US Senate calls for structured finance probe

The structured finance businesses of leading financial institutions in the United States are set to face a major business practice investigation during the next six months, with top US regulators set to introduce a new code of governance for structured finance deals by the year-end.

The move follows a call by a Senate subcommittee for Federal regulators to prevent future “misconduct” similar to that allegedly perpetrated by JP Morgan Chase, Citigroup and Merrill Lynch related to a number of their transactions with now-bankrupt energy company Enron.

“Enron’s deceptions were shocking,” said Carl Levin, chairman of the permanent subcommittee on investigations, which called for the move. “And equally shocking was the extent to which respected US financial institutions like [JP Morgan] Chase, Citigroup and Merrill Lynch helped Enron carry out its deceptions and mislead investors and analysts about the company’s finances.”

Levin, a democrat senator for Michigan, and Susan Collins, the ranking republican senator on the permanent subcommittee, said in a statement last Friday that evidence from subcommittee hearings in July and December last year “shows that several of the largest US financial institutions have been designing, participating in and profit from complex financial transactions that involved deceptive accounting or tax strategies”.

Levin and Collins called for the United States’ most powerful regulators, the Federal Reserve, Office of the Comptroller of the Currency and the Securities Exchange Commission to immediately conduct a one-off joint review of banks and securities firms participating in complex finance products, to ensure in future that they do not facilitate the use of deceptive accounting in company financial statements and reports.

The subcommittee said that at present there is a “gap in Federal oversight” that exists because “the SEC does not generally regulate banks, and bank regulators do not generally regulate accounting practices overseen by the SEC”.

It set an aggressive timetable for the joint revue, with regulators expected to issue joint guidance on acceptable and unacceptable structured finance products, transactions, or practices in June. “By the end of 2003, the Federal Reserve, OCC and SEC should each take all the necessary steps to ensure the financial institutions they oversee have stopped participating in unacceptable structured finance products, transactions or practices,” said the subcommittee in its first recommendation.

The subcommittee also called for the SEC to issue a regulation, guidance or other policy document stating that it is the SEC’s policy to take enforcement action against financial institutions that offer deceptive financial products or participate in deceptive financial transactions with a US publicly traded company.

Once such a document has been issued by the SEC, the Fed and OCC should instruct their bank examiners to evaluate structured finance activities to determine whether they violate the new SEC policy during their routine examinations. The bank regulators should then use their agency’s full powers to force banks to desist engaging in such activities.

The July subcommittee investigations centred on allegations that Citigroup and JP Morgan Chase participated in deceptive ‘pre-pay transactions with Enron worth around $8 billion. These pre-pay deals characterised the transactions as energy trades rather than loans to allow Enron to claim the loan proceeds were cashflow from business operations rather than cashflow from financing. The December hearing looked at an alleged “sham asset sale” from Enron to Merrill Lynch just before the end of 2000. This allowed Enron to book ‘sale’ revenue on its financial statements, but Enron had secretly promised Merrill Lynch a resale of the assets within six months and guaranteed a 15% return on the deal, the subcommittee asserted.

Financial institutions have typically defended their positions. But JP Morgan Chase said last week that it would set aside $900 million in reserves to cover potential costs from a raft of private litigation and regulatory probes related to Enron and other matters.