CSFB Bankers Used Hollywood Style Financing to Hide Enron Debt
By Edward Robinson
New York, Oct. 28 (Bloomberg) -- In 1998, investment banker Laurence Nath started to work with one of the most prolific deal- making companies in the U.S.: Enron Corp. Over the next three years, Nath and his team at Donaldson, Lufkin & Jenrette Inc. toiled in the center of Enron's universe of off-balance-sheet affiliates, partnerships and joint ventures.
The Houston-based energy company used many of these ``special- purpose entities'' to inflate profit and cash flow and keep $25.1 billion in debt off its ledger in the third quarter last year -- almost twice what it reported to investors.
Nath, who'd sharpened his skills in off-balance-sheet finance by working with film studios in Hollywood in the mid-1990s, was just one of scores of bankers who helped Enron structure deals that kept the company's true financial status under wraps.
Now, plaintiffs' attorneys are demanding that the banks repay the $30 billion investors lost in Enron's downfall, and lawmakers are probing the banks' relationships with Enron.
In securities fraud suits filed in Texas, Alabama and Ohio, investors are alleging that banks such as Nath's current employer, Credit Suisse First Boston, collaborated with Enron to defraud the public.
``I think the banks will be the deep pockets everyone goes after,'' says Cynthia Richson, director of corporate governance at the State of Wisconsin Investment Board, which manages $61.5 billion in assets for 478,000 current and former state workers.
Special-Purpose Entities
The investors' lawyers are assailing one of Wall Street's most valued practices: structuring complex, and often untested, financial transactions that result in regulatory, tax or accounting benefits for corporate clients.
Nath, cohead with James Fields of CSFB's structured finance group, helped design two special-purpose entities -- named Marlin Water Trust and Osprey Trust -- that moved debt off Enron's balance sheet, according to their prospectuses. The entities possessed a crucial feature: Enron's guarantee that investments in Marlin and Osprey would be covered by Enron equity.
Last year, that obligation reached $3.3 billion; Enron did not disclose the commitment to its own stockholders until it filed an amended quarterly financial report with the U.S. Securities and Exchange Commission on Nov. 19, 2001 -- two weeks before it declared bankruptcy.
``Nath and his team structured numerous illicit (special- purpose entities) to engage in transactions with Enron to improperly boost Enron's reported profits while moving billions of dollars of debt off Enron's balance sheet,'' states a 500-page class-action complaint filed by William Lerach of plaintiffs firm Milberg Weiss Bershad Hynes & Lerach LLP on April 8 in U.S. district court in Houston.
University of California
Lerach is representing the regents of the University of California, the lead plaintiff in the class action, which encompasses all federal claims against Enron and its banks by the company's stockholders and employees; they are seeking $30 billion in damages.
CSFB spokesman Pen Pendleton defends the propriety of the work Nath and his team executed for Enron. ``Unlike the controversial partnerships that led to Enron's bankruptcy, Osprey and Marlin were fully and widely publicized to potential investors,'' says Pendleton. ``The structures were reviewed and approved by outside law firms and Enron's external auditors. Rating agencies also reviewed the structures and assigned them an investment-grade rating.''
Communicating through Pendleton, Nath declined to comment.
In addition to CSFB, the suit names Citigroup Inc., J.P. Morgan Chase & Co., Canadian Imperial Bank of Commerce, Bank of America Corp., Merrill Lynch & Co., Barclays Plc, Deutsche Bank AG, Alliance Capital Management LP and Lehman Brothers Holdings Inc. as codefendants.
Outside Law Firms
The suit also names Enron officers and directors; Enron's auditor, Arthur Andersen LLP; and two of its outside law firms: Vinson & Elkins LLP and Kirkland & Ellis.
All defendants have filed motions to dismiss the suit, arguing that the plaintiffs have produced no evidence of wrongdoing and that case law bars plaintiffs from wringing damages from institutions that may have aided -- though not committed -- securities fraud.
Given its scale, an Enron settlement could surpass the $1.02 billion 30 brokerages paid in 1998 to settle allegations they fixed the spreads on Nasdaq stocks, says James Newman, executive director of Securities Class Action Services, a research firm.
``But for the involvement of the investment banks, Enron never would have happened,'' says Thomas Krebs, a lawyer representing Retirement Systems of Alabama in a separate, $260 million securities fraud suit filed in state court in March against Merrill Lynch, J.P. Morgan, Citigroup, CSFB and Bank of America.
More Allegations
Allegations against the banks continue to emerge. On Oct. 1, the criminal complaint filed by federal prosecutors against Enron's former chief financial officer, Andrew Fastow, alleged that Merrill participated in a plan to falsify Enron's earnings. According to the complaint, an unnamed ``financial institution'' invested $7 million in three Enron-owned electricity-generating barges in Nigeria with the proviso that Enron would repay it with 15 percent interest within six months.
Fastow -- who's charged with fraud, conspiracy and related crimes -- used the transaction to inflate Enron's 1999 fourth- quarter earnings by $12 million, says the complaint.
Documents released in July by the U.S. Senate Permanent Subcommittee on Investigations show the ``financial institution'' is Merrill and that its bankers knew the deal would boost Enron's profit: ``Jeff McMahon, (Executive Vice President) and Treasurer of Enron Corp., has asked ML to purchase $7 MM of equity in a special purpose vehicle that will allow Enron Corp. to book $10 MM of earnings,'' Merrill banker Robert Furst wrote to colleagues in an internal memorandum on Dec. 21, 1999.
`Never Knowingly Assisted'
``Merrill never knowingly assisted Enron in falsifying its financial results,'' says William Halldin, Merrill's spokesman. ``The transaction was so small that it seems inconceivable that it could have manipulated Enron's income statement.'' Merrill Lynch is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.
Allegations against the banks are also mounting on Capitol Hill. In July, the same subcommittee, chaired by Democratic Senator Carl Levin of Michigan, found that Citigroup, J.P. Morgan, CSFB and other banks had arranged sham commodity trades that funneled $8 billion to Enron from 1996 to 2001.
``The evidence indicates that Enron would not have been able to engage in the extent of the accounting deceptions it did, involving billions of dollars, were it not for the active participation of major financial institutions willing to go along with and even expand upon Enron's activities,'' Robert Roach, the subcommittee's chief investigator, testified on July 23.
Commodity Trades
The transactions that Levin's panel cited, dubbed ``prepays,'' looked like commodity trades in which capital was advanced to Enron in exchange for oil or natural gas to be repaid at a future date. They were actually loans disguised as trades so Enron could account for the fresh capital as cash flow from operations instead of as debt, said Roach.
If the prepays had been accounted for properly, he said, Enron's debt-to-equity ratio would have been 96 percent instead of the 69 percent it reported.
``Enron's practice of using prepay transactions to understate debt and overstate cash flow from operations made its financial statements look much stronger,'' testified Roach. ``That, in turn, helped Enron maintain its investment-grade credit rating and support -- even boost -- its share price.''
`Oomph to Revenues'
The subcommittee said the banks helped Enron book the debt as cash flow. On Sept. 28, 2000, Steve Wagman, a banker at Citigroup's Salomon Smith Barney unit, wrote in an e-mail to a colleague that a prepay ``gives some oomph to revenues,'' adding later in the message, ``E gets money that gives them cflow but does not show up on the books as big D Debt.''
E is Enron, and cflow is cash flow, according to the subcommittee, which obtained and released the e-mail.
The banks executed prepays to attract more investment banking business from Enron, said Roach. On Sept. 17, 2001, Osmar Abib, a CSFB banker, sent an e-mail to a colleague, James Moran, asking about a prepay: ``Please remind me as to who at Enron originally asked for this deal and why we agreed to do it (and most importantly what did CSFB get from it besides being nice guys again).''
Moran replied, ``We agreed to do the deal as it was a special request/favor from Ben. Not sure if we got anything specific other than a relationship building chip.'' Ben, said the subcommittee, is former Enron Treasurer Benjamin Glisan.
CSFB arranged a $150 million prepay in 2001, while Citigroup arranged $4.8 billion in 14 transactions from 1993 to 2001 and J.P. Morgan Chase arranged $3.7 billion in 12 transactions from 1992 to 2001.
No. 1 Underwriter
CSFB -- together with DLJ, which CSFB acquired in November 2000 -- has been the No. 1 underwriter of Enron stocks and bonds since 1985, having arranged $7.4 billion in offerings, according to Bloomberg data.
CSFB spokesman Pendleton says the bank didn't execute prepays for Enron in exchange for investment banking business. ``Accounting for the transaction was the responsibility of Enron, its auditors and its counsel,'' says Pendleton.
Citigroup CEO Sanford Weill addressed the prepay allegations in a letter to employees on Aug. 7, decreeing that if a client does not record a loan or other transaction that raises capital as debt, it must disclose the deal's details to investors, or the bank will not execute it.
Some securities lawyers argue that investors and lawmakers, in their zeal to avenge Enron's sins, have embarked on a witch hunt that threatens to punish bankers who did legitimate work for the company.
`Thrown Into the Fat'
``Anyone who was associated with Enron is being thrown into the fat,'' says Daniel Dooley, head of PricewaterhouseCoopers LLP's securities litigation consulting practice. ``We're going to wake up five years from now and regret jumping to conclusions and condemning people before all the facts are in.''
Lynn Turner, former chief accountant at the SEC, counters that more than enough facts are in to show that when it came to helping Enron, the investment banks scrapped their duty to be honest with investors.
``For Wall Street, lining its own pockets with gold comes well before protecting the average American investor,'' says Turner, now director of the Center for Quality Financial Reporting at Colorado State University. ``Wall Street has told millions of investors in this country that it does not have a conscience.''
Public pension funds, which lost more than $3 billion on Enron stock and bonds, are taking the rare step of suing the very banks they depend on for advice and securities offerings.
`Hand in Glove'
``There is no way our fund can make any informed investment decisions, because the investment bankers were operating hand in glove with Enron to defraud the public,'' says Krebs, the lawyer for the Alabama pension fund, which manages $25.1 billion in assets for 275,000 active and retired teachers and state workers.
CSFB has some explaining to do on Enron, says Alfredo Rotemberg, comanager of the Armada International Equity Fund, which this past summer sold 100,000 shares of Credit Suisse Group, CSFB's Zurich-based parent. That was its entire position.
``Enron created vehicles that burned money, destroyed money,'' he says. ``The investment bankers were the first to see this, and they are paid big amounts of money to save us investors, not destroy us. So what did they do when they discovered this? That is the question that needs to be answered.''
The work of Nath's team with Enron is raising additional questions. Colleagues describe Nath as a cerebral and disciplined banker with an affinity for financial puzzles. ``He had a reputation for being smart, creative and on the cutting edge,'' recalls Garrett Moran, cohead of DLJ's investment banking group until 2000, who hired Nath and nine other bankers from Citibank in August 1998.
Hollywood Deals
Nath's friends are shocked that lawsuits are accusing Nath of participating in fraud at Enron. ``There's not an ounce of guile in him,'' says Paul D'Addario, a colleague and managing director in CSFB's Los Angeles office. ``He is very professorial, very earnest, and he loves structured finance. Enron was a great client for him.''
In 1996, Nath, who then was with Citibank, had not yet plunged into the world of pipelines and waterworks at Enron. He and fellow banker Andrew Sriubas were paying visits to studio heads in Hollywood and pitching them a new way to finance moviemaking by using off-balance-sheet deals.
Nath was the deal architect, presenting intricate, statistical analyses of film finance, while Sriubas, who later jumped to DLJ with Nath, schmoozed with studio CFOs, according to a media banker who knows both men and discussed the deals with Nath during that period.
`Boatloads of Money'
`Titanic,' the $200 million epic released in 1997, was ushering in the era of $100-million-plus movies, and studio chieftains were eager to find new ways to finance them.
``They were spending boatloads of money, and alternative finance structures made sense,'' says Patrick Russo, a banker with Houlihan Lokey Howard & Zukin, a Los Angeles-based investment bank.
Nath and Sriubas found two takers: News Corp.'s Twentieth Century-Fox Film Corp., which raised $1 billion in 1996 in a deal called New Millennium, and Universal Studios Inc., then a unit of Seagram Co. and now part of Vivendi Universal SA, which raised $1.1 billion in 1997 in a deal named Galaxy.
Universal bundled future revenue from a three-year slate of 45 movies -- including Steven Spielberg's `Jurassic Park' sequel, `The Lost World' -- as an asset-backed security, which is an instrument backed by notes or receivables. The security was held in a limited liability company called Galaxy off its balance sheet.
Investment-Grade Credit
The bankers then invited outside investors to put money into Galaxy; the investors contributed about 4 percent of Galaxy's capital. This tactic enabled Universal to keep Galaxy -- and its debt -- off the balance sheet because accounting rules require that, to remain unconsolidated, such entities must receive at least 3 percent of their equity capital from outside investors.
On the strength of Universal's investment-grade credit rating, Citibank loaned Galaxy the rest of the capital on terms akin to those used in a commercial paper transaction: at 0.27 percent above the London interbank offered rate, on a 364-day term, says Brian Mulligan, Universal's point person on Galaxy, who went on to become the studio's cochairman in 1999.
No one had ever packaged a group of movies together as an asset-backed security before, let alone financed the venture with such a cheap loan, say Hollywood bankers. ``They were groundbreaking deals,'' says Russo.
Enron's Promise
Mulligan says Nath exploited one of Tinseltown's most cherished tenets: A group of films in different genres -- from action star vehicles to romantic comedies, to G-rated children's fare -- almost always makes money over three to five years. ``He understood that the winners offset the losers and securitized what people think of as an inherently risky business,'' says Mulligan. ``Consequently, we could borrow at commercial paper rates for film financing, which was unique.''
By 1998, Nath was at DLJ working on his first major deal for Enron. Two years prior, Kenneth Lay, Enron's then CEO, had promised investors his company would generate a compound annual earnings growth rate of 15 percent over the next five years, even as it embarked on a $23 billion global expansion program.
Off-balance-sheet finance became the instrument for meeting Lay's ambitious goal, according to the criminal complaint against Fastow.
Water Business
In July 1998, Enron formed a new company called Azurix Corp. to penetrate the $300 billion global water business. Enron acquired Wessex Water Plc, a water supplier and wastewater services company in southwestern England, for 1.7 billion pounds ($2.6 billion) as Azurix's centerpiece.
To keep Azurix's debt off its balance sheet, Enron's finance department tapped Nath to design a structure that would maintain it as an unconsolidated entity rather than as a division or subsidiary.
According to Marlin's prospectus, Azurix was installed in a holding company called Atlantic Water Trust. Enron invested $846 million in Atlantic and held a 50 percent voting interest. Another vehicle called Marlin Water Trust, owned by institutional investors, held the other 50 percent.
In December 1998, Marlin sold $1.02 billion in senior secured notes at 7.09 percent due Dec. 15, 2001, according to the prospectus. DLJ and BT Alex. Brown Inc. were the offering's joint underwriters. Nath and Fields served as directors on Atlantic's board from November 2000 to November 2001.
Trigger Event
Marlin was backstopped with a feature that would protect its debt holders at the expense of Enron's stockholders. If Enron's credit rating got downgraded to below investment grade and its stock traded at less than $37.84 for three consecutive trading days, a ``note trigger event'' would occur, according to the Marlin prospectus.
Enron would have to make Marlin's debt holders whole by issuing Enron stock or, short of that, cash.
While Enron's commitment to Marlin investors was a bet that its stock would never fall too far, it did not disclose the obligation to its own stockholders in financial filings with the SEC.
The equity guarantee prompted Moody's Investors Service to bestow a Baa2 investment-grade credit rating on Marlin even though Enron had had no experience in the highly regulated global water industry, according to a research note issued on March 7, 2000.
Standard & Poor's rated Marlin debt at investment-grade BBB. The feature won praise among structured finance experts because few believed that given Enron's rising fortunes in the late 1990s, a ``note trigger event'' would ever hit.
`Quite Ingenious'
``This was quite ingenious,'' says Steven Schwartz, a law professor at Duke University who has studied Enron's labyrinthine finances. ``The stock of an issuing company does have real value, but clearly, this was an experiment that went awry,'' he adds.
In 1999, Enron Treasurer Glisan worked with Nath on a similarly structured off-balance-sheet deal called Osprey Trust. It held debt and assets such as natural gas pipelines and power plants. Like Marlin, Osprey issued public debt, raising 315 million euros ($307.6 million) in a European offering and $750 million in the U.S. in 2000.
Osprey's noteholders were also supported by Enron equity, with a trigger price of $59.78, according to Osprey's prospectus issued on Sept. 28, 2000.
Among Osprey's buyers were mutual funds, including the Putnam Income Fund, which held $7.9 million worth of Osprey notes, and American Express Co.'s AXP Bond Fund, which held $10 million, according to the funds' annual reports.
Primary Purpose
Osprey's primary purpose was to raise $1.07 billion in 2000 for Whitewing LP, an off-balance-sheet entity holding energy assets.
Osprey also was linked to LJM2 Co-Investment LP, the partnership created in October 1999 by Fastow to buy assets from Enron. LJM2 invested $47 million in Osprey.
Fastow also tapped CSFB itself for equity capital: In June 1999, a CSFB affiliate called ERNB Ltd. invested $7.5 million in LJM Cayman LP, LJM2's precursor, according to a report by an Enron board special investigative committee.
Tying these off-balance-sheet entities together was their use of Enron stock. In 1996, Enron put stock into Nighthawk, an entity set up by Citibank, and later into Whitewing.
As Enron's share price tripled from Jan. 1, 1998, to Dec. 31, 2000, Fastow and Glisan shifted some of the ``excess stock value'' in Whitewing to another set of entities called Raptor, according to a memorandum of an interview between Richard Causey, Enron's chief accounting officer, and two lawyers from Vinson & Elkins, on Aug. 31, 2001.
Even More Deals
CSFB pitched Glisan even more off-balance-sheet deals supported by Enron stock, according to the memorandum of an interview on Dec. 17, 2001, between Ryan Siurek, a finance department director, and lawyers from the special committee. ``Investment banks were always presenting different hedging vehicles to Enron,'' Siurek told the lawyers, according to the memorandum.
In January 2001, Enron's stock started a long decline, losing almost half of its value by the end of the second quarter. Enron's bankers were alarmed: If the stock continued to fall, Enron would have to make good on its ``triggers'' and disgorge equity to those who'd invested in off-balance-sheet vehicles like Marlin and Osprey.
According to a lawsuit brought by the regents of the University of California, an unnamed Enron manager and two unidentified CSFB managing directors discussed the problem in late June 2001. ``Do you know how much off-balance-sheet debt you have?`` a banker asked the Enron manager, who replied, about $1 billion to $2 billion. ``Try $8-$12 billion,'' the banker said, adding that if Enron's shares hit $20, the company would crumble.
Financial Legerdemain
William Lerach, the regents' lead attorney, says the meeting demonstrates CSFB's knowledge of Enron's financial legerdemain. ``CS First Boston knew that Enron was falsifying its publicly reported financial results and that its true financial condition was much more precarious than was publicly known,'' Lerach states in the suit.
He argues that when CSFB and the other banking codefendants managed Enron's stock and bond offerings, they neglected to inform prospective investors of Enron's real financial picture, thereby violating the disclosure rules of the Securities Act of 1933.
In a May 8 motion to dismiss the suit, CSFB lawyer Lawrence Finder calls the suit an ``epic novel'' with no evidence that his client broke the law. ``Plaintiffs, who have allegedly suffered a loss in the wake of Enron's bankruptcy, are casting about in search of a deep pocket,'' Finder states in the motion.
Private Placement Offering
Lerach also accuses the banks of violating the stock manipulation provisions of the Securities Exchange Act of 1934 by participating in LJM2. As LJM2's general partner and Enron's CFO, Fastow used the partnership to take nonperforming assets off Enron's balance sheet and manufacture earnings through bogus transactions with Enron and other off-balance-sheet entities, according to the criminal complaint.
LJM2's private placement offering, which was prepared by Merrill and promised investors a 30 percent annual return, highlighted Fastow's ability to control both sides of such transactions.
``The Partnership expects to benefit from having the opportunity to invest in Enron-generated investment opportunities that would not be available to outside investors,'' states the offering.
CSFB, Citigroup, J.P. Morgan Chase and other financial institutions invested at least $143 million in LJM2 -- 37 percent of its equity capital, according to an internal LJM2 funding document. The prospectus ``was an invitation to join in the benefits of self-dealing transactions with Enron,'' says Lerach in the suit.
Crackdown on Crime
On Oct. 16, 2001, Enron charged $544 million against earnings and reduced stockholders' equity by $1.2 billion to account for its transactions with LJM2. That was the revelation that set off the chain reaction that eventually bankrupted Enron.
Melvyn Weiss, senior partner at Milberg Weiss, is pessimistic about whether a crackdown on white-collar crime by the U.S. government will curb corporate fraud in the future.
``There will be caution for a while, and then the aggressive companies will start to cut corners, and when the next bull market hits, they'll use any excuse they can to hype the stock,'' says Weiss. ``We shouldn't be led down the primrose path.''
That's unlikely, say some disillusioned Enron shareholders. ``Serious damage has been done,'' says the State of Wisconsin Investment Board's Richson. ``It looks like the banks are just running amok.''
After Enron, she says, investors won't trust Wall Street for a very long time. |
