Enron Mail

From:james.derrick@enron.com
To:e..haedicke@enron.com
Subject:FW: EML Capital Adequacy and Liquidity
Cc:
Bcc:
Date:Wed, 7 Nov 2001 12:47:25 -0800 (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