Page 3 of 5 CREDIT
BUST BYPASSES BANKS Part 1: The
rise of the non-bank financial
system By Henry C K Liu
themselves did not make any
false "statements" about their conduct, they could
not be liable to the Enron victims even if they
knowingly participated in the scheme to defraud
Enron shareholders. The court ruled that Enron
Corp shareholders could not proceed as a class
against three investment banks for allegedly
participating in fraudulent behavior that led to Enron's
collapse.
The
University of California asserts that the appeals
court decision absolving the banks from liability
was wrong because the banks were uniquely
positioned to create contrived financial
transactions to distort a public company's
financial statements.
The ruling awards
the banks "get out of jail free" cards to commit
fraud without being held accountable, lawyers
representing the university argued. The ruling, in
essence, declares that the mastermind of the bank
robbery who planned the heist, recruited the other
robbers, provided the weapons, drove the getaway
car and went back to the hideout to split up the
loot is not legally responsible, just because he
did not show his face inside the bank.
As
the sole dissenting judge summarized, the ruling
"immunizes a broad array of undeniably fraudulent
conduct from civil liability ... effectively
giving secondary actors license to scheme with
impunity, as long as they keep quiet".
The
appeals court split decision is inconsistent with
the express language of the broad anti-fraud
prohibition of 10(b) of the Securities and
Exchange Act of 1934 and Rule 10b-5, which makes
it unlawful for "any person, directly or
indirectly", to "employ any device, scheme, or
artifice to defraud" or "to engage in any act,
practice, or course of business which operates ...
as a fraud or deceit upon any investor".
In an extraordinary admission, the appeals
court's two-member majority acknowledged: "We
recognize, however, that our ruling ... may not
coincide, particularly in the minds of aggrieved
former Enron shareholders who have lost billions
of dollars in a fraud they allege was aided and
abetted by the defendants at bar, with notions of
justice and fair play."
Units of Citigroup
Inc arranged an unusual financing technique for
Enron that enabled the energy trader to appear
rich in cash from trading rather than saddled with
debt. In a series of deals known as Yosemite,
Citigroup's multifarious scheme helped Enron
borrow money over a period of three years that was
booked as proceeds from trades instead of loans.
The deals involved bond offerings and trades with
an offshore entity to help manipulate the
company's weak cash flow upward to match its
growth in paper profits, at a time when the gap
had grown to as much as $1 billion a year.
Enron would not have been able to defraud
investors but for the willing participation of
Wall Street banks. Evidence supports the
allegation that Citigroup, the nation's largest
financial institution, which also owned
commercial-bank and investment-bank units, helped
Enron disguise debt on its balance sheet through
complex financial accounting arrangements at the
company.
Although Citigroup actions
technically might have been in accordance with
then-lax accounting principles, they raised
questions over whether Citigroup helped shield
important material information from Enron
investors. Citigroup denied wrongdoing, noting
that lenders should not be held responsible for
how a client such as Enron accounted for the
financing arranged by its bankers.
In a
statement, Citibank said: "The transactions we
entered into with Enron were entirely appropriate
at the time based on what we knew and what we were
told by Enron. We were assured that Enron's
auditors had approved them, and we believed they
were consistent with accounting rules in place at
the time."
Citibank was saying that the
problem was with the rules of the game and that it
had only been a clever player. Pathetically, it
was the only true statement in the whole sordid
affair.
SEC scrutiny of
banks Citigroup rival JPMorgan Chase and Co
also faced after-the-fact SEC scrutiny for similar
deals through a vehicle known as Mahonia, which
was the subject of a page 1 story in the Wall
Street Journal in January 2003.
Mahonia
drew wide scrutiny after a lawsuit with insurers
who had guaranteed the transactions through surety
bonds. The insurers refused to pay Morgan, arguing
that prepaid transactions in effect generated
loans, not trades. Their view was confirmed by
presiding US District Judge Jed S Rakoff, who
wrote in an opinion that the Mahonia transactions
"appear to be nothing but a disguised loan".
The SEC investigated both Citigroup and
JPMorgan on whether the banks helped Enron hide
debt and artificially boost cash flow for
regulatory violations, and the office of Manhattan
District Attorney Robert Morgenthau also examined
the deals for criminal offenses. Enron, which had
a reputation of browbeating its bankers, was
accused of putting pressure on Citigroup to carry
out elements of the deals.
As with the
Mahonia arrangement, Citigroup's Yosemite
transactions involved commodity "pre-pay"
transactions, in which money is paid up front for
commodities such as natural gas or oil to be
delivered at a future date, a practice common in
the energy market. But Senate hearings documents
showed that the Yosemite transactions were
manipulated to make debt appear on Enron's public
disclosures as trades through a series of "round
trip" prepaid transactions.
In each of the
four Yosemite deals, Citigroup set up a trust that
raised money from investors in Europe and the US.
Then the money moved to a Citigroup-sponsored
special-purpose vehicle in the Cayman Islands
known as Delta, which then sent the money in a
circle through a series of oil trades, first to
Enron then to Citigroup, and then back to Delta,
each time moving the money through oil pre-pay
contracts. Oil never actually changed hands, and
the trades in effect canceled one another out in
what amounted to financial manipulation.
Cash settlement is common in commodity
transactions, but the round-trip nature of the
trades is one uncommon aspect that drew the
scrutiny of US congressional investigators. So did
the accounting effect of the circular trades,
which allowed Enron to borrow money from the
Yosemite investors but record it as cash generated
from its operations - because that pre-pay
contracts were booked as trades rather than loans.
The distinction was central because the company's
burgeoning debt levels were starting to raise red
flags among shareholders well in advance of
Enron's final collapse.
The use of
pre-pays as a monetization tool is a sensitive
topic for both ratings agencies and institutional
investors. Documents show that Enron routinely
kept Yosemite transaction details in a "black
box". Only two participating parties would know
the precise details: Enron and Citigroup. This
type of "black box" opaqueness is present in many
over-the-counter derivate products, "conduits" and
"special investment vehicles" that are causing the
current ABCP credit crisis.
Enron would
put into Yosemite an extra payment called a "magic
note" that ensured that Yosemite's investors
received promised interest on their investments.
Those investors were led to believe they were
buying assets from Enron that had revenue streams.
In fact, Enron simply was paying - out of its
other revenues - interest on its magic note, a
bond with a yield of as much as 49% in one
instance. The return was spread out among Yosemite
investors to make sure they were paid the promised
interest on their investment in the trust. All of
this became a belated concern to regulators
because the debt did not appear as such in Enron's
public filings.
Banks blame
auditors Citigroup put the blame squarely
on Enron and its then-auditors at Arthur Andersen
LLP. "I wish I'd never heard of Enron," Citigroup
chairman and chief executive officer Sanford I
Weill said in an interview. He might have added
that he wished he had never heard of Jack Grubman.
Grubman, star telecom analyst of Citigroup
investment-banking firm Salomon, entered a quid
pro quo with Weill to upgrade his
"independent" rating of AT&T to help Solomon
land a huge deal AT&T was preparing to finance
a spinoff of its wireless-telephone
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