If their latest words on how banks should handle the risks of complex structured-finance deals are any indication, banking and securities regulators think it’s high time to put the ghost of Enron behind them.
In a final guidance on high-risk structured finance released on January 5 by the Securities and Exchange Commission, the Federal Reserve Board, and three other federal regulatory agencies, for example, the rulemakers plunked mention of the energy giant’s catastrophic failure down into two footnotes.
The document purports to help banks curb the legal and reputational risks of engaging in “elevated risk” complex structured finance transactions (CSFTs). In footnote 2, the regulators cite the Enron case as evidence of the “strong and coordinated civil and administrative enforcement actions” against certain banks involved in CSFTs that seemed to have been used to shield “their customers’ true financial health from the public.” In footnote 3, they mention a Senate subcommittee probe into those banking arrangements.
Only in the sparsely worded citations to the footnotes does the name “Enron” appear, along with the names of JP Morgan Chase and Citigroup. While those banks didn’t admit or deny any wrongdoing, they struck hefty settlements ($135 million by JP Morgan and $120 million by Citigroup) in July 2003 with the SEC on charges that they had used structured finance to help Enron fiddle with its financials.
The terseness was a marked comedown from the play the regulators gave Enron and the banks in the agencies’ first version of the statement. Issued in May 2004, that first proposal placed a meaty two-paragraph discussion in the body of the statement, up near the front. (The authors of the statement also include the Office of the Comptroller of the Currency; the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation.)
More importantly, in the earlier version, the regulators linked the debacle in Houston clearly to the need to set up guidelines for managing perilous structured finance risks: “The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions as well as the substantial legal and reputational risks that financial institutions face when they participate in complex structured finance transactions that are designed or used for improper purposes,” they said then.
But times have clearly changed, and “Enron” seems no longer to be the rallying cry for regulators that it was more than two years ago. Recent moves by the Securities and Exchange Commission and the Public Company Accounting Oversight Board aimed at making it easier for smaller companies and their auditors to comply with the internal-controls rules under Sarbanes-Oxley provide further evidence of that.
Thus, in crafting their final advice to the banks, the regulatory agencies seem to have felt the need to put the past behind them and place new emphasis on the positive. They declare, for instance, that market-risk and credit-risk derivatives, asset-back derivatives with customized cash flow, and other familiar examples of structured finance “serve important purposes, such as diversifying risks, allocating cash flows, and reducing cost of capital.”
Thus, structured finance — even the more complicated varieties of it — is now “an essential part of U.S. and international capital markets,” the agencies assert.
Indeed, the fast-changing nature of the structured finance marketplace demands a more flexible regulatory approach, many feel. “What’s new and different today will be plain vanilla tomorrow,” M. David Krohn, a partner at the Alston & Bird LLP law firm told CFO.com. (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.)
The regulators struck “the right balance” between a “less prescriptive, more principles-based” approach in their guidelines and one that zeroes in on the most risky deals, according to Krohn. In any event, the release of the statement won’t change banks’ behavior very much, since a fair number of them took heed of the more stringent earlier guidelines of the 2004 proposal and have already begun implementing tougher risk management procedures on their own, he says. Further, he says that he continues to see banks involved in high-risk CSFTS “requiring appropriate representations about accounting treatment” from their clients.
At the same time, the final statement’s more sanguine view of structured finance likely came as welcome relief to many banks. But corporate banking clients looking for a bit more freedom in their financings will also probably be cheered, since their banking counterparties are no longer being asked to police their clients overly hard.
After all, the original proposal called for banks to review how companies planned, accounted for, and disclosed CSFTs in both their financial and tax reporting. Under certain circumstances, regulators suggested, banks should even “communicate directly with the customer’s independent auditors.”
Among others with similar views, the American Bankers Association shot back, complaining that the “insistent subtext” of the proposal was that banks should “insert themselves into their customers’ business dealings and corporate governance.” Critics also felt that the proposal was too broadly scatter-shot, dragging in plain-vanilla deals for unnecessary scrutiny.
Still, the positive response to the revision was by no means unanimous, suggesting that the legacy of Enron might not go so gentle into that good night. Sen. Carl Levin, the chairman of the U.S. Senate Permanent Subcommittee on Investigations — the unit the recommended that the agencies take action on structured finance risks in the first place — was highly dissatisfied with the final statement.
Reacting to the release of the statement, Levin said that, back in 2004, the rulemakers “proposed tough new guidance to prevent the abuse of CSFTs from corrupting financial statements and abetting tax evasion.” Now, however, “those same regulators have inexplicably issued a much weaker final guidance than proposed in 2004,” he said.
Among other things, Levin criticized the regulators for eliminating “plainspoken language” in the original guidance that warned against stuctured-finance abuses, “including a description of the CSFTs that should be avoided and the risks they present, such as CSFTs that facilitate deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax evasion.”
The senator also threw down the gauntlet to the regulators. “Congress needs to watch very closely to see if this weakening of the guidance results in weaker enforcement or an increase in structured finance abuse,” he said.
Another group of critics even suggests that the regulatory agencies “invite reckless participation in illegal conduct either as a primary fraud doer or an aider and abettor of another’s fraud.” That statement came in a rare critical letter in response to the proposed final version of the statement in May 2006 written by four law professors who served as expert witnesses in a case Enron shareholders brought against the Vinson & Elkins law firm.
The professors — George M. Cohen, University of Virginia Law School; David a Dana, Northwestern University Law School; Susan P. Koniak, Boston University Law School; and Thomas Ross, University of Pittsburgh Law School — charged that the statement gives banks the discretion to market a new product highly “indicative of fraud” without additional scrutiny or an independent outside assessment.
Among the transactions that the statement says “may” warrant added scrutiny are ones that lack “economic substance or business purpose,” are designed mainly “for questionable accounting, regulatory, or tax objectives,” and ones that involve circular risk transfers. The lawyers’ concern was that the regulators failed to say “these things are presumptively bad,” Cohen told CFO.com. The “red flag” characteristics cited in the statement “all point in the direction of fraudulent deals,” he says. “For the agencies to say something weaker than that is an encouragement of misbehavior.”