liability Company Agreement of McGarret VI, L.L.C., Dec. 7, 2000 (the "McGarret F Asset LLC Agreement") (entered into in connection with the McGarret F Hawaii transaction) [AB000034302-AB000034343].

144 See supra Section III.D., Accounting Treatment and Financial Statement Disclosure.

145 See The Role of the Board of Directors in Enron's Collapse, Report of the Permanent Subcomm. on Investigations, Senate Comm. on Governmental Affairs, 107th Cong. (July 8, 2002) (the "Permanent Subcommittee on Investigations Report"), at 7 and Exhibit 39 (available at http://www.senate.gov/-gov affairs/070902enronboardreport.pdf); see also Bank Presentation, supra note 22, at 59.

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risk of a decrease in the value of the asset below the amount due on the loan. This aspect of the transaction makes it more closely resemble in practical consequence a loan to Enron rather than a sale of that asset. The Total Return Swaps were marked to market by Enron with the result that Enron, in fact, reported on its balance sheet, and in its income statement, the effects of subsequent decreases or increases in the value of the financed

asset. 146

Enron viewed these transactions as "balance sheet management" efforts rather than as irrevocable and final dispositions of the assets. 147 As part of these management efforts, Enron monetized several types of assets in the FAS 140 Transactions, including shares of common stock or warrants to purchase common stock of both publicly traded and private companies, partnership interests, membership interests in limited liability companies formed in connection with relationships between Enron and third parties and interests in trusts formed in connection with other financial transactions undertaken by Enron.

Structure of a Typical Enron FAS 140 Transaction

A typical Enron FAS 140 Transaction began with the contribution by the Sponsor of an asset to an Asset LLC.¹⁴⁸ In exchange for this contribution, which was treated as a capital contribution of the asset, the Sponsor received a Class A Interest in the Asset LLC, representing all of the voting power 149 and an insignificant portion of the economic

146 See supra Section III.D, Accounting Treatment and Financial Statement Disclosure.

14' Permanent Subcommittee on Investigations Report, supra note 145, at 22 and Exhibit 17.

148 See, e.g., Section 4.01, Third Amended and Restated Limited Liability Company Agreement of McGarret VI, L.L.C., Oct. 17, 2001 (the "McGarret V Asset LLC Agreement") (entered into in connection with the McGarret V Hawaii transaction) [AB000043281-AB000043337].

149 See, e.g., id. Section 6.01.

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interests 150 i_n the Asset LLC.          In addition, the Sponsor was entitled to a special cash distribution from the Asset LLC in the amount at which the asset was valued by Enron.¹⁵¹ The Asset LLC sold its Class B Interest, entitled to no voting rights' ⁵² and substantially all of the economic interests in the Asset LLC,' 53 to a special purpose entity, generally a trust (the "Trust"), in exchange for a payment in the amount of the special distribution to be made by the Asset LLC to the Sponsor. 154

The Trust financed the purchase price of the Class B Interest by selling an equity interest in itself to a third party, often an affiliate of one of its Lenders, and by borrowing under a Credit Facility provided by those Lenders. The equity was generally entitled to be repaid the amount of its investment plus an annual rate of return.' 55  Generally, the amount of the equity was equal to at least 3% of the purchase price for the Class B Interest, 156 plus the amount of fees due to the Lenders. The right of the equityholder to receive payment with respect to its equity was subordinated to the right of the Lenders to

150 See, e.g., id. Section 5.02 and Exhibit A.

151 See, e.g., Section 5.03, Amended and Restated Limited Liability Company Agreement of McGarret II, L.L.C., June 29, 2000 (the "McGarret B Asset LLC Agreement") (entered into in connection with the McGarret B Hawaii transaction) [AB000032510-AB000032553], and the Asset Notice, May 31, 2000 [AB000032450-AB000032455].

152 See, e.g., Section 3.01, McGarret V Asset LLC Agreement, supra note 148.

153 See, e.g., id. Section 5.02 and Exhibit A.

154 I_n some transactions, such as the Hawaii Transaction and the Cerberus Transaction, the Asset LLC issued its Class B Interest to another limited liability company of which the Sponsor was the sole member (the "Transferor LLC") in return for a promissory note in the same amount as the amount of the special distribution that was to be made to the Sponsor by the Asset LLC. The Transferor LLC then sold the Class B Interest to the Trust in exchange for a payment in the same amount as that of the promissory note issued by the Transferor LLC to the Asset LLC (and, therefore, in the same amount as the special distribution to be made by the Asset LLC to the Sponsor). See, e.g., infra, Section III.H., The Hawaii Transaction - Structure of the Hawaii Transaction, and Section III.F., The Cerberus Transaction - Structure of the Cerberus Transaction.

155 See, e.g., Section 1.01, Second Amended and Restated Hawaii II 125-0 Trust Agreement, as amended, Nov. 20, 2000 (the "Hawaii II Trust Agreement") (definition of "Certificate Yield," which is set at 15% per annum yield) (entered into in connection with the Hawaii Transaction) [AB000030744-AB000030805].

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receive payment with respect to the related advance under the Credit Facility. 157                                                                                 it

appears that the amounts due to the equityholder were not supported by the Total Return

Swaps. 158 In some transactions, the Trust was intended to be a "qualifying" special

purpose entity under FAS 140 and only a nominal equity interest was held by a third 159

ply.

At the closing of the FAS 140 transaction, upon payment of the purchase price for the Class B Interest by the Trust, the Asset LLC¹⁶⁰ would typically use those funds to make the special distribution to the Sponsor, 161 thus immediately conveying the full proceeds of the transaction to the Sponsor.

156 See, e.g., Section 1(b)(iii), Subscription Agreement between CIBC Inc. and Hawaii 11 125-0 Trust, Nov. 20, 2000 (the "Hawaii II Subscription Agreement')[AB000030838-AB000030868].

157 See, e.g., Series Certificate of Beneficial Ownership for Series McGarret V, Oct. 17, 2001 (the "McGarret V Series Certificate") (issued in connection with the McGarret V Hawaii transaction) [AB000043256-AB0000432631.

158 See, e.g., Section 2, Total Return Swap Confirmation between ENA and Hawaii II Trust, Oct. 17, 2001 (the "McGarret V Swap Confirmation") [AB000043270-AB000043280].

159 See, e.g., infra Section III.F., The Cerberus Transaction.

160 I_n transactions that involved a Transferor LLC, the Transferor LLC would receive the purchase price from the Trust and use those funds to repay its note (in that same amount) to the Asset LLC. After receipt and payment of the funds, the Transferor LLC played no substantial further role in the transaction. See infra Section III.H., The Hawaii Transaction - Structure of the Hawaii Transaction.

161 See, e.g., Section 5.03, McGarret B Asset LLC Agreement, supra note 151.

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Below is a simplified diagram of a typical Enron FAS 140 Transaction.

After giving effect to the transactions completed at the closing, the Asset LLC held the asset, 162 and the Sponsor, through its Class A Interest, and the Trust, through its Class B Interest, owned the Asset LLC.¹⁶³ A third party (typically an affiliate of one of the Lenders) owned the equity interest in the Trust (which was nominal in the case of Trusts structured as "qualifying" special purpose entities), 164 and was entitled to receive a specified yield (often 15% per annum) on that equity interest. 165 The Trust also owed to its Lenders the amount advanced under the Credit Facility plus interest. As a condition of the Credit Facility, Enron, ENA or one of Enron's other affiliates would enter into a Total

162 See, e.g., Section 6.01, McGarret V Asset LLC Agreement, supra note 148. '63 See, e.g., id. Section 3.01.

164 See, e.g., infra Section III.F., The Cerberus Transaction.

16s See, e.g., Section 1.01, Hawaii II Trust Agreement, supra note 155 (definition of "Certificate Yield").

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Return Swap with the Trust or the Lenders, thereby providing a creditworthy source of funds for the repayment of amounts due under the Credit Facility to the Lenders, all as described below under the heading Allocation of Risk in a Typical Enron FAS 140 Transaction.

Although the Class A Interest gave the Sponsor all voting control over the Asset LLC, and therefore apparent control over the asset owned by that Asset LLC, and the Sponsor was typically designated the managing member of the Asset LLC with exclusive power to manage the business and affairs of the Asset LLC,¹⁶⁶ it did not have complete control over the Asset LLC. For example, the Sponsor could not sell the asset held by the Asset LLC without the consent of the Trust as the holder of the Class B Interest. 167 Moreover, the business of the Asset LLC was generally limited to holding the asset and making the payments contemplated by its limited liability company agreement. 168 _In some cases, an independent manager of the Asset LLC must also consent to certain major actions by the Asset LLC, such as declaring bankruptcy or dissolving or selling all or substantially all of its assets. 169 The Certificate Holder could instruct the Trust to sell the Class B Interest, but most sales were subject to an auction procedure and to certain rights of first refusal and rights of first offer in favor of the Sponsor. 170

166 See, e.g., Section 6.01, McGarret V Asset LLC Agreement, supra note 148.

167 See, e.g., Section 6.01, Amended and Restated Limited Liability Company Agreement of Timber I, L.L.C., Sept. 27, 2001 (the "Timber I LLC Agreement") (entered into in connection with the Nikita Transaction) [AB000322025-AB000322085].

161 See, e.g., id. Section 2.04. 169 See, e.g., id. Section 6.06. ^17° See, e.g., Section 3.03, McGarret V Asset LLC Agreement, supra note 148.

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Accounting Treatment of a Typical Enron FAS 140 Transaction

Enron accounted for the FAS 140 Transactions as described under the section of this Report entitled Accounting Treatment and Financial Statement Disclosure. Allocation of Risk in a Typical Enron FAS 140 Transaction

The Total Return Swaps. The FAS 140 Transactions contain several features that allocate benefits and risks in a manner that more closely resemble a loan than a commercial sale of an asset to a third party.                              One of the more important features is the Total Return Swap. In general, the Trusts are responsible for making payments due with respect to their Credit Facilities. As a condition of the Credit Facility, Enron or one of its affiliates would enter into a Total Return Swap with the Trust or the Lenders."' Through the Total Return Swaps:

•      Enron (or its affiliate) agreed to make payments when due of amounts sufficient to pay principal, interest and other amounts payable by the Trust under the Credit Facility; and

•      Enron (or its affiliate) was entitled to amounts received with respect to the Class B Interest (whether proceeds of a sale of the Class B Interest or distributions from the Asset LLC as a result of the sale of the underlying asset or other income produced by the Class B Interest) in amounts payable by Enron on the related debt financing, then to the equity holder up to its specified return, and finally, all remaining amounts. 172

In other words, although the Sponsor, a subsidiary of Enron, was "selling" the asset to a purportedly unrelated third party, Enron or ENA"³ was responsible for providing the

¹'¹ See, e.g., Section 2, McGarret V Swap Confirmation, supra note 158; Section 4.2(a)(i)(E), Facility Agreement of Hawaii 11 125-0 Trust, Nov. 20, 2000 (the "Hawaii 11 Credit Facility") [AB000030869­AB000031162].

172 See, e.g., Section 2, McGarret V Swap Confirmation, supra note 158.

¹⁷' Where ENA was the counterparty to a Total Return Swap, Enron was often the guarantor of its obligations under that Total Return Swap. See, e.g., Enron Guaranty between Enron Corp. and Hawaii 11 Trust, Dec. 7, 2000 (the "McGarret F Guaranty") [AB000034268-AB000034276].

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Trust with sufficient cash to repay the debt financing obtained by the Trust in order to make the purchase, thereby retaining the risk of a decrease in the value of that asset below the amount of the debt. It simultaneously acquired or retained control of the asset (through the Class A Interest) and the contractual right to receive the eventual proceeds from the Class B Interest, thereby retaining substantially all of the benefits or appreciation in value of the asset. In short, substantially all of the risks and rewards of the asset remained with Enron or ENA.

The Asset LLC Put Option. Another structural element by which Enron (through the Sponsor) assumed or retained the risk of the transaction is the put option incorporated in several of the FAS 140 Transactions, pursuant to which the Sponsor granted to the Asset LLC the right to require the Sponsor to repurchase a portion of the contributed asset at a fixed price on any date on which a payment was due under the Credit Facility. 174 These funds would then be distributed by the Asset LLC to the Trust and applied to make the payment due on that date. ^t'⁵ The Asset LLC assigned to the Trust the right to deliver notices of exercise of the put to the Sponsor. 176            If the put were exercised on any payment date, then no payment under the Total Return Swap on that

"⁴ See e.g., Sections 2 and 3, Put Option Agreement between EAH and Aeneas, Nov. 29, 2000 (the "Put Option Agreement") (entered into in connection with the Cerberus Transaction) [AB000113196­AB000113204].

175 See, e.g., Section 5.02, Amended and Restated Limited Liability Company Agreement of Aeneas L.L.C., Nov. 29, 2000 (the "Aeneas LLC Agreement") [AB000113227-AB000113225]; Section 5.01, Trust Agreement between Wilmington Trust, as Owner Trustee, and GSS Holdings, as the Certificate Holder, Nov. 29, 2000 (the "Heracles Trust Agreement") [AB000293293-AB000293336].

1'6 See, e.g., Put Option Assignment between Aeneas and the Heracles Trust, Nov. 29, 2000 (the "Put Option Assignment") (entered into in connection with the Cerberus Transaction) [AB000113196­AB000113197].

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