When the Financial Accounting Standards Board released its exposure draft of new accounting rules for special-purpose entities (SPEs), in late 2002, the nation’s financial regulators sent FASB chairman Robert H. Herz decidedly mixed signals.
On the one hand, the Securities and Exchange Commission wanted Herz to make the rules effective as soon as possible. SPEs were the prime vehicle for the fraud that brought Enron down, and were widely used by other companies to take liabilities off their balance sheets, obscure their financial condition, and obtain lower-cost financing than they deserved. Not surprisingly, the SEC was anxious to head off other financial fiascos resulting from such abuse.
At the same time, however, the Federal Reserve Board pressed Herz to slow down. That’s because the new rules threatened to complicate the lives of the Fed’s most important charges: large, multibusiness bank holding companies that happen to earn sizable fees by arranging deals involving SPEs. Stuck between this regulatory rock and hard place, Herz told the Fed and the SEC to get together and work out a timetable that satisfied both constituencies.
And they did. But the rules, known as FIN 46 (FASB Interpretation No. 46), have only recently taken effect in some cases, and have yet to do so in others. While the delay in the rules’ effective date may reflect the complexity of the transactions covered by FIN 46 as much as the controversy generated by the rules themselves, the conflict between the Fed and the SEC over the matter stems from a deeper problem: the Fed and the SEC have very different regulatory missions that can sometimes come into serious conflict.
The problem surfaced in December 2002 during congressional hearings on the extensive role that certain banks—including Citigroup, J.P. Morgan Chase & Co., and Merrill Lynch & Co.—played in deceptive transactions involving Enron SPEs. Those hearings by the Senate Permanent Subcommittee on Investigations, led by Sen. Carl Levin (D-Mich.), identified what he and thenranking minority member Sen. Susan M. Collins (R-Maine) termed “a current gap in federal oversight” of the banks that helped them aid and abet Enron’s fraud. “The SEC does not generally regulate banks, and bank regulators do not generally regulate accounting practices overseen by the SEC,” notes the report, which went on to say that this “is a major problem and needs immediate correction.”
That correction has yet to be made. The onus of doing so is on the Fed, as the chief regulator of the nation’s financial system. Yet Fed chairman Alan Greenspan shows little inclination to do much about the problem.
Yes, the markets have recovered from Enron, at least for the time being. But the penalties and other punishment that regulators meted out to the banks for their role in the fraud display at best a worrisome inconsistency. And that suggests that problems arising from the regulatory gap identified by senators Levin and Collins could recur. Unless the gap is closed, it could undermine other regulatory efforts aimed at improving corporate governance. That, in turn, might have a short-term impact on investor confidence, still fragile some two years after Enron’s failure. And in the long term, future Enrons could slip through the gap undetected.
If nothing else, the question of what should be done about it deserves a place on the agenda when the Senate considers Greenspan’s nomination for a fifth term, as is expected after his current four-year stint ends in June.
To be sure, both Citigroup and Chase agreed, after their role at Enron was exposed, to avoid new financing arrangements that pose similar legal and reputational risk. And under FIN 46, all deals involving SPEs must be disclosed on the balance sheet of either the bank, the borrower, or a third party. But it remains to be seen how effective the new rules will be in preventing future off-balance-sheet frauds (see “Longer Paper Routes“).
Complicating matters is the combination of commercial and investment banking and insurance blessed by the Gramm-Leach-Bliley Act of 1999, which ended the last vestiges of separation enacted by the Glass-Steagall Act and made the Fed the financial system’s primary regulator. But while the central bank supervises private banks involved in these lines of business, including Citigroup and Chase, the Fed’s primary interest isn’t stopping financial fraud, but making sure the U.S. banking system remains safe and sound. “The Fed doesn’t even believe in firewalls,” says Dimitri B. Papadimitriou, president of the Levy Economics Institute at Bard College.
In contrast to the multiline banks (called “universal,” in industry parlance), monoline investment banks such as Merrill are subject to regulation by the SEC, whose regulatory mission is the protection of public investors. With that in mind, the commission sets reserve requirements for Merrill as well as for the broker-dealer affiliates of Citigroup and Chase, along with those of such foreign institutions as the Canadian Imperial Bank of Commerce (CIBC). But the SEC, unlike the Fed, doesn’t inspect their operations.
Thus, to prosecute violations of securities law by banks, the SEC depends on bank supervisors to turn over evidence of such activity. Yet the Fed clearly has a reason to look the other way—that is, to ensure the profitability of the banks it oversees. “In doing so, it doesn’t care very much about” the interests of investors, charges Papadimitriou. In fact, Chase and Citigroup were treated much more leniently than Merrill and CIBC (see “Unequal Treatment,” at the end of this article).
Regulators dismiss any suggestion that Citigroup and Chase were given special treatment. Last February, at a conference held by The Bond Market Association (TBMA) in New York, SEC official Annette Nazareth waved off suggestions by CFO that the regulators’ differing objectives might cause them to work at cross-purposes when it came to questionable structured-finance deals. Indeed, Nazareth, the SEC’s director of the division of market regulation, and her counterparts at the Fed and the Office of the Comptroller of the Currency (OCC) insisted at the December 2002 Senate hearings that they had more than sufficient means of preventing banks from aiding and abetting corporate fraud. And that testimony was reiterated in a letter to the Senate investigations subcommittee from the officials several weeks later.
“The SEC and the federal banking regulators have a long history of cooperation on enforcement matters including referrals by the banking regulators of securities laws violations and, when appropriate, coordinated investigations,” read the letter. It went on to say that “We intend that this cooperative relationship will develop and continue.”
But the hearings themselves produced no evidence that bank supervisors played a critical role in helping the Bush administration’s corporate task force uncover exactly what the banks did to help Enron mislead investors. In her testimony, Nazareth cited the bank regulators’ help in the SEC’s recent prosecution of PNC Financial Services Group for overstating its earnings because it failed to consolidate three SPEs that it effectively controlled. However, nothing in that testimony indicated the investigation was initiated by the SEC in response to evidence turned over by the bank regulators.
Advise and Reject
In January 2003, the Senate subcommittee issued a report with three recommendations for plugging the regulatory gap between the Fed and the SEC. One was that the agencies, along with the OCC, jointly develop guidelines for acceptable and unacceptable structured-finance transactions, products, and practices. Another was that the SEC issue a regulation or guidance that it promised to take “enforcement action” against a financial institution that participated in a deceptive transaction with a publicly traded company. The third was that the Fed’s and the OCC’s bank examiners would routinely examine a bank’s structured-finance activities for evidence of impropriety.
Nazareth and her fellow regulators, however, rejected key parts of the subcommittee’s recommendations. It’s not that they deny that there is a problem. In fact, they’ve responded to the criticism by conducting a review of structured-finance operations at financial institutions and working on guidance for best practice in this area. At press time, a top aide to Levin allowed that the senator was “pleased” by the time and effort the regulators have devoted to the review, but added that Levin has yet to see a written product of their work.
But the regulators contend that it’s difficult to come up with clear-cut rules because of the increasing complexity of financial products. That was evident in their rejection of the subcommittee’s request to create a list of permissible and prohibited transactions. “Our work has confirmed that the permutations of structured transactions can be virtually endless,” they said in their letter. “The appropriateness of any particular product can depend very much on the specific factual context in which the product is provided, which can vary greatly from transaction to transaction and can be highly complex.”
However, the Enron deals had one basic objective in common: to lay off private debt on the public by disguising its true nature. And the Fed regularly publishes lists of permitted and prohibited transactions for banks it oversees. As a result, says Tom Schlesinger, founder and executive director of the Financial Markets Center, a nonprofit research institute, “it’s difficult to understand the logic” of the assertion that the wide variety of uses for structured finance militates against issuing a list of what’s permissible and what’s not.
Regardless, the agencies contend that compiling a prohibited-transactions list “is not the most effective approach,” as Nazareth and her fellow regulators said in their letter to the Senate subcommittee. Instead, they wrote, “as we…plan to reiterate in supervisory guidance, it is the responsibility of banks, broker-dealers, and other financial-services companies to develop and maintain policies and procedures to assure that they are in compliance with all applicable laws and regulations.”
In other words, the regulators’ solution is to remind the bankers that they have to obey the law, and to ask the public to take it on faith that regulators will turn over evidence of wrongdoing to prosecutors.
Just Say No?
The regulators’ stance reflects the fact that the Gramm-Leach-Bliley Act embraced financial deregulation. Indeed, bank regulators contend that legal and reputational risk encourages considerable self-restraint on the institutions they oversee. Granted, private litigation against the banks could yield bigger penalties than those imposed by the regulators. But the decision by Judge Melinda Harmon in December 2002 to dismiss investor claims against banks involved in the Enron case would seem to close the door to future such actions.
True, the decision did lead to a settlement between the banks and the government. But Brad S. Karp, an attorney at New York firm Paul, Weiss, Rifkind, Wharton & Garrison LLP, believes that other courts are unlikely to cite Harmon’s ruling as precedent. Karp told the TBMA conference that Harmon ignored important parts of a 1994 Supreme Court ruling that limited banks’ legal liability in such matters, and says she has been “widely criticized for her reasoning and jurisprudence” in the case.
As for reputational risk, some academics question whether this, too, provides much incentive for self-restraint. Richard Portes of the London Business School points to new game-theory research that suggests that the conventional view of this risk overestimates its importance. As Portes puts it, bank customers may not avoid dealing with an institution whose reputation has been besmirched, because they may well believe that they themselves are smart or powerful enough to negotiate fair terms nonetheless.
What’s more, self-regulation will be reinforced by the new international bank regulatory scheme, known as Basel II, scheduled to go into effect late in 2006. The proposed rules focus less on capital-reserve requirements imposed by regulators than on their evaluation of institutions’ ability to manage risk. Citigroup and Chase, in short, will be able to decide for themselves whether their reserves are sufficient for the risks they are taking.
Greenspan himself professes great faith in such an arrangement. In remarks last May at a conference sponsored by the Chicago Fed, he sharply challenged the view that the government is better than the banks themselves at ensuring effective risk management. “Private regulation generally is far better at constraining excessive risk-taking than is government regulation,” he said. “Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties.”
But the market did nothing to prevent Enron—or Parmalat, another scandal involving SPEs. And unless the regulatory gap is closed, they are unlikely to be the last bank-engineered financial meltdowns to roil the markets and shake investor confidence.
Indeed, some academics contend that structured finance and other types of securitization only encourage Enron-like behavior, because the public markets are inherently less transparent than private sources of financing. Greg Hannsgen, a research associate at Bard’s Levy Economics Institute, said in a recently published working paper, Hannsgen writes that unlike commercial lenders that impose covenants on corporate borrowers and have a personal acquaintance with their management, “securities owners may be too far removed from the activities of a corporation to prevent insiders from engaging in fraud or managing improperly.”
If there are a few financially engineered meltdowns still to come, it will be hard to argue that more-dramatic regulatory action—consistently severe punishments of the banks, prohibitive rules, or even structural change—isn’t necessary. When it comes to structured finance, a double standard may be better than no standard at all—but not by much.
Ronald Fink is a deputy editor of CFO.
If the Federal Reserve Board and the Securities and Exchange Commission pursue the same agenda, why were Merrill Lynch & Co. and the Canadian Imperial Bank of Commerce (CIBC) treated so differently by the Corporate Fraud Task Force—a team with representatives from the SEC, the FBI, and the Department of Justice (DoJ) set up to prosecute perpetrators of Enron’s fraud—than were Citigroup and J.P. Morgan Chase & Co.? After all, all four banks did much the same thing.
Under settlements signed with the SEC last July, Citigroup and Chase were fined a mere $101 million (including $19 million for its actions relating to a similar fraud involving Dynegy) and $135 million, respectively, which amounts to no more than a week of either’s most recent annual earnings. And they agreed, in effect, to cease and desist from doing other structured-finance deals that mislead investors. That contrasts sharply with the punishment meted out by the DoJ to Merrill and CIBC, each of which not only paid $80 million in fines, but also agreed to have their activities monitored by a supervising committee that reports to the DoJ. Even more striking, CIBC agreed to exit not only the structured-finance business but also the plain-vanilla commercial-paper conduit trade for three years. No regulatory agency involved in the settlements would comment on the cases, though the SEC’s settlement with Citigroup took note of the bank’s cooperation in the investigation.
But Brad S. Karp, an attorney with the New York firm Paul, Weiss, Rifkind, Wharton & Garrison LLP, suggested recently that the terms of the SEC settlement with its client, Citigroup, reflected a lack of knowledge or intent on the bank’s part. As Karp noted more than once at a February conference on legal issues and compliance facing bond-market participants, the SEC’s settlement with Citigroup was ex scienter, a Latin legal phrase meaning “without knowledge.”
However, the SEC’s administrative order to Citigroup cited at least 13 instances where the bank was anything but in the dark about its involvement in Enron’s fraud.
As Richard H. Walker, former director of the SEC’s enforcement division and now general counsel of Deutsche Bank’s Corporate and Investment Bank, puts it, all the banks involved in Enron’s fraud “had knowledge” of it. Yet Walker isn’t surprised by their disparate treatment at the hands of regulators. “The SEC does things its way,” he says, “and the Fed does them another.” —R.F.