the tickle on the wrist

[Eubulides <paraconsistent@xxxxxxxxxxx>]

[New York Times]
July 29, 2003
A Warning Shot to Banks on Role in Others' Fraud
By FLOYD NORRIS


Enron lied to investors about its financial condition, but it could not
have done so without active help from its friendly bankers. And that help
constituted fraud.

That was the conclusion reached by the Securities and Exchange Commission
and the Manhattan district attorney as they disclosed settlements
yesterday with two of the nation's largest financial institutions, J. P.
Morgan Chase and Citigroup.

"If you know," said Stephen Cutler, the S.E.C.'s enforcement director,
that "you are helping a company mislead its investors, then you are in
violation of securities laws."

That is not the way financial institutions have seen it in the past. "Our
view historically," wrote Marc J. Shapiro, vice chairman of J. P. Morgan
Chase in a letter to Robert M. Morgenthau, the Manhattan district
attorney, "was that our clients and their accountants were responsible for
the clients' proper accounting and disclosure of the transactions." Now,
he said, his bank will "hold ourselves to a higher standard."

The settlements do not create precedents to the extent they would had the
cases been litigated, but they serve notice on banks and other financial
institutions that they will face major legal difficulties if they are
caught engaging in transactions similar to the ones that Citigroup and J.
P. Morgan did with Enron before that company went broke.

It is clear that both banks knew quite well that they were entering into
transactions with Enron that were in reality loans for hundreds of
millions, and even billions, of dollars. But they were structured in
convoluted ways to allow Enron to report them not as loans - which would
have shown the company to be deeper in debt than it wanted to appear - but
as other kinds of liabilities related to its trading activities.

In some cases, Enron even found ways to account for borrowed money as
providing cash flow from operations, thus making it look like the company
was making money that it was not. In one case, it borrowed money from
Citigroup and bought Treasury bills, which it immediately sold. It claimed
the proceeds of the sale increased operating cash flow by $500 million.

The two banks thus had superior knowledge over other Enron creditors
because they knew Enron's financial picture was not as good as it
appeared. But that information did not do them much good - they ended up
as Enron's two largest creditors when it filed for bankruptcy in December
2001 - in part because each did not understand that Enron had other
partners in deception, and thus did not know the total amount of hidden
debt.

Weeks before Enron filed for bankruptcy, it disclosed many loans that it
had previously hidden. When one J. P. Morgan executive expressed shock at
the amounts involved, his colleague reponded: "Shutup and delete this
email."

Citigroup may have had a slightly better understanding than J. P. Morgan
of what was going on, or maybe it was just more averse to taking on large
risks. It unloaded some of its disguised loans to Enron through bonds sold
to institutional investors, largely pension funds, which suffered losses
when Enron collapsed.

The deals at the heart of yesterday's case created little in the way of
dubious reported income for Enron; the company did that through other
transactions that produced paper profits without producing operating cash
flow. These deals provided cash flow to reduce the gap - closely watched
by some investors - between reported profits and cash flow.

After Enron collapsed, Citigroup realized far earlier than J. P. Morgan
that what it had done looked bad. It was more cooperative with
investigators, and that is one reason it got off with a lighter
punishment. The S.E.C. agreed to fine Citigroup in an administrative
proceeding, in which the company accepted a "cease and desist" order. J.
P. Morgan, on the other hand, faced a civil suit filed by the S.E.C. in
federal court, and had to accept an injunction barring it from future
violations of securities laws.

In some of the transactions at issue, it was at least arguable that
Enron's accounting was permissible under generally accepted accounting
principles, particularly if one looked at each separate transaction rather
than at the entire structure of related transactions. The banks knew what
was going on, but they comforted themselves by saying that was not their
business.

J. P. Morgan may have gone further. It signed letters, which the S.E.C.
and Mr. Morgenthau say were deceptive, in an effort to persuade Enron's
auditors that the accounting was proper. Even after investigations began,
Mr. Morgenthau said, J. P. Morgan insisted that one company it had
created, called Mahonia, was independent of the bank despite substantial
evidence to the contrary. Mahonia, Mr. Morgenthau noted, was able to
engage in billions of dollars of transactions even though its nominal
capitalization totaled 10 British pounds, or about $16.

Now both Citigroup and Morgan Chase promise that they will not engage in
similar transactions in the future unless the borrower makes complete
disclosure. That would defeat the purpose of such structures. Presumably
other major financial institutions will be similarly reluctant, knowing
both of yesterday's settlements and of a decision last December by a
federal judge in Houston that allowed private suits filed by investors to
proceed against financial institutions.

What is not clear is just how far this new candor will extend. Many
derivative transactions are designed in large part to produce either
financial results or tax results different from a straightforward - but
economically identical - transaction that does not include derivatives.
Others are designed to get around regulations affecting particular
industries, by enabling a bank, for example, to get the economic benefits
of owning stock in a certain company even though it is not allowed to buy
such shares.

If banks and other financial institutions were required to certify that
regulators and tax officials were informed of the purpose of such
transactions, that could severely depress the market for many such
derivatives. But the S.E.C.'s mandate does not extend that far.

For Citigroup and J. P. Morgan, yesterday's settlements are far from the
end of their exposure to Enron. They still face the suits filed by
investors. In addition, Neal Batson, Enron's bankruptcy examiner,
concluded in a report released yesterday that "there is sufficient
evidence of inequitable conduct" by six financial institutions, including
Citigroup and J. P. Morgan, to allow a bankruptcy judge to push their
claims down in priority when the Enron bankruptcy case is settled.

That would mean the financial institutions, which also include Merrill
Lynch, Deutsche Bank, Barclays and the Canadian Imperial Bank of Commerce,
would recover less of their $5 billion in claims, leaving more for other
creditors.

Making that case would not be easy, however, said Lynn M. LoPucki, a law
professor at the University of California at Los Angeles. He said that
creditors arguing for such a course would have to take on the substantial
cost of trying to prove the case that the S.E.C. made yesterday but was
not required to prove because the banks reached settlements.

Mr. Morgenthau, the district attorney, said in an interview that he
thought "it would be appropriate" for the banks to suffer in the
bankruptcy case, given their role in Enron's deception.