This page uses the Enron fraud and collapse to describe the nature and intent of structured finance. It looks at the way the financial institutions used it to aid and abet Enron's fraud. It examines the roles of Citigroup bankers and analysts, accountants, lawyers, and also the political strategies used by these groups.
Enron was the first of the great corporate collapses of the 21st century. Like the others it blew up in a massive scandal of fraud and greed. A close look at what happened gives a very different picture to that revealed in the sound grabs and headlines which penetrate our consciousness in far off Australia.
- - - - everyone instantly gets an epic fraud in which arrogant high-fliers stacked the deck to fleece thousands of peons to the tune of zillions. The United States of Enron The New York Times January 19, 2002
The Real Story
The real story is not about Enron. The real story is about structured finance and the giant financial institutions who developed it, embraced it and used it as a vehicle for their own ends without any regard for the social consequences. They set up and arranged the fraud.
The real story is also about the large number of credible financial giants who participated in Enron's fraud. Without their active participation this fraud could not have occurred.
A Sick System
This is not a few bad guys, but a sick and disturbed system and we in Australia are increasingly part of that system and embrace the beliefs which give it legitimacy. Increasingly we think the way it thinks. It is interested in making money from our health care system.
It is not about illegality but about the morality and ethics of all of those involved. Some of them believed that what they were doing was legal and much of it may well have been. That it was totally immoral and quite unacceptable clearly did not worry them at all.
Once again Citigroup was at the helm making arrangements for the largest portion of the scam. Citigroup was less brazen in its denials when it was prosecuted and this is why it earned a lesser fine for its complicity than Morgan Chase and Merrill Lynch. Those defrauded are also pursuing a long list of other banks for compensation. They too played their part in what happened and picked up the scraps from the trough.
The Deceivers Deceived
To some extent the financiers also were victims. Because they were competitors and because Enron used several of them to assist in the fraud none of them realised how imminent the collapse was until too late. They lost money too but much less. Enron kept its own council and played one against the other.
Structured Finance and Conscience
Structured finance was the credible sounding vehicle which the co-conspirators advising Enron used to make what they were doing sound legitimate. Somewhere deep down they obviously knew that what they were doing was wrong. This was never formally objectified and recognised. It was officially seen as legitimate and the investment banks protested angrily when they were accused of complicity in fraud.
This deeper recognition of what they were doing is seen in the emails and private notes made by individuals as they interacted with one another and experienced doubts. It was the undeleted emails that finally gave the lie to public assertions, and led to large fraud settlements by the banks. It prompted shareholder litigation against the banks claiming US $25 billion.
Enron, the champion of energy deregulation that grew into one of the nation's 10 largest companies, collapsed yesterday, after a rival backed out of a deal to buy it and many big trading partners stopped doing business with it.
Enron, based in Houston, was widely expected to seek bankruptcy protection. With $62 billion in assets as of Sept. 30, it would be the biggest American company ever to go bankrupt, dwarfing the filing by Texaco in 1987 ENRON'S COLLAPSE: THE OVERVIEW; ENRON COLLAPSES AS SUITOR CANCELS PLANS FOR MERGER The New York Times November 29, 2001
The first step is to look at the rather mundane fraud and subsequent collapse at Enron. In broad pattern this was little different to those documented at WorldCom, other DotCom companies, and in health care on these web pages. As with the others effort directed to competition, takeovers, and consolidating markets led to neglect of the business and excess debt. As competition cut into profits there was insufficient income to support this debt. This was followed by the misuse of the customer and attempts to defraud the system by manipulation the books to hide the problems. When these failed financial collapse followed.
The real interest lies in the banks and auditors who designed the fraud and set it up. They made lots of money from it. If their behaviour elsewhere is any guide they encouraged, even suggested the fraud claiming it was legal.
Enron tells us more about what may well have happened behind the scenes in all the other failed companies. It exposes the role the financial institutions very probably played in other frauds. They may have played a similar role in the health care scandals in the USA. It tells us what they might do in Australia.
Structured finance was not created for
Enron's benefit. It was a product financiers marketed to those who
needed it. In the market there are always winners and losers who need
this sort of help and will jump at it.
The Enron Story
Enron was a power company selling electricity and gas. It capitalised on the opportunities presented by the privatisation of these resources in the USA and across the world. It was one of the products of the late 20th century's embrace of markets as the primary vehicle for social policy and human activity. It seized the opportunities presented by deregulation.
Superficially its story is little different to those of the DotCom companies, the technology companies and the health care corporations which built their empires in a competitive market where survival depended on mergers and takeovers. To accomplish this Enron traded on the gullibility of the investing public whom it systematically defrauded.
The collapse of Houston-based Enron destroyed the retirement savings of thousands of employees and damaged outside investors and pension funds across the nation. Banks Pay $289M in SEC Charges Officials say J.P. Morgan Chase, Citigroup knew Enron was trying to mislead investors Associated Press July 29, 2003
Like others in the sector it started small and grew rapidly by takeovers and mergers raising money from banks and the share market. It was in the business of corporate competition and market capitation rather than the business of supplying gas and power. These services were manipulated, bought and sold in pursuit of these primary marketplace goals. As in health care the actual services supplied could not support the expensive baggage of the marketplace and suffered from their manipulation for market outcomes rather than customer benefit.
Enron was at the centre of the electricity scandals in California where companies were accused of exploiting the state and its citizens.
A giant power station in India became the subject of dispute with local companies. It was closed and its rusting remnants are a fitting memorial to Enron.
These disputes give some idea of the nature of the company. Its ultimate customers, the citizens of California and India did not gain any benefit from the investment of their taxes, savings and pensions in Enron.
By the time Mr. Skilling was named chief executive, the company had become a lightning rod for political outrage over the electric power crisis in California, which was experiencing brownouts and price spikes. Enron's traders bought and sold electric power, and California utility officials were accusing it and other national power companies of manipulating that esoteric market to reap windfall profits at consumers' expense. Enron and other major trading companies denied the accusation, but there were demands for a full-scale investigation. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
We already know, thanks to a 1997 article in Time, that Bill Clinton nudged Mack McLarty to lend the administration's weight to an Enron bid on a $3 billion power-plant project in India, and that the Democrats received $100,000 from Enron just four days before the Indian government came through. The United States of Enron The New York Times January 19, 2002
Citibank has since lent Enron large amounts for everything from working capital to building a power plant in India ENRON'S COLLAPSE: LENDERS; 2 EarlyEnron Lenders Didn't See the End Coming The New York Times January 22, 2002
Mr. Lay (Enron founder) had several conversations last year with Donald L. Evans (Bush government), the current commerce secretary, about Enron's troubled Dabhol power plant project in India.
The power plant, which was supported by both the Overseas Private Investment Corporation and Export-Import Bank loans, has been shut since June by a dispute between Enron and the government of the state in which the plant is situated. Vice President Dick Cheney raised the issue in June with Sonia Gandhi, the leader of India's main opposition party. Enron Received Many Loans From U.S. For Foreign Projects During the 1990's The New York Times February 21, 2002
At $2.9 billion, the Dabhol power project on India's west coast was the biggest foreign investment in the country's history and was planned to be the largest gas-fired power plant in the world. Since the collapse of the Enron Corporation, which built it, Dabhol has become one of India's deepest financial quagmires.
The Dabhol project, 150 miles south of Bombay on the Arabian Sea, can generate 2,184 megawatts of power, enough for two million average homes in the United States. Indian lenders supplied most of the money to build it and are owed some $1.5 billion. They want the plant reopened. Foreign creditors, including Citigroup, Bank of America and ABN Amro, are owed $340 million; they want to force the project's part-owner and only customer, the Maharashtra state utility, to buy out its partners in the plant, with the proceeds to repay creditors.
Enron shut it down in June 2001 when the utility, complaining of high rates, refused to pay its bills. It has been idle since then, rusting in the salt air. Creditors Intensify Their Fight On Enron-Built Plant in India The New York Times April 23, 2003
Enron became a giant abstraction, a paper exercise. Its success in takeovers, its size, and its apparent wealth made it a powerful force on Wall Street and in the corridors of power.
That wealth, the takeovers it funded, and its credibility did not come from power or gas. It came from US citizens. Private investors and institutional investors like pension funds were all drawn to the promised profits. Investors money was brought in by the banks who lent large sums and then hedged these with insurers and other investors. Government gave large amounts to assist Enron in exploiting international opportunities. It was a bottomless pit. A lot went in and very little came out.
This money was locked into the company's shares. Everyone with shares made money but it was only paper money until the paper was sold on to someone else. The real money had been squandered in the takeovers and other market activities.
The problem for Enron was that those who had invested had been promised and expected to get more money from selling gas and electricity and this was not happening. Like the majority of other companies in this position it sought to hide the truth from the public and borrow more money to fill the hole.
A blatant fraud was concocted to create the illusion of real money, but those involved did not see it as fraudulent. They were shielded by the legitimacy given to the arrangements by the marketplace and by the complicity of Enron's partners, the banks and the accountants. They designed and implemented the fraud on Enron's behalf.
Senior staff deluded themselves that things would improve and that those profits would eventually come. They all knew that the value of the company lay in the price of its shares. This is what they had borrowed against and the share price had to be kept up at all costs.
After the interview, as Mr. Skilling led the film crew out onto the trading floor, he was asked what his top priority would be as chief executive. His answer came lightning-fast: "To get the stock price up," he said.
Few people outside Enron knew how important that single goal was.
What made Enron's stock price so important was the fact that some of the company's most important deals with the partnerships run by Mr. Fastow -- deals that had allowed Enron to keep hundreds of millions of dollars of potential losses off its books -- were financed, in effect, with Enron stock. Those transactions could fall apart if the stock price fell too far. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
An elaborate process was set up in order to hide the losses and the company's dept so that it would appear to be profitable. The investment banks advising Enron did this for them making large profits for themselves. The intention was to hide losses and dept and to show a profit, while at the same time borrowing more money. This money would not have been forthcoming had investors known the true state of affairs. From their comments it appears that Enron and the banks both believed that what they were doing was legal and acceptable.
In the late 1990s the imprisonment of normal children in psychiatric hospitals was seen by corporate staff as a legitimate and desirable means of generating profits for psychiatric chains. A complex web of rationalisations was used to justify this. The same thing happened on Wall Street. Complex systems, called structured finance were developed and used to justify deception and the exploitation of the investing public. The forces and mechanisms were similar.
The critical importance of image
In the health and aged care marketplace the illusion of success based on high quality care and putting patients first was critical to credibility and to corporate success. This has usually been far from the real situation in the hospitals and nursing homes.
Enron and its staff lived in a similar schizophrenic world. They maintained the illusion of great success and polished it until it shone brightly. Staff all identified with this illusion, even as the company crumbled around them.
With the huge Raptor losses shuffled away, Enron reported $425 million in earnings, another banner quarter.
"We're all dancing here. It's pretty good stuff."
For about 15 minutes, Mr. Skilling laid out the details of Enron's performance. Nothing was said by any of the Enron executives about the Raptors, the single most important transaction in the quarter.
(Skilling In response to a question) Enron had been in the business for 10 years, he said; it analyzed the credit quality of every trading partner it had -- some 5,000 in total -- every day. There was no reason for anyone to worry about credit exposures; Enron knew everything it needed to know.
For, unknown to almost everyone there, Enron was secretly falling apart. Even as the celebrations (party to celebrate Enron's success) unfolded, accountants and trading experts at the company's Houston headquarters were desperately working to contain a financial disaster, one that threatened -- and ultimately would destroy -- everything Enron had become. A handful of executives were struggling to sound the alarm, but with Enron's confidence in its destiny, the warnings went unheeded.
It is two completely different tales -- the public image, polished by its most senior officers, of an innovative powerhouse on the verge of reshaping the world, and the hidden truth of a company plagued by secrets, whose executives were struggling to hold it together. It was like a gleaming ocean liner seemingly powering forward, its passengers dining in luxury, while, below the waterline, its sweaty crew frantically bails against the force of an in-rushing sea.
And on Feb. 5, scores of special bonus checks were cut for Enron executives, who would collect tens of millions of dollars because of the company's strong reported profits.
The mood that same day was far less jubilant in the nearby offices of Arthur Andersen, Enron's outside accounting firm. There, David B. Duncan and Thomas H. Bauer -- two of the firm's lead accountants on the Enron account -- joined a group of six colleagues in a conference room for a meeting. Six more Andersen executives were patched in by speakerphone. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
Attempts by people in the know to draw the attention of senior management to the problems were ignored or sidetracked. Jeff Skilling the new CEO got the message about what was happening when whistle blowers started writing to him. Instead of dealing with the issues he resigned "for personal reasons" after just 6 months in the job. Mr Lay the chairman and founder took over as CEO again. He met a second complaint by referring it to the company's lawyers who assured them that all was in order. The actual deals were probably legal. Their intention was not.
After 18 years as a tax attorney, Mr. Mintz had been delighted in October 2000, when he had been moved to that floor to work as a lawyer with Mr. Fastow's finance division. After two days of orientation, Mr. Mintz set to work, finding files upon files of documents detailing the transactions of the Fastow partnerships. What he saw troubled him.
Mr. Causey was blunt in his advice. "I wouldn't stick my neck out," he said, according to Mr. Mintz's Congressional testimony. Mr. Mintz interpreted that as a warning to avoid tangling with Mr. Skilling over the partnerships, he said.
Eventually, the three men agreed that Mr. Mintz should send a memo to Mr. Skilling, diplomatically raising his concerns.
Mr. Skilling never responded, according to Mr. Mintz's testimony.
On Aug. 14, stunning the market, Jeff Skilling announced he was resigning after just six months as chief executive, citing undisclosed personal reasons. He left assuring investors that the finances of Enron had never been better. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
But this letter was not some mundane complaint. The writer described in detail problems with Enron's partnerships, problems that the letter claimed would cause huge financial upheavals at the company in as little as a year. "I am incredibly nervous that we will implode in a wave of accounting scandals," the letter's author wrote. "Skilling is resigning for 'personal reasons,' but I think he wasn't having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in two years."
Two days earlier, Ms. Watkins shared her worries with James A. Hecker, an Andersen accountant she knew.
On Oct. 15, Vinson & Elkins (lawyers) delivered its report saying that no further investigation into the partnerships was necessary. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
The collapse starts
Ultimately economic reality set in and Enron's share price started to fall. The arrangements made depended on the share price being maintained at a reasonable level. If it dropped too far then the arrangements would unravel throwing the losses back on to Enron's books and this is what happened. Enron was forced to disclose a US $600 million loss. There was much more still hidden.
But that optimistic prospect (at the celebrations) had actually evaporated, sometime during those weeks, when auditors from Andersen discovered a mistake they had made, more than a year earlier, in Enron's books. The way they accounted for the Enron shares that had been used to finance the Raptor partnerships had incorrectly added $1 billion to the assets on Enron's balance sheet. Correcting the mistake would reduce those assets by $1 billion.
By this point, Mr. Lay and his advisers had also decided to dismantle the Raptor arrangements. That meant that the investment losses kept at bay for so long would have to be reported to shareholders.
The next day, Enron announced it was deducting $1 billion from its third-quarter earnings, producing its first quarterly loss in more than four years.
As one thread pulled away, the whole garment unraveled. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
A Life Line is offered
In desperation Enron tried to sell itself to its largest rival Dynegy. The financial institutions who knew what was happening jumped at this life line. Their analysts raved about the prospects and Enron's basic soundness as a business. The banks promised to invest more.
Wall Street found nothing but good news in Dynegy's $9 billion takeover of the Enron Corporation yesterday.
Three days after Dynegy, an energy marketing and trading company based in Houston, agreed to take over Enron, its giant crosstown rival, Dynegy executives came to New York to assure investors that the deal would sharply increase their company's profits. They met a receptive audience.
Enron's stock fell almost 80 percent in the weeks leading up to the deal as Enron said it had overstated its earnings by almost $600 million since 1997 and forced out several top executives.
A $1.5 billion cash infusion from Dynegy should restore the confidence of Enron's business partners and keep Enron stable until the takeover is complete, he said. To bolster Enron further, J. P. Morgan Chase and Citigroup may each invest an additional $250 million, executives close to the deal said.
Mr. Lay said in an interview that Enron had been forced to sell itself because of "the relentlessness of all the articles and the shorts." "We realized that we needed to do something to stabilize the ship," he said. "A good company was being badly tarnished." Suitor for Enron Receives Approval From Wall St. The New York Times November 13, 2001
Enron said it was in talks with lenders to restructure $9.15 billion in debt that will come due by the end of 2002. "If the Dynegy deal closed, that would be the best thing for the banks," said one analyst following the debt. Circling the Wagons Around Enron; Risks Too Great To Let Trader Just Die The New York Times November 22, 2001
The Lifeline is Withdrawn
Enron's share price was falling so rapidly that it had to renegotiate the sale. It did not disclose its true situation to Dynegy. When Dynegy realised what this was it walked away.
With Enron's shares in free fall as more information comes out about its hidden debts, J. P. Morgan Chase has been scrambling to maintain the support of other banks while simultaneously keeping the merger with Dynegy on track. Chase and J. P. Morgan's Paper Anniversary; A Year After the Merger, Rosy Plans Meet Reality The New York Times November 23, 2001
But traders and Wall Street analysts said the business had steadily deteriorated amid questions about the depths of Enron's financial straits. Many traders have curtailed dealings with Enron, and the executives close to the talks said Dynegy officials scouring Enron's books were having difficulty this week figuring out how much cash the trading operation was generating.
Both companies are seeking promises from Enron's bank lenders to extend debt repayment dates until after the merger closes. And they are also discussing adding provisions that could limit Dynegy's ability to back out of the combination.
The two companies are also working to arrange a cash infusion of $500 million from J. P. Morgan Chase and Citigroup that would provide Enron with desperately needed new cash.
If Enron were to lose its investment-grade status, it could be forced to repay or refinance up to $3.9 billion in debt, while other traders would probably further curtail business. But by late yesterday, Moody's decided not to issue a statement after receiving assurances from Enron and Dynegy officials that a renegotiated deal would be announced soon, the executives said. A Moody's spokesman declined comment.
Though yesterday's gains halted a four-day slide in Enron shares, the stock is down 95 percent this year after disclosures of major losses as well as significant accounting errors that led Enron to admit it overstated profits during the last five years by nearly $600 million. Trying to Restore Confidence in Enron to Salvage a Merger The New York Times November 28, 2001
According to the report, officials at Moody's Investors Service -- a major credit-rating agency -- decided the night of Nov. 7, 2001, to downgrade Enron's rating, putting it below investment grade. Within hour
s, Enron and officials at Citigroup and J. P. Morgan Chase -- which had also lent the company large sums -- started an aggressive campaign to forestall the downgrade. Senate Report Says Rubin Acted Legally in Enron Matter The New York Times January 3, 2003
But again, the truth of Enron was far different than its projection of strength. The company was hemorrhaging cash; it burned through $2 billion in just the week after it signed the merger agreement. Worse, it could not account for where a large portion of that money had gone. And it told Dynegy nothing about it.
Enron owed $690 million, payable within days.
Mr. Watson of Dynegy was soon on the phone with Mr. Lay, and sent a follow-up letter documenting their discussion. "We have not been consulted in a timely manner regarding developments since November 9," the letter said. "We were not briefed in advance on the issues in your 10-Q. Our team had to make repeated phone calls to your finance and accounting officials in an attempt to obtain information. Some of the most significant information in the Q was never shown to us at all." ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
Dynegy's decision to walk away from Enron leaves Citigroup and J. P. Morgan Chase licking their wounds after an effort to burnish their reputations as deal makers.
As lead advisers and lead bankers for Enron, the banks had the chance to build influence in the merger business. Unlike other Wall Street firms, Citigroup and J. P. Morgan have large balance sheets and have boasted of their ability to provide both loans and advice. ENRON'S COLLAPSE: THE LENDERS; Citigroup and J.P. Morgan Are Left With Bruised Egos and Exposure to Loans The New York Times November 29, 2001
Enron entered bankruptcy in December 2001, and the long process of unravelling the mess and prosecuting those responsible started. Enron was one of the first and at the time the largest of the corporate scandals and bankruptcies. The complexity of its fraud and the number of parties involved has meant that it has taken longer that the others to unravel. At the end of 2003 this is still happening. The actions grind their way through the courts. Investors seek US $25 billion from the banks whom they are holding responsible for the fraud.
Many Others Behaved Similarly?
If the financial service groups were doing this for Enron, who else were they doing it for. They did not create structural financing just for Enron.
There can be little doubt that such practices had become widespread. Even an Enron executive realised this. Dynegy, the company that wisely backed away from its takeover of Enron was doing the same things. It too eventually collapsed. It was helped by Citigroup and Andersen, the same bankers and auditors in the same way. While Dynegy was fined only US $3 million for its fraud, Citigroup which set up the Dynegy fraud was fined US $19 million.
Citigroup was marketing its structured finance packages to all those in need, exploiting the opportunities presented. The reports show how rapidly successful money making ideas spread.
"Given the events at Enron, given the short time period in which it happened, given the economic disaster, it fundamentally challenges everything I think about the way companies work," said Allan Sommer, former vice president for corporate systems at Enron. "If Enron was able to hide this the way they did, why couldn't other companies do it, too?" ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
Investment bankers at some big Wall Street firms helped create and find investors for complex partnerships that the Enron Corporation used to mask its true financial condition. Then they started helping other companies in the same way.
Bankers at Citigroup, Credit Suisse First Boston and Deutsche Banc Alex. Brown found ways for Enron to remove lagging assets from its balance sheet by selling bonds backed by Enron's stock.
After hatching that idea, some of those bankers took it on the road and sold it to other corporations that wanted to make their financial statements look better, too. ENRON'S MANY STRANDS: PARTNERSHIPS; Wall Street Found Others Willing to Copy Enron's Deals The New York Times February 14, 2002
Evidence disclosed by the committee today also showed that the two banks engaged in deals with similar characteristics with other companies. J. P. Morgan Chase told the panel that seven companies entered into "commodity prepaid forward transactions," including Columbia Natural Resources Inc. and Occidental Petroleum. Citigroup said it did prepay deals in 1992 with the Arkla Exploration Company and in 1993 with the Amerada Hess Corporation. Citigroup and Chase Defend Their Enron Roles The New York Times July 24, 2002
In the meantime, perhaps the S.E.C. should demand the banks name other companies that bought Enron-type products. Many more deceptions might be found. Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
Dynegy, one of the nation's largest energy traders, agreed today to pay $3 million to settle accusations that the company had used a series of off-balance-sheet partnerships to doctor its financial statements and mislead investors.
The Securities and Exchange Commission, which settled the civil case, also said that Dynegy had engaged in so-called round-trip, or phony, trades and that the company repeatedly had sought to mislead investors about the success of its trading operations.
For Dynegy, the accusations concern transactions that were code-named Project Alpha, which the investigators said the company used to bolster profit and cash flow statements in 2001 with the help of Arthur Andersen, its former auditor.
Like its peers, Dynegy, which once sought to acquire Enron for $9 billion, has seen its fortunes vanish almost overnight. Its longtime chairman and chief executive, Charles L. Watson, resigned in May. Dynegy's shares, which peaked at $47.50 last November, closed today at $1.20.
The deal, developed by Andersen, cost Dynegy $35.8 million, according to the S.E.C. Dynegy to Pay $3 Million In Settlement With S.E.C. The New York Times September 25, 2002
Citigroup will also pay $19 million to settle SEC charges that it helped Dynegy Inc. manipulate its financial statements. USA: JP Morgan Chase, Citigroup to Pay in Enron Case Associated Press July 28, 2003
Like other fraudulent practices structured finance has been globalised and there is every indication that Citigroup's advice played a critical role in the Parmalat fraud in Italy. That too could not have occurred without the assistance of structured finance.
The collapse of Enron triggered a multitude of investigations by state and federal agencies across the USA, as well as an avalanche of court actions by investors. US senate and congressional hearings were open to the public.
In addition the US Securities and Exchange Commission investigated, prosecuted and fined. The department of justice were involved but it is not clear how many directors will be prosecuted and put in prison - if any. It is exceptional for real corporate criminals to be imprisoned. Junior and intermediate executives pay the costs of pleasing their boses in order to survive in the company.
Of the conspirators Enron is bankrupt and Arthur Andersen is gone. Only the banks have the money to pay compensation. The civil courts are likely to extract the largest penalties and this will come from the banks unless they can exploit the legal system to their advantage. Investors are looking for US $25 billion.
"The examiner's report (bankruptcy court) underscores the complicity of the investment banks in Enron's collapse," said Andrew Entwistle, a lawyer who represents some of the creditors in the Enron bankruptcy case, said today. "The Wall Street banks used structure finance to aid and abet Enron's fraud."
Over the past two years, the examiner said that Enron was prolific in the use of special purpose entities to raise money, and that around the time Enron filed for bankruptcy it listed about $13 billion as debt on the balance sheet but about $25 billion in off-balance-sheet debt, largely because of transactions like these. Enron Examiner Raises More Questions The New York Times September 22, 2002
Andrew Fastow, former Enron Corp financial mastermind, is negotiating a plea bargain and another former Enron executive is expected to face charges soon, sources close to the case said yesterday.
Fastow has pleaded not guilty to 98 counts of fraud. money laundering, insider trading and falsification of accounting records.
Former Enron Chairman Kenneth Lay and former chief executive Jeffrey Skilling have not been charged in the case, although several mid-level executives have pleaded guilty, agreed to co-operate or face trial.
If Fastow cuts a plea deal, it is unclear if he would agree to cooperate with investigators - - -
"If I were Skilling or even Lay, I would be sweating bullets over the possibility of Fastow agreeing to talk," said a lawyer close to the case - - - . Ex-Enron financial whiz in plea talks Courier Mail January 9, 2004
Indeed, structured finance deals are designed to achieve particular outcomes -- even ones that may seem illogical or misleading -- by building the transaction through an aggressive and rigorous reading of the rules. Morgan Set Up Deal for Enron To Cut Millions From Tax Bill The New York Times December 7, 2002
The deals demonstrate the aggressiveness in recent years of major banking institutions in putting together structured finance deals, which combine complex investment vehicles with efforts to evade or maneuver around accounting, tax or other rules. Inquiry Said To Examine Citigroup Role In Enron Deal The New York Times December 9, 2002
Doing it Milton Friedman's way
Structured finance was the ultimate expression of market theorist, Milton Friedman's dictum that company executives had a fiduciary duty to do everything they could to maximise profits for shareholders within the limits of the law. The banks did exactly that and of course helped themselves along the way. I have not heard that Friedman said anything about social responsibility and intention to defraud. The market was supposed to be self correcting.
In many of those transactions, the complaint says, senior bank officers themselves secretly invested in the partnerships, receiving quick, outsized profits for participating in deals that disguised Enron's true financial health. Enron Investors Say Lenders Took Part in Fraud Scheme The New York Times April 8, 2002, Monday
With the new aggressive competitiveness in the marketplace and a whatever it takes approach, commercial contracts and arrangements have been progressively designed to legally circumvent the intention of laws and regulations. The ultimate consequences of this were never a consideration. That was something the ambitious banker would studiously ignore - except perhaps in cynical emails to his mates.
I have included a number of extracts about this structured finance debate in this review because they are so revealing of the corporate position and corporate thinking. Structured finance has been very successful and nothing has been done to control it. It will continue to be a problem for market stability and for investors. It is likely to be used by health care corporations, possibly by venture capitalists seeking to boost profits prior to a float such as that planned for Affinity Health.
The investment banks devised strategies specifically for tax avoidance and in order to manipulate accounts so that they would be opaque to investors and analysts alike. The information, which investors needed in order to know what was actually happening inside a company was hidden. Banks like Citigroup would have been active in developing these strategies during the many years they were involved in laundering money for the dictators who pillaged their countries, for the drug barons and for the Russian Mafia.
Senator Carl Levin, Democrat of Michigan, called yesterday for increased penalties against accounting firms that design and sell abusive tax shelters and announced Congressional hearings next week to spotlight the firms, their executives and their sales practices.
The Congressional investigation into abusive tax shelters arose out of scrutiny by lawmakers of the failure of Enron and the banks and law firms that helped that company burnish its financial results and hide its indebtedness.
Mr. Levin said that the creation and promotion of abusive tax shelters had not received national attention because the products are so complex and labyrinthine. Nevertheless, he said the sales of these shelters are as much a scandal as the accounting frauds and mutual fund misconduct that have dominated the news recently.
"This is part of a bigger picture of the financial community having to clean house," he said in the interview. "The domination of greed in the financial community has too often corrupted professional standards, and people who should be our leaders in honest dealing too often get down in the muck." Senator Urges Action on Tax Shelters The New York Times November 11, 2003
Investment advisers, bankers and lawyers specialised in these areas. Provided it was legal it was considered legitimate and even desirable. Those with plenty of money benefited most from these services and they paid well for them. The morality of it was never considered seriously.
Over the past decade or so, an industry has emerged of corporate advisers that use complex financial instruments to help companies find ways around the types of safeguards being adopted.
Relying on transactions involving derivatives and other complex investment tools, this business -- part of "structured finance"-- has allowed some corporations to transform financial reports effectively into marketing material, masking evidence of earnings volatility and indebtedness. It is the financiers in this business who helped Enron create its off-the-books partnerships -- vehicles called special-purpose entities -- which can allow corporations to pretty up financial reports. A Higher Standard for Corporate Advice The New York Times December 23, 2002
History of Structured Finance
Structured finance started gradually in the 1970's. With the new whatever it takes and provided it works philosophy it soon broadened into the lucrative field of deception. A strange judicial decision in 1994 set a precedent which shielded financiers from culpability for aiding and abetting fraud. After this it was open slather for the banks - anything which was legal was OK.
Structured finance began to emerge in the late 1970's and quickly became one of the main routes corporations used to raise cash. In essence, rather than borrowing simply based on its own credit rating, a corporation could move an asset into a separate legal entity and then borrow against that asset's value. Because the separate entity, known as a special purpose vehicle, was legally distinct from the corporation, a lender could seize the asset even if the company sought bankruptcy protection. In other words, banks gained extra security for their loans, allowing them to make borrowing less expensive.
The problems emerged when companies like Enron realized that those separate legal entities could then be used to buy assets from the company, allowing it to book income. In essence, an ethereal marketplace had been created, with "sales" done for the benefit of the company often without a real buyer on the other side of the table. After Enron, Bankers Weigh Clients' Motives The New York Times September 19, 2003
In a document created at Citigroup as part of a presentation of the stock-backed partnership structure, one benefit is described as removing "certain items from 'plain view,' thus enhancing the appearance of balance sheet. "Among the accounting benefits the presentation document listed was "minimal footnote disclosure." But a Citigroup official said the bank had chosen not to market that structure to its clients.
The bankers who devised partnerships of this type are members of a small fraternity of creative financiers whose specialty is known on Wall Street as structured finance. They help companies finance a variety of risky ventures, like oil pipelines and Hollywood movies, off their balance sheets.
In certain industries, including entertainment and energy, off-balance-sheet partnerships are common. ENRON'S MANY STRANDS: PARTNERSHIPS; Wall Street Found Others Willing to Copy Enron's Deals The New York Times February 14, 2002
Expertise in structured finance soon became a valuable asset and those who generated large profits from it were poached with offers they could not refuse. Soon everyone was doing it and no one was looking at the social implications. The game was to make loans so that the companies could go further into debt without affecting their credit rating.
In 1998, when Donaldson, Lufkin & Jenrette wanted to become a bigger player in structured finance, it raided Citibank, hiring away a team of about 10 bankers led by Laurence J. Nath and James E. Fields. At Donaldson, which was later acquired by Credit Suisse, Mr. Nath and Mr. Fields set to work on the Marlin Water Trust, a partnership Enron wanted to create to hold its water utility assets.
The structure for that private placement borrowed from a deal Citibank had done for Enron in 1997, people close to it said. Devised by Elliott Conway, a structured finance banker at Citibank, that deal, known as Nighthawk, was financed by banks, not the sale of bonds. So it was not rated by the major credit agencies, Standard & Poor's and Moody's Investor Service. ENRON'S MANY STRANDS: PARTNERSHIPS; Wall Street Found Others Willing to Copy Enron's Deals The New York Times February 14, 2002
With multiple competing banks pushing up the ante it soon became the way things were done. Because the deals were secured using company stock the banks set trigger levels to protect themselves. Should the share price fall below a certain level the trigger would activate. This was big money.
That trigger was a feature of a $1.4 billion bond sale that Donaldson managed for the Osprey Trust, an Enron partnership, in late 1999. That transaction effectively refinanced the smaller Nighthawk deal that Citigroup had done for Enron the year before. Of the money raised, $578 million went to buy out Nighthawk's equity interest in Osprey, people close to that deal said.
In that case, the stock-price trigger was set at $28. If Enron's stock had been at $28 or less for three days when the company's debt was downgraded to junk status, the company had to supplement Osprey's assets with stock.
The stock-price triggers were set at different levels in the two Marlin partnerships for which Credit Suisse First Boston and the Deutsche Bank unit underwrote bonds. All told, the banks raised almost $4 billion for those three partnerships. ENRON'S MANY STRANDS: PARTNERSHIPS; Wall Street Found Others Willing to Copy Enron's Deals The New York Times February 14, 2
The companies saw nothing wrong in setting out to deceive investors. The arrangements had all been vetted by lawyers. They were legal and therefore acceptable.
"Enron was following the letter of the law in nearly all of its deals," said Frank Partnoy, a finance professor at University of San Diego Law School and a former derivatives trader. "It is fair to say that the most serious allegations of criminal wrongdoing at Enron had almost nothing to do with the company's collapse. Instead, it was the type of transaction that is still legal." A Higher Standard for Corporate Advice The New York Times December 23, 2002
The banks have responded that those transactions -- which critics say allowed Enron to disguise loans as trading liabilities -- properly followed accounting rules, and were the workaday product of a widely used business known as structured finance. Citigroup Is Linked to a Deal That Let Enron Skirt Rules The New York Times July 23, 2002
"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." A Warning Shot to Banks On Role in Others' Fraud The New York Times July 29, 2003
Not long ago, as Mr. Shapiro remarked in an interview yesterday, "All the people who won awards as the best chief financial officers were people who arranged transactions that removed debt from their balance sheets." Now, he added: "That is seen as bad. A year ago it was seen as good. It is a black and white difference."
But Mr. Shapiro does not think that difference will extend to court. He told analysts that Chase had no legal liability because it believed -- and still believes -- that Enron's accounting for the transactions was proper. Beautifying Balance Sheets Was Routine. Is It Now a Crime? The New York Times July 26, 2002
Deryck C. Maughan, a vice chairman who heads Citigroup's international operations, said they thought that the company's biggest Enron-related problem was that the arcane financing techniques Citigroup supplied to Enron were hard to understand and therefore looked suspicious.
"It's hard to reduce structured finance to a sound bite," Sir Deryck said, referring to the specialized area of finance that is behind much of Enron's opaque balance sheet
Gerald R. Ford, the former president, who is a special adviser to Citigroup's board and a friend of Mr. Weill, said: "I think it's a perception problem. Having served 25 years in Congress, I know what Congress does when they have a chance to exploit something that looks bad on the surface." In Two Days, Citigroup Chief Traded Halo For Headaches The New York Times July 27, 2002
The banks maintain that they engaged in no wrongdoing and that they cannot be held responsible if a client inappropriately accounted for a transaction. Underwriting Fraud The New York Times August 25, 2002
What was considered legitimate and desirable under structured finance was a long way from what had been considered legitimate, and had been enshrined in law and practice after the so called New Deal in the USA in the 1930s. The changes at that time were designed to remove conflicts of interest and to tightly control any tendency to misrepresent or deceive.
The free market philosophy saw these as obstructions to legitimate business and as unreasonably restricting market activity. These restraints were removed. Conflicts of interest were institutionalised by the creation of giant megacorps. Market theorists, working in behind closed doors think tanks, (no doubt aided by massive campaign donations and intense lobbying) won the day over common sense and the community's sense of right and wrong.
Restraints became dependant on self regulation within companies using compliance structures, and on bodies controlled and staffed by the marketplace - the fox guarding the henhouse. An article in the New York Times by Martin Mayer, author of "The Bankers" and "The Fed," addressed the issues well.
Deception is invited by "structured finance," in which a bank's loans are broken into different marketable assets -- each with its own risks, repayment schedules, accounting treatment, tax consequences, even names. Organizing these arrangements, as Citibank and J.P. Morgan Chase did for Enron, facilitates other deceptions. If an institution is both a bank lending its own resources and a broker selling its loans to the public -- and also includes an insurance company with premium income to invest -- its senior officers and its favorite clients are forever under the temptation once felt by the railway conductor who took in cash fares.
It wasn't always this way, of course. Neither the dot-com nor the telecom disasters could have occurred in a world where basic financing for small and ambitious companies had to be funneled through the lending officers of banks, who were trained to ask boring questions about how the investment of the money they lent would pay back the loan and to follow up at regular intervals.
Faith in the mantras of financial engineering bred contempt for the New Deal legislation, which was designed to ensure that publicly traded companies and the financial institutions that dealt with them would have to tell investors what and how their businesses were doing. Legal walls were built to separate functions -- to make commercial banks specialize in short-term loans and investment banks in long-term ones, to insure saving deposits and to leave equity investments at risk -- in the hopes of enforcing clarity.
As the world grew more complicated, these separations became increasingly expensive. Regulators collaborated in finding ways around the law, and eventually Congress removed major restraints that had forbidden firms to mingle apples and oranges and to move important activities "off the balance sheet." Over the counter and behind closed doors, banks and investment banks "shifted their risks" by selling complicated partnerships and derivative instruments to mutual funds, pension funds and especially insurance companies.
Most of these scandalous activities were legal, and many still are. (Loans to insiders are now prohibited.) The vice in each is that only the insiders know what is happening. The guiding principle of the New Deal legislation was that sunshine is the best disinfectant, and that's still true. Chanting the mantra that big boys can take care of themselves, Congress in the 1980's and 1990's made it possible for consenting adults to do financially awful things behind closed doors. Banking's Future Lies in its Past The New York Times August 25, 2002
The financiers also hid behind a 1994 legal ruling which protected them from prosecution if they had not themselves been part of the fraud. The judges ruling invited legislators to fix this problem, but the law makers did not do so. Even after the Enron debacle they have done little more than tinker with the law. This is not surprising when most of their campaign finance comes from corporate donors.
In the decision, handed down in Central Bank of Denver v. First Interstate Bank of Denver, the high court virtually invited Congress to rewrite securities laws if lawmakers did indeed intend for such suits to be brought. Not only did Congress decline to do so, but in 1995 it also adopted legislation making civil securities fraud suits more difficult to bring.
As a result, experts said, advisers have faced little risk in helping clients achieve the accounting results they wanted through structured finance.
"These gatekeepers were once subject to high litigation risk, but as you went through the 1990's, the deterrence that may have kept them honest just started to disappear," said John C. Coffee Jr., a professor at Columbia University Law School. "Not only had the legal risk gone down, the benefits of acquiescing to the client went up. And when costs go down and benefits go up, you're going to see the output increase." A Higher Standard for Corporate Advice The New York Times December 23, 2002
The US Securities and Exchange Commission (SEC) did not accept the judges 1994 ruling and fined the banks. They may well not have won this if contested in a court of law, but the public climate was such that the banks settled willingly.
It was a state judge who did what the legislature had failed to do. She interpreted the 1994 high court ruling more narrowly and allowed Enron creditors to sue the banks for restitution because of their complicity in the fraud which caused Enron's collapse. What will happen when this comes to trial if it is not settled first remains to be seen.
Ultimately, it has appeared that even with changes in the rules, corporate advisers could be comfortable in the knowledge that their potential liability, both criminal and civil, was limited if their financial engineering deceived investors.
Now, with Judge Harmon's ruling, the ground has shifted, and such business is potentially fraught with peril. A Higher Standard for Corporate Advice The New York Times December 23, 2002
In a decision that broke new legal ground, a federal judge in Houston ruled yesterday that banks, law firms and investment houses that helped construct Enron's off-the-books partnerships could be sued by investors seeking to regain billions of dollars they lost when the company collapsed.
The judge in the case, Melinda Harmon, ruled that the defendants could be construed as having "substantial participation" in the preparation of false statements about Enron's finances because the evidence supported claims that they acted with an intent to deceive. That was a critical element of the decision because the Supreme Court has ruled that corporate advisers cannot be held liable for "aiding and abetting" a securities fraud, only for participation in it.
For the defendants, the ruling seemed a rebuke to one of their primary lines of defense: that the financial institutions and legal firms being accused of fraud were actually engaging in the normal practices of their business, like selling a security or making an investment.
But, in unusually strong language, Judge Harmon ruled that the actions of the defendants, when viewed in their totality, could support a claim that they had crossed the line from normal business into practices undertaken with the intent to defraud.
"These transactions were not isolated, one-of-a-kind instances of violations of the statutes," Judge Harmon wrote, "but deliberate, repeated actions with shared characteristics that were part of an alleged common scheme through which defendants all profited handsomely." Ruling Leaves Most Players Exposed to Suits on Enron The New York Times December 21, 2002
Ultimately, Judge Harmon ruled that corporate advisers like Citigroup, J. P. Morgan Chase and Merrill Lynch could be deemed primary participants in a fraud if they constructed corporate transactions with the knowledge that such deals would mislead investors about the company's finances. That ruling both accepted -- then sidestepped -- the Supreme Court's 1994 holding that advisers could not be liable for "aiding and abetting" a corporation in a securities fraud. A Higher Standard for Corporate Advice The New York Times December 23, 2002
In a Nutshell
Whatever the legal fine hairs neither the facts nor the morality are in dispute, Citigroup and other banks organised and implemented a number of highly complex and devious strategies in order to allow Enron to deceive investors and defraud them.
The banks knew what the purpose of the transactions was and they connived in this. They were richly rewarded for doing so. Whether the banks marketed the structured products to Enron and others is not clear although the circumstances suggest that they did. It is also not known whether the banks assured Enron that the actual deals were legal but it is likely they did. Enron's own lawyers accepted this.
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. A Warning Shot to Banks On Role in Others' Fraud The New York Times July 29, 2003
It may well be that bankers, analysts and Enron had all turned a convenient blind eye to the issue of intention. They hid behind plausible business phrases like "balance sheet management" and "special-purpose entities". That they were deceiving others and defrauding them was clearly not a serious consideration at a senior level. One wonders if it even crossed their minds. Some staff expressed their concerns in private.
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. A Warning Shot to Banks On Role in Others' Fraud The New York Times July 29, 2003
It remains to be seen whether any of the companies will attempt to contest the issue in a court of law. The fallout for them in terms of credibility even if they succeed may be enough to deter them. If the banks win then the public may force the government to legislate effectively and this is something neither Wall Street nor the market theorists in government want to do.
The preliminary report suggested that Enron, with the help of its former auditor, Arthur Andersen, violated accounting rules by creating a series of complicated financial transactions that often treated loans as sales that pumped up Enron's reported revenue, profit and cash-flow.
The report also found that Enron viewed many of these transactions as "balance sheet management," that they were not always arms-length transactions, and that many of the company's debts were not disclosed to investors.
According to legal experts and people involved in the bankruptcy case, these findings are the latest examples of how complicated structured-finance transactions may have allowed Enron to obfuscate its financial condition and possibly defraud investors of billions of dollars.
"The examiner's report (bankruptcy court) underscores the complicity of the investment banks in Enron's collapse," said Andrew Entwistle, a lawyer who represents some of the creditors in the Enron bankruptcy case, said today. "The Wall Street banks used structure finance to aid and abet Enron's fraud."
In the report, the examiner suggested that many of the deals were a sham. He said that Enron often set up the partnership and backed it with Enron's credit to help it obtain financing. Enron then sold the partnership an asset but often retained control of the asset and essentially made interest payments back to the partnership as part of the deal. Most of the time, the examiner said, the assets were difficult to sell or did not have sufficient cash flow to cover the partnership's purchase price. Enron Examiner Raises More Questions The New York Times September 22, 2002
Examples of structured financial deals used to help Enron illustrate the problems and criminality inherent in these structured arrangements and the thinking behind them.
Some Enron frauds were remarkably complicated, masterpieces of sophisticated financial engineering. When investigators try to explain them, they produce charts that would make Rube Goldberg proud. Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
The partnership schemes engineered for Enron were simply a ruse to hide losses and report profits that were not real. The partnerships were separate companies set up by senior Enron staff and funded independently but guaranteed by Enron stock. They commenced in 1997 when Enron suffered a major loss and was short of cash.
The bankers worked with Enron to arrange the partnerships, which made the company appear more profitable than it was. Then the Wall Street firms sold big investors several billion dollars worth of bonds issued by the partnerships -- and earned tens of millions in fees.
What was unusual about these bonds is that they were backed by Enron's stock, even though the partnerships were not owned by Enron, - - - - . ENRON'S MANY STRANDS: PARTNERSHIPS; Wall Street Found Others Willing to Copy Enron's Deals The New York Times February 14, 2002
The allegations spelled out in the lawsuit describe an unusually close relationship between Enron and its financial backers, which, if true, could create enormous liability for the banks and other financial institutions in the company's collapse.
As portrayed in the lawsuit, the debacle at Enron began in 1997, when the company experienced a severe financial shock because of a $400 million loss in a British natural gas transaction and a $100 million charge relating to deals involving a fuel additive. By autumn of that year, Enron stock lost one-third of its value.
The solution was found in the partnerships, managed by Andrew S. Fastow, the company's chief financial officer. With them, Enron was able to move assets and debt off its books, and engage in rapid transactions that allowed the company to boost its reported profitability.
As a result, the complaint says, LJM2 and related partnerships served only as vehicles to accommodate the defendants in the manipulation, falsification and artificial inflation of Enron's reported financial results, while enriching the LJM2 investors. Enron Investors Say Lenders Took Part in Fraud Scheme The New York Times April 8, 2002, Monday
In the report to the bankruptcy court in New York which appointed him examiner in the case, Neal Batson detailed six transactions in which Enron created partnerships - - - .
Yet he said that between 1997 and 2001, Enron raised $1.4 billion in cash through such deals. Enron Examiner Raises More Questions The New York Times September 22, 2002
In one complicated set of transactions mentioned in the report, for instance, Enron set up a partnership called Hawaii 125-0. Enron sold the partnership some of its assets in NewPower Holdings, including common stock. Enron agreed to pay Hawaii interest and fees to hedge the stock so that Enron could book $370 million in income in 2000, about 14 percent of its profits that year. Enron Examiner Raises More Questions The New York Times September 22, 2002
Prepay schemes :: Loans hidden in sales
The banks set up companies, many of them off shore. Enron then sold them gas, oil or other products to be delivered in the distant future but for which they paid immediately. There was never any intention to actually deliver the gas. It was simply a loan arranged so that Enron could declare it as a profit instead of a debt. The company later sold the gas back to Enron so that the loan was repaid.
In the four years before Enron's bankruptcy, J. P. Morgan Chase engaged in seven prepays that lent $2.6 billion to the company, while Citigroup lent it a total of $3.8 billion over two and a half years. 2 Banks Settle Accusations They Aided in Enron Fraud The New York Times July 29, 2003
The key, according to committee investigators, was to structure transactions that appeared to be trades in which both Enron and the banks took risks and stood to make gains. The basic trade was one in which money was paid by the banks upfront in exchange for the delivery of a commodity, particularly natural gas and oil, at a future date.
But instead investigators allege that the "trades" were conducted through offshore entities controlled by the banks, and that the purpose was to funnel loans to Enron that could be disguised as trading revenues.Structural deception' by banks in Enron case Financial Times (London,England) July 24, 2002
The transactions involved a web of corporations -- several of them based in the Channel Islands -- including Mahonia and Stoneville Aegean Ltd. that at first blush seem independent but whose records show are linked companies with ties to Morgan.
The companies traded gas in a circle, with Enron both being required to deliver the commodity on a future date and being owed the same amount of gas for delivery on the same date at the same price.
The transactions involving Citigroup and Delta, which is based in the Cayman Islands, functioned in a similar way, according to a lawsuit filed by Enron shareholders. According to that suit, Citigroup used Delta to carry out $2.4 billion of financial "swaps" with Enron that "perfectly replicated loans and were, in fact, loans," but were not disclosed on Enron's books. Enron Criminal Investigation Is Said toExpand to Bankers The New York Times June 26, 2002
Technically, experts have said, such transactions -- known as prepays -- follow the requirements of the accounting rules, even if ultimately they can disguise the total debt held by a corporation. Citigroup Is Linked to a Deal That Let Enron Skirt Rules The New York Times July 23, 2002
At issue are more than $8 billion in so-called prepay deals the banks did with Enron, in which the company received money upfront in exchange for agreeing to deliver commodities at a later date. These deals involved supposedly independent third parties that the money flowed through; one entity, Mahonia, was used in deals with J. P. Morgan Chase, while an entity called Delta Energy was used in Citigroup deals.
The banks said the dealings were commonplace and conformed with proper accounting. "Prepaid forward contracts have been used for many years and are widely recognized as an entirely proper tool," Jeffrey Dellapina, a J. P. Morgan Chase managing director, said in comments echoed by Citigroup officials. Both banks also denied that they controlled Mahonia or Delta. Citigroup and Chase Defend Their Enron Roles The New York Times July 24, 2002
Other Loans became profits
The permutations on the schemes were endless which is why it took so long to unravel. Sometimes they kept it to a simpler fraud.
And then there is Project Nahanni, apparently named for a Canadian national park known for the wolves that live there. In that relatively simple deal, Enron borrowed money from Citigroup to buy Treasury bills. Within days, it sold the Treasury bills and paid the money back to Citi.
Why bother? Citigroup told Enron that it could report the $500 million it received from selling the bills as operating cash flow. It did just that, reassuring investors and credit rating agencies that its profits were genuine. Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
Many of the structured deals were arranged to minimise or avoid tax. Morgan Chase made a lot of money for Enron by doing this.
J. P. Morgan Chase engineered a complex transaction for Enron last year to allow the company to obtain hundreds of millions of dollars in tax deductions that normally would not have been permitted, people involved in the inquiry into the company's finances said yesterday.
The transaction -- known internally at J. P. Morgan as Slapshot -- was put together by the company's structured finance group. It involved entities in Nova Scotia, Quebec City and the United States and was intended to give Enron enormous financial benefits through a reduction of its tax obligation in Canada, where it owned a paper mill.
In the case of Slapshot, lawyers approved of the deal before it was executed. "The structure was reviewed with two Canadian law firms and found to be legal and appropriate under Canadian law," said Kristin Lemkau, a spokeswoman for J. P. Morgan.
Throughout the transaction, obligation after obligation was designed to cancel out. In the end, the only pieces left standing would be the interest payments from C.P.S. to Hansen of $440 million. In other words, the $375 million in original principal was converted into interest through a loan where ultimately very little real money changed hands.
The benefit to Enron was twofold. One, the $375 million in debt was moved off its balance sheet and into C.P.S. Two, it received a share of the economic benefit from the transaction through its ownership of C.P.S. This entailed yet another special-purpose entity, called Sundance, which was jointly owned by Enron and Citigroup. Morgan Set Up Deal for Enron To Cut Millions From Tax Bill The New York Times December 7, 2002
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. A Warning Shot to Banks On Role in Others' Fraud The New York Times July 29, 2003
Senator Dorgan said. "But investment banks were enabling the Enron partnerships and participating in them, and we need to understand what happened."
Dozens of Wall Street firms were involved in financing Enron's rapid rise, selling its stocks and bonds, arranging acquisitions and, later, putting together the off-the-book deals that masked Enron's true financial condition. In doing so, these firms earned tens of millions of dollars in fees and put billions of dollars of Enron securities into the market.
They helped Enron on the way up and on the way down. As Enron's downward spiral began, Wall Street firms -- among them Credit Suisse First Boston, Citigroup and Deutsche Banc Alex. Brown -- helped finance Enron's side partnerships that removed lagging assets from the company's balance sheet. In these deals, the banks arranged partnerships that allowed Enron to appear more profitable than it actually was and then sold several billions of dollars in bonds backed by Enron stock. Congress's Scrutiny Shifts to Wall Street And Its Enron Role The New York Times February 19, 2002
How Many Banks?
J. P. Morgan Chase and Citigroup were the main banks involved. Merrill Lynch & Co was also involved and it was the first to reach a settlement. There were undoubtedly many lesser players as is illustrated by the number included in investor fraud actions.
The firms named in the lawsuit are J. P. Morgan Chase, Citigroup, Credit Suisse First Boston, Canadian Imperial Bank of Commerce, Merrill Lynch, Bank of America, Barclays Bank, Deutsche Bank and Lehman Brothers.
"Instead of protecting the public from the Enron fraud, the bankers knowingly chose to become partners in deceit," said William S. Lerach, senior partner at Milberg Weiss Bershad Hynes & Lerach, the lead lawyer in the suit. "They were not only willing participants but profiteers." Enron Investors Say Lenders Took Part in Fraud Scheme The New York Times April 8, 2002, Monday
It is interesting that in the Enron scandal and the furore over structured finance the vast majority of articles refer to Citigroup rather than the specific subsidiaries involved. Citibank is hardly mentioned. When writing about the earlier transactions they don't refer to Citicorp or to Citibank and one is left to assume that the Citigroup referred to as so close to Enron in the early years was John Reed's Citicorp and Citibank. In contrast the articles on the WorldCom and other scandals all target Salomon Smith Barney (now Citigroup Global Markets) much more specifically.
Only an occasional article refers to Salomon Smith Barney but they reveal that it was undoubtedly a major player in the Enron scandal. It is the probable reason why Michael A. Carpenter, once a possible successor to Weill was fired by Weill.
Shares of Citigroup, the nation's largest financial services company, fell 25 percent in two days early last week, as senators released information and held hearings about whether bankers at Salomon and J. P. Morgan Chase helped Enron conceal debt. Shares of Citigroup have rebounded but remain down 36 percent so far this year.
Though no one questions the profitability of the investment bank, competitors and former colleagues are wondering if Mr. Carpenter did enough to track the bankers involved in the Enron and WorldCom financings. A Strategist and Cost-Cutter Seeks to Steer Citigroup Through Scandals The New York Times August 2, 2002
Having helped transform Salomon Smith Barney into a profitable investment bank, Michael A. Carpenter, left, has been trying to limit damage to Salomon and its parent, Citigroup, ever since Enron's collapse. Mr. Carpenter has faced questions about Salomon's role in financing Enron and WorldCom. BUSINESS DIGEST Trying to Steer Through Scandals The New York Times August 2, 2002
The Salomon unit is under investigation for its role in financing the failed Enron Corporation, WorldCom and several other troubled telecommunications companies. Salmon Smith Barney Chief Ousted in Citigroup Shuffle The New York Times September 9, 2002, Monday
Citigroup and Morgan Chase have been good friends to and very close to Enron from its early days. They made loans at strategic moments to protect it from takeovers, and then helped build its empire. Note that the report uses the word Citigroup for the company in the 1980s. It would have been Citicorp (Citibank) or Salomon Smith Barney at that time. The report below suggest that it was Citibank which formed the initial relationship but perhaps Salomon Smith Barney which did the structured finace later. A report I quoted earlier indicates that the first structured deals were made in 1997 by Citibank before the merger to form Citigroup. Other reports quoted later indicates these deals started in 1993 but also that Salomon Smith Barney and Carpenter were involved in some deals. The relative culpability of Salomon Smith Barney and Citibank in the structured finance and Enron scandal remains unclear
Enron's modern era dates back to the mid-1980's, and throughout that period Citigroup and J. P. Morgan Chase have been there to lend with both hands.
Both were also around in the early days of Kenneth L. Lay's tenure as Enron's chief executive: J. P. Morgan Chase helped to finance the merger that created Enron in 1985 and Citigroup helped Mr. Lay pay off a corporate raider a year later.
Citigroup's bond was forged in 1986, when it helped the company fend off Irwin Jacobs, an aggressive Minnesota investor who was accumulating a big stake in Enron stock. Another financial company, Leucadia National, had bought a smaller stake.
Enron had been formed in mid-1985 by the merger of Houston Natural Gas and InterNorth. Among the banks providing financing for the deal was one that later became part of what is now J. P. Morgan Chase.
To help pay for the shares it bought, Enron borrowed more than $100 million from Citibank, now a unit of Citigroup, and another bank. The assistance that Citibank gave Mr. Lay then formed the cornerstone of the complex relationship between Enron and Citigroup in recent times. ENRON'S COLLAPSE: LENDERS; 2 EarlyEnron Lenders Didn't See the End Coming The New York Times January 22, 2002
The banks did many billions of dollars of business for Enron and arranged many loans. They advised the company on its businesses and its deals. When Enron wanted to increase its income or remove its losses from the balance sheet the companies advised and helped them do so, making tidy profits along the way.
The benefits for the banks were obvious as well. Investigators say that Citigroup, for instance, earned about Dollars 167m between 1997 and 2001 through its work for Enron. Structural deception' by banks in Enron case Financial Times (London,England) July 24, 2002,
Major New York banks, meanwhile, engaged in circular trades with Enron that allowed the company to obtain billions of dollars in loans without disclosing them to shareholders, according to trading records and court documents. Enron Criminal Investigation Is Said toExpand to Bankers The New York Times June 26, 2002
In the six years before Enron filed for bankruptcy protection, major banks helped the company camouflage more than $8 billion in financing and increase its cash flow through deals permitting Enron to raise money without listing it as loans on financial statements, Senate investigators have found.
The panel's investigation has found that J. P. Morgan Chase, in 12 deals, did more than $3.7 billion of the questionable transactions with Enron from 1992 to 2001, and that Citigroup did 14 deals valued at $4.8 billion from 1993 to 2001. Senate Hearing Set on Enron's Bankers The New York Times July 22, 2002
Senior credit officers of Citigroup misrepresented the full nature of a 1999 transaction with Enron in the records of the deal so that the energy company could ignore accounting requirements and hide its true financial condition, according to internal bank documents and government investigators.
The records and interviews with investigators demonstrate for the first time that bankers intentionally manipulated the written record of their dealings with Enron to allow the company to improperly avoid the requirements of accounting rules and the law, thus keeping $125 million in debt off its books. Citigroup Is Linked to a Deal That Let Enron Skirt Rules The New York Times July 23, 2002
A summary of the investigation released by the committee (US government) was explicit: "Internal communications show that the financial institutions not only understood that Enron intended to engage in this deceptive accounting, they actively aided Enron in return for fees and favourable considerations in other business dealings." Structural deception' by banks in Enron case Financial Times (London,England) July 24, 2002,
Citigroup and J. P. Morgan have been accused by members of Congress and a variety of lawyers of helping Enron disguise billions of dollars worth of debt by creating special-purpose entities offshore with names like Mahonia, which was based in the Isle of Jersey in the English Channel, and Delta, based in the Cayman Islands. Senator Carl Levin, Democrat from Michigan, called the deals "phony transactions." Lawyer Proves a Thorn for Enron's Partners The New York Times September 21, 2002
Settling the Allegations
Three of the banks, Merrill Lynch, Citigroup and JP Morgan Chase settled the fraud actions taken by the SEC but without admitting fault. Investors have now targeted the companies. They are looking for US $25 billion.
Merrill Lynch & Company said yesterday that it had agreed to pay $80 million to settle a regulatory investigation into two transactions with Enron, the failed energy trader.
"We're happy we can put this behind us," a Merrill spokesman said. Merrill to Pay $80 Million to Settle Enron Inquiry The New York Times February 21, 2003
JP Morgan Chase and Citigroup agreed Monday to pay a total of nearly $300 million for their roles in Enron's manipulation of its financial statements.
JP Morgan will pay $135 million and Citigroup will pay $101 million as part of the settlement, the Securities and Exchange Commission said. The banks also agreed to pay $50 million total to the state and the city to settle a similar charges.
In addition to the federal payments, the two banks agreed to pay $50 million total to the state and the city to settle a similar investigation, the Manhattan district attorney's office announced shortly after. JP Morgan Chase, Citigroup to Pay in Enron Case Associated Press July 28, 2003
JP Morgan and Citigroup are among 11 banks and brokerages negotiating a possible settlement with Enron shareholders seeking at least $25 billion in a consolidation of lawsuits in Houston. USA: JP Morgan Chase, Citigroup to Pay in Enron Case Associated Press July 28, 2003
Reading Mr. Batson's voluminous report (for bankruptcy court) makes it clear that the banks were not "looking the other way" as Enron misled investors. They were instead dreaming up and selling financial products to allow Enron to mislead. Some of those products appeared to squirm within accounting rules, but even then the banks found themselves engaging in practices that they knew should invalidate the accounting.
It was a profitable business. As one J. P. Morgan executive put it, Enron was "enticed to pay a premium" over normal interest rates to obtain money in ways that would be, in Mr. Batson's words, "inscrutable to rating agencies, creditors and other users of Enron's financial statements." Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
I have examined the responses of the marketplace, the financiers, and the international commercial community to the Enron and other scandals on another page dealing with these issues. Denial and rationalisation is market wide. The response of Australian business to similar massive frauds is described on the main Citigroup page.
A Long History Together
The links between the banks and Enron go back a long way. "Citigroup" established its close relationship early when the company was still small making loans at critical points in order to support its founder Kenneth L. Lay. As time went on Enron brought in other banks to compete and even used strong arm tactics exerting pressure on banks to do what it wanted. It played one against the other. Until right at the end none of them had the whole picture although Citigroup was probably more aware. It took steps to protect itself by hedging its loans to Enron. To others Enron must have seemed a safe bet. Those who helped spread the risks ended by losing the money.
As it happened, the banks that aided the fraud also lost billions. They seem to have been surprised to learn that they were lied to by the very company that paid them to help deceive others. But their losses are worthy of little sympathy, considering that Enron could never have mounted such a vast fraud without the banks' help. Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
And there were dangers as well from refusing such deals. "In some cases, Enron explicitly pressured some financial institutions to participate in particular prepay transactions, as a favour and inducement for Enron to channel additional business their way," investigators said. Editorial comment: Structural deception' by banks in Enron case Financial Times (London,England) July 24, 2002,
Congressional investigators are examining a series of undisclosed deals between Enron and Citigroup that raise questions about whether the bank ignored its internal guidelines and sidestepped accounting requirements in order to satisfy an important client, according to people involved in the inquiry.
In the first deal, involving a venture between Enron and Citigroup called Sundance, investigators are examining why Citigroup allowed the deal to go forward even though risk managers and others at the bank lodged strong objections, telling Michael A. Carpenter, the former head of Citigroup's corporate and investment banking unit, that the transaction was too aggressive and put the bank at risk.
On Dec. 27, 2000, a Citigroup banker sent an e-mail message to colleagues about Bacchus (another prepay deal), stating that "we made a lot of exceptions to our standard policies, I am sure we have gone out of our way to let them know that we are bending over backwards for them. . . . let's remember to collect this i.o.u. when it really counts." Inquiry Said To Examine Citigroup Role In Enron Deal The New York Times December 9, 2002
Both Citigroup and Morgan Chase must have known that Enron was not the good investment it seemed to be. They lent Enron money in various deals but then hedged this by arrangements with insurers and others so that they carried the risk and the losses when Enron went under. Although the press commented on the arrangement critically Citigroup was not challenged in the courts. Morgan Chase was.
To protect itself, Citigroup created securities that functioned like an insurance policy. If Enron stayed healthy, buyers of the securities would receive a steady return. But if Enron ran into trouble, Citigroup would stop paying the return, keep the investors' principal and instead give them Enron debt. Now those investors are left to fight for repayment in bankruptcy proceedings.
The securities, totaling $1.4 billion, were issued from August 2000 to May 2001.
The other big lender to Enron, J. P. Morgan Chase, has put its exposure at more than $2.6 billion. J. P. Morgan Chase relied on surety bonds for some protection. Those bonds are now the subject of a legal dispute, but Citigroup's special securities appear to have provided substantial protection.
Craig Woker, a financial services analyst at Morningstar, the investment research company, said gloating would seem inappropriate after Enron's demise. But he wondered whether Citigroup had simply been extra cautious or had special information at the time.
The type of hedge used by Citigroup has become popular among financial institutions in the last decade to remove risk from their balance sheets. In the Enron case, though, Citigroup sold the securities at unusually favorable rates.
Whatever the reason for Citigroup's move, the terms of the $855 million issue were unusually good for Citigroup and poor for investors.
Thomas J. McCool, the General Accounting Office's managing director for financial markets and community investment, said this week that the rates seemed low for credit linked to a company whose rating never rose higher than Baa1. ENRON'S MANY STRANDS: A HEDGE; How Citigroup Hedged Bets On Enron The New York Times February 8, 2002
Lawmakers also gave particular scrutiny to Citigroup's efforts to sell complex securities beginning in 1999 -- deals that allowed the bank to shift some of its exposure in Enron to other investors.
Documents Citigroup helped prepare for these deals raise "questions regarding Citigroup's representation of Enron's financial condition," the Senate panel concluded. Citigroup officials said the information was properly disclosed in the financial documents. Citigroup and Chase Defend Their Enron Roles The New York Times July 24, 2002
It seems that Morgan Stanley did not do this as well as Citigroup. The insurers refused to pay claiming that they had been misinformed and deceived. Morgan Chase sued but had to compromise and settle the case. It illustrates the legal issues. If Morgan Chase had lost in this case its culpability in participating in the fraud and knowing about it would be established. Defrauded investors were looking for US $25 billion. They may well have won against the insurers on the legal technicalities but no one wanted to bring this to court and perhaps force government into legislation.
On the anniversary of Enron's bankruptcy filing, J. P. Morgan went to court yesterday to try to collect about $1 billion owed to it by 11 insurance companies that had guaranteed certain oil and gas contracts the bank had arranged with Enron.
The payments, known as prepay forward sale contracts, were made in return for promises by Enron to deliver oil and gas over several years. The insurers that guaranteed the contracts have refused to pay because, they say, the policies were obtained fraudulently.Trial Opens in J.P. Morgan's Effort To Collect Insurance on Enron Deal The New York Times December 3, 2002
J. P. Morgan Chase announced yesterday that it would receive about $580 million from insurance companies as part of a settlement resolving one of the most contentious disputes touched off by Enron's collapse.
The settlement is a partial victory for J. P. Morgan, which had sought nearly $1 billion from the insurers and will take a charge of about $400 million to cover the difference. MORGAN RESOLVES DISPUTE ON ENRON The New York Times January 3, 2003
We see exactly the same problem that we saw with WorldCom and other DotCom companies. Analysts employed by the investments banks doing or wanting to do business with Enron maintained a positive outlook and a buy recommendation right to the end - until the company went bankrupt. Citigroup was one of them. It was more difficult to fault them on this because the bankruptcy came more rapidly. One analyst received one of Gretchen Morgenson's "Better off unawarded" awards
THE OFTEN WRONG BUT NEVER IN DOUBT AWARD -- To Ron Barone, the research analyst at UBS Warburg who covered Enron, or perhaps more accurately, who through it all was one of Enron's loudest apologists. - - - - A believer until the bitter end, Mr. Barone waited until Nov. 28, when Enron's shares had more value as wallpaper than as stock, to replace his "strong buy" label on the stock with a "hold." A Roster Of Awards Better Off Unawarded The New York Times December 30, 2001
Almost every major investment bank was still touting Enron's stock long after it had begun to slide toward zero. Hundreds of investment bankers now hope that one casualty will be the relatively new concept of the all-in-one American financial firm. Wall Street; Assessing the Role Of the Financiers The New York Times December 2, 2001
Enron's collapse has focused new attention on the Wall Street analysts, whose judgments about stocks are widely assumed to be driven as much by a desire to help their firms win investment banking business from the companies they follow as to give investors sound guidance.
Analysts at firms like Goldman Sachs, Lehman Brothers, Salomon Smith Barney and UBS Warburg recommended the stock to investors well into the fall, after Enron's problems started to become public. ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002
In the months before it collapsed, the company received almost uniform buy ratings.
Analysts who help their firms win banking work are more valuable than those who do not, and Wall Street always finds a way to reward its most valuable performers. ENRON'S MANY STRANDS:THE HEARINGS; Washington Wants Wall St. Changes. But How? The New York Times February 28, 2002
The problem, Mr. Schilit said, is that analysts who question the value of a popular company are branded as controversial. "If you want to move up the hierarchy of the Wall Street establishment, you don't rock the boat," he said. ENRON'S MANY STRANDS: THE OVERVIEW; WALL ST. ANALYSTS FAULTED ON ENRON The New York Times February 28, 2002
There is an interesting twist to the failure of analysts with Enron. The investments banks were actively involved in arranging the fraud so they had some idea how bad Enron's position was and how close to bankruptcy. In the DotCom scam we noted how barriers which should have kept information confidential were ignored when it was in Citigroup's interest to pass information around.
When the analysts reporting on Enron were brought before government committees they claimed that they did not have this information because the company behaved appropriately and did not share it. Congressmen could only note how much it would have cost the banks if analysts had reported adversely.
These Congressional inquiries, still in their early stages, will examine the way Wall Street firms structured and sold Enron's limited partnerships. They also will look into the reasons Wall Street firms were issuing recommendations to buy Enron stock while they had detailed information about Enron's poor financial condition.
Among the questions to be explored is whether Wall Street firms urged investors to buy Enron shares in order to protect their relationships with Enron. Others will ask why some investment banks had an accurate picture of Enron's poor financial health but did not share it with their own customers. Congress's Scrutiny Shifts to Wall Street And Its Enron Role The New York Times February 19, 2002
A committee aide said that analysts from J. P. Morgan Chase, Lehman Brothers, Credit Suisse First Boston and Citigroup would be among those expected to testify. Enron Is Said to Be Negotiating With Andersen The New York Times February 23, 2002
Another senator, Jim Bunning, a Republican from Kentucky, said he was incredulous that the analysts said they had not been aware of what investments their firms owned in the companies they researched. ENRON'S MANY STRANDS: THE OVERVIEW; WALL ST. ANALYSTS FAULTED ON ENRON The New York Times February 28, 2002
It is also all but certain to lead to charges of wrongdoing by Enron's directors and officers, as well as its outside auditor, lawyers said. ENRON'S COLLAPSE: THE LAWYERS; And the Winners in the Case Are . . The New York Times December 4, 2001
The giant accounting firm, Arthur Andersen's life was on the line. It had an extremely poor track record. It had been caught up in a number of other frauds and penalised on previous occasions. It had bitterly fought The SEC when it had tried to regulate accounting practices. It had not fired the staff involved after a previous fraud.
Both companies (two previous bankruptcies) used Arthur Andersen as their outside auditor, and in each case investors accused the firm of helping to cover up financial fraud. Andersen paid $110 million to settle lawsuits by Sunbeam shareholders and $7 million to settle claims brought by the S.E.C.; the firm confirmed last week that it had received S.E.C. subpoenas in the agency's Enron investigation. ENRON'S COLLAPSE: THE LAWYERS; Andthe Winners in the Case Are . . The New York Times December 4, 2001
And considerable ill will grew between the commission and the industry when the Levitt S.E.C. pushed for restrictions on consulting services that accounting firms could provide to their auditing clients. Andersen was one of the three firms that bitterly fought the rules, though it played a role in eventually working out a settlement.
Unfortunately for Andersen, the last major auditing scandal, in the eyes of regulators, was one that involved the same firm. When Andersen settled charges filed by the S.E.C. in the Waste Management case last year, it became the first large accounting firm in decades to face a civil fraud accusation by the S.E.C.
Andersen appeared to survive the Waste Management case very well. But government officials took note of the fact that even some accountants who were penalized by the S.E.C. in that case were allowed to keep their jobs, and that there was no sign of internal reform by the firm. Andersen may have learned from that case that scandals could be endured; regulators may have learned that Andersen could not be trusted to reform itself.
It was with those divergent views that Andersen leaders and Justice Department officials met in this case. The result was an indictment that Andersen could not believe would come -- and that may help put the firm out of business. Lessons For Andersen From Scandal At Salomon The New York Times March 18, 2002
Andersens was very much part of the Enron fraud as it had both helped with some accounting and also acted as external auditor. Like HealthSouth and Ernst & Young, Enron had employed past Andersen staff. Andersen knew what Enron was doing and went along with its accounting. It had signed off on these accounts and they did not stand up to scrutiny.
Moreover, Enron turned over to Andersen some responsibility for its internal bookkeeping, blurring a fundamental division of responsibilities that companies employ to assure the honesty and completeness of their financial figures. Further obscuring the line between an independent auditor and corporate management, many of Enron's financial executives had moved there from Andersen. ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002
Worst of all when the scandal broke and investigations started Andersen illegally set out to destroy vast quantities of presumably incriminating documents and were caught. Andersens had to wear a criminal plea and that put it out of business.
Accountants make large amounts of money from the companies they work with. Auditing the books is only one of these. Whether Arthur Andersen's handling of their responsibilities in this situation is representative can be debated. Other accounting firms have also signed off on fraudulent accounts then claimed that the fraud was undetectable. Ernst and Young did this for HealthSouth.
Mr. Johnson (spokesperson for Congressional Committee) said that the Andersen memo about Ms. Watkins's concerns suggested that the firm was well aware that Enron's accounting was suspect long before the company had disclosed its problems.
"It's clear now to us that key players at both Enron and Andersen knew of the problems months before the company imploded," Mr. Johnson said. ENRON'S COLLAPSE: THE OVERVIEW; AUDITOR RECEIVED WARNING ON ENRON FIVE MONTHS AGO The New York Times January 17, 2002
David B. Duncan, the Arthur Andersen accountant whose destruction of records related to Enron led to a criminal indictment of the firm, has agreed to plead guilty to obstruction of justice and serve as a government witness, people involved in the case said yesterday.
With Mr. Duncan's agreement to cooperate, the government now has its highest-ranking and most knowledgeable witness to the financial decisions that ultimately pushed Enron into filing for bankruptcy protection.
Notes from one meeting showed that Mr. Duncan specifically mentioned the S.E.C. inquiry. In the three days that followed, records contained in 26 trunks and 24 smaller boxes were shredded at Andersen, a huge increase over the amount destroyed in previous weeks. At the same time, huge numbers of e-mail messages were deleted.
The effort at document destruction spread beyond Houston. Calls went from that office to London and to Portland, Ore., both of which had done work on the Enron account. In response to the instructions from the Houston auditors, documents were shredded and e-mail messages were deleted.
Senior Andersen executives learned of the shredding weeks later, when lawyers for the firm discovered that laptop computers in Houston had been virtually wiped clean of e-mail messages. The lawyers investigated further and discovered the shredding. Andersen alerted the government to what the lawyers had discovered and dismissed Mr. Duncan.
For weeks, the firm hoped that its decision to report the wrongdoing would save it from prosecution, but government officials concluded that Andersen -- which had been the accountant for several entities in recent years that were undone by fraud -- had a track record that required a criminal charge. GUILTY PLEA SEEN IN THE SHREDDING OF ENRON RECORDS The New York Times April 9, 2002
At various times issues were referred to lawyers to see whether they were legal. These lawyers had ticked off on the original transactions but not ticked off on the issue of intention.
When people within Andersen and Enron expressed concern about what was happening with the partnership arrangements, the matter was referred to lawyers who did business with the firm. They did not pick up on the fraud and accepted the transactions as legal.
Enron was the largest client of Vinson & Elkins, one of the largest law firms in Houston.
The ties between the firm and its client were close. James V. Derrick Jr., the executive vice president and general counsel of Enron, joined the company from the firm. As Enron grew bigger and more sophisticated, the firm's billings rose substantially.
The firm gave advice to Enron about the partnerships the company was setting up as it remade itself into a trading company in the late 1990's. It was asked by Enron to review those partnerships after Mr. Lay received a letter from a senior Enron executive, Sherron S. Watkins, raising questions about the company's financial structure.
When the firm reported back to Enron in October, it concluded that the issues raised by Ms. Watkins "do not, in our judgment, warrant a further widespread investigation by independent counsel and auditors." ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002
Something is wrong with the corporate lawyers, too. After Enron began to fall apart, Houston-based Vinson & Elkins accepted an assignment to put its approval on off-the-books deals it helped set up, and, worse, agreed not to ask questions about egregious, see-no-evil accounting. The lawyers replaced their shingle with a doormat -- but have you heard a disapproving peep from any bar association? ' You Wuz Robbed!' The New York Times February 11, 2002
The expanded lawsuit, due in Federal District Court in Houston, also names two law firms, Vinson & Elkins and Kirkland & Ellis, accusing them of complicity in the frauds. Vinson was Enron's chief law firm, and was involved on behalf of the company in the partnership dealings that ultimately played the critical role in its downfall. Enron Investors Say Lenders Took Part in Fraud Scheme The New York Times April 8, 2002, Monday
Whom can the country turn to for an honest investigation? Democrats and Republicans alike are so beholden to accounting-industry money that they scuttled an attempt by Arthur Levitt, the former S.E.C. head, to regulate conflicts of interest in companies like Andersen two years ago The United States of Enron The New York Times January 19, 2002
While these comments and this material describes the US situation it is clear that Australia is steadily moving in the same direction.
Wherever we look when examining the giant companies we see strong political influence and political power. Every one of the giant health and aged care companies has sought influence at state and federal levels, usually successfully. Political donations and lobbying are as much tools of the trade as scalpels and bandages. They are productive enterprises. Many millions of dollars have been spent by aged care chains (eg Florida), and HMOs to block pressures from the community (eg Patient Bill of Rights) or promote legislation they support (eg President Bush's Medicare package).
Corporations have manipulated the perceptions of the community, most famously in the Harry and Louis advertisements used to defeat president Clinton's health care package. Vast sums are spent on marketing ideas and image. The most effective corporate strategy has been to form and fund "front" community groups that vigorously support corporate views and so create the illusion of a ground roots movement coming from the community. The giant pharmaceutical companies have been particularly adept at this.
Many believe that this corporate power is the reason why there have been no realistic changes to the US health system and why even a massive community revolt like that which occurred with managed care has resulted in only token responses.
If we look at the campaign donations made to politicians and the way in which money influences campaigning and election results then it becomes obvious that no more than a minority of those who genuinely oppose the corporate position will be elected.
The companies involved in the Enron fraud are good examples of the way the political process is appropriated for corporate purposes.
Some studies indicate that the majority of political candidates come from what some authors classify as the "corporate class". Corpwatch which tracks corporate conduct publishes this sort of information on its web site. Democracy in the USA has increasingly become an abstraction, an illusion, and a slogan, but with less and less grounding in the real world people live in.
It (the Grubman/Weill nursery school drama) reinforces his thesis, he said, that Americans don't practice democracy as often as they preach it.
The idea of democracy is just that, Mr. Homberger (author who writes about America and New York) said -- a lovely but impractical theory.
"The whole democratic ideal, the idea that you thrive on merit alone, is part of the American mythology, but it is not the way people conduct themselves." Doing Unto Others in a Big Way The New York Times November 24, 2002
Then there is the lobbying where past politicians are paid vast sums in return for their influence in the corridors of power. The corporate position is always put up front while community groups vainly struggle to get their views heard.
Donations Backfire for Enron
In the Enron fraud the large political donations backfired. Large donations from Enron and Arthur Andersen were a political millstone, paraded in the media. Politicians who had received large donations fell over themselves in the rush to condemn Enron, demonstrate that they were not influenced by donations and show their determination to punish those responsible. With so much corporate support at stake these were largely empty promises.
The largest Congressional recipient of Andersen donations has been Representative Billy Tauzin, the Louisiana Republican who heads the House Energy and Commerce Committee, one of the 10 Congressional committees examining Enron's collapse. He has received $57,000 from Andersen in the last decade. ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
The final punishments were a whimper, and the legislative changes were simply to patch over the obvious cracks. The hoped for breaking up of the giant financial services companies to remove conflicts of interest and reduce the pressures towards dysfunctional conduct never eventuated. The ideological model remained unchallenged.
Enron donated generously to both political parties but with more to the republicans. It employed lobbyists to put its position. Arthur Andersen, other accounting firms and the banks, particularly Citigroup were never far behind, and sometimes in front.
Enron had close links with the Clinton administration and was a recipient of government largesse in the form of loans and political assistance during this period.
Enron's chairman Kenneth Lay was an associate and friend of Bush and Cheney. He had supported Bush during the election and was one of the privileged who got special treatment because of the size of his donation. After the fraud was exposed Bush was so embarrassed that he stupidly denied this relationship, a relationship easily confirmed.
Political Links and Donations
Though the Bush administration has been in office only a year, Enron's oily fingerprints are all over its actions as well as its resumes and stock portfolios. Mr. Lay helped hand-pick the head of the government agency in charge of regulating his own business and stood to gain a $254 million corporate tax rebate in the administration-blessed stimulus bill (despite the fact that Enron used almost 900 offshore "subsidiaries" to avoid paying any income taxes at all in four of the last five years).
The Clinton Democrats had eight years of Enron exposure, and while never receiving remotely the sums that the Republicans did, nonetheless had their own contacts (and presidential golf outing) with Mr. Lay
Then again, who in either party hasn't cashed an Enron check? No fewer than 71 senators and 188 congressmen have been on the Enron gravy train. All but 5 of the 56 members of another investigative committee, House Energy and Commerce, got Enron or Arthur Andersen dough. The United States of Enron The New York Times January 19, 2002
Enron was not shy in making its views known on Capitol Hill, at the White House and among the regulatory agencies -- or in spreading campaign contributions around to Republicans and Democrats alike to ensure it would get a hearing. Since 1989, Enron has given $5.95 million to the two parties, with 74 percent going to Republicans, according to figures compiled by the Center for Responsive Politics, a watchdog group. .
"But if you look back over the last five years, what they did get was no oversight." ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002
Republicans complain that Mr. Lieberman should recuse himself because his former chief of staff, Michael Lewan, was a lobbyist for Enron.
The bipartisan criticism of Mr. Lieberman reflects how deeply Enron, its campaign money and its deregulatory agenda have become imbedded in Washington's money culture these last dozen years.
Enron has given more than $700,000 to Mr. Bush since 1993; no company has given him more. In addition, Enron's chairman, Kenneth L. Lay, was one of the "pioneers," raising more than $100,000 for Mr. Bush's campaign, and he and his wife gave a total of $10,000 to Mr. Bush's Florida recount fund. Enron and Mr. Lay also contributed a total of $200,000 to Mr. Bush's inaugural festivities.
The Enron dealings of Senator Phil Gramm, Republican of Texas, and his wife, Dr. Wendy Gramm, a member of the Enron's board of directors and former head of the Commodities Futures Trading Commission, have also drawn scrutiny because of their involvement in regulatory issues affecting Enron. ENRON'S COLLAPSE: THE POLITICIANS; Enron Spread Contributions on Both Sides of the Aisle The New York Times January 21, 2002
Nearby, in the exclusive "Pioneers" box on the parade route, Ken Lay watched the festivities. He was there amidst an elite group of about 200 men and women who had each raised $100,000 for Mr. Bush's campaign. Nearby, other Enron executives watched the parade from the elegant Willard hotel and office complex, two blocks from the White House, where the company's law firm, Vinson & Elkins, has its Washington office.
It had been a weekend to savor. Enron and its top two executives had kicked in $300,000 for the inauguration, and the company was one of the few to donate $50,000 for the Texas State Society's 2001 Black Tie and Boots Inaugural Ball, where Mr. Bush and the first lady stopped by to salute their Texan friends, including Mr. Lay.
The day after the inauguration, Mr. Lay attended a private luncheon at the White House, where he was able to spend a few minutes with the new president, a luncheon guest said. That night, Enron hosted a private dinner for several congressmen.---------.
Enron's sharp elbows had already been noticed in Washington. Curtis L. Hebert Jr., then chairman of the Federal Energy Regulatory Commission, had gotten a call from Mr. Lay early in the year. As Mr. Hebert recalled the incident, Mr. Lay said that Enron would continue to support him in his new job if he dropped his reservations about electricity deregulation. Mr. Hebert said he had refused. ENRON'S MANY STRANDS: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within The New York Times February 10, 2002
Note that Geoffrey Barbakow, the CEO who orchestrated the 2002 debacle at Tenet Healthcare was also one of Bush's pioneers. He too resigned in a cloud of controversy.
Enron like almost all of giant corporations and health care groups employed lobbyists to keep its views and its interests constantly in front of politicians.
Enron also hired as lobbyists two influential members of Mr. DeLay's inner circle, Ed Buckham and Karl Gallant. And Enron and Mr. Lay were also contributors to the Republican Majority Issues Committee, a group close to Mr. DeLay. ENRON'S COLLAPSE: THE POLITICIANS; Enron Spread Contributions on Both Sides of the Aisle The New York Times January 21, 2002
Enron was not alone in its contributions. It auditor, its lawyers and its financial partners were all making their mark on the political process.
Critics have also pointed out that Citigroup, Enron's largest lender, is Mr. Lieberman's top donor, giving his campaigns $112,000 since 1997, campaign records show. A longtime Republican strategist put it this way, "Lieberman's problem is simple -- Enron's biggest creditor is his campaign's biggest contributor." .
Enron, Arthur Andersen and Vinson & Elkins, a Houston law firm, are among the most generous contributors to Mr. Bush's 2000 presidential campaign. ENRON'S COLLAPSE: THE POLITICIANS; Enron Spread Contributions on Both Sides of the Aisle The New York Times January 21, 2002
Yet taking on Wall Street is not an easy matter. Not only has Wall Street been a leading campaign contributor, but it supports a powerful lobbying force with considerable influence. Congress's Scrutiny Shifts to Wall Street And Its Enron Role The New York Times February 19, 2002
It is not surprising then that despite all the rhetoric and the aggressive posturing very little happens at the end of the day. Only one multiple offender is put out of business, the others pay a fine which sounds large but is only a fraction of their annual profit, and none of the key players goes to prison. There is no effective legislative response.
One might expect Congress to change the bankruptcy law to make it crystal clear that banks with dirty hands should not prosper when a company they aided in fraud goes under. Instead, the bankruptcy bill now being pushed through Congress goes out of its way to help the banks. Bankrupt Thinking: How the Banks Aided Enron's Deception New York Times August 1, 2003
Arthur Andersen and Political Influence
The profession has succeeded in fighting off tougher regulation over the decades, but it reached its apex in political power only in the last few years, a reflection of the industry's mushrooming campaign contributions and increased lobbying. ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
The most revealing story about political power and financial interests is that of the five big accounting firms including Arthur Andersen.
Arthur Andersen may have had reason to view Enron through a flattering lens, - - - - . At the same time that it was acting as Enron's auditor, it was seeking and getting lucrative consulting work from Enron, mirroring a trend among the five big accounting firms.
Andersen was also successfully lobbying against the Securities and Exchange Commission's effort two years ago to limit just that type of dual role; some regulators felt it created a conflict of interest by raising questions about whether an auditor would challenge the management of a company from which it sought more business. ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002
Over the years they have resisted attempts to reign them in and reduce the conflicts of interest to which they were exposed. During the Clinton administration Arthur Levitt who was chairman of the US Securities and Exchange Commission pressed strongly for tighter regulation of the accounting industry. He was put under extreme pressure by politicians who had been lobbied by the accountants. He failed in his attempt.
When Arthur Levitt Jr., then chairman of the Securities and Exchange Commission, tried to impose tough conflict-of-interest rules on the accounting industry two years ago, he was hit by a barrage of high-powered lobbying, including calls from 10 or 11 senators. The senators, whom he did not identify, warned that if he did not relent on the new regulations, the agency's appropriations could be cut, he said.
Mr. Levitt said the calls reflected the political influence of the industry, which ultimately succeeded in weakening his proposals to reduce the potential conflicts of interests at accounting firms.
"I have never been subjected to a more intensive and venal lobbying campaign," said Mr. Levitt, who led the S.E.C. for almost eight years, - - - - .
Among other proposals, Mr. Levitt sought to prohibit an accounting firm from performing both accounting functions and consulting services for the same company. That proposal threatened billions of dollars in revenues at the Big Five firms, and their defeat of the proposals in 2000 illustrated the industry's growing influence in Washington. Had the Levitt proposals been in place, it would not have been possible for Andersen to bill Enron $27 million for consulting services last year while also billing $25 million for audits.
The industry has contributed more than $53 million since 1990 to congressional and presidential candidates. More than $14 million of those contributions came in 2000, putting accountants in the same category of more established big donors like telephone companies, higher education and the building trade unions.
Moreover, 94 current senators and more than half the current members of the House have received some campaign donations from Andersen since 1989, according to a study for the Center for Responsive Politics, a nonpartisan group that studies the influence of money in politics. ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
When Mr Bush became president Levitt was replaced by Harvey Pitt, an Arthur Andersen lawyer. The response of the SEC to the frauds over the last few years has been under-whelming. It was Mr Spitzer, the attorney general in New York who picked up the ball and set the pace. Mr Pitt and the SEC were embarrassed into a game of catch up and eventually secured settlements and a criminal plea from Andersen. The reports in the New York Times expose the situation. Pitt has been replaced by Donaldson.
Harvey Pitt, the Bush administration's chief at the S.E.C., was actually an Arthur Andersen lawyer. The United States of Enron The New York Times January 19, 2002
L. Pitt, a securities lawyer, once represented all five major accounting firms as well as the American Institute of Certified Public Accountants before he took over at the S.E.C. last summer.
On Thursday, Mr. Pitt announced plans to create a group dominated by experts from outside the accounting industry to discipline unethical accountants. That role is now filled by an industry group. Unlike Mr. Levitt, Mr. Pitt said that it was unnecessary to adopt any rules that would restrict accounting firms from performing multiple services for clients.
At the height of the fight between the industry and Mr. Levitt in the second half of 2000, all the Big Five accounting firms sharply increased their political donations and spending on lobbying. Andersen doubled its lobbying budget, to $1.6 million. The investment paid off. ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
Following the revelation about Arthur Andersen, accountants were once again threatened by restrictions and doubled their efforts. President Bush rose to the occasion by appointing two more accountants to the SEC's five man committee, one from Ernst & Young. Ernst & Young was the accounting firm that looked past HealthSouth's accounting fraud.
The accounting firms, including Andersen, are hiring teams of lobbyists -- former senior aides to lawmakers and presidents, both Republican and Democrat -- as well as using their own formidable staffs. While there is talk in Washington of significant oversight and toughened enforcement, Congressional aides and some experts say it will not happen, at least not without changes in campaign finance rules, because of the industry's political muscle.
The profession's growing influence is perhaps most apparent at the S.E.C. Last month, President Bush said he would nominate partners from two of the Big Five accounting firms, PricewaterhouseCoopers and Ernst & Young, to two vacancies on the five-member commission.
Of the 20 largest contributors to President Bush's 2000 campaign, three accounting firms -- including Andersen -- gave more money than Enron. All Big Five accounting firms were among the campaign's top 20 contributors.
During the last presidential election, Andersen was the fifth-largest contributor to Mr. Bush's campaign, giving more than $145,000 through its employees and political action committee, according to the Center for Responsive Politics. The fourth-largest was Ernst & Young, which gave more than $179,000; PricewaterhouseCoopers was eighth, contributing more than $127,000.
Enron, by contrast, gave about $113,800. Andersen also organized a big Bush campaign fund-raiser. ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
Those who have studied the political system and the fate of past attempts to do something about the out of control markets are not optimistic about progress.
"It's just whimsical," said James D. Cox, a law professor at Duke University who has written a textbook on accounting and legal issues. "There will be a lot of posturing about how bad Enron and Andersen are. But at the end of the day, if we can't get campaign finance reform, it's hard to believe we get tighter standards. These are two very related issues." ENRON'S COLLAPSE: THE LOBBYING; Auditing Firms Exercise Power In Washington The New York Times January 19, 2002
After all, if there's one thing the Enron debacle has already taught the nation, it's the chaos that can result from underregulation. Making Political Sense of the Committees Making Sense of Enron The New York Times February 11, 2002
I have dealt with the ideological problems and the legislative changes which predisposed to the DotCom scandal and made it possible. Exactly these same factors created conflicts of interest and set the scene for the Enron debacle. There were some additional factors.
Heavily influenced by the giant corporations, that regulations were designed to control, law makers persuaded by market theorists, progressively dismantled legislation. Oversight was delegated to the industry. At the same time the belief in markets increased competitive pressures so intensifying the tensions between social responsibility and corporate wealth. Serious problems and oversight failure were inevitable. As in health care the increased costs of oversight (e.g.by the SEC) were not funded and the regulatory system fell down.
Competitors and critics have pointed to the roles played by Citigroup and J. P. Morgan as evidence that legislation passed two years ago, allowing commercial and investment banks to combine, was a bad idea. Though the odds of any reversal are very slim, a question is being asked anew: Can banks that are on the hook for huge sums to a corporation provide unbiased advice? Wall Street; Assessing the Role Of the Financiers The New York Times December 2, 2001
Mr. Torres added that conflicts were likely to continue growing in the aftermath of the repeal three years ago of the Glass-Steagall Act, a move that has allowed mergers of banks, Wall Street firms and insurers. ENRON'S MANY STRANDS: THE OVERVIEW; WALL ST. ANALYSTS FAULTED ON ENRON The New York Times February 28, 2002
These corporate scandals raise serious regulatory issues for the banking industry. - - - - - but now the Bush administration and Congress must determine whether remedial regulations are needed in light of the recent scandals. Underwriting Fraud The New York Times August 25, 2002
The system of safeguards that was put in place over the years to protect investors and employees from a catastrophic corporate implosion largely failed to detect or address the problems that felled the Enron Corporation, say regulators, investors, business executives and scholars.
In Enron's case, the questions extend to the political influence wielded by the company. But increasingly the focus has turned to the entire framework of legislation, regulation and self-governance in which it operated.
"This was a massive failure in the governance system," said Robert E. Litan, director of economic studies at the Brookings Institution, the research organization. "You can look at the system as a series of concentric circles, from management to directors and the audit committee to regulators and analysts and so forth. This was like a nuclear meltdown where the core melted through all the layers." .
The lack of scrutiny by the energy regulatory commission was one reason that William A. Rainier, the chairman of the Commodity Futures Trading Commission, told Congress in 2000 that he was "deeply concerned" about a bill that would exempt energy trading from his commission's review because dealers in energy derivatives had no other regulator. His objections were largely ignored, and the exemption, heavily backed by Enron, became law.
The 2000 law built on a 1993 ruling by the futures commission that exempted energy trades. The chairwoman at the time was Wendy L. Gramm. Soon after she left the commission, Ms. Gramm became a well-paid director of Enron.
Because Enron was publicly traded, its financial reports were subject to scrutiny by the Securities and Exchange Commission, at least in theory. In practice, the commission has enough staff to review corporate reports only on a limited basis, and Enron's have not gotten a thorough vetting by the commission at least since 1997, people familiar with the commission's work said. ENRON'S COLLAPSE: THE SYSTEM; Web of Safeguards Failed as Enron Fell The New York Times January 20, 2002