U.S. Securities and Exchange Commission
Litigation Release No. 18252 / July 28, 2003
Accounting And Auditing Enforcement Release No. 1820 / July 28, 2003
Securities and Exchange Commission v. J.P. Morgan Chase & Co., Case No. H-03-28-77 (MH) (S.D. Tx.)
SEC Charges J.P. Morgan Chase In Connection With Enron's Accounting Fraud
J.P. Morgan Chase Simultaneously Settles Charges for $135 Million
The Securities and Exchange Commission ("Commission") today charged J.P. Morgan Chase & Co. with aiding and abetting Enron Corp.'s securities fraud. The Commission's complaint, filed in U.S. District Court in Houston, alleges that J.P. Morgan Chase aided and abetted Enron's manipulation of its reported financial results through a series of complex structured finance transactions, called "prepays," over a period of several years preceding Enron's bankruptcy. These transactions were used by Enron to report loans from J.P. Morgan Chase as cash from operating activities. The structural complexity of these transactions had no business purpose aside from masking the fact that, in substance, they were loans from J.P. Morgan Chase to Enron. Between December 1997 and September 2001, J.P. Morgan Chase effectively loaned Enron a total of approximately $2.6 billion in the form of seven such transactions.
Simultaneous with the filing of the complaint, J.P. Morgan Chase agreed to file a consent and final judgment settling the Commission's action against it. In the consent, J.P. Morgan Chase has agreed, without admitting or denying the allegations of the complaint, to the entry of a final judgment permanently enjoining it from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Exchange Act Rule 10b-5. J.P. Morgan Chase also has agreed to pay disgorgement, penalties and interest in the amount of $135 million. The Commission intends to have these funds paid into a court account pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002 for ultimate distribution to victims of the fraud.
Specifically, the complaint alleges that between December 1997 and Enron's demise in 2001, J.P. Morgan Chase and Enron engaged in seven of these prepay transactions in order to disguise loans as commodity trades thus achieving Enron's desired accounting and reporting objectives. As the complaint alleges, the clearest indication that the J.P. Morgan Chase/Enron prepays were disguised loans was their structure. In general, in a prepay transaction (also known as a prepaid forward sale contract) the purchaser pays for a commodity upfront, in full, at the time the contract is made, and the seller agrees to deliver the subject commodity on future dates, often over the course of several years. In effect, the seller bets that the market price of the subject commodity would be lower at the time of delivery than at the time the contract is made. The purchaser bets the opposite way: that the market price of the commodity at the time of delivery will exceed the price it paid at the time of contracting. In a typical prepay transaction, therefore, each side assumes commodity price risk.
According to the complaint, the critical difference in the J.P. Morgan Chase/Enron prepays -- and the reason that these transactions were in substance loans -- was that they employed a structure that passed the counter-party commodity price risk back to Enron, thus eliminating all commodity risk from the transaction. This was accomplished through a series of simultaneous trades whereby Enron passed the counter-party commodity price risk to a J.P. Morgan Chase-sponsored special purpose vehicle called Mahonia, which passed the risk to J.P. Morgan Chase, which, in turn, passed the risk back to Enron.
As in typical prepays, the complaint alleges, Enron received cash upfront. In contrast to typical prepays, according to the complaint, with all elements of the structure taken together, Enron's future obligations were reduced to the repayment of cash it received from J.P. Morgan Chase with negotiated interest. The interest was calculated with reference to LIBOR. Since all price risk and, in certain transactions, even the obligation to transport a commodity were eliminated, the only risk in the transactions was Chase's risk that Enron would not make its payments when due, i.e., credit risk. In short, the complaint alleges, these seven prepays were in substance loans.
According to the complaint, Mahonia was included in the structure solely to effectuate Enron's accounting and financial reporting objectives. Enron told J.P. Morgan Chase that Enron needed Mahonia in the transactions for Enron's accounting. Mahonia was controlled by Chase and was directed by Chase to participate in the transactions ostensibly as a separate, independent, commodities-trading entity. As the complaint further alleges, in order to facilitate Enron's accounting objectives, J.P. Morgan Chase took various steps to make it appear that Mahonia was an independent third party.
The Commission alleges that J.P. Morgan Chase knew that Enron engaged in prepays to match its so-called mark-to-market earnings (paper earnings based on changes in the market value of certain assets held by Enron) with cash flow from operating activities. By matching mark-to-market earnings with cash flow from operating activities, Enron is alleged to have sought to convince analysts and credit rating agencies that its reported mark-to-market earnings were real, i.e., that the value of the underlying assets would ultimately be converted into cash.
The Commission further alleges that J.P. Morgan Chase also knew that prepays yielded another substantial benefit to Enron: they allowed Enron to hide the true extent of its borrowings from investors and rating agencies because sums borrowed in prepay transactions appeared as "price risk management liabilities" rather than "debt" on Enron's balance sheet. In addition, Enron's obligation to repay those sums was not otherwise disclosed. Significantly, according to the Commission's allegations, J.P. Morgan Chase considered prepays to be unsecured loans to Enron, rather than commodity trading contracts, and based its decisions to participate in these transactions primarily on its assessment of Enron's credit.
The Commission brought this action in coordination with the New York County District Attorney's Office. The Commission also acknowledges the assistance of the Federal Reserve and the New York State Banking Department.
The Commission's investigation is continuing.
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