Hot Potato
Credit derivatives, of course, are not the only financial innovation that exposes corporations to banks' penchant for risk transfer. Indeed, healthy companies are more likely to experience that when taking part in a structured financing, particularly securitization. Instead of lending a company its own money, the bank acts as a middleman, raising money for the company by selling bonds backed by company assets that represent future cash flow (such as receivables). For companies, securitization has the added benefit of being off balance sheet for accounting purposes (despite a slew of new disclosure rules).
In and of itself, securitization is a widely accepted practice. Securitization of trade receivables alone has grown from $2.4 billion in 1985 to $305 billion in 2004, and securitization overall is a $1.8 trillion market. But it and other forms of structured finance rely on techniques that were badly abused by Enron. "Transparency and the degree to which accounting and disclosure standards achieve their goals can be greatly diminished by the use of structuring, even when that structuring appears to comply with the standards," wrote the SEC in a June study of off-balance-sheet liabilities required by Sarbanes-Oxley. That comment concerned lease accounting, but the SEC staff warned that it saw similar corruption of accounting standards for securitization and derivatives. "Interpretation No. 46(R), which addresses the consolidation of variable interest entities (including SPEs), could well suffer a similar fate. In some cases, securitizations and derivatives have been used in accounting-motivated transactions."
Banks, of course, are painfully aware of this: many paid billions in fines and settlements over transactions they helped structure for Enron. "Recent events demonstrated that structured-finance transactions, in part because of their complexity, were subject to abuse," notes M. David Krohn, a partner at law firm Alston & Bird LLP. (Krohn served as the lead structured-finance lawyer for Enron's bankruptcy examiner, although a court-imposed gag order prevents him from commenting on the case.)
And where there's structured financing, says Krohn, there are banks. "They market it, they structure it, they serve as counterparties for related derivatives contracts," he says. This, in turn, creates another type of risk: reputational and legal risk, which has recently become a hot potato between banks and their clients.
In May 2004, banking regulators and the SEC issued proposed guidelines intended to help banks avoid reputational and legal risk stemming from "a wide array of structured-finance products, including financial derivatives for market and credit risk, asset-backed securities with customized cash-flow features, and specialized financial conduits that manage pools of purchased assets."
While the responses from individual banks, particularly those involved with Enron, were understandably muted, their industry groups objected strenuously that far from reducing banks' reputational and legal risk, the guidelines actually shifted more risk to banks by requiring that they police their corporate customers.
No Stinking Badges?
"A surprising number of financial institutions expressed to us serious concerns about the proposed statement," the American Bankers Association (ABA) wrote to regulators, adding that the primary cause of all of its concerns was the "insistent subtext" that banks should "insert themselves into their customers' business dealings and corporate governance."
The guidelines did propose that banks "ensure that financial-institution staff appropriately reviews and documents the customer's proposed accounting treatment of complex structured-finance transactions, financial disclosures relating to the transactions, and business objectives for entering into the transactions." They also suggested that banks develop policies for "analyzing and documenting the customer's objectives and customer-related accounting, regulatory, or tax issues." Under certain circumstances, banks would also be required to seek review from "higher levels of [the] customer's management" or even "communicate directly with the customer's independent auditors."
The guidelines also required extensive document retention, including minutes of "critical" meetings with clients, all client correspondence, and — particularly galling to critics — documents about transactions proposed but ultimately disapproved. "The proposed standards appear more aptly designed to affect the deputization of financial institutions as prosecutorial archivists," complained a joint letter from three industry groups.
Regulators also urged banks to decline any transaction that might result in a customer issuing a materially misleading financial statement, or, failing that, "condition [the bank's] participation upon the customer making express and accurate disclosures" through legally binding representations and warranties. While few companies should object to agreeing to simply disclose a transaction, says Krohn, "if banks are looking for a covenant that you'll account for it in a certain way, that creates some risk until your accountants have signed off."
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