JPMorgan Chase chairman and CEO Bill Harrison followed suit five days later, creating a policy review office that, among other responsibilities, "will help ensure that we do not participate in transactions that are not properly disclosed by our clients."
Both proposals are vague — effectively, the banks are doing no more than insisting that companies follow existing SEC regulations and Sarbanes-Oxley. But even that is a dramatic change from their heated protestations during the Enron hearings that they are blind to their clients' accounting decisions. Indeed, JPMorgan Chase's Feldstein still obliquely suggests that rival Citigroup may have gone too far, noting that for a bank to require disclosure or review it with auditors "is impractical, not our expertise, and presumes a sort of paternalistic relationship which is entirely inappropriate and I would think would anger our clients."
Perhaps Feldstein should be more worried about investor anger. With Andersen out of business and Enron bankrupt, the banks' deep pockets guarantee they will be vigorously sued for their alleged role in propping up Enron's finances. "These top banks were involved in Enron's day-to-day business operations," says William S. Lerach, of Milberg Weiss Bershad Hynes & Lerach, who is leading the class-action securities-fraud litigation against Enron. "They helped them structure these SPE transactions that were used to falsify the financial results."
Some observers say the banks are extremely vulnerable. "The banks are going to see claims like they've never seen before. The evidence from the congressional investigation is so compelling that it raises a significant risk that these firms will face humongous settlements," warns Turner, who thinks the evidence compiled by Senate investigators will force the banks to settle rather than face a jury. "If they go to trial, the jury will hang them before the trial starts," he says.
The End of the Beginning
Scrutiny of a company's actual debt — not just what's reflected on the balance sheet — will not end when FASB issues its new SPE rules. The Sarbanes-Oxley Act orders the SEC to issue rules requiring disclosure of "all material off-balance-sheet transactions... and other relationships of the issuer with unconsolidated entities." Within the next year, the SEC will study the extent of off-balance-sheet transactions and the use of SPEs, and report "whether generally accepted accounting rules result in financial statements of issuers reflecting the economics of such off-balance-sheet transactions to investors in transparent fashion."
In other words, companies will no longer be able to use off-balance-sheet treatment of debt to make it look as if they're less leveraged than they really are. "For the first time ever, we are going to find out about how much people are really hiding," says Turner of the impending SEC report, "and I think the world is going to be shocked when they see that. It is going to be a clarion call for action." If he's right, the changes that CFOs have recently seen in structured finance will be only the beginning.
Tim Reason is a staff writer at CFO.
Cash Not in the Bank
While it is far too early to estimate the cost that investor lawsuits against Citigroup and J.P. Morgan Chase & Co. might exact on corporate finance, the immediate fallout of the banks' deals with Enron is all too apparent. Enron's prepaid gas and oil swaps were far from typical structured finance transactions, but coupled with WorldCom's manipulations, they have already resulted in heightened scrutiny of cash-flow statements. "Although the statement of cash flows is much less susceptible to accounting manipulations than the income statement, recent developments have shown that it is far from sacrosanct," wrote Standard & Poor's analyst Scott Sprinzen in a recent report on financial reporting transparency.
The SEC has said it would like FASB to revisit the cash flow reporting rules laid out by FAS 95. That, too, could have significant implications for the cost of capital, since the primary concern of bond investors as well as commercial lenders is whether a firm's cash flow is sufficient to cover interest payments. (Citigroup and JPMorgan Chase, of course, are now at the front of the creditors' line because Enron's cash flow wasn't what it appeared to be.) —T.R.
Waiving the Red Flag
One of the more interesting defenses of structured finance raised by banks is that Enron essentially "overdosed" on it. Enron conducted $8.5 billion in prepaid forward swaps with Citigroup and J.P. Morgan Chase & Co. and at least $1 billion with six other banks.
Since those deals helped Enron conceal the loans as cash flow from gas trades, the banks could claim that they had no way of knowing how much Enron was also borrowing from their rivals — or whether it could handle the growing load. "We don't do due diligence," says Andrew T. Feldstein, head of JPMorgan Chase's structured financing products. "If our client is advised by capable counsel and capable accounting firms, we assume our client is providing factual information to those constituents as well as to its regulators."
But Arthur Andersen's approval of Enron's accounting depended on the independence of each party to the gas trades — including Mahonia, the special-purpose entity created by JPMorgan Chase. A taped phone call obtained by Senate investigators records JPMorgan Chase and Enron employees crafting a response after Andersen demanded a letter confirming that Mahonia met the criteria. "You also want to make sure that Mahonia seems independent," says one of the voices on the tape.
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