For those already exhausted by the torrent of Enron disclosures, I would not recommend reading the "Consolidated Complaint" filed by defrauded investors for a literary experience. The class-action lawsuit is 500 pages long, not counting appendixes, and dense with tedious legal repetitions and the mind-numbing complexities of Enron's financial transactions, most already known. On the other hand, this document tells an eye-popping story of how the Wall Street system really works, and it resonates with political significance because the plaintiffs' lawyers are redirecting public outrage--and multibillion-dollar damage claims--at the best and most powerful names in American finance. Nine leading banks and financial houses have been added as defendants and depicted as intimate insiders in what the lawsuit calls the "Enron Ponzi scheme." They were the engineers, it is asserted, who devised manipulative deals concealing the truth. They were also principal beneficiaries of this massive scam.
The "Enron Nine" (if we may call them that) are J.P. Morgan Chase, Citigroup, Credit Suisse First Boston, Canadian Imperial Bank of Commerce, Bank of America, Merrill Lynch, Barclays, Deutsche Bank and Lehman Brothers. These financial institutions collaborated with the now-bankrupt energy company in its financial sleight of hand--the deals that enabled Enron to inflate its profits, conceal its burgeoning debts and push its stock price higher and higher. Together and individually, the banks and brokerages raised at least $6 billion for Enron through the debt or stock issues sold to unsuspecting investors from 1996 through 2001, when the Enron illusion finally expired. Another $4 billion or more was channeled into Enron's "partnerships" like Jedi, Chewco and LJM1 and LJM2, which became the principal mechanism for hoodwinking shareholders. These deals were often hurriedly arranged at year's end to paper over the company's true condition and keep the fraud from collapsing.
Enron was "the golden goose of Wall Street," according to the investors' complaint. The banks "earned" hundreds of millions, billions altogether, in securities commissions and consulting fees as well as from the inflated interest rates they charged Enron on disguised loans. In fact, selected senior managers at Morgan, Citigroup, Merrill and others even invested millions of their own money in Enron's secretive "special entities," promised extraordinary returns of 1,000 percent or more. As one reads through these financial intricacies, the gut question is the same one asked about Richard Nixon during the Watergate scandal: What did the bankers know and when did they know it? If they were not ringleaders, then they must be as gullible as the shareholders who were bilked. And, if these allegations are true, why isn't there also a federal grand jury looking into the possibility of criminal fraud?
At this point, these are only allegations. Though most of the supporting facts are already established, the legal risk of launching this bold foray against the financial establishment is considerable. It might lose, because the plaintiffs must prove not simply that the banks aided and abetted Enron's deceptions but that they were also principal authors. The banks are somewhat shielded from liability by Supreme Court rulings and the "tort reform" law that Congress enacted for the financial industry back in 1995 [see Greider, "Enron Democrats," April 8 and "Enron: Crime in the Suites," February 4]. They also have deep pockets. As a practical matter, Enron itself is not going to have much left for compensating shareholders after the bankruptcy court gets through with it. Indeed, in bankruptcy proceedings, the creditors standing first in line with claims on the carcass are the same banks--led by J.P. Morgan and Citigroup--accused by this lawsuit of fueling the fraud. Other, less privileged creditors may decide to challenge the legitimacy of the banks' claims, using a similar argument that Morgan, Citigroup and others were actually Enron insiders, not arms-length lenders.
"The Enron fiasco represents a massive wealth transfer from public investors...to corporate insiders, Wall Street bankers and the accounting and legal professionals who perpetrated the fraud," the lawsuit declares. Nearly $25 billion was lost by people, pension funds and other institutional investors who purchased Enron shares at fraudulently inflated stock prices, peaking above $90, only to see the stock price collapse, eventually to pennies. This vast class of injured parties is led by the University of California's Board of Regents on behalf of its pension fund, which lost $145 million. The lawsuit was crafted by William Lerach and a squad of lawyers from Milberg Weiss Bershad Hynes & Lerach, the West Coast firm that has successfully pursued scores of investor-fraud lawsuits. Arthur Andersen and two premier law firms, Vinson & Elkins of Houston and Kirkland & Ellis of Chicago, are included among the co-defendants (led by Enron and thirty-eight of its executives and directors) because they blessed the legality of the fraud. Lerach is currently trying to negotiate a separate settlement with Andersen that could bolster his case enormously if the firm agrees to turn over its internal documents. The Wall Street Journal editorial page is already attacking Milberg Weiss and the California regents, a sure sign the citadel of finance is rattled.
Win or lose, the lawsuit poses numerous embarrassments for Washington politics, and Congressional reformers should study it for a summary of the corrupted laws that need to be re-examined. Perhaps the most important one is this: The merger of commercial banks and Wall Street investment houses, ratified by Congress in 1999 and legalizing the new financial conglomerates like Citigroup and J.P. Morgan Chase, has already reproduced the very scandals of self-dealing and swindled investors that led to the legal separation of these two realms seventy years ago in the Glass-Steagall Act. Morgan and Citigroup senior executives, for example, consulted Enron's top executives almost daily on how to solve the company's deepening financial problems, but that knowledge was never shared with investors to whom the banks sold Enron shares and debt securities or, for that matter, with other banks who took a share of syndicated loans. The banks' stockbrokers maintained "strong buy" recommendations even as Enron entered its "death spiral," as the lawsuit calls it.
Meanwhile, Morgan and Citigroup executives, evidently nervous about the looming meltdown, were arranging insurance to hedge their own commercial-lending exposure to Enron. Morgan's insurance company subsequently refused to pay up on the grounds that the bank had concealed the fraudulent nature of its Enron transactions. Morgan sued to collect; a federal judge ruled for the insurer. Likewise, Citibank's supposed commodity swap with Enron was in fact a disguised loan, the suit claims. "In interacting with Enron, Citigroup functioned as a consolidated and unified entity," the lawsuit charges. "There was no so-called Chinese wall." But when Congress repealed Glass-Steagall, it was assured that the new mega-banks would keep their conflicting obligations separated by "firewalls" within the organizations. That promise, always improbable sounding, now appears to be a hoax. When you think about it, how could a bank's senior managers compartmentalize what they knew about Enron's internal troubles as investment counselors and separate it from their fiduciary obligations as bankers to the people who park their savings with the bank? Especially when some of the bankers were personally invested in schemes set up to conceal the truth?
The lawsuit also documents the duplicitous uses of freewheeling stock options. Even as company officials worked with the bankers to keep the game going, Enron insiders were cashing stock options and selling off $1.2 billion of their own shares. The lawsuit provides a narrative in five-color charts that depict the timeline of how Enron execs pumped up profit and the stock price with repeated gimmicks devised by their bankers, but meanwhile sold their own stakes on the "good news."
The theory of the case goes like this: Enron's glory days were actually quite brief. Its trading business was launched in 1990, but big flaws in the business plan were already apparent to insiders by 1995. The venture was simply not as profitable as its founders had imagined or the expanding marketplace of energy deregulation was not keeping up with their expansive promises to investors. Either way, the company started cooking its books, inflating profits from legitimate long-term energy contracts by booking future-year returns upfront (an accepted practice that requires a company to downgrade its profits in subsequent years when initial claims prove wrong). Instead of acknowledging error, Enron began its ventures in self-dealing--setting up the "special purpose entities" (SPEs) with Star Wars names to pretty up its balance sheet. These transactions evolved into Super Ponzi.
The essential element of a Ponzi scheme is the promise of quick, extravagant returns paid to initial investors, financed with the stream of money raised from subsequent investors. (Charles Ponzi's 1920s fraud, the Security Exchange Company, looks quite moderate alongside Enron.) The illusion always collapses eventually because, despite what you might think, there is not an infinite supply of gullible fools. Enron's run-up, like Ponzi's, required a willing suspension of disbelief among otherwise astute investors, and that is why the prestigious banks (not to mention auditors and law firms) were so vital to the scheme. If J.P. Morgan or Citibank or Merrill Lynch was managing the new security issue and itself lending to Enron, who could doubt its soundness? The cumulative impression, as one reads through the labyrinth of deal-making, is that of a deranged bookkeeper concocting a paper castle in the air. Only these bankers were doing the construction, as the legal complaint repeatedly reminds. Did they too get caught up in the illusion? Or were they just trying to protect their golden goose?
Enron's "partnerships" essentially allowed the company to sell assets to itself--a Brazilian utility, commodity trading contracts, broadband capacity--and to rig the prices and profits on both sides of the transaction, then book the sale as rising revenues for Enron and thus send the share price higher. "In order for Enron's accounting scheme to work, the parties involved had to be controlled by Enron," the lawsuit explains. "But this control and affiliation had to be concealed." The selected private investors, who received lucrative rewards for putting up front money for Jedi or Chewco or the others, understood this reality because they were assured by Enron execs managing the schemes of exclusive access to the company's charmed opportunities. If they knew, the bankers who arranged the SPEs must also have known.
Keeping Enron's stock price aloft was the crucial imperative for all these parties. The company was borrowing billions in the short-term money market to finance its expansions but had to issue long-term debt securities to pay off the short-term paper. If the share price faltered, Enron could lose its investment-grade credit rating and access to long-term credit. The banks would lose their ability to sell more debt and their own commercial loans to Enron might even be imperiled.
With its distinctive circular logic, Enron was in effect creating "profits" from its own soaring share price--and vice versa. The fatal flaw, however, was embedded in the deals themselves. To reassure outside investors and presumably the bankers, these special entities included a promise that if things went poorly and the share price fell, the entities would be made whole again with--guess what?--new issues of Enron stock, a consequence sure to drive the share price still lower. This bind gave insiders a strong motive to maintain the deception. If they stopped pedaling, the bicycle would fall over.
So, as the lawsuit describes, the financiers and Enron executed an accelerating series of concealed transactions--new "entities" created to offload more debt from Enron and gull more shareholders. These deals typically occurred at year's end or the close of a quarter when a very bad financial report was bearing down on the company or when old investors were withdrawing from the existing partnerships. The bankers had to find new money and invent new entities to cover the looming discrepancies of older ones. Law firms had to vet the documenting papers for legality. Arthur Andersen auditors had to approve the accounting. Or else all of them would have a lot of explaining to do.
One of the most egregious episodes occurred in December 1999 when Merrill Lynch was managing the creation of LJM2 but couldn't find sufficient outside capital to make the partnership look like a bona fide "independent" entity. Enron had just executed one of its most brazen fictions--announcing that its new trading of fiber-optic broadband capacity was off to a tremendous start and promised unprecedented profit levels (in fact, the broadband market was drowning in too much capacity, and Enron trading partners like Global Crossing were on the brink of their own meltdowns). As Christmas approached, Enron's banks announced an early gift for high-level collaborators at the other banks--all of them would put up virtually 100 percent of the LJM2 financing and thus reap the bonanza for their banks and for themselves as personal investors. For six months Enron stock had been trading at around $40, but thanks to corporate lies and this new infusion of phony financing, the share price shot up to above $70. And a very Happy New Year was had by all.
The Enron Nine, having already announced their innocence, will get their turn when they file their rebuttals in the next month or two. One line of defense is likely to be that while these deals may sound fictitious and fraudulent to unsophisticated outsiders, they are actually standard transactions in high finance. The scariest implication of Enron is that maybe they are right, at least in a narrow legal sense. The terms of finance, the meaning of profit and loss, capital and ownership, have been so pushed out of shape by a generation of "market reform" politics, that it is possible that Enron, except for the scale of its fraud, does resemble Wall Street routine far more than anyone is ready to admit.
The daunting task of reform, already facing growing timidity in Congress, may require letting the lawyers dig to the bottom of this mess--aggressive trial lawyers like Milberg Weiss and courageous public prosecutors. In that regard, New York Attorney General Elliot Spitzer has bravely stared down Merrill Lynch on the duplicity of its stock analysts and may win important structural reforms from it and other Wall Street firms. Michael Chertoff, the tough Republican prosecutor who is US assistant attorney general, stood his ground against enormous pressure to let Arthur Andersen off the hook on its criminal indictment.
William Lerach, the trial lawyer who has taken on Wall Street banking, is gutsy enough but might, of course, settle the shareholders' case for the right money--big money. But if the banks refuse to deal and the Enron Nine go to public trial, it could become an educational spectacle that turns them into the O.J. Simpson of modern American capitalism.