Investment banks’ duties to their clients  depend on the activities in which the investment banks engage. SPEs may also create certain tax advantages for the participating parties. Investment banks played  key roles in each of the transactions discussed in this report. (See  appendix II for a detailed description of these transactions and the roles  played by investment banks.) In a publicly available Chase document related to the  design of the Slapshot transaction, Chase indicated that an advantage of  one aspect of the structure of the transaction was that it provided “no road  map for Revenue Canada.” If Chase knowingly and substantially assisted  Enron in evading taxes, resulting in the reporting of incorrect information  in Enron’s financial statements, and such reporting was a violation of the  securities laws, SEC would have the authority to bring an enforcement  action against Chase for aiding and abetting Enron’s securities fraud. Section 705 of the Sarbanes-Oxley Act mandates that we review  investment bank involvement in the failure of Global Crossing, “including  with respect to transactions involving swaps of fiber optic cable capacity.”  It has been reported in the press, and plaintiffs have alleged in civil  actions, that Global Crossing improperly reported as revenue the proceeds  it received from sales of fiber optic capacity and services in transactions  with counterparties; however, to our knowledge, no investment banks  were involved in these transactions. Investment Banks and Federal Financial Regulators Have Begun Strengthening Their Oversight of Structured Finance Transactions Since Enron’s Collapse

According to the investment banks we spoke with, the transactions  discussed here were vetted through their internal risk management  processes. For example, one investment bank told us that it had been engaging in  prepay transactions with Enron for about a decade and that it had closely  reviewed the initial transactions but not subsequent prepays, which were  not seen as a new type of transaction. Bank regulators said that these are positive steps toward strengthening  internal processes but noted that it is too early to evaluate how well the  changes will work. Each regulator is responsible for  specific activities. Federal financial  regulators noted that prior to Enron’s collapse they had not viewed  reputation risk from structured transactions as a high-risk area, primarily  because (1) the risk focus was on traditional market, credit, and  operational risks; (2) the size and volume of transactions were small  relative to the total capital of relevant financial institutions; (3) many such  transactions are conducted with investment-grade firms; and (4) with  respect to securities firms, many of the activities may have taken place in  affiliates outside of the SEC-regulated broker-dealer. Federal Financial Regulators Have Made Changes to Their Oversight Processes As a Result of the Enron Scandal

Federal financial regulators said that since the Enron scandal they have  refined their approach to supervising certain operational aspects of the  institutions that are involved in complex structured transactions. Based on the results of these reviews, the agencies intend to  develop consistent guidance and best practices for the entities within their  respective regulatory jurisdictions that they believe are necessary to  clarify their expectations for sound control and oversight mechanisms. Conflicts of Interest Reportedly Affected Research Analysts’ Ratings of Enron and Global Crossing

According to some allegations, some research analysts at investment  banks recommended Enron and Global Crossing securities to investors in  order to get lucrative investment bank deals for their firms. The primary one is the adequacy  and effectiveness of barriers between the research and investment  banking functions of investment banks. SEC, NASD, and NYSE will examine  investment banks for compliance with Regulation AC and self-regulatory  organization rules on such conflicts of interest. We are encouraged that investment  banks are beginning to strengthen their risk management practices by,  among other things, gaining additional assurances of the underlying intent  behind and the anticipated accounting treatment and presentation of  complex structured finance transactions they facilitate for their clients. Investment banks are not typically  responsible for their client’s accounting. Since investment banks might be tempted to participate in  profitable but questionable transactions when successful SEC prosecution  is in doubt, it is especially important that regulators be alert to this  possibility and be ready to use the rest of their enforcement tools to deter  such actions. We did not have sufficient public information to determine  the extent of investment bank involvement in the latter transactions. As noted, there are currently ongoing and extensive litigation and  investigations involving Enron and Global Crossing generally.
Why GAO Did This Study

In the wake of a series of recent corporate scandals and bankruptcies, the Sarbanes-Oxley Act mandated that GAO study the involvement of investment banks with two companies, Enron and Global Crossing. In this report, the term "investment bank" includes not only securities firms but also those bank holding companies with securities affiliated or business divisions that assist clients in obtaining funds to finance investment projects. Since the activities identified in this report are the subject of ongoing and extensive investigations and litigation by competent authorities, it is not our role to determine the propriety of any of the parties' activities. To help the Congress better understand the activities of investment banks with respect to these companies we agreed to provide publicly available information on the roles investment banks played in designing, executing, and participating in certain structured finance transactions, investment banks' and federal regulators' oversight of these transactions, and the role that the banks' research analysts played with Enron and Global Crossing.

What GAO Found

Certain investment banks facilitated and participated in complex financial transactios with Enron despite allegedly knowing that the intent of the transactions was to manipulate and obscure Enron's true financial condition. The investment banks involved in the transactions we reviewed contended that their actions were appropriate and that Enron had not revealed its true purpose in obtaining their assistance. While investment banks are not responsible for the financial reporting of their clients, if it is proven that the investment banks knowingly assisted Enron in engaging in securities law violations, SEC has the authority to take legal action against them. Oversight responsibility for the investment banks' part in these transactions lay with both the banks themselves and the federal regulators. Investment banks told us that they had vetted transactions involving Enron through their risk management and internal control systems. Since Enron's collapse, these firms reportedly have been taking some steps to strengthen their internal controls, in part because they are now more sensitive to reputation risk. Federal financial regulators noted that before Enron's collapse they had not viewed structured transactions with investment-grade counterparties as particularly high risk in their exams. They subsequently are refining their approach to supervising structured transactions, and bank regulators now plan to include more transactions in their exams. Regulators are currently conducting targeted reviews of structured finance transactions at large firms and plan to develop guidance or best practices that clarify their expectations for sound control and oversight mechanisms. In the wake of the scandals, research analysts at investment banks who made favorable recommendations for failed firms have also come under public scrutiny. Investment banks allegedly pressured analysts covering Enron and Global Crossing to give investors favorable or misleading investment recommendations in order to keep or win lucrative work from the companies, creating serious conflicts of interest. Although the investment banks denied the allegations, several have been investigated by regulators and involved in litigation about conflicts of interest between their research and investment banking departments. Certain federal regulators and self-regulatory organizations have all adopted additional regulations addressing such conflicts. Although investment banks are not typically responsible for their client's accounting, it is a violation of law to facilitate transactions that an investment bank knows will materially misstate the client's financial statements. Since investment banks may be tempted to participate in profitable but questionable transactions, it is especially important that regulators be alert to this and be ready to use their enforcement tools to deter such actions. We are encouraged that investment banks and regulators are strengthening their oversight of the appropriateness of transactions, but it is too soon to evaluate the effectiveness of reforms.