Message-ID: <19297641.1075861941405.JavaMail.evans@thyme> Date: Wed, 7 Nov 2001 12:47:25 -0800 (PST) From: james.derrick@enron.com To: e..haedicke@enron.com Subject: FW: EML Capital Adequacy and Liquidity Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: quoted-printable X-From: Derrick Jr., James X-To: Haedicke, Mark E. X-cc: X-bcc: X-Folder: \MHAEDIC (Non-Privileged)\Haedicke, Mark E.\Inbox X-Origin: Haedicke-M X-FileName: MHAEDIC (Non-Privileged).pst Mark, which attorney is handling this matter? Jim -----Original Message----- From: =09Gold, Joe =20 Sent:=09Wednesday, November 07, 2001 10:38 AM To:=09McMahon, Jeffrey; Sherriff, John Cc:=09Kitchen, Louise; Bowen Jr., Raymond; Brown, Michael - COO London; Gol= d, Joe; Derrick Jr., James; Farmer, Michael; Heffron, Kevin; Hutchinson, Mi= chael; Jones, Timothy; Lynch, Drew Subject:=09EML Capital Adequacy and Liquidity Jeff / John, We have drafted a note relating to the business operations of Enron Metals = Limited (EML). As you know we have been particularly concerned about watchi= ng our cash position and thought that it would be of benefit for you to und= erstand the unique situation that EML has from a regulatory standpoint. Aft= er your review, we would be happy to set up a meeting to discuss. If you co= ncur with the actions suggested, please advise. If there is any balance sh= eet, debtor/creditor or cash forecast information that you require, please = let us know. Drew Lynch, Kevin Heffron, Jonathan Marsh, and Joe Gold Introduction Enron Metals Limited (EML) maintains a unique position within Enron Corp. = EML is one of Enron's two businesses regulated by the UK Financial Service= s Authority (FSA - the UK financial regulator) and Enron's only remaining b= rokerage business. Given its special status, EML has responsibilities to i= ts clients that are codified and enforced by the rules of the FSA and the L= ME (metals exchange) of which it is a member. As a result of this regulato= ry oversight, there are several differences between EML and Enron's other b= usinesses: 1)=09EML must conduct its business in compliance with prescriptive regulato= ry rules relating, among other areas to capital adequacy and conduct of bus= iness. Failure to comply with these regulatory requirements can result in d= isciplinary action being taken against the company itself and its officers. 2)=09By virtue of its position as an LME broker, there are certain circumst= ances in which EML is regarded as acting as agent for its clients. EML's p= olicy has been to avoid acting as agent where possible; however, EML's cond= uct is evaluated by the FSA in light of the potential for that relationship= to exist. How EML conducts itself with clients is tightly regulated by th= e FSA and the LME. 3)=09Because the FSA has a duty to protect the orderliness of UK markets an= d to protect against systemic risk, EML's position as a provider of liquidi= ty and the potential for it to disturb the market through its conduct or la= ck of conduct is also an area for concern with the FSA and the LME. As a co= nsequence of this concern, the FSA requires regulated entities to maintain = prescribed amounts of capital to protect against certain risks such as posi= tion and credit risk. The rules relating to regulatory capital require FSA = regulated firms to calculate a financial resources requirement in accordanc= e with rules and to maintain financial resources in excess of this requirem= ent. These rules are prescriptive as to the types of capital, which can be = used by way of regulatory capital, and a breach of these rules is regarded = as extremely serious. An ongoing ability to meet a financial resources requ= irement usually results in the FSA issuing an order requiring the firm to c= ease carrying on business. 4)=09EML's board members and its traders are subject to direct regulatory o= versight by the FSA and can be disciplined in their individual capacity for= a breach of the rules. Penalties for individuals include significant fines= and possible expulsion from the industry. The duties owed by board members= under the FSA's rules are in addition to those owed under general UK law r= elating to directors' duties. Directors Overriding Ring Fencing Obligation In the light of recent developments there is a premium on being able to dem= onstrate to the FSA that, to the full extent possible, the financial streng= th of EML is ring-fenced from any financial problems being encountered by t= he rest of Enron. In order to make certain that we fulfil this obligation = we have changed the way we do business in the ways discussed below. Issues Surrounding Liquidity As we are all aware over the past week, as a result of the reputation probl= ems the corporation has been faced with, we have substantially increased th= e hands on financial and managerial oversight of EML. This was a precautio= n against knock on problems causing liquidity issues for EML. Clearly the = goal was to be able to feel absolutely certain that the financial standing = of EML was fully and completely ring- fenced from any problems related to t= he non-EML related problems of Enron. This of course needed to be accompli= shed within the framework of continuing to be a fully integrated Enron comp= any as far as shared services and inter company commercial relationship was= concerned =20 The FSA does not regulate the method under which a regulated entity obtains= and distributes its cash. In the event, that cash is lent outside of EML,= it must be collateralised by an LC in order to preserve the regulatory cap= ital of the firm; however, the firm has a number of options to preserve its= day to day liquidity.=20 =20 In its position as an LME broker, EML must have access to cash for two purp= oses. First, it must be able to post margin to the London Clearing House (= LCH). In the event that liquidity ever prevented EML from posting collater= al to the LCH, it would be in breach of the LCH rules and regulatory enforc= ement action could ensue. In addition it would be declared a defaulter and = the LCH would have the right to close out all of its positions. Second, it= must be able to post margin to its clients. A failure to make a contractu= al payment to a client would likely result in FSA action if it were referre= d to the FSA. A third potential use of cash is to make payments to in-the-= money clients in the event that they wish to close their account. While th= ere is no contractual right for a client to cash in their mark-to-market pr= ofits, the failure of EML to make such payment would cause reputation quest= ions. Previously, we believed there were only a small number of potential scenari= os where we might be faced with not having sufficient liquidity. However ce= rtain significant components of these scenarios have unfortunately come to = fruition and the amount of cash maintained by EML and its ring fencing from= the rest of Enron has become a concern. EML has or is in the process of l= osing $60,000,000 of unsecured LC's, which were primarily used in lieu of c= ash at the LCH. EML has had to use its cash to replace or secure those LC'= s. Additionally, a number of clients have requested that their accounts be= transferred. Those transfers have reduced EML's cash balance. Was the re= maining $50 mm unsecured LC (which has been issued by a single bank) to be = withdrawn we are not currently in position to immediately manage the liquid= ity impact. The work done and the events of this past week have highlighted the need fo= r being fully prepared for any foreseeable eventuality. Therefore we have = agreed to start to do the following a.=09Change the way our financing works so as to maintain our excess liquid= ity on our own balance sheet rather than being a provider of liquidity to t= he rest of the enterprise b.=09Improve our overall cash management function so as to have the control= as well as the oversight be the direct responsibility of EML personnel c.=09Manage the business so as to maximize liquidity within the constraints= of continuing to do business on a normal basis d.=09Obtain financial information on a much more timely basis e.=09Periodically perform a number of analytical stress scenario tests so a= s to be certain that we continue to have sufficient internal liquidity f.=09 Undertake to formalize arrangements with EMGL for provision of additi= onal liquidity whether on an unsecured subordinated or senior basis when ou= r own liquidity is insufficient to run the business on normal basis Operational Risk =20 In theory, EML could be run on a small cash balance held in its own account= s and rely on Enron Corp. for the remaining portion of its day to day cash = needs. EML's board have been resistant to this practice for several very p= ractical reasons. First, it is possible that the LCH could unexpectedly ca= ll on EML to provide a large amount of collateral on an immediate basis. I= f EML relied on Enron Corp.'s daily wire transfer for its liquidity needs, = it would be in danger that either a liquidity shortfall at Corp. or an acco= unting or administrative error somewhere in the system could trigger either= capital or liquidity events as EML's clearing account at Citibank would be= substantially overdrawn. Given the likelihood that an LCH or FSA event mi= ght create a cascade for Enron, EML's board is reluctant to put that much f= aith in the 100% accuracy of our operational safeguards. Capital As noted above, EML is subject to the FSA's regulatory capital rules and mu= st calculate its financial resources on a daily basis. The FSA requires th= at EML notify it if its capital base is less than 110% of the minimum finan= cial resources requirement. For a variety of reasons, there were occasions= when EML violated the 110% threshold on occasions in 2001. Because these v= iolations were self-contained and easily remedied the FSA did not take enfo= rcement action and EML instituted an internal procedure whereby it maintain= s financial resources in excess of 120% so that it has a sufficient buffer = not to trigger the FSA notification requirement. In the current climate the= FSA has expressed concerns about the possible systemic risk that might ari= se from Enron's perceived financial weakness. Accordingly, if one of those = violations occurred today, the FSA would likely commence a formal investiga= tion of EML and could issue an order requiring EML to cease trading in ligh= t of the need to reassure the FSA and in light of the sizable changes in EM= L's cash position and client positions that have been occurring on a daily = basis, EML's board has been attempting to maintain a regulatory capital lev= el of 130%. Clearly the ability to maintain sufficient liquidity and exces= s capital adequacy go hand in hand. =20 Liquidity and Capital Adequacy Stress Testing The stress testing noted above has been based on the following types of sce= narios, which would cause liquidity issues for EML 1)=09Changes in market prices causing additional losses by internal or exte= rnal clients for whom we either provide credit or receive margin collateral= rather than cash resulting in EML financing these losses at the LCH 2)=09Changes in market prices causing additional losses by the EML house ac= count resulting in EML financing these losses at the LCH 3)=09Clients with credit balances transferring those balances to other LME = brokers 4)=09Withdrawal of LCH letters of guaranty by the providing banks and the i= nability to replace the bank guaranty on an unsecured basis resulting in ca= sh being placed either with the issuing bank or the LCH directly=20 5)=09Credit exposures leading to credit losses Recommendations The result of the stress testing has been to make us consider the following= changes to the way we do our business in addition to trying to increase ov= erall operational liquidity 1)=09To fully draw down the remaining $25 mm available under the $125 mm s= ubordinated facility 2)=09To monetize the inter-company marked to market positions (+$20 mm) 3)=09To increase the subordinated facility to $175 mm and extend the maturi= ty by six months to July 2002 4)=09To monetize to the degree possible all external marked to market profi= ts and other assets held by EML 5)=09To stop providing credit for in house Enron counterparts and to switch= to a either one way or mutually margining with a zero or very low threshol= d for calling margin 6)=09To stop providing or reduce the amount of credit for clients, other th= an a select group of key relationship clients=20 7)=09To continue to move large physical positions to the physical trading c= ompanies (EMCL and EMCC) therefore shifting the need for inventory finance Current Situation Unsecured Guaranty=09=09=09$65 mm Secured Guaranty=09=09=09$15 mm Subordinated Loans=09=09=09$107 mm EML Cash Balance:=09=09=09$59 mm Cash required to replace Withdrawn guaranty=09=09=09($20mm) EML Regulatory Capital Level:=09128% Excess Reg. Capital over 110%:=09$30 mm Conclusion The attached financial analysis shows the result of the initial stress test= ing. The analysis shows certain low probability sets of circumstances where we w= ould have liquidity issues. Given these possible eventualities we would ur= ge that we move forward on points noted in bold above in addition to comple= ting point f in the Issues Surrounding Liquidity Section