Subject: EML Capital Adequacy and Liquidity
From: [email-masked]
To: [email-masked], [email-masked]
Cc: [email-masked], [email-masked], [email-masked], [email-masked], [email-masked], [email-masked], [email-masked], [email-masked], [email-masked], [email-masked]
Date: Wed, 7 Nov 2001 08:38:13 -0800 (PST)

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 watching our cash position and thought that it would be of benefit for you to understand the unique situation that EML has from a regulatory standpoint. After your review, we would be happy to set up a meeting to discuss. If you concur with the actions suggested, please advise.  If there is any balance sheet, 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 Services Authority (FSA - the UK financial regulator) and Enron's only remaining brokerage business.  Given its special status, EML has responsibilities to its clients that are codified and enforced by the rules of the FSA and the LME (metals exchange) of which it is a member.  As a result of this regulatory oversight, there are several differences between EML and Enron's other businesses:
1)	EML must conduct its business in compliance with prescriptive regulatory rules relating, among other areas to capital adequacy and conduct of business. Failure to comply with these regulatory requirements can result in disciplinary action being taken against the company itself and its officers.

2)	By virtue of its position as an LME broker, there are certain circumstances in which EML is regarded as acting as agent for its clients.  EML's policy has been to avoid acting as agent where possible; however, EML's conduct 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 the FSA and the LME.

3)	Because the FSA has a duty to protect the orderliness of UK markets and to protect against systemic risk, EML's position as a provider of liquidity and the potential for it to disturb the market through its conduct or lack of conduct is also an area for concern with the FSA and the LME. As a consequence of this concern, the FSA requires regulated entities to maintain prescribed amounts of capital to protect against certain risks such as position and credit risk. The rules relating to regulatory capital require FSA regulated firms to calculate a financial resources requirement in accordance with rules and to maintain financial resources in excess of this requirement. 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 requirement usually results in the FSA issuing an order requiring the firm to cease carrying on business.

4)	EML's board members and its traders are subject to direct regulatory oversight 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 relating to directors' duties.

Directors Overriding Ring Fencing Obligation

In the light of recent developments there is a premium on being able to demonstrate to the FSA that, to the full extent possible, the financial strength of EML is ring-fenced from any financial problems being encountered by the 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 problems the corporation has been faced with, we have substantially increased the hands on financial and managerial oversight of EML.  This was a precaution 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 the non-EML related problems of Enron.  This of course needed to be accomplished within the framework of continuing to be a fully integrated Enron company as far as shared services and inter company commercial relationship was concerned  

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 capital of the firm; however, the firm has a number of options to preserve its day to day liquidity. 
 
In its position as an LME broker, EML must have access to cash for two purposes.  First, it must be able to post margin to the London Clearing House (LCH).  In the event that liquidity ever prevented EML from posting collateral to the LCH, it would be in breach of the LCH rules and regulatory enforcement 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 contractual payment to a client would likely result in FSA action if it were referred 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 there is no contractual right for a client to cash in their mark-to-market profits, the failure of EML to make such payment would cause reputation questions.

Previously, we believed there were only a small number of potential scenarios where we might be faced with not having sufficient liquidity. However certain 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 losing $60,000,000 of unsecured LC's, which were primarily used in lieu of cash 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 remaining $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 liquidity impact.

The work done and the events of this past week have highlighted the need for being fully prepared for any foreseeable eventuality.  Therefore we have agreed to start to do the following
a.	Change the way our financing works so as to maintain our excess liquidity on our own balance sheet rather than being a provider of liquidity to the rest of the enterprise
b.	Improve our overall cash management function so as to have the control as well as the oversight be the direct responsibility of EML personnel
c.	Manage the business so as to maximize liquidity within the constraints of continuing to do business on a normal basis
d.	Obtain financial information on a much more timely basis
e.	Periodically perform a number of analytical stress scenario tests so as to be certain that we continue to have sufficient internal liquidity
f.	 Undertake to formalize arrangements with EMGL for provision of additional liquidity whether on an unsecured subordinated or senior basis when our own liquidity is insufficient to run the business on normal basis

Operational Risk  

In theory, EML could be run on a small cash balance held in its own accounts 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 practical reasons.  First, it is possible that the LCH could unexpectedly call on EML to provide a large amount of collateral on an immediate basis.  If 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 accounting 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 might create a cascade for Enron, EML's board is reluctant to put that much faith in the 100% accuracy of our operational safeguards.

Capital

As noted above, EML is subject to the FSA's regulatory capital rules and must calculate its financial resources on a daily basis.  The FSA requires that EML notify it if its capital base is less than 110% of the minimum financial resources requirement.  For a variety of reasons, there were occasions when EML violated the 110% threshold on occasions in 2001. Because these violations were self-contained and easily remedied the FSA did not take enforcement action and EML instituted an internal procedure whereby it maintains 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 arise from Enron's perceived financial weakness. Accordingly, if one of those violations occurred today, the FSA would likely commence a formal investigation of EML and could issue an order requiring EML to cease trading in light of the need to reassure the FSA and in light of the sizable changes in EML'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 level of 130%.  Clearly the ability to maintain sufficient liquidity and excess capital adequacy go hand in hand.  

Liquidity and Capital Adequacy Stress Testing

The stress testing noted above has been based on the following types of scenarios, which would cause liquidity issues for EML

1)	Changes in market prices causing additional losses by internal or external clients for whom we either provide credit or receive margin collateral rather than cash resulting in EML financing these losses at the LCH
2)	Changes in market prices causing additional losses by the EML house account resulting in EML financing these losses at the LCH
3)	Clients with credit balances transferring those balances to other LME brokers
4)	Withdrawal of LCH letters of guaranty by the providing banks and the inability to replace the bank guaranty on an unsecured basis resulting in cash being placed either with the issuing bank or the LCH directly 
5)	Credit 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 overall operational liquidity

1)	To fully draw down the remaining $25 mm available under the  $125 mm subordinated facility
2)	To monetize the inter-company marked to market positions (+$20 mm)
3)	To increase the subordinated facility to $175 mm and extend the maturity by six months to July 2002
4)	To monetize to the degree possible all external marked to market profits and other assets held by EML
5)	To 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 threshold for calling margin
6)	To stop providing or reduce the amount of credit for clients, other than a select group of key relationship clients 
7)	To continue to move large physical positions to the physical trading companies (EMCL and EMCC) therefore shifting the need for inventory finance

Current Situation

Unsecured Guaranty			$65 mm
Secured Guaranty			$15 mm
Subordinated Loans			$107 mm
EML Cash Balance:			$59 mm
Cash required to replace
Withdrawn guaranty			($20mm)

EML Regulatory Capital Level:	128%
Excess Reg. Capital over 110%:	$30 mm

Conclusion

The attached financial analysis shows the result of the initial stress testing.
The analysis shows certain low probability sets of circumstances where we would have liquidity issues.  Given these possible eventualities we would urge that we move forward on points noted in bold above in addition to completing point f in the Issues Surrounding Liquidity Section