Financial Services Quarterly

Enron accusations force banking rethink

Chris Groobey, International Financial Law Review, November 2003

This article focuses on the recent enforcement actions taken against Citigroup, JP Morgan and Merrill Lynch, who arranged structured finance transactions on behalf of Enron and were subsequently charged with assisting to manipulate earnings. The new procedures and mechanisms implemented by the banks in the aftermath of Enron's collapse provide useful guidelines for bankers and advisers to other companies that participate in, or arrange, structured finance transactions.

The enforcement action defines new liabilities for banks involved in structured finance transactions and for the arrangers of such transactions. In each case, the banks settled the charges brought by federal and state regulatory authorities in the United States without admitting liability. Merrill Lynch paid a fine of US$80 million, JP Morgan paid a fine of US$135 million and Citigroup paid a fine of US$120 million.

All three banks have since adopted new internal approval procedures for structured finance transactions and have submitted to increased oversight by regulators and independent auditors.

Banks lending into structured finance transactions and investment bankers and arrangers helping to structure such transactions cannot control the standard of financial reporting produced by their clients. However, they can reduce their exposure to a client's fraudulent activities by paying attention to the client's motivations for entering into a specific transaction and by refusing to participate in a transaction that they suspect could be used to mislead the investing public.

The author suggests that the charges brought provide a "roadmap" for bankers and advisers to follow and sets out a number of "red flags" to watch out for, summarised below.

The "Red Flags"

Bank should enforce disclosure by client	Arrangers should enforce their clients' obligations to disclose the full impact of a transaction.
Be wary if transaction increases operating income	Additional attention and scrutiny is necessary where the main objective of the transaction is to increase operating income, but where it appears that no true operations support the income.
Substance over form	Arrangers must consider whether the transaction is, in substance, a loan. If a participant in a structured finance transaction is entitled to an agreed return on their investment and is exposed to a credit risk that does not exceed that of a commercial lender, the transaction will be classified as a loan. Any attempt to treat it as operating income in the financial records of the client could result in an action against the bank as a counterparty.
Use of SPV's to disguise relationship between parties	Extra scrutiny is warranted where the fundamental reason for the creation of a special purpose entity is to enhance the distance between other participants in the transaction.
Timing of transaction will influence regulators	Regulators in the United States have indicated that they now will assume that all year-end transactions are undertaken for the purpose of meeting earnings expectations. Where the timing of a particular transaction coincides with the end of a reporting period, arrangers should exercise due caution to protect themselves from liability for their involvement in what might be a fraudulent transaction.
Courts will look through artificial separation of deals	Arrangers should be aware of the readiness of courts to group together transactions that, when viewed as a whole, result in reductions in risk to counterparts, return of sold assets or repayment of at-risk funds.
Emergency solutions may be a sign of fraud	Arrangers should be especially careful in dealings with clients who seek rapid balance sheet solutions where a failure to execute a transaction has created a shortfall in operating income.
Always get it in writing	Arrangers should be wary of oral or side agreements where the complete transaction is not contained in the governing documents.
Ethics will prevail	At the end of the day, arrangers must be confident that the transaction is ethical. Regulators in the United States have emphasised their desire to shift the focus of the review process from a strict reading of the applicable rules to an analysis of the ethical standard of the transaction.

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