Page 5 of 5 CREDIT
BUST BYPASSES BANKS Part 1: The
rise of the non-bank financial
system By Henry C K Liu
20 months since Enron
declared bankruptcy in December 2003. The various
defendants and respondents include three major
financial institutions, Enron's former chief
financial officer, and eight other former senior
Enron executives. The SEC garnered a pathetic $324
million for the "benefit" of the victims of the
Enron fraud.
Despite the banks' denials of
any wrongdoing, many investors say
the
banks had or should have had knowledge about the
true state of Enron's finances.
Enron's
use of pre-pays arranged by banks was so extensive
that accounting firm Arthur Andersen created
guidelines that it gave to banks about what was
needed for these structures to appear on Enron's
books as trades rather than debt. "For pre-pays to
be treated as trading contracts, the following
attributes must exist," the brochure said, citing,
among other things, that "the purchaser of the gas
must have an ordinary reason for purchasing the
gas". A Houston federal jury convicted Arthur
Andersen in June 2003 of obstructing justice after
the government accused the firm of destroying
documents related to Enron.
An array of
executives, lawyers, bankers and institutions were
formally named in an amended class-action
complaint for their alleged role in the Enron
scandal. Lawyers for the Regents of the University
of California, the court-appointed lead plaintiff
in the case, said the defendants "pocketed
billions of dollars" while Enron investors were
being defrauded. Among those on the list were:
Andersen, Enron auditor; Enron's banks, including
JPMorgan Chase and Citigroup; and Enron's lawyers,
including Vinson & Elkins. Enron board members
such as Wendy Gramm, wife of the influential
Republican senator Phil Gramm, were also named.
Wendy Gramm, an economist who had called
for deregulation of the energy industry, headed
the Commodity Futures Trading Commission (CFTC)
from 1988 to 1993. After a heavy lobbying campaign
from Enron, the CFTC exempted it from regulation
in trading of energy derivatives. Subsequently,
Gramm resigned from the CFTC and took a seat on
the Enron board of directors, where she was paid
$1.85 million.
This lack of CFTC oversight
contributed to Enron's accounting irregularities,
and the failure of the hedge fund Amaranth
Advisors from losses resulting from betting on the
wrong side of natural-gas prices last September.
The fall of Andersen Arthur
Andersen, Enron's auditor, with 2001 revenue of
$9.4 billion, offered to settle its part in the
case for $300 million, reduced from its initial
$750 million offer and indicative of its dire
financial circumstances brought on by deserting
clients and disintegrating worldwide structure.
But it failed to cut a deal in time to be removed
from the suit.
Joseph Berardino,
Andersen's chief executive, who resigned over the
issues, was named a defendant. Andersen was
convicted on June 15, 2002, of obstruction of
justice for shredding documents related to its
audit of Enron. Since the SEC does not allow
convicted felons to audit public companies, the
firm agreed to surrender its licenses and its
right to practice before the SEC on August 31,
2002. This in effect ended the company's
operations.
The Andersen indictment also
put a spotlight on its faulty audits of other
companies, most notably Sunbeam, Waste Management
and WorldCom.
Sunbeam, a
household-appliances manufacturer, acquired three
other companies: Coleman, Signature Brands and
First Alert with $1.7 billion of debt, which it
cited in a court filing as leading to the
bankruptcy.
In the late 1990s, Sunbeam CEO
Al Dunlap used accounting tricks to paint a
picture of a turnaround in earnings that didn't
exist. With a pay package that included more than
7 million shares and options, Dunlap stood to make
more than $200 million personally if he could keep
Sunbeam's stock price flying. In the spring of
1998, when Dunlap and his team ran out of tricks,
Sunbeam corrected its books, it declared
bankruptcy on February 6, 2001, and the stock
price plunged from $53 at its peak to just
pennies.
In an ominous harbinger of the
Enron scandal, the SEC discovered that Andersen
accounting documents had been destroyed. In 2001,
Andersen paid $110 million to settle (without
admitting legal responsibility) a class-action
suit by shareholders of Sunbeam over wildly
"mis-stated" corporate financial statements in the
1990s.
In the case of Waste Management -
which in 1998 issued the largest corporate
restatement before Enron - the company had
exaggerated its earnings by $1.7 billion. The
SEC's investigation found a long-running cover-up
- not just by Waste Management, but by Andersen as
well.
Andersen and Waste Management paid a
steep price in stockholder settlements, but no one
went to jail. The SEC fined Andersen $7 million in
June 2001, and Andersen promised to shore up its
internal oversight - but by then it was already
deeply enmeshed in new trouble at Enron.
The bankruptcy of WorldCom on July 22,
2002, came one month after it revealed that it had
improperly booked $3.8 billion in expenses.
WorldCom surpassed Enron as the biggest bankruptcy
in history, which led to a domino effect of
accounting and other corporate scandals that
continue to tarnish US business practices.
WorldCom, with $107 billion in assets,
collapsed under its $41 billion debt load. Its
bankruptcy dwarfed that of Enron, which listed
$63.4 billion in assets when it filed a year
earlier. Immediately upon filling for bankruptcy
protection, WorldCom lined up $2 billion in
debtor-in-possession financing from Citigroup,
JPMorgan and GE Capital that would allow it to
operate while in bankruptcy.
The WorldCom
bankruptcy was precipitated by the revelation on
June 25, 2002, that it had incorrectly accounted
for $3.8 billion in operating expenses. The
admission cast WorldCom into the top tier of
scandal-ridden companies alongside Tyco
International, Global Crossing, Adelphia
Communications and Enron.
On May 31, 2005,
the US Supreme Court unanimously overturned
Andersen's conviction on the ground of serious
flaws in jury instructions. In the court's view,
the instructions allowed the jury to convict
Andersen without proving that the firm knew it had
broken the law or that there had been a link to
any official proceeding that prohibited the
destruction of documents.
The opinion,
written by the late chief justice William
Rehnquist, was also highly skeptical of the
government's concept of "corrupt persuasion" -
persuading someone to engage in an act with an
improper purpose even without knowing an act is
unlawful. The Supreme Court was in effect saying
that common-sense unethical business behavior can
be technically legal. The court seemed to view
Andersen's destruction of incriminating documents
as merely an attempt to manage public relations,
in opposition to the lower court's view of
criminal obstruction of justice.
Conduits dispersed The problem
for the banks now is exacerbated when asset-backed
commercial paper conduits are no longer issued by
one issuer and sold to one investor. ABCP now
combine a variety of debt categories from
different issuers and are sold to a large number
of investors, making full disclosure difficult to
understand even by "sophisticated" investors.
Notes from conduits now account for half of the $3
trillion global commercial paper market.
High public officials who are in the
position to know, ranging from the chairman of the
Federal Reserve to the secretary of the US
Treasury, repeatedly gave assurances to the
investing public that were not only at variance
with discernible trends but turned out to be
materially false within weeks. The "basic facts"
about the market that the SEC claims as its
mission to make available to all investors were
systemically distorted and withheld from the
investing public with denials by officials of
distress firms and their regulators up to days
before the adverse information surfaced as
undeniable facts.
These officials can now
rest at ease for misleading investors because the
high court of the United States of America has
declared "corrupt persuasion" to be legal, that
persuading someone to engage in an act with an
improper purpose even without knowing an act is
unlawful is not criminal behavior.
Next: Bank deregulation fuels
credit abuse
Henry C K Liu is chairman of a New York-based
private investment group. His website is at
www.henryckliu.com.
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