Limits in Structured Finance Transactions
Many bankers and financial advisers may be wondering when they risk being charged with aiding in manipulating earnings in the wake of recent enforcement actions against three New York investment banks for acting as counterparties in transactions with Enron.
Each of the investment banks recently settled — without admitting guilt or liability — charges brought by federal and state regulatory authorities arising from transactions with Enron and, in one bank’s case, with Dynegy. The three are Citigroup, JP Morgan and Merrill Lynch.
In September, the US Department of Justice also brought criminal charges against three former investment bankers at Merrill Lynch in connection with transactions arranged for Enron, and prosecutors have indicated that criminal investigations of similar transactions are continuing. Enron itself also sued its former banks and investment banks at the end of September, alleging fraud and unjust enrichment in connection with transactions they engaged in with Enron.
The charges define new liabilities for banks lending into structured finance transactions and for arrangers of such transactions. They also provide a roadmap that bankers and financial advisers should follow to ensure they do not expose their companies and themselves to criminal or civil liability.
What Did They Do?
The transactions that drew the regulators’ attention took different forms. Some involved commodities, others involved financial instruments and still others involved hard assets. Each of them was a loan in substance.
In the commodities area, Enron entered into approximately $8.3 billion of prepaid forward commodities transactions with its investment banks that were criticized by the US Securities and Exchange Commission and the Manhattan district attorney as being fraudulent. “Prepaids” can be routine transactions that are a normal part of commodities trading. However, in the case of the Enron prepaids, regulators charged that the transactions were “trades” on paper only. For example, in one set of prepaids, the arranging investment bank paid a one-time amount to a special-purpose entity formed by the bank in return for the special-purpose entity’s, or SPE’s, promise to make future deliveries of a commodity. The SPE then entered into a matching agreement to buy the commodity from Enron for a payment substantially equal to the amount the SPE received from the bank. The net effect of these two agreements was that Enron agreed to make future deliveries of a commodity to the bank in return for an up-front payment from the bank. Enron and the bank then entered into a series of swaps and physical sales that caused Enron to reclaim possession of the commodity and repay the bank’s investment in the transaction at a significant premium. The transaction gave the impression that three independent entities were engaged in legitimate, arm’s-length commodities trading but, according to the government, the contracts eliminated all market-price risk to the bank and guaranteed an agreed-upon return for the bank. Based on these facts and those relating to similar transactions, the regulators determined that Enron’s reporting of the proceeds of the prepaids as cash flow from operations rather than proceeds from loans was fraudulent. The regulators then sanctioned the investment banks for participating in the transactions on the basis that the banks knew or should have known that their purpose was to cause Enron’s finances to appear more healthy than they really were.
Another transaction that the SEC criticized involved creation of an SPE to which a bank lent money. A few weeks before the end of Enron’s fiscal year, the SPE used the borrowed money to purchase Treasury bonds and contributed the bonds to a partnership controlled by Enron. The partnership then sold the Treasury bonds. The proceeds from the sale were reported on Enron’s financial statements as cash from operations. Three weeks into the new fiscal year, Enron arranged for the SPE’s loan to be repaid in full with interest. The regulators determined that the net economic effect of this transaction was that the bank made a loan to Enron. They were also troubled by the short life of the transaction, especially when it originated shortly before the end of Enron’s reporting period.
The SEC also took issue with another transaction on grounds that it was an “asset-parking” arrangement. In this transaction, an investment bank purchased an asset from Enron on December 29, 1999, and Enron reported the proceeds as income from operations in its fiscal year ending December 31, 1999. However, Enron had given verbal assurances to the bank that it would arrange for repurchase of the asset from the bank within six months at an agreed price that included a specified rate of return. Just prior to the agreed repurchase deadline, an Enron affiliate purchased the assets on the agreed terms. The SEC argued that this transaction constituted more of a bridge loan than a true sale and sanctioned the bank for accommodating its client despite “express concerns that [the bank] could appear to be aiding and abetting Enron’s earnings manipulation.”
No matter whether they involved commodities, financial instruments or hard assets, the common thread to the transactions — the regulators charge — is that they originated from a client’s desire to manipulate its financial results. Wall Street considers operating income more tangible than gains from mark-to-market activities and indicative of a strong and growing business. According to the regulators, when Enron and Dynegy believed they would not be able to post sufficient income from operations to satisfy Wall Street and fulfill their own projections, they turned to their bankers to devise transactions that would create operating income even though no true “operations” supported the impact on the balance sheet. Because the transactions arose from the clients’ desires to manipulate financial results, it did not matter whether the effect of the transactions on earnings was “material” or whether they were legal on a stand-alone basis. From the regulators’ point of view, it only mattered that the banks participated in the transactions whose purpose was to manage earnings in a manner that misled investors about the companies’ true financial health.
What Law Was Broken?
Last March, the SEC filed civil charges against Merrill Lynch and four of its former employees for aiding and abetting Enron’s securities fraud. Merrill settled on a lesser charge and paid a fine of $80 million, but the four individuals are contesting the allegations.
In July, JP Morgan paid $135 million to settle allegations that it assisted Enron in manipulating its financial statements, and Citigroup paid $120 million to settle similar allegations with respect to Enron and Dynegy. In September, Merrill Lynch faced criminal charges relating to its dealings with Enron but agreed to adopt companywide reforms and accept monitoring by the government in return for the Department of Justice foregoing prosecution. Three former Merrill Lynch investment bankers also face criminal charges of conspiracy to commit fraud, perjury and obstruction of justice arising from their professional dealings with Enron.
The government charged in each case that the banks and bankers violated SEC Rule 10b-5. That rule prohibits, among other things, “engaging in a course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.” Publishing materially misleading financial statements “in connection with” the purchase or sale of a publicly-traded security, as Enron and Dynegy are alleged to have done, constitutes a violation of Rule 10b-5. Banks and other financial intermediaries also face liability for their clients’ violations of Rule 10b-5 when they “aid and abet” or are deemed to be the “cause” of the violation.
To charge a company with aiding and abetting, the government must prove improper manipulation of earnings, knowledge that this was occurring, and substantial participation by the company charged with aiding and abetting in the manipulation. A company cannot put its head in the sand. Actual knowledge is not required if there were red flags that should have caused the company to inquire further. Aiding and abetting is a more serious charge than that a company helped to “cause” the earnings fraud. There is a debate among securities lawyers about what exactly must be shown to establish “cause.” Companies accused of aiding and abetting sometimes settle for the lesser charge of helping to “cause” the misleading financial reporting.
The government charged that all three investment banks were aware that the purpose of the transactions they engaged in with Enron and Dynegy was artificially to inflate earnings. No one has suggested it was illegal for the banks to make loans to the companies or to document the transactions in the form they did. Securities lawyers used to focus after such charges on whether the earnings misstatements were “material,” or amounted to at least 5% of earnings. What is novel about the latest enforcement actions is they suggest the government’s new approach is to make materiality irrelevant in cases where a bank or arranger was aware of an improper purpose by its counterparty in the transaction. Obviously, proving such knowledge is harder in cases where a bank merely lends into a transaction than where the bank pitched the idea for the transaction and helped to structure it. As the SEC put it bluntly in one of the cases, “if you know or have reason to know that you are helping a company mislead its investors, you are in violation of the federal securities laws.”
Citigroup, JP Morgan and Merrill Lynch have all adopted new internal approval procedures for structured finance transactions and have submitted to increased oversight by regulators and independent auditors. These new review procedures, and the regulators’ criticisms of the transactions arranged for Enron and Dynegy, are a guide about where to draw lines for other companies that participate in or arrange structured finance transactions.
Potential Red Flags
Banks lending into structured finance transactions and investment bankers and other arrangers helping to structure such transactions do not control their clients’ financial reporting, but they can reduce their exposure to a client’s fraudulent disclosure by examining the client’s motivations for entering into a specific transaction and, if necessary, refusing to participate in a transaction that they suspect could be used to mislead the investing public. They should be alert to the following “red flags” and ask questions that they might not have thought to ask in the past.
How does the client intend to report the transaction on its financials? If the transaction is in substance a loan, will it be reflected as proceeds of financing activities? Or as cash flow from operating activities? Is the repayment obligation disclosed? Arrangers can protect themselves from liability by enforcing their clients’ obligations to disclose the full impact of a transaction. For example, Citigroup now states that, with respect to all clients that have publicly-traded securities, it will execute a material financing that will not be accounted for as debt on the client’s balance sheet only if the customer agrees to disclose the net effect of the transaction on its financial statements.
Does the transaction, or group of transactions, have a legitimate business purpose? The government alleged that certain Enron and Dynegy transactions had no business purpose other than to allay investor, analyst and rating agency concerns about cash flows from operations and outstanding debt. If the primary purpose of a transaction is to boost operating income, and it appears that there are no true operations to support the income, then the transaction warrants additional scrutiny. For example, Merrill Lynch has agreed with the Department of Justice that it will not engage in any transaction near the end of a client’s fiscal year where Merrill knows or believes that the client’s “primary motivation” for the transaction is to achieve accounting objectives, including off-balance-sheet treatment, without first subjecting the transaction to a rigorous internal review process.
When all is said and done, is the transaction nothing more than a loan? A loan consists of an advance of money, repayment of the money and payment of an agreed rate of return. The government treats discrete transactions that are interrelated steps in a larger deal as a single transaction for purposes of distilling the net effect. If a participant in a structured finance transaction is exposed to no more credit risk than a commercial lender and is entitled to an agreed return on its investment, then the transaction will be viewed as a loan and any treatment of it as operating income on the client’s financials may result in liability for the bank participating as a counterparty.
What is the purpose of any special-purpose entity involved in the transaction? If an SPE is formed largely to create distance from one of the other participants in the transaction, and in particular to enter into a discrete transaction that offsets another discrete transaction with an affiliate of the SPE, then the proposed transaction warrants closer scrutiny. In a July letter to US and New York bank regulators, the Manhattan district attorney said “the use of special purpose entities by banks calls for particular scrutiny,” described SPEs as the “source of much mischief” and recommended that SPEs be used only when “there is a genuine need and only when their function is transparent to all concerned parties, including investors, creditors and regulators.” The DA further recommended that banks and financial institutions be prohibited from utilizing SPEs that are chartered or domiciled in locations with unreasonably strict corporate and bank secrecy laws (including, in the DA’s opinion, the Cayman Islands, the British Virgin Islands and the Bahamas), saying that “it is courting disaster for responsible authorities to continue to permit SPEs to be set up in offshore secrecy havens.”
Is the transaction expected to close just prior to the end of a reporting period and are there continuing obligations after the end of the reporting period? Is there an “early” termination option? As described above, the Enron “asset-parking” transaction was created and closed shortly before the end of Enron’s fiscal year (and allowed Enron to meet Wall Street’s financial expectations) and then unwound shortly thereafter. Regulators have indicated that year-end transactions will be assumed to have been entered into for the purpose of meeting earnings expectations, which could give rise to liability for misleading investors. Merrill Lynch has promised the Department of Justice that all year-end transactions will pass a special internal review process before the company will participate in the transaction.
Does the transaction offset another substantially contemporaneous transaction executed with the same or affiliated parties? As part of the analysis of the net effect and business purposes of transactions, regulators will group together transactions that, when viewed as a whole, result in reductions in risk to counterparties, return of “sold” assets or repayment of “at risk” funds. One “prepaid” transaction in which JP Morgan acted as a counterparty was memorialized by an Enron-designed tombstone with the slogan “let the circle be unbroken,” a fact that the Manhattan DA mentioned in his report to federal and state regulators as an indication of the absence of risk for the participants and the transaction’s true purpose of generating misleading financial results.
Is the client seeking to counteract a delay or failure of another transaction? Banks and investment bankers need to be wary when clients approach them looking for quick, balance-sheet solutions to shortfalls in operating income that result from a failure to close another, genuine transaction. For example, the Enron “asset-parking” transaction described earlier was instigated by Enron only after an expected sale of the asset failed to close.
Is the client seeking to replace debt with funds characterized as other than debt? For example, would the transaction result in debt being retired by funds that would be characterized as a minority interest in a subsidiary? Clients perceived by Wall Street as being overleveraged or hindered by excess debt may be seeking to reduce their reported debt without actually reducing their true repayment obligations. This is a red flag requiring caution — not an indication necessarily that the transaction is flawed.
Are verbal assurances or other side agreements (whether written or oral) an important part of the deal? If the entire deal cannot be reflected in the principal governing documents, the side agreements may raise questions in the minds of regulators. Enron’s “asset-parking” transaction would not have been consummated had not Enron given verbal assurances to the bank that its financial participation would not be at risk. If those verbal assurances had been reduced to writing, Enron’s desired accounting treatment would not have been possible as the putative “sale” would have been required to have been accounted for as a financing activity.
Even if the transaction complies with the rules, is it ethical? Does it give rise to “reputational risk” for the bank acting as a counterparty or the investment bank that structured it? Regulators have indicated that their ultimate goal is to shift the transaction review process from one that is based on a strict reading of the applicable rules to one that is more grounded in ethics. Citigroup now examines the “economic reality” of a transaction as well as its legal form, and Merrill Lynch’s new review committee is charged with reviewing the “reputational risk” of a transaction as well as its legality. For purposes of avoiding liability, subjective, qualitative factors deserve at least as much consideration as more concrete, quantitative matters.
by Chris Groobey, in Washington